Beware of (dis)incentives

11/01/2018

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The ‘ratcheting’ up of bonus goals can make workforces less motivated, so managers need a clear system of communicating changes to incentives, says a new study co-authored by Francisco Brahm of Cambridge Judge Business School.

Incentives are common in many industries, especially in sales, so in theory every salesperson knows that the more they sell in a certain month or year the more they will earn in that period – thus they have an incentive to work harder, sell more, and take home more money.

But in practice, this may work well only for an initial incentive period. That’s because managers have a tendency to “ratchet” up the incentive targets to make it more challenging in subsequent periods. As a result, savvy salespeople realise that selling above a certain level may not be in their long-term interest – because they will have to sell more in future periods just to make the same amount of money.

So how should companies deal with this tricky ratcheting issue in a way that benefits the firm but also keeps the salesforce happy?

A just-published research paper co-authored by Francisco Brahm, a PhD candidate at Cambridge Judge Business School, says that managers need to pay attention not only to the rules for incentive schemes but also on procedures used to update those schemes’ parameters – in order to build a long-term reputation for fairness among employees.

“Employees can be highly sophisticated in their response to incentive schemes,” says the paper published in the journal Management Science. “Although the rules for updating incentives schemes over time (such as ratcheting) are frequently not written down into contracts, employees quickly learn from them and incorporate them in their decision process. This emphasises the need for great care in the design and implementation of any compensation scheme, specially into how you update it over time.”

The study focuses on the salesforce of the largest Chilean beverage company, Compañía de las Cervecerías Unidas (CCU), which provides beer and wine in addition to soft drinks and spirits, and whose sales force receives on average 55 per cent of their monthly earnings from sales incentives. The study looked at the “direct effect” of incentives, which as expected produced positive reactions from salespeople, as well as the “strategic effect” of changing incentive parameters.

“We found evidence of strategic behaviour in salespersons. If the salespersons have learned that increments in sales lead to higher goals in future periods (i.e., goal ratcheting) then they adjust their present behaviour leading to the opposite result,” the study concluded.

Francisco says the paper underlines the importance of transparent communication between managers and employees. “The boss should strive to be clear as to how he will handle any update to the incentive guidelines in the future, ideally avoiding ratcheting, or at the very least consider its consequences,” he says.

However, in many cases, avoidance of ratcheting is not possible nor desirable. Uncertainty can be high enough so that managers don’t want to have their hands tied up. For example, conditions in an industry can change unexpectedly in a way that may require different incentive guidelines – for example, if an entire industry gets a huge spurt in demand that may have little to do with the skill or effort of a given firm’s salesforce.

“In those cases, the boss shouldn’t write down in a precise way how incentives will change in the future, but instead build up a reputation for fairness in explaining and updating the incentive guidelines,” Francisco says.

The research paper – “Incentives and ratcheting in a multiproduct firm: a field experiment” – is co-authored by Francisco Brahm, PhD candidate at Cambridge Judge Business School, and Joaquin Poblete, Associate Professor at the PUC School of Management in Santiago, Chile.

 

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