One Performance Measure to Rule Them All
We encourage interested readers to skim a very short essay on Our Control Framework to gain familiarity with the way that we use certain terms in this essay. As time permits, we plan to post additional introductory and reference material.
A Common Fallacy:
″My subordinates should be rewarded the same way that I am. That will align their incentives with mine, and they will do what they are supposed to do.”
We often observe senior managers rewarding their subordinates on the same basis for which they, themselves, are held accountable. Our response in those situation is always the same. We ask why?
Included in our criticism is the common policy of rewarding relatively low-level employees based upon firm-wide profits or share appreciation, including cases of granting employees restricted stock in the hope that the grants motivates the employee to act appropriately. The problem is that for very good reasons most employees can’t determine which actions and decisions will maximize such general and noisy variables, and the small effect they may have can be easily overwhelmed and hidden by events outside their control.
In this essay, we explain how such a fallacy can be expensive.
Risk Aversion:
Before proceeding, note our working premise: most individuals are risk-averse with respect to compensation.
That means that if everything else is equal, such an employee would prefer a certain salary to the same level of expected risky pay, e.g., some combination of lower salary and unknown bonus that, on average, adds to the same amount.
Alternatively, that means for a given level of expected (but risky) pay, the firm could pay a lower salary and keep the person just as satisfied (on that dimension).
That’s important because if the firm can satisfy (and retain) the employee with less, fixed pay, it can lower its expenses.
Moral Hazard:
The problem is that when the employee’s effort is unobservable or the reasons for his decisions are unknown, it may be difficult or impossible to motivate him without providing incentive pay that varies with respect to one or several variables. Huckleberry Finn said it best: “Well, then, says I, what’s the use you learning to do right when it’s troublesome to do right and ain’t no trouble to do wrong, and the wages is just the same?”
Now if effort is unobservable that means that any signal of effort (worth considering) must be noisy; it doesn’t perfectly explain effort. (But, of course, some signals are “better” than others.)
And, if the variable does not perfectly signal effort, there is a change the signal is wrong, and that imposes risk on the person, i.e., he did the right thing but may not be rewarded for it. That imposition of risk hurts the person – increases their dissatisfaction – so, they must be compensated for it. That additional compensation is the risk premium or the average, additional pay required.
So varying compensation based upon some signal of effort, e.g., profit, cost control, sales volume, etc. makes sense only if the firm is attempting to motivate the employee to behave in a particular way. It’s costly, but it is worth doing if it motivates the employee to take actions that, on average, increase expected profits more than the expected increase in pay.
So, if monitoring the employee is too expensive or infeasible, the issue becomes the best way to structure incentive pay to motivate the person to coöperate, and the “best way” we mean the cheapest way to motivate the desired behavior, and that depends upon the environment, the available signals of the person’s efforts, and certain characteristics of those signals. It would be truly remarkable if the solutions to all incentive problems within an organization were the same, i.e., pay everyone based upon the appreciation in share price.
Below, we discuss a few statistical characteristics, but there are others not mentioned here.
Desirable Characteristics of Performance Measures:
To find the best performance measures for a particular task, we advise using a relatively simple, five-step process. 1 Usually, those measures are variables or combinations of variables that (somewhat) inform about the person’s decisions and efforts. Usually, they are something that the person can influence, but they need not be.
When we analyze a random variable’s suitability as a performance measure, two of the characteristics that we consider are its sensitivity and precision to the employee’s effort. (If they exist.)
- Sensitivity considers how the employee’s effort influences the performance measure; on average how will the variable change as the employee’s effort changes? Visually, one can think of sensitivity as the slope of line relating the expected value of the measure to the employee′s effort. So, in a graph, a variable whose expected value changes faster with respect to effort (has steeper slope) represents a more sensitive measure than another with a flatter slope.
- Precision is the inverse of statistical variance and measures the accuracy of the variable as an indication of effort. (Presuming those statistical values exist.) Precision can be thought of as the narrowness of the (probabilistic) range of values that the variable can take for a given level of effort. The higher the precision, the better the inference about the employee’s actual effort. So, a perfectly precise measure is the same as observing the employee’s action.
All things equal, when the employee is risk-averse, increases in sensitivity and/or precision (of a performance measure) allow for more accurate inferences. More accurate inferences permit the payment of a smaller risk premium while still motivating the desired behavior.
So, in most situations, it would be highly unlikely for one measure to be optimal for all employees. That means that the use of a single gross (and less personally-informative measure) for all employees will (1) increase compensation costs by making it more risky (than it need be) and (2) destroy or reduce employees’s motivation to act cooperatively.
Corporate Profit or Share Price as Performance Measures:
So let′s analyze corporate profit and share price change in terms of sensitivity and precision.
Now, exactly how sensitive is corporate profit or share price to any individual′s effort? We′ll answer that one: not very.
How precisely does corporate profit or share price reflect an individual′s effort? Again, not very, especially for lower-level employees.
Share prices for large corporations change almost continuously during a trading day (and are influenced by many exogenous factors). Can those changes be attributed to any single employee′s effort or lack of effort throughout the day? Over a month, a quarter, a year? No, usually not.
So, is there a compelling reason to reward employees on such general measures? Anything is possible, but one would have to tell a very special story about a very special environment.
Now, before we describe the motivational problems associated with using the wrong measures, let′s consider a simpler analogy that avoids those messy human behavior and motivation issues.
Optimal Performance Measures for a Car:
Consider an automobile. Most of us are familiar with these devices used for swift transportation; presumably their purpose is to travel either a certain distance or at a certain rate of speed. Either purpose provides a natural performance measure: an odometer for distance and a speedometer for speed.
Suppose one′s purpose for operating an automobile is speed. From the control perspective of the driver — say, a race car driver — would one be satisfied with the speedometer as the sole measure of performance? “Don′t need a gas gauge, we have a speedometer; don′t need thermometer, we have a speedometer; don′t need tire pressure monitors, we have a speedometer… ad nauseum.”
Unless the reader is particularly ornery, he or she should readily agree that the use of only a speedometer to measure the efficacy of each sub-function of an automobile would not provide enough specific feedback to allow the driver to maximize his speed or average speed. “Hey, we′re going very fast. There′s no reason to stop for gas!”
Such sentences seem extremely silly, yet they are analogous to a policy of ignoring individual signals of effort and imposing one’s own particular performance measure on subordinates and no different than rewarding all subordinates on, say, divisional economic profit when they may have responsibility for only costs or only revenues or for neither?[4. Yeah, yeah, yeah, any information economist worth his salt should be able to easily construct counter-examples, but that is clearly not the point of the essay.]
So, if you want to get an indication of whether someone did what they were supposed to do, measure and account for (at least) some variables in their particular (decentralized) environment, including ones that they control or influence.
Using overly-general ones impose unnecessary risk on subordinates, and if those subordinates are risk averse — and who′s not — that imposition leads to either higher expected compensation costs and possibly lower effort and the subsequent reduction in output or higher employee turnover. 2
In addition, we’ve tried to explain, in a non-technical way, why artificially constraining the number of measures reduces transparency and the ability to control. (Again, think of a car with only a speedometer.)
Behavorial Implications:
As yet we haven′t described the more damaging qualitative aspects of such policies. Here are a few behaviors that we have observed:
- Distracted employees with an unnatural fixation on share price rather than the task at hand.
- The sense of alienation that follows from these types of realizations.
- “My job’s not important enough for anyone to care about (or understand or measure) what I do; so, I get paid for what my boss does.”
- “I’ll get paid when he (or she) gets paid; otherwise, it doesn’t matter.” This might include the follow-up: “So, I’ll spend my time sucking up. That will increase my chances of getting paid more than actual work will.”
- The sense of forsakenness that follows from the conclusion, “It doesn’t matter what I do, I can’t influence those things; so, why bother?”
- The sense of the organization is arbitrary as in the following sentiment: “They only pick those things because they can manipulate them. That way, if they don’t want to pay us they don’t have to. They have eleven ways to win anyway. So, why bother?”
- Cases where employees will take greater risks because they think that no one is watching.
Through the years, we′ve heard many other similar comments and sentiments.
So, where should one begin?
By asking: What do you want the employee do? And, how can you tell if they′re doing it? (Not perfectly, but statistically.)
To do that, one needs to understand their jobs; how their jobs create value. If you need more help than that, please give us a call at 1.412.779.9028. That is why we are here.
By the way, if after reading our essay you are still thinking: “We’re a team, we have a common goal and should a common measure,” then we recommend that you try coaching a sports team with that singular control mechanism. If that is too onerous, please reread the above essay.
Finally, if you do agree with our analysis, then you might also wonder why many consulting firms sell a single performance measure as the unqualified best in every case. If one doesn’t (generally) exist within a firm, how could it exist across the entire economy? Our hunch is that it is best for them, but necessarily for you or your subordinates or shareholders.
Copyright © 2008 2010, Spero Consulting.
Footnotes:
- When effort is observable and there are no important information asymmetries, there is generally no good motivational reason to give employees risky pay, but there may be valid budgetary, regulatory, or risk-sharing reasons. ↩
- If employees are less satisfied, it is likely that at least a few will leave. ↩
