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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 is always the same: we wonder why?  ¹  We are more sympathetic for the converse—being rewarded on the same bases as one’s subordinates—but that discussion is for another day and another post.

Risk Aversion:

Before proceeding, note our working premise that most individuals are risk-averse with respect to compensation.  This means that the employee prefers a certain salary to the same expected level of risky pay, and for a given level of expected (but risky) pay, the firm could pay a lower salary and keep him just as satisfied on that dimension.  ²

Desirable Characteristics of Performance Measures:

In a decentralized environment, when effort is unobservable, we advise using a relatively simple, five-step process to find suitable performance measures.  ³

When we analyze a variable’s suitability as a performance measure, two of the characteristics that we consider are the variable’s sensitivity and precision to the employee’s effort.

• 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, a steeper slope represents a more sensitive measure.
• Precision is the inverse of statistical variance and measures the accuracy of the variable as an indication of effort.  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.

All things equal, when the employee is risk-averse, increases in sensitivity and/or precision (of a performance measure) reduce risk, lower expected compensation costs, and (possibly) induce higher levels of effort. ⁴

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?  I′ll answer that one: not very.

How precisely does corporate profit or share price reflect any individual′s effort?  Again, not very, especially for lower-level employees.

Share prices for large corporations change almost continuously during a trading day.  Can those changes be attributed to any single employee′s effort or lack thereof throughout the day?  Over a month, a quarter, a year?  No, usually not.

So, is there a compelling reason to reward employees on these general measures?  Anything is possible, and if a valid reason exists then it′s use is only worthwhile when the expected benefits exceed the increased expected compensation and motivational costs. 

At this point, you might be thinking, “Ah, that consultant is very clever and devious. He begins with a quote regarding some generic, unspecified performance measure.  Then through some sleight-of-hand, he equates all generic ones with two particular ones—corporate profit and share price—and he demonizes those two as uneconomical measures and by implication all other global measures.  He is either devious or confused; I can′t tell which.”

While it is possible that we are both, we will ignore the insults for the moment, to mention that the three examples are of the same kind, but they may differ by a matter of degree (or not).

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, one 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 a sentence seems extremely silly, yet it is analogous to policy of ignoring individual signals of effort and imposing one’s own particular measure on subordinates.  Is it any different than rewarding all subordinates on, say, divisional economic profit when they may have responsibility for only costs or only revenues or neither? [5.  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, what have we done so far? 

1. We′ve described how overly-general performance measures impose unnecessary risk on subordinates.  If those subordinates are risk averse—and who′s not—that imposition leads to either higher expected compensation costs and possibly lower effort and output or higher employee turnover. ⁵
2. We′ve shown that artificially constraining the number of measures reduces transparency and the ability to control.

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 actually 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 followinng 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?”

We′ve heard many other similar comments and sentiments.  If we were teaching an academic course on incentives, we would mention that they are, in fact, implications of our first point above, but we won’t do that here.

So, where should one begin?

Why at the beginning, of course!  ⁶ And the beginning consists of the questions: What do you want the employee do? And, how can you tell if they′re doing it?  If you need more help than that, please give us a call: 412.779.9028. That is why we are here.⁷

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?  My hunch is that it is best for them, but necessarily for you or your subordinates.

Copyright © 2008 Spero Consulting

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