We all want to be involved in an incentive program. These programs represent our opportunity to participate in the success of the enterprise (the downside, after all, is seldom our fault). We also (naively) believe that incentive programs are good because they align the interests of the company with those of the individual employee. However, almost any incentive system devised by mankind, is strongly subject to the law of unintended consequences (LUC). Here are just a few LUC effects that will kick in for some incentive measures:
- EPS. If you measure executives on Earnings Per Share, there will be a sudden massive interest in buy-back schemes. If we can’t raise E let’s reduce the number of shares. At best it will probably bias the business towards other sources of equity than issuing new share capital.
- ROTC. Return on total capital seems logical. However, the equally logical executive will tend to under-invest in response. A range of investment opportunities will be ranked by expected return, and although this may not always correspond to reality, it will be approximately correct. To raise ROTC he or she simply avoids investments that are below the objective. If you set an objective of 25% and your cost of capital is 8% then you can forget about all those possibilities between 8% and 25% that would make your company wealthier because these will reduce the average ROTC. The effect is to have a much more conservative investment policy than would be the case. The higher you set the objective, the worse the problem.
- On-time Delivery. OTD is a favorite measure that is supposed to show how good plant managers are. Good plant managers are experts at gaming the system. Typically an ERP system will report OTD by comparing actual ship dates against the planned ship dates. Changing how the plant operates to make it more flexible and customer-friendly is a lot of work. Much easier to push lead-times out so that we can make sure that we don’t disappoint customers by late shipments. The ERP system will only register a late when something is actually shipped, so if a date is missed, an enterprising plant manager will call a customer and ask him to cancel the order and resubmit it under a slightly different part number (maybe there might be a discount involved for the new part), so that it will appear to go out on time.
- ROI. Return on investment is usually measured at a point in time. The R is probably operating income for the trailing twelve months, but the I is most likely to be an instantaneous reading at the end of the reporting period. Under-investing will help here (see under ROTC), but so will deft management of working capital. The easiest way to reduce WC is to stop paying suppliers for a month, and really pound on receivables. (Inventory is harder to control). You can let it rip again the month after the bonus is calculated.
- Revenue per employee. This is easy – just outsource swathes of production and revenue per employee will surge.
- Gross Margin percentage. Brace yourself for a rapid slowdown in growth as lower margin products get dropped. In the worse manifestation you will find that gross margin (and revenue) will actually fall, as managers drop lower-margin products (or raise prices, thereby killing demand) and find that plant fixed costs are under-absorbed, causing aggregate margin to fall. This scenario is particularly painful because not only do managers make poor decisions but they don’t even get the bonus they are aiming at.
All this isn’t to say that one shouldn’t have an incentive program. Overall, they probably are good. Just don’t be unrealistic about its effectiveness. Be alive to the gaming of the system, and be ready to change the criteria regularly. Also, referring to an earlier posting, don’t make closing a specific number of acquisitions an objective. Remember, people will respond, and will meet the objectives. After all, that’s the idea, isn’t it?
