Ethics Series Part 2: Incentives and Compensation

Last week we discussed the pickle or ethical dilemma of empire building. Sales managers, like our hypothetical friend Tom Hansen from Ethics Corp, are motivated through bonuses and advancement opportunities to expand their responsibility beyond its optimal size. Empire building is part of a deeper ethical problem for organizations called the agency problem. Fundamentally, individuals engage in selfish behaviors that maximize their own utility. The problem arises when these behaviors (like a short-term focus, gamesmanship of metrics, or worse, theft) destroy firm value.

Is there perfect way to incentivize managers to add value to the company and avoid agency costs? Organizations must have three distinct systems linking employee behaviors to the value-generating performance (Zimmerman, 2011). Keep in mind that Tom is currently paid a salary plus bonuses based sales revenue volume.

1. Measurement system: How is Tom’s performance measured?

Measurement systems can be team or individually based, both of which have ethical consequences. Tom is currently rated solely on his individual results, and as such he is motivated by self-interest to do whatever it takes to expand his sales volume, even if it costs the company money. Individual evaluation can motivate Tom to push harder, but it can also lead to managers hogging resources at the company’s expense. For example, if a neighboring territory manager needs help landing a huge account, Tom has no incentive to share a top performing sales person or a best practice because his own relative performance will suffer.

Team measurement systems can help solve this, but could also cause employees to shirk their responsibilities to other team members. For example, if Tom is measured based on the company’s overall performance, he could slack off and let the other territory managers carry the load. The larger the organization the worse this free-loading problem becomes since employees feel like their individual contributions make less of an impact. So, should Ethics Corp include team measurements in Tom’s compensation package?

2. Rewards and punishment system: What is the compensation for Tom’s success?

Reward systems can include financial or non-financial incentives. Financial rewards include salaries, raises, bonuses, commissions, and retirement plans. Non-financial rewards, or perquisites, include illustrious job titles, public recognition awards, sports tickets, or better office space. A 2009 study published by the University of Arizona found perks are highly correlated with management motivation and creating firm value (Chen, 2009). Is Ethics Corp limiting its motivational influence over Tom by only using financial rewards? Or could the company get the same motivation with fewer financial rewards and more non-financial rewards?

3. Decision rights system: What authority and resources has the company assigned to Tom?

The company shareholders or owners delegate all responsibility to the CEO. The CEO keeps some authority and delegates the rest until all responsibility is accounted for. A key tenet to compensation is aligning authority and incentives. For example, Tom is currently measured and rewarded on sales volume. Let’s assume as a territory manager Tom has control over pricing and offering discounts to customers. By delegating pricing decision rights to Tom but paying him only on sales volume the company is incentivizing unethical behavior. Tom could offer customers unnecessarily deep discounts to close more sales.  Or he can lower prices to make closing sales easier. This would allow him to take on more direct reports who require less supervision expanding his bonus generating revenue.

Is Ethics Corp measuring Tom on the wrong metric – his individual sales volume? Shouldn’t a manager with pricing control be measured on profitability too? Or maybe Ethics Corp should tighten the reigns, centralize pricing decisions, and give territory managers less authority. What about the profitability of the company, the company’s stock price, or value to shareholders?

Hopefully this example illustrates the complexity of organizational incentives and the impact of incentive decisions on dynamic employee behaviors. The three systems are interrelated and their effectiveness depends on the balance between them. What is the right balance that minimizes agency costs and maximizes profitability for Ethics Corp?