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Dilbert On The Importance Of Incentives…

May 21st, 2010 · 4 Comments

Incentives are often used to mitigate what is known in economics as the principal-agent problem, which is just a fancy way of saying “managers want employees to work really hard, but employees would rather sit on the couch and eat cheetos.”

There are two ways of overcoming this misalignment of incentives. One is for the manager to sit and watch the employee and make sure that he is working hard. Not surprisingly, this is pretty inefficient, since a lot of the point of the manager hiring an employee is so that he can run off to the golf course or whatever rather than being stuck in the office. Also, who then watches the manager to make sure that he is vigilant enough in watching the employees?

This is where incentives (or pay-for-performance, in management speak) becomes relevant. Most incentive systems implicitly acknowledge the fact that it’s difficult and/or irrelevant to see the employee’s inputs in terms of effort, ability, etc. and instead give a payout based on output. This gives the employee a reason to not shirk (a fancy term for sitting on the couch and eating cheetos) and better aligns the incentives of the employee with those of the manager.

In practice, it is the case that pay-for-performance is a bigger part of an employee’s compensation when the underlying level of effort and competence is difficult to observe. For example, salespeople who are on the road talking to clients all day are paid almost exclusively on commission, since what else (at least in the short term) is stopping them from going and hanging out at a sports bar instead and then reporting back that people just weren’t interested in the product? In other words, with lack of proper incentives you run the risk of getting something like this:

Don’t say I didn’t warn you.

Tags: Incentives

4 responses so far ↓

  • 1 John Carey // May 21, 2010 at 3:47 pm

    People respond to incentives. I read that somewhere.

  • 2 econgirl // May 21, 2010 at 4:41 pm

    As the Stand-Up Economist points out, incentives by definition are things that motivate people, so this statement is a tad tautological. But yes. 🙂

  • 3 Dain // May 24, 2010 at 5:52 pm

    Very interesting TED Talk from Dan Pink on the efficacy of ‘pay-for-performance’ incentive structures:

  • 4 Dave // May 25, 2010 at 1:52 pm

    Of course, you need to be careful that you properly incent people. Salesmen are the classic example because their incentives are based pretty much entirely on the revenue they produce, whether or not that revenue actually results in profit.

    Here is one example, among many, that I’ve encountered in my career:

    At one company I worked at, an entire engineering team threatened to quit if the company didn’t fire a particular salesman. This guy would sell anything for whatever price the customer was willing to pay — it made sense from his perspective — the result was an incredible amount of revenue, which resulted in an incredible amount of commissions for him. Because he grossly over-promised and under-bid contracts, the engineering staff would be under a lot of pressure — they would be working sixty hour weeks (for no additional pay) to get the work done that he had promised to the customer, and they still wouldn’t be able to complete the projects on-time or under-budget, so they would get chewed out. Meanwhile, the sales guy was off to the golf course in his Mercedes by 4pm every afternoon and was being honored with awards from the board of directors. You can imagine what this did to morale. Customers weren’t too happy either. And, needless to say, none of the projects the salesman sold actually made a profit, but since he was focused on revenue, not profit, he didn’t care.

    Anyway, one day, the guys from the engineering team that usually got stuck with the projects this salesman sold dropped by my desk: “Dave, you studied physics in college, right?” “Yes.” “Can you do some calculations for us and let us know if this is workable?” So I did the calculations and came back with the response: “This is only workable if you can figure out a way to move data faster than the speed of light.” The salesman had so over-promised, without checking with engineering at all, that he had actually committed to solving a problem that could only be solved if you could figure out a way to break the laws of physics. That was the straw that broke the camel’s back: That entire project team threatened to walk out if they didn’t fire the salesman. It went all the way up to the CEO, who actually didn’t want to fire the salesman because, it turns out, the CEO’s bonus was also based on revenue, not profit. But, in the end, the CEO didn’t have much of a choice — he couldn’t afford to lose an entire engineering team, so he reluctantly fired the salesman. However, nothing changed at all with company policy — everything is still revenue based, not profit based.

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