Strategy. Innovation. Brand.

principal-agent problem

Jewelry and Perverse Incentives

Careful! It’s a perverse incentive!

With a perverse incentive, a company incents its employees to behave in ways that are contrary to the company’s interests. The company, in other words, pays employees to do things that reward the employee but prevent the company from reaching its stated goals. (See here and here for more detail).

Why would a company do that? Sometimes the stated goals of the company are not its actual goals. For instance, the company may say that it aims to increase customer satisfaction. That’s nice wind dressing but the real goal may be to “make the numbers”. So, the company may incent its sale force to act in ways that make the numbers even if such behavior also reduces customer satisfaction. In this example, studying the perverse incentive can help us understand what the company’s real goals are. This seemed to be the case at Wells Fargo, for instance.

In other cases, one business process conflicts with another. Perhaps each process is perfectly fine when running in isolation. When they run in tandem, however, they create perverse incentives. A good example comes from Signet Jewelers, the owner of several retail jewelry chains, including Jared’s, Kay Jewelers, and Zales. (I discovered this case in the business pages of the New York Times. Click here for the original article.)

The Signet situation involves two different business processes: sales and financial credit. By combining the two, Signet created a perverse incentive. Each business process works fine in and of itself. It’s the combination that spawns confusion. Here are the two processes:

  1. You’re a banker who makes loans to individuals and companies. Your goal is to make profitable loans that are repaid in a timely manner. Your compensation is based on this. If you make a lot of good loans, your compensation goes up. If you make risky loans that aren’t paid back, your compensation goes down. Your incentives line up nicely with the bank’s goals.
  2. You’re a manager at a retail jewelry chain. You aim to sell more jewelry than you did last month or quarter or year. If you do, your compensation goes up. If you don’t, it goes down. Again, your incentives line up nicely with your company’s goals: to sell more jewelry.

Now let’s change the scenario. You’re now the manager of a retail jewelry store that also offers loans to its customers to enable them to buy more jewelry. Your compensation is based on how much jewelry you sell.

It sounds like a good idea. So, what’s wrong with this picture? To sell more jewelry, you have a strong incentive to give loans to non-credit-worthy individuals. You make the sale, but a relatively high proportion of the loans you make go bad and are not repaid. The company either writes off the loans or spends a lot of money with debt collectors trying to redeem them. The net result is often a negative: you sell more but also lose more.

The Signet example is just one of many. Once you’re familiar with the concept of perverse incentives, you can find them most everywhere, including the morning paper.

 

Perverse Incentives

But is it for the right thing?

But is it for the right thing?

Let’s say I’m a successful sales rep at a business-to-business software company that’s trying to improve customer satisfaction. The company wants me to take good care of my customers, tell the truth, and make them feel loved.

At the same time, the company pays me based on how much software I sell each quarter. It’s in my best interest to sell as much as I can even if I have to stretch the truth a bit and promise more than I can deliver. Of course, stretching the truth and failing to deliver often result in lower customer satisfaction.  So the company is incenting me to behave in ways that defeat its own objectives.

In Britain, this is known as the principal-agent problem. In this case, the principal is the company. I’m an agent acting on the company’s behalf. The problem is that the agent’s incentive (my commission) is different than the principal’s objective. We’re working at cross-purposes.

Paul Nutt and other American writers generally refer to this situation as a perverse incentive. According to Wikipedia, a perverse incentive”… has an unintended and undesirable result which is contrary to the interests of the incentive makers.”

Examples abound. We may strive for smaller government but we typically pay government managers based on how many employees they have, not on the profits they generate (since they generate no profits). We encourage orphanages to place children with families, but we pay subsidies based on how many children are in the orphanage.

The examples may sound bizarre but perverse incentives are all too easy to create. Nutt gives a particularly perverse example: the company that proclaims, “We will not accept failure.” While that may sound bold and brave, it sets up a perverse incentive.

Every company fails from time to time. When a failure occurs, it’s in the company’s best interest to analyze it, understand it, and use it as a teachable moment. But companies that don’t accept failure will never get a chance to do this. Employees associated with the failure will bury it as deeply as they can. Otherwise, they’ll get fired.

What should you do when you inevitably encounter a perverse incentive? The first thing is to make sure it’s known. Many times executives set lofty goals (“we will never fail”) without realizing just how perverse they are. Calling attention to perversity is a useful first step.

Second, it’s time to discuss alignment. We often think of alignment in terms of focusing on the same goal. That’s good but only if the incentives for achieving that goal are also aligned. A comprehensive and detailed review of incentives will help identify areas of misalignment. This is when a good HR department is worth its weight in gold.

 

 

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