Strategy. Innovation. Brand.

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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