Bonuses, Commissions, and Quotas

Well, your local economist is at it again. ;) I was cleaning to try and clean out some clutter and free up some space. I happened upon one of my favorite papers I wrote in an old Economics class. I'll share it with you and let you guys reply with your thoughts. I know when I presented it in class, I got quite a mixed reaction of agreements and people who thought I was a fool. You can decide for yourself. :devil:



Bonuses, Commissions, and Quotas
Negative Effects of Incentive Pay


Introduction

Drive Sales. That is the goal of every company. Increase revenue, decrease costs, and pursue the ever-elusive profit for your net income. What is the single biggest control mechanism for a company? Budgets. A well-laid plan, set out in a budget can keep a company on the path toward profit. A budget also symbolizes projections and expectations of the company. It shows what they expect to spend in the future, and hopefully those expenditures go along with increased expected revenues for the companies’ financial projections. Financial projections are a major factor in increasing investment in the company. A company that shows a reliable history and good looking future projections will drive demand for bonds or stock they issue to get the capital needed for growth.

So the basic thing I’m focusing on is the start of this domino effect. If there is anything that adversely affects profit, it will also hurt the long-term projections. Also, some very common budget control mechanisms for cost are bonuses, commissions, and quotas. One of the largest costs of many companies is wages, salaries, and labor. There is a great temptation to link wages as directly as possible to revenues in order to control costs and margins. I believe these alleged control mechanisms actually hurt long-run profits. Profit that does not meet expectations will hurt capital investment needed in the future for expansion.

Unfortunately, I could not find any studies with research data that focuses on the negative effects of tying compensation directly to sales or revenue. But there are tons of anecdotal and allegorical stories that lend themselves to common sense conclusions of the long-term negative impact. There were some studies I found that show tying compensation to sales increases performance of employees. But I believe that excelling personal performance does not always equal the greatest profit for the company. This sounds like a fallacy, but I hope to change your mind by the end of this paper.


Literature Review

The Wall Street Journal had an article in 1988 about Du Pont and a plan they were putting in place to tie wages to sales with an incentive plan. This was by no means a unique article. There are always new plans being proposed by companies all the time to create incentives for their employees to increase revenues. I chose to use this article as a reference because it had a follow up article a few years later about how this incentive plan failed in the long run.

Alfie Kohn wrote a book, Punished by Rewards, which is mostly about the negative effects of rewarding children too much as a motivational tool in education and in the home. But there is a part of the book that pertains to rewards in the workplace as well. I feel he touched on the lessons of the stories I will share in the personal analysis but only looked at short-term effects in the workplace.

There was an article in The Freeman that questioned incentive pay. It gave a few examples of the short-term negative effects on morale of the workers. While the performance of workers immediately increases, it leads to an overall drop in morale for anyone but the top performers. After these short run effects, it is my belief that the effects of lowered morale hurt long-term margins and profits.

Personal Analysis

It is my strong belief that tying pay to revenues hurts long-term profits. The causes of these negative effects also lead to inaccurate forecasts and budgeting which cost companies more when they have to revise their projections. I am going to share 3 basic situations based on the major forms of pay incentives, bonuses, commissions, and quotas. These may show increased individual performances, but will hurt the bottom line in the long run. The conclusions I will draw from these stories are based on the assumption that employees will act in their own self -interest. This is a fair assumption and true in almost all cases. It is also the logical way to find the common sense conclusions of each situation.


Quotas

The first example is the easiest to analyze. The quota system is simply requiring a certain number of units of production or sales by a salesperson per day or some other time period measurement. Let’s look at the classic production line in a factory. A factory producing widgets has a capacity of 5000 units. There are three choices of the quota the manager can set. We can require 4000, 5000, or 6000 units per day. In other words, make the goal less, equal, or greater than the actual performance capability of the facility.

When we require 4000 units, the workers acting in their own self-interest will produce 4000 units. Because there is no sense in exerting yourself or doing more than you have to do. So now the factory has underperformed. Because we required less work, the employees did less work. A greater amount of the fixed costs of the factory are used per unit. Fewer products mean less potential sales, which leads to less revenue and thus, less profit.

When we require 5000 units, the workers acting in their own self-interest will produce 5000 units. However, there is no room for error when your goal is right at capacity. So now whenever there is a machine issue or a sick worker or any kind of snafu, then the factory will not meet expectations. It is a great source of stress to know there is no margin for error and having the Sword of Damocles hanging over the head of the workers if any little thing goes wrong on any day. This stress leads to major morale issues. Workers get angry with anyone perceived to cause a slowdown in production or feel inadequate when unable to perform to expectations. There is a myriad of negative impacts on the cohesion of the team of employees and this lack of chemistry is a the start of many domino effects that lead to reduced efficiency (higher error costs from more substandard quality units), and higher turnover (increased training and HR costs). These are just two easy to see samples of extra costs from decreased morale. There are many more that affect long-term profit of the company.

The last quota option is to require 6000 units. The reason behind setting a goal like this, even though capacity is only 5000, is to try and get the employees to excel. Maybe with a goal too high, they can achieve greater than capacity. An efficient engine of perfect harmony with everyone hitting on all cylinders may actually allow the factory to produce 5500 or even the 6000 goal. The likelihood of this type of excellence on any regular basis is highly unlikely. The workers are no fools. The experienced employees will know that 6000 is more than the factory can produce and immediately start their day with a feeling of hopelessness. Because there is no sense in exerting yourself or stressing over a perceived unachievable goal, the employees will simply not even make the effort needed for 6000 units. So now the factory will probably underperform. If the employees have no sensible motivation then the factory will not even reach the 5000 mark of capacity. The numbers could be as low as 4500 or 4000 or even 3500 which is below the low goal we set in the first supposition. When the employees gave less effort, less work gets done. As the efficiency drops from this hopelessness and morale plummets all the long term effects described in the 5000 scenario will happen, only at a faster pace. Costs rise, and profits go down.


Commissions

Now let’s look at Commissions. These are probably the most common incentive that ties wages directly to sales. This is a long proven method of increasing employee performance. But that does not mean it affects the bottom line in the most profitable manner. The first and most obvious drawback of commissions is that it promotes competition within the company. While the goals of the company is to grab greater market share and grow sales, the goal of an employee acting in their own self-interest is to get as many sales as possible at the companies location. This leads to in-fighting and corrosive office politics. There will be star performers and underachievers. These underachieving may not be doing a poor job, they may just not work at the peak hours that the stars do, or they may be morally unwilling to pull underhanded office politic tactics to gain more sales. They may be great salesman in their industry, but in comparison to the stars, they just appear to be underperformers.

These office politics lead to lower morale and detrimental effects similar to those in the quota section. The same myriad of negative impacts on the cohesion of the team of employees and the lack of chemistry is the same start of many domino effects that lead to higher turnover (increased training and HR costs), and reduced loyalty (lowered future sales from fewer return customers). After all, customers don’t like to shop at places with an air of hostility where employees treat them like chum in a shark tank because each customer is viewed as a commission rather than a person.

The office politics are not the only detrimental effects that come from commission sales programs. Let’s look at a senior employee that has is highly valued by the company for his consistent performance. His efforts have been rewarded with average monthly commissions of $1000 in addition to his base salary. Now suppose the industry he is in hits a large downswing. Nobody is at fault; it’s just the movement of the markets and will most likely shift back sometime in the next few years. The commission portion of his wages lowers to $500 and lowers his income. Is he less valuable as an employee? Is he less valuable as a person? Does he deserve to have to deal with making the personal cutbacks to reduce his cost of living? The answer to all these questions should be “no,” he has not fundamentally changed as an asset to the company. We know the executives are not voluntarily taking a pay cut when the company hits a lull in sales growth. A lull in the market as a whole is just one example of why a person’s commission income may lower, even though they are not putting any less effort into producing sales. There are countless other reasons this could happen. The important part is the questions after the income decline occurs and the effects on the employee.

These issues will put pressure on the employees’ home life. This will lead to stress at not being able to make ends meet the way he used to. Stress at home always leads to lower efficiency at work. No matter how much we pretend work and home life are separate, we all know that is humanly impossible. Every aspect of our lives affects every other facet of our lives, whether we want it to or not. It is just the nature of the human subconscious. This lowered efficiency at work leads to the same effects discussed in earlier sections. The stress may lead to turnover and the loss of a valued employee, which introduces human resources costs of hiring a replacement and the training costs of preparing the replacement. The new employee would lack the experience of the man being replaced and thus sales would lower, reducing revenues. Reduced revenues lead to a greater impact of fixed costs and thus lower profits.

Bonuses

Bonuses are very similar to commissions. They lead to the same results for the same reasons. So I will not repeat the arguments already used in the previous section. However, there are a few additional issues with bonuses that more directly effect the financial statements as opposed to a domino effect that eventually shows on financial statements.

One of the classic bonus examples is a salesman exceeding projected sales or a given expectation. Let’s say there is an agricultural company that sells produce. It asks the salesman how many cans of green beans he thinks he can sell this year. The company expects a number in the 4 to 7 million can range. The experienced salesman knows this and sends the company his estimate of 4 million even though he knows he can sell 6 million cans. The company plants enough green bean fields at planting season for 4 million cans. Later that year the salesman sells contracts for 6 million cans and is highly praised for excelling beyond expectations. The company has to buy 2 million cans worth of beans from a third party in order to meet the demand, but sales are made and revenues are increased, so everyone is happy. However, those 2 million cans cost more to get them from the third party so profit margin was not as high on. If the salesman had told them in the first place that he could sell 6 million, then the company could have planted enough beans and had greater profit. But, because bonus pay was based on exceeding expectations, the salesman low-balled the projection he submitted in order to receive the bonus.

The broad problem with all bonuses is that they are tied to specific numbers in the financial documents. Managers get bonuses for keeping costs below a target number, analysts get bonuses for investing with returns higher than a target percentage, executive get bonuses for revenues exceeding target numbers etc… and there are many other examples bonuses that are tied to target numbers on various financial documentation. Let’s look at a manager that needs to keep maintenance costs on a printing press below $10,000 for the year. The 11th month rolls around and the year to date number have breached the $9,000 mark. Some expensive routine maintenance was needed in that last month, but the manager postponed the needed maintenance until the 12th month is over. The company lost money when the machinery did not work as efficiently. It was unable to produce the needed units and sales dropped. In fact, early in the first month the machine totally broke down before the postponed maintenance could be performed and the repair costs were well over $4000 to get it running. Now it’s obvious the manager met his goal of keeping maintenance costs below the target and earned his bonus. But is the company better off for telling him to achieve this goal? The obvious answer is “no” the lost profits and large repair bill has greatly impacted the bottom line.

As stated before, bonuses are generally tied to specific numbers. People acting with our assumption that they act in their own self-interest will focus on the number that achieves their bonus. They do anything in their power to achieve the goal number of that line item, even to the detriment of other items and long run ramifications. This is also the heart of many SEC investigations and financial scandals. People will do whatever financial trickeration they could possibly do in order to manipulate the books to show the numbers necessary for the maximum possible paycheck. Not all this manipulation is illegal, and some people are willing to bend the rules more than others. But either way, the bonus system focuses people on their target numbers, rather than the big picture and what will be best for the long-term profits and earnings of the company.



Conclusion

One of the hardest arguments to make is to show the negative impacts of incentives when they all show obvious increased performance in individuals. I hope I have shown in my examples that the short-term choices people make to maximize pay from incentives may show this. But, I believe this increased performance can be raised even more by other methods. Incentives may increase revenues, but fair pay that is not tied to revenues will increase the bottom line even more. It is my strong belief that a generous salary and team building that generates a deep seeded sense of ownership will lead employees to make the best decision for the long-term earnings of the company.

Personal Aside

It was very difficult to find studies with empirical data focused on proving negative effects of incentive pay. But I really enjoyed writing about this topic. Incentive pay is something I have long been opposed to because of the corrupting effects it has. I would like to expand on this hopefully find more research data to use, but I can find no studies that focus on the negative impacts of incentives. I can't even find a study on the long-term results of an incentive program.

I hope you enjoyed yet another foray into my addled brain. :dizzy:

I once knew a man who was a very good car salesman. Although a part of his income came from commissions on sales, it didn't seem to drive him to sell more cars. The secret to his success was based in something more esoteric than just moving product. It was based upon his attention to customer service and his personal relationships with them. He would devote a portion of his day in contacting one or two of his customers and asking them how the car he sold them was going, were they happy with it, did they need anything? As a result he had a large list of return customers who would come to him every three or four years to update their vehicles with a new model.

If he was rewarded only by the number of sales made a day, week, month or year, that level of customer service would not fit in and he would probably have lost those regular customers and had to rely on generating a much higher customer traffic to achieve the same number of sales. If you know and trust the salesman and he takes the time to contact you just to see how everything is going, you are more likely to go to him first when you start thinking about a new car. Whereas a dealership that is looking to increase customer traffic and forgets about customer service might sell you a car once but there would be no motivation for you to go back to them first, especially if there are a dozen dealerships offering similar cars in your area.

Customer loyalty is intangible on a balance sheet and so it is being forgotten about more and more in the modern world. Many bosses would consider a salesman was wasting time with follow-up calls and maintaining contacts, as that isn't actually selling a car today. Yet he outsold the flash young men who tried to sell a car to everyone who walked through the door.

Thanks Rodri for the excellent example of greater long-term financial success when financial incentives were not the motivating factor.

I've got some experience as a manager, and I've observed similar difficulties. When people are encouraged to set personal gain as their primary motivation, they lose track of most of the virtues that would permit them to excel at their profession.

If one looks at the real estate market, one will see a marvelous example of high pay yielding poor-quality work. An agent receives a set commision on a sale, usually 3% of the net price; both the buying and the listing agent get their cut. The listing agent has an incentive to close the sale at the highest practicable price, but the buyer's representative has no similar incentive to pursue a lower price. Likewise, each will be motivated to close the deal quickly in order to get paid as soon as possible; neither has any apparent vested interest in representing the client's interest efficiently.

A good worker aspires to perform as well as possible. The role of management should always be to encourage this, to provide for it, to foster an environment where excellence becomes the standard. Goals should be clear and common to all.

How to make this happen... well, that's always the big mystery. But it does happen.

Yeah, there are drawbacks, but no alternative. There is only so much room for promotion and once they hit the glass ceiling, they lose all incentive.

Well, there is one alternative, negative reinforcement. But thats just miserable and in my opinion, evil.

There are alternatives; that's what I'm advising - and I presume that's Rota's point as well, though that's his to make at his leisure.

A good leader will lead by example; a wise employer will inspire and guide the workers rather than merely exploiting them. Soldiers fight for a cause, yes, but when the bullets start flying, they tend to fight for each other. As well, when punishments and rewards are wisely designed and administered, people will work for them when the bullets aren't flying - in the slow times, the moments between crises.

These are basic truths of leadership. If you want prime examples of their absence, look at the above examples (or read Dilbert).

The funny thing is, in the average McDonalds, they aim to follow these practices. It's too large an organization to ensure effect or efficiency, but in some places it is done well enough to create a decent crew. Much depends on the personality of the mid-level managers - but with proper guidance, these can be trained.

Quote:

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Originally Posted by Gnerphk

There are alternatives; that's what I'm advising - and I presume that's Rota's point as well, though that's his to make at his leisure.

A good leader will lead by example; a wise employer will inspire and guide the workers rather than merely exploiting them. Soldiers fight for a cause, yes, but when the bullets start flying, they tend to fight for each other. As well, when punishments and rewards are wisely designed and administered, people will work for them when the bullets aren't flying - in the slow times, the moments between crises.

These are basic truths of leadership. If you want prime examples of their absence, look at the above examples (or read Dilbert).

The funny thing is, in the average McDonalds, they aim to follow these practices. It's too large an organization to ensure effect or efficiency, but in some places it is done well enough to create a decent crew. Much depends on the personality of the mid-level managers - but with proper guidance, these can be trained.

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Yes, there are alternatives. When I was in management, I didn't offer financial incentives. The company gave everyone a bonus based off end-of-the-year numbers, of course. But, during the year, managers had a few options of small reward programs they could use. I used none of them. Instead, I had a "team meeting" at least once a month. This was at least 4x more often than any other manager at my location. I shared EVERYTHING I could with my team. Except for a few proprietary bits of info I could not share, I told them our financial numbers. Our sales, our costs, our profit margins. I shared every bit of info I could about how our section runs, and what it costs to run it. I shared info about where the most profit is made, and what costs take the biggest bite out of our budget.

I engendered a real sense of ownership. A few months after I became manage, every employee in my section became very cost and profit conscious. They were all acting like an entire team of assistant managers, not like a bundle of regular sales employees. The maintenance cost of our huge printer went down, because they all started taking MUCH better care of it. They realized the maintenance of that machine was a huge cost for us.

I shared with them all the processes of my job so they could see what I do. A lot of low-level sales people think that when their boss disappears into they back, they are goofing off and just chatting/snacking/etc, this breeds animosity and disgruntled workers. I showed them how I create our budget, how I order supplies, how i create/submit a profit/loss statement every month. My people knew what I did in the back, so if they didn't see me helping on the sales floor, there was no resentment. Eventually, I taught them each how to do at least one of my manager tasks. By doing this, I was able to take my vacation and my regional manager did not need to find a neighboring manager to fill in and keep an eye on my people. I was able to walk away from the job for over a week, and everything that needed to be done, still got completed.

A sense of ownership... it's a HUGE motivational tool. I gave it to my people, and in return, they made my life easier. They also gave our section better end-of-the-year numbers than anyone in the region, and in the top 3% of the entire country.