Photo: iStock
Photo: iStock

Opinion | Incentives may not drive performance

What incentive plans really accomplish? Do they motivate? Do they drive outcomes?

The power of incentive plans in driving desired outcomes is highly exaggerated. Some of these statements may sound familiar: “Our incentive plan is not driving the right behaviours"; “Our sales staff don’t believe this incentive plan can help us meet next year’s stiff targets", or “Our delivery teams need to be incentivised for driving account growth".

There has been much debate on what incentive plans really accomplish. Do they motivate? Do they drive outcomes? Or do they just end up converting a part of the fixed cost to variable cost with very limited ability to influence outcomes?

Irrespective of whether the problem was with the skill set of the individual, or with the manager’s competence, or the lack of role clarity, the solution that invariably comes up is about creating an incentive plan. My experience in implementing incentive plans, and active involvement in the associated debates, leads to some of these observations:

Most real problems cannot be solved by an incentive plan. In some specific situations, however, a good solution can be cemented by a well-designed incentive plan.

Incentive plans can motivate when outcomes can be directly linked to an individual’s efforts. Small and self-sufficient teams with clearly defined goals, which are largely under their control, can also be motivated by incentive plans. In such cases, the incentive has to be a significant component of earnings. Therefore, it is very common to see compensation structures of sales representatives with the on-target commission being anywhere between 40%-60% of total compensation. If the incentive is a miniscule part of their total compensation, it is unlikely to drive performance. Every individual makes an unconscious trade-off on the effort needed to achieve a stretch goal and the additional incentive that achieving the stretch goal would result in. If the incentive is a small component of the total earnings, the trade off easily tips in favour of taking it easy.

In most other cases, creating an incentive structure is really about moving some of the fixed cost to variable. The justification though is that it would drive performance.

Take any leading Indian IT services company where the wage bill could be as high as 60% of the revenue. If the wage bill is entirely fixed, which means that it would be incurred in full irrespective of the performance of the company or the individuals, then the net profit is subject to the vagaries of the business environment. In this example, let us assume that the other costs are 25%. In which case the net profit is 15%. If the actual revenue drops by, say 10%, then the net profit drops from 15% to 5%. On the other hand, if the variable component of the wage bill were, say 20%, then the break-up of the wage bill would be 48% fixed and 12% variable. In which case if the revenue dropped by 10%, the company has leeway to cut the variable payout and still claw back on profitability to hit the 15% target.

Incentive plans can also serve the purpose of retention, especially if they are structured as deferred payouts. If the deferred payouts are linked to performance, in my opinion, it is again like converting a part of the fixed cost to variable and not necessarily driving outcomes.

Rewarding for results (as opposed to driving results) is one of the most common objectives of an incentive plan. We don’t think there’s a very strong causal link between an incentive plan and ‘results’ in most cases. There are exceptions, of course. However, we have found that obtaining support for an incentive plan from a sponsor is easiest if you argue that it will drive performance.

Leaders ought to be problem solving, conducting better reviews, having difficult conversations, coaching their team, communicating expectations, or just providing direction, if they need to drive desired outcomes. Instead they often end up creating complex incentive plans, hoping they’d work. They don’t eventually. And when an incentive plan fails, the subsequent discussion instead of solving the real problem funnily goes somewhat like this, “Can we tweak the plan? Maybe we should have a sharper payout ratio for achievement beyond the target?"

Using well-designed incentive plans to drive performance is not a bad thing especially in some contexts, but using incentive plans blindly to address more fundamental management failures can be fatal.

T.N. Hari is head of human resources at and adviser to several venture capital firms and startups.