Crafting Incentive Systems That Actually Work

Willie Choi

Willie Choi

Control is a central theme of accounting. It’s no coincidence that in many companies the head accountant is called the controller. Companies use both formal and informal controls to motivate employees.  Formal controls include the carrot (performance incentives) and the stick (audits), and provide explicit incentives to encourage employees to exert effort and to refrain from engaging in opportunistic activities.  In contrast, informal controls include corporate culture and values, norms such as interpersonal trust and reciprocity, and informal information exchange, and they provide implicit incentives to exhibit organizationally desirable behaviors.  In my research, I explore how formal and informal controls affect employee behavior.

In a study published in The Accounting Review, my co-authors (Gary Hecht and Bill Tayler) and I examine the effects of formal controls (incentive compensation) on behavior when used in conjunction with a firm’s strategic performance measurement system.  These measurement systems connect a firm’s strategy to a set of performance measures.  However, employees may lose sight of the end goals the measures are intended to represent, and subsequently think and act as though the measures are the goal unto itself.  This phenomenon, which we call surrogation, can hinder an employee’s decision making.  For example, a car salesperson who receives a bonus for each customer who gives him a perfect satisfaction rating might inform and constantly remind (or badger) car buyers about the importance of giving him the best possible rating on the survey.  Even worse, the salesperson may give the customers excessive discounts, which will clearly increase customer satisfaction, but will hurt the dealership’s bottom line.

In our study, we find that incentive compensation exacerbates surrogation, with this effect being stronger when employees are compensated with a single measure (e.g. a bonus only for perfect satisfaction ratings) than when they are compensated on multiple measures of a strategic construct (e.g. a bonus for perfect satisfaction ratings, repeat sales, and the number of new customers via referrals).  Our study shows that the old adage “you get what you pay for” is true. Incentive compensation influences behavior by changing how you think.

In another study, also published in The Accounting Review, I examine the effects of trust, a type of informal control.  Research shows that trust can be a powerful motivator, and can generate greater mutual gains for both the employer and the employee.  One way employers can signal trust early on is by offering a signing bonus. My study shows that the effects of signing bonuses can’t be viewed in a vacuum, but rather, must be considered within the broader labor market context in which they are offered.  In particular, I find that the labor market competition – that is, whether there is excess demand for labor or excess supply of labor – affects whether prospective workers view the signing bonus as a signal of trust.  When there are more job openings than workers to fill those jobs, employers are more likely to offer a signing bonus.  Unfortunately, workers are less likely to view the signing bonus offer as a signal of trust, because they think the signing bonus is simply the employer’s attempt to avoid getting shut out of the market.

The opposite is true when there is more supply than demand. Workers who receive a signing bonus feel more trusted by the employer, and as a result, they tend to reciprocate the signal of trust by working harder.  But, there’s a catch.  In these environments, employers expect more from their workers, and these workers are less likely to meet their employer’s expectations.  This can jeopardize the worker’s employment over the long term because fulfilling the employer’s expectations plays a critical role in an organization’s worker retention.

In conclusion, companies are wise to offer economic incentives to motivate their employees. As my research demonstrates, popular measures such as performance measurement systems and signing bonuses don’t always have the full desired effect. The onus is on management to examine the context and create the ideal system of control.