How NOT to Do Incentive Pay

Last Updated Sep 21, 2009 7:01 PM EDT

One of the most compelling case studies on how pay-for-performance can fail took place at Hewlett-Packard in the early 1990s — and to this day, the lessons are as relevant as ever. In fact, compensation consultant and Harvard Business School professor Michael Beer has used the Hewlett experiment to help Merck, Agilent Technologies, and other giants reshape their compensation plans.

Then, as now, Hewlett-Packard prided itself on being a high-commitment workplace, with the kind of decentralized management that gives employees a role in decision- making and offers them challenging careers. It was the type of place willing to take a chance when its workers offered it a challenge.

Curiously, HP had no bonus system in those days, and did not in fact regard money as a motivator. So what was proposed was unusual, highly experimental for the HP culture. The company had several self-managed teams of 200 to 300 workers at various sites around the country. Managers at 13 of these sites asked to adopt a pay-for-performance model, hoping to boost productivity and encourage a focus on team rather than individual performance. They designed a plan that tied 10 to 20 percent of their workers’ pay to their team’s performance.

The experience of Hewlett’s San Diego production unit was typical. Management set a series of production goals — parts or units moved per hour, per day, for instance — for several teams, and based their workers’ pay on three levels of rewards. They figured that most of the teams, 90 percent, could reach Level 1. Of that, maybe 50 percent would reach Level 2. And it was likely that only 10 to 15 percent could reach Level 3, the highest and most productive. Achieving Level 3 status meant each worker on the team would receive a bonus from $150 to $200 for that month.

They were wrong. For the first six months, nearly every team hit the two highest levels. Good for employees, who were suddenly — if briefly — flush, but bad for the bottom line. Management found itself paying out more than it had expected, so it adjusted the target numbers upwards, essentially moving the goal posts during the game. A bad mood began to set in.

The slow delivery of parts from other units affected their work and frustrated the teams. High-performing teams refused to allow workers they saw as less experienced join them. Less movement between teams meant that less knowledge was shared or transferred among employees. Workers who bought cars and new homes had trouble paying loans when they could not achieve their numbers. The whole experiment grew increasingly messy, and workers became irritated.

“As soon as the pay system didn’t work, people began to complain,” says Beer, who is co-founder of TruePoint consulting and author of High Commitment High Performance: How to Build a Resilient Organization for Sustained Advance, which was published this summer. “And the more workers complained, the more managers had to redesign the system.”

Other units had similar troubles and within three years HP scrapped the entire experiment. When it did, relieved workers threw management a party. One problem, says Beer, is that self-interest took over. “The HP experience shows the more you focus people on monetary incentives, the more you use money as a goal and a driver, the more dysfunction you have,” he says. “We’ve seen the same thing on Wall Street.”

It becomes a sort of vicious cycle: Employees focus on doing what they need to do to gain rewards — and that just feeds their self-interest even more. In short, people chase the money — often, Beer says, “at the expense of doing other things that would help the organization.”

To avoid these missteps, Beer counsels his clients and students to consider a number of factors when designing and implementing a compensation system. First off, he says, ask yourself if your current compensation system is hurting you. So if it’s not broke, you don’t need a new bonus system to fix it.

So if you decide to go with a pay-for-performance model, figure out your definition of performance. Success is never merely about numbers, so don’t turn your reward system into a numbers game.

Other things to ask: Will this system help individuals work with other groups in the company? Or will it hurt his or her ability to work with others? Will it help develop talent? Or will it do the opposite?

“Define success more broadly,” Beer advises. “Remember, you want to reward behavior that will help both your company and your employees grow in the business.”

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