Can we get people to work harder and perform better if we make their pay performance-related – e.g. with performance bonuses or commissions? Does this work? What does the evidence say? We know that people respond to incentives, but, as Gene Tunny and Tim Hughes discuss this episode, getting those incentives right can be tricky.
What’s covered in EP177
- What is performance-related pay? [0:41]
- The types of jobs in which performance-based pay works and doesn’t – e.g. fast food vs real estate [8:09]
- The importance of getting incentives right and having transparency [23:16]
- Performance-related pay is a difficult thing to put into practice [28:24]
- Group-based incentive schemes – evidence from a recent European study of the Hydrema manufacturing business [52:54]
Links relevant to the conversation
Transcript: How performance-based pay can motivate employees, but there are risks – EP177
N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.
Gene Tunny 00:06
Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, thanks for tuning into the show. In this episode, Tim Hughes and I chat about performance related pay, can we get people to work harder and perform better if we make part of their pay performance related? Of course, if you don’t perform at work, you can get sacked. So your pay does end up being related to performance in one sense. But what we’re talking about here are such things as performance bonuses and commissions. That is where you don’t just get a regular predictable salary, but part of your compensation is at risk. Does this work? What does the evidence say? We know that people respond to incentives. But as Tim and I discuss this episode, getting those incentives right can be tricky. Okay, let’s get into the episode. Please stick around to the end for some additional thoughts for me. Tim Huges, good to be chatting with you again
Tim Hughes 01:30
Gene, good to be here.
Gene Tunny 01:31
Excellent Tim, I thought it’d be good for us to have a quick conversation on performance related pay. I’ve been thinking about this following on from this whole debate between Steven Crowder and the daily wire, which I talked about with John Humphries on his Australian taxpayers Alliance Econ Chat, earlier in the week, and I thought it’d be good for us to have a chat about a related issue, which is performance related pay I got starting to think about this. Well, when John and I were talking, we were talking about well, does the actual form of the contract matter? Or is it just all about the dollars that are being paid? Or that they expect to earn out of the contract? I mean, obviously, the money is important, but how do the contractual terms affect the amount of effort that you put in, in your work? And so I was thinking about that in the context of the debate between Crowder and daily wire, and then it reminded me that I should cover this issue of performance related pay on the programme, because I think it’s an important, an important issue.
Tim Hughes 02:36
Yeah, sure. It’s an interesting area for sure.
Gene Tunny 02:38
Yeah. I mean, did you have any thoughts on that whole crowder and daily wire?
Tim Hughes 02:41
I’d never heard of it until you mentioned it. So I didn’t even know if, so he’s a comedian, that guy?
Gene Tunny 02:47
Yeah. Yeah. So he’s on the right wing in the US. He’s more of the Magga type, Crowder, whereas the daily wire and more of the traditional Republican, and I think Ben Shapiro was originally anti Trump. So yeah, the different parts of the conservative movement in the States.
Tim Hughes 03:09
I think I know now, I haven’t heard of him. But as we often talk about like, it’s it’s good to be exposed to different areas and different views. So yeah, looking forward to hearing about it.
Gene Tunny 03:23
It’s just all over YouTube and social media, people are commenting on it and say, John went through it. And John’s view is that well, all they’re arguing over is the amount of money involved. And it’s not necessarily about, you know, the concern Crowder had was that daily wires just doing the bidding of big tech.
Tim Hughes 03:42
But so what was what’s the what’s the juice? Like? What was the story? Between those two guys? It was a it was a contract. Yeah.
Gene Tunny 03:49
It was a contractual dispute. Well, they were trying to recruit, Crowder to their platform, and they offered him $50 million over four years, but the payment that they have for you, yeah, but what they would pay would step down if he was demonetized on different platforms like YouTube and Okay, Twitter, or Facebook, or whatever. And he was saying, well, you’re doing the bidding of big tech. But look, it costs the money. So it makes sense to, to scale the contract down. And so in John’s saying, look, it’s just all about money. These contractual negotiations are just all about money, ultimately.
Tim Hughes 04:26
Just out of interest. So when he says you’re doing the bidding of big tech, what does it mean by bidding? Like, I can understand that, like big tech may affect that income? So if it’s monetized that’s basically the issue. Yeah. But how can they be doing the bidding of big tech? I don’t understand that.
Gene Tunny 04:43
Well, maybe I haven’t expressed that very well. But the idea is that, well, a lot of these conservatives think that big tech is trying to censor conservative voices. Yeah. And so he’s saying, well, you’re just going along with what they want. Alright, okay. I’m accepting that in the pocket. Yeah, no. Yeah, maybe that’s I don’t know. That was his concern. But look, as John said, it just all comes down to money and at what price you’re willing to, to work for Daily Wire and also to give up the IP because he would have to give up IP and the shows that are produced while he was at. At Daily Wire, they would get the copyright in that. Yeah. So yeah, ultimately, it all came down to money, but it did get me thinking well, okay, well, how would you structure a contract? To get the best performance out of a person was daily while we’re designing the contract, they were proposing a contract in a certain form to get the best outcome from their point of view. And then also, as possibly was from Crowder’s point of view, too, because there’s going to be more money available for both if he’s not demonetize, right, yeah. Yeah. I mean, he may think that, well, that’s bad for his brand. Or maybe he’s playing the longer term game. And he’s thinking well, yeah, I mean, I’m all about being edgy. I don’t care about whether I’m monetized on YouTube or not. But then again, he should have appreciated that if he wasn’t monetized on YouTube, then that’s less money overall. So the Daily Wire is trying to design a contract, where it’s essentially trying to encourage him to be monetized or as monetized as much as possible so that there’s more money for them. Now Share, They Share part of that with Crowder, and depending on what the share of the total revenue that YouTube was of the total revenue that comes in from Crowder, he may well have been better off with the deal they were offering, because he was I think they’re only going to dock 25%. Well, they’re going to dock 25% If he gets demonetized on YouTube, okay, I thought this was an interesting case. And it just got me thinking about incentives and how do you structure contracts.
Tim Hughes 06:56
yeah, yeah, it’s an interesting area, because I know we talked a little bit about this. And certainly, from my experience, like, you know, if you’ve got an incentive, as an employee, or if you can give incentives as an employer to get the mix, right is the tricky thing, because you know, you want something that’s attainable, and sustainable. So if it’s too easy to get the reward, you know, the employer can lose out. If it’s too hard, then the employee loses out. So it’s a bit of a fine balance. And obviously, this is used pretty successfully with commission based work, you know, where there’s a base salary plus commission, and they’re usually done over a period of time, so they can get that amount, you know, pretty much right? And some people can do really well with that. Particularly in real estate. Yeah, well, and with salesmen, it’s a big one for sales, of course, of all sorts of industries where no sales are used. And it makes a lot of sense, you know, if you’re a really good salesperson, then you can be rewarded for that. And if you’re not so good, then, you know, you, you don’t get so much. And so sort of a fair way of doing it. So I think now, wherever possible, it makes a lot of sense to have that involvement in the company. You know, that’s, that’s properly rewarded.
Gene Tunny 08:09
Yeah, exactly. So I thought this would be a good topic to, to talk about. So in the great majority of employment agreements, I would think would not involve any performance related pay that there’s really isn’t any incentive there. But they rely upon, well, the incentive is if you do the job, then you’ll keep your job. But if you don’t, we’ll get rid of you. So I guess that’s the that’s how it works, right? And but if you can monitor how people are working, and you’ve got a good, a good eye on that you can, you’re able to properly understand the contribution output and the profitability of the firm. And in many cases, I suppose you can, you can do that. If someone’s working at McDonald’s, they’ve got a sense of whether that person is able to prepare the number of Big Macs an hour that’s required or whatever they need to do. So you can monitor that sort of activity. And in those cases, there’s no real need to provide any incentive, if they do a better job, or if they suppose they will have to meet a particular level of service or or do so much an hour. And if they do more than that, well, it doesn’t really lead to more money or more profitability for McDonald’s because basically, McDonald’s ends up serving everyone who comes in and tries to buy something off them anyway, doesn’t it?
Tim Hughes 09:39
I mean, that I know people who’ve worked in McDonald’s and they seem to have obviously it’s all about systems have completely been the leader in that kind of business for a long time. Many people, many businesses have incorporated, that whole framework of heavily systemized but of course, it means that the expectations of what needs to be done? Pretty accurate, but I think they do have, you know, opportunities to sort of move within McDonald’s. So the scale or the pay scales quite clearly set out.
Gene Tunny 10:12
You’re right. And just after I gave McDonald’s as an example, I thought I better check that McDonald’s doesn’t actually have performance related pay. Because that was just the first thing that occurred to me. But I think most of the people are working there, they’re just going to be getting paid the award rate or whatever it is, or whatever. Yeah, the agreement. But it turns out, it looks like there is some performance related pay. This is in the UK, McDonald’s restaurants put motivation and reward at heart of business strategy. So I’ll put a link to this. This is for the the top restaurants and it looks like they give a bit of a bonus a small bonus in some cases. So each month, all employees in the top 10% of restaurants based on mystery shopper scores receive a bonus of 50 P for each hour, they have worked in a two week period. Okay, so that seems that seems okay. But it’s not related to your individual performance. It’s related to how the whole store goes. And that’s probably not as strong an incentive as if it’s an individual performance pay performance related pay measure?
Tim Hughes 11:26
Yeah, and I guess put put a big part of that, because they work as teams, obviously. So to pick out an individual for having particular performance would be hard, but collectively, for that branch, you know, there might be incentives, if not, with McDonald’s with other similar kind of fast food chains. But I know, for instance, in the states, if you work in hospitality, a lot of the jobs are paid, not very much on the understanding that they’re going to receive, you know, pretty good amount of tips throughout the week. Yeah, because it’s customary and traditional to do it in most places. As I understand over there, I worked in Austria, myself in ski resorts years ago. And that was a big thing. There was you lived on your tips, it was fantastic. You know, it made a big difference. And you could save your wages, which weren’t high, because of it. Whereas in the UK, it was less likely you’re gonna get tipped, you know, you’re gonna be hungry. If you’re, if you’re working in hospitality in most places in the UK, and probably in Australia, too, to be fair. It’s not as customary here, either. So.
Gene Tunny 12:30
That is because we have high award wages, or well, maybe not high. If you’re, if you’re working in these jobs, you probably don’t think they’re that high. But yeah, relative to what you get paid elsewhere in the world, we’re doing the same job. It’s quite, it’s a bit higher than that. Yeah.
Tim Hughes 12:44
I mean, yeah, you get to the high end of that kind of scale, you get the concierge is at top hotels around the world. And who knows how much those guys make and women, of course, like in those roles of being in really flush hotels, where a lot of people have a lot of money and just dropping $100 bills everywhere.
Gene Tunny 13:04
Yeah, exactly. And I’ll put a link in the show notes to some of these articles I found on McDonald’s. So just put some clarity around exactly what they’re doing. That was just the first company that occurred to me, but my contention would be, and I think the evidence shows this as the majority of jobs out there. There’s no real performance related pay. Say, if you’re in the public service, generally not. Some public service agencies will offer bonuses, there’ll be some there’ll be some assessment of how you’ve gone through the year, and maybe they’ll pay you a little bit of a bonus. So a lot of that’s, I think that’s rare in the public. Yeah.
Tim Hughes 13:48
I would imagine it’s industry specific. So they’re probably like situations like that with? Well, certainly with government employees, where it will probably be difficult to put any of those kinds of things in place. Maybe not with all departments, but certainly with most we were talking earlier about it clearly is more suited to certain industries and others. And one of the interesting areas at the moment, because there’s a lot of people doing side hustles side gigs, doing their own kind of little business, while they’re still working for, you know, an employer. So their main employment is earning X amount of money every week, but putting time and energy into their own little gig, which is a tricky one, because like, you know, again, depending on what the work is, but if it’s not easily quantifiable, people can be putting less energy and time into their main job. So it’s a problem for the employer, where it’s like, clearly people aren’t getting satisfied from their roles or the work that they’re doing in that main job. And something that we both heard Phil Dibella talking about fairly recently was being an intrapreneur like so. Basically an entrepreneurial spirit within a company so you can be an intrapreneur and what you might be able to offer to that company. So, if a company is open to different sorts of ideas and innovations from within the company, then there might be a space and place for someone to grow within that company. Yeah. And and share their ideas and use that energy within within the business.
Gene Tunny 15:19
Yes, certainly. So if you can demonstrate that you’re, you are making a material impact on the profitability of the firm beyond your normal job, or what you’re doing at the moment and your job or what your role is, and you’ll make your contributions much greater than what you’re getting paid for, then that’s an opportunity to redefine your role to get a better better pay from your boss. And you can be this is what Seth Godin calls the linchpin be indispensable in the business you are and you can be a linchpin in your own business, but you can also be a linchpin in someone else’s. Yeah.
Tim Hughes 15:55
And of course, that that comes down to a symbiosis where obviously, the manager or your superior needs to be receptive to that. I mean, they need to be good ideas, of course, but if it’s a receptive environment that encourages that, they would need that to work. So there’s a few things obviously that have to come together. And again, that would be industry specific. And, you know, within guidelines or, you know, whatever, I think forward thinking companies can certainly take advantage of that, you know, with the event of encouraging intrapreneurship within their own company.
Gene Tunny 16:30
Yeah, exactly. So with, let’s think about the economics of, of all of this. So we’ve identified that there’s performance related pay in more sales and, and in real estate and in in other sales jobs. And that’s because it’s a way of compensating the top salespeople, and it motivates them, it motivates them to hustle or to work harder to make more phone calls or to aggressively go after properties to sell. I mean, what’s going on there? I mean, why is real estate different from, say, working behind the counter at office works or something?
Tim Hughes 17:10
I guess, with real estate, you make a significant sale less often. Whereas like with most retail, it’s going to be a less significant sale? pretty often. Real estate is a bit of an outlier, I think, isn’t it? Because depends where it is. And like, you know, it might be a handful of sales for some people who can do extremely well. Yeah. But you know, that it comes down to, yeah, just very few sales that are really significant. And, of course, are a big, dry periods. There’s not much happening in real estate. So it’s a very, up and down kind of market.
Gene Tunny 17:44
Yeah. So it’s obviously because or, or this, this is what I’m thinking is because this is so competitive, and there are big gains to the people who win, but the people who make the actual sale happen. There are big gains to to that company because of the commission that’s involved. And that’s shared with the agent, isn’t it? And that’s because it can’t just always observe what the agents doing because they’re often out and about, and it’s a job where they may have to work more than the usual hours, they often have to work after hours. There’s a lot of hustling involved, though, to get the sale. They might have to really go above and beyond and sharing the commission or having commission based pay. That’s a way of incentivizing them.
Tim Hughes 18:38
Glengarry Glen Ross Yeah. Like coffee’s for closers is the same. Is that same thing? Like, I can only imagine. I mean, I haven’t worked in that area at all. But I can only imagine it’s, well, pretty stressful. I mean, because if you’re not selling you’re not earning. And there’s a lot of jobs like that where its base salaries is either non existent, or it’s just minimal. So you really, the incentive is you have to you have to sell. Yeah, with real estate, it’s feast or famine, it would appear.
Gene Tunny 19:06
Yeah, I have to look more into that just exactly how they compensated. So if you’re a real if you’re an agent working at the Ray White, you’d be getting as a base salary, wouldn’t you? And then they’d be paid, you’d be getting a bonus or you’d be getting a share the commission that’s charged on the transaction, would you I would imagine, but I can’t say I’m not sure. I don’t know either. But I know I’ve got the sense that it’s related to that because Yeah, real estate is one of those industries where the high fliers the top real estate agents are just yeah, they’re they’re making a lot of money. Yeah, they appear to be making a lot of money. I know that having the BMW that’s part of the act out of the bottle. Yeah.
Tim Hughes 19:52
It’s definitely a regional thing as well. Like, depending on where you were, you’re an agent. You know, obviously the the margins are bigger in the The more expensive suburbs more competitive I imagined to. Yeah. But is that is that thing like sales is definitely the most common way of having incentives. And it makes sense from all sides and employers and employees, there’s a margin that can be shared. And it makes sense. If you haven’t made that sale, then the margin is not there. So it’s probably the most common one, and the fairest one too.
Gene Tunny 20:29
Okay, we’ll take a short break here for a word from our sponsor.
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Gene Tunny 21:04
Now back to the show. The places where I’ve seen performance related pay is in consulting. So consulting firms often have a bonus scheme run bankers in banks, for their investment bankers, they’ll have a bonus scheme, hedge funds, they have bonus schemes for their for their people. And they’ll have their salary, but they’ll also be a bonus on top of that. And the idea is that if you’re a better performer, then you can get a generous bonus. And some of these bonuses can be pretty generous, like some of the bonuses that they’ll have in the City of London or on Wall Street for some of these bankers. I mean, that can be millions, millions of pounds or millions of dollars. Yeah, because a really good year. And if, if that particular banker, or trader, if they’ve done well, or it looks like they’ve performed well, like they’ve done incredibly well in the deals that they’ve signed, or on the trades that they’ve been executed. So there’ll be some link there, and I suppose why the bonuses work there to to incentivize people as well. If you’re working in that sort of industry, you’re probably you may be highly motivated by money to begin with. And so the prospect of more money is going to motivate you to work harder. And there’s also that the inability or the, it’s something where you can’t really closely monitor what they’re doing. And you’ve got to rely upon the person putting in the effort going, they’re going the extra mile, so to speak, to get the best outcome for the business or for the for the bank or for the for the consulting firm. So billing more hours getting projects done more quickly. So you can then get another project in, send the invoices out.
Tim Hughes 22:56
So actually, I mean, to be fair, this is where a lot of problems come though, wasn’t that the foundation of the GFC with mortgages been given for properties that shouldn’t have been mortgaged? And so a lot of a lot of deals been done that shouldn’t have been done on paper were worthless, and then that started the whole GFC process. Isn’t that correct? Like? Yes, yeah, absolutely. Like it was basically. And it was that incentive to yeah, get the Commission’s that was driving those deals, you know, so if, if it’s a bad deal, then yeah.
Gene Tunny 23:30
Yeah. The mortgage originators, who were signing people up. And the story was there all these people who had who were getting loans who had no income, no job, no assets, the ninja loans they called? Yeah, yeah, yeah.
Tim Hughes 23:45
Yeah. So it’s that thing of like, getting incentives right, is really important and having transparency as well. Yeah. So clearly, there wasn’t enough transparency with that.
Gene Tunny 23:56
Well, I guess the, the incentives weren’t there, they weren’t designed well, from the point of view of the of the company or from society. I mean, they it was all about the short term, it was all about, just sign as many people up as possible, right, as many loans or get as many loans approved. And regardless of who these people are, and so, yeah, it’s people who shouldn’t be getting loans. And then you’ve got the people in the bank. So the investment banks who, then they’re bundling up all of these mortgages, some of which, the people who, who have the loans, they’re going to be the first people to just walk away when things get tough, and they can’t service their mortgage, they just walk away and then this, this was part of the problem. What was happening is that all of these mortgages that weren’t worth as much as nominally they were worth they’ll be packaged up and then sold as a financial product, the mortgage backed securities and you know there were people making money out of that. The the investment bankers who were selling that to pension funds. And yeah, they were doing well in the short term. But it was there from a longer term perspective and for the companies themselves. And for the society, it really wasn’t. It really wasn’t great. Yeah, it’s terrible.
Tim Hughes 25:23
So it can see how it’s important to get all those elements, right. Clearly, there was a lot of people, I’m sure the writing on the wall was visible for a lot of people, but they’re just getting in there and doing it while they can.
Gene Tunny 25:34
Yeah, one point I should make, I think for the companies that fell over. So if you think about Lehman Brothers, and Bear Stearns, certainly what happened, those bad short term incentives did cost them in the long term. But one of the problems with the financial crisis was that some companies that probably acted, you know, that acted pretty sketchy, pretty badly in the lead up to the crisis. Ended up getting bailed out. Yeah, yeah. So and, you know, that’s, that’s a problem.
Tim Hughes 26:07
That’s a different, a different episode as well, I guess there’s a there’s a whole.
Gene Tunny 26:10
Yeah. Too big to fail episode. This is part of the problem. We’ve got that this is what happened during that episode. During that the financial crisis that’s caused a lot of the political problems we’ve had since then, I think, because people see Wall Street getting bailed out. So Bernie Madoff went to jail, but probably a lot of other people who should have gone to jail.
Tim Hughes 26:38
Well, yeah, and it’s, it’s difficult not to be cynical, when you see people getting away with, with things where, in other circumstances, people would be sent to jail. And so yeah, having being accountable and taking responsibility should be across the board for sure.
Gene Tunny 26:57
Yeah, exactly. I was just thinking team with the consulting firm example, because that’s what I know a lot better because I was working for a consulting firm before I went out on my own. Now, I mean, my pay is purely performance based. It’s just, it’s purely performance based. Rather, there’s no salary that doesn’t, there’ll be maybe I do effectively pay myself a salary, but I’ve got to generate, yeah, I’m gonna generate the revenue. Whereas if you’re working for a firm, you can the link between the work you do and the amount of money will the salary you get is indirect. There is a bonus scheme to try to encourage people to work harder. And that certainly does motivate a lot of people in consulting firms. And that can make sense, I think, because when you’re in a consulting firm, there’s a lot of extra effort or a lot of a lot of additional things you could do that it’s hard for the employer to hold you accountable for or monitor how you’re going with those things. I mean, we’re talking about well, how well are you really putting yourself out there to try and bring in new business? Yeah, how well, are you trying to get the deals done that sort of thing? How hard are you really working? How intensively are you working when you’re working on jobs to try and do them as quickly as possible, so you can bill as soon as possible, that sort of thing can be difficult to observe. And so therefore, it can make sense for some performance related pay. And so it can benefit the employer too, because they can pay you a bit less than you expect to earn if you’re a high performer, because you’re counting on the getting a bonus. So from the employers point of view, it’s they like it because okay, it’s some of the risk has been taken by the employee. And if they’re a dud, well, if or if they have a bad year, well, we don’t pay him as much. And then okay, if they make money for us, and you were happy to share some of that profit. It’s a difficult thing to put into practice, though, in consulting firms, I think, because the amount of money in the bonus pool and this is a problem with banking to what can happen is if you could have a really great year, and you could be a star, but if overall the whole firm doesn’t do well. Say the economy has a downturn, the economy, but say you might have had a great year, if you if you’re if your bonus scheme, and I think one of the problems in practice is that many bonus schemes are like this. They’re linked to the last financial year profitability or last quarter profitability. If the firm has a bad quarter or a bad financial year, you’ll suffer even though you’re a star, right? So you’ve really got to be careful how you design these bonus schemes because that sort of thing will cause resentment because the person who thought they did really well that year they’ll be mad because they had a great year, but because the firm didn’t have a great year, they didn’t get as much money. And then the other things that can happen is that if, if you don’t design your performance related pay scheme properly, then you’re gonna have all sorts of disputes between your staff, it doesn’t necessarily encourage a collegiate environment, because you may be trying to maximise your billable hours as a share of the total billable hours on a project. And therefore you might not want to bring someone else in the firm to take part in it because you’d have to share any upside with that person. And attribution. So say someone often, often there’ll be performance related pay linked to whether you’re bringing in projects or bringing in jobs. But then how do you attribute the contribution of bringing in the job? Does the fact that my cousin your consulting business, that he knows the person, he’s got a contact in the energy business and then the person there rings up Mike and says, Oh, Mike, do you know anyone who could help me out on on this job? And Mike goes, Oh, yeah, Janine over there. She could probably do it. She’s got the skill set. And then Janine talks to I didn’t give the guy in the energy business, and I did a berry berry. Berry. And then Barry goes, I’ve got this problem, I need this, this issue analysed. And Janine goes, Oh, yeah, I can do that. I can build this sort of model. And Janine does this really big pitch, she does this really great proposal, which convinces Barry that she’s going to solve his problems. And then Barry goes, Oh, that’s great. I’ll give you this big contract to deliver that. And then she goes, oh, that’s great. And then, and then Mike goes, hang on. I’m the one who introduced you to Barry. Yeah, yeah, I want 50% of that, if any profit on that job.
Tim Hughes 31:53
And Janine did 90% of the work? And yeah, it gets tricky, for sure. And I think this is where it’s industry specific. And also, you don’t want to create an environment where people are jealous, and and sabotaging other people that you don’t design it. Well, that’s exactly. So this is the thing. And I think this is where it gets industry specific. Because and this is also where intrapreneurs can help because you have to come up with your own solution, you have to come up with your best design for the situation that you’re in. There’s not one that sort of suits all.
Gene Tunny 32:25
Well, I think the best thing is, is actually to be generous. And you you win overall, you win the long game by being generous. Yeah, it’s that it’s a win, win and grand he’s got that give and take is that Adam grants thesis, I can’t remember. I’ll put a link in the show notes. But I think you do better in the long run by being generous and not being greedy.
Tim Hughes 32:49
Isn’t it one of Stephen Covey’s Seven Habits of win win? That’s, I think so. So because that’s, that’s basically what it is, isn’t it? Because, yeah, one you want it to be any incentive shall be a positive thing within a team with, you know, for an individual within a team within a department and company. Yeah. And you can have friendly competition and everything. But it’s so easily done, where it can be a negative force, you know, like, yeah, tricky, tricky thing.
Gene Tunny 33:17
And I must admit, I mean, I’d probably, maybe I wasn’t as collegiate as I should have been in jobs where I’ve had a bonus where there was a bonus scheme. And I look back on that and think, Ah, I probably wasn’t always being a team player. And I regret that. But that’s just the way it’s set up. So you got to set up the system so that it does encourage collegiality, and it doesn’t just rely on people doing the right thing out of the goodness of their heart, because when money’s involved, they won’t necessarily do that. It’s a good boy,
Tim Hughes 33:48
it’s a good point, actually, like you can design this around the behaviour that you want to encourage, you know, so if you can imagine that, it might encourage negative behaviour, like, you know, if it’s not a fair system, then you can end up with someone that happy employees.
Gene Tunny 34:04
Yeah, so I’m gonna have to try and dig up some examples of bonus schemes that work because I’ve seen various bonus games, not necessarily, I’m not necessarily making a comment on any organisation I’ve worked in. I’m talking generally about consulting businesses I’ve seen because I’ve known a lot of people who do consulting work, and I’ve heard of various different models. I haven’t heard of one that seems to get everything right. There seems to be issues with all of them. I don’t know how you design it, but you certainly have to have your bonus linked, not just to the short term results, but to the longer term outcomes, they maybe have to have it linked to profitability over several years. Yeah. which avoids the issue of well, what if someone has a great year but the whole company doesn’t do very well? And then they don’t have there’s no money to pay the bonus. And you also want to see whether, okay, maybe this person, you don’t want to pay someone a bonus if they’re actually making things worse in the long run, because they’re because they’re really toxic to work with, like, they might be a high performer, they might be generating a lot of sales or doing a lot of work. But they could be a nasty piece of work. And that’s no good for your company’s morale of other team members for your reputation.
Tim Hughes 35:19
It’s actually interesting, because it would be very hard to imagine a perfect system for any scenario. So I would imagine that any good incentive scheme would be constantly evolving, constantly being receiving feedback and, and changing because of all those reasons that we’ve mentioned, you know, like people who might just be a passenger and thinking I’ll just do as little as possible and, and try and, you know, right off the back of other people’s hard work, if it was a team incentive, you know, so it would have to be a very flexible, mobile kind of incentive system, you would imagine.
Gene Tunny 35:53
Yeah, I might look more into this. What are some examples of schemes that have done? Well, because there’s been, there must be a literature on this. So there must be people must have written about this. But what I’ve done is to prepare for this conversation, as I’ve looked up, or what is generally what does the economic literature tell us about the you know, the effectiveness of performance related pay? And? Well, as you probably expect, given that we do see examples of performance related pay out there, it must work, right? Companies wouldn’t be adopting it if it if it didn’t work in some way. And so there’s a great article on the IZA website. So that’s an institute that looks at labour market issues, I think it’s German. So the Z must mean something, mister, must be some German words, starting with Z. I could be wrong about that. I dont know why its IZA, I don’t know exactly why it’s IZA. But there are a great think tank that looks at labour market issues. There’s a great article by these two Italian academics performance related pay and productivity, I’ll link to it in the show notes. And what they find is, so the pros of performance related pay, linking paid or performance is expected to increase worker motivation, effort and loyalty to the firm, pay incentives, raise job satisfaction, lower absenteeism and turnover rates and have a sizeable effect on company performance. Right. So they’re actually finding that their review of the literature tells them that it’s a positive thing. They’re saying that this is a good point, I think the diffusion of remote work may involve a shift from input to output based compensation schemes such as performance related pay, I think it’s a really clever point. What that saying is that as more people are working from home, we really have to start thinking about performance related pay, because there’s less well, in the old days, I mean, where you had to go into the office, then that was how you were signalling your contribution of the firm, wasn’t it? That was your you were you were visibly in the office or you weren’t there. And then the boss could come and give you the tasks to do. And so I guess, just hourly base pay made more sense in that environment than if people are working at home where we’ll really when, when we’re during COVID. And afterwards, we’ve made this shift to working from home and now the boss isn’t really observing whether you’re turning up for work or not, are they they’re just they just expect you to get a certain amount of work done. Yeah. And to be contactable, generally, I mean, available. So it’s a different sort of thing. And so I guess it would force us to think more about how we could design a performance related pay scheme for jobs where in the past, maybe we didn’t have a performance related pay scheme, even though possibly they were amenable to one or they could have, there could have been a performance related pay scheme. But because of the power of debt, well, the status quo inertia, perhaps we didn’t think about that. It’s an
Tim Hughes 39:03
interesting point. Because in that situation, if it’s task based and say somebody’s working from home, it’s performance based, you’re not getting paid any more necessarily, or that might be part of the deal. But if you can do your work in six hours instead of eight, your bonus is you get two hours to yourself to do something else. So I think it’s really interesting point because I think looking at work to be quantifiable by tasks done and those kinds of things if possible, again, it’s an industry specific kind of thing, then absolutely. If you get the balance, right, where the right amount of work is fair within a certain period of time, then yeah, allows people to do that work well within that timeframe or not.
Gene Tunny 39:47
Yeah, another point they make is that digital technologies may improve performance measurement, thus improving the targeting and performance related pay. So how to think more about that in In professional services, jobs, that’s probably less relevant because you do see, I mean, you’d see the the effectiveness of their work in terms of how well, their their products or whatever they’re doing. They’re, you know, are they completing jobs on time? Is the customer satisfied? I’m not sure exactly what that points getting out there. Maybe I’ll have a closer look at the article. But I suppose if you guess you could really, you could monitor what they’re doing. If you mean, that sounds awful. But if you’re recording their screen, or their time spent on the computer, perhaps I mean, I’d hate to do a job like that if someone was doing that.
Tim Hughes 40:42
Yeah, I guess, if it’s tasks, down to what tests are being done, then you can quantify it that way. But for sure, I mean, to be fair to employers, like there’ll be employees milking, you know, the opportunity to work from home, you know, so it’ll be, it’ll be sort of a bit of give and take from both sides, I imagine as to the benefits of that. And again, industry specific, the creative industries. I know, for instance, I got a good friend who is in architecture, and that kind of industry is very collaborative. And so the value of having people in the same place and the interaction is and that energy is really valuable to that kind of industry, where you lose that when everyone’s working from home. So it does, it does have different impacts for different industries, for sure.
Gene Tunny 41:33
Yeah. So I’ll go over the cons are trying to get through these quickly. The effects of performance related pay schemes differ significantly, according to their design and the types of firms. Okay, so we were talking about before about how like performance related pay is going to make more sense in some circumstances and others in terms of the design, one of the points they make here, in the author’s main message. So they say that individual schemes linked to performance have been shown to be associated with higher firm productivity, while group performance related pay and financial participation generally exhibit smaller effects on performance. Right. Okay. It’s the individual incentive that matters. I mean, that that makes sense. Because if you’re say there’s a group incentive, there’ll be people in the group who are thinking, Well, I mean, I can end up working a lot harder. But if Jack doesn’t pull just doesn’t do work as hard as the others don’t, you know, they really don’t work any harder than I could do all this extra work, and we’re not going to get the prize anyway. So why should I bother? That’s what’s gonna happen, isn’t it?
Tim Hughes 42:42
Every scenario you can imagine will be happening somewhere. So yeah,
Gene Tunny 42:45
yeah. I mean, that’s a, I think that’s the issue, or it’s less likely that you’re the relationship between the performance of the firm, and you’re relying on the other group members to perform. Whereas if your incentive is linked to how you perform, then I think that’s more of an incentive to work harder, because it’s not, you know, it’s not contingent on the others working hard as well.
Tim Hughes 43:14
I hadn’t thought about it before. But the ultimate incentive scheme that works, the fairest is when you’re self employed. And you, you know, whatever work you you do and bring in is, that’s your income. Well, that’s the fairest of all incentive schemes, you know, and anything beyond working for yourself, like with more people just gets trickier and trickier, I guess, you know, like, there’s more things to consider as to how it might be fair. But yeah, if you’re working for yourself self employed, that is the ultimate payment incentive scheme.
Gene Tunny 43:45
Yeah, you kill what you ate. Now you eat what you kill.
Tim Hughes 43:49
Well, to be fair, if you’re gonna eat it, it’s probably gonna die in the process if you haven’t already killed it.
I think that’s what they say. You eat what you kill. Is that it? Yeah, that would make sense. Yeah,
Gene Tunny 44:00
I think so. Yeah, I’ll go with that. I’m pretty sure I’ve heard that it’s some of the consulting firms have worked in.
Tim Hughes 44:06
But it’s fair. And that would be the thing of like, you know, you you get out of it, what you put in and that’s pretty much every case of being self employed, you know, a very fair and reasonable way for for things to unfold.
Gene Tunny 44:19
Yeah, yeah, exactly. Okay. Now, some of the other cons. When pay incentives are real design, the effects can be perverse and counterproductive. And I think we’ve covered that. Yeah, about the problems that can happen. If you have badly designed schemes. People don’t work together. I mean, you could even have some people who are deliberately they could sabotage the work of others to make themselves look better. It’ll be happening, that hoard information. Yeah.
Tim Hughes 44:49
But that’s where I think the flexibility and you know giving allowing people to contribute towards these schemes, I think would be a good thing. And you can only imagine that that would make for a better scheme if people had a little bit of autonomy or choice in in how they worked.
Gene Tunny 45:08
Yeah. Another couple of good points on the cons when performance is difficult to measure or when employees intrinsic motivation is relevant, performance related pay may generate distorted incentives and have unintended consequences on worker morale. So I think that maybe that’s the case where somebody thinks that, well, I’m actually making a huge contribution to the company, but because of the way that the incentive scheme is structured, and what what it measures, so particularly if you’re in a support role, so say the, it’s the, the bankers or the consultants who are getting the bonuses, but someone who’s in a support role, maybe they’re an executive assistant, and they’re not getting, they’re not getting a bonus, because their output is less the contribution they make to the profitability, the firm’s less recognisable, then maybe they get their morale starts to suffer. I don’t know if it’s exactly what they’re if that’s what they’re driving out there. But I think the point, that point makes sense to me that the other con that they identify is that linking pay to performance may generate excessive stress and be detrimental to long term performance. Now, I guess that’s correct. So this is where you got to get the balance, right? Because if you’ve got a lot of your workers compensation linked to performance related pay is also linked to performance. So a big part of their compensation is expected to be the bonus. And their normal salaries lower than that could put a lot of pressure on them. That could create a lot of stress for the worker.
Tim Hughes 46:46
Yeah, for sure. I mean, because there’ll be, again, industry specific, but depending on seasonal, or, you know, upturns downturns in markets, you know, can be things out of their control. So there’s certainly situations where you’re willing and able to work, and there’s no work there to be done. So, you know, real estate’s a good example of that, you know, when, when no one selling well, no one’s making commission, you know, so that would certainly be, you know, relative to the real estate market. But yeah, you know, yeah,
Gene Tunny 47:17
I’ve got to look more into exactly the compensation schemes there. I thought I understood it. But when I started talking about it with you, it was clear my level of understanding was not at the level it should be. So I’ll try and clarify that. But I think yeah, that’s a good example, where there is performance related pay, okay, well not try and wrap this up. I will end with the author’s main message, their final words here. So performance related pay is a relevant policy to improve firm performance, and competitiveness. Although the adverse effects on work intensification and employees physical strain and psychological stress should not be overlooked. Looking forward, new patterns of work from home and remote work will increase the relevance of performance related pay. Yep, yep. I think that’s probably true. Because it’s not about how many hours you turn up to the office for. I mean, one of the issues I had when I was in the workforce many years ago was because I, I like to walk around. And I mean, I like to think I did a lot of work when I was working for companies, or for public service, or whatever. But one complaint, and maybe this happens in every workforce, but there was one, at least one or two times when there was a complaint made that I wasn’t at my desk enough, or I wasn’t in the office, because I was that was walking around thinking about a problem, or I was out trying to hustle. And yet, I’d be someone would criticise me because I wasn’t actually at work. And that’s the wrong way to think about it, isn’t it? I mean, it’s, it’s what you’re achieving, ultimately.
Tim Hughes 48:59
Completely, I mean, I guess, you know, that would be a good case for, you know, what work has been done, you know, and who cares who’s walking around, it’s, you know, it’s very good for you. But if you’re getting the work done, because, I mean, that’s definitely a thing where people might be busy, they might be work for many hours, but they’re not necessarily being very productive. And when there’s presenteeism, where people can be at work, and just not very good. Yeah. And especially when they’re side gigs happening, you know, because their energy and thoughts are being put to another, another pursuit. So in containing that, now, if any managers out there looking to encourage intrapreneurship, you know, this is possibly worth looking into.
Gene Tunny 49:43
Yeah, we’ll have to get Phillip Di Bella on the show to chat about that, because Phil’s just around the corner.
Tim Hughes 49:49
Yeah, he’s got a lot of good stuff. And that was when I hadn’t heard that term before, intrapreneur. But it makes a lot of sense because it’s an outlet for people who have ambition, but don’t Uh, you know, you don’t necessarily have to leave your job to have ambition. So yeah, it’s, um, depends on the culture within that company whether they can allow that to happen or not.
Gene Tunny 50:10
Exactly. Okay. Do you have any other thoughts, Tim, before we wrap up?
Tim Hughes 50:14
No, I just got to make sure that whatever I’m eating is dead before I eat it and hopefully, hopefully I can bring something in to keep me sustained.
Gene Tunny 50:20
Fanastic. Tim, thank you so much.
Tim Hughes 50:25
Thanks, Gene. You’re welcome.
Gene Tunny 50:33
Okay, I hope you found that informative and enjoyable. My main takeaway from looking at performance related pay is the importance of getting the design of the scheme right. So you actually motivate good behaviour. You end up with some bad behaviour if you don’t get the incentives right. As Tim and I discussed, on balance performance related pay schemes can be beneficial and boost overall business productivity and profitability. But that’s not guaranteed. We see that individual incentives work better when teamwork is limited, as in real estate, but they can be problematic when teamwork is required. One thing I should have noted in the main conversation is that rewards don’t have to be monetary. In a 2009 article on performance related pay, which I’ll link to in the show notes The Economist observed in their 1982 book In Search of Excellence, Tom Peters and Robert Waterman mentioned the great variety of non monetary incentives used by the excellent companies that they studied. They said that excellent companies actively look for excuses to hand out rewards. at Hewlett Packard, for instance, they found members of the marketing team who would anonymously send one pound bags of pistachio nuts to salesman who sold a new machine. That’s a bit of a quirky example, but it does illustrate that rewarding high performance and then be complicated. Celebrating wins with a team dinner or pizza night could be good for team morale. For example, I’ll put links in the show notes to articles mentioned in the episode, including to the eyes at a article on performance related pay and productivity. It’s really good and it’s easy to read. I’ll also add some links on how real estate agents get paid and on performance related pay at McDonald’s. This is how you can check out what McDonald’s has tried in Australia and in the UK. The Australian scheme does look better designed than the British scheme, because the Australian McDonald’s employees get extra benefits based on the individual performance rather than their team performance. My suspicion is that a group based incentive may be too weak to motivate performance. That said individual incentives can be difficult to apply when people have to work very closely together, and where it’s difficult to assess individual contributions. And in many businesses, teamwork is probably something you want to encourage. So it may be that you need to have a group incentive scheme of some kind, or an incentive scheme based on a mix of individual and group incentives. I’d say that you need to look at businesses and their workforces on a case by case basis to work out what’s right for that business. For now, I’d note that one of the major concerns with group based incentives is the free rider problem. Some employees may try to freeride on the efforts of other team members. However, there’s an intriguing new quasi experimental study which suggests the free rider problem may not be a big deal for some companies. The study was done by Anders Frederickson, Daniel Hanson and Colleen Flaherty Manchester, from Office University Siemens Gamesa in the University of Minnesota respectively. The researchers have written about the study in an ice at a discussion paper and an Avox EU article that I’ll link to in the show notes. They took advantage of the fact that a European dump truck manufacturer, high dreamer, introduced a group based incentive scheme and it’s planned in Denmark but not in Germany. Hence, they could treat the workers at the plan in Denmark as a treatment group, and the workers in Germany as a control group. The researchers then use what’s called difference estimation to establish that the group based incentive scheme increased performance by 19%. The researchers note that, despite free writing concerns stemming from group based incentives, being part of a group may have influence workers paid based on the performance of the group will naturally not tolerate that team members shirk, which leads to peer pressure. And team members even without peer pressure may feel some kind of internal pressure such as guilt or shame if they do not deliver in a team context. Okay, that sounds like a fair point to me. This new study adds to a small number of existing studies that actually suggest group based incentives can be beneficial in some businesses, particularly whereas there’s a close knit group which can prevent members from free riding How widely applicable is this finding? It may be too hard to say based on the limited number of studies so far, I might have a closer look at the evidence regarding performance related pay schemes and return to the topic in a future episode. But for now, I hope the discussion in this episode helps you understand the relevant issues and trade offs. Okay, please let me know what you think about this episode. What were your takeaways or thoughts on performance related pay? Do you have any experiences with performance related pay that you’d like to share? Where you’d like me to take a closer look at some of the issues covered? I was thinking that it may be worthwhile having a bonus episode discussing the methodology of the hydrangea study, as the difference in differences method can be very powerful. Let me know what you think. Feel free to email me at contact at economics explore.com. I’d love to hear from you. Thanks for listening. rato thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact@ economicsexplored.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.
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