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Do Incentive Plans Really Drive Performance?

20 Mins


By Team Artha

If your Head of Sales is constantly tweaking incentive plans to improve sales performance, it is a good idea to enroll him in a professional course on “Sales Force Management”. This is an early sign of losing the plot.


In one’s early years of organizational life, one can’t be faulted for concluding that every problem can be fixed by an appropriately designed incentive plan. You were fresh out of college, where you were conditioned to believe that the world is rational and everyone has been wired to maximizing their value. We were all told that Adam Smith’s proverbial invisible hand drove the free market. It is only after one has been exposed to the ground reality for a sufficiently long period of time does one figures out that the reality on the ground is different from the assumptions that economists made in their rather simplistic models. Startups are much more prone to failures on this front because they do not have the advantage of experience with what does not work on the ground and hence tend to go through the whole cycle of trial and error.

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 folks need to be incented for driving account growth”. “Our warehouse staff needs to be incented to turn up on days when there is peak demand”.
Irrespective of what the problem was – skill set of the individual, manager’s competence, or lack of role clarity – the solution proposed invariably centred around the creation or tweaking of an incentive plan. There’s been substantial debate on what incentive plans really accomplish. What are the objectives with which incentive plans are designed and implemented?
Do incentive plans help retain talent in a competitive market? Do they help align managerial remuneration and wage bill (a significant chunk of the cost) with a company’s performance? Do they drive performance and ultimately reduce the cost to revenue ratio? Do they simply serve as a motivation tool?
It’s helpful to understand what incentive plans can achieve and what they can’t.

My experience in implementing incentive plans and active involvement in the associated debates leads to some interesting conclusions:

  • Most real problems cannot be solved by an incentive plan. In some situations, however, once the solution is determined and implemented, it could be cemented and accelerated by an appropriate incentive plan.
  • When salaries constitute a significant chunk of the total cost, it’s common to see a greater percentage of variable pay in the pay mix. This improves the operating leverage and preserves profitability in difficult times. However, even when an incentive plan is designed to improve operating leverage, it’s common to publicly posture that it’s the incentive plan that will drive and motivate performance.
  • Incentives can serve the purpose of rewarding “results”. Here the purpose is not to drive performance but to reward performance. There is a slim chance that by rewarding for performance, you can also drive performance. However, the context and plan design that reward performance is very different from contexts and plan designs that drive performance. Plans that reward performance (rather than motivating performance) have a significant component of performance being determined by collective outcomes that are not necessarily in the direct control of the individuals concerned. In any case, rewarding “results” is generally considered both fair and safe. Take the case of top management, whose bonuses are determined by the startup’s performance, which is an outcome of the interplay between several complex factors. It’s not easy for the board to assess to what extent such performance was influenced by what management did (or did not do) and to what extent it was influenced by factors outside management’s control. It’s possible that poor performance was because of severe headwinds, and perhaps, no other management team may have done any better; on the other hand, when the startup has done well, a different management team may have delivered better results. Rewarding for results is one of the most common objectives of an incentive plan. I don’t think there’s a very strong causal link between an incentive plan and “results” in most cases, except in some contexts and with special plan design. However, I have found that obtaining support for an incentive plan from a sponsor is easiest if you argue that it will motivate performance.
  • In some contexts, the retention of talent is the most important driver of an incentive plan. Take the case of a startup where investors want to maximize medium-term growth and value and have identified stability in the management team as an important prerequisite. The Board may come up with an attractive gain-sharing plan where a percentage of the startup’s valuation on exit is shared with the management team. One can debate whether the purpose of this plan is to motivate the management team to create value or whether it’s really to keep a good team stable during this critical period. I believe that the primary purpose of a plan like this is retention. A poor quality management team cannot create better value just because a gain-sharing plan has been put in place. Stock options too can be viewed as a form of incentive. Unless grants are tied to performance, options do not drive performance. But options can drive retention, especially if the employee has to leave significant value on the table in case of a premature departure. As long as you clearly understand the objective your incentive plan accomplishes, it is fine. If you design an incentive plan with features that drive retention and expect it to drive performance, then you are being naïve.
  • Having said this, 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. The origins of incentive plans can actually be traced to these situations. 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 (or incentive) being anywhere between 40%-60% of total compensation. If the incentive is a minuscule part of their total compensation, it is unlikely to drive performance. Every individual makes an unconscious tradeoff between the amount of incentive they would earn through extra effort and the value of leisure and relaxation (whether on the job or outside). If the incentive is a small component of the total earnings, the trade-off easily tips in favour of leisure and relaxation and hence does not drive performance. I am surprised how some seasoned leaders don’t seem to figure this out. There was a case where the leadership team at a startup had instituted an incentive plan for their blue-collar workforce where the incentive that an individual could make on meeting targets was around 5% of the guaranteed compensation, and one had to work hard to hit the target. You can clearly imagine the outcome. It just didn’t drive performance.
  • Another common phenomenon is that the pre-sales and delivery teams keep coming up with a case for some kind of a commission on sales they are indirectly driving. These teams seem to generally believe that the sales personnel they support are making millions in commissions while they remain unrewarded even though their support is instrumental in winning these deals. They don’t seem to get the idea that a sales commission plan is designed around the basic belief that you pay for “results” and not for “effort”. Compensation structures for sales folks, therefore, are designed around two broad principles: a) the base pay is just sufficient to keep the lights on, and b) in good years you can hit the jackpot, while in bad years you can barely pay the fees for your college-going kids. Sales folks are used to this, and this gives them the adrenaline rush. The presales and the delivery folks are not comfortable with these consequences. They are used to reasonably steady incomes. Their pay at risk is a minuscule component of their total pay. And their guaranteed pay is pegged at a competitive level. Therefore, while they yearn for a commission on the sales they drive, they are not willing to compromise on their steady and reasonably well pegged guaranteed compensation. Their expectation is that the commission is on top of an attractive and competitive base pay! In other words, they want to have their cake and eat it too! This does not work.
  • Tying incentive payouts to a laundry list of objectives (or key results) is another common flaw. So, the way this plays out is an on-target incentive amount is defined – say $10000. This is tied to ten objectives. There could be some objectives with a weight of 5%. A weighted average performance is computed at the end of the period, and the payout is linked to this. Can you imagine an individual paying serious attention to all these objectives or even being able to discriminate between them? The incentive is being wasted by linking it to too many things. Obviously, not all men are equally important. If you think hard, you will figure out that some are more important than others. One reason why managers do this is they try to bung in everything that they expect the individual to do. If customer-facing people are not turning up in assigned uniforms, instead of taking some tough actions, you try and put this as one of the ten objectives with a weight of 5%. It is anyone’s guess whether this will achieve the desired results. You cannot escape discharging your role as a manager and expect the incentive plan to do it for you. This brings us back to the first point, which is incentive plans can only cement a solution and not be the primary solution.

Do Sales Commission Plans work?

Sales commission plans are structured with two primary objectives:

  • Align the “cost of sales” to sales outcomes (I am certain that more than half the sales folks would not agree that this is an important objective)
  • Drive sales outcomes by providing the carrot.

Great sales leaders completely understand that the right sales skills are what drive sales, period. Incentive plans just act as the proverbial icing on the cake. Therefore, they don’t spend too much time on ‘engineering’ the commission plans and instead spend almost all their time coaching their sales reps and building a great sales team – a good part of which is letting go of those that are not shaping up and hiring new ones. The sales function, more than any other function, needs constant churn and clean up to maintain a healthy ability to deliver results. If you see your sales head spending time on engineering sales commission plans, you have a serious problem on hand.

Selling at startups is very different from selling at large mature companies.

A lot of the selling that happens at startups is driven by evangelistic founders. I have seen two startups where sales leaders who came with a terrific track record at large companies fail spectacularly. One was a niche provider of IT services that also had aspirations for product development and consulting. They didn’t see themselves as just another low-cost provider of services. This startup had graduated to a stage where it was critical to hire a global head of sales. They hired someone who had led large global sales teams at a large and respected provider of IT services. The failure stemmed from this individual’s inability to deeply understand why clients bought from the company he had just joined and how this company was different from the much bigger players in this space. He continued with the same spiel he dished out when he was with his previous company. He struggled to adapt and make changes to his selling style. He was not sufficiently hands on either, and over a period of time, the founders as well as the rest of the culture torchbearers in his new company found it difficult to relate to him. What the founders had expected was someone who understood the discipline and rigour of the sales process well but could adapt to a different domain and a fundamentally different value proposition. The second example is of a provider of knowledge services in the research space. This startup, too, was at a stage where it was critical to hire a global head of sales. They hired someone who had led large teams at reputed American MNCs. In the final analysis, in this case, too, both the outcomes and the underlying reasons were exactly the same as in the previous case. Both the new heads of sales had to leave within a year.

In Conclusion

I have often seen managers trying to substitute elementary management processes with incentive plans, hoping they’d work. They don’t eventually. Oftentimes, when managers ought to be conducting better reviews, having difficult conversations, teaching their team members how to do a job better, communicating expectations, or providing direction and coaching, they suggest implementing an incentive plan. It’s not difficult to fathom why. By suggesting that an incentive plan should be put in place, they are buying time, and if things do not work, the problem was with the plan design! The subsequent discussion goes somewhat like this, “can we try and tweak the plan? Maybe we should have a sharper payout ratio for achievement beyond the target? Or should we have a threshold up to which we do not pay an incentive?” Well designed incentive plans in the right context and with the right objective and expectation is a perfectly smart thing to do, but using incentive plans to solve for more fundamental management failures can be setting of a culture of a weak-kneed approach to dealing with problems.

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Team Artha