How may compensation structures contribute to risk in organizations?
Executives design strategies to lead their corporations toward excellence. In order to be effective these strategies must be communicated, so individual goals and objectives are created to align responsibilities across the organization. These objectives often are tied to monetary rewards for success. Employees, for the most part, want to succeed, and if there is a monetary reward attached to their actions, they will be particularly industrious. If the objectives are not carefully communicated, the personal motivation to achieve a monetary reward may conflict with the intended strategic outcome. The following three examples discuss how unforeseen corporate risk was created from poorly designed employee objectives.
A company had product lines that were marketed under several different brand names. An annual revenue increase was an overall corporate goal, so quarterly sales objectives by product and brand were given to the sales team. As they created their Annual Plan, they discovered that some of the sales goals could not be achieved for the first two quarters so they included revenue from new models that would not be introduced until months later. Unfortunately, the Annual Plan was the basis for production planning and procurement. Component inventories were stocked in the first quarter, and when the design for the new models changed, obsolescence resulted. Instead of inspiring sales efforts, the objectives resulted in manipulation that skewed financial planning, resulted in obsolete inventories, and provided an unrealistic basis for measuring progress.
Increased productivity was a corporate goal at a manufacturing plant. To inspire performance, specific goals were set for the different phases of the manufacturing process, and production workers were included in a quarterly bonus payout tied to the measurements. The objective of fewer mistakes on the production line was measured by the amount of scrap material that was generated. After some time scrap significantly decreased, and the plant celebrated a more accurate and productive process. An audit however found that scrap reporting was being manipulated, and scrap materials were being hidden. Instead of a more efficient production process, the result was sabotage and an incentive to smuggle items out of the plant.
A food processing plant was focused on quality. Compliance with government regulations and a good reputation in the marketplace were mandatory for success. Objectives tied to compensation were given to the quality control department to ensure that there would be no issues. One of the responsibilities of the quality control supervisor was a subjective smell-touch-taste test on food product that had been held in the lab several days beyond the shelf life. The purpose was to document results so that faulty processing functions affecting food storage and distribution could be addressed. As part of the supervisor’s performance plan, a 95% pass rate was defined as the goal for this test. In the weeks that followed, the success rate steadily rose. Was the quality of the product truly improving, or had the supervisor been motivated to be less rigorous in his assessments?
Objectives that aim to drive a specific behavior or performance goals that are beyond an employee’s control are often open to manipulation. Unintended consequences may expose the organization to risk or fraud. When designing compensation strategies to achieve corporate goals, executives must recognize the actions (both positive and negative) that will be motivated. Then, they must monitor measurements carefully to verify that improvements actually reflect the desired outcome.
This post was contributed by Janet Hintz, a Director with Vonya Global. Janet is a seasoned advisor, focused on helping her clients find alternatives that align financial and operational objectives, increase productivity, and strengthen internal control. If you would like to contact or connect with Janet directly you can find her profile on LinkedIn: https://www.linkedin.com/in/janethintz.