Why are rewards tied to individual performance so dangerous?
WOMACK’S YOKOTEN - When managed poorly and tied to the wrong performance metrics, financial rewards can seriously damage your organization, Jim Womack warns in his latest column.
Words: Jim Womack, Founder and Senior Advisor, Lean Enterprise Institute
In the mid-2000s, toward the end of the Old GM, I closely observed an effort to "lean" the office processes at General Motors. The President of GM North America believed that GM had matched Toyota's productivity and quality in its assembly plants (which was almost true.) "Now", he said, "we will beat them in the office!"
Thirteen value streams were picked for analysis, for example the process of designing and building vehicle prototypes for testing, a task that challenged GM's highly vertical organization because many functions were involved. At the first report-out on the findings about the current-state value streams, the President asked his senior management team if they had any questions about what had been discovered and about the proposed experiments to countermeasure highly visible problems.
There was a long silence and then the global purchasing director said, "I have only one question. What will this do to my bonus?" I was floored and immediately defaulted to "bad people" analysis. I wanted the President to fire this bad person on the spot. How could anyone think their bonus was the point of this exercise rather than building a more competitive company, especially when GM was sailing toward the falls?
But on reflection I realized that the purchasing director had simply taken the logic of executive bonuses to its logical conclusion: He was being graded individually on a set of performance metrics and his bonus was quite large in relation to his total compensation. It was only human that he wonder how some of the experiments would affect him personally. What was unusual about his behavior was only that he had said out loud what every other senior manager was probably thinking!
Perhaps I had been naïve to that point about the effect of incentives on managers. I suddenly realized that individual performance metrics, when tied to large individual bonuses, are a potentially lethal combination for an organization. Yet the common view amongst senior managers and shareholders in most companies (then and now) was (and is) that gearing financial rewards to individual performance metrics – often mindless in my view – was simply common sense: Humans need incentives to perform at their best and [to make matters worse] these incentives should be for performance during a specified block of time (quarters and years being the most common), which churns demand and production without reference to customer needs or organizational capacity.
Since that day at GM I've done a lot of thinking about the lean take on bonuses. Here's what I've concluded:
"Standard bonuses" for every employee based on the financial performance of the company (or of a large business unit) can support the creation of a lean enterprise. Periodic bonuses for all employees as a percentage of their base compensation, geared to the financial success of the business, is what Toyota has always done. (It is also what my friend Art Byrne practiced at Wiremold in his years as CEO.) But, if bonuses in times of good results are good, compensation cuts in bad times are good too. This is what Toyota also did in 2010 when all employees went without their annual bonus and senior managers not only got no bonus but took a 10% reduction in their base compensation. (This in a company that had $25 billion in the bank!) Toyota's idea is that companies are in business for the long term (indeed, the very long term) and need long-term employees. So everyone needs to be flexibly compensated in order to sail a straight course through downturns while sharing in the upturns in order to ensure there is a long term for everyone. Think of this as the highest level of heijunka, to sustain stable employment despite spikes and troughs in the market.
But what about individual bonuses for good performance for senior managers? Should the CEO and the other C-suite folks get very large bonuses for good performance on selected metrics, bonuses far higher in the percentage of compensation than most employees? Here I always find myself performing a thought experiment: Would the CEO or COO or CFO or president of a business unit have performed worse without the incentive of a large personal bonus? Instead of smart ideas and long days spent deploying them, would they have proposed stupid ideas and spent a lot of time playing golf instead? My observation is that good managers working with a supportive team are always going to play with lots of energy whatever the amount of money on offer. Their sense of self-worth (more powerful than their sense of net-worth) depends on it.
So why don't the owners or shareholders just pay (perhaps considerably more) for the value of the job and forget about the enormous executive bonus? That is, pay for the value-creating work involved in performing a given role?
One answer, I think, is that neither owners nor investors have much idea of what this value-creating work might be and no means of monitoring it. So they default to the idea that large incentives are effective for ensuring good performance and leave aside questions about the actual work needed and how it is performed. They then have the satisfaction of saying that they have done their job as financial stewards by setting goals and measuring the results ("holding their feet to the fire") without actually having to think about the work or do much work themselves. This is classic modern management behavior at the level of organizational governance.
A second answer is that good senior managers – whatever those are – will be recruited by other firms if they don't have a pot of gold in prospect. Maybe so. But, again, what are these managers actually doing to claim their prize? Might it be better to attract managers who are there for the simple pleasure of doing a great job for their team rather than the quick financial hit? (Remember that they will still get a good salary. And they will get a bonus as well if there are good business results, but at the same percentage as everyone else on the team.)
As we drill down in organizations, I fear that the effects of bonuses for individual performance get worse. At the level of function heads, and at the level below of plant and office managers, there are enormous moral hazards inherent in individual bonuses that measure results for one manager in only one part of the organization. These create the false impression that good performance can be the result of individual rather than team action. And they cause bad behavior because they are most easily achieved by burden shifting from one part of the organization to another. (Remember the GM purchasing manager.) They promote the opposite of team play.
Perhaps smart managers at higher levels can do sophisticated "metrics analysis" to devise individual financial bonuses that avoid these hazards. But why not instead judge managers and their teams on the state of their value creating processes and the actual steps taken to improve them? Creating stable processes producing to takt time and steadily improving them is the core work of managers at these levels, not something special that managers do to quality for a bonus! And when managers are failing in this core work they need intense coaching or, in extremis, a different job, not a bonus to "incentivize" them. By contrast, when they succeed the measures of their success should be visible to everyone. Eliminating financial bonuses doesn't mean eliminating psychic bonuses for achieving great results as a team.
Fortunately, at the bottom of organizations where frontline value creators live, piece rates, individual bonuses for meeting or exceeding total production targets, and group bonuses have largely disappeared in the developed countries. W. Edwards Deming knew they were terrible for quality and Taiichi Ohno knew they led to over production (the worst form of waste.) The answer pursued instead has been to determine the rate of customer demand (in order to calculate takt time) and to design everyone's work to produce steadily at the needed rate. The work of front-line and mid-level managers in this situation is to achieve stability in production and to steadily improve the value-creating process over time. Visible process measures for entire value streams, with coaching of managers to achieve them, serve customer needs as well as the business success of the organization. No individual bonuses needed. (Instead there are bonuses for everyone in good times.)
So, we have done the right thing about individual bonuses at the bottom of most organizations and Toyota has shown us how to do the right thing at the top. What's needed now is creative thinking about alternatives to individual bonuses in the middle.
Management expert James P. Womack, is the founder and senior advisor to the Lean Enterprise Institute. The intellectual basis for the Cambridge, MA-based Institute is described in a series of books and articles co-authored by Jim himself and Daniel Jones over the past 25 years. During the period 1975-1991, he was a full-time research scientist at MIT directing a series of comparative studies of world manufacturing practices. As research director of MIT’s International Motor Vehicle Program, Jim led the research team that coined the term “lean production” to describe Toyota’s business system. He served as LEI’s chairman and CEO from 1997 until 2010 when he was succeeded by John Shook.