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Incentive Pay Might Gets Results,But Not Always The Ones You Want

by Allan Z. Gilbert
Posted On: 2/14/2010

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Allan Gilbert, vending, vending business, vending route, vending machine, automatic retailing, office coffee service, OCS, foodservice, coin-op, coin machine, vending news, small business, business trends, service economy, retirement investment

After almost two years of finger-pointing, it is clear that there is no one villain who can be blamed for the problems facing the economy. Everyone -- politicians, bankers, mortgage brokers, Wall Street, rating agencies, speculators and even ordinary citizens -- must accept some level of responsibility for what we allowed to happen. If we hope to prevent it from happening again, we have to identify our mistakes and learn from them. Congress claims to be working on financial regulatory reform. However, I will be amazed if any level of substantive change comes out of those efforts. Legislators are beholden to lobbyists, and lobbyists are supported by the industries being regulated. The fact is we have the best politicians that money can buy. It's fairly easy to identify a major mistake after it has been made, but it will not be easy to change things. I refer, specifically, to the practice of incentive pay - and I promise the problem is relevant to vending and OCS.

Hundreds of millions of bonus dollars were paid to bankers, brokers and insurance executives as incentive pay, because they made their respective firms wealthy. They designed and sold financial instruments, securitized mortgages and collateralized debt obligations (CDOs) that were so exotic that hardly anyone, even in the financial service industries, understood them or their inherent risks. They convinced their own managers and customers to buy, hold and trade extremely high-risk securities simply because they earned inordinate profits by selling these products. As a result, they provoked a crisis that almost destroyed the world's financial systems.

How could this happen? Incentive pay is supposed to reward people for doing the right things, not the wrong things. Were the incentive programs poorly designed? Is there some deep structural problem with incentive programs in general?

Barry Schwartz, an author and psychology professor at Swarthmore College, wrote a fascinating article in the November 23 issue of Business Week titled "The Dark Side of Incentives." He argued that when incentive pay programs were first introduced, less than a generation ago, they were widely hailed as a miracle of human engineering because they focused people with "laser-like precision" on attaining worthwhile goals. After 35 years of research, however, he has come to the conclusion that there are serious, systemic flaws inherent in most incentive pay programs. He said: "They [incentive programs] get you exactly what you pay for, but it never turns out to be what you want."

Schwartz's reasoning was based on the fact that most incentive programs tie an individual's compensation to some sort of index. For example, it would not be unusual for a company to agree to pay its chief executive a bonus dependent upon how well the official managed to increase the value of the company's stock, as reflected in its price per share (the index).

The compensation committee would agree to this incentive contract, believing that the chief executive would increase the share price of the stock by improving profits, as share price is usually a multiple of profits. It assumed that in order to do this, the CEO would implement programs to increase sales, reduce costs, develop new products, raise prices and improve advertising. Unfortunately, it doesn't always happen that way. There are other ways to influence the share price of a stock.

When a person's compensation is tied to the share price of a stock, he could find ways to manipulate stock value that are not necessarily in the best interests of other stockholders, and have nothing to do with real profits. For example, he could use the company's hard-earned cash for share buybacks. This doesn't increase profits, but it raises the price of a share by reducing the number of shares outstanding. He also could commit the company to a course of action that sounds exotic, costs a lot of money and increases the price per share, but that will result in no real, continuing benefit to the bottom line - and he might know that. He doesn't care about continuing profits. He just wants to maximize this year's bonus based upon share price as of a fixed date.

When the pay of smart people is determined by an outside index, they will find a way to move the index up, often without improving the company, and in some cases actually jeopardizing its continuing existence.

Witness what happened on Wall Street. Traders loaded their companies' balance sheets up with toxic assets that produced immediate profits based upon accounting standards approved by the Financial Accounting Standards Board. They did so because their incentive compensation was tied directly to the value of profits they brought into the firm. The fact that the ownership of those assets posed a real and continuing threat to the operations of their employer didn't even enter their thoughts. They could not have cared less about the risks to, or even the survival of the company that employed them. They were only concerned with the millions they would make in bonus pay. Schwartz contends that incentive programs not only don't work most of the time, but they often backfire.

Consider the example of Israeli daycare centers that, in an attempt to influence parents to pick up their children on time at the end of the day, started to fine the parents for being late. Interestingly enough, when the fines were instituted, the incidence of lateness actually increased. It seems that incentives (in this case, a disincentive) tend to remove the "moral dimension" from decision-making. The parents knew that they should arrive on time to pick up their children. However, they came to view the penalty as a fee for service. When there is a fee involved, they ask, "What's in my selfish best interest?" When no money is involved, they ask, "What are my responsibilities - to the other parties, or to society, or to my country?"

Schwartz concluded, "Despite our abiding faith in incentives as a way to influence behavior in a positive way, they consistently do the reverse."

He obviously feels that incentives have absolutely no redeeming social value. While I agree with much of what he says, I think his condemnation goes a bit too far. There are some situations in which incentive pay actually works well.

In my September 2006 article about route driver commissions, I made a case for commission-based pay for employees who have full control over their level of productivity. For example, "stitchers" who work in a sportswear factory are customarily paid so much for each garment they sew. It's called "piecework." The faster they work, the more money they make; of course, they are penalized for work that doesn't meet quality standards.

Similarly, a salesman who doesn't punch a time clock - and decides how many calls to make each day and how hard to work - should be compensated on a well-designed incentive program. The harder and more effectively he works, the more sales he will make. The salespeople who make more sales should make more money. Up to this point in the discussion, the salesman has total control of his productivity, so sales commissions work well.


But suppose we gave the salesman license to vary the selling price of our products? Would a commission on sales still be appropriate? The salesman could "game" the system by offering customers lower prices to improve his sales record. Under those circumstances, it could be said that commissions should be based upon the relative profitability of the sales, rather than the actual level. Also, commissions should only be paid after the customer has paid in full for the order.

Another area where incentive pay makes good sense is the waitstaff in a restaurant. They have total control over their productivity. They are in a position to influence the size of the check by suggesting menu items to patrons; they can make themselves indispensable to the customer by providing great service; and they are in a position to insure that the food is delivered to the customer's specifications by appropriately conveying the order to the chef. A good waiter is the consummate commission salesman. The best earn great tips.

Because that article was about route driver commissions, however, I was forced to conclude that vending and OCS drivers have very little substantive control over their productivity. Therefore, compensating them on an incentive basis for a substantial portion of their pay probably didn't make a lot of sense. I agree that the driver has a lot of control over how fast he works, and how much time he wastes each day. However, speed of work and lack of time wasted, while important, are the smallest components of a highly productive route. The more important profit drivers for route productivity are:

1) Route scheduling: getting the driver to the machine only after enough product has been sold to justify the cost of service;

2) Eliminating wasteful trips into the location to check inventory;

3) Eliminating order picking in the truck (high-cost center). Replace it with pre-kitting in the warehouse (low-cost center);

4) Designing individual machine plano-grams that maximize the level of sales at each location;

5) Stretching the number of days between services as far as possible, to maximize sales volume per service.

Unfortunately, all of these functions are controlled either by management or supervisors. So why are we paying our routepeople more than half of their week's pay as a commission on sales?

Please don't misunderstand. I believe that some level of a route driver's pay should be incentive-based, if only to encourage him to work faster and not waste time. These are variables he can control. However, it doesn't require an incentive equal to more than half of his pay to focus his attention on these two items.

I did an informal survey, back in 2006, which found that the most common basis for route driver pay was a base salary plus a commission equal to 5% of sales. And total driver compensation, if memory serves, was approximately 9% of sales. If you trust those percentages, it suggests that drivers were earning almost $400 a week in commissions in 2006. Wouldn't an additional $100 or $150 a week convince a driver not to waste time and work faster? Why does it take $400 to get his attention?

Whenever I have this kind of discussion with operators, their eyes tend to glaze over and they say, what difference does it make? There is no way we can lower our drivers' wages. And they are correct; they can't and shouldn't attempt to do that. However, they can and should attempt to alter how the total is calculated.

This industry is on the brink of achieving a sorely-needed quantum leap in route productivity as DEX technology begins to pay off. But the way most operators have structured their route compensation plans insures that most of the savings in productivity will go directly to the drivers, unless some changes are made.

If you had 10 routes averaging $8,000 a week, for example, and your drivers earned base salaries of $350 per week plus 5% of gross sales, your average driver would be earning approximately $750 weekly. (Your total route support costs would obviously be much greater when you add in the costs of vehicles, benefits, uniforms and supervision.) If you were able to consolidate your routes using DEX technology, and do the same amount of business ($80,000 a week) with seven route drivers rather than 10, unless you changed the way drivers' salaries are calculated, you would give away most of the savings.

With seven routes doing $80,000 a week, each now averages $11,428, or an increase of $3,428 per week over the previous $8,000 average. At a commission rate of 5% of gross sales, the drivers have been granted gratuitous pay increases of approximately $170 a week for working the same number of hours. They won't be working any harder, but will be working much smarter due to your hard work and capital expenditures. They will, however, get to keep more of the savings than the operation's owner, unless the basis of route driver compensation is changed.

As I said, you certainly won't be able to reduce the driver's total pay, nor should you; but you can and should renegotiate how it is calculated. Offer a much higher base salary and a much lower percentage of gross sales. And do it now, before you implement the productivity improvements.

ALLAN Z. GILBERT founded New England Vending Corp. (Lowell, MA) in 1959, and led its expansion into a leading regional provider of full-line vending, coffee service and foodservice management. He founded Data Intelligence Systems Corp. (DISC), a computer software publisher and system integrator for vending, and Lemon Tree Systems Inc., which franchised a vending-and-cafeteria concept. He established Merrimac Financial Associates in 1984, and it made an initial public offering through the New York Stock Exchange in 1998. He became managing partner of The Merrimac Consulting Group in 1988.