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Commitments and incentives

December 18, 2012

“The question of incentives is fundamental to economics.”

This statement comes from a working paper published by Harvard Business School “When Good Incentives Lead to Bad Decisions“. As any mature contracts or commercial professional knows, incentives play a major part in shaping the way that bids and negotiations are managed. When pitched wrongly, they frequently lead to delayed involvement, withheld information and poor judgment. This observation is reinforced by the working paper, which reports on research findings that were based on loan decisions using three distinct incentive models.

Not surprisingly, incentives that were based entirely on contract closure led to a much higher level of accepted risk, with a 5% detriment to overall business profitability. Rewards that included consequences for actual performance led to a more conservative approach – and a 3% improvement in profits. These findings are unlikely to surprise many contracts professionals (who would point out that it is both Sales and Procurement incentives that currently distort behavior). But there are some other interesting points that emerged:

1) The scale of the incremental reward / claw-back for performance has to be quite large before it has a strongly beneficial effect.

2) The timing of payment is also key. Significant delay in granting the incentive reduces the impact and the quality of personnel.

3) The incentives appear to have a direct impact on judgment, more than on moraility. In other words, people did not make bad decisions just because they wanted to gain immediate reward; an incentive scheme that provided immediate reward instead leads them to believe that things are less risky than they truly are.

A problem with changing the system is that, while the effct on profits muight be positive, the impact on revenue would most likely be negative. Also, in circumstances where one company changed to a more balanced risk – reward system while its competitors did not, it might lose many of its most talented dealmakers, who would be incented to move to a less risky sales environment.

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