Incentives Drive Behavior

One of the most basic facts of human nature is that incentives drive behavior. As children, we quickly learn that we only get dessert if we eat our vegetables. Punishments, or disincentives, influence behavior in the opposite way.

This concept extends to the workplace and to all levels of organizations. But what continually fascinates me is how many business problems can be explained, at least partially, by incentive misalignment.

Let me give a real-life example. Organization X was struggling with excessive inventory at certain retail locations. The regional manager defended the high level of inventory using consumer expectations of immediate product availability and long lead times from the manufacturer. A new leader then arrived and was skeptical about the situation. She proceeded to change the manager’s primary performance metric from factory sales to retail sales. By re-aligning individual incentives with broader organizational goals, the leader influenced the regional manager to reduce inventory and only hold what was needed to support end customer sales.

The idea that incentives drive behavior is by no means a revelation. It is rather intuitive and taught in nearly every management course at business school. An organization is a group of people working toward a common goal. People are humans, and human actions (behavior) are driven by incentives.

So, if it is widely known that incentives drive behavior, why do individual incentives so often end up misaligned with broader organizational goals?

Two probable explanations are competing priorities and the flaw of uniform incentives. First, most jobs require employees to deliver on multiple performance objectives. Even with appropriate incentives for each deliverable, the relative importance of individual objectives will wane from time to time. Second, most companies utilize standardized incentives which invariably do not appeal in the same way to every individual.

However, the most common explanation can be summarized by the old adage: actions speak louder than words. In my experience, while managers are rarely unaware of the correlation between incentives and behavior, they often hesitate to actually change performance metrics to align with organizational objectives. In other words, they view change as a last resort. They believe behavior can be adjusted through verbal or written directives or disincentives.

Who hasn’t heard a manager say, on top of X (the primary objective) we need to also drive towards Y? If Y is an organization goal, then performance metrics should be physically adjusted to elicit behavior aligned with Y, in addition to X. Employees are humans and humans react most acutely to real incentives.

As I face business problems, more and more often my first line of questioning is not strictly finance- or market-related, but about who owns the relevant decision rights and what their associated performance metrics are. If a misalignment exists, I strongly believe managers should more seriously consider changing incentives as the first move, not the last.