Companies who reward their employees on the basis of specific goals typically perform better. It is, however, crucial to select suitable goals and choose the right time to introduce them, argues University of Amsterdam Professor Jan Bouwens, who carries out research in this field.
The research by Professor Jan Bouwens covers a vast field, which he describes as research into ‘control systems within companies ensuring people’s contribution to the creation of value’. By this, Bouwens refers to ‘social value’, which includes – positive – effects within the company as well as effects on society as a whole. One of Bouwens’ research topics concerns the identification of incentives leading to the creation of the highest possible value by managers and staff within companies. Bouwens believes that using performance-related remuneration schemes has positive effects. ‘Research shows that companies applying performance targets have a higher chance of creating additional social value. However, selection of the right goals is key.’
Bouwens has been Professor of Accounting at the Faculty of Economics and Business at the University of Amsterdam (UvA) since September 2015. Previously, he held a similar chair at Tilburg University, and was also part of the academic communities of a number of universities including Harvard and Cambridge. Bouwens regularly investigates corporations as part of his research activities.
According to Bouwens, there are numerous performance indicators which a company can use to influence the behaviour of its managers and staff. 'Any standard will have its disadvantages. So you should search for balance, but introducing several targets in conjunction is not a solution. Steering based on too many indicators creates confusion for managers and may result in ineffective work processes.’
Bouwens cites the example of the managers of a food manufacturer. They receive extra payment on the basis of profits made. However, the company also highly values sustainability. 'Managers could be called to account for sustainability results, or the ‘green factor’ in their profits. But this may very well result in vague performance targets. The targets would be too ambiguous and become ineffective', says Bouwens.
Another example concerns rewarding customer satisfaction along with a profit target. ‘Contrary to what one might believe at first glance, customer satisfaction and profits do not always go hand in hand, so targeting both can result in opposing incentives.’ Bouwens refers in this respect to the situation at banks. ‘Prior to the credit crisis, customers were very satisfied with the loans they got. However, when the credit crisis occurred, debts turned into a heavy burden and customers suddenly became dissatisfied. It must be stressed that banks need to value current and future customer satisfaction alike. To do this effectively, banks should push to use the knowledge of their own staff to assess what loans mean to a customer in good times and in bad times. For the bank and for society as a whole, the best results are achieved when bank managers can unambiguously focus on long term profits.
On the basis of research such as this, Bouwens concludes that a performance indicator which is related to profits best supports the company’s objective of creating value. Bouwens believes that profit is an univocal target, which moreover allows for flexibility.
Yet, a standalone profit target can be harmful, Bouwens found in an investigation of a major European transport company. The managers of the various divisions that each cover a large city and its periphery have to account for the profits within their own division. This had a negative side effect, however. The largest and most powerful divisions were able to land the most interesting and lucrative orders. The smaller divisions suffered and the outcome for the company as a whole was suboptimal.
This was partly alleviated by promoting social cohesion within the company. ‘The tendency to secure orders to the detriment of other divisions was lower among divisions led by managers who met each other in person regularly,’ says Bouwens. ‘It would appear that knowing each other encourages more social behaviour.’ When this was found, the company introduced quarterly meetings for all its division managers while carefully limiting attendance to avoid events too big to be successful. Profits could be maintained as a performance target while smoothing out the rough edges.’
Bouwens points out that it may be feasible when managers are to account both for the profit of their own division and that of the company as a whole. ‘This can have positive effects in companies where managers can choose to cooperate. If cooperation is not possible, part of the staff may no longer identify themselves with the company as they are to account for results which they cannot influence.’
Bouwens mentions the positive example provided by a food manufacturer that he investigated. This company is made up of a large number of divisions, some of which engaged only in internal deliveries of semi-finished products. ‘As a result, when demand for semi-finished products from other divisions diminishes, the division manufacturing these semi-finished products will face higher costs, and subsequently raises its prices. And this in turn may result in a further decline in sales of the end product by other divisions. When the managers of the semi-finished products division are expectedto account for both the total profit and the division profit, they will make efforts to reduce their costs and lower their prices rather than increase them.’
Special circumstances may require special measures. In the 1990s, the American airline Continental Airlines almost failed because their planes almost invariably arrived behind schedule. The board of the company decided that the site managers were only to account for timely arrival of the aircraft and would no longer determine their budgets nor the number of staff. ‘It worked perfectly, and planes began to arrive on time again.’ After some time, the company could return to its more traditional performance targets.
To conclude, Bouwens argues that careful thinking is required for determining how to define the profit variable that managers and staff are to account for. ‘It is of course relatively easy to increase profits in the short term by suspending all investments and so reducing costs. But in the long term, this will damage the company.’ This brings Bouwens to the conclusion that companies should define profits in terms that allow managers to focus on a longer term, such as the Economic Value Added (EVA), a widely used performance management measure.
More information? Please email J.F.M.G.Bouwens@uva.nl.