An academic classic, on the folly of rewarding A while hoping for B

In Kerr’s paper, An Academic Classic, On the Folly of Rewarding A While Hoping for B, he discusses how humans often set up systems that do not encourage the behaviour that is actually desired.  One of the examples that I found to be interesting was that of soldiers in Vietnam versus soldiers in World War Two.  The way that the soldiers were being rewarded in WWII was with the knowledge that if the war is won, they will go home; in Vietnam, the end of the war was not well defined and soldiers had to stay to fulfil their tour of duty no matter what was going on.  The difference in these rewards was the cause of the difference between the disciplined and obedient WWII soldier and the mutinous Vietnam soldiers.  In both of these cases, the Generals were hoping that their soldiers would be obedient, but only in one case were the goals of the soldiers in line with the goals of the Generals.    The same principles apply directly to agency issues where managers may be compensated in a way that rewards behavior that is really the opposite of what the company needs for sustained performance.   The errors in this area are summarized by Kerr; in business we hope for long-term growth and environmental responsibility while rewarding short term (quarterly) results.  It is expected that employees will employ teamwork, but they are rewarded for individual performance.  Employees and managers are expected to report bad news early and exercise candor, but they are rewarded for reporting good news and agreeing with their superiors.  In this same light, executive compensation can be a point of contention for managers and shareholders alike.  It is one of the greatest embodiments of agency issues as executives work extremely hard in order to increase the value of their company while also expecting to be rewarded for their performance.  If they are not paid enough they will take their skills to a competitor, and if their skills have been deemed worthwhile the shareholders will want to keep them.  In Rappaport’s article, New Thinking on how to link Executive Pay with Performance, he discusses some innovative ways to avoid compensating executives handsomely even when they are not delivering.  The idea of indexed stock options eliminates executive compensation being extremely high when the market is up and low when the market is down and instead requires the company’s stock to outperform the market (or a designated index of competitors) to make exercising options worthwhile.  This strategy has multiple effects on executives’ behaviour.  As Kerr says, when managers are not performing the way that they should be it may be time to evaluate the behaviors that are actually being rewarded; the company may not be rewarding what they think they are rewarding.  If managers were receiving options in a bull market, they would not necessarily need to be performing well to exercise their options and receive generous compensation.  In this situation they could easily become complacent while their pockets continued to be padded by the rising market.  Indexing stock option compensation also has the merit of being more valuable the longer those managers hold the options relative to a fixed price option; this also makes managers want to stay with the company longer.  Although this solves some problems for executive compensation, operating managers are not able to partake in this scheme.  Operating managers in charge of business units are less able to influence the price of the overall company’s stock and it would not make sense for them to be penalized for the poor performance of other departments if they have performed well.  Haspelagh, Noda, and Boulos go into these issues in further detail in their article It’s not Just About the Numbers, they refer to it as value based management (VBM).  This style of management focuses on people first, and expects the numbers to follow, and it does not only focus on senior executives.  Just as it was noted by Kaplan and Norton, it is vital for the entire organization to buy into this type of management for it to be successful.  Business units and their operational managers are structured into value centers with strategic goals in line with the VBM program that has been implemented by the overall company.  In order for this to be successful it is necessary to keep the accounting behind the VBM simple, clearly identify value drivers, integrate VBM budgets with the strategic goals of the company, and ensure that they are able to properly manage the performance data that is being produced.  With all of this being said, it is very important for corporate managers to communicate their actions not only across the company, but also to shareholders.  When everyone is used to having their eye on the stock price and short term metrics like EPS, it may be difficult for executives, operational managers, and employees to carry out truly value creating activities.  The example of PepsiCo’s CEO Indra Nooyi announcing restructuring that would reduce profits shows the current disconnect between perception, rewards, and actual value creation; she had fallen out of favor with the board of directors, and the financial media was predicting a meltdown.  Nooyi’s persistence in pursuing a value creating plan that she knew would work in the long term while appearing like a bad idea in the short term proved to be successful.  This is a true example of a CEO doing B despite being rewarded for A.  If executive compensation, and performance measurement at all management levels, is going to truly drive value for shareholders it has to take a long-term strategic approach.  This is not an easy task, but as the business community begins to realize that long term value destruction is caused by the short term performance measurement and compensation structures that are currently commonplace, there is a strong chance that new measures and a more strategic approach will continue be implemented.