Eliminating Self-Defeating Incentives
By Walter M. Denekas, CTP
Associate, Carl Marks Advisory Group LLC
The electric motor plant was in chaos! Finished goods output was only 50% of market demand. Production planners were frantically expediting orders, while purchasing department personnel were alternately trying to prove that they had ordered missing materials and were scurrying to replace them.
Meanwhile, the aisles were choked with unfinished work-in-process (WIP) that were stacked in bins reaching the ceiling. Management knew they had problems, but there were so many, they didn’t know where to start in addressing them.
The root cause of the problems—when it was finally identified—was the plant’s incentive system, which measured department foremen on labor efficiency and overhead absorption without taking into account how their activities impacted other areas of the plant. Identifying and eliminating such self-destructive incentives are crucial to solving a host of problems that often plague companies needing the help of turnaround professionals.
Good Intentions
The problem at the electric motor plant started innocently enough. The shaft foreman was making 100 shafts for motor type A and noticed that he had a second order for 100 more of the same shafts the following week.
If he made both orders that same day, he reasoned, he’d save a setup and improve his department’s weekly labor efficiency and overhead absorption.
Across the plant, the coil winding department foreman was pursuing the same strategy, but he was winding coils for motor type B. In the process, both foremen had used up the material they needed to make that week’s order for the alternate motor.
As a result, neither type of motor could be fully assembled, nor could either order be completed until new material arrived.
Unable to finish the scheduled orders, but still needing to maintain department efficiency levels, the foremen began matching the orders they had to whatever material was on hand, many times going out weeks or even months ahead.
Every week, the problem of getting anything shipped out the door became more complex.
This was a classic case of a self-defeating incentive system, one that reasonably—but wrongly! —assumed that optimizing each department’s performance would optimize the entire plant’s operation.
The whole situation was remedied when the performance measurement was changed from labor efficiency to one that assessed performance against a finished goods schedule. Each shop day was assigned a specific final-assembly schedule, and this timetable was then shifted backward on the calendar for each lower subassembly.
Department foremen reported day by day on their production against the daily schedules, and no credit was given for early or late orders.
Material control personnel were responsible for checking the availability of critical, long-lead-time materials before releasing each day’s schedule, and foremen were given 24 hours to report back on other material or tooling issues that would prevent them from meeting the schedule.
In 90 days, the plant’s output had doubled, inventory was down 40%, and stockouts were down 90%, with the remainder consisting largely of parts on allocation by suppliers.
Company Culture
Self-defeating incentives are far more prevalent than most turnaround professionals might suspect, and ferreting them out is not easy. These practices are usually so embedded in a company’s culture, so taken for granted, that they typically aren’t even mentioned during the turnaround assessment process, unless by accident.
For example, a company that manufactured bathroom scales had a first-rate product, fashionable styling, and excellent placement with the country’s largest mass retailers, yet it was operating only at breakeven.
Interviews with the marketing department during the assessment revealed a group that was enthusiastic about its product’s superiority to any competitors in function, appearance, depth of line, and most other features.
They estimated that these functional advantages should command a 10% to 15% price premium over competitors’ products. However, when they were asked how they dealt with competitors’ pricing, which was 10% to 15% lower than their products, they replied, “We have a policy never to lose an order on price. We’ll meet the price if we have to.”
By matching the price of a product that was worth 10% to 15% less than theirs based on customer value, the company unwittingly forced its competition to go to new, lower prices.
The company continued to match these price reductions, setting up a vicious downward pricing spiral. The company’s willingness to sell a superior product at prices equal to what its competitors charged was ratcheting price levels down to the point that the whole industry was becoming unprofitable.
To test this theory, the turnaround team raised the price of one bellwether item by 25%. The sales force complained fervently, but the loss of market share, if any, wasn’t measurable.
With increasing confidence, the company raised prices by 15% on the rest of the product line in stages that covered 18 months and watched as its competition kept pace 10% to 15% below them. The company made a 15% operating profit during the period and eventually went on to acquire its competitor.
As the previous example illustrates, well-intentioned incentives can become self-destructive based on how these policies influence the behaviors of people outside the company. One big-ticket manufacturer of high-tech electronics equipment, for example, had quarterly quotas for its sales force.
At the end of the quarter, if sales were short of quotas, the sales force had great leeway to offer special pricing and other incentives.
By the end of the second round of these incentives, the company’s whole market had learned that it was best to wait to place orders until the last two weeks of the quarter, when prices dropped.
From that point on, the company had set a vicious cycle in motion, and the effect on margins, production, material planning, and service levels was disastrous.
The only way out of the situation involved enduring two sub-par quarters and toughing out the consequences of eliminating the quarter-end incentives.
Identifying and eliminating self-destructive incentives work best when they’re still confined to a turnaround client’s company. Once they reach industry levels, they can be impossible to eradicate.
The auto industry, for example, has the consumer market hooked on rebates to sell cars. An automaker that tries to eliminate the practice on its own is likely to lose ground fast to competitors.
Resistance to Change
How does a turnaround team seek out and destroy self-destructive policies and incentives?
First, team members should ask their clients how it persuades their customers to buy from the company. What are the client’s competitive advantages, and how does it respond to its competitors’ sales tactics? What criteria are used for determining raises and promotions for people at all levels of the company?
Then, the turnaround team should ask the client a second important question: what are the possible, unintended consequences of these policies? What might customers be doing to take advantage of this policy, ultimately to the client’s disadvantage?
Next, the turnaround team must ask if those unintended consequences can be eliminated by replacing or reversing a policy.
In the cases of the motor plant and the scale company, doing away with counterproductive incentives solved the problems.
In the case of the auto industry, however, any company that tries to discard its rebate program on new-car sales may see its market share hammered.
The turnaround team should be prepared for a fight when it attempts to eliminate self-defeating policies. They can be deeply ingrained practices, and changing them usually involves considerable short-term risk and economic pain.
In the case of the motor plant, some of the short-term effects were overstaffing and “hits” to labor efficiency and plant overhead absorption as WIP was consumed from inventory.
For the scale company and the electronics firm, raising prices and dropping quarter-end incentives raised the prospect of losing market share and being forced to endure a couple of weak sales quarters.
The resistance from within the client’s management ranks will be the toughest obstacle for the turnaround team.
It is important to fight this because self-destructive incentives typically throw tentacles into many unrelated areas, wreaking damage throughout an organization. Domino effects are likely to show up in operations in every functional area of a company.
Once these self-destructive policies are changed, a whole host of problems, such as margin erosion, low productivity, and chaotic material planning, seem to self-correct.
The tactic doesn’t depend on luck or unusual skill. It often generates more cash than it takes to implement, even if it causes some adverse short-term impact on a company’s profit and loss statement.
Perhaps most important, rooting out self-destructive incentives will make other turnaround strategies more effective.
Walter M. Denekas, CTP is a turnaround consultant with Carl Marks Consulting Group, LLP. Before joining CMCG, he managed successful turnarounds for several private companies and a number of underperforming divisions of Fortune 500 companies. Denekas holds a professional engineer’s license and is a member of TMA’s New Jersey Chapter.