Sins of Commission Performance-based pay isn't just for CEOs and salespeople anymore. But short-term rewards could be costly in the long run.
By Jeffrey Pfeffer

(Business 2.0) – One recent Sunday afternoon, my wife and I arrived at Putnam Toyota in Burlingame, Calif., to test-drive a Camry. When we told the salesperson we were deciding between that and a few other cars, he quickly determined that we were unlikely to make a purchase that day and sent us to a distant lot down the street--essentially blowing us off. My wife was similarly shafted while shopping for shoes at Nordstrom. The employee, seeing the difficulty of finding something for her narrow, hard-to-fit feet, began taking longer and longer to return, waiting on other customers in the meantime--until we left.

Not a great way to build customer loyalty. It's hardly surprising that though we did end up buying a Camry, we bought it from another dealership, Toyota 101. And my wife no longer shops for shoes at Nordstrom. But in both cases, Putnam Toyota and Nordstrom got just what they wanted, as signaled by their incentive systems.

Commission-based sales in retail aren't anything new, of course, and CEOs have long been rewarded on the basis of company performance. But individual incentive pay is spreading across organizations. In fact, a Hewitt survey published in September 2003 showed that 77 percent of companies now offer some form of variable pay--like productivity-based bonuses or rewards for cross-selling--compared with 59 percent in 1995. A separate study by Watson Wyatt in 2003 found that 78 percent of companies offer short-term incentive pay below executive ranks. Programmers might be rewarded for the number of bugs they fix, for example. There's even a move to introduce merit pay into the federal civil service, and some school systems have toyed with teacher salaries tied to test scores.

Much controversy surrounds incentive pay, including whether people are really that motivated by money and whether pay-for-performance systems are fair. But I think the most fundamental problem with incentive pay is that it works too well. Employees do respond to incentives, not just because of cash but also because rewards are how a company signals what it deems important. They provide a guide for people who want to do a good job. But few organizations have sufficient foresight or simple enough objectives to avoid the problems that arise when employees take the incentive system and its messages seriously.

Putnam Toyota and Nordstrom both rely on individual commissions to compensate their salespeople. (By contrast, Toyota 101 does not use a commission system.) Given an incentive to sell, it makes perfect sense for a salesperson not to bother with someone who isn't going to generate revenue right away. While lost customer loyalty won't affect that salesperson directly, it can affect the company's results down the road.

Sanitation workers in Albuquerque, N.M., are paid for performance and go home with full pay if they finish early. But the incentive-paid drivers seem to be involved in more accidents, and in 2002, 15 of the 24 workers with the highest incentive pay went to the landfill with trucks over the legal weight limit the most often. To take another example, teachers who receive incentives to enhance test scores will do just that, possibly by cheating. One study, conducted by Brian Jacob of Harvard's John F. Kennedy School of Government and Steven Levitt of the University of Chicago, found that minor changes in teacher incentives produced strong responses in cheating, from giving students questions in advance to falsifying scores.

Most organizations are pursuing success along multiple dimensions--not just sales and productivity but also customer loyalty and innovation. Typical individual incentive schemes are too crude to reflect the complexities of business. But there are some reasonable solutions. As former software executive Barrett Joyner once told me, "Instead of using incentive schemes to signal what people ought to do, try something unusual: Talk to them." In lieu of annual performance reviews and occasional raises, provide ongoing feedback. Try switching to collective incentives like profit sharing or bonuses that reward people based on company performance. And most important, don't let pay take the place of leadership and company culture.

Business 2.0 columnist Jeffrey Pfeffer is the Thomas D. Dee II Professor of Organizational Behavior at Stanford University's Graduate School of Business.