IV. Incentives
❝ To the economically illiterate, if some company makes a million dollars in profit, this means that their products cost a million dollars more than they would have without profits. It never occurs to such people that these products might cost several million dollars more... without the incentives to be efficient created by the prospect of profits
Thomas Sowell
Profit is a powerful incentive that inspires entrepreneurs to be alert and take risks to anticipate and satisfy customer demands. Finding less expensive ways to make existing products and developing new and better ones is not only profitable for the discovering entrepreneur, it is beneficial for society.
At MAT, we use incentives to attempt to align the interest of each employee with the interests of both the company and society. This means we strive to pay employees a portion of the value they create for the company. We believe this approach tends to attract and retain the right people, and motivates them to be principled entrepreneurs.
Structuring incentives to bring about productive behavior without adverse unintended consequences is challenging. Proper incentives must not only motivate employees to create value and signal what is valued they must also motivate employees to create that value in a principled manner. To design effective incentives, we must first have an understanding of human action.
Human Action
Ludwig von Mises posits that three requirements must be present for individuals to take action. These are: (1) unease or dissatisfaction with the present state of affairs, (2) a vision of a better state, and (3) belief that they can reach the better state.
Customers switch when they become dissatisfied with their current supplier, believe another supplier will serve them better and are able to switch. When just one of these requirements is missing, people will not act.
Companies that fail to provide conditions that meet all three requirements create a culture of inaction. Companies that encourage creative destruction, provide a vision of how to create value and facilitate decision making, create a culture of Principled Entrepreneurship.
Aligning Incentives
A successful system of incentives must align the individual interest of employees with the general interest of the company. If a result will be good for the employee, it must also be good for the company, and vice versa. This is especially true in all areas of compliance. The effectiveness of our compliance program increased dramatically once we began holding everyone involved accountable, especially those in the management chain.
Scheme
Provide incentives that harmonize the interest of the individual with those of the company.
Compensation should be consistent with the notion that no two employees are alike, and thus their contributions can vary considerably.
No limit should be put on an employee's compensation so employees will not put a limit on the value they create.
Incentives should be structured in a way that effectively attracts, motivates and retains principled entrepreneurship.
These goals are accomplished by rewarding achievement that contributes to the long-term value of a company.
Companies should avoid a sense of entitlement regarding compensation. Automatic raises (such as cost-of-living adjustments) and pay formulas based on titles, certificates, diplomas, seniority or experience - such as the Hay system - are destructive compensation schemes. So are bonuses paid for performance relative to budget, rather than for value created.
At MAT we do not reward roles. Rather, we reward people for specific contributions and results, not for some generalized or averaged result.
Marginal Contributions
To estimate an employees marginal contribution is an important element in an effective compensation system. Marginal contribution refers to the portion of value created that can be assigned to a specific change, factor or individual.
Understanding Marginal Contributions
In order to obtain a MC, the employer must ask the following:
What results were achieved?
Would the opportunity have been captured without the employee?
What would the results have been without this individual?
How did this employee contribute to our culture?
How well has the employee embodied the principles of the company?
Incentive Mechanism
There are several tools for accomplishing this, including:
Annual incentive compensation
Spot bonuses
Multi-year rolling profit-based compensation
A key role of managers is to retain and motivate employees who are adding superior value by paying for value created and ensuring competitiveness.
❝ To achieve the greatest fulfillment, we must passionately learn, challenge and experiment to create value as we apply sound theory and practice in every aspect of our lives.- Charles G. Koch
Last updated