Title: Why Do Firms Use Non-Linear Incentive Schemes? Experimental Evidence on Sorting and Overconfidence (PDF)
Authors: Ian Larkin (Harvard University) and Stephen Leider (University of Michigan)
Publisher: Harvard Business School, Working Paper No. 10-078
Date Published: March 2010
Performance-related compensation is commonplace among salespeople; according to recent surveys, almost 90 percent receive some kind of bonus payment, whether in the form of stock options, goal-based rewards, or commissions based on a percentage of revenue generated. But these plans have been widely criticized by academics and compensation experts who fear they encourage undesirable behavior on the part of sales teams, such as offering products at cut-rate prices just to meet a quarterly sales quota despite the possibility of eroding the value of the product in the marketplace. However, the authors of this paper examined the long-standing practice and found some unrecognized benefits for employers if they let salespeople determine their own bonus plans.
In a series of experiments, 179 participants were told to choose how they wanted to be compensated — by either a flat rate or a payout schedule that rewarded them more for every successive correct answer on a set of math questions. The researchers found that overconfident subjects were 45 percent more likely to opt for the flexible compensation plan, costing themselves 15 percent of potential payouts during the nine-round test, than those who rated themselves as less confident. Confidence was measured in a variety of ways, including self-reported expectations of performance prior to testing and personality questionnaires that asked subjects to rate their level of agreement with statements such as “I am a good driver,” which reflect overconfidence. Despite receiving continuous reports telling them how much money they were losing, overconfident people were still as likely in the final round of the test as in the first to pick the wrong bonus scheme. The authors concluded that incentive-based compensation plans designed with employee participation are valuable to employers in two ways: They attract talented salespeople, and they can reduce a company’s payroll costs when overconfident employees fail to hit lofty, self-imposed targets.
Bottom Line: Bonus-related compensation plans are popular with salespeople, who often have an exaggerated sense of their own potential and may end up making less than if they were paid a flat salary.
- Matt Palmquist was a founding staff writer and is currently a contributing editor at Miller-McCune magazine. Formerly, he was an award-winning feature writer for the San Francisco–based SF Weekly.