Aligning Incentive Programs with Business Goals

During the early 20th century, the Soviet Union sought to cultivate an art culture that aligned with its socialist ideals. Jazz, with its roots in American culture and its associations with individuality and improvisation, was antithetical to Soviet values. So, in the 1940s and 1950s under Stalin’s regime, jazz was banned with a goal of stifling Western influence. The hope was that the result would be a homogeneous cultural landscape aligned with the Soviet ideology.

However, the ban on jazz had the opposite effect of what the Soviet authorities intended. Instead of eradicating jazz, it was pushed underground, where it flourished as a form of cultural and political resistance. Secret jazz clubs emerged, and musicians covertly exchanged jazz records, often recorded over state-approved music or smuggled from the West.

Soviet composers began incorporating jazz themes into their music, blending Western jazz elements with traditional Russian motifs. Dmitri Shostakovich, for example, incorporated jazz influences into his “Jazz Suites” and “Piano Concerto No. 1,” infusing them with syncopated rhythms and bluesy melodies. Alexander Tsfasman, a pioneer of Soviet jazz, wrote pieces like “Suite for Jazz Orchestra No. 1” and “The Jazz Suite,” which melded jazz harmonies with classical orchestration. Nikolai Kapustin composed works like his “Concerto for Piano and Orchestra No. 4,” seamlessly integrating jazz improvisation techniques with classical structures.

Jazz came to demonstrate the resilience of cultural expression and the futility of heavy-handed censorship. The government’s attempt to suppress jazz inadvertently made it a potent symbol of resistance and innovation.

The futile attempt to ban jazz in the Soviet Union reminds me of the “cobra effect” in economics. As the story goes, in colonial India, the British governor was concerned about the number of wild cobras. He incentivized the population to hunt cobras by instituting a government bounty for cobra skins. 

The plan appeared to work fabulously. Citizens had turned in thousands of cobra skins. There was a reduction in wild cobras, so the governor ended the bounty program.

The governor did not know that by placing a bounty on cobras, he had incentivized local farmers to breed cobras. With the bounty’s abrupt elimination, the farmers were no longer incentivized to raise cobras. So, they released the cobras they had raised. The result was there were more wild cobras than there had been before the bounty.

This article discusses one of my guiding maxims: Be careful what you incentivize. Whether negotiating a contract, managing a business, or operating a rental property, people eventually turn toward their incentives and often follow the easiest path to accomplish them. 

If carefully chosen, those incentives can benefit the business or investment, but the opposite is true if the incentives aren’t aligned with the business or real estate owner’s goals. I’ll provide examples of how the cobra effect can affect business owners and real estate investors, along with recommendations on preventing unintended consequences. 

What Happens When Incentives Don’t Align With Goals

Businesses often develop incentive programs or policies by focusing only on whether the programs can lead to desired results. Since those initiatives frequently can incentivize several responses, businesses must consider what behavior the program might incentivize, especially if it doesn’t accomplish the desired business goal. 

Below are examples of what can happen when businesses and real estate investors don’t evaluate how others might respond to incentives.

Apartment Occupancy Incentives Lead to More Tenants Who Don’t Pay Rent

A real estate investor contracted to purchase an apartment complex. The investor was concerned that the seller might not continue to work hard to obtain and keep tenants during the contract period. Therefore, as a condition to closing, the investor included that the complex maintain its current occupancy percentage through the closing date. The investor carefully watched occupancy percentages, and the complex had a high occupancy level at closing. 

A week after the closing, the new owner/investor noticed that although there was a high occupancy percentage, many tenants had not paid rent. The seller was incentivized only to keep tenants in apartments and had stopped evicting tenants who did not pay their rent. So, the new owner had less revenue than expected and had to invest the time and expense of evicting dozens of tenants.

The investor/buyer wanted to ensure continued economic success at the apartment complex. But instead of including contract incentives to maintain the complex’s revenue, they focused on occupancy. A better requirement would have been a stated monthly revenue collected on current rents or “economic occupancy,” meaning paying tenants.

Leasing Commission Incentives Lead to Residents Who Can’t Afford Rent

A senior housing community needed to increase its revenue. To incentivize sales personnel to obtain new resident contracts, the owner established a bonus program that paid managers a bonus based on the number of resident contracts signed per month. At the end of the month, staff members received a bonus based on the number of new resident contracts they procured during the previous month.

Several months after the bonus program started, the owner noticed that despite many new contracts and increased residency, the community’s revenue wasn’t increasing. Upon investigation, the owner learned that sales personnel had promised several months of free rent in the new resident contracts. Some contracts had rented units for below-market rates. Others had been rented to individuals without the means to pay the rent.

 It was a case of the owner not crafting a plan focused on the desired outcome and not considering what behavior they might be incentivizing. The owner wanted to increase revenue and identified increased occupancy as a way to increase revenue. The owner incentivized increased occupancy – without tying the incentive to the ultimate goal of increased revenue. A better approach would have been to provide a bonus only for new contracts at market rents (without unauthorized free rent) signed with renters with sufficient income to afford the rent payments.

Budget Incentives

A Company noted that payroll costs were skyrocketing. Overtime pay had increased even though the number of hours worked had not. Half of the full-time employees worked only 30 hours per week while the other half performing the same job function worked 50 hours per week. The company was paying overtime, so the employees working 50 hours per week received 65 hours of pay – compared to 30 hours of pay for those who worked 30 hours per week. 

Noting the average hours worked per employee was 40 hours (for which the company was paying an average of 42.5 hours per employee), management reasoned that the company could save 2.5 hours of payroll per week per employee by redistributing employee workloads.

To incentivize managers to distribute workload evenly (and minimize overtime), the company established a bonus program that rewarded managers who reduced the amount of overtime for their teams. The program seemed to work well. Overtime pay and total payroll expenses decreased, and managers enjoyed significant bonuses.

After several months, the Department of Labor notified the company that an employee had complained that they were not being paid for overtime. Rather than take the time to adjust employee schedules to minimize overtime (as the company had intended), one manager changed employee time cards so those who worked overtime would not be paid for the extra hours. The company faced an audit, penalties, and a significant attorney fee expense.

The company had a time card system that required the employee to approve the initial entries, but there were no checks and balances against changes to the time cards. As a backstop, the company also should have had processes in place to ensure that time cards weren’t altered. For instance, the company could have required that employees and managers both approve any modifications to time cards after submission. This change would have made it more challenging for managers to circumvent the system.

To disincentive undesired behavior, the bonus program should have made managers ineligible for bonuses if they engaged in unlawful activity or violated Company policies. While the better option would be to foresee possible abuses of the program, this provision in the bonus program might have made it less likely that managers would attempt to engage in undesirable behavior.

Developing Appropriate Incentives to Accomplish Goals

In these examples, the parties established a “reward” that they hoped would result in a desired business goal. However, the desired business goal was only one possible outcome the reward could generate.

Similarly, instead of making the desired cultural landscape more appealing, the Soviet Union attempted to crush jazz, a popular alternative. But that didn’t change the fact that jazz was more attractive than the Soviet ideology to many.

When developing incentives, it’s essential not only to look at the goal and select a reward that results in the desired goal. It’s critical to also understand the other stakeholders’ goals and consider what behavior is being incentivized.  

Ideally, there will be a single pathway to a reward, which would inevitably align with the goal. Failing that, the desired pathway should be the most attractive one. Otherwise, businesses may find themselves with their industry equivalent of excess cobras or underground jazz clubs.

© 2024 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

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