In this post, you’ll learn:
- What types of business need an incentive system, and
- How to design a simple and effective incentive system.
But first, here’s my favorite story on the power of incentives.
It’s about FedEx, the supply chain management and logistics business.
Essentially, FedEx gets packages from Point A to Point B. Whether it’s a letter from Anchorage, Alaska to Miami, Florida. A Christmas present from Helsinki, Finland to London, England. Or a spare part for an airplane from Paris, France to Cairo, Egypt. That’s what they do. But at the core of the FedEx business model is their promise and track record of on-time delivery.
There are many starting points, and many ending points. Lot’s of Point A’s, and lots of Point B’s. Pretty much every city in the world. So FedEx built a system that required all packages to be reliably distributed onto aircrafts at a central facility each night. This made the efficient sorting and dispatch of packages critical to FedEx and the integrity of their delivery service.
However, the system had no integrity for the customers if the night shift couldn't get planes out on time. And they rarely did.
FedEx Management tried, unsuccessfully, to motivate their night crew to fulfill their obligations in a timely and efficient manner, with little success. At the time, FedEx staff were paid by the hour. The longer they took to complete the task, the more money they made.
An incentive that clearly promoted hours worked.
After trying several different incentive programs, FedEx management happened upon one that worked. The answer: rather than paying employees based on hours worked, they paid them a fixed amount per shift, allowing them to go home as soon as their shift had finished.
Almost overnight, the problem disappeared.
Because they wouldn’t earn any extra money for taking longer, and they wanted to go home, FedEx employees immediately increased productivity. This is a good example of making sure the correct behavior is rewarded.
FedEx had tried everything in the world, and finally somebody realized that they were paying employees on the night shift by the hour, and that maybe if they paid them by the shift, the system would work better.
Just like that, that solution worked.
What Types of Business Need an Incentive System
Incentives relate to people, not equipment or machinery.
So only businesses where people are important to the results need to think about an incentive system. That is to say, where a large proportion of their operational or financial outcomes are driven by the performance of their people.
Here’s my more specific answer: an incentive system is required for any business with (1) a sizable team, (2) that drives an important operational or financial outcome and (3) where that team has a highly variable performance.
This team could be a:
- Customer service team
- Product team
- Operations team
- Marketing team
- Sales team
The only question business owners need to ask is: What teams do you have that drive your operational and financial outcomes?
How to Design a Simple and Effective Incentive System
If you had an answer to that last question, I encourage you to consider incentives for your business. To ensure that your employees are incentivised in the most appropriate manner to drive the right behavior.
Here’s my approach to incentives, and I’ll keep it short and sweet.
The Matrix Method
I have a simple incentive system and it requires business owners to embrace the “AND”. Not revenue OR profit margin, number of customers served OR customer satisfaction, volume produced OR quality. Both, at the same time.
This requires (1) determining the goal you are trying to achieve, (2) identifying two unconnected drivers of this goal, (3) finding the metrics that best measure the result of these drivers, and (4) using these two opposing measures to design an incentive plan.
This is how to do it:
- Determine the goal you are trying to achieve. This goal could be an operational or financial goal. For example, higher customer satisfaction, higher product quality or increased profits. Your goal will be determined by your industry, business and personal ambitions.
- Identify the drivers of your goal. For example, these drivers will be around customers, product, operations, sales, marketing, financials or employees. You’ll be designing your incentives around these drivers.
- Pinpointing the metrics that best measure the performance of these drivers. For example, a customer metric might be your Net Promoter Score, a product metric might be the number of returns and a financial metric might be profit margin.
- Finally, decide the two value drivers and two metrics that you believe will best help you achieve your goals (there are some examples below). These are your two metrics that you will design your incentive plans around for your team. For example, the performance of your sales people and whether they will be paid their bonus will be based on achieving a revenue target and a target profit margin. If they achieve their revenue goal they will get 25% of their bonus, if they achieve their target profit margin they will get 25% of their bonus and if they achieve both they will get 100% of their bonus (this is just an example).
Here are some examples:
- Customer service: Customer calls and NPS score
- Operations team: Production rate and return rate
- Sales team: Revenue and margin
It’s important to think about all the behavior, positive and negative, it might encourage and all the behavior, positive and negative, it might discourage. By putting measures against each other, your employees need to balance both drivers, which will benefit your business.
Famous investor Charlie Munger once said that he thinks he’s been in the top 5% of his age cohort all his life in understanding the power of incentives, and all his life he’d underestimated it. That never a year passes where he doesn’t get some surprise that pushes his limit a little farther.
Incentives matter. You’ve probably never given them any thought.
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