Incentives: people do what they are paid to do
How pay schemes shape behaviour, a sales commission example with the numbers, and a real case where targets went badly wrong.
Key takeaways
- An incentive is a reward for doing something: a commission, a bonus, a promotion, even praise.
- Paying on revenue when profit matters: staff discount or chase low-margin sales.
- A cliff, where a bonus starts only at a threshold: staff near the line pull sales forward from next period, and staff far below it give up.
- Short term only: staff hit this year's number in ways that hurt next year, such as selling to customers who will cancel.
Key idea
An incentive is a reward for doing something: a commission, a bonus, a promotion, even praise. People respond to the incentive they actually face, not the one the company hopes for. When a case says "staff are doing something odd", ask first how they are paid and measured.
A commission is a share of a sale paid to the person who made it. If it is a share of revenue, the salesperson gains from every sale, even one at a price that loses the company money. If it is a share of profit, the salesperson cares about price too. The design detail decides the behaviour.
Worked case
Why store staff give away discounts
The prompt
A fictional electronics retailer in the UAE sells a laptop at a list price of AED 2,000. It costs the retailer AED 1,400. Store staff earn 5 percent of revenue as commission and may give up to 15 percent off. Margins are falling because staff give the full discount on most sales. Show what the discount costs the salesperson and the company, then test a commission of 15 percent of gross margin instead (illustrative numbers).
The structure
- Compare the salesperson's gain with the company's gain, with and without the discount
- Gross margin at full price and at 15 percent off
- Commission on revenue: what the salesperson loses by discounting
- What the company loses by discounting
- Key: Commission on margin: does the salesperson now feel the discount?
Working it through
1. Margin at full price
AED 2,000 minus AED 1,400.
Gross margin at full price (AED):2,000 - 1,400 = 6002. Margin at 15 percent off
The price falls to AED 1,700, but the cost stays AED 1,400.
Gross margin at 15 percent off (AED):2,000 × 0.85 - 1,400 = 3003. Salesperson's loss with a revenue commission
5 percent of 2,000 is AED 100; 5 percent of 1,700 is AED 85.
Commission lost by discounting (AED):2,000 × 0.05 - 2,000 × 0.85 × 0.05 = 154. Company's loss
The company keeps margin minus commission: 600 minus 100 = 500 at full price, 300 minus 85 = 215 with the discount.
Company profit lost by discounting (AED):(600 - 100) - (300 - 85) = 2855. Salesperson's loss with a margin commission
15 percent of AED 600 is 90; 15 percent of AED 300 is 45.
Commission lost by discounting, margin scheme (AED):0.15 × 600 - 0.15 × 300 = 45
The recommendation
Pay commission on gross margin, not revenue. Today a discount costs the salesperson AED 15 but costs the company AED 285, so discounting to close a sale is the rational choice for staff. With 15 percent of margin, the same discount costs the salesperson AED 45, three times as much, while the commission at full price stays similar (AED 90 against AED 100). Expect fewer discounts. The risk is that some sales are lost; test the scheme in a few stores first and track both margin and sales volume.
Risks: Staff may push the highest-margin products even when they do not suit the customer; A change in pay can upset good staff; explain it and show the maths.
Next steps: Run the new scheme in 10 stores for one quarter and compare margin per store with similar stores.
A real case: sales targets at Wells Fargo
In 2016 the US Consumer Financial Protection Bureau found that Wells Fargo employees, spurred by sales targets and pay incentives, had opened about 1.5 million deposit accounts and about 565,000 credit card accounts that customers may not have authorised. The bank paid a USD 100 million fine to the regulator, plus other penalties (CFPB). In 2020 Wells Fargo agreed to pay USD 3 billion to resolve criminal and civil investigations into sales practices from 2002 to 2016; the agreed statement of facts describes sales plans that called for aggressive growth and managers who pushed staff to sell products customers did not want or need (US Department of Justice). The lesson for a case: an aggressive target with weak checks does not create value; it creates the appearance of value, and later a large cost.
Four patterns to look for in any pay scheme
- Paying on revenue when profit matters: staff discount or chase low-margin sales.
- A cliff, where a bonus starts only at a threshold: staff near the line pull sales forward from next period, and staff far below it give up.
- Short term only: staff hit this year's number in ways that hurt next year, such as selling to customers who will cancel. Holding back part of a bonus, or taking it back later (a clawback), helps.
- Individual only: staff compete with colleagues instead of helping them. A team element helps where work is shared.
A salesperson in India earns a bonus of 2 percent of all quarterly sales, but only if sales reach INR 50 lakh (5,000,000). One week before quarter end she is at INR 48 lakh. A customer is ready to sign a INR 3 lakh order next month. If she persuades the customer to sign this week instead, what bonus does she earn, in rupees?
When behaviour looks irrational (salespeople discounting, managers hoarding budget, drivers rushing deliveries), say: "Before we change the process, I would like to understand how these people are paid and measured, because that is usually what drives the behaviour." Then put numbers on what the person gains and what the company loses, as in the laptop example.
Staff earn commission on revenue. Why might they give discounts too easily?
What is a clawback?
Sources for this lesson (3)
- US Consumer Financial Protection Bureau: CFPB fines Wells Fargo USD 100 million for the widespread illegal practice of secretly opening unauthorized accounts (September 2016, official)
- US Department of Justice (US Attorney offices): deferred prosecution agreement with Wells Fargo, USD 3 billion, with statement of facts on sales practices from 2002 to 2016 (February 2020, official)
- Recognized public explanations of case-interview concepts and terms
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