Incentives for Enterprise

Excerpt from “Unrelenting Innovation: How to Create a Culture of Market Dominance” by Gerard Tellis (Jossey-Bass, February 2013).

In “Unrelenting Innovation: How to Create a Culture for Market Dominance”award-winning USC Professor Gerard Tellis shows how to drive relentless innovation in a company by influencing the true catalyst of innovation: culture.

To reveal innovation’s key drivers and detractors, Tellis spearheaded a study of 770 companies in 15 countries, seeking the origins of 90 radical innovations, and 66 new markets spanning more than 100 years. What he found was that innovation is born not of R&D investment, patents, size, or country of origin, but of the internal culture of the firm. This culture of innovation cannot be invented or enforced, but can be nurtured with three key practices:

  1. Providing asymmetric incentives for enterprise
  2. Fostering internal markets
  3. Empowering innovation champions

With these guidelines, any company can avoid destructive complacency and forge a culture of relentless innovation—and market dominance. Here is an excerpt from Chapter 5: Incentives For Enterprise.

By Gerard Tellis

“Changing the attitude and behavior of hundreds of thousands of people is very, very hard to accomplish…You can’t mandate it, can’t engineer it. What you can do is create the conditions for transformation. You can provide incentives”

—Lou Gerstner, former CEO of IBM (Gerstner, Lou (2002), “Who Says Elephants Can’t Dance?”New York, NY, HarperCollins, pp. 187)

Indeed, incentives are the most powerful practice for creating a culture of innovation. However, traditional incentives in many organizations may be aligned for seniority, loyalty, or sales productivity, but not for innovation. We may believe that rewards for seniority and loyalty increase productivity and retain good employees. Our instinct is to treats failure as bad and success as good. So we reward success and penalize failure. Even for little children, we use rewards to motivate good behavior and penalties to discourage bad performance. But are these beliefs, instincts, and practices good for innovation? This chapter shows why traditional incentives stifle innovation, why failure must not be shunned, and why incentives for enterprise promote innovation. Incentives for enterprise are asymmetric, with strong rewards for success and weak penalties for failure in innovation. This chapter discusses the power and characteristics of incentives, including their economics and psychology.

Traditional Incentives: Winning Loyalty

Traditional incentives often are based on longevity in the organization, with perks and rewards increasing with the number of years of employment. This incentive scheme has many motivations. First, it is based on a simple, easily measured and implemented scheme. Second, it motivates loyalty to the organization and reduces the costs of employee turnover. Third, unions prefer it perhaps because it is objectively tracked and fosters social equity. In contrast, enterprise-based incentives can lead to much inequity. However, traditional incentives based on longevity do not foster innovation. Such incentives reward employees even when their performance falls below average so long as they put in the years. Longevity-based incentives motivate employees to hang on to an organization even when they are under-performing. Over time, organizations with longevity-based incentives will be left with loyal employees but not innovators—they would have jumped ship to join organizations that better reward innovation.

Traditional incentives often are tied to seniority in the organization, with higher incentives reserved for senior managers and lower incentives for junior managers. If seniority itself is based on longevity, then such incentives have all the disadvantages of longevity-based incentives. Moreover, rewarding seniority rather than enterprise stimulates envy and status flaunting but not innovation.

Traditional incentives often are tied to sales of existing products or satisfaction of current customers. However, even such performance-based incentives do not foster a culture of innovation. Focusing on existing products instead of on new products encourages attention to current details but hampers new ideas and innovations for the future. Linking incentives to current customer satisfaction limits development of new markets and customers that may become important in the future.

To foster innovation, firms need incentives for enterprise. Such incentives, unlike traditional ones, reward employees for developing and implementing innovations: new ideas, products, services, or businesses. In such a system, bonuses, raises, promotions, and perks all are tied to the quality and number of innovations. Even young or new employees may do better than veterans if the former are more innovative than the latter.

One important characteristic of incentives for enterprise is that they are asymmetric in their reward structure: strong rewards for success with weak penalties for failure. An asymmetric incentive structure encourages employees to take on risky projects, a prerequisite for innovation. Failure naturally elicits shame. Reinforcing or even maintaining such natural reactions to failure suppresses risk taking. Embracing and learning from failure can be powerful.

Asymmetric Incentives: Turning Failure into Success

For many incumbents, embracing failure goes contrary to the grain of good management practice. Progress is measured by good results. Failure is penalized. Executives from organizations have told me that their organizations do, indeed, have asymmetric incentives, but they are the opposite of that proposed here: They offer weak or no rewards for success and strong penalties for failure! Why does this come about? Success is part of the implicit contract in employees hiring; so is avoiding failure. Thus, the incentive structure takes success for granted and does not especially reward it, but punishes failure. In particular, one senior executive of a major multinational corporation once lamented that his employees were risk averse. On further discussion, I found out that the problem was not with the employees but with the corporation. It had low rewards for success with innovations but penalties for failure. The result was risk-averse employees.

A formal study by Professors Gina O’Connor and Christopher M. McDermott found a pervasive reward structure that was non-conducive to innovation (O’Connor, Gina Colarelli and Christopher M. McDermott, 2004, “The Human Side of Radical Innovation,” Journal of Engineering Technology Management, 21, 11-30). Over six years, the authors studied 10 large established firms including IBM, 3M, DuPont, GE, Texas Instruments, and Nortel Networks. The authors found that in most cases, firms provided what I here call perverse incentives: strong penalties for failure but weak rewards for success. As one innovator told them, “The origin of the breakthrough success often is forgotten, but an R&D effort that does not succeed is never forgotten.” In another case, when sales forecast of an innovation were not met, a team member was “put in the penalty box.” Most team members viewed innovation projects as career risks, given the low probability of success and high penalties for failure. As a result, key team members threatened to or more often quit during or after the project or were fired during the project.

In sharp contrast to this practice, the asymmetric reward structure that I call incentives for enterprise involves strong incentives for success with weak or no penalties for failure. Such an incentive structure motivates innovation. Innovation requires exploring new possibilities, traveling unexplored terrain, and investing in uncertain options. Failure is common. Inan environment where the individual is allowed to fail and learn from failure, innovation thrives. In a culture where errors are shamed, innovation suffers. Jeffrey Pfeffer of the Stanford School of Business warns, “Companies that want to encourage innovation and entrepreneurship, therefore, have to build a forgiveness culture, one in which people are not punished for trying new things.” (Pfeffer Jeffrey (2003), “Too much Management Can Block Innovation, Stanford GSB News, September, http://www.gsb.stanford.edu/news/research/ob_toomuchmgmt.shtml).

Thus, incentives for enterprise must be based on innovative performance and not on seniority or longevity or even performance on current products. Such incentives must be asymmetric, with strong rewards for success and weak penalties for failure. Constructing such incentives needs constant watchfulness and deliberate intent, because the natural human tendency is just the reverse: to shame failure and overlook success or take it for granted.

Excerpt from “Unrelenting Innovation: How to Create a Culture of Market Dominance” by Gerard Tellis (Jossey-Bass, February 2013), part of the Warren-Bennis Leadership Series.

Gerard J. Tellis is a professor of marketing, management, and organization, Neely Chair of American Enterprise, and director of the Center for Global Innovation at the USC Marshall School of Business. Dr. Tellis is an expert in innovation, advertising, global market entry, new product growth, quality, and pricing. His book,“Will and Vision,” was cited as one of the top 10 books in business by the Harvard Business Review and was the winner of the American Marketing Association Berry Award for the best book in marketing over the last three years.

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