1. Bad ideas
2. Misleading derived KPIs
3. Do it right: selecting KPIs and incentive calculation methodology
4. Replicating the incentive calculation formula along the vertical hierarchy: vertical harmonization of KPIs
5. Horizontal aligning of KPIs for different parts of the value chain
6. Incentives for CEOs and top executives
7. About the incentive system in general or the IEM Paradigm in the context of an incentive calculation methodology

"People are responsive to stimuli"

According to IEM cybernetics, matching employees' incentives to the marketing strategy (on the left side of the picture) is a major internal task for an executive (on the right side).
It's simple as ABC.

It's also very profitable.

Being duly implemented, this approach can transform executive's chores into a life of an IEM superstar: nothing should be "managed" any longer, employees diligently do their best at work. They themselves create "intangible" incentives, while the HR office is crowded with applicants.

1. Bad ideas

Briefly on a flawed employee incentive system. There is no time to explain:

• In an incentive calculation formula, use less indicators reflecting individual employee's results and more KPIs of general nature representing results for the entire department or even company.

As if they are intended to strengthen the team spirit. If janitor's compensation depends on the company's profit, just imagine how well he will perform her duties!

• Or even better — for indicators determining the reward, put more weight on indicators representing no actual results whatsoever.

For example, employee's remuneration will depend on the score given to this employee by his immediate superior. It would be wrong If you think that such approach will make employees to curry favor with the boss. You know little about how a business works.

• There is a similar situation when an appraisal is made by coworkers.

Do you really think that in this case employees wouldn't be in collusion instead of doing their best at work?

• If you failed to force yourself and decide that an employee's salary must depend on her personal results there is another approach called targeting.

Set targets for every month or quarter by guesswork, adjust approved targets for the next quarter since the targets for the previous quarter are exceeded to save your money. How would you think employees will do their job when preoccupied with targets? Will they intentionally keep reaching targets to avoid them being adjusted?

Unlikely.

But you will always have targets met. It doesn't matter that you miss 30-70% in revenue and several times in profit (if any).

• Another powerful tool based on the previous one is individual targets.

In addition to all the above benefits, you will get a deserving of a movie intrigue. The company's life will be vivid and intense. As well as consumers' experience.

• One more spice — a lengthy formula to calculate a reward with many factors.

You need more square roots and logarithms in it! Let no one knows how to get paid more! This is the fog of war, as Carl von Clausewitz puts it, that best motivates employees to meet targets for the company.

• Adjust incentive calculation methodology frequently.

Do your best to surprise your employees with a new salary calculation formula each 6 months or every quarter which is even better. This will help you to improve employees' trust with you and to add stability in their lives. This may make them very enthusiastic about their work.

• It is even better to introduce a new formula retrospectively.

At the end of a month, you can announce a new methodology to calculate salary to be in force as of the next month. — So what's a new methodology? — It's a question, we'll see at the end of the next month.

• Be cautious — an employee MUST NOT be able to monitor the indicators with which her salary is calculated.

It would be better to not disclose them at all. Employees should be informed of the final result of calculations on the pay day. Let them just be faced with it. As it is known, the talks of how they fool us among employees are the best way to establish their trust with the employer.

• Introduce new methodologies fast and decisively.

There is nothing to discuss! No preliminary discussions or notifications explaining a new methodology are needed. Be bold and decisive! Stubborn be your second name. Haven't we already mentioned to introduce a new methodology retrospectively?

• When it faces resistance from employees and creates a threat of a strike, you are free to withdraw it.

Find and blame scapegoats. Show your employees what a helpless leader you are. Apart of cancellation of a new methodology, you can increase salaries.

• Be consistent in your inconsistency.

It doesn't matter that there are not any measurable KPIs for a certain job position (luckily, there are actually few such positions). You can pay artists per m2 of their paintings, cops per crimes solved and poets per words.

Thus you win.

2. Misleading derived KPIs

Let's examine a widespread mistake in selecting KPIs: giving priority to derived KPIs instead of absolute ones.

This is almost always the case if there is an "intricate plan". Let's use the average spent as a target for salesmen instead of the goods sold or revenue, for example. May they court every customer, and the sales volume, revenue, etc. will increase alongside.

Alas, if this were so. As a result, in a long run we could have an increase in the average spent and decrease in all other figures. Or a lot less increase than we could have had if there were not any fancy incentive techniques.

The main principle behind any incentive technique is that an average person does exactly that job that he is paid for. And this is really so.

So, if you pay for increase in the average purchase amount you will get it. This can be achieved by salesmen using different more or less dirty tricks in preparing reporting. However, other figures that should actually be of interest to a wise executive like a sustained long-term growth in revenue may be negatively affected.

Here is another example to illustrate this approach. Let's assume that the head of sales wants to motivate salesmen to be proactive in getting new customers to boost sales. So, incentive targets for them are set accordingly like the income from new accounts.

You can probably imagine what this approach will eventually result in. Right you are, there will be an increase in new accounts (the existing customers could be converted into new ones), while the sales volume, income and other figures will at best stay at the same level.

Given all of the above, the main principle to select a KPI correctly becomes obvious:
it must reflect as closely as possible the absolute figures in which shareholders are interested.

These figures can hardly be manipulated with by bottom level employees as compared to fancy KPIs like the number of answered phone calls per hour, the average income per order and so on.

You should remember that a private entrepreneur is motivated better than anyone else. He gets all he earned. His income equals her profit. The closer the incentive methodology applied by your company to this extreme, the more efficient it is.

3. Unified approach to select KPIs

Let's recall the balanced scorecard method paying attention to the adjective "balanced". It is very important notion often missed by incentive methodology developers. By the way, this can be added to the "Bad ideas" as well.

Why is it so important and what "balanced" actually means?

In most cases, the job performed by an employee cannot be measured with a single indicator.

For example, if we pay a saleswoman for the sales volume than the profit will certainly be impacted.

This is to say that in our example with the saleswoman, the sales volume is an important but not sufficient measure. The Sales Volume KPI must be balanced by another indicator, i.e. the cost of goods sold. The saleswoman must be motivated to sell both high-margin and low-margin products.

One may ask, why shouldn't we set her a target for the gross revenue from sales? It may be a good idea in some cases but in competitive market... One should remember that low-margin products are sold at their cost or even below it.

We can only imagine salesman's throes when he realizes that he'll lose money if he sells this particular TV set. However, IEM systems have a solution for this, though it is somewhat sophisticated.

According to IEM cybernetics (and proved by extensive practical experience):

a) There is a pair of measurable balanced KPIs for any job position one of which represents the amount of work done and the other measures its quality.

b) Using this pair of KPIs as the base for incentive calculation methodology guarantees the best possible result.

Let's name this conclusion the Amount Quality Rule (AQR) for convenience.

Note the word "base" in the AQR's definition as other indicators can be added to the methodology as well, but they should be:

• Additive, that is they can be added or deducted and not be used as multipliers for the amount/quality figures

• Their share in the total result of calculation must be significantly lower than the base AQR pair It must not exceed 25%.

It can easily be noted that our example with saleswoman's incentive targets set for the sales volume and cost of goods sold is in line with AQR. The sales volume represents the amount of work done by the saleswoman and the cost of goods sold measures the quality of this work.
Genius is in simplicity. AQR is simple and it works.

In practice, the most difficult task is to determine correctly the measure of quality for a job position.
Nevertheless, such measures always exist. The matter is that whether your incentive calculation methodology makes it possible to collect and process them.

Why two component AQR is best as an incentive calculation formula. 
Can the incentive calculation formula be improved by adding more indicators to its base? May be three indicators would be better than two. No.

Firstly, the number of KPIs must be even (2, 4, 6, 8, etc.) so that they are balanced. Thus, the greater the number of KPIs in the base of the incentive calculation formula, the more "amount-quality" pairs you have.

This instantly requires to balance the priority of pairs by setting weight factors for them by guessing. But such guessing contradicts the IEM order imperative.

Secondly, since the basic KPIs measure the main target set for the company, this target can be diluted if there are several pairs of KPIs. In other words, an executive who can't define the basic KPI pair just doesn't know what he wants to achieve.

Thirdly, even two balanced KPIs of a single AQR pair sometimes can't be understood correctly by employees. Adding more KPI pairs would be just an illustration to the proverb: he who chases two rabbits, catches neither.

Less important KPIs should be included in the formula as an additional component.

4. Replicating the incentive calculation formula along the vertical hierarchy: ascending synthesis of KPIs

The base of the incentive calculation formula for a department head is the same as that for department employees, except for KPIs for the entire department are used in the former (ascending synthesis of KPIs).

That is a salesman is paid for the sales volume and cost of goods sold, while the head of the Sales Department is paid for the sales volume and cost of goods sold by the entire department.

Additional indicators for different hierarchy levels vary independently and do not affect efficiency of the incentive calculation methodology provided that the 25% share principle is observed.

If you can't harmonize KPIs for a department head and its employees then there is a problem with the organizational structure. By fixing this problem, you can significantly improve efficiency for no additional cost.

5. Horizontal aligning of KPIs for different parts of the value chain

KPIs for employees of the departments which are neighbors in the value chain MUST NOT contradict each other but to motivate employees to achieve their targets fast and smoothly along the entire value chain.

If salesmen of a trading company are paid for the sales volume then warehousemen should be motivated with the transshipment volume. But if you set shortage of goods in warehouse as a basic KPI for warehousemen, you'll get a permanent dead-end conflict at the sales — warehouse level.

The shortage of goods in warehouse may as well be set as a measure of quality or as an additional KPI. Order fulfillment time can be used as an alternative KPI to measure quality.

6. Incentives for CEOs and top executives

What targets should CEO's remuneration depend on? Some believe it should be profit, others like the idea of market capitalization. These measures can hardly be called efficient.

The solution is unexpected: such KPIs DO NOT and CANNOT exist. IEM Cybernetics proves it mathematically.

That is why the best financial incentive for a head of the IEM Enterprise is a good old salary. Its amount does not matter (the derivative of any constant is zero), but this very person must consider it fair.

This conclusion looks unexpected only at first glance. Confucius, whose ideas regarding complex system organization remained underestimated in the Western culture, addressed his written rules with prescribed punishments to the ignorant common people, while educated people followed much stricter unwritten rules of honor. There was the only punishment and it was imposed by the offender himself.

The ERP formula in which the CEO is the king crowns the bureaucracy pyramid.

The IEM formula suggests that the leader is in the heart of business, its core and symmetry center.

The scope of IEM formal Cybernetics application is limited by the process being formalized. Tasks the IEM leader solves are all of creative nature only. That is why they cannot be measured with any imaginable (as well as unimaginable) quantitative measures.

The IEM leader is an artist and creator in business. Steve Jobs invented iPhone being directed by the same stimuli which made Michelangelo sculpt David and Gaudí erect the Sagrada Familia.

There is not any way to create talents. All that a wise Governing board can do is to find a good CEO and then disturb him as little as possible. First of all, with randomly selected KPIs.

Any attempt to motivate the CEO with any set of quantitative KPIs is an enforced pushing towards "local optima" trap. In the end, there is a zero effect at best, or usually a great damage.

The same logic is applied for motivating top executives. The closer the task to the IEM leader level, the less correlation with financial incentives KPIs should have.

However, if here are many such positions in your company at the operational (!) level (designers, creators, poets must not be taken into account), it's a sign that instead of a IEM leader this job position is taken by someone incapable of doing his job.

7. About the incentive system in general or the IEM Paradigm in the context of an incentive calculation methodology

A sound incentive calculation methodology for the entire company is always based on the IEM principles:

• "Closed" — it covers all the employees in the value chain

• "Ordered" — it is based only on measurable KPIs

• "Integral" — its KPIs are aligned for different parts of the value chain

• "Symmetrical" — the incentive calculation formula is replicated for all management levels

• "Unified" — it ensures good results for organizations of any type or from any industry with standardizable business processes. The IEM incentive calculation methodology can be extended beyond the company to cover its partners as well to create more value for shareholders of all companies involved.

Dualistic nature pertained to practical implementation of IEM systems in regard to the incentive calculation methodology results in two mutually balanced indicators of amount and quality.

Unicity of the AQR pair in the incentive calculation formula for every job position results from the IEM unicity and comprehensiveness building principle.

As we pointed out earlier, Marketing has been the most important and true innovation of Henry Ford: positioning the automobile as a mass market product.

Another Ford's revolutionary idea was to implement elements of an incentive calculation methodology in line with IEM logic.

By matching workers' incentives and shareholders' interests, Ford (its General Manager James Couzens, to be more precise) made it possible for workers to earn good money, and the workers became so efficient that they brought a fortune to Ford and his partners.

Henry Ford's formula of success — a marketing revolution in the automotive industry PLUS financial incentives for workers in line with the IEM Paradigm.

And let the business media keeps telling its stories about the assembly line and other Taylorism.
 

P.S. And now some history of Ford Corp. (from The Essential Drucker by Peter Drucker)

The years immediately prior to World War I were years of great labor unrest in the United States, growing labor bitterness, and high unemployment.

Hourly wages for skilled men ran as low as fifteen cents in many cases. It was against this background that the Ford Motor Company, in the closing days of 1913, announced that it would pay a guaranteed five-dollar-a-day wage to every one of its workers — two to three times what was then standard.

James Couzens, the company’s general manager, who had forced this decision on his reluctant partner, Henry Ford, knew perfectly well that his company’s wage bill would almost triple overnight. But he became convinced that the workmen’s sufferings were so great that only radical and highly visible action could have an effect.

Couzens also expected that Ford’s actual labor cost, despite the tripling of the wage rate, would go down — and events soon proved him right. Before Ford changed the whole labor economy of the United States with one announcement, labor turnover at the Ford Motor Company had been so high that, in 1912, sixty thousand men had to be hired to retain ten thousand workers. With the new wage, turnover almost disappeared.

The resulting savings were so great that despite sharply rising costs for all materials in the next few years, Ford could produce and sell its Model T at a lower price and yet make a larger profit per car. It was the saving in labor cost produced by a drastically higher wage that gave Ford market domination.