Pay-for-performance incentives may put innovation at risk

Managers looking to create social conditions that lead to open, diversified and large networks—which are known to spur innovation—should avoid implementing pay-for-performance incentives that rest on short-term and quantitative performance metrics. According to new research published in Strategic Management Journal, such pay incentives result in more closed and smaller networks in organizations, suggesting that managers can use incentive plans to design innovation networks in their organizations.

The study, titled “Pay and networks in organizations: Incentive redesign as a driver of network change,” was published Aug. 26 and written by Hitoshi Mitsuhashi, of the School of Commerce at Waseda University in Tokyo, and Azusa Nakamura, of the Department of Management and Technology at Bocconi University in Milan.

“[F]rom a practitioners’ standpoint, our findings highlight the role of managerial policies in shaping networks in organizations,” the authors write.

Mitsuhashi and Nakamura looked to answer two questions in particular, based on gaps in existing research: What can managers do to create social conditions that promote certain networks that are preferable for their goal attainment? And what management policies are available if they want to exert some influence on networks in their organization?

What was known from existing research about networks—and what Mitsuhashi and Nakamura built their study on—are the types of networks that increase work performance and how such preferable networks emerge.

For their work, the study authors focused on the change of incentive plans from those that weakly link short-term individualized contributions with remuneration to those that tightly link them. For example, switching from seniority-based pay to a performance-based incentive plan.

They also looked at the effects of such an incentive redesign on corporate innovators, arguing that the shift would cause two particular habits in the employees: They would deliver more measurable short-term outcomes and they would seek a fair share of the credit on the outcomes that they jointly achieve with others in their networks. These habits, the authors hypothesized, would prompt corporate innovators to build easily manageable networks to quickly execute projects and get rewarded.

To test the theory, Mitsuhashi and Nakamura used Japanese electronics firms’ patent application filing data, focused on co-innovator networks and adopted a quasi-experimental research design. They chose Fujitsu Limited and NEC Corporations as the treatment group, and the companies’ performance-based incentive plans as the treatment effects. The researchers conducted difference-in-differences (DID) analyses and estimated the incentive plans’ effects by comparing individual employees before and after the plans took effect with individuals in control groups.

Based on interviews with corporate innovators who experienced the incentive redesign in these firms and HR experts who observed their responses, they found three areas of change took place when incentive plans were redesigned based on performance. First, they found that corporate innovators became more goal-oriented and focused more on achievement. Second, the short cycle of performance evaluation created a short-term orientation among employees and increased their risk aversion. Third, the incentive redesign made innovators more individualistic and they became more sensitive about who made what contributions, even deterring others from claiming specific achievements in team settings.

The results supported the authors’ theory that the incentive redesign leads to more closed and smaller networks in organizations. They also found some evidence—although inconsistent—that it caused innovators to build networks with others who have similar expertise.

“A critical message from these observations is that before engaging in incentive redesign, companies need to understand that, No. 1, (it) influences goals that employees pursue, No. 2, employees might adapt their networks to the renewed goals and, No. 3., the updated networks might not be ones that managers prefer,” Mitsuhashi says.

While the findings help to further the understanding of pay and networks in organizations—and highlights their intersection—it offers practical advice for managers: Moving to a pay-for-performance incentive model that relies on short-term and quantitative performance metrics could come at the risk of innovation within the organization.