September 5, 2017

Ensuring that everybody wins

Can bonus programs be designed to benefit workers while growing company profits?

A study in the August issue of AER looked at the effectiveness of a bonus program for employees of a bakery chain in Germany.

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There is no “I” in team.

So goes the cliche invoked by countless soccer coaches, Cub Scout den masters, and corporate retreat leaders. Meanwhile, team members listen politely and secretly wonder about  who is the weak link.

The so-called “free-riding” problem — when a laggard benefits by the hard work of more productive people — is a constant challenge when it comes to motivating teams of people. Still, it is an issue that companies must address as teamwork becomes increasingly more important to working in the modern economy.

A paper that appears in the August issue of the American Economic Review says that bonus programs can be an effective way for companies to motivate team members to achieve common goals. Even more, the strategy can be lucrative for both the company and its employees.

“Nowadays people are quite skeptical about bonus systems,” said Matthias Heinz, one of the paper’s co-authors, in an interview with the AEA. “I think what we can show here is that bonus systems work, but it all depends on how they are designed.”

The paper, which focuses on the retail sector, comes as retailers struggle to find new ways of driving sales amid a race to the bottom on price with discount stores and online competitors like Amazon. It also counters previous research suggesting that productivity gains among retail workers did not benefit workers. Indeed, this recent study shows that workers’ wages increased alongside company profits.

Though bonuses are used widely to motivate corporate executives, they are less commonly used for rank-and-file employees. Some corporate managers worry that lazy team members could ride on the coattails of more industrious employees, sharing in the gains equally even though they did not share the work. They also worry that paying bonuses would cancel out any profitable sales gains.

Incentive Pay
Bonuses are used by organizations of all sizes to incentivize employees. However, not all companies adopt the same approach. The chart below shows the prevalence of various types of bonus programs, by company size. Organization sizes are defined as follows: Small (1-99 employees), Mid (100-749 employees), Large (750-4,999 employees), and Enterprise (5,000 or more employees).

These were some of the concerns that a struggling bakery chain in Germany had when Heinz and his co-authors Guido Friebel, Miriam Krueger, and Nikolay Zubanov, proposed the idea.

It was a large company with a century-long heritage, but had recently seen its sales drop amid pressure from supermarket chains like ALDI, which had just begun selling baked goods inside their stores.

The bakery chain needed to evolve. It couldn’t compete on price, so it decided to differentiate its products by focusing on high-end baked goods. But specializing in gourmet breads and pastries wasn’t going to solve the problem. The company needed to motivate its relatively low-paid shop employees to increase sales.

The researchers suggested giving them bonuses. They received a curious response.

“When we suggested this with the company, the reaction was we have never thought of this before,” Heinz said.

Some other managers also responded with the typical concerns about eroding profits and encouraging free riding. Still, they decided to give it a try.

So, starting in April 2014, the bonus program was rolled out to half of the 193 bakery shops in the company’s fleet. Locations that reached their sales target for the month got a bonus of 100 Euros, divvied up among the employees according to their hours worked. The bonus increased by 50 Euros for each percentage point above the target that they hit, and was capped at 300 Euros.

The experiment worked. Sales in shops with the bonus program increased by around 3 percent. Employee wages increased by 2.2 percent, on average, and up to 12 percent for some people. But it didn’t cancel out company profits. For every dollar paid out in bonuses, the company generated an extra $3.80 in sales and $2.10 in operational profit.

The program was so successful that the bakery chain expanded the bonuses to all its other stores.

When we suggested this with the company, the reaction was we have never thought of this before.

Matthias Heinz

Often stores will try to boost sales by “upselling” more expensive products to customers. But that’s not what happened here, Heinz said. It seems these small 7-person teams became more efficient, achieving sales gains by moving customers through the checkout lines faster and drawing more people into the stores.

It didn’t work everywhere. Shops in smaller cities didn’t achieve the same sales gains as stores in more urban areas. It doesn’t matter how efficiently a store’s employees work if there isn’t enough traffic in town to support sales growth.

Communication with the employees was also critical to making the program work, Heinz said. It’s not enough to offer bonuses and then assume employees will work harder. They had to clearly explain how the employee could receive the bonus, giving them examples of the number of baked goods that had to be sold in a day in order to hit their target. A 1 percent increase above the sale target for a mid-sized store, for example, might equal ten additional rolls, two loaves of bread, two sandwiches, and four cups of coffee per day.

“If bonus schemes are too complicated and people don’t understand it, then they don’t work at all,” Heinz said.

Once they do understand the bonus program and get on board, then there’s the potential for everyone to benefit.

“Team Incentives and Performance: Evidence from a Retail Chain” appears in the August issue of the American Economic Review.