Success and Sustained Innovation through Intelligent Individual Incentives
Since 1895, Lincoln Electric has lead its industry by following a core set of beliefs revolving around the support of its workforce. This article will explore the process that guides Lincoln Electric and will hopefully give some insights to entrepreneurs and managers looking to achieve long term success in their firms.
Recognize the Goal
All firms follow profit. While some may claim to focus on social impact, and may in fact produce positive societal outcomes, to continue operating, cash is king. Lincoln produces welding gear. Its profit is a function of cost, the competitive price offered to customers, and quantity sold. By continually driving down costs while improving their product, Lincoln outpaces their competitors and remains the market leader.
Profit = Quantity x (Price - Cost)
Decentralized Optimization: The Worker is Key
To drive down costs, Lincoln works from the bottom up. They reward workers heavily for devising cost-saving measures. Those who save costs are given an immediate payout. These factors heavily incent the workforce to reduce the costs of production and innovate processes.
Bonuses are used to align the interests of the firm and the worker. The pool of firm profits are largely distributed to the workers, and not to investors. Workers thus have a stake in firm profitability.
Bonuses could account for half of your compensation, and are based on factors that drive firm profits. Workers are scored on criteria that are used to allocate the bonus pool:
- Ideas and Cooperation
This transparent process gives specific and achievable aims to the individual that benefit the firm overall.
Innovation is encouraged by guaranteed employment, which negates the concern of process improvements leading to fewer jobs.
These measures make the firm and the individual share a common, singular goal. The tighter the alignment, the more the workforce becomes a highly efficient de-centralized success-seeking engine, which pulls the firm upward. Clear incentives to innovate coupled with job security is the key to building a sustainable business.
Advantage Over Most Firms
While this solution may seem intuitive, its clarity is key to its effectiveness; all parties can understand their role instantly. In typical firms, process innovation is disincentivized. What motive would any worker have to reduce the time it took to complete their task? It could cost them a job. But without innovation throughout, firms are destined for failure.
Everyone is a Worker
While workers and managers may feel like distinct groups, they are both in fact workers. A worker is anyone who, on a day to day basis, drives the motion of the firm.
Todays managers are often well incentivized by bonuses tied to performance, and as such serve as a model for all worker compensation. This compensation should however be sensitive to a transparent equitable distribution of profits. If the upper-paid workers make disproportionate amounts of money, lower-paid workers are disincentivized to work in the firms favour. Only through an equitable distribution of earnings can all workers be appropriately and evenly incentivized. And only though this balance can the firm be successful in the long run.
Similar pressures can be seen between the firm and its sources of capital. While investors seek an adequate return on their investment, the distributing of profits externally risks starving the workforce of motivation. Why improve performance if the benefits do not impact you? Investor and worker returns must be balanced based upon their contributions to firm success.
Continuous Employment: An Asset
Lincoln guarantees continuous employment. While this might sound like a ticking time-bomb, this is crucial to their ability to continually innovate. With workers un-afraid of optimizing the process, Lincoln constantly outpaces its competitors on cost reductions.
By viewing spare man-power as an asset rather than a liability, this risk can be turned into a strength. When time is spare, due to either new efficiencies or changes in demand, workers at Lincoln shift their focus to:
- Developing new products
- Exploring new markets
- Devising new operating efficiencies
- Building up an inventory to sell later
- Spending time resting
These activities all drive firm value by targeting aspects of the profit formula or bettering the individual. New products and markets expand the quantity, new efficiencies reduce costs, inventory can support periods of high demand, and rest time rewards the workforce. Overall, when workers have idle time, they are unleashed on pursuing long term firm growth.
Lessons for Firms Today
While many companies today do not produce welding equipment, the practices at Lincoln can be extrapolated to advise any company looking to succeed in the long run by constantly innovating faster than their competitors. As such the following should be applied.
The Incentive Model: Equate Team and Individual Goals
The drive of the founder and of the first hire should be tightly aligned, by sharing the potential upside and downside risk with the first hire they are highly motivated to work towards the success of the firm.
This of course is challenged by the desire for earnings stability, and as such should be balanced carefully. Lincoln has provided stable earnings despite this risk by growing year over year. Perhaps the pressure on all employees to succeed is enough to ensure the firm does meet its goals.
Whether you run a team or a company, ensure the individual and group goal are one. This could take the form of sharing the successes and failures evenly in terms of compensation or notoriety.
The Software Company — A Suitable Candidate. While the work of manufacturing and software may appear distinct, the software firm has a leg up on manufacturers, like Lincoln. In tracking quality Lincoln has to contribute significant efforts to tying the work of the individual to a particular finished good. This is done so that machines that break can be tied back to the individual who made them. This measure incentivizes quality production. In the world of software, with tools like git, code can be easily and cheaply tied to its creator. This traceability allows the firm to incentivize workers to produce quality work in a way not before possible.
A Collection of Entrepreneurs
Instead of viewing the firm as a collection of employees and levels of management, structure the firm as a collection of entrepreneurs. By maximizing the ability of the individual to feel the reward or punishment of their actions, the quality of work is continually driven upward. This drive is due to the availability clear feedback signals. Alternatively, when employees are insulated from their successes or failures, they are robbed of their rightful share in the upside as well as the indications that they have failed. Success and failure teach, so let them.
Individual Motivation Beyond Money
While the profit sharing model proposed may work for some businesses, it is by no means the only method to motivate the workforce to work towards the firms goals. In fact, some companies such as early stage startups may be working without wages. To assess the potential options available, consider the following management insight from James Lincoln:
Some think paying a man more money will produce cooperation. Not true. Many incentives are far more effective than money. Robert MacNamara gave up millions to become Secretary of Defence. Status is a much greater incentive.
— James Lincoln.
Lincoln also provides the following list of incentives he believes are critical to driving workers:
The incentives that are most potent when properly offered are:
1. Money in proportion to production.
2. Status as a reward for achievement
3. Publicity of the worker’s contributions and skill.
— James Lincoln.
The Startup — Pre-Wage Motivation. The startup can thus strive to clearly attribute success to the individuals that contributed to a particular initiative. Status can be gamified into micro-achievements that have the capacity to provide multi-annual boosts to the commitment of the workforce. Overall the goal of the firm should be clearly and constantly articulated through a strong vision to inspire employees in a common direction. By pairing an awareness of the direction with a clear understanding of the potential upside, employees can be driven to move the firm towards its goal.
Lincoln offers a different risk profile to their employees, they have a share in high upside, but at the cost of a significant downside risk. If a worker at Lincoln is sick, the firm looses productivity, and as such the worker is not paid. In many firms today, we mitigate this with sick days, a sort of collective insurance for illnesses. While you might not benefit greatly from this, the few who are very sick get to experience more benefit. This is a fair system that does truly reduce the downside risk of getting sick. If you’re ill you still get paid.
I would like to posit that these systems are beneficial, but not ideal. People take sick days when they really do not need them, and this practice has a cost that is indirectly felt by all members of the firm. It is a burden on the wages of everyone.
Consider for a moment the following scenarios to illustrate this point.
Firm A — The Ideal World: 10 units are produced by two workers. Each worker receives the profit generated by 5 units. Both workers never fall ill.
Firm B — Our Reality: 9 units are produced by two workers. Each worker receives the profit generated by 4.5 units. One of the workers was sick and as such the firm was able to produce less output this year. Knowing that one worker was compensated the same as another for less work, the worker who did not fall ill has no incentive to work more than another worker and decides to be more lenient in taking their own sick days. In the following year, 8 units are produced by two workers. Each worker receives the profit generated by 4 units, however this year one worker was indeed ill and the other was ensuring they were not working harder than their peer for the same compensation.
By no means am I implying that the support of workers through sickness is a bad practice. Reality dictates that some workers will get very sick, and in those cases it is ideal to sacrifice some of the upside profit from every other employee to support that one worker in their time of need. However, the issue may arise where this practice can be abused. In this case of abuse, the output of the entire firm is hurt which through reducing profits hurts all members of the firm.
The argument in favour of compensating workers only for work completed is the elimination of the cost of freeloading on the sickness support system. Perhaps workers can be paid more by a system that does not account for illness. By eliminating the inefficiency of freeloading, we put the decision to not work in the hands of the worker and have them experience the full weight of their decision. This system could be superior in offering higher earnings, due to the elimination of freeloading, which allows for days when the worker chooses to not work while still making more money than they would have under a system providing for sick days.
The counterargument to this approach is a lack of support for the extremes of sickness in which the worker is unable to make up for their days of productivity lost with higher earnings. The worker looses money here, and is sick.
In assessing the extent to which a firm should limit the downside risk of sickness it is important to understand the meaning of work and other institutions in life. Is it the firms role to provide for your life in its entirety, or should other institutions like insurance and government be taking on the task of social support?
A similar problem is present in the aging of the workforce. While workers can have high earnings in their youth, as they age and their productivity falls, so do, at Lincoln at least, their earnings. A well planned career would ensure savings from the plentiful years of youth are used to support old age. However if an individual does not save appropriately or is the victim of unfortunate circumstances, under this system they are out of luck.
Aging raises the question of the purpose of the firm, if the firm exists to produce value for its customers, then the support of the sick or old in need hinders its ability to do so. If the firm exists to insure every worker is insulated from the risks of life, then pensions and sick days become a better option. The true question is whether the firm or an external institution is more efficient, in dollar terms, in mitigating potential risks in the lives of employees. I would posit that a conglomerated system is bound to become inefficient, as the goals of various organization become confused and intertwined. As such separating work and personal insurance seems logical.
The Challenge Today
While an arc welder is easily identifiable, the ability for management and firms in some industries to track the individuals contribution towards the final work product of a company is not as simple. This poses one of the main challenges to implementing this framework in many firms.
Lincoln is not for everyone, and neither are the policies it lives, but by understanding the broad spectrum of possibilities available to firms, it can be possible to make more optimal decisions on how we choose to administer them.
By leveraging the decision making power and motivations of the individual, firms might be able to improve their ability to innovate in a consistent manner. It seems intuitive to ensure the employee feels as the firm does, success and failure. By aligning the needs of the firm and the individual, success for both can perhaps be more easily reached.