Ideas for Leaders #059

Driving Risk Appetite Higher or Lower: Penalties Vs Rewards

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Key Concept

‘Innovate or die’ we are told. What if an organization’s ability to innovate could be enhanced by managing risk-taking behaviour through monetary incentive schemes and through a culture that tolerates failure? In this Idea we identify the precise levers that shift risk appetite, and show how they can be tweaked to foster innovation.

Idea Summary

In many organizations, collaborative innovation teams are utilized to manage new product development initiatives. This involves different types of managers (marketing, operations, engineering, etc.) working together to allocate resources to a project. This remains an effective way to spark innovation, but the process can be greatly enhanced by understanding the role that rewards and penalties can play in the decision-making of managers.

In a controlled laboratory experiment, subjects were asked to decide the level of resources to invest in each of eight projects that were presented in sequence.

The results were three-fold. Firstly, subjects choose to allocate more resources when the reward is high or when the penalty is low. Secondly, the way in which project control is administered moderates the effects of both rewards and penalties; for example, when control over critical project decisions is shared, subjects do not internalize the effects of reward or penalty as much as they do when control rests with one individual. Finally, when rewards and penalties are balanced so that both are high or both are low, subjects tend to exhibit a greater risk appetite.

One of the important implications to note is that managerial rewards do not positively influence actions as much (and penalties do not negatively influence actions as much) when the control of a project is shared between multiple functional (or technical) managers.

Taken together these insights have important implications for senior executives charged with delivering innovation and creating growth. While the first instinct is to assume that firms should always encourage risk taking (perhaps because of the potential value associated with risky innovation initiatives), it is important to remember that there are many instances in which firms would do well to encourage less risk appetite (as is often the case with process improvement programs).

Business Application

Shifting risk appetite can have big consequences in an organization. By understanding them as levers, leaders can purposefully balance or imbalance rewards and penalties to alter the risk appetite of managers and perfect the setting for innovation.

For example, low penalties combined with low rewards leads to an increased risk appetite. In this way, firms retain a higher portion of profit when projects succeed. On the other hand, low penalties combined with high rewards lead to a decreased risk appetite, with managers investing more to increase the likelihood of project success.

High penalties combined with low rewards also lead to a decreased risk appetite, with managers investing less to reduce penalties when projects fail. On the other hand, high penalties and high rewards lead to an increased risk appetite.

These findings bring to light the levers that must be used if a firm wants to drive higher or lower risk appetite. Since there are situations in which either of these may be desirable, set rewards and penalties in a manner that is aligned with your firm’s strategy.

These insights have both short and long-term implications for firms. On the one hand, penalties imposed on managers emerge from the organizational culture, which is, for all intents and purposes, fixed in the short term; therefore, the firm can only alter incentives (rewards) in the short term. Changing penalties, however, requires cultural change, which is usually a long term undertaking.