Member of the Department of of Strategy faculty until 2017
Alvin J. Huss Professor of Management and Strategy; Professor of Strategy
When Donald F. Hastings took over as CEO of the welding-supply manufacturer Lincoln Electric in July 1992, he anticipated a little time for celebration. But literally less than a half hour later, the new executive’s bubble burst: The European operations of his Cleveland-based company reported $7.5 million in losses, which, added to losses in Latin America and Japan, made for a devastating overall $12 million second-quarter plunge in assets. “I could imagine the headline in the local newspaper,” Hastings later recalled in the Harvard Business Review: “New CEO at Lincoln Electric Fumbles in First 24 Minutes on the Job.”
Hastings remembered how his thoughts then “raced ahead to December” 1992, when the company would be expected to pay out millions in bonuses to its 3,000 American workers. Year-end bonuses had long been Lincoln’s style, comprising more than 50 percent of the company’s often $70,000–$80,000-level salaries. Small wonder that Lincoln’s workers signed on for life and the company dominated its market. So, on that July day in 1992, Hastings had to decide: Set a possibly dangerous new precedent by borrowing to pay the bonuses, or not pay them and undermine worker motivation?
Such dilemmas spurred a forthcoming analysis by Jin Li, an assistant professor of management and strategy, and Niko Matouschek, a professor of management and strategy, both at the Kellogg School of Management. Their analysis focuses on what are known as relational contracts. Such “contracts” cannot be quantified or written down (at least to a lawyer’s satisfaction) the way, for instance, a sales agreement might be: Sell $100,000 worth of our product and get a 5 percent commission. Instead, relational contracts represent more casual understandings between management and labor about things like performance bonuses.
The researchers were interested in how relational contracts affect worker productivity. “You look at any narrowly defined industry—there are big differences in productivity,” says Li, noting that it is important to explain these differences so that firms know what they must do to keep their workers motivated. “But there are obstacles,” he adds. “There are frictions that prevent the firms from keeping their promises.”
What Li and Matouschek wanted to explore was the question: “What are the sources of these obstacles and how can firms manage and deal with their obstacles successfully?”
One of their biggest concerns, Li and Matouschek describe in their recent paper, was that of information asymmetry: “Managers are typically better informed about the challenges and opportunities that their firms face and therefore often have private information about the opportunity costs of their workers,” they write. That is, workers are often unclear as to whether they are being denied a bonus because their firm genuinely needs to direct resources elsewhere, or because the firm is simply being cheap—in which case punishment, by way of lower productivity, is in order. In the absence of this knowledge, workers may simply choose to punish their manager no matter what the reason behind the broken promises.
Workers vs. Management
In order to better understand this phenomenon, the researchers modeled interactions between a manager and a worker. The manager offers the worker a compensation package (a formal wage as well as the informal promise of a bonus), which the worker can either accept or reject. If he accepts, he chooses how hard to work. Later, once the manager determines how costly it will be to provide the bonus, she decides whether or not to do so. Deciding not to offer a bonus ensures that she will either have to increase her worker’s salary the next time around, or simply accept less effort from the worker (who after all has no idea why he has been denied his bonus).
The researchers found in their research of such scenarios that when managers could tap into unlimited funds to pay their workers, the optimal relational contract was one in which the worker was promised a bonus, which was paid when opportunity costs were low but denied when they were high. This led workers to be maximally productive after being paid a bonus—and assured of yet another bonus—but to punish their managers by gradually lowering productivity when they were denied a bonus. (Punishing a manager by dramatically lowering productivity would leave the manager with less money to pay a bonus the next time around.)
“The more trust you have from the workers, the more flexibility you will have in dealing with what economists call ‘shock’—a bad situation.” — Jin Li
When companies were tight on liquidity, however, managers had a tougher time dealing with such conflicts, and at times lost their workers. But all is not lost when this occurs, the researchers write: Managers can also “induce the worker to respond to a conflict by providing more effort rather than less. Essentially, the worker understands that more effort relaxes the firm’s liquidity constraint, which, in turn, allows the manager to pay him a larger bonus.”
In the American workplace, trust between workers and management is key. Otherwise, workers are likely to punish firms with decreased productivity, or even abandonment, just when their efforts are needed most.
“How do you actually manage trust from the workers? That’s subtle,” says Li. “That has to do with: How much trust do the workers have in you in the first place? You can almost think of trust as one of the resources you have. The more trust you have from the workers, the more flexibility you will have in dealing with what economists call ‘shock’—a bad situation.” He continues, “I think this can be applied not just to an economic situation but to our lives, as well. To relationships in general … friends, spouses, parents and kids.”
In the end, Hastings borrowed the cash—some $52 million—to pay out bonuses. But he also did something else. He decided to tell all to his troops. In fact the CEO instituted a financial education program to assure employees that no money was being hidden from them. He shared the fact that Lincoln planned to offset its losses abroad by boosting production domestically. The goal was an increase in sales, from $1.8 million to $2.1 million per day in the U.S. market and a jump in production, from 75 to 80 percent of capacity per day, to 100 percent. New hires would be added, but the veteran workers training them would have to give up holidays and postpone vacations.
They did that, and more; daily sales at Lincoln Electric shot up that next year to $3.1 million. “By October 1993,” says Hastings, “it was clear that Lincoln would be okay.”
Li, Jin and Niko Matouschek. Forthcoming. “Managing Conflicts in Relational Contracts.” American Economic Review.