Managing Trust in the Workplace
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Leadership Oct 7, 2013

Man­ag­ing Trust in the Workplace

The per­ils of break­ing promis­es to employees

Based on the research of

Jin Li

Niko Matouschek

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.”

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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?

Rela­tion­al Con­tracts

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.”

Build­ing Trust

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.”

Featured Faculty

Jin Li

Member of the Department of of Strategy faculty until 2017

Niko Matouschek

Professor of Strategy, Department Chair of Strategy

About the Writer

Joan Oleck is a freelance writer based in Brooklyn, New York.

About the Research

Li, Jin and Niko Matouschek. Forthcoming. “Managing Conflicts in Relational Contracts.” American Economic Review.

Read the original

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