Get the incentives right: Charlie Munger on the 'most important management lesson'

Munger died on November 28, a little over a month before his 100th birthday on January 1.

His views on incentive schemes have been quoted and paraphrased several times. One of the famous ones is "show me the incentive and I'll show you the outcome", though it isn't clear where he said those exact words. What is clear is that he had a strong opinion on incentives, even crediting them with having "super powers".

In a speech titled the Psychology of Human Misjudgement, he elaborated on the theme.

He discussed it under one of the human tendencies, which he called reward and punishment superresponse tendency.

Munger discussed the example of Federal Express. It required all packages to be shifted among aeroplanes every night, and this had to be done fast. The company tried every method possible to pursuade its employees to do this task quickly but nothing worked until someone figured out the flaw in the system. The workers were getting paid by the hour, so longer hours worked well for them. When FedEx started paying employees by the shift and said that employees could go home when the work was finished, everyone rallied to finish fast!

Another example he gave was of Xerox. Its founder Joeseph (Joe) Wilson couldn't figure out why customers were buying the older inferior model instead of the new one. Later, he figured out that the salesman was given a larger incentive to push the older one instead of the new one.

He even cited individuals who suffered for not spotting the right incentives.

Munger spoke of an in-house counsel of an investment banking firm who, when advising his client, appealed to the client's moral duty instead of telling the client that not following his advice would result in the client being "clobbered to smithereens".

Both client and the counsel lost their careers, said about the case he personally witnessed.

In this context, Munger also pointed to the importance of making bad behaviour difficult.

In fact, he called people who create things like the cash registers--which make "dishonest behaviour hard to accomplish"--one of the "effective saints of our civilisation".

He said that employees could dissuade people from behaving badly with "antidotes" such as sound accounting practices, rigorous internal audits and severe public punishment for "miscreants", besides "behaviour preventing" routines and machines such as cash registers.

Free market capitalism has succeeded largely because there is no incentive-caused bias, he said.

Also read: Raamdeo Agrawal explains Charlie Munger’s compounding strategy, and why only a few get it

"Most capitalist owners in a vast web of free-market economic activity are selected for ability by surviving in a brutal competition with other owners and have a strong incentive to prevent all waste in operations within their ownership. After all, they live on the difference between their competitive prices and their overall costs and their businesses will perish if costs exceed sales," he said.

"Replace such owners by salaried employees of the state and you will normally get a substantial reduction in overall efficiency as each employee who replaces an owner is subject to incentive-caused bias as he determines what service he will give in exchange for his salary and how much he will yield to peer pressure from many fellow employees who do not desire his creation of any strong performance model," he added.