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Ideas for Leaders #059
Driving Risk Appetite Higher or Lower:
Penalties Vs Rewards
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
10.13007/059
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.
Further Reading
Tolerance for Failure and Incentives for Collaborative Innovation, Hutchison-Krupat. J, Chao. R, Darden
Business School Working Paper No. 1921550 (2012)
Further Relevant Resources
Jeremy Hutchison-Krupat’s profile at Darden Business School
Raul O. Chao’s profile at Darden Business School
Darden Business School’s profile at IEDP
Authors
Hutchison-Krupat, Jeremy
Chao, Raul O.
Institutions
University of Virginia Darden Business School
Source
Darden Business School Working Paper
Idea Conceived
2011
Idea posted
January 2013
DOI number
Subject
Cross-cultural Management
HR Management
Behavioral Economics
Creativity and Innovation
Product Development
Research & Development
Leadership
Risk Management
Reward Management
© Copyright IEDP Ideas for Leaders 2013
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