Get the Kinks Out

By PON Staffon / Business Negotiations, Daily

Adapted from “Should You Get the Kinks Out?” by Ian Larkin (professor, Harvard Business School), first published in the Negotiation newsletter.

You may have heard about the power of contingent contracts in negotiation. As an example, imagine that a supplier has proposed you pay a bonus of 10% if the fault rate for its products is less than 3%, a bonus of 15% if the fault rate is less than 1.5%, and so on.

Such contingent contracts are a powerful method for overcoming differences in beliefs about the future and aligning incentives between negotiators. Contingent contracts with “kinks,” or increased rewards for meeting certain targets (or penalties for failing to meet targets), are common. Some experts warn that kinks can distort your counterpart’s behavior. Yet in many cases, the benefits of kinks outweigh the costs of potentially destructive behavior.

To see why kinks can cause distortion, let’s look at the contract the supplier proposed. Arguably, it gives the supplier an incentive to increase the quality of its products. But once the supplier hits a kink—for example, the 3% fault rate required for a 10% bonus-it may not invest further in quality enhancements if the next bonus seems unattainable. Even more troubling, a supplier may react to kinks by replacing low-quality products with high-quality ones solely to win a bonus for a particular delivery—and then unload the low-quality products on you in its next delivery. Overall, quality wouldn’t increase, yet the supplier would still earn a bonus.

Although it’s true that kinks should be managed, you don’t need to avoid them at all costs. In fact, recent research suggests two motivational benefits of kinks.

First, laboratory experiments have found that people are more efficient at assigned tasks when they are paid using a kink (such as $1 for the first 10 mazes solved and $2 for every maze after that) than when paid a linear fee (such as $1.75 for each maze solved). We perform at our best when the kink is set at a target that’s difficult but not impossible to reach. The kink becomes a motivating factor that enables people to meet tough goals. In the case of your supplier, make sure to set difficult but realistic fault rates.

Second, and important in many environments, kinked contracts appeal to those who are optimistic and confident. In lab experiments similar to those just described, many participants were attracted to the high benchmarks offered by kinks.

This finding suggests that when you’re seeking optimism and confidence in a partner or employee, kinks can help with selection and retention. Consider that salespeople are often paid using kinked compensation. In sales, hearing no is a fact of life, and the time between successes can drag. By offering compensation with kinks, you can screen out employees or business partners who lack the positive disposition needed to sustain them through lean times. In your case, the supplier proposing kinks was expressing confidence in the quality of its products.

In sum, when negotiating a contingent contract that has kinked incentives, keep potential distortions in mind. But remember that you can often use kinks to resolve strong differences in forecasts and to attract, motivate, and retain confident partners.