Spotlight: Erik Madsen

Expert Advice and Incentive Contracting

Erik Madsen

Erik Madsen

Imagine stepping into the role of divisional manager at a large firm.  The company has fallen on hard financial times and your CEO calls for each division to root out inefficiencies.  You decide to bring in an operations consulting team to lend much-needed expertise toward identifying cost cuts, avoiding penny-wise but pound-foolish proposals.  You’d also like to rely on their past experiences on similar engagements to size the project; that is, to decide how much time and energy should be invested toward streamlining operations.  But your consulting team is expensive and paid by the hour, and you’re concerned that giving them discretion would lead predictably to a protracted, expensive engagement.  What should you do?

Absent an effective management strategy, this misalignment of incentives prevents you from giving your consultants discretion on project size, wasting their expertise.  This inefficiency is particularly acute in the modern business landscape, where process and supply chain expertise is concentrated in consulting groups habitually hired by large corporations.  In recent work I explore how deadlines and bonus schemes can be used as management tools to address this issue and boost the value-add of consulting projects. 

I propose writing two key provisions into consulting contracts: a sunset clause and a project completion bonus.  The sunset clause imposes an upper limit on project scope, with room for extensions if efficiency gains continue to be found.  Meanwhile the bonus is a contingent one, taking into account how long the project lasted and how much cost-cutting was achieved.  I show that, when designed properly, these two tools used in concert can profitably align consultants’ incentives to size their project.    

How does this work?  Absent a completion bonus, your consultants would never suggest the project be wrapped up.  So bonuses are absolutely necessary to get helpful input.  If there were no accompanying cap on project scope, buying your consultants’ knowledge this way would be very costly.  The sunset clause alleviates this problem, reducing foregone consulting fees and thus the compensating bonus due when the project ends.  So bonuses and sunset clauses working together can utilize your consultants’ information without entailing huge incentive payments.  The optimal timing of the sunset clause trades off the expense of bonus payments against the lost gains when projects are wrapped up too early.  One natural feature of this contractual design stands out: since your consultants have less to lose wrapping up the project if the sunset clause is about to be triggered, the termination bonus will decline with the project’s lifespan.

The most difficult design problem of this management scheme is how best to take into account the success of the project in finding cost cuts.  My research lays down a rigorous mathematical model in which this question can be answered precisely.  Unsurprisingly, your contract should react to cost-cutting success by pushing back the sunset time and boosting termination bonuses.  But not all cuts are created equal – cuts found early in the project should be given little weight, while cuts near the sunset time should have large impacts on the lifespan of the engagement and on bonuses.

At first glance, this result simply reflects the fact that you learn more about whether the project is worth continuing from successes late in the project than from ones early on.  However, this logic fails to account for the fact that your contract aligns the team’s incentives to give honest advice.  This means there can’t be any value to attempting to independently learn from project successes; you should simply trust in your consultants’ advice instead.  This leaves a puzzle, since any incentive power of conditioning on cost cuts can’t stem from learning about the state of the project. 

My work illuminates the true forces shaping design of an optimal contract.  Rewarding the discovery of cost cuts is valuable because it decreases the payoff from lying to extend an exhausted project, without penalizing the team when the project really is worth continuing.  So the average size of bonus payments can be shrunk if they are made more sensitive to cost cutting.  On the other hand, since cost cutting is an uncertain process, this sort of adjustment increases the riskiness of bonuses, which entails more riskiness in the sunset time to preserve incentives for honesty.  This turns out to be costly: because you discount future returns, instances in which the project is forced to terminate early hurt you more than instances in which the project is extended further into the future help you.  The optimal sensitivity to cost cuts then trades off savings in incentive payments against the costs of inefficient project operation.  Critically, this tradeoff leans toward variability late in the project.  Initially the value of shrinking bonus payments at the cost of project lifespan should be about zero, or you’d have written a contract with smaller bonuses and a more stringent sunset clause to begin with.  Thus you shouldn’t condition on the discovery of cost cuts very much at this phase of the contract.  On the other hand, late in the contract you benefit significantly from gambling to extend the project, which is about to be terminated otherwise, and incur a minor cost by increasing bonuses, which are small at this point.  So reacting sensitively to new cost cuts makes good business sense near termination.  In my work I formalize this reasoning to derive the dynamics of an optimal incentive contract over the lifespan of the consulting engagement.

My work builds on a robust economic literature on principal-agent problems, which study alignment of incentives between managers or firm owners and the employees working under them.  Extending the methodology of this literature, I develop concrete proposals for overcoming potential dysfunction resulting from the widespread use of consultants in modern management practice.