Balancing Incentives, Risk and Tolerance of Failure for Collaborative Innovation

12 August 2014

Financial incentives for managers of innovative projects, a firm’s tolerance for failure, and the number of managers involved in the projects all influence resource allocation (and chances for success) for those projects. 

Idea Summary

Innovation through collaborative teams can succeed or fail in large part based on resources dedicated to the venture. While many factors may ultimately impact success or failure, all else being equal, if more resources are allocated to a project, the risk that it fails is less.

Whether or not managers are willing to dedicate those resources depends on several factors, including the financial rewards and financial penalties that might accrue from the success or failure of the innovation project. When managers are offered a greater share of the profits, they are more willing to dedicate the resources that give the innovation venture a greater chance of success. The reverse is true, however.  When managers must bear a greater share of the cost (in the form of explicit or implicit penalties), they are less willing to put resources into the venture. What is interesting is that higher rewards lead to higher resource allocation when the penalties are also high. If, however, the penalties are low, offering rewards have little impact on how resources are allocated to the venture.

The impact of the financial levers on an individual’s resource allocation decision is altered slightly when more than one individual is determines the resources allocated to the venture. Specifically, the total resources allocated are greater if two individuals share decision-making. This means that the structure of decision-making — the control that an individual has over the total resources allocation — related to the innovation project makes a difference in an individual’s resource allocation.

Another factor that plays a role in resource allocation decisions — and thus improves or reduces the chances of success — is the environment in which the decisions are made. Specifically, an individual’s decisions are affected by an organization’s tolerance for failure. Individuals are willing to take more risk (and thus allocate less) if they operate in an environment in which the tolerance for failure is high; conversely, they’ll want to invest more when tolerance for failure is low.

Once again, project structure enters into the equation. When the resource allocation decision is made by one individual, the beneficial impact of a high tolerance for failure environment is muted. Specifically, when one individual controls the decision, the difference between the resources allocated in a low tolerance and high tolerance environment is not as great as when multiple individuals determine the resources allocated.

Business Application

The growth of a company depends on innovation and new product development (NPD). NPD and innovation, however, requires managers to make decisions about the allocation of resources that will impact the risk inherent in the project (the better-financed the project, the lower the risk of failure).

How can firms manage resource allocation and risk taking related to its innovation and NPD initiatives? 

  1. Assess the Tolerance for Failure. The first step is to assess the tolerance for failure in the organization. Flexible rules and low levels of bureaucracy, or policies that allow continued investment in promising projects despite early failures, are signs of a corporate culture with a high tolerance for failure. A culture that is focused on cost control, on the other hand, reflects a low tolerance for failure. 
  2. Use Financial Incentives As Appropriate for Corporate Culture.Intuitively, financial incentives, such as a greater share in the profits, leads to more resource allocation and thus less risk: managers are willing to invest more to ensure a greater chance of success. However, the research also shows that this effect is a bit muted when penalties for failure are low. Thus, in high-tolerance firms, financial incentives don’t make much difference. Managers are going to be willing to take risks regardless of the financial incentives involved.
  3. Develop Project Structures that Fit the Goals and Cultural Attributes of the Firm. Another managerial lever for the firm is project structure — specifically whether decision-making is in the hands of one individual or is shared among individuals. In general, individual decision makers are more willing to take risks than multiple decision makers. Once again, this is especially true in low-tolerance firms, where risk can be penalized. In high-tolerance firms, managers will be more free to take risks.

The bottom line, particularly for firms with a low tolerance for failure, is that financial incentives present the best levers for senior executives to influence the decisions and outcomes of collaborative innovation projects. But project structure can also be an influential lever. Executives must manage the interplay of all three levers — financial incentives, project structure, and corporate culture — as they decide how best to influence innovation collaborations in their companies.