When building your home, imagine telling your architect to keep it simple and cost-effective, envisioning elegant, inexpensive Kota stone for the floors. Next thing you know, you’re being shown imported, super-expensive Italian marble that costs more than your entire project budget! The more it costs, the better they feel… while your wallet is screaming in protest.

Having taken up building renovation projects recently, one particular problem that I have given a lot of thought to is the misalignment of incentives. As a client, I obviously want to get a project done with the best quality, in the least amount of time, and at the lowest cost possible. Time aside, good quality can be achieved through many combinations of materials, not all of which are expensive. But here’s where the misalignment comes in—architects, for whom the pricier the material, the more they earn, often suggest costlier options even when there are perfectly good, and sometimes better, alternatives available. This issue of incentives is not unique to architecture. Let’s explore how this plays out across different industries and what can be done to fix it.

Architects: Designing for the Bottom Line

This situation reflects a classic economic problem: the principal-agent theory. In this model, the “principal” (the client) hires the “agent” (the architect) to act on their behalf. However, the architect’s financial incentives—when tied to a percentage of the overall project cost—may not align with the client’s goal of keeping costs down. The architect, with more technical knowledge and control over decisions (like material choice), might propose higher-cost options that benefit them more than the client.

Solution? To solve this principal-agent problem, contract design matters. Instead of paying architects a percentage of project costs, alternatives like fixed-fee contracts or shared savings models can realign incentives. In shared savings, if the architect delivers the project under budget, both the architect and client benefit from splitting the savings. This way, the architect is motivated to find cost-effective solutions, aligning their financial gain with the client’s budget goals.

• How the shared saving model works: In this model, the consultant (architect, doctor, etc.) and the client share any savings that result from completing the project under budget or by optimizing resource:.
  • Incentive for cost control: Because the agent has a stake in the savings, they are incentivized to minimize unnecessary expenses without compromising quality. This promotes a more efficient allocation of resources.
  • Focus on innovation: Agents may explore innovative, cost-effective solutions (e.g., cheaper materials or treatments) to maximize their share of the savings, which can drive efficiency in both process and outcome.

For example, when working with a top educational architect on a school project, we chose a model where they charged a per square foot fee rather than a percentage of the project cost. While this removed the incentive to inflate costs, the architect wasn’t responsible for project management. That meant the onus was on us and our Project Management Consultant (PMC) to save costs after the specifications were given. It mostly worked, but it required vigilance to keep costs under control.

Doctors: When Treatment Becomes a Business

In healthcare, a similar principal-agent problem occurs between doctors and patients. Patients (principals) trust doctors (agents) to make decisions about their care. However, when doctors benefit financially from recommending more tests or procedures, their incentives may misalign with the patient’s need for efficient and necessary care.

Most Indians visiting private hospitals have probably faced this classic situation: you go in thinking it’s just a simple viral fever, but before you know it, you’re being sent off for blood tests, sonographies, MRIs, and even a CT or PET scan—just in case! Of course, if you can afford it, you’d rather not take the chance. And that’s exactly what the doctors would like you to believe, right?

Solution? Here too, contract design can help. Value-based care or capitation models are designed to overcome this principal-agent misalignment. Instead of paying doctors per procedure (which incentivizes more tests), these models pay them a fixed amount to manage a patient’s health over time. The doctor is rewarded for delivering better long-term outcomes rather than ordering more tests or procedures, realigning their incentives with the patient’s needs.

• How performance based payment works: Agents are paid based on specific outcomes, such as project completion within a certain timeframe or achieving a particular health outcome:
  • Improved focus on results: Agents are no longer rewarded for the volume of services (e.g., number of tests, materials used) but for the quality of results. This leads to more targeted, efficient efforts focused on achieving the desired outcome.
  • Prevents over-utilization: By removing incentives tied to over-prescription (tests, materials, etc.), agents are more likely to focus on what is truly necessary, optimizing both time and resource use.

A great example of how incentives can be aligned is to allow insurers a direct role in healthcare delivery, the model used by Kaiser Permanente in the United States. As both an insurer and a healthcare provider, Kaiser Permanente has a unique system that encourages doctors to focus on patient outcomes rather than maximising the number of procedures or tests performed.

Kaiser Permanente employs its doctors on a salary basis, but what makes the model effective is that bonuses are tied to patient outcomes and efficiency metrics, not the volume of care provided. This structure aligns the incentives of doctors with long-term patient health, promoting preventive care, reducing unnecessary tests, and keeping overall healthcare costs down.

The Broader Problem Across Industries

This misalignment of incentives isn’t limited to architects and doctors. The principal-agent problem affects many industries, where the agent’s financial interests are at odds with the client’s goals.

Lawyers working on hourly rates are incentivized to drag out cases. The more hours they log, the more they earn. Clients, on the other hand, want fast and efficient resolution. A better approach could be fixed fees or success-based bonuses tied to case outcomes, ensuring that both the lawyer’s and client’s interests are aligned.

For instance, General Electric (GE) implemented a system with its legal advisors where lawyers are paid based on the resolution of cases rather than the time spent on them. This model realigns the lawyer’s incentives with the client’s goal of a quick, cost-effective resolution. By focusing on outcomes rather than hours, this structure reduces the potential for inflated billing and ensures that lawyers work efficiently toward the client’s desired result.

Construction companies working on cost-plus contracts benefit from higher project costs because their fees are a percentage of the total. A project management agency can act as an intermediary, aligning the incentives of both the contractor and the client. The project manager ensures costs are optimized, timelines are adhered to, and quality standards are met. Using a performance-based or shared savings model, the project manager and contractor would be incentivized to complete the project on time and within budget, aligning their goals with the client’s interests.

In large-scale construction, we see the principal-agent problem addressed through better contract structures. A prime example is the Heathrow Terminal 5 project, where an open-book contracting approach was used. Instead of each contractor inflating costs to maximize profits, the project operated under a shared savings model. Costs were openly shared between the client and the contractors, and savings were split when the project came in under budget. This alignment of incentives ensured that everyone was working toward the same goals of efficiency and cost control, rather than maximizing their individual profits.

Realigning Incentives: The Path Forward

The key to fixing these misalignments is to design compensation structures that ensure both parties—service provider and client—are working toward the same goal. Here’s how:

• Fixed-fee plus bonus: Set a base fee, but offer a bonus for coming in under budget or achieving measurable goals.
• Shared savings models: Split any savings from cost efficiencies between the consultant and client. This encourages the consultant to find cost-effective solutions.
• Outcome-based payments: In healthcare, for example, doctors should be paid based on patient health outcomes, not the number of tests or procedures performed.
• Transparent pricing: In industries like healthcare or construction, transparent pricing can help clients make informed decisions, reducing the likelihood of inflated costs.

You don’t want to be in a situation where you ask your contractor to build a cozy home, only to end up with a marble fountain and gold-plated sinks—sure, it’s fancy, but it’s not what you asked for (or can afford!). Understanding the principal-agent problem helps explain why the people you hire sometimes make decisions that serve them more than you. By smartly designing contracts that align incentives—whether it’s with your architect, lawyer, or doctor—you can make sure everyone’s working toward the same goal: yours. Because at the end of the day, it’s your project, your health, your case—and those should be the only priorities that matter, and your wallet, of course!