Compensation

Chapter 09
Pay-For-Performance: The Evidence
©McGraw-Hill Education. All rights reserved.
What Behaviors Do Employers Care About?
Employers want employees to perform in ways that lead to
better organizational performance.
• HR’s job is to devise policies that lead employees to behave in ways
that support the corporate goals.

Employee behavior is a function of motivation, ability, and

environment.
• Success depends on finding people with ability.
• Pay and other rewards should reinforce desired behaviors.
• The culture should point in the same direction.

If employers fail to recognize skills requirements (HR planning),

it is difficult to arrange training and develop compensation to
reward these new skills.
©McG
Exhibit 9.1: The Cascading Link Between
Organization Strategy and Employee Behavior

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©McG
Exhibit 9.2: The Big Picture, or Compensation
Can’t Do It Alone!
©McG
What Behaviors Should Be Reinforced?
Compensation should reinforce the following behaviors.
• Attraction - It should make recruiting and hiring easier.
• Retention – It needs to make sure good employees stay.
• Development – After attracting and retaining good employees,
concentrate on building further knowledge and skills.
• Performance – Compensation should motivate employees to apply
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their abilities in ways that contribute to organizational performance.

The impact on performance measures a sound compensation

package.
©McG
Do Incentives Work?
Incentives work in some situations and not in others.
• A low-incentive component is appropriate in organizations with
highly variable annual performance.
• Larger-incentive components are appropriate in companies with
stable annual performance.

Individual employee performance varies.

Companies offering an array of rewards as part of the

compensation package are better able to get employees to adjust,
be flexible, and show commitment.
©McG
What Is the Conclusion?
Organizations should address the following four questions.
• How do we attract good employment prospects to join our company?
• Job characteristics and recruiter behaviors are key elements.
???
• How do we retain these good employees once they join?
???
• How do we get employees to develop skills for current and future jobs?
???
• How do we get employees to perform well while they are there?
• The compensation challenge is to design rewards that enhance job
performance.
???
©McG
How to Get These Behaviors – What Theory Says
In the simplest sense, motivation involves what’s important to a
person, and offering that in exchange for some desired behavior.
Data suggests employees prefer pay systems influenced by:
• Individual performance.
• Changes in the cost of living.
• Seniority.
• Market rate.

Flexible compensation allows employees to choose rewards

which best suit their personal needs.
©McG
Motivation Theories
Several theories focus on content – identifying what is important
to people – Maslow and Herzberg.
Other theories focus on rewards in exchange for behaviors.
• Expectancy theory holds that employers choose behaviors that yield the
most satisfactory exchange.
• Equity theory believes people are highly concerned with equity of the
exchange process.
• Agency theory depicts employees as agents who enter an exchange with
principals.

GOAL-SETTING THEORY FOCUSES ON DESIRED

BEHAVIOR.
SPECIFIC/MEASURABLE/ACHIEVABLE/RELEVANT/TIME-
BOUND
• Self Determination Theory integrates motivation theories under a
©McG
What Practitioners Say
In the past, employees learned about expected behaviors through
socialization or performance management.
Now, companies ask, “What do we want our compensation
package to do?”
Compensation is but one of many rewards influencing behavior.
• Employers may overpay in cash and miss the opportunity to let
employees construct a satisfying and less-expensive reward package.

If employers don’t offer rewards other than money, they may find
that compensation produces unintended consequences.
©McG
Exhibit 9.5: Components of a Total Reward –
aka Total Compensation System

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©McG
Wage Components and Risk
RISK is defined in terms of stability of income, or the ability to
accurately predict income level from year to year.
• Base pay is the guaranteed portion of income.

Companies have moved toward compensation programs higher

on the risk continuum.
• New forms of pay are less entitlement-oriented and more linked to the
uncertainties of individual, group, and corporate performance.
• Employees are increasingly expected to share the risks of the company.
• Some research suggests employees may need a risk premium to stay
and perform in a company with pay at risk.
©McG
Do People Join a Firm Because of Pay?
Job candidates look for organizations with reward systems that
fit their personalities.
• Materialistic – more concerned about pay level.
• Low self-esteem – wants large, decentralized organization with little
pay for performance.
• Risk takers – want more pay based on performance.
• Risk-averse – want less performance-based pay.
• Individualists – want pay plans based on individual performance, not
group performance.

Talented employees are attracted to strong links between pay and

performance.
• There is a positive impact of reward choice as long as employees view
the choices available as attractive.
©McG
Do People Stay (or Leave) Because of Pay?
Equity theory documented that workers who feel unfairly treated
in pay react by leaving the firm.
• Dissatisfaction with pay may be a key factor in turnover.
• Even the way an organization pays can impact turnover.

A scarce talent approach of retaining workers may use a pay-for-

performance pay to appeal to those few with the needed skills.
Besides money, other rewards influencing the decision to stay:
• Job satisfaction – work enjoyment.
• Pay and benefits.
• Social – coworkers are fun.
• Organizational commitment – not a job jumper, loyal.
• Organizational prestige – company or industry respect.
©McG
Do Employees Develop Skills Because of Pay?
The answer is unknown.
Skill-based pay is intended to pay employees for learning new
skills that will help with current and future performance.
Evidence is starting to accumulate that pay for skill may not
increase productivity.
• But it does focus people on believing in the importance of quality.
• And in turning out significantly higher quality products.
©McG
Do Employees Perform Better Because of Pay?
A well-designed plan linking pay to behaviors generally results in
better individual and organizational performance.
Numerous studies and evidence shows a correlation between
performance and pay, merit pay, bonuses, and profit-sharing.
Critics contend that incentives are both morally and practically
wrong.
• Alfie Kohn suggests that extrinsic rewards (money) reduces intrinsic
rewards (enjoyment of the task for its own sake).
• POLICE/FIRE/EMS/HEALTHCARE
• Critics of his interpretation point out that not all jobs are intrinsically
interesting and his studies looked at people in isolation.
©McG
Should Pay be Tied to Performance?
Performance-based pay is less likely when the job involves
multitasking, important quality control issues, or teamwork.
Do employees think pay and performance should be linked?
• Evidence indicates management and workers alike say “Yes.”

How does this performance improvement occur?

• One view suggests the incentive effect and the sorting effect.

Experts estimate that for every dollar spent on any

performance-based pay plan, it yields $2.34 more in
organizational earnings.
Recognize that such plans can, and do, fail.
• Poorly implemented incentive pay plans can hurt rather than help.
©McG
Designing a Pay-for-Performance Plan
Efficiency involves three general areas of concern.
• Strategy – the plan must support corporate objectives and link well with
HR strategy.
• Structure – will it allow flexible variations on a general plan?
• Standards – employers should be concerned with objectives, measures,
eligibility, and funding.

Equity, or fairness, includes two types of concern to employees.

• Distributive justice – fairness in the amount distributed.
• Procedural justice – fairness in determining rewards.
• A key element in fairness is communication.

Compliance with existing laws is a must for a pay-for-

performance system.
Compensation
Chapter 10
Pay-For-Performance Plans
©McGraw-Hill Education. All rights reserved.
What Is a Pay-For-Performance Plan?
Many compensation practices are lumped under pay-for-
performance, such as:
• Incentive plans, variable pay plans, compensation at risk, earnings at
risk, success sharing, risk sharing, and others.

People used to think of pay as primarily entitlement.

Pay-for-performance plans move toward pay that varies with

some measure of individual or organizational performance.

Many surveys on pay-for-performance omit the starting point of

all these plans, merit pay.
©McG
How Widely Used is PFP?
99% of organizations use some form of short-term incentive plan.
• The use of variable pay in general has increased.

The greater interest in variable pay can be traced to two trends.

• Increasing competition from foreign producers forces U.S. firms to cut
costs and/or increase productivity.

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• Today’s fast-paced business environment means employees must be
willing to adjust what they do and how they do it.

The most common performance basis is a combination of

corporate, unit, and individual objectives.

Long-term incentive plans are more likely to be used for

officers/executives and other higher job levels.
©McG
The Important Role of Promotion in PFP
Merit pay is widely used and the average merit pay increase is
about 3% per year.
• An average employee would double their salary in about 23 years.
• Higher performers will get larger merit pay increases and their salary
will increase faster, but it will still take a while.

Salary increases due to promotion are much larger, ranging

around 15%.
• Salary could double every 5 years.
©McG
Pay-For-Performance: Merit Pay Plans
A merit pay system links increases in base pay to how highly
employees are rated on a performance evaluation.
• Most use a merit increase grid to determine merit pay on the basis of
performance and also position in the salary range, or grade.
• Captured by the compa-ratio – employee salary divided by range midpoint.
• Ratios are plugged into the grid to determine size of merit increase.
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At the end of a performance year, employees are evaluated.
• Merit pay increases, unlike variable pay, is added into base pay.
• What the employee does this year is rewarded every year the employee
remains with the employer.
©McG
Exhibit 10.4: Merit Increase Grid Example
©McG
Exhibit 10.5: Distribution of Performance Rating
and Average Merit Increase and Short-Term
Incentive Payout by Performance Rating
©McG
Concerns About Merit Pay
Merit pay increases fixed compensation costs over time.
• One response is to use merit bonuses or other variable pay plans.

Merit pay becomes costly if too many high performance

ratings are awarded.
• Control the number of high ratings and/or improve the accuracy and
credibility of performance ratings.

Merit pay differentials are too small to motivate

performance.
• Use larger differentials and include the role of promotions to strengthen
merit pay differentials.

Individual performance is a deficient measure when work is

interdependent and requires cooperation to obtain objectives.
• Broaden criteria to include cooperation and other factors.
©McG
Evidence for Merit Pay
PFP plans create an environment that rewards excellence.

Most discussion of merit pay focuses on incentive effects.

• How does merit pay influence performance of current employees?

Merit pay may also have significant sorting effect causing

employees who do not want pay tied to performance to leave.

For merit pay to live up to its potential, it must be managed.

• This requires a complete overhaul of the way raises are allocated.
• Unless the reward difference is larger for every increment in
performance, many employees will say, “Why bother?”.
©McG
PFP: Short-Term Incentive Plans
Merit bonuses differ from merit pay in that employees receive
an end-of-year bonus that does not build into base pay.
• Over time, these can be considerably less expensive than merit pay.

Spot awards are given for exceptional performance, often on

special projects or for performance exceeding expectation.

ANY ISSUES WITH THIS?

Individual incentive plans offer a promise of pay for some

objective or pre-established level of performance.
• All plans have one common feature: an established standard.
• These plans do not work for every job.
©McG
Exhibit 10.6: Relative Cost Comparisons

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Jump to long image description.

©McG
Exhibit 10.7: Customer Service Bonus Scheme
at Prometric Thomson Learning Call Centers

Jump to long image description.

©McG
**Individual Incentive Plans: Returns and Risks
Individual incentive plans are not widely used.
• Outside of sales, less than 4% of employees work under such plans.

There is strong evidence that individual incentives, on average,

have substantial positive effects on performance.

Besides not fitting many jobs in the economy, another reason for
their limited use is that things can go wrong.
• Incentive plans can lead to unexpected, and undesired, behaviors.
• A common problem is employees and managers end up in conflict.
• Systems often focus on one small part of what it takes for the company to
succeed.
• Employees then focus on that one small part.
©McG
Individual Incentive Plans: Examples
Even though these plans are less popular, there are still notable
successes.
• Most sales positions have some part of pay based on commissions, a
form of individual incentive.

The biggest success story is the merger of individual incentives

with efforts to reduce health care costs.
• Companies deposit money into employee health reimbursement
accounts for participating in various health incentive programs.

The longest-running success belongs to Lincoln Electric

company.
• The compensation and the reward package fit together.
• Both culture and the performance review system supports the
different pay components.
©McG
Team Incentive Plans
When focusing on people working together, we shift to team or
group incentive plans.
• The established standard measures team performance to determine the
magnitude of the incentive pay.

Despite increased interest in teams and team compensation, many

reports are not encouraging.
• Teams come in many varieties.
• The “level problem” creates difficulty equalizing when assigning
rewards.
• Some plans are simply too complex.
• Control and fairness are key issues.
• Team-based plans are simply not well communicated.
©McG
Team Incentive Plans – Measures
Team performance standards are typically based on:
• Productivity improvements. (OR/SURGERIES)
• Customer satisfaction measures. (PRESS-GEHNEY)
• Financial performance. (PROFIT)
• Quality of goods and services. (BY WHOSE MEASURE)

OUTSIDE EMPLOYEE’S/TEAM’S CONTROL!!!

Historically, financial measures have been used.

• Increasingly, this is seen more as a means to inform stock analysts than
managers trying to improve operating effectiveness.

Decide which type of group incentive plan best fits the

objectives.
• Firms high on business risk and those with uncertain outcomes are
better off not having incentive plans at all.
©McG
Comparing Group and Individual Incentive
Plans
Incentive plans boost performance.
• Individual incentives yield higher productivity gains, but group
incentives often are right when team coordination is the issue.

Type of task, organizational commitment to teams, and the type

of work environment may warrant individual or group plans.

Individual incentive plans have better potential for delivering

higher productivity.

Group plans can suffer from the free rider problem.

• Free riders have a harder time loafing when there are clear performance
standards.
©McG
Large Group Incentive Plans
There are two plan types for incentivizing large groups.
• Gain sharing plans use operating measures to gauge performance.
• Profit sharing plans use financial measures.

Gain sharing identifies areas where employees have some

impact on savings – such as reduced scrap.
• Studies report positive results.
• Can lead to the sorting effect.
©McG
Exhibit 10.16: Three Gain-Sharing Formulas
©McG
The Scanlon and Rucker Gain Sharing Plans
Two major components are vital to success of either plan.
• A productivity norm requires effective measure of the base-year and
employee acceptance.
• Effective work/productivity/bonus committees whose primary
function is to evaluate suggestions for improving productivity and/or
cutting costs.
The plans differ from individual incentive plans in their focus.
• Individual plans focus on wage incentives to motivate.
• The Scanlon/Rucker plans focus on organizational behavior variables.
• The key is participation developed through group unity.

Two important differences in the Scanlon and Rucker plans.

• Rucker plans tie incentives to a variety of savings, not just labor.
• Rucker plans are more linkable with individual incentive plans.
©McG
Exhibit 10.17: Examples of a Scanlon Plan
©McG
Gain Sharing: Improshare
Improshare (Improved Productivity through Sharing) is easier to
administer and to communicate.

First, a standard is developed identifying the expected hours

required to produce an acceptable level of output.
• The standard comes either a time-and-motion study or from a base-
period measurement of the performance factor.

Any savings arising from production of the output in fewer

than expected hours is shared by the firm and the workers.
• Gains are split 50-50 between employees and management.
©McG
Profit Sharing Plans
Profit sharing continues to be popular due to its focus on a
predetermined index of profitability.

On the downside, most employees do not feel their jobs have a

direct impact on profits.

The trend in variable-pay design is to combine the best of gain

sharing and profit sharing plans.
• A funding formula is linked to some profit measure.
• The plan must be self-funding.
• Dollars given to workers are generated by additional profits gained
from operational efficiency.
• Along with financial incentive, employees have a sense of control
©McG
Earnings-at-Risk Plans
Any incentive plan could be an earnings-at-risk plan.

Incentive plans fall into one of two categories.

• Success sharing.
• Employee base wages are constant and variable pay adds on a
predetermined amount in successful years.
• If the company does poorly, employees forgo any variable pay.
• Risk sharing.
• Base pay is reduced by some amount relative to the level that would be
offered in a success-sharing plan.

These plans shift part of the risk to the employee.

• They may result in decreased satisfaction with pay in general and the
process used to set pay – may increase turnover.
©McG
Group Incentive Plans
Group PFP plans are gaining popularity in team-based
companies.

Group-based plans, particularly gain-sharing plans, may cause

organizations to evolve into learning organizations.
• Employee suggestions evolve from first-order learning experiences into
suggestions exhibiting second-order learning characteristics.
• Suggestions that help the organization break out of existing patterns of
behavior and explore different ways of thinking and behaving.

All group incentive plans have common features.

• The size of the group that participates in the plan.
• The standard against which performance is compared.
• The payout schedule.
©McG
PFP: Long-Term Incentive Plans
Long-term incentives focus on performance beyond one year.

Growth in such plans is partly due to a desire to motivate longer-

term value creation.
• There is very little evidence that stock ownership by management leads
to better corporate performance.
• There is some evidence that stock ownership is likely to increase
internal growth, rather than more rapid external diversification.

As of June 2005, companies are required to report stock options

as an expense.
• Prior, they were viewed as a free good under old accounting rules.
©McG
Employee Stock Ownership Plans (ESOPs)
Some companies link employees to success or failure of a
company through ESOPs.
• The effects are long-term and employee’s working harder means
nothing at the time.
• Management cannot predict what makes stocks rise, a central ingredient
in the reward component of ESOPs.

Why use an ESOP?

• They foster employee willingness to participate in decision-making.

Impact is modest with little impact on productivity or profit.

• Critics argue the plans are not used effectively.
• If combined with high goal setting, improved communication, and
greater participation, ESOPs may have a positive impact.
©McG
Performance and Broad Based Option Plans
Performance plans feature corporate performance objectives for a
time three years in the future.
• Driven by financial earnings or return measures and pay out for meeting
or exceeding specific goals.

Broad-based option plans (BBOPs) are stock grants with a

firm giving employees shares of stock over a designated time
period.
• The strength of BBOPs is versatility.
• Depending on their distribution, they reinforce performance or inspire
greater commitment and retention.
• They are a growing trend.
• Colliding with this trend is shareholder pushback against equity awards
for all but the top 1% of employees.
©McG
Combination Plans: Mixing Individual and
Group
The goal is to motivate individual behavior and insure employees
work together to promote team and corporate goals.

Plans start with the standard individual and group measures.

Variable pay level depends on how well individuals perform and

how well the company does on its macro measures.
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A typical plan might call for a 75-25 split.
• 75% of the payout is based on individual performance and 25% on
corporate performance.

An alternative might be a self-funding plan.

• Triggers specific payouts only after the company reaches a certain profit
target.
*****ACH EXAMPLE*****
©McG
Does Variable Pay Improve Performance Results?
Pay-for-performance plans:
• That introduce variability into the level of pay an employee
receives.
• Seems to have a positive impact on performance if they
are designed well.

Too often the plans have:

• Too small a payout for the work expected.
• Unattainable (or too easy) goals.
• Outdated or inaccurate metrics.
• Or too many metrics making it difficult to determine what
is important.