Theory and Evidence

Pay-for-Performance: Theory and Evidence

Chapter Outline

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What Behaviors Do Employers Care About? Linking Organization Strategy to Compensation and Performance Management

What Does It Take to Get These Behaviors? What Theory Says

What Does It Take to Get These Behaviors? What Practitioners Say

Does Compensation Motivate Behavior?

Do People Join a Firm Because of Pay?

Do People Stay in a Firm (or Leave) Because of Pay?

Do Employees More Readily Agree to Develop Job Skills Because of Pay?

Do Employees Perform Better on Their Jobs Because of Pay?

Designing a Pay-for-Performance Plan

Efficiency

Equity/Fairness

Compliance

Your Turn: Burger Boy

The primary focus of Part 3 was on determining the worth of jobs, independent of who performed those jobs. Job analysis, job evaluation, and job pricing all have a common theme. They are techniques to identify the value a firm places on its jobs. Now we introduce people into the equation. Now we declare that different people performing the same job may add different value to the organization. Wesley is a better programmer than Kelly. Erinn knows more programming languages than Ian. Who should get what?

If you stop and think about it, employment is about a contract. When you accept a job, you agree to perform work—to complete tasks—in exchange for rewards. Sometimes this contract is simple. You agree to cut your neighbor’s grass for $25. When you’re done, she pays you the money. As we grow up, the contracts become more complex. Your first job after college will involve a contract, although the terms of that contract won’t be spelled out fully. You will sign an agreement to perform tasks to the satisfaction of your employer. Rarely are the “satisfaction” terms clearly defined upfront. You hope you’ll get feedback along the way that helps make the performance standards more apparent. In exchange, the contract reads, you will receive a certain amount of pay. Let’s hope it’s a big number! But you might be a bit disappointed in the rest of the contract, because it’s rare that there will be any mention of other rewards Page 307(e.g., how interesting your work is and how collaborative your co-workers are) besides money (and perhaps related benefits). You take it on faith that the employer will do right by you beyond just the monetary component of the job.

At the extreme of employment contracts are those between an employer and a union representing workers (Chapter 15). Unionized employees aren’t willing to take it on faith that the employer will provide fair compensation for work performed. Some union contracts are hundreds of pages long and specify in the tiniest detail what a worker will get as rewards under different work conditions.

Whether the employment contract is simple or complex, though, we still struggle with both sides of the agreement. How do we decide if a worker is performing the job satisfactorily and how much should we pay for that performance?

Entering people into the compensation equation greatly complicates the compensation process. People don’t behave like robots. Believe us, the auto industry has tried replacing people with robots. On some jobs, like welding car parts together, robots work just fine. Robots can tighten a bolt and oil a joint. But for many jobs (though not as many as in the past) it’s easier and cheaper to do things the old-fashioned way—with people. The challenge is to design a performance and reward system so that employees support what the company is trying to accomplish. Indeed, there is growing evidence that the way we design HR practices, like performance management, strongly affects the way employees perceive the company. Well-known organizations, like The Container Store and Costco, both pay more and have more sophisticated performance-tracking methods that lead to happier employees.1 And this directly affects corporate performance.2 The simple (or not so simple, as we will discuss) process of implementing a performance appraisal system that employees find acceptable goes a long way toward increasing trust for top management.3 And that new performance appraisal and reward system has an impact on other parts of HR. The pool of people we recruit and select from changes as our HR system changes. In Chapter 2, we talked about sorting effects. Not everyone “appreciates” an incentive system or even a merit-based pay system. People who prefer pay systems that are less performance-based will “sort themselves” out of organizations that have these pay practices and philosophies. Those people either won’t respond to recruitment ads, or, if already employed, may seek employment elsewhere.4 So as we discuss pay and performance in this chapter and in Chapters 10 and 11, remember that there are other important outcomes that also depend on building good performance measurement tools.

In Chapter 1 we talked about compensation objectives complementing overall human resource objectives and both of these helping an organization achieve its overall strategic objectives. But how does an organization achieve its overall strategic objectives? In this part of the book, we argue that organizational success ultimately depends on human behavior. Why did the St. Louis Cardinals in 1967, the Cleveland Cavaliers in 2016, and the Philadelphia Eagles in 2018 win a championship? Answer: It was a team effort, but it sure helped to have had on those teams, respectively, Bob Gibson (“Rapid Robert”), LeBron James (“Greatest player on the planet”), and Nick Foles (no real nickname just yet)—for example, Bob Gibson went 3-0 (in a best-of-seven series!) and gave up a total of three earned runs in those three (complete) games he pitched. (The New England Patriots won in 2019 for a change. Are Tom Brady and Bill Belichik still there?) Or how did Dumbledore’s Army and the Order of the Phoenix win the Page 308Battle of Hogwarts? Surely, it was because of superior wizarding talent (and not being evil)! That’s behavior in its simplest and purest form. Our compensation decisions and practices should be designed to increase the likelihood that employees will behave in ways that help the organization achieve its strategic objectives (incentive effect) and to attract and retain such employees to the organization (sorting effect). This chapter is organized around employee behaviors. First, we identify the four kinds of behaviors organizations are interested in. Then we note what theories say about our ability to motivate these behaviors. And, finally, we talk about our success, and sometimes lack thereof, in designing compensation systems to elicit these behaviors.

WHAT BEHAVIORS DO EMPLOYERS CARE ABOUT? LINKING ORGANIZATION STRATEGY TO COMPENSATION AND PERFORMANCE MANAGEMENT

The simple answer is that employers want employees to perform in ways that lead to better organizational performance. Exhibit 9.1shows how organizational strategy is the guiding force that determines what kinds of employee behaviors are needed.

EXHIBIT 9.1 The Cascading Link Between Organization Strategy and Employee Behavior

As an illustration, Nordstrom’s department stores are known for extremely good quality merchandise and high levels of customer satisfaction—this is the organization strategy they use to differentiate themselves from competitors. Nordstrom’s success isn’t a fluke. You can bet that some of their corporate goals, strategic business unit goals (SBU goals, where a strategic business unit might be a store), department-level goals, and, indeed, individual employee goals are linked to pleasing customers and selling high-quality products. The job of Human Resources is to devise policies and practices (and compensation falls in this mix) that lead employees (the last box in Exhibit 9.1) to behave in ways that ultimately support corporate goals. When you walk into a Page 309Nordstrom’s, you see employees politely greeting you, helping without suffocating, and generally making the shopping experience a pleasant one. These are behaviors that support Nordstrom’s strategic plan. Every organization, whether they realize it or not, has human resource practices that can either work together or conflict with each other in trying to generate positive employee behaviors. One way of looking at this process is evident from Exhibit 9.2, which says that behavior is a function of the ability, motivation, and opportunity to perform. We first saw this idea in Chapter 2.

EXHIBIT 9.2 The Big Picture, or Compensation Can’t Do It Alone!

Let’s use an example from the classroom. You have to make a presentation tomorrow. Twenty percent of your grade (the reward) depends on it. Do you have the ability? Can you speak clearly, be interesting, and send a good message? Are you motivated? (Or is this class unimportant to you? Would you prefer to watch the finale of “Walking Dead” on TV?) And is the opportunity to do well (e.g., without environmental obstacles) present? (One of your authors was making a presentation a few years ago in Indonesia when an earthquake hit. Ruined the speech!)

Wanting to succeed isn’t enough. Having the ability but not the motivation also isn’t enough. Many a player with lots of talent doesn’t have the motivation to endure thousands of hours of repetitive drills, or to endure weight training and general physical conditioning. Even with both ability and motivation, a player’s work environment (both physical and political) must be free of obstacles. A home run hitter drafted by a team with an enormous ball park (home run fences set back much farther from home plate) might never have the opportunity to reach his full potential.

The same thing is true in more traditional jobs. Success depends on finding people with ability—that’s the primary job of recruitment, selection, and training. Once good people Page 310are hired, they need to be motivated to behave in ways that help the organization. (Note, part of selection is also to hire motivated people, so the triangles interact with each other, as denoted by the three-pronged arrow in the center of Exhibit 9.2.) This is where compensation enters the picture. Pay and other rewards should reinforce desired behaviors. But so, too, should performance management, by making sure that what is expected of employees, and what is measured in regular performance reviews, is consistent with what the compensation practices are doing. And perhaps most important of all, the culture of the organization (the informal rules and expectations that are evident in any company) should point in the same direction. Finally, HR needs to establish policies and practices that minimize the chances that outside “distractors” hinder performance.

In the 1980s, Nabisco was slow to recognize customer demand for “soft batch” cookies. Why? They had a centralized organization structure in which it took a long time for sales information to reach the top decision makers. No matter how much ability or motivation the sales staff has, it’s hard to sell cookies the public doesn’t want. What did Nabisco do? They decentralized the company (organization design), creating divisions responsible for different product lines. Now when sales people say consumer preferences are changing, response is much more rapid. Similarly, if we don’t recognize changing skill requirements (human resource planning), it’s hard to set up revised training programs or develop compensation packages to reward these new skills instantly. Knowing in advance about needed changes makes timely completion easier. As a further illustration, if we have inefficient processes (such as too many steps in getting approval for change), organization development (the process for changing the way a company operates) can free up motivated workers to use their skills.

The key lesson from Exhibit 9.2 is important: Compensation can’t do it all alone. Try changing behavior by developing a compensation system to reward/motivate that behavior. If you haven’t selected the right people (and/or provided the necessary training/development) or if you haven’t designed the work and the culture to provide the opportunity to leverage employees’ motivation and ability, you’re destined for failure. Not taking into account the importance of differences in how people respond to different pay systems is another potential pitfall.5 When you’re out working in HR, and your boss asks you to “fix” something (such as pay or performance appraisal), make sure the change fits with what other HR programs in the organization are trying to do. Otherwise trouble lurks.

So, what behaviors does compensation need to reinforce? First, compensation should be sufficiently attractive to make it possible to recruit and hire good potential employees (attraction).6 Second, we need to make sure the good employees stay with the company (retention). The recession of 2008–2010, which still has a lingering impact today, severely tested companies’ layoff strategies. Losing money? Layoff workers! But sometimes laying off workers means cutting future stars. Some wiser companies kept costs down by reducing labor costs without layoffs—by, for example, temporarily reducing salaries, bonuses, 401(k) retirement contributions, and/or work hours. Caterpillar, FedEx, Black and Decker, Honeywell, the New York Times, and the State of Pennsylvania are examples of organizations that reduced labor costs without layoffs.7 If we can succeed at these first two things, we can then concentrate on Page 311building further knowledge and skills (develop skills). And, finally, we need to find ways to motivate employees to perform well in their jobs—to take their knowledge and abilities and apply them in ways that contribute to organizational performance.

For example, whether we’ve developed a sound compensation package can only be determined by the impact on performance. We can’t tell if our compensation system helps recruit and select good employees if we don’t know how to measure what constitutes good.We can’t tell if employees are building the kinds of knowledge base they need if we can’t measure knowledge accumulation. We can’t reward performance if we can’t measure it! As a simple example, think about companies where piece-rate systems are used to pay people. Recently, one of the authors went to a sawmill, looking for wood to build a dining room table. Talks with the manager revealed they used a simple piece-rate system to motivate workers. For every board foot of lumber cut using giant saws, workers were paid a fixed amount. There is little ambiguity in this measure of performance, and this makes it easy to create a strong link between units of performance and amount of compensation. One of the biggest recent advances in compensation strategy has been to document and extend this link between ease of measuring performance and the type of compensation system that works best.

Let’s take a minute to talk about each of the cells in Exhibit 9.3. They help explain why incentives work in some situations and not in others. The columns in Exhibit 9.3 divide companies into those with widely variable performance from year to year and those with much more stable performance across time. What might cause wide swings in corporate performance? Often this occurs when something in the corporation’s external environment fluctuates widely. A perfect example is gas prices. Sometimes when airlines are reporting high profits, it is not because they’ve done anything particularly well, but because airline fuel costs have dropped significantly.8 It probably wouldn’t be fair, and employees would certainly object, if a large part of pay were incentive-based in this kind of environment. Lack of employee control translates into Page 312perceptions of lack of opportunity to perform well and unfair treatment if pay is tied to these uncontrollable things. Situations B and D both suggest that a low-incentive component is appropriate in organizations with highly variable annual performance. Conversely, as situations A and C indicate, larger-incentive components are appropriate in companies with stable annual performance.

EXHIBIT 9.3 Performance Measurement Relationship to Compensation Strategy

This table extrapolates the findings from two studies: Matthew C. Bloom and George T. Milkovich, “The Relationship among Risk, Incentive Pay, and Organizational Performance,” Academy of Management Journal 14(3), 1998, pp. 283–297; Anne Tsui, Jone L. Pearce, Lyman W. Porter, and Angela M. Tripoli, “Alternative Approaches to the Employee-Organization Relationship: Does Investment in Employees Pay Off?” Academy of Management Journal 40(5), 1997, pp. 1089–1121.

The rows in Exhibit 9.3 note that individual employee performance also can vary. Some jobs are fairly stable, with expectations fairly consistent across time. What I do today is basically the same thing I did yesterday. And tomorrow looks like a repeat too! In other jobs, though, there might be high fluctuation in the kinds of things expected of employees, and for these jobs there is high demand for employees who are willing to be flexible and adjust to changing demand. Here, using incentive pay exclusively might not work. Incentive systems are notorious for getting people to do exactly what is being incentivized. Pay me big money to sell suits, and that’s just what I’m going to do. You want me to handle customer returns, too? No way, not unless the compensation system rewards a broader array of duties. Evidence suggests that companies are best able to get employees to adjust, be flexible, and show commitment when a broader array of rewards, rather than just money, is part of the compensation package.9 For example, why does Lincoln Electric (a major producer of welding machines) outproduce other companies in the same industry year after year? Normally we think it’s because the company has a well-designed incentive system that links to level of production. Certainly this is a big factor! But when you talk to people at Lincoln Electric, they suggest that part of the success comes from other forms of reward, including the strong commitment to job security—downsizing simply isn’t part of the vocabulary there—which reinforces a willingness to try new technologies and new work processes (a culture that supports innovation). Situation A, with low variability in corporate performance but unclear performance measures for employees, describes the kind of reward package that fits these job and organizational performance characteristics.

When we distill all of this, what can we conclude? We think the answer depends on how we respond to the following four questions:

  1. How do we attract good employment prospects to join our company?
  2. How do we retain these good employees once they join?
  3. How do we get employees to develop skills for current and future jobs?
  4. How do we get employees to perform well while they are here?

First, how do we get good people to join our company? How did Nike get LeBron James to serve as a corporate spokesperson? Part of the answer is cold hard cash—$90 million guaranteed before LeBron had even played his first NBA game.10 But it isn’t always just about the money. LeBron asked for and got artistic input on the products designed by Nike. Even when the decision doesn’t involve millions of dollars, the long-run success of any company depends on getting good people to accept employment. One particularly good study of this very question found that job characteristics (including rewards and tasks/abilities required) and recruiter behaviors were key elements in the decision to join a company.11Page 313

Second, the obvious complement to the decision to join is the decision to stay. How do we retain employees? It doesn’t do much good to attract exceptional employees to our company only to lose them a short time later. Once our compensation practices get a good employee in the door, we need to figure out ways to ensure it’s not a revolving door. Max Scherzer left the Detroit Tigers, a perennial pick for a division title, to play with the Washington Nationals. Was it the $210 million contract, including a $50 million signing bonus and an annual average salary of $30 million? Or was it because the Washington Nationals are favored to win the World Series? What does it take to retain key people? Money?12 Or are other rewards important? And does their absence lead us to use money as the great neutralizer?

Third, we also must recognize that what we need employees to do today may change—literally overnight! A fast-changing world requires employees who can adjust more quickly. How do we get employees, who traditionally are resistant to change, to willingly develop skills that might not be vital on the current job but are forecast to be critical in the future? Another compensation challenge!

Finally, we want employees to do well on their current jobs. This means performing— and performing well—tasks that support our strategic objectives. What motivates employees to succeed? The compensation challenge is to design rewards that enhance job performance.

WHAT DOES IT TAKE TO GET THESE BEHAVIORS? WHAT THEORY SAYS

Another way of phrasing these same questions is to ask, “What motivates employees?” For example, we know that people differ in the importance they attribute to money. That is partly because people differ in the value they place on money and partly because the same person may place a different value on money depending on their circumstances (e.g., their age, wealth, aspirations).13 We all know someone who just isn’t motivated by the almighty dollar. But even for these people, it’s possible to design a pay system that is appreciated—one in which the link between effort and pay is evident. Although money is not everyone’s prime motivator, money is, on average, the most important reward in surveys of employees. Also, whatever money’s importance, given most people’s strong preference to be treated fairly, almost nobody likes to be underpaid or reacts well to it. Is it any wonder, then, that figuring out the motivation equation is a major pastime for compensation experts?14 In the simplest sense, motivation involves three elements: (1) what’s important to a person, and (2) offering it in exchange for some (3) desired behavior. As to the first element, what’s important to employees, data suggest most employees prefer pay systems that are influenced primarily by individual performance and the market rate, with seniority also important to some.15 To narrow down specific employee preferences, though, there has been some work on what’s called flexible compensation. Flexible compensation is based on the idea that only the individual employee knows what package of rewards would best suit personal needs. Employees who hate risk could opt for more base pay and less incentive pay. Trade-offs between pay and benefits could also be selected. The key Page 314ingredient in this new concept is careful cost analysis to make sure the dollar cost of the package an employee selects meets employer budgetary limits.16 Absent widespread adoption of flexible compensation systems, we need to answer these three questions the old-fashioned way—by going back to theories of motivation to see what “makes people tick.”

In Exhibit 9.4 we briefly summarize some of the important motivation theories.17 These theories try to answer the three questions we posed above: What’s important? How do we offer it? How does it help deliver desired behaviors? Pay particular attention to the “So What?” column, in which we talk about the theories’ views on how employee behavior is delivered.

EXHIBIT 9.4 Motivation Theories

Some of the theories in Exhibit 9.4 focus on content—identifying what is important to people. Maslow’s and Herzberg’s theories, for example, both fall in this category. People have certain needs—such as physiological, security, and self-esteem needs—that influence behavior. Although neither theory is clear on how these needs are offered and how they help deliver behavior, presumably if we offer rewards that satisfy one or more needs, employees will behave in desired ways. These theories often drive compensation decisions about the breadth and depth of compensation offerings. Page 316Flexible compensation, with employees choosing from a menu of pay and benefit choices, clearly is driven by the issue of needs. Who best knows what satisfies an employee’s needs? The employee! So let employees choose, within limits, what they want in their reward package.

Theories of a second sort, best exemplified by expectancy theory, equity theory, and agency theory, focus less on need states and what rewards best satisfy those needs and focus more on motivational processes, including how perceptions of needs and other factors (equity/fairness, risk, linkages between effort, performance, and pay) are processed cognitively to determine motivation and behavior.18Many of our compensation practices recognize the importance of a fair exchange. Page 317We evaluate jobs using a common set of compensable factors (Chapter 5) in part to let employees know that an explicit set of rules governs the evaluation process. We collect salary survey data (Chapter 8) because we want the exchange to be fair compared to external standards. We design incentive systems (Chapter 10) to align employee behavior with the needs (desired behaviors) of the organization. All of these pay decisions, and more, owe much to understanding how the employment exchange affects employee motivation.

Expectancy theory argues that people behave as if they cognitively evaluate what behaviors are possible (e.g., the probability that they can complete the task) in relation to the value of rewards offered in exchange. According to this theory, we choose behaviors that yield the most satisfactory exchange. Equity theory also focuses on what goes on inside an employee’s head. Not surprisingly, equity theory argues that people are highly concerned about equity, or fairness of the exchange process. Employees look at the exchange as a ratio between what is expected and what is received. Some theorists say we judge transactions as fair when others around us don’t have a more (or less) favorable balance between the give and get of an exchange.19 Even greater focus on the exchange process occurs in the last of this second set of theories, agency theory.20 Here, employees are depicted as agents who enter an exchange with principals—the owners or their designated managers. It is assumed that both sides to the exchange seek the most favorable exchange possible and will act opportunistically if given a chance (e.g., try to “get by” with doing as little as possible to satisfy the contract). Compensation is a major element in this theory, because it is used to keep employees in line: Employers identify important behaviors and important outcomes and pay specifically for achieving desired levels of each. Such incentive systems penalize employees who try to shirk their duties by giving proportionately lower rewards.

At least one of the theories summarized in Exhibit 9.4 focuses on the third element of motivation: desired behavior. Identifying desired behaviors—and goals expected to flow from these behaviors—is the emphasis of a large body of goal-setting research. Most of this research says that how we set goals (the process of goal setting, the level and difficulty of goals, etc.) can influence the performance levels of employees.21 For example, workers assigned “hard” goals consistently do better than workers told to “do your best.”22

A final theory we will mention (not shown in Exhibit 9.4) purports to integrate motivation theories under a broad umbrella. Called self-determination theory (SDT), this approach believes that employees are motivated not only by monetary rewards (referred to as extrinsic motivation), but also by intrinsic motivation, which is enjoyment or satisfaction that comes from performing the work itself and produces a sense of autonomy. According to SDT, intrinsic motivation produces the highest-quality motivation.23

WHAT DOES IT TAKE TO GET THESE BEHAVIORS? WHAT PRACTITIONERS SAY

In the past, compensation people didn’t ask this question very often. Employees learned what behaviors were important as part of the socialization process or as part of the performance management process.24 If it was part of the culture to work long hours, Page 318you quickly learned this. One of our daughters worked as a business consultant for Accenture, a very large consulting company. She learned quickly that 70- to 80-hour work weeks were fairly common. Sure, she had very good wages for someone with a bachelor’s degree in biology and no prior business experience, but it didn’t take long to burn out when weeks of long hours turned into months. If your performance appraisal at the end of the year stressed certain types of behaviors, or if your boss said certain things were important to her, then the signals were pretty clear: Do these things! Compensation might have rewarded people for meeting these expectations, but usually the compensation package wasn’t designed to be one of the signals about expected performance. That has not been true for many years!25 Now compensation people talk about pay in terms of a neon arrow flashing “Do these things.” Progressive companies ask, “What do we want our compensation package to do? How, for example, do we get our product engineers to take more risks?” Compensation is then designed to support this risk-taking behavior. Compensation people will also tell you, though, that money isn’t everything. But they will also tell you that money (and the sense of achievement and recognition that go with it) is very important. Indeed, there is no better way to ensure that you will hear from an employee than if that employee feels his/her pay is not equitable/fair, given what that employees sees as his/her contributions.

e-Compensation

The International Society for Performance Improvement has web information on performance journals, strategies for improving performance, and conferences covering the latest research on performance improvement techniques. Go to the society’s website, www.ispi.org.

Here, however, we do want to identify the many other rewards in addition to compensation that influence employee behavior. Sometimes this important point is missed by compensation experts. Going back at least to Henry Ford, we tend to look at money as the great equalizer. Job boring? No room for advancement? Throw money at the problem! More money is a solution sometimes (e.g., as a compensating wage differential to offset undesirable job attributes). In other cases, however, workers may value improvement in another reward area. To find out, you can ask them (e.g., in a survey). Surveys of workers in general (not as useful as a survey of your own workforce, but still of some use) report that workers generally also highly value other job rewards such as empowerment, recognition, and opportunities for advancement.26 Entire books, for example, illustrate hundreds of ways to give meaningful recognition to employees.27 And there is growing sentiment for letting workers choose their own “blend” of rewards from the 13 we note in Exhibit 9.5. We may be overpaying in cash and missing the opportunity to let employees construct both a more satisfying and less-expensive reward package. Known as flexible compensation, this idea introduced earlier is based on the notion of different rewards having different dollar costs associated with them. Armed with a fixed sum of money, employees move down the line, buying more or less of the 13 rewards as their needs Page 319dictate.28 While widespread use of this type of system may be a long time in the future, the cafeteria approach still underscores the need for integration of rewards in compensation design.

EXHIBIT 9.5 Components of a Total Reward System

If we don’t think about the presence or absence of rewards other than money in an organization, we may find the compensation process producing unintended consequences. Consider the following three examples, which show how compensation decisions have to be integrated with total reward system decisions:

Example 1: A few years ago McDonald’s completed a worldwide “employment branding” exercise. Their goal was to find out what people liked about jobs at McDonald’s and to feature these rewards in the recruitment strategy for new employees. Three things emerged as strengths at McDonald’s: (1) an emphasis on family and friends in a social work environment; (2) flexibility in work assignments and work schedules; and (3) development of skills that helped launch future careers.29

Example 2: This example comes from airline industry leader Southwest Airlines.30 Southwest Airlines promotes a business culture of fun and encourages employees to find ways to make their jobs more interesting and relevant to them personally. All this is accomplished (at least on the surface) without using incentives as a major source of competitive advantage. Indeed, pay at Southwest isn’t any higher than for competitor airlines, yet it’s much easier to recruit top people there. Fun, a good social environment, is a reward! A somewhat different view is that fun and a good social environment are indeed crucial to Southwest’s culture and competitive advantage. However, it may be that incentives are too. Southwest “pays by the trip,” meaning that employees earn more, the more flights they work. (Planes only make money for Southwest when they are in the Page 320air.) Southwest employees also have significant ownership in the company through a discount stock purchase program, and they receive profit-sharing checks when the airline is profitable, which it has been for 45 years in a row!31 For example, in the most recent year, Southwest paid out $543 million in profit sharing to its 56,110 employees, which works out to an average of $9,677 per employee.32 Of course, earning more money for working more flights and from ownership and profit sharing only happens when Southwest does well. That is an example of alignment between the interests of Southwest Airlines and its employees. Add fun and a good social environment, and apparently you can be profitable 45 years in a row, even in an industry marked by regular bankruptcies.

Example 3: Consider the relationship between the different forms of compensation and another of the general rewards listed in Exhibit 9.5: security. Normally we think of security in terms of job security. Drastic reductions in middle-management layers during the downsizing decade of the 1980s increased employee concerns about job security and probably elevated the importance of this reward to employees today. Maybe that’s why new millennial workers are concerned not only about employment risk but also about compensation risk. There is evidence that compensation at risk (variable pay, which is a payment based on performance objective achievement that does not become part of base pay in future years) may leave employees less satisfied both with their pay level and with the process used to determine pay.33 Security as an issue, it appears, is creeping into the domain of compensation. It used to be fairly well established that employees would make more this year than they did last year, and employees counted on such security to plan their purchases and other economic decisions. The trend today is toward less stable and less secure compensation packages. The very design of compensation systems today contributes to instability and insecurity. And that in turn leads some potential employees to reject a firm or some current employees to decide it’s time to leave. Of course, it may be the case that when such plans offer enough upside earnings potential for high performance that high performers may actually prefer to work under such plans (see incentive and sorting effects discussed in Chapter 1, later in this chapter, and in Chapter 10).

Exhibit 9.6 outlines the different types of compensation components, roughly in order from least risky to most risky for employees. We define risk as variance (lack of stability) of income and/or the inability to predict income level from year to year. Base pay is, at least as far as there are any guarantees, the guaranteed portion of income, as long as employees remain employed. Since the Depression there have been very few years when base wages did not rise or at least stay the same.34 Across-the-board increases, cost-of-living increases, and merit increases all help the base pay component increase on a regular basis. Of course, there always has to be an exception to the rule—and the Great Recession of 2008–2010 spawned many cuts in corporate base wages. The next seven components are distinguished by increasing levels of risk/uncertainty for employees. In fact, risk-sharing plans actually include a provision for cuts in base pay that are only recaptured in years when the organization meets performance objectives. For example, under a plan at E.I. du Pont de Nemours & Company, all employees put 6 percent of their salaries Page 322at risk and were paid a sliding percent of this based on how close the firm comes to its annual goals. If the company achieved less than 80 percent of goal, there was no pay increase. In the 80 to 100 range the increase was 3 to 6 percent. At 101 to 150 percent, increases were very lucrative to “pay for” employees taking a risk in the first place—in the 7 to 19 percent range.35

EXHIBIT 9.6 Wage Components

All of this discussion of risk is only an exercise in intellectual gymnastics unless we add one further observation: Over the last several decades, companies have been moving more toward greater use of variable pay programs, which are higher on the risk continuum. We will say more on the degree to which organizations use pay for performance, including variable pay, in Chapter 10.

This greater compensation risk that employees are now asked to bear reflects the result of an evolution over time in forms of pay that are less entitlement-oriented and more variable and linked to individual, group, and corporate performance.36 Employees increasingly are expected to bear a share of the risks that businesses have solely born in the past. It’s not entirely clear what impact this shifting of risk will have in the long run. Some are concerned that efforts to build employee loyalty and commitment may be a casualty of this greater use of variable pay and risk in pay systems.37 Indeed, some surveys suggest a downward trend in engagement levels for employees, although it may be that such trends, whether upward or downward, depend as much or more on the cyclical nature of the economy.38 Consistent with the idea of a compensating pay differential for risk, some surveys suggest that Page 323employees may need a risk premium (higher pay) to stay and perform in a company with pay at risk.39 Even a premium might not work for employees who are particularly risk-averse. Security-driven employees actually might accept lower wages if they come in a package that is more stable.40 On the other hand, some employees may be willing to accept higher risk in return for a greater chance to earn large payouts when performance is high. Also, some employees are not interested in a traditional employment model of lifetime employment with one organization and steady but modest merit increases over the course of their careers. As always, there are pros and cons to each approach, and employees will to some degree self-select/sort themselves into organizations that fit their preferences and out of organizations that do not.

In any case, for the remainder of this chapter, we will return to the more general question of what impact these different forms of pay have on motivating the four general behaviors we noted earlier.

e-Compensation

IOMA is the Institute of Management and Administration. It specializes in finding studies from a wide variety of places that discuss different aspects of pay for performance. The index for IOMA’s website is at www.ioma.com.

DOES COMPENSATION MOTIVATE BEHAVIOR?

Now let’s look at the role of compensation in motivating the four types of behavior outlined earlier: the decision to join, to stay, to develop skills, and to perform well.

Do People Join a Firm Because of Pay?

Level of pay and pay system characteristics influence a job candidate’s decision to join a firm, but this shouldn’t be too surprising.41 Pay is one of the more visible rewards in the whole recruitment process. We know, for example, that high-ability applicants do select companies because they provide pay for good performance.42 This so-called sorting effect has been shown both for good employees choosing a company and for bad employees leaving a company—all because they do (or do not) like the pay system being used.43 Job offers spell out the level of compensation and may even include discussions about the kind of pay, such as bonuses and profit-sharing participation. Less common are statements such as “You’ll get plenty of work variety,” or “Don’t worry about empowerment,” or “The workload isn’t too heavy.”44 These other rewards are subjective and tend to require actual time on the job before we can decide if they are positive or negative features of the job. Not so for pay. Being perceived as more objective, it’s more easily communicated in the employment offer.

Recent research suggests job candidates look for organizations with reward systems that fit their personalities.45 Below we outline some of the ways that “fit” is important.Page 324

None of these relationships is particularly surprising. People are attracted to organizations that fit their personalities. Evidence suggests that talented employees are attracted to companies that have strong links between pay and performance.51 One way to get this linkage is to give employees some control over the rewards they received. Thirty years ago no company ceded this control to employees. Now almost all major companies allow employees to have some reward choice. And the impact of reward choice is positive: up to 40 percent improvement in performance but only if the choices available are attractive to employees.52

It’s not a big jump, then, to suggest that organizations should design their reward systems to attract people with the desired personalities and values. For example, if we need risk takers, maybe we should design reward systems that have elements of risk built into them.

Do People Stay in a Firm (or Leave) Because of Pay?

Employee decisions to leave are influenced by their performance and the degree to which pay is performance-based.53 How does pay affect this relationship? Much of the equity theory research in the 1970s documented that workers who feel unfairly treated in pay react by leaving the firm for greener pastures.54 This is particularly true under incentive conditions. Turnover is much higher for poor performers when pay is based on individual performance (a good outcome!). Conversely, group incentive plans may lead to more turnover of better performers—clearly an undesirable sorting effect.55 When AT&T shifted from individual to team-based incentives a number of years ago, star performers either reduced their output or quit. Out of 208 above-average performers, only one continued to report performance increases under the group incentive plan. The rest felt cheated because the incentives for higher individual performance were now spread across all group members.56

Clearly, as we saw in Chapter 7, pay can be a major factor in decisions to stay or leave. Data suggest that dissatisfaction with pay can be a key factor in turnover.57 Too little pay triggers feelings of being treated unfairly. The result? Turnover. Supporting this, pay that employees find reasonable can help reduce turnover.58 Even the way we pay has an impact on turnover. Evidence suggests that some employees are uncomfortable with pay systems that put any substantial future earnings at risk or pay systems that link less to personal effort and more to group effort.59 Another recent study found that superior-performing Page 325employees were less likely to leave if they received bonuses. No such positive result was found with pay increases (thus changing base pay) in that study.60 We need to make sure, as one critic has noted, that we don’t let our design of new reward systems rupture our relationships with existing employees.61 However, as we have argued, negative sorting effects (high performers leaving) are more likely if base-pay growth does not keep up with performance over time.62 Recent efforts to use different types of compensation as a tool for retaining workers have focused on what is called scarce talent. For example, information technology employees have been scarce for much of the past decade, if not longer. One way to retain these workers is to develop a variable-pay component for each project. For example, reports of variable pay linked to individual length of stay on a project, to peer ratings, and to project results suggest that this pay-for-performance combination may appeal to scarce talent.63

The next time you go into an Applebee’s restaurant, think about how the company has historically used compensation to reduce turnover. In an industry where manager turnover hovers around 50 percent, Applebee’s has been known to allow general managers to earn as much as $30,000 above base salary for hitting targets for sales, profitability, and customer satisfaction. To discourage turnover, this extra compensation is deferred for two years.64

Besides money, other rewards also influence the decision to stay in a firm (retention). According to one recent study, the rewards that are effective in helping to retain employees in tough economic times are as follows:65

Source: John P. Hausknecht, Julianne Rodda, and Michael J. Howard, “Targeted Employee Retention: Performance-Based and Job-Related Differences in Reported Reasons for Staying,” Human Resource Management 48, no. 2 (2009), pp. 269–288.

Do Employees More Readily Agree to Develop Job Skills Because of Pay?

We don’t know the answer to this question. Skill-based pay (Chapter 6) is intended, at least partially, to pay employees for learning new skills—skills that hopefully will help employees perform better on current jobs and adjust more rapidly to demands on future jobs. For example, the U.S. Army pays ROTC cadets in college to learn new languages. Hot spots like the Mideast command monthly premiums of $100 to $250 per month.66 Anyone know Farsi (spoken in Iran)?

We do know that one complaint about skill-based pay centers on cost implications. More employees request training, spurred by the promise of skill-based increments. Page 326Poorly administered plans, allowing more people to acquire certification in a skill than are actually required, creates cost inefficiencies. This leads to plan abandonment. So is the net result positive? Whether the promise of skill-based pay is fulfilled is unclear. Evidence suggests that while pay for skill may sometimes but not always increase productivity, it does focus people on believing in the importance of quality and in turning out significantly higher quality products.67

Do Employees Perform Better on Their Jobs Because of Pay?

No matter what stand you take on this question, someone is going to disagree with you.68 However, a well-designed plan linking pay to behaviors of employees generally results in better individual and organizational performance.69 One study looked at the HR practices of over 3,000 companies.70 One set of questions asked: (1) Did the company have a formal appraisal process, (2) Was the appraisal tied to the size of pay increases, and (3) Did performance influence who would be promoted? Organizations significantly above the mean (by one standard deviation) on these and other “high-performance work practices” had annual sales that averaged $27,000 more per employee. WorldatWork surveyed 1,001 organizations (most, but not all, in the private sector) and 92 percent reported they used individual performance to determine salary increases. Further, 84 percent also used variable pay that was tied to performance.71

In his review, Heneman reports that 40 of 42 studies looking at merit pay show higher performance when pay is tied to performance.72 Strong evidence suggests that linking pay to performance does increase motivation of workers and lead to improved performance.73 Locke and colleagues analyzed studies where individual incentives were introduced into actual work settings. Productivity increased on average 30 percent.74 Other meta-analyses draw similar conclusions—money does motivate performance.75

Looking at this from the opposite direction, consulting firm data indicate that high performers received not only significantly higher merit increases than average performers (4.5 percent versus 2.6 percent) but also higher bonuses (140 percent of target versus 99 percent of target).76 One study of 841 union and nonunion companies found gain-sharing and profit-sharing plans (both designed to link pay to performance) increased individual and team performance 18 to 20 percent.77 How, though, does this translate into corporate performance? A review of 26 studies gives high marks to profit-sharing plans: Organizations with such plans had 3.5 to 5 percent higher annual performance.78 Gerhart and Milkovich took the performance-based pay question one step further. Across 200 companies they found an 8 to 20 percent increase in return on assets for a 10 percentage point (from 10 percent to 20 percent) increase in the size of a bonus (as a percentage of base salary).79 Further, they found that the variable portion of pay (which also included the percent of employees eligible for long-term incentives) had a stronger impact on individual and corporate performance than did the level of base pay.

If all this research isn’t enough to convince you, consider Google’s position on the matter. In recent speeches the top HR person at Google, Laszlo Bock, says the people you hire and the way you treat them (the rewards) make for happier and more productive workers. With evangelical zeal he advocates transparency Page 327in communications, obtainable goal setting, and less hierarchical organizations (fewer levels so employees can empower themselves to grow and learn).80 Bock also advocates “Pay unfairly (it’s more fair!).” Bock explains that a small percentage of employees create a large percentage of the value and that their pay must recognize their disproportionate contributions.

Conversely, numerous critics, led by Alfie Kohn, argue that incentives are both morally and practically wrong.81 The moral argument suggests that incentives are flawed because they involve one person controlling another. The counterargument to this notes that employment is a reciprocal arrangement. In periods of low unemployment especially, workers can choose whether they want to work under compensation systems with strong pay-for-performance linkages (as in the case of incentive systems). We do know that applicants aren’t totally risk-averse. Some, especially high performers, tend to prefer performance-based pay rather than a totally fixed salary. Generally, if pay depends on individual performance, applicants find the company more attractive. Team-based incentives, in contrast, are less attractive, although it depends on the person.

Kohn also suggests that incentive systems can actually harm productivity, a decidedly negative practical outcome. His rationale is based on citations mostly to laboratory studies where subjects work in isolation on a task for either pay or no pay. His conclusion, based heavily on the work of Deci and colleagues, is that rewarding a person for performing a task reduces interest in that task—extrinsic rewards (money) reduce intrinsic rewards (enjoyment of the task for its own sake).82 Critics of this interpretation point out at least two important flaws in Kohn’s conclusions.83 First, the pragmatics of business demand that some jobs be performed—indeed, many jobs—that aren’t the most intrinsically interesting. Although Target may be a great store for shopping, spending day after day stocking shelves with towels and other nonbreakables falls far down the intrinsic-interest scale.84 If incentives are required for real-world jobs to be completed and thus to create value for an organization and its consumers, so be it. This may simply be one of the costs of doing business. However, the idea that pay-for-performance would only be used to compensate people for doing uninteresting jobs flies in the face of reality. As we have seen, pay-for-performance is much more likely to be used for higher-level jobs and the payouts are also much higher in higher level jobs. That is likely because high level jobs have more impact on organization performance. Higher level jobs are also interesting, challenging (yes, intrinsically motivating), but people in intrinsically interesting jobs still want to be recognized for their achievements, earn a good living for themselves and their families, and be paid equitably (in line with other high achievers).85

Second, studies cited by Kohn frequently looked at people in isolation. In the real world people interact with each other, know who is performing and who isn’t, and react to this when rewards are allocated. Without any link to performance, the less-motivated employees will eventually recognize that harder work isn’t necessary. These issues raise the basic question, “Should we tie pay to performance?” One view says, “Not always.” Employers are less likely to offer performance-based pay when the job involves multitasking, important quality control issues, or team work. In all three cases performance is harder to measure, and employers shy away Page 328from linking pay as a consequence.86 Alternatively, we could break the issue down to a series of questions.

The first question perhaps should focus on an obvious but often overlooked issue: Do employees think any link at all should be made between pay and performance? Substantial evidence indicates that management and workers alike believe pay should be tied to performance. Dyer and colleagues asked 180 managers from 72 different companies to rate nine possible factors in terms of the importance they should receive in determining the size of salary increases.87 This group believed the most important factor for salary increases should be job performance. Following close behind is a factor that presumably would be picked up in job evaluation (nature of job) and a motivational variable (amount of effort expended). Other research supports these findings.88

Another way to make the pay-for-performance argument is to look at the ways HR professionals try to cut costs. At the top of the list: Create greater distinction between high and low performers!89 In other words, really pay for performance! Once we move away from the managerial ranks, though, other groups express a different view of the pay-performance link. The role that performance levels should assume in determining pay increases is less clear-cut for blue-collar workers.90 As an illustration, consider the frequent opposition to compensation plans that are based on performance ratings (merit pay). Unionized workers prefer seniority rather than performance as a basis for pay increases.91 Part of this preference may stem from a distrust of subjective performance measurement systems. Unions ask, “Can management be counted on to be fair?” In contrast, seniority is an objective index for calculating increases. Some evidence also suggests that women might prefer allocation methods not based on performance.92 It’s probably a good thing that, in general, workers believe pay should be tied to performance, because the research we’ve reported suggests this link makes a difference.93

How does this performance improvement occur? One view suggests, as we have emphasized (see Chapter 1), that linking pay to performance occurs through two mechanisms, an incentive effect and a sorting effect.94 The incentive effect means pay can motivate current employees to perform better. The sorting effect means people sort themselves by what is important to them. So if Company X pays for performance, and you don’t want to play by those rules (i.e., work harder or smarter to perform better) you sort yourself out, most easily by leaving Company X and finding another company with different rules for getting rewards. Recall the Lazear study we discussed in Chapter 1. Employee productivity (windshields installed per employee) at Safelite Glass increased 44 percent when pay practices switched from salaries (which were unlinked to windshields installed) to individual incentives (where pay depended on number of windshields installed). The interesting hook in this study was a separate analysis of employees who were present before and after the change in pay system (stayers) versus those who left and were replaced. Only one-half of the 44 percent increase (i.e., a 22 percent increase) came from increased productivity of the “stayers” (i.e., the incentive effect). The other half (i.e., the other 22 percent increase) was due to the sorting effect: Less productive workers (who did worse under the new incentive system) left and were replaced by more productive workers who would earn more money under the new incentive system.95Page 329

Thus, people sort themselves into or out of organizations based on a preference for being paid based on personal performance or something else.96 Of course, the most obvious sorting factor is ability. Higher-ability individuals are attracted to companies that will pay for performance, thus recognizing their greater contribution.97 High performers will also leave firms that don’t reward their performance (pay for something like seniority rather than performance) and go to those that do. Coming at this from a different angle, data also suggest that some people make job choices based on effort aversion. “Find me a job where I don’t have to work hard!” Obviously, jobs where high performance is expected are less likely to be attractive to these prospective employees.98

When we look at pay and group performance (instead of individual performance), the evidence is mixed. In general, though, we think that group pay (whether the group is a team or an entire organization) leads to small increases (relative to individual pay for performance) in productivity. A recent study suggests that, to be effective, group incentives are most effective when paired with complementary HR practices. Specifically, group incentives work if you have implemented a team-based structure where members monitor team performance and personally sanction “free riders.”99

Before we rush to add a variable-pay component (one form of pay for performance) to the compensation package, though, we should recognize that such plans can, and do, fail. Sometimes, ironically, the failure arises because the incentive works too well, leading employees to exhibit rewarded behaviors to the exclusion of other desired behaviors. (See Chapter 10 for further discussion of the risks of such plans.) Exhibit 9.7 documents one such embarrassing incident that haunted Sears for much of the early 1990s.100

EXHIBIT 9.7 Sears Makes a Mistake

Apparently the Sears example is no fluke. Other companies have found that poorly implemented incentive pay plans can hurt rather than help. Green Giant, for example, used to pay a bonus based on insect parts screened in its pea-packing process. The goal, of course, was to cut the number of insect parts making their way into the final product (anyone planning on vegetables for dinner tonight?). Employees found a way to make this incentive system work for them. By bringing insect parts from home, inserting, and inspecting, their incentive dollars rose. Page 330Clearly, the program didn’t work as intended. Experts contend this is evidence that the process wasn’t managed well. The second author of your book also recollects the first author was working with an oil drilling company. They attached a sizable incentive to compensation for geologists if they could reduce the time to explore for a well site and set up the drilling operation. They couldn’t figure out why so many more wells were being reported as dry (no oil) than had been the case historically!101 (Could it be that well sites were suddenly being chosen more on the basis of their ease of setting up a drilling operation—perhaps those in less remote locations—and chosen less on the basis of how much oil is in the ground there?) What does this mean in terms of design? We return to the risks (as well as the potential returns) possible from the use of incentive pay in Chapter 10.

DESIGNING A PAY-FOR-PERFORMANCE PLAN

Our pay model suggests effectiveness is dependent on three things: efficiency, equity, and compliance in designing a pay system.

Efficiency

Efficiency involves three general areas of concern.

Strategy

Does the pay-for-performance plan support corporate objectives? For example, is the plan cost-effective, or are we making payouts that bear no relation to improved performance on the bottom line? Similarly, does the plan help us improve quality of service? Some pay-for-performance plans are so focused on quantity of performance as a measure that we forget about quality. Defect rates rise. Customers must search for someone to handle a merchandise return. A number of things happen that aren’t consistent with the emphasis on quality that top organizations insist upon.

The plan also should link well with HR strategy and objectives. If other elements of our total HR plan are geared to select, reinforce, and nurture risk-taking behavior, we don’t want a compensation component that rewards the status quo. Be careful, though. The Federal National Mortgage Association, also known as Fannie Mae, which buys mortgages from banks and re-sells them to investors, changed its performance metrics from return on assets and cost management to total earnings and earnings per share. No problem, you say? One view is that it was a problem because the CEO of Fannie Mae was part of the “team” that wrote legislation and he took this as an opportunity to influence the laws to fit his company’s strategy. In this telling, he got rich but also helped start the 2008 financial crisis.102

Finally, we address the most difficult question of all—how much of an increase makes a difference? What does it take to motivate an employee? Is 3 percent, the recent average of pay increases, really enough to motivate higher performance? One review of the evidence suggests that an increase must be at least 6 to 7 percent Page 331“to be seen as meaningful” and goes on to say: “Obviously, people prefer any raise to no raise at all. But small raises, when presented as rewards for merit, can be dysfunctional. Organizations with small pay raise pools may wish to think seriously about their allocation of merit raises.”103

Structure

Is the structure of the organization sufficiently decentralized to allow different operating units to create flexible variations on a general pay-for-performance plan? For example, IBM adapted performance reviews to the different needs of different units, and the managers in them, resulting in a very flexible system. In this system, midpoints for pay grades don’t exist. Managers get a budget, some training on how to conduct reviews, and a philosophical mandate: Differentiate pay for stars relative to average performers, or risk losing stars. Managers are given a number of performance dimensions. Determining which dimensions to use for which employees is totally a personal decision. Indeed, managers who don’t like reviews at all can input merit increases directly, anchored only by a brief explanation for the reason.104 Different operating units may have different competencies and different competitive advantages. We don’t want a rigid pay-for-performance system that detracts from these advantages, all in the name of consistency across divisions.

Standards

Operationally, the key to designing a pay-for-performance system rests on standards. Specifically, we need to be concerned about the following:

  • Objectives: Are they specific yet flexible? Can employees see that their behavior influences their ability to achieve objectives (called the “line-of-sight” issue in industry)?
  • Measures: Do employees know what measures (individual appraisals, peer reviews of team performance, corporate financial measures, etc.) will be used to assess whether performance is sufficiently good to merit a payout?
  • Eligibility: How far down the organization will the plan run? Companies like PepsiCo and Starbucks believe all employees should be included. Others think only top management can see how their decisions affect the bottom line.
  • Funding: Will you fund the program out of extra revenue generated above and beyond some preset standard? If so, what happens in a bad year? Many employees become disillusioned when they feel they have worked harder but economic conditions or poor management decisions conspire to cut or eliminate bonuses.

Equity/Fairness

Our second design objective is to ensure that the system is fair to employees. Two types of fairness are concerns for employees. The first type is fairness in the amount that is distributed to employees. Not surprisingly, this type of fairness is labeled distributive justice.105Does an employee view the amount of compensation received Page 332as fair? As we discussed earlier in the section on equity theory, perceptions of fairness here depend on the amount of compensation actually received relative to input (e.g., productivity) compared against some relevant standard. Notice that several of the components of this equity equation are frustratingly removed from the control of the typical supervisor or manager working with employees. A manager has little influence over the size of an employee’s paycheck. It is influenced more by external market conditions, pay-policy decisions of the organization, and the occupational choice made by the employee. Indeed, recent research suggests that employees may look at the relative distribution of pay. For example, some major league baseball teams have met with mixed success in trying to buy stars via the free-agent market. Some speculate that this creates feelings of inequity among other players. Some evidence suggests that narrower ranges for pay differences may actually have positive impacts on overall organizational performance.106

Managers have somewhat more control over the second type of equity. Employees are also concerned about the fairness of the procedures used to determine the amount of rewards they receive. Employees expect procedural justice.107 Evidence suggests that organizations using fair procedures and having supervisors who are viewed as fair in the means they use to allocate rewards are perceived as more trustworthy and command higher levels of commitment.108 Some research even suggests that employee satisfaction with pay may depend more on the procedures used to determine pay than on the actual level distributed.109

A key element in fairness is communications. Employees want to know in advance what is expected of them. They want the opportunity to provide input into the standards or expectations. And if performance is judged lacking relative to these standards, they want an appeals mechanism. The importance of open communication also extends to upper management. In firms that practice greater transparency of pay practices, executives perform better when told what the linkage is between pay and performance.110 In a union environment, this is the grievance procedure. Something similar needs to be set up in a nonunion environment.111 As evidence, only 15 percent of employees who feel well informed indicate they are considering leaving their company. This jumps to 41 percent who think about leaving if they feel poorly informed about the way the pay system operates.112

Compliance

Finally, our pay-for-performance system should comply with existing laws. We want a reward system that maintains and enhances the reputation of our firm. Think about the companies that visit a college campus. The interview schedules fill up quickly for some of these companies because students gravitate to them. Why? The companies’ reputations.113 We tend to undervalue the reward value of a good reputation. To guard this reputation, we need to make sure we comply with compensation laws.Page 333

Your TurnBurger Boy

This is a true case. Jerry Newman (second author of this book) spent 14 months working in seven fast-food restaurants. He wrote about his experiences in the book My Secret Life on the McJob (McGraw-Hill, 2007). This is a description of events in one store—which we’ll call “Burger Boy.”

It’s a hot Friday in Florida, and lunch rush is just beginning. Chuck is working the pay window and is beginning to grouse about the low staffing for what is traditionally the busiest day of the week. “Where the heck is LaVerne?” he yells to no one. Chuck has only worked here for six weeks but has prior experience at another Burger Boy. Marge, typically working the fries station (the easiest job at this Burger Boy), has been pressed into service on the front drive-through window because two of 10 scheduled workers have called in sick. She can handle the job when business is slow, but she clearly is getting flustered as more cars enter the drive-through line. I’m cooking, my third day on job, but my first one alone. I’ve worked the grill for 10 years as a volunteer at Aunt Rosie’s Women’s Fast-Pitch Softball Tournament, but nothing prepared me for the volume of business we will do today. By 11:30 I’ve got the grill full of burgers. Lucy is going full-speed trying to keep up with sandwich assembly and wrapping. She’s the best assembler the place has and would be a supervisor if she could just keep from self-destructing. Yesterday she lit a can of vegetable spray with a lighter and danced around the floor, an arc of flame shooting out from the can. She thinks this is funny. Everyone else thinks she’s nuts. But she’s rumored to be a friend of the manager, Nancy, so everyone keeps quiet.

“Marge, you’ve got to get moving girl. The line’s getting longer. Move girl, move,” shouts Otis, unfazed by the fact that Marge really isn’t good enough to work the window and clearly is showing signs of heavy stress. “I’ll help her,” chimes in Chuck. “I can work the pay window, then run up front to help Marge when she gets way behind.” Otis says nothing and goes back to the office where he begins to count the morning receipts for the breakfast rush.

My job as cook also includes cooking baked potatoes in the oven and cooking chicken in the pressure cooker, so I have little time to do anything besides stay on top of my job. Finally, at noon, in comes Leon. He will replace Otis at three, but for now he is a sorely needed pair of hands on the second sandwich assembly board. Leon looks over at me and shouts above the din, “Good job, Jerry. Keeping up with Friday rush on your third cooking day. Good job.” Page 334That’s the first compliment I’ve received in the two weeks I’ve worked here, so I smile at the unexpected recognition. By 12:30 we’re clearly all frazzled. Even with Chuck’s help, Marge falls farther behind. She is now making mistakes on orders in her effort to get food out the drive-through window quickly. Otis comes barreling up front from the office and shouts for everyone to hear: “We’re averaging 3:05 (minutes) on drive time. Someone’s in trouble if we don’t get a move on.” He says this while staring directly at Marge. Everyone knows that drive times (the amount of time from an order being placed until the customer receives it) should be about 2:30 (two minutes, thirty seconds). In my head I do some mental math. The normal staffing for a Friday is 13 people (including management). Because of absenteeism we’re working with eight, including Otis and Leon. By noon Marge is crying, but she stays at it. And finally things begin to slow at 1 p.m. We know rush is officially over when Lucy tells Leon she’s “going to the can.” This starts a string of requests for rest breaks that are interrupted by Otis, “All right, for God’s sake. Here’s the order of breaks.” He points to people in turn, with me being next to last, and Marge going last. After Lucy, Chuck is second, and the others fill in the gap ahead of me. When my turn finally comes I resolve to break quickly, taking only 6 minutes instead of the allotted 10. When I return Otis sneers at me and chides, “What was that, about a half hour?” I snap, I’m angry, and let him know it. “If I could tell time, would I be working fast food?” Now I realize I’ve done the unforgivable, sassing my boss. But I’m upset, and I don’t care. My only care is I’ve just claimed fast food is work for dummies, and I absolutely don’t believe this. But as I said, I was mad. Otis looks me over, staring at my face, and finally decides to let out a huge bellow, “You’re okay, Newman. Good line!”

It’s now 2:10 and Marge has told Otis twice that she has to leave. Her agreement with the store manager at the time of hire was that she would leave no later than 2:30 every day. Her daughter gets off the school bus at 2:45, and she must meet her at that time. Otis ignores her first request, and is nowhere to be seen when, at 2:25, Marge looks around frantically and pleads to no one in particular, “What should I do? I have to leave.” I look at her and declare, “Go. I’ll tell Otis when he comes out again.” Marge leaves. Ten minutes later we have a mini-surge of customers. Leon yells, “Where the hell is Marge? That’s it; she’s out of here tomorrow. No more chances for her.” When he’s done ranting, I explain the details of Marge’s plight. Angrily Leon stomps back to the manager’s office and confronts Otis. The yelling quickly reaches audible levels. Everyone in the store, customers included, hear what is quickly broadening into confrontations about other unresolved issues:

  • Leon: “I’m sick of coming in here and finding nothing stocked. Otis, it’s your job to make sure the lunch shift [roughly 10 a.m.–2 p.m.] stocks items in their spare time. It never happens and I’m sick of it. Now you tell me you’re leaving and sticking me with a huge stocking job.”
  • Otis: “I’m sick of your whining, Leon. I work 50–60 hours a week. I’m sick of working 10–12 hours a day for crappy wages. You want things stocked . . . you do it. I’m going home and try to forget this place.”

With that Otis drops what he has in his hands, a printout of today’s receipts so far, and walks out the door. Leon swears, picks up the spreadsheet, and storms back to the office. I finish my shift and happily go home. No more Burger Boy for this burger boy.

  1. What appear to be the problems at this Burger Boy?
  2. How many of these problems could be explained by compensation issues?
  3. How many other problems could be lessened with diligent use of rewards other than pay?
  4. Are hours of work a reward? What might explain why I was happy to be working 20 hours per week, but Chuck was unhappy with 30 hours per week? How might schedules be used as a reward?Page 335

Summary

Why not admit it? We don’t know what makes people tick! Reading this chapter should prove that we have more unanswered questions than supposed truths. We know that employee performance depends upon some blend of skill, knowledge, and motivation. If any of these three ingredients is missing, performance is likely to be suboptimal. This chapter concentrates on the motivation component of this performance triangle. Rewards must help organizations attract and retain employees; they must make high performance an attractive option for employees; they must encourage employees to build new skills and gradually foster commitment to the organization. A tall order, you say! The problem is especially big because we are just starting to realize all the different things that can serve as rewards (or punishments) for employees. This chapter outlines 13 rewards and makes a strong case that fair administration of these rewards can lead a company to higher performance levels.

 

 

Chapter Ten

Pay-for-Performance: Types of Plans

Chapter Outline

What Is a Pay-for-Performance Plan?

How Widely Used Is Pay for Performance (PFP)?

The Important Role of Promotion in Pay for Performance

Pay-for-Performance: Merit Pay Plans

Pay-for-Performance: Short-Term Incentive Plans (Individual-Based)

Merit Bonuses aka Lump-Sum Bonuses

Individual Spot Awards

Individual Incentive Plans

Individual Incentive Plans: Returns (But Also Risks)

Individual Incentive Plans: Examples

Pay-for-Performance: Short-Term Incentive Plans (Team-Based) 

Comparing Group and Individual Incentive Plans

Large Group Incentive Plans

Gain-Sharing Plans

Profit-Sharing Plans

Earnings-at-Risk Plans

Group Incentive Plans: Advantages and Disadvantages

Group Incentive Plans: Examples

Pay-for-Performance: Long-Term Incentive Plans

Employee Stock Ownership Plans (ESOPs)

Performance Plans (Performance Share and Performance Unit)

Broad-Based Option Plans (BBOPs)

Combination Plans: Mixing Individual and Group

Does Variable Pay (Short-Term and Long-Term Incentive Plans) Improve Performance Results? The General Evidence

Your Turn : Pay at Delta and American Airlines

Appendix 10-A: Profit-Sharing (401K) at Walgreens

WHAT IS A PAY-FOR-PERFORMANCE PLAN?

Good question! Many different compensation practices are lumped under the name pay for performance. When your Mom told you last summer she would give you 20 dollars to cut the grass, that’s a pay-for-performance plan! When you didn’t do a very good job because you were rushing to make a pickup game on the local court, and she paid you anyway, that’s still a pay-for-performance plan, just not a very good one. Indeed, it sounds like your Mom learned about pay for performance from many of the managers we’ve met, whose plan seems to be “Don’t distinguish between good and bad performance and pay everyone about the same.”Page 345

Listen long enough and you will hear about incentive, variable pay plans, compensation at risk, earnings at risk, success sharing, risk sharing, and others. (Recall our discussion of these in Chapter 9.) Sometimes these names are used interchangeably. They shouldn’t be. The major thing all these plans have in common is a shift in thinking about compensation. We used to think of pay as primarily an entitlement. If you went to work and did well enough to avoid being fired, you were entitled to the same size check as everyone else doing the same job as you. Pay-for-performance plans signal a movement—sometimes a very slowmovement—away from entitlement and toward pay that varies with some measure of individual or organizational performance. Of the pay components we discussed in Chapter 9, only base pay and across-the-board increases don’t fit the pay-for-performance category. Curiously, though, many of the surveys on pay for performance tend to omit the grandfather of all these plans, merit pay, which, as we will see, is very widely used.

Exhibit 10.1 provides another way to classify pay-for-performance plans—in this case, short-term incentive/variable pay plans—and shows the breadth of these types of plans in use.

EXHIBIT 10.1 Use of Short-Term Incentive/Variable Pay Plans

Source: WorldatWork and Deloitte Consulting LLP, Incentive Pay Practices Survey: Publicly Traded Companies, February 2014.

How Widely Used Is Pay for Performance (PFP)? 

Exhibit 10.1 also provides data on the use of the short-term incentive plans (where the performance period is 12 months or less) in organizations. We see that 99 percent of organizations surveyed use some form of short-term incentive plan for at least some of their employees, and also that most have multiple short-term incentive plans. What in the past was primarily a compensation tool for top management (and is still significantly more likely to be used for them) is now often used for lower-level employees too. The use of variable pay in general has increased. For example, in 1990 the average budget for base salary increases was 5.5 percent. More recently, it was down to 3.0 percent. One reason is a decline in wage and price inflation. However, that does not explain the simultaneous increase in merit bonus/variable pay budgets from 4.2 percent in 1990 to roughly 13 percent today.1

The greater interest in variable pay probably can be traced to two trends. First, the increasing competition from foreign producers forces American firms to cut costs and/or increase productivity. Well-designed variable pay plans have a proven track record in motivating better performance and helping cut costs. Plus, variable pay is, by definition, a variable cost. No profits, or poor profits, means no extra pay beyond base pay—when times are bad, compensation is lower.2 Second, today’s fast-paced business environment means that workers must be willing to adjust what they do and how they do it. There are new technologies, new work processes, and new work relationships. All these require workers to adapt in new ways and with a speed that is unparalleled. Failure to move quickly means market share goes to competitors. If this happens, workers face possible layoffs and terminations. To avoid this scenario, compensation experts are focusing on ways to design reward systems so that workers will be able—and willing—to move quickly into new jobs and new ways of performing old jobs. The ability and incentive to do this come partially from reward systems that more closely link worker interests with the objectives of the company.3Page 346

Other evidence points to the very strong overall reliance on pay for performance (PFP), including variable pay, especially in private sector organizations. World- at-Work surveys its members (compensation professionals) about practices in organizations. Its survey results indicate that pay for performance (PFP) is very widely used. Specifically, 94 percent of organizations have merit pay programs, 99 percent (as we have seen) have short-term incentive plans (payment based on attainment of financial, operational, and individual goals during a period of 12 months or less), and 88 percent have long-term incentive plans (payment based on attainment of goals over a period of longer than 12 months usually related to performance in terms of company stock price/return). However, these percentages underestimate the use of PFP in the private sector, given that 22 percent of Page 347responding organizations were in the nonprofit, not-for-profit, or public sectors, where we know that the use of PFP (as well as its intensity when it is used) is considerably lower than in the private sector. Also, the typical long-term incentive plan, which, as noted, is based on company stock performance, is not possible in organizations where there is no stock/ownership. Thus, the typical U.S. private sector company relies especially heavily on PFP, and the percentage of private sector organizations using two or more of the above PFP plans is probably close to 100 percent.

One important caveat is that the roughly 13 percent merit bonus/variable pay percentage applies only to organizations that use such plans and only to the employee groups in such companies covered by such plans. (By contrast, merit pay plans cover almost all employees and, as we will see shortly, nearly all organizations.) Exhibit 10.2 reports short-term incentive/variable payouts and the performance basis used for them as a percentage of base pay, by employee group, in organizations using such plans and in all organizations (on average), adjusted for the fact that not all organizations use such plans and that organizations using such plans do not use them for all employee groups. Again, we see that short-term incentive payouts as a percentage of salary are larger than merit increases. Moreover, for some employee groups (those at higher job/pay levels), short-term incentive/variable payouts are much larger than merit increases. We also see that the most common performance basis for short-term incentive/variable payouts is a combination of corporate, unit, and individual objectives.

EXHIBIT 10.2 Estimated Short-Term Incentive/Variable (Bonus) Pay as a Percentage of Salary and Performance Basis, by Employee Group

Source: Barry Gerhart and Meiy Fang, “Pay for (Individual) Performance: Issues, Claims, Evidence and the Role of Sorting Effects,” Human Resource Management Review 24 (2014), pp. 41–52; Barry Gerhart, “Incentives and Pay for Performance in the Workplace,” Advances in Motivation Science 4 (2017), pp. 91–140; WorldatWork, “Incentive Pay Practices Survey: Publicly Traded Companies,” 2014.

Note: The “All Organizations” column estimates reflect an adjustment for the fact that not all organizations use such plans and for the fact that organizations that do use such plans do not use them for all employee groups. The term “nonexempt” refers to employees covered by the Fair Labor Standards Act and the term “exempt” refers to employees not covered by the Act. See Chapter 17.

Note: Although “merit bonus” (for a significant role for subjective performance) and “short-term incentive” (primarily for objective performance) are defined differently, the terms tend not to be as distinct in surveys.

Page 348

The details on performance objectives beyond the split across corporate, business unit, and individual reported in Exhibit 10.2 gets a bit confusing, which reflects the great variety in design specifics of plans in different organizations and for different employee groups. But here goes: In almost all (97 percent of) short-term incentive plans, payouts are based to some degree on financial (i.e., organization-level) performance—most commonly revenue (43 percent), followed closely by various (organization-level) profit measures. In addition, “overall individual performance (e.g., performance evaluation or rating)” was used by 48 percent of organizations. (These plans would be closer to the definition of a merit bonus plan, specifically.) Operational measures of performance were often used also, with the most common being customer satisfaction (28 percent).

Long-term incentive plans (where the performance period is more than 12 months) are also more likely to be used for officers/executives and other higher job levels. Indeed, Exhibit 10.3 shows that, on average, the lowest job levels, where most employees are, receive only a very small percentage of the value of long-term incentives granted by organizations. Long-term incentive plans (especially for top executives) will be covered further in Chapter 14. Here, we note that they include stock grants, stock option grants, performance share grants, performance units, and other programs where the payout depends on shareholder return and/or other corporate financial performance measures.

EXHIBIT 10.3 Allocation and Use of Long-Term Incentive Plans

Source: Barry Gerhart. “Incentives and Pay for Performance in the Workplace,” In Advances in Motivation Science 4 (2017), 91–140; WorldatWork, “Incentive Pay Practices Survey: Publicly Traded Companies,” 2014.

Note: The term “nonexempt” refers to employees covered by the Fair Labor Standards Act and the term “exempt” refers to employees not covered by the Act. See Chapter 17.

The Important Role of Promotion in Pay for Performance

As noted above, merit pay is widely used by organizations and for all types of employees. As we will see in our discussion below, the average merit pay increase is about 3 percent per year. At that rate, it would take an employee about 23 years to Page 349double his/her salary from say $70,000 to $140,000 or from $100,000 to $200,000. Yet, we know that many of you will go on to earn much more than $140,000 or even $200,000 per year. Although it is true that if you are a higher performer, you will get larger merit pay increases and that your salary will increase faster, it will still take a while. So, how will some of you end up making much higher salaries than described here? The answer is that you will get promoted to higher job levels (i.e., salary ranges/grades) and that salary increases due to promotion are much larger than 3 percent. For instance, if you return to Chapter 3 and examine the pay structure for engineers at Lockheed Martin, you will see that a promotion brings a salary increase of roughly 21 to 23 percent. At that rate, one’s salary doubles after three or four promotions. Except at higher job levels, promotion increases are probably more in the range of 15 percent (based on looking at typical midpoint progressions—the percentage difference in salary midpoints of adjacent salary ranges).4Using 15 percent, an employee’s salary would double after 5 promotions.

Because promotion is based importantly on performance, any discussion of how strongly pay and performance are related must recognize that it is about much more than merit pay increases, which are within-grade increases. For many employees, their performance will be rewarded with higher pay more strongly through their high performance leading to promotions to higher levels, either within their current organization or within an organization that they move to.5

PAY-FOR-PERFORMANCE: MERIT PAY PLANS

merit pay system links increases in base pay (called merit pay increases) to how highly employees are rated on a performance evaluation. (Chapter 11 covers performance evaluation.) However, most organizations use a merit increase grid, which determines merit pay increases not only on the basis of performance rating, but also on the basis of an employee’s position in the salary range/grade (i.e., how close to the minimum versus maximum). Position in range is nicely captured by the compa-ratio, defined as employee salary divided by salary range midpoint. Thus, in a salary range that goes from a minimum of $50,000 to a maximum of $70,000 with a midpoint of $60,000, an employee with a current salary of $53,000 would have a compa-ratio of $53,000/$60,000 = .88, whereas an employee in that same salary range with a salary of $67,000 would have a compa-ratio of $67,000/$60,000 = 1.12. If both employees have the highest performance rating, the employee with the compa-ratio of .88 would get a larger merit increase than the employee with a compa-ratio of 1.12 because the lower-paid employee (with the compa-ratio of .88) is farther away from where his/her salary should be in the salary range if his/her performance were to stay at that high level over time. For example, in the following merit increase grid, the first employee (with the compa-ratio of .88) would receive a 7 percent merit increase (resulting in a new salary of $56,710), whereas the second employee (with the compa-ratio of 1.12) would receive a merit increase of 3 percent (resulting in a new salary of $69,010). One can imagine what would happen without the compa-ratio element of the merit increase grid. If a high-performing employee received a 7 percent salary increase each year, his/her salary would double every 10 Page 350years! That would be fine if the value generated for the organization of that same level of high performance also doubled every 10 years. However, that may not be likely in most jobs. Typically, to double one’s contribution to the organization, one must get promoted to higher-level jobs that allows more impact on organization performance.

Exhibit 10.4 provides an example of a merit increase grid. We can also look at the degree to which companies award different merit increases to employees with different performance ratings. Exhibit 10.5 shows that, on average, in companies using a 5-point rating scale, employees with the highest rating of 5 receive a 4.5 percent merit increase on average, compared to, for example, a 2.6 percent merit increase for an employee in the middle performance category. Exhibit 10.5 also shows that about 7 percent of employees receive the highest rating and about 56 percent of employees receive the middle category performance rating. Of course, this distribution of employees across performance rating categories will have major cost implications. In some companies, as we discuss further in Chapter 11, most employees fall into the top two performance categories, which would translate into more higher merit pay increases and more cost. Finally, Exhibit 10.5 shows that higher performance ratings translate not only into higher merit pay increases, but also into higher short-term incentive payouts.

EXHIBIT 10.4 Merit Increase Grid Example

aEmployee salary divided by midpoint of their salary range.

EXHIBIT 10.5 Distribution of Performance Rating and Average Merit Increase and Short-Term Incentive Payout by Performance Rating

Source: Mercer LLC, 2016/2017 United States Compensation Planning Survey and 2017/2018 United States Compensation Planning Survey.

Note: Incentive payouts from 2016/2017 survey. Merit increases from 2017/2018 survey. Merit increases nearly identical (4.7%, 3.6%, 2.6%, 1.0%, 0.1%) in 2016/2017 survey.

At the end of a performance year, the employee is evaluated, usually by the direct supervisor. A key feature of a merit pay increase is that, unlike variable pay programs Page 351(short-term incentives and long-term incentives), the increase is added into base pay. This point is important. In effect, what an employees does this year in terms of performance is rewarded every year for as long as the employee remains with the employer. Once awarded, that merit pay increase is there forever. With compounding, this can amount to tens of thousands of dollars over an employee’s work career.6

Year after year, there are concerns about merit pay. One concern is that it increases fixed compensation costs over time. One response has been to use merit bonuses and/or other forms of variable pay plans. Another concern is that merit pay becomes costly if too many high performance ratings are awarded. A response is to control the number of high ratings and/or improve the accuracy and credibility of performance ratings. (See Chapter 11.) Another concern is that merit pay differentials based on performance are too small to motivate performance. That is a challenge. However, larger differentials can be used. Additionally, as discussed above, the strength of merit pay differentials will be greatly underestimated if the role of performance in promotions and resulting salary growth over time is not included. Another potential problem, true of any pay-for-performance program, is that individual performance is a deficient measure in organizations where work is interdependent and requires cooperation to achieve team/organization objectives. A possible solution is to broaden performance criteria to include cooperation and other factors that contribute to team/organization success. Our view is that it has been difficult to study and document the effects of merit pay plans on performance. However, the evidence that does exist is positive.7 Further, when one considers the theory and evidence on pay-for-performance plans broadly, it appears to us that organizations use such plans with good reason: in their absence, an environment is created that does not reward excellence and employees who aspire to excellence will decide to look elsewhere.8

In this vein, it is important to again keep in mind the idea of incentive and sorting effects, first introduced in Chapter 1. Most discussion of merit pay focuses on incentive effects: how does merit pay influence performance of current employees. However, merit pay may have a significant sorting effect in that people who don’t want to have their pay tied to performance don’t accept jobs at such companies or leave when pay for performance is implemented. By contrast, people who do prefer to be paid for their performance (likely higher performers on average) are more likely to join and stay with companies that more strongly link pay to performance via merit pay and other pay-for-performance programs.9

Meanwhile, at the state and municipal levels, public schools in Minnesota, Ohio, Denver, and Philadelphia led the way to merit pay for teachers.10 In Cincinnati, for example, teachers began to be held accountable for things they control: good professional practices. Teachers argue they should be held to standards similar to those for doctors: not a promise of a long healthy life but a promise that the highest professional standards will be followed. To assess teacher professional practices in Cincinnati, six evaluations were conducted over the school year, four by a trained teacher evaluator (essentially a trained teacher) and two by a building administrator. The size of pay increases was directly linked to performance during these observational reviews. However, in this case the plan did not survive.11Perhaps because of these pioneering attempts, in 2006 Congress appropriated $99 million per year to school districts, charter schools, and states Page 352on a competitive basis to fund development and implementation of performance-related pay programs for principals and teachers.12 In another vein, the public sector is also experimenting with bonuses for better student test scores. Teachers who show improved student scores can receive up to $8,000 in annual bonuses in Chicago and up to $15,000 in Nashville.13 Be careful what you wish for, though! New York State teachers and principals recently were caught cheating on the grading process for regents’ exams. The lure of bonuses totaling as much as $3,500 for teachers, and increased funding for principals’ schools if pass rates improved, was too tempting.14

Of course, we could always design a system like that used in South Korea, a country whose students consistently outperform ours. Teachers in private schools often are paid on incentive. The dollar amount can be staggering if you’re judged to be a good teacher. Kim Hi-Koon is an after-school tutor who makes 4 million per year because of his performance. He teaches three hours of lectures then spends 50 or so hours tutoring students online, developing lesson plans, and writing texts.15

If we want merit pay to live up to its potential, it needs to be managed better.16 This requires a complete overhaul of the way we allocate raises: improving the accuracy of performance ratings, allocating enough merit money to truly reward performance, and making sure the size of the merit increase differentiates across performance levels. To illustrate the latter point, consider the employee who works hard all year, earns a 5 percent increase as our guidelines above indicate, and compares herself with the average performer who coasts to a 3 percent increase. First we take out taxes on that extra 2 percent. Then we spread the raise out over 52 paychecks. It’s only a slight exaggeration to suggest that the extra money won’t pay for a good cup of coffee. Unless we make the reward difference larger for every increment in performance, many employees are going to say, “Why bother?”

PAY-FOR-PERFORMANCE: SHORT TERM INCENTIVE PLANS (INDIVIDUAL-BASED)

Merit Bonuses aka Lump-Sum Bonuses

Merit bonuses differ from merit pay increases in that employees receive an end-of-year bonus that does not build into base pay. Because employees must earn this increase every year, it is viewed less as an entitlement than as merit pay.17 It also provides employers a way to make pay vary more in line with variations in company performance by reducing fixed salary costs that can grow rapidly through merit pay increases. As Exhibit 10.6 indicates, merit bonuses can be considerably less expensive than merit pay over the long run.

EXHIBIT 10.6 Relative Cost Comparisons

Notice how quickly base pay rises under a merit pay plan. After just five years, base pay is almost $14,000 higher than it is under a merit bonus plan. It should be no surprise that cost-conscious firms report switching to merit bonuses. It also should be no surprise that employees aren’t particularly fond of merit bonuses. After all, the intent of merit is to cause shock waves in an entitlement culture. By giving merit for several years, a company is essentially freezing base pay. Gradually this results in a repositioning relative to competitors. The message becomes loud and clear: “Don’t Page 353expect to receive increases in base pay year after year—new rewards must be earned each year.” Consider the bonus system developed by Prometric Thomson Learning call centers, which register candidates for computerized tests. The centers have very clear targets that yield specific employee bonuses, as shown in Exhibit 10.7. At Prometric, each day is a new day when it comes to earning bonuses.

EXHIBIT 10.7 Customer Service Bonus Scheme at Prometric Thomson Learning Call Centers

Individual Spot Awards

Spot awards are seen by many organizations as being effective.18 Usually these payouts are awarded for exceptional performance, often on special projects or for performance that so exceeds expectations as to be deserving of an add-on bonus. The mechanics are simple: After the fact, someone in the organization alerts top management to the exceptional performance. If the company is large, there may be a formal mechanism for this recognition, and perhaps some guidelines on the size of the spot award (so named because it is supposed to be awarded “on the spot”). Smaller companies may be more casual about recognition and more subjective about deciding the size of the award. The Pharmacy School at the University of California at San Francisco has a pretty typical spot award program. Awards are given for such behaviors as “effectively resolved a complaint situation,” or “went beyond the expected by staying late to get a grant out on time.”19Page 354

Individual Incentive Plans

These plans differ from the merit and lump sum payments because they offer a promise of pay for some objective, preestablished level of performance. For example, offering students financial incentives for getting better grades actually works. These students end up having better first- and second-year grade point averages. The “bribe” worked even better for impatient students. (Yeah, we know, get on with the story.)20

All incentive plans have one common feature: an established standard against which worker performance is compared to determine the magnitude of the incentive pay. For individual incentive systems, this standard is compared against individual worker performance. Because it’s often difficult to find good, objective individual measures, individual incentive plans don’t work for every job. How, for example, would you come up with an incentive plan for construction laborers? Maybe this wouldn’t be difficult if they did the same thing all day: Your goal is to dig 5 feet of trench, 2 feet wide by 18 inches deep, every hour. But construction laborers aren’t limited to shovel jobs. They also help pour concrete, assist carpenters and masons framing buildings, etc. The job is too complex for an individual incentive plan. Even a repetitive job like working on an assembly line isn’t well suited to individual incentives. One of us (Newman) used to work on a Ford assembly line building Lincolns. Even if workers wanted to build faster to make more money, the line went by with a new car frame every 55 seconds. There is no room here for individual differences, we would argue.

Despite this constraint, a number of different individual incentive plans exist. Their differences can be reduced to variation along two dimensions and can be classified into one of four cells, as illustrated in Exhibit 10.8.

EXHIBIT 10.8 Individual Incentive Plans

The first dimension on which incentive systems vary is in the method of rate determination. Plans set up a rate based either on units of production per time period or on time period per unit of production. On the surface, this distinction may appear trivial, but, in fact, the deviations arise because tasks have different cycles of operation.21 Short-cycle tasks, those that are completed in a relatively short period of time, typically have as a standard a designated number of units to be produced in a given time period. For example, a book distributor we worked with had an incentive plan for Page 355packers. Number of books packed is a short-cycle task, with only seconds taken to get a book from a supply stack and place in a shipping box. For long-cycle tasks, this would not be appropriate. It is entirely possible that only one task or some portion of it may be completed in a day. Consequently, for longer-cycle tasks, the standard is typically set in terms of time required to complete one unit of production. Individual incentives are based on whether or not workers complete the task in the designated time period. Auto mechanics work off a blue book that tells how long, for example, a fuel injection system should take to replace. Finish faster than the allotted time and the full pay is awarded.

The second dimension on which individual incentive systems vary is the specified relationship between production level and wages.The first alternative is to tie wages to output on a one-to-one basis, so that wages are some constant function of production. In contrast, some plans vary wages as a function of production level. For example, one common alternative is to provide higher dollar rates for production above the standard than for production below the standard.

Each of the plans discussed in this section has as a foundation a standard level of performance determined by some form of time study or job analysis completed by an industrial engineer or trained personnel administrator. The variations in these plans occur in either the way the standard is set or the way wages are tied to output. As in Exhibit 10.8, there are four general categories of plans:

  1. Cell 1: The most frequently implemented incentive system is a straight piecework system. Rate determination is based on units of production per time period, and wages vary directly as a function of production level. The major advantages of this type of system are that it is easily understood by workers and, perhaps consequently, is more readily accepted than some of the other incentive systems.
  2. Cell 2: Two relatively common plans set standards based on time per unit and tie incentives directly to level of output: (1) standard hour plans and (2) Bedeaux plans. A standard hour plan is a generic term for plans setting the incentive rate based on completion of a task in some expected time period. A common example we introduced earlier can be found in any neighborhood gasoline station or automobile repair shop. Let us assume that you need a new transmission. The estimate you receive for labor costs is based on the mechanic’s hourly rate of pay, multiplied by a time estimate for job completion derived from a book listing average time estimates for a wide variety of jobs. If the mechanic receives $40 per hour and a transmission is listed as requiring four hours to be removed and replaced, the labor cost would be $160. All this is determined in advance of any actual work. Of course, if the mechanic is highly experienced and fast, the job may be completed in considerably less time than indicated in the book. However, the job is still charged as if it took the quoted time to complete. The “surplus” money is split between the employee and the service station. Standard hour plans are more practical than straight piecework plans for long-cycle operations and jobs that are nonrepetitive and require numerous skills for completion.22
  3. Bedeaux plan provides a variation on straight piecework and standard hour plans. Instead of timing an entire task, a Bedeaux plan requires division of a task into Page 356simple actions and determination of the time required by an average skilled worker to complete each action. After the more detailed time analysis of tasks, the Bedeaux system functions similarly to a standard hour plan.
  4. Cell 3: The two plans included in cell 3 provide for variable incentives as a function of units of production per time period. Both the Taylor plan and the Merrick plan provide different piece rates, depending on the level of production relative to the standard. The Taylor plan establishes two piecework rates. One rate goes into effect when a worker exceeds the published standard for a given time period. This rate is set higher than the regular wage incentive level. A second rate is established for production below standard, and this rate is lower than the regular wage.
  5. The Merrick system operates in the same way, except that three piecework rates are set: (1) high for production exceeding 100 percent of standard; (2) medium for production between 83 and 100 percent of standard; and (3) low for production less than 83 percent of standard. Exhibit 10.9 compares these two plans.
  6. Cell 4: The three plans included in cell 4 provide for variable incentives linked to a standard expressed as a time period per unit of production. The three plans include the Halsey 50–50 method, the Rowan plan, and the Gantt plan.

EXHIBIT 10.9 The Taylor and Merrick Plans

The Halsey 50–50 method derives its name from the shared split between worker and employer of any savings in direct cost. An allowed time for a task is determined via time study. The savings from completion of a task in less than the standard time are allocated 50–50 (most frequent division) between the worker and the company.

The Rowan plan is similar to the Halsey plan in that an employer and employee both share in savings resulting from work completed in less than standard time. The major distinction in this plan, however, is that a worker’s bonus increases as the time required to complete the task decreases. For example, if the standard time to complete a task is 10 hours and it is completed in 7 hours, the worker receives a 30 percent bonus. Completion of the same task in 6 hours would result in a 40 percent bonus above the hourly wage for each of the 6 hours.Page 357

The Gantt plan differs from both the Halsey and the Rowan plans in that the standard time for a task is purposely set at a level requiring high effort to complete. Any worker who fails to complete the task in the standard time is guaranteed a preestablished wage. However, for any task completed in standard time or less, earnings are pegged at 120 percent of the time saved. Consequently, workers’ earnings increase faster than production whenever standard time is met or exceeded.

Individual Incentive Plans: Returns (But Also Risks)

Although individual incentive plans receive much attention (probably because they carry risks—see below), it turns out that they are not widely used. One estimate is that fewer than 7 percent of U.S. employees are covered by individual incentive plans and almost half of those are in sales occupations. Thus, outside of sales occupations, fewer than 4 percent of employees work under such plans.23 There is strong evidence that individual incentives, on average, have substantial positive effects on performance.24

However, besides not fitting many jobs in the new economy, another reason for their limited use is that with such plans, things can go wrong—sometimes spectacularly wrong.25 For example, as we have noted, incentive plans can lead to unexpected, and undesired, behaviors. Certainly Sears, one of our examples in Chapter 9, did not want the public relations nightmare of having mechanics sell unnecessary repairs, but the incentive program encouraged that type of behavior. Please don’t think Sears is an isolated example. Workers in a subsidiary of Caterpillar were placed on an incentive system to find problems with rail cars that could be repaired and charged back to their respective owners. Under pressure employees—just like at Sears—manufactured problems (smashing brakes with hammers, ruining wheels with chisels) and then making the “repairs.”26 This is a common problem with incentive plans: Employees and managers end up in conflict because the incentive system often focuses only on one small part of what it takes for the company to be successful.27 Employees, being rational, do more of what the incentive system pays for. Sales staff provide a perfect example. Try developing a unit-based sales system that doesn’t prioritize products by offering different levels of incentives. In this case the smart salesperson sells the easiest product to unload (e.g., discounted and bargain prices products).28 As a sad example, New York teachers and administrators were put on an incentive system to get student pass rates and graduation numbers up. Both these rates increased, not because of better performance, but because standards were lowered so the incentive would be paid out. In another example, evidence suggests that hospitals using some types of pay for performance are more likely to “upcode” medical conditions into more complex categories, which brings higher reimbursements from Medicare.29 The cause of the Great Financial Crisis is typically attributed in significant part to the fact that incentives were improperly designed such that they drove mortgage loan originators to sell/approve more mortgage loans to make more money for themselves and the company, but without an adequate incentive to be careful not to sell/approve mortgages for people unlikely to be able to afford them. Wells Fargo has paid substantial fines for creating incentives for its customer-facing employees to open more customer accounts to drive more revenue, even opening accounts for customers without their knowledge! Exhibit 10.10 outlines some of the general potential problems, as well as potential advantages, with individual incentive plans.Page 358

EXHIBIT 10.10 Advantages and Disadvantages of Individualized Incentive Plans

Sources: Michael Coates, Psychology and Organizations, Heineman Themes in Psychology, Boston: Heineman, 2001; T. Wilson, “Is It Time to Eliminate the Piece Rate Incentive System?,” Compensation and Benefits Review 24, no. 2 (1992), 43–49; Pinhas Schwinger, Wage Incentive Systems (New York: Halsted, 1975).

Individual Incentive Plans: Examples

Even though pure individual incentive systems are not as widely used as sometimes thought, there are notable successes. Of course, most sales positions have some part of pay based on commissions, a form of individual incentive. One of today’s biggest success stories is the merger of individual incentives with efforts to reduce health care costs. For example, Jet Blue deposits $400 into employee health reimbursement accounts for participating in various activities such as smoking cessation programs or running in Ironman contests. In general, health incentives are on the rise: 57 percent of companies used them in 2009, while over 80 percent are expected to use them this year.30 Perhaps the longest-running success with individual incentives, going back to before World War I, belongs to a company called Lincoln Electric. In Exhibit 10.11, the compensation package for factory jobs at Lincoln Electric is described. Notice how the different pieces fit together. This isn’t a case of an incentive plan operating in a vacuum. All the pieces of the compensation and reward package fit together. Both culture and the performance review system support the different pay components. Lincoln Electric’s success is so striking that it’s the subject of many case analyses.31Page 359

EXHIBIT 10.11 Lincoln Electric’s Compensation System

PAY-FOR-PERFORMANCE: SHORT-TERM INCENTIVE PLANS (TEAM-BASED)

When we move away from individual incentive systems and start focusing on people working together, we shift to team or group incentive plans. The group might be a work team. It might be a department. Or we might focus on a division or the whole company. Or it might even be a pirate ship! Around 1750 Captain Henry Morgan, infamous pirate, recruited and motivated his men using a simple group incentive plan: an even split of all “booty” captured (of course, after distribution of shares to Captain Morgan and his top men). “No prey, no pay” was an early tagline, and it worked: A good day for a pirate was 1,000 pound sterling, far more than the 13 to 33 pounds sterling earned by merchant seamen in more legitimate vessels.32 The basic concept is still the same, though. A standard is established against which worker performance (in this case, team performance) is compared to determine the magnitude of the incentive pay. With the focus on groups, now we are concerned about group performance in comparison against some standard, or level, of expected performance. The standard might be an expected level of operating income for a division. Or the measure might be more unusual, as at Litton Industries (now a part of Northrop Grumman Corp). One division has a team variable-pay measure that is based on whether customers would be willing to act as a reference when Litton solicits other business. The more customers willing Page 360to do this, the larger the team’s variable pay.33 In a second study, four food processing plants moved to team-based structures and implemented team incentive plans. The team incentive component resulted in productivity increases of 9–20 percent.34 Some group incentive plans have even higher success goals—like winning a war. Napoleon took over an army that was underfed and demoralized. He developed one of the earliest profit sharing plans by promising soldiers a share of any bounty achieved. When Napoleon defeated Italians in what is now the Piedmont region, he demanded gold and silver from the defeated foe. Morale soared when Napoleon then shared this with his troops.

Despite an explosion of interest in teams and team compensation, many of the reports from the front lines are not encouraging.35Companies report they generally are not satisfied with the way their team compensation systems work. Failures of team incentive schemes can be attributed to at least five causes.36 First, one of the problems with team compensation is that teams come in many varieties. There are full-time teams (work group organized as a team). There are part-time teams that cut across functional departments (experts from different departments pulled together to improve customer relations). There are even full-time teams that are temporary (e.g., cross-functional teams pulled together to help ease the transition into a partnership or joint venture).

With so many varieties of teams, it’s hard to argue for one consistent type of compensation plan. Unfortunately, we still seem to be at the stage of trying to find the one best way. Maybe the answer is to look at different compensation approaches for different types of teams. Perhaps the best illustration of this differential approach for different teams comes from Xerox.

Xerox has a gain-sharing plan that pays off for teams defined at a very broad level, usually at the level of a strategic business unit. For smaller teams, primarily intact work teams (e.g., all people in a department or function), there are group rewards based on supervisory judgments of performance. Units that opt to have their performance judged as teams (it is also possible to declare that a unit wouldn’t be fairly judged if team measures were used) have managers who judge the amount to be allocated to each team based on the team’s specific performance results. For new teams, the manager might also decide how much of the total will go to each individual on the team. More mature teams do individual allocations on their own. In Xerox’s experience, these teams start out allocating equal shares, but as they evolve the teams allocate based on each worker’s performance. Out of about 2,000 work teams worldwide at Xerox, perhaps 100 have evolved to this level of sophistication. For problem-solving teams and other temporary teams, Xerox has a reward component called the Xerox Achievement Award. Teams must be nominated for exceptional performance. A committee decides which teams meet a set of predetermined absolute standards. Even contributors outside the core team can share in the award. If nominated by team members, extended members who provide crucial added value are given cash bonuses equal to those of team members.

A second problem with rewarding teams is called the “level problem” or “line of sight” problem. (See Expectancy Theory in Chapter 9.) If we define teams at the very broad level—the whole organization being an extreme example—much of the motivational impact of incentives can be lost. As a member of a 1,000-person team, I’m unlikely to be at all convinced that my extra effort will Page 361significantly affect our team’s overall performance. Why, then, should I try hard? Conversely, if we let teams get too small, other problems arise. TRW found that small work teams competing for a fixed piece of incentive awards tend to gravitate to behaviors that are clearly unhealthy for overall corporate success. Teams hoard star performers, refusing to allow transfers even for the greater good of the company. Teams are reluctant to take on new employees for fear that time lost to training will hurt the team—even when the added employees are essential to long-run success. Finally, bickering arises when awards are given. Because teams have different performance objectives, it is difficult to equalize for difficulty when assigning rewards. Inevitably, complaints arise.37

The last three major problems with team compensation involve the three Cs: complexity, control, and communications. Some plans are simply too complex. Xerox’s Houston facility had a gain-sharing plan for teams that required understanding a three-dimensional performance matrix. Employees (and these authors!) threw their hands up in dismay when they tried to understand the “easy-to-follow directions.” In contrast, Xerox’s San Diego unit has had great success with a simple program called “bet the boss.” Employees come to the boss with a performance-saving idea and bet their hard effort against the boss’s incentive that they can deliver. Such plans have a simplicity that encourages employee buy-in. With a good line of sight as it’s called, employees can see a clear link between their effort and the rewards they receive.

The second C is control. Praxair, a worldwide provider of gases (including oxygen) extracted from the atmosphere, works hard to make sure all its team pay comes from performance measures under the control of the team. If mother nature ravages a construction site, causing delays and skyrocketing costs, workers aren’t penalized with reduced team payouts. Such uncontrollable elements are factored into the process of setting performance standards. Indeed, experts assert that this ability to foretell sources of problems and adjust for them is a key element in building a team pay plan.38 Key to the control issue is the whole question of fairness. Are the rewards fair given our ability to produce results? Recent research suggests that this perception of fairness is crucial.39 With it, employees feel it is appropriate to monitor all members of the group—slackers beware! Without fairness, employees seem to have less sense of responsibility for the team’s outcomes.40

The final C is a familiar factor in compensation successes and failures: communication. Team-based pay plans simply are not well communicated. Employees asked to explain their plans often flounder because more effort has been devoted to designing the plan than to deciding how to explain it. Conversely, the more transparent the plan, the more employees trust management and respond positively to the incentive effects of the plan.

Although there is much pessimism about team-based compensation, many companies still seek ways to reward groups of employees for their interdependent work efforts. Companies that do use team incentives typically set team performance standards based on productivity improvements (38 percent of plans), customer satisfaction measures (37 percent), financial performance (34 percent), or quality of goods and services (28 percent).41 For example, Kraft Foods uses a combination of financial Page 362measures (e.g., income from operations and cash flow) combined with measures designed to gauge success in developing managers, building diversity, and adding to market share.42 Exhibit 10.12 summarizes some of these measures.

EXHIBIT 10.12 A Sampling of Performance Measures

As Exhibit 10.12 suggests, the range of performance measures for different types of corporate objectives is indeed impressive.43 For example, if the corporate objective is to reward short term performance, the measures outlined in Exhibit 10.13 could be used.

EXHIBIT 10.13 Private Company Bonus Performance Measures

Source: WorldatWork and Vivien Consulting, “Private Company Incentive Pay Practices,” January 2012.

Historically, financial measures have been the most widely used performance indicator for large group incentive plans. Increasingly, though, top executives express concern that these measures do a better job of communicating performance to stock analysts than to managers trying to figure out how to improve operating effectiveness.44Page 363

Whatever our thinking is about appropriate performance measures, the central point is still that we are now concerned about group performance. This presents both problems and opportunities. As Exhibit 10.14 illustrates, we need to decide which type of group incentive plan best fits our objectives. Indeed, we should even ask if an incentive plan is appropriate. Recent evidence, for example, suggests that firms high on business risk and those with uncertain outcomes are better off not having incentive plans at all—corporate performance is higher.45

EXHIBIT 10.14 Types of Variable Pay Plans: Advantages and Disadvantages

Source: Adapted from Kenan S. Abosch, “Variable Pay: Do We Have the Basics in Place?,” Compensation and Benefits Review 30, no. 4 (1998), pp. 12–22.

Comparing Group and Individual Incentive Plans

In this era of heightened concern about productivity, we frequently are asked if setting up incentive plans really boosts performance. As we noted in Chapter 9, the answer is yes. And individual—rather than group—incentives win the productivity “medal.” We also are asked, though, which is better in a specific situation—group or individual incentive plans. Often this is a misleading question. Individual incentives yield higher productivity gains, but group incentives often are right in situations where team coordination is the issue. One study found that changing from individual incentives to gain sharing resulted in a decrease in grievances and a fairly dramatic increase in product quality (defects per 1,000 products shipped declined from 20.93 to 2.31).46

As we noted in Exhibit 10.14, things like the type of task, the organizational commitment to teams, and the type of work environment may preclude one or the other type of incentive plan. Exhibit 10.15 provides a guide for when to choose group or individual plans. When forced to choose the type of plan with greater productivity “pep,” experts agree that individual incentive plans have better potential for—and probably better track records in—delivering higher productivity. Group plans suffer from what is called the free-rider problem. See if this sounds familiar: You are a team member on a school project and at least one person doesn’t carry his or her share of the load. Yet, when it comes time to divide the rewards, they are typically shared equally. Problems like this caused AT&T to phase out many of its team reward packages. Top-performing employees quickly grew disenchanted with having to carry free riders. End result—turnover of the very group that is most costly to lose.Page 364

EXHIBIT 10.15 The Choice between Individual and Group Plans

Source: WorldatWork and Vivien Consulting, “Private Company Incentive Pay Practices,” January 2012.

Page 366Research on free riders suggests that the problem can be lessened through use of good performance measurement techniques. Specifically, free riders have a harder time loafing when there are clear performance standards. Rather than being given instructions to “do your best,” poorer performers who were asked to deliver specific levels of performance at a specific time actually showed the most performance improvement.47

Large Group Incentive Plans

When we get beyond a small work team and try to incentivize large groups, there are generally two types of plans. Gain-sharing plans use operating measures to gauge performance. Profit sharing plans use financial measures.

Gain-Sharing Plans

Our discussion of team-based compensation often mentioned gain-sharing plans as a common component. As the name suggests, employees share in the gains in these types of group incentive plans. With profit-sharing plans (surprise) the sharing involves some form of profits. Realistically, though, most employees feel as if little they can do will affect profits; that’s something top-management decisions influence more. So gain sharing looks at cost components of the income ledger and identifies savings over which employees have more impact (e.g., reduced scrap, lower labor costs, reduced utility costs). It was just this type of thinking that led the United States Post Office to an annual cost avoidance of $497 million under its gain-sharing plan.48 Page 367Other studies of gain sharing report similar positive results. Indeed, the empirical evidence on gain sharing appears to be quite favorable.49 One study of 1,600 employees in an auto parts company showed gain sharing over five years reduced labor, material, tool purchase, scrap, rework, and supply costs. The total savings were $15 million over the five-year period. There were also decreases in absenteeism (by 20 percent) and grievances (by 50 percent).50

In a particularly good study of a major retailer, stores with gain-sharing incentives had 4.9 percent higher sales, 3.4 percent higher customer satisfaction, and 4.4 percent higher profit than stores without the incentive plan. In our experience these effects are pretty typical of gain-sharing plans—improvements in the 4–5 percent range. Keep in mind, though, gain-sharing plans can lead to the sorting effect we talked about in Chapter 9. Good employees want to be rewarded for their individual effort and performance. Changes to group plans, like gain-sharing, can lead to turnover. Just ask AT&T. They found that very-high- and very-low-performing individuals had much higher turnover rates under gain-sharing than other employees.51 The following issues are key elements in designing a gain-sharing plan:52

  1. Strength of reinforcement: What role should base pay assume relative to incentive pay? Incentive pay tends to encourage only those behaviors that are rewarded. For example, try returning an unwanted birthday present to a store that pays its sales force solely for new sales. Tasks carrying no rewards are only reluctantly performed (if at all).
  2. Productivity standards: What standard will be used to calculate whether employees will receive an incentive payout? Almost all group incentive plans use a historical standard. A historical standard involves choice of a prior year’s performance to use for comparison with current performance. But which baseline year should be used? If too good (or too bad) a comparison year is used, the standard will be too hard (or easy) to achieve, with obvious motivational and cost effects. One possible compromise is to use a moving average of several years (e.g., the average for the past five years, with the five-year block changing by one year on an annual basis).
  3. One of the major problems with historical standards is that changing environmental conditions can render a standard ineffective. For example, consider the ice cream company that based profit sharing on a financial measure that had been easily achieved the prior year. What they didn’t expect was a dramatic increase in milk costs. It was clear by the third month of the fiscal year that the goal wasn’t going to be met, and grumblings among employees were mounting. The targets were adjusted and ice cream makers rejoiced.53 Such problems are particularly insidious during economic swings and for organizations facing volatile economic climates. Care must be taken to ensure that the link between performance and rewards is sustained. This means that environmental influences on performance, which are not controllable by plan participants, should be factored out when identifying incentive levels.
  4. Sharing the gains split between management and workers: Part of the plan must address the relative cuts between management and workers of any profit or savings generated. This also includes discussion of whether an emergency reserve (gains Page 368withheld from distribution in case of future emergencies) will be established in advance of any sharing of profits.
  5. Scope of the formula: Formulas can vary in the scope of inclusions for both the labor inputs in the numerator and the productivity outcomes in the denominator.54 Recent innovations in gain-sharing plans largely address broadening the types of productivity standards considered appropriate. Given that organizations are complex and require more complex measures, performance measures have expanded beyond traditional financial measures. For example, with the push for greater quality management, we could measure retention of customers or some other measure of customer satisfaction. Similarly, other measures include delivery performance, safety, absenteeism, turnaround time, and number of suggestions submitted. Four specific examples are:55
  1. Great care must be exercised with such alternative measures, though, to ensure that the behaviors reinforced actually affect the desired bottom-line goal. Getting workers to expend more effort, for example, might not always be the desired behavior. Increased effort may bring unacceptable levels of accidents. It may be preferable to encourage cooperative planning behaviors that result in more efficient work.
  2. Perceived fairness of the formula: One way to ensure the plan is perceived as fair is to let employees vote on whether implementation should go forward. This and union participation in program design are two elements in plan success.56
  3. Ease of administration: Sophisticated plans with involved calculations of profits or costs can become too complex for existing company information systems. Increased complexities also require more effective communications and higher levels of trust among participants.
  4. Production variability: One of the major sources of problems in group incentive plans is failure to set targets properly. At times the problem can be traced to volatility in sales. Large swings in sales and profits, not due to any actions by workers, can cause both elation (in good times) and anger (in bad times). As stated above, a good plan ensures that environmental influences on performance, which are not controllable by plan participants, should be factored out when identifying incentive levels. The second author once worked with an ice cream producer that experienced huge unexpected increases in milk costs. End result? The original profit goal was unattainable. To their credit, the company adjusted the profit target to reflect the uncontrollable cost change. One alternative would be to set standards that are relative to industry performance. To the extent data are available, a company could Page 369trigger gain sharing when performance exceeds some industry norm. The obvious advantage of this strategy is that economic and other external factors hit all firms in the industry equally hard. If our company performs better, relatively, it means we are doing something as employees to help achieve success.

Exhibit 10.16 illustrates three different formulas that can be used as the basis for gain-sharing plans. The numerator, or input factor, is always some labor cost variable, expressed in either dollars or actual hours worked; the denominator is some output measure such as net sales or value added. Each of the plans determines employees’ incentives based on the difference between the current value of the ratio and the ratio in some agreed-upon base year. The more favorable the current ratio relative to the historical standard, the larger the incentive award.57 The three primary types of gain-sharing plans, differentiated by their focus on either cost savings (the numerator of the equation) or some measure of revenue (the denominator of the equation), are noted below.

EXHIBIT 10.16 Three Gain-Sharing Formulas

Scanlon Plan

Scanlon plans are designed to lower labor costs without lowering the level of a firm’s activity. Incentives are derived as a function of the ratio between labor costs and sales value of production (SVOP).58 The SVOP includes sales revenue and the value of goods in inventory. To understand how these two figures are used to derive incentives under a Scanlon plan, see Exhibit 10.17.Page 370

EXHIBIT 10.17 Examples of a Scanlon Plan

In practice, the $50,000 bonus in Exhibit 10.17 is not all distributed to the workforce. Rather, 25 percent is distributed to the company, 75 percent of the remainder is distributed as bonuses, and the other 25 percent is withheld and placed in an emergency fund to reimburse the company for any future months when a “negative bonus” is earned (i.e., when the actual wage bill is greater than the allowable wage bill). The excess remaining in the emergency pool is distributed to workers at the end of the year.

To look at the impact of Scanlon plans, consider the retail chain that adopted a Scanlon plan in six of its stores and compared results against six control stores chosen for their similarity.59 Presence of a Scanlon plan led to stores having higher customer satisfaction, higher sales, and lower turnover.

e-Compensation

HR Guide provides information about gain-sharing plans, including critiques of plans and statistical studies. The website is at http://www.hr-guide.com/data/G443.htm

Rucker Plan

The Rucker plan involves a somewhat more complex formula than a Scanlon plan for determining worker incentive bonuses. Essentially, a ratio is calculated that expresses the value of production required for each dollar of total wage bill. Consider the following illustration:60

  1. Assume accounting records show that the company expended $.60 worth of electricity, materials, supplies, and so on, to produce $1.00 worth of product. The value added is $.40 for each $1.00 of sales value. Assume also that 45 percent of the value added was attributable to labor; a productivity ratio (PR) can be allocated from the formula in item 2.
  2. PR (labor) × .40 × .45 = 1.00. Solving yields PR = 5.56.
  3. If the wage bill equals $100,000, the expected production value is the wage bill ($100,000) × PR (5.56) = $555,556.
  4. If actual production value equals $650,000, then the savings (actual production value minus expected production value) is $94,444.
  5. Since the labor contribution to value added is 45 percent, the bonus to the workforce should be .45 × $94,444 = $42,500.
  6. The savings are distributed as an incentive bonus according to a formula similar to the Scanlon formula—75 percent of the bonus is distributed to workers immediately and 25 percent is kept as an emergency fund to cover poor months. Any excess in the emergency fund at the end of the year is then distributed to workers.

Implementation of the Scanlon/Rucker Plans

Two major components are vital to the implementation and success of a Rucker or Scanlon plan: (1) a productivity norm and (2) effective worker committees. Development of a productivity norm requires both effective measurement of base-year data Page 371and acceptance by workers and management of this standard for calculating bonus incentives. Effective measurement requires that an organization keep extensive records of historical cost relationships and make them available to workers or union representatives to verify cost accounting figures. Acceptance of these figures, assuming they are accurate, requires that the organization choose a base year that is neither a “boom” nor a “bust” year. The logic is apparent. A boom year would reduce opportunities for workers to collect bonus incentives. A bust year would lead to excessive bonus costs for the firm. The base year chosen also should be fairly recent, allaying worker fears that changes in technology or other factors would make the base year unrepresentative of a given operational year.

The second ingredient of Scanlon/Rucker plans is a series of worker committees (also known as productivity committees or bonus committees). The primary function of these committees is to evaluate employee and management suggestions for ways to improve productivity and/or cut costs. Operating on a plantwide basis in smaller firms, or a departmental basis in larger firms, these committees have been highly successful in eliciting suggestions from employees. It is not uncommon for the suggestion rate to be above that found in companies with standard suggestion incentive plans.61

Scanlon/Rucker plans foster this type of climate, and that is perhaps the most vital element of their success. Numerous authorities have pointed out that these plans have the best chance for success in companies with competent supervision, cooperative union-management attitudes, strong top-management interest and participation in the development of the program, and management open to criticism and willing to discuss different operating strategies.62 It is beyond the scope of this discussion to outline specific strategies adopted by companies to achieve this climate, but the key element is a belief that workers should play a vital role in the decision-making process.

Similarities and Contrasts Between Scanlon and Rucker Plans

Scanlon and Rucker plans differ from individual incentive plans in their primary focus. Individual incentive plans focus primarily on using wage incentives to motivate higher performance through increased effort. While this is certainly a goal of the Scanlon/Rucker plans, it is not the major focus of attention. Rather, given that increased output is a function of group effort, more attention is focused on organizational behavior variables. The key is to promote faster, more intelligent, and more acceptable decisions through participation. This participation is won by developing a group unity in achieving cost savings—a goal that is not stressed, and is often stymied, in individual incentive plans.

Even though Scanlon and Rucker plans share this common attention to groups and committees through participation as a linking pin, there are two important differences between the two plans. First, Rucker plans tie incentives to a wide variety of savings, not just the labor savings focused on in Scanlon plans.63 Second, this greater flexibility may help explain why Rucker plans are more amenable to linkages with individual incentive plans.

Improshare

Improshare (Improved Productivity through Sharing) is a gain-sharing plan that has proved easy to administer and to communicate.64First, a standard is developed that Page 372identifies the expected hours required to produce an acceptable level of output. This standard comes either from time-and-motion studies conducted by industrial engineers or from a base-period measurement of the performance factor. Any savings arising from production of the agreed-upon output in fewer than the expected hours is shared by the firm and by the workers.65 For example, if 100 workers can produce 50,000 units over 50 weeks, this translates into 200,000 hours (40 hours × 50 weeks) for 50,000 units, or 4 hours per unit. If we implement an Improshare plan, any gains resulting in less than 4 hours per unit are shared 50–50 between employees and management (wages times number of hours saved).66

One survey of 104 companies with an Improshare plan found a mean increase in productivity during the first year of 12.5 percent.67By the third year the productivity gain rose to 22 percent. A significant portion of this productivity gain was traced to reduced defect rates and downtime (e.g., repair time).

Profit-Sharing Plans

Profit sharing is also positively related to productivity and productivity growth. One study of 6 million employees across 275 firms found 3.5–5.0 percent higher profits in companies that used profit sharing than in those that didn’t.68 Productivity was much higher in plans where payouts were that year than in plans where payment was deferred (as in profit sharing used for a pension program). Also, these plans worked much better in smaller (less than 775 employees) companies.

Even in companies that don’t have profit sharing plans, many variable pay plans still require a designated profit target to be met before any payouts occur. Our experience with chief executive officers is that they have a hard time giving employees extra compensation if the company isn’t also profiting. Thus, many variable pay plans have some form of profit “trigger” linked to revenue growth or profit margins or some measure of shareholder return such as earnings per share or return on capital. Despite modestly positive results, profit sharing continues to be popular because the focus is on the measure that matters most to the most people: a predetermined index of profitability. When payoffs are linked to such measures, employees spend more time learning about financial measures and the business factors that influence them.

On the downside, most employees don’t feel their jobs have a direct impact on profits. A small cog in a big wheel is difficult to motivate very well. For example, before the big crunch in the auto industry Ford Motor and GM gave profit sharing checks of about $7,500, compared to $2,250 at Fiat-Chrysler.69 You can bet the Chrysler employees wondered if their counterparts at Ford and GM were working more than three times as hard. If you guessed that they blamed the difference on bad management decisions, you’re right on target.

The trend in recent variable-pay design is to combine the best of gain-sharing and profit-sharing plans.70 The company will specify a funding formula for any variable payout that is linked to some profit measure. As experts say, the plan must be self-funding. Dollars going to workers are generated by additional profits gained from operational efficiency. Along with having the financial incentive, employees feel they have a measure of control. For example, an airline might give an incentive for reductions in lost baggage, with the size of the payout dependent on hitting profit targets. Page 373Such a program combines the need for fiscal responsibility with the chance for workers to affect something they can control.

Earnings-at-Risk Plans

We probably shouldn’t separate earnings-at-risk plans as a distinct category. In fact, any incentive plan could be an at-risk plan. Think of incentive plans as falling into one of two categories: success sharing or risk sharing. In success-sharing plans, employee base wages are constant and variable pay adds on during successful years. If the company does well, you receive a predetermined amount of variable pay. If the company does poorly, you simply forgo any variable pay—there is no reduction in your base pay, though. In a risk-sharing plan, base pay is reduced by some amount relative to the level that would be offered in a success-sharing plan. AmeriSteel’s at-risk plan is typical of risk-sharing plans. Base pay was reduced 15 percent across the board in year 1. That 15 percent was replaced with a .5 percent increase in base pay for every 1 percent increase in productivity beyond 70 percent of the prior year’s productivity. This figure would leave workers whole (no decline in base pay) if they only matched the prior year’s productivity. Each additional percent improvement in productivity yielded a 1.5 percent increase in base wages. Everyone in AmeriSteel, from the CEO on down, is in this type of plan and the result has been an 8 percent improvement in productivity.71

Clearly, at-risk plans shift part of the risk of doing business from the company to the employee. The company hedges against the devastating effects of a bad year by mortgaging part of the profits that would have accrued during a good year. Not surprisingly, a key element of incentive design is to identify possible risks and incorporate design features that minimize them.72 At-risk plans appear to be met with decreases in satisfaction with both pay in general and the process used to set pay.73 In turn, this can result in higher turnover.

Group Incentive Plans: Advantages and Disadvantages

Clearly, group pay-for-performance plans are gaining popularity in today’s team-based environment. Other factors play a role, though. One factor with intriguing implications suggests that group-based plans, particularly gain-sharing plans, cause organizations to evolve into learning organizations.74 Apparently the suggestions employees are encouraged to make (how to do things better in the company) gradually evolve from first-order learning experiences of a more routine variety (maintenance of existing ways of doing things) into suggestions that exhibit second-order learning characteristics—suggestions that help the organization break out of existing patterns of behavior and explore different ways of thinking and behaving.75

Exhibit 10.18 outlines some of the general positive and negative features of group pay-for-performance plans.76

EXHIBIT 10.18 Group Incentive Plans: Advantages and Disadvantages

Group Incentive Plans: Examples

All incentive plans, as we noted earlier, can be described by common features: (1) the size of the group that participates in the plan, (2) the standard against which performance is compared, and (3) the payout schedule. Exhibit 10.19 illustrates some of the more interesting components of plans for leading companies.Page 374

EXHIBIT 10.19 Corporate Examples of Group Incentive Plans

PAY-FOR-PERFORMANCE: LONG-TERM INCENTIVE PLANS

All of the individual and group plans we have discussed thus far focus on short time horizons for performance and payouts. Usually the time horizon is a year or less. Now we shift to variable pay plans where the time horizon is longer than a year. Such programs force executives to think long term, and develop strategic plans that don’t sacrifice tomorrow’s riches for today’s small gains.

Exhibit 10.20 shows different types of long-term incentives and their definitions. These plans are also grouped by the level of risk faced by employees having these incentives, as well as the expected rewards that might come from them.Page 375

EXHIBIT 10.20 Long-Term Incentives and Their Risk/Reward Tradeoffs

Long-term incentives (LTIs) focus on performance beyond the one-year time line used as the cutoff for short-term incentive plans. Recent explosive growth in long-term plans appears to be spurred in part by a desire to motivate longer-term value creation.77 The empirical evidence that stock ownership by management leads to better corporate performance varies by study.78 There is some evidence, though, that stock ownership is likely to increase internal growth, rather than more rapid external diversification.79

All this talk about stock options neglects the biggest change in recent memory. As of June 2005 companies were required to report stock options as an expense.80 Prior to this date, generally accepted accounting rules didn’t require options to be reported as an overhead cost. They were (wrongly) viewed as a free good under old accounting rules.81 Think about the executive issued 500,000 shares with a vesting period of five years (the shares can be bought in five years). After five years, the CEO can purchase the stock at the initial-offer price (if the market price is now lower than that, the stock option is said to be “underwater” and is not exercised).82 Page 376If the executive bought the shares, they were typically issued from a pool of unissued shares. The money paid by the CEO was treated like money paid by any investor . . . found money? Not really. Options diluted the per-share earnings because they increase the denominator applied to net profits used to figure per-share earnings. (OK, OK we promise, no more accounting terms!) Cases like Enron, which did not expense options, gave an unrealistic picture of profits and helped to elevate stock prices. The publicity from this case increased pressure to change accounting rules and led to the changes that began affecting most companies in 2006.83 Microsoft asserts that it will still continue to offer stock options to rank and file employees, but insiders admit that the modest movement in their stock prices have lessened the appeal of this vehicle for retaining top talent. No more instant multi-millionaires like the roaring 90s.84As a direct result of the changing rules, some companies, like Coca Cola, Dell Inc., Aetna Inc., Pfizer Inc., McDonald’s Corp., Time Warner Inc., ExxonMobil Corp., and Microsoft Corp either stopped granting options or only grant them to executives.85

Employee Stock Ownership Plans (ESOPs)

Some companies believe that employees can be linked to the success or failure of a company in yet another way—through employee stock ownership plans.86 At places like PepsiCo, Lincoln Electric, DuPont, Coca-Cola, and others, the goal is to increase employee involvement in the organization, and hopefully this will influence performance. Toward this end, employees own 28 percent of the stock at Lincoln Electric. At Worthington Industries, an oft-praised performer in the steel industry, employees augment wages by 40–100 percent between profit sharing and stock ownership.87

Despite these high-profile adoptions, ESOPs don’t make sense as an incentive. First, the effects are generally long-term. How I perform today won’t have much of an impact on the stock price at the time I exercise my option.88 Nor does my working harder mean more for me. Indeed, we can’t predict very well what makes stock prices rise and this is the central ingredient in the reward component of ESOPs. So if the performance measure is too complex to figure out, how can we control our own destiny? Sounds like ESOPs do poorly on two of the three Cs we mentioned earlier as causing incentive plans to fail. Why then do over 6,000 companies have ESOPs covering more than 14 million employees with assets of well over $1.3 trillion in the stock of their companies?89 The answer may well be that ESOPs foster employee willingness to participate in the decision-making process.90 And a company that takes advantage of that willingness can harness a considerable resource—the creative energy of its workforce.

If we just look at the impact of ESOPs on productivity or financial outcomes, leaving aside the positive effect on employee participation, the results are very modest. ESOPs have little impact on productivity or profit.91 Critics of ESOP argue that companies don’t use these programs effectively. If more firms would combine ESOPs with high goal setting, improved employee communication with management, and greater participation in decision making by employees, maybe ESOPs would have more positive results.92Page 377

Performance Plans (Performance Share and Performance Unit)

Performance plans typically feature corporate performance objectives for a time three years in the future. They are driven by financial earnings or return measures, and they pay out for meeting or exceeding specific goals.

Broad-Based Option Plans (BBOPs)

For the past 15 years broad-based option plans represented a growing trend. BBOPs are stock grants: The company gives employees shares of stock over a designated time period. The strength of BBOPs is their versatility. Depending on the way they are distributed to employees, they can either reinforce a strong emphasis on performance (performance culture) or inspire greater commitment and retention (ownership culture) of employees. There is growing evidence that the incentive effect of BBOPs is relatively small, and declines as the number of employees included grows. The smaller size of the effect in larger plans is explained by the free rider effect—“I can coast and get the same size benefit as others, and not get caught!”93 Some of the best-known companies in the country offer stock grants to employees at all levels: Southwest Airlines, Chase Manhattan, DuPont, General Mills, Procter & Gamble, PepsiCo, Merck, Eli Lilly, Kimberly-Clark, Microsoft, and Amazon.com.94 For example, Starbucks has a stock grant program called Beanstock, and all employees who work at least 500 hours per year, up to the level of vice president, are eligible (broad-based participation).95 If company performance goals are reached, all employees receive equal stock grants worth somewhere between 10 and 14 percent of their earnings. The grants vest 20 percent each year, and the option expires 10 years after the grant date. This program exists to send the clear signal that all employees, especially the two-thirds who are part-timers, are business partners. This effort to create a culture of ownership is viewed as the primary reason Starbucks has turnover that is only a fraction of the usually high turnover in the retail industry.

Colliding with this trend, though, is increasing shareholder pushback against equity awards for all but the top 1 percent of employees. The public simply doesn’t believe that lower level employees can affect stock price with their performance! Bowing to this pressure, Coca-Cola is eliminating stock options for all but the top 1 percent. They will shift to cash awards for performance instead.96

Combination Plans: Mixing Individual and Group

It’s not uncommon for companies to use both individual and group incentives. The goal is to both motivate individual behavior and to insure that employees work together, where needed, to promote team and corporate goals. These combination programs start with standard individual (e.g., performance appraisal, quantity of output) and group measures (e.g., profit, operating income). Variable pay level depends on how well individuals perform and how well the company (or division/strategic business unit) does on its macro (e.g., profit) measures. A typical plan might call for a 75–25 split. Seventy-five percent of the payout is based on how well the individual worker does, the other portion is dependent on corporate performance. An alternative might be a completely self-funding plan, often favored by CEOs who don’t like to Page 378make payouts when the company loses money. These plans specify that payouts only occur after the company reaches a certain profit target. Then variable payouts for individual, team, and company performance are triggered.

DOES VARIABLE PAY (SHORT-TERM AND LONG-TERM INCENTIVES) IMPROVE PERFORMANCE RESULTS? THE GENERAL EVIDENCE

As the evidence pointed out in Chapter 9, variable pay-for-performance plans (short-term incentives and long-term incentives) seem to have a positive impact on performance if designed well. Notice that we have qualified our statement that variable-pay plans can be effective if they are designed well. Too often though the plans have too small a payout for the work expected, unattainable (or too easy) goals, outdated or inaccurate metrics, or even too many metrics making it hard to determine what is important.97 A quite different problem is that the payouts are quite large for high performance, but the behaviors taken to achieve those particular aspects of performance cause major problems. As such, incentive pay plans are sometimes described as high return, but high risk plans. When they go wrong, they go wrong in a big way. In the preceding sections, we have further addressed issues in design and the impacts they can have.

Your TurnPay at Delta and American Airlines

Most of the Your Turns in earlier chapters asked you to apply your knowledge of a specific chapter to answer a real world question. Now we are going to move one step further and give you information about two companies that operate in the same industry. American Airlines and Delta both make information available about base wages and profit sharing. Data in the exhibit are annual salaries. Importantly, note that American’s profit sharing in recent years has produced a payout that is about 2% of salary for its pilots, whereas Delta’s profit sharing’s payout has been about 15% of pilot salary. (So, for example, a pilot at American flying a 777 with 12 years of experience received a profit sharing payment of $332,000 x .02 $6,640 on top of his/her $332,000 salary.) These data are only for airline pilots. The pilot is the number one authority, and in charge, in the cockpit of an airplane. Mistakes and heroic good decisions are likely to be attributed to the pilot in most circumstances. In this exercise we would like you to deduce what these two airlines believe about:

  1. The importance of base wages relative to variable pay (profit sharing)
  2. The likely behavioral impact of profit sharing in this case, assuming the payout is based on overall net revenue of the organization. Some impacts might be positive or negative. What is your assessment of the use of profit sharing, given what we’ve said about when to use such a compensation tool?
  3. How important is seniority in each of these situations? Should the importance be more or less? Why?
  4. Do these airlines pay for skill acquisition? What data do you have to support your position? Should skill acquisition be rewarded?Page 379
  5. Do you have any predictions about attraction and retention for each company? What about labor relations?
  6. Does the external environment influence any of your answers?

EXHIBIT 10.21 Pilot Annual Salaries by Plane Type and Years of Experience

Note: Pilots are paid by the hour. Annual salaries in the exhibit are estimates based on the contractual hourly rate and estimated hours flown. Hourly rates change regularly because a new contract is typically negotiated every three years between pilots and the airline.

Summary

Pay-for-performance plans can work. But as this chapter demonstrates, the design and effective administration of these plans is key to their success. Having a good idea is not enough. The good idea must be followed up by sound practices that recognize rewards can, if used properly, shape employee behavior.

 

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