CHAPTER 4
Incentive Pay
Learning Objectives
4-1. Explore the incentive pay approach.
4-2. Describe the differences between incentive pay methods and traditional pay methods.
4-3. Summarize five types of individual incentive pay plans.
4-4. Explain two types of group incentive plans.
4-5. Discuss two types of company-wide incentive plans.
4-6. Summarize considerations when designing incentive pay programs.
Outline
I. Exploring Incentive Pay
II. Contrasting Incentive Pay with Traditional Pay
III. Individual Incentives
IV. Group Incentives
V. Companywide Incentive Plans
VI. Designing Incentive Pay Programs
VII. Key Terms
VIII. Discussion Questions and Suggested Answers
IX. End of Chapter Case; Instructor Notes, and Questions and Suggested Student
Responses
X. Crunch the Numbers! Questions and Suggested Student Responses
XI. Assisted-graded Questions
Lecture Outline
I. Exploring Incentive Pay
A. Compensation, other than base wages or salaries, which fluctuates according to
employees’ attainment of some standard such as a pre-established formula,
individual or group goals or company earnings
1. Effectiveness based on three assumptions
a. Individual employees and work teams differ in how much they contribute to
the company, and in how well they do it
b. The company’s overall performance depends on the performance of its
employees
c. How well it attracts, retains, and motivates high performers
2 Adds to base pay as a one-time payment
3. Designed to control payroll costs or to motivate employee productivity
II. Contrasting Incentive Pay with Traditional Pay
A. Traditional pay plans based on:
1. Fixed hourly wage or annual salary
2. Raises based on length of service or supervisor’s subjective ratings
B. Incentive pay programs are designed to reward employees and teams for performance
1. Classified into three categories
a. Individual-incentive plans
b. Group-incentive plans
c. Company-incentive plans
III. Individual Incentives
A. Individual incentives are appropriate when
1. Performance can be measured objectively
2. Employees have sufficient control over work outcomes
3. The incentives do not create a level of unhealthy competition among workers
B. Defining Individual Incentives
1. Individual incentive plans reward employees for meeting such work-related
performance standards as quality, productivity, customer satisfaction, safety, or
attendance
2. Managers should choose factors that are within the individual employee’s control
when they create individual performance standards
C. Types of Individual Incentive Plans
1. Piecework Plans-
a. Two types:
i. Rewards based on individual production against an objective standard
ii. Rewards based on individual performance standards that include both
objective and subjective criteria
b. Two advantages to companies using piecework plans in manufacturing
settings:
i. Incentive effect refers to a worker’s willingness to work diligently to
produce more quality output
ii. Sorting effect refers to an employee’s choice to stay versus leave for
another job, probably one without an incentive pay contingency
2. Management incentive plans award bonuses to managers when they meet or
exceed objectives based on sales, profits, production or other measures
3. Behavioral encouragement plans award employees for specific behavioral
accomplishments such as good attendance or safety records
4. Referral plans award employees for referring new customers or recruiting
successful job applicants
C. Advantages of Individual Incentive Plans
1. Can promote the relationship between pay and performance
2. Can promote an equitable distribution of compensation within companies
3. These plans are compatible with the individualistic cultures
D. Disadvantages of Individual Incentive Plans
1. Have the potential to promote inflexibility
2. Supervisors set performance standards
3. May encourage undesirable workplace behaviors
IV. Group Incentives
A. Use of teams in workplace increasing
1. Companies that use teams need to change individualistic compensation practices
so that groups are rewarded for their behavior together
2. Team-based organizational structures have higher expectations of employees
B. Defining Group Incentives
1. Group incentive programs reward employees for their collective performance
2. Well-designed group incentive plans reinforce teamwork, cultivate loyalty to the
company, and increase productivity
C. Types of Group Incentive Plans
1. Team-based or Small Group Incentive Plans
a. Each team member receives a financial reward upon completion of the group
goal
b. Work (process) teams are organizational units that perform the work of the
organization on an ongoing basis
c. Project teams are of people assigned to complete a one-time project
d. Parallel teams or task forces include employees assigned to work on a specific
task in addition to normal work duties
e. Rewards allocated three ways
i. Equal incentive payments to all team members
ii. Differential payments to team members based on their contributions to
the goal
iii. Differential payments determined by a ratio of each team members’
base pay to the total base pay of the group
2. Gain Sharing Plans
a. Defined as group incentive systems that provide employees an incentive based
on improved company performance
b. Three main components
i. Leadership philosophy, which refers to a cooperative organizational
climate that promotes high levels of trust, open communication, and
participation
ii. Employee involvement systems, drives organizational productivity and
includes improvement suggestions and problem-solving ideas
iii. Bonuses, which are awarded when actual productivity exceeds targeted
productivity levels
3. Scanlon Plan
a. Developed by Joseph Scanlon in 1935 and emphasized employee involvement
b. Includes three main components:
i. Emphasis on teamwork to reduce costs, assisted by
management-supplied information on production concerns
ii. Suggestion systems that route cost-saving ideas from the workforce
through a labor–management committee that evaluates and acts on
accepted suggestions.
iii. A monetary reward based on productivity improvements to encourage
employee involvement
c. Gain-sharing formulas are based on the ration between labor costs and sales
value of production which is the sum of sales revenue plus the value of goods
in inventory
4. Rucker Plan
a. Developed by Allan W. Rucker in 1933
b. Emphasizes employee involvement and provides monetary incentives
c. Uses a value-added formula to measure productivity, which is the difference
between the value of the sales price and the value of materials used to make
the product
d. Larger Rucker ratio indicates that the value added is greater than the total
employment costs
e. Rucker Ratio = Value added/Total employment costs
5. Improshare
a. Invented by Mitchell Fein in 1973
b. Defined as “Improved Productivity through Sharing” it measures productivity
physically rather than in terms of dollar savings
c. Aims to produce more products with fewer labor hours
d. Based on labor hour ratio formula which is standard based on analyzing the
historic relationship between the number of labor hours needed to complete a
product is determined
D. Advantages of Group-Incentive Plans
1. Companies can more easily develop performance measures for group plans than
individual plans as there are fewer groups and individuals
2. Greater group cohesion
E. Disadvantages of Group-Incentive Plans
1. May lead to higher employee turnover because of the free-rider effect where some
employees make fewer contributions
a. The most productive employees may leave when equal rewards are given for
unequal contributions
2. Group members may feel uncomfortable with the fact that other members’
performance influences their compensation level
V. Companywide Incentive Plans
A. Defining Companywide Incentives
1. Instituted in the 19th century as a way for companies to ease workers’:
a. Dissatisfaction with low pay
b. Belief that company management paid them substandard wages while earning
substantial profits
2. Defined as systems that reward employees when the company exceeds minimally
acceptable performance standards
3. Advocates believe that well-designed programs make workers’ and owners’ goals
more compatible as workers strive toward increasing company profits or value
B. Types of Companywide Incentive Plans
1. Profit sharing plans pay a portion of company profits to employees
a. Current profit sharing plans award cash to employees typically on a quarterly
or annual basis as part of their core compensation
b. Deferred profit sharing plans place cash awards in trust accounts for
employees for retirement
c. Calculating Profit Sharing Awards
i. Fixed first-dollar-of-profits formula uses a specific percentage of annual
profits, contingent upon the successful attainment of a company goal.
ii. Graduated first-dollar-of-profits formula is based on percentages of pre- or
post-tax profits and motivates employees to strive for extraordinary profit
targets by sharing even more of the incremental gain with them
iii. Profitability threshold formulas fund profit sharing pools when profits fall
within predetermined minimum and maximum levels
ii. Not widely used, as it may be difficult to quantify each employee’s
contribution
d. Advantages of Profit Sharing Plans
i. Enables employees to share in companies’ profits
ii. Allows companies greater financial flexibility
e. Disadvantages of Profit Sharing Plans
i. Can undermine the economic security of employees, particularly if it
represents a sizable portion of direct compensation
ii. May fail to motivate employees because they do not see a direct link
between their efforts and corporate profits.
2. Employee Stock Option Plans
a. Represent a long-term company-wide incentive plan that provides employees
with stock options
b. Company stock represents total equity of a company
c. Company stock shares represent equity segments of equal value
d. Stock options describe an employee’s right to purchase company stock
VI. Designing Incentive Pay Programs
A. Five Key Considerations
1. Should the plan be based on group or individual employee performance
2. What level of risk will the employees be willing to accept in their overall
compensation package
3. Should the incentive pay replace or complement traditional pay
4. What criteria should be used to judge performance
5. Which time horizon for meeting goals would be most effective
a. Long-term
b. Short-term
c. Some combination
B. Group versus Individual Incentives
1. Group incentives are most suitable where the nature of work is interdependent and
the contributions of individual employees are difficult to measure
2. Individual incentives are most suitable for employees whose work is independent
not interdependent, such as meeting production goals or sales quotas
C. Level of Risk
1. Increases as incentive pay represents a greater proportion of total core
compensation
2. Should be dependent on the extent to which an employee controls the attainment
of the desired goal
D. Complementing or Replacing Base Pay
1. When complementing base pay, the company awards incentive pay in addition to
base pay and fringe benefits
2. Companies may reduce base pay by placing the reduced portion at risk in an
incentive plan
3. Companies in cyclical industries such as retail could benefit as compensation
expenditure would vary with levels of business activity profitability of the
company
E. Performance Criteria
1. Measures used to appraise performance should be quantifiable and accessible
2. Measures should relate to the company’s competitive strategy
3. If more than one measure is relevant, each should be weighed to reflect its relative
importance to the company’s competitive strategy
F. Time Horizon: Short-Term versus Long-Term
1. “Rule-of-thumb” is that short-term is five years or fewer
2. Incentives for professionals’ and executives’ are generally long-term
End of the Chapter
VII. Key Terms
Incentive pay: Rewards employees for partially or completely attaining a predetermined work
objective
Variable pay: Rewards employees for partially or completely attaining a predetermined work
objective
Piecework plans: Rewards employees based on their individual hourly production against an
objective output standard and are determined by the pace at which manufacturing equipment
operates
Incentive effect: Refers to a worker’s willingness to work diligently to produce more quality
output than simply attending work without putting in the effort
Sorting effect: Addresses an employee’s choice to stay versus leave his or her employer for
another job, presumably one without an incentive pay contingency
Management incentive plans: Award bonuses to managers when they meet or exceed
objectives based on sales, profit, production, or other measures for their division, department, or
unit
Behavioral encouragement plans: Employees receive payments for specific behavioral
accomplishments
Referral plans: Employees receive monetary bonuses under for referring new customers or
recruiting successful job applicants
Spot bonuses: Relatively small monetary gifts provided to employees for outstanding work or
effort during a reasonably short period of time
Group incentive programs: Reward employees for their collective performance, rather than for
each employee’s individual performance
Team-based incentives: When each group member receives a financial reward for the
attainment of a group goal
Gain sharing: group incentive systems that provide participating employees with an incentive
payment based on improved company performance for increased productivity, increased
customer satisfaction, lower costs, or better safety records
Scanlon plan: Include monetary rewards to employees for productivity improvements
Sales value of production (SVOP): The sum of sales revenue plus the value of goods in
inventory
Rucker plan: Incentive plan that emphasizes employee involvement and provides monetary
incentives to encourage employee participation using a value-added formula to measure
productivity
Value-added formula: Value added is the difference between the value of the sales price of a
product and the value of materials purchased to make the product
Improshare: Improved Productivity through Sharing—measures productivity physically rather
than in terms of dollar savings like those used in the Scanlon and Rucker plans
Labor hour ratio formula: A standard is determined by analyzing historical accounting data to
find the number of labor hours needed to complete a product
Free-rider effect: When some employees make fewer contributions to the group goals because
they possess lower ability, skills, or experience than other group members
Profit sharing plans: Pay a portion of company profits to employees, separate from base pay,
cost-of-living adjustments, or permanent merit pay increases
Current profit sharing: award cash to employees, typically on a quarterly or annual basis
Deferred profit sharing: Place cash awards in trust accounts for employees
Employee stock option plans: Present a long-term company-wide incentive plan that provide
employees with stock options
Company stock: Represents total equity of a company
Company stock shares: Represent equity segments of equal value
Stock options: Describe an employee’s right to purchase company stock