CHAPTER 10
PAY-FOR-PERFORMANCE PLANS
Overview
This chapter focuses on pay-for-performance plans. There are a wide variety of
pay-for-performance plans—incentive plans, variable-pay plans, compensation at risk, earnings
at risk, success sharing, etc. Sometimes these names are used interchangeably, but they should
not be. The major thing these names have in common is a shift in thinking about compensation.
Pay used to be viewed as an entitlement—if you went to work and did well enough to avoid
being fired, you were entitled to the same size paycheck as everyone else. Pay-for-performance
plans signal a movement away from entitlement toward pay that varies with some measure of
individual or organizational performance.
The greater interest in variable pay can be traced to two trends. First, increasing competition
from foreign producers forces U.S. 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. Second, the fast-paced business environment means employees must be willing to adjust
what they do and how they do it—new technologies, new work processes, and new work
relationships require employees to adapt in new ways. Failure to move quickly may result in lost
market share. To avoid this scenario, compensation experts are focusing on designing reward
systems that more closely link employee interests with the objectives of an organization.
This chapter is organized around the key categories of pay-for-performance plans—short-term,
team-based, and long-term. The major components of the various plans are presented, along with
the advantages and disadvantages of individual and group incentive plans. The evidence in this
chapter indicates pay-for-performance plans can work. However, the design and effective
administration of these plans is the key to their success. Sound practices that recognize rewards
can, if used properly, shape employee behavior.
Lecture Outline: Overview of Major Topics
I. What Is a Pay-for-Performance Plan?
II. Does Variable Pay Improve Performance Results? The General Evidence
III. Specific Pay-For-Performance Plans: Short Term
IV. Team Incentive Plans: Types
V. Explosive Interest in Long-Term Incentive Plans
VI. Your Turn: Comparing Airlines
VII. Appendix 10-A: Profit-Sharing (401k) at Walgreens
Learning Objectives
Define a pay-for-performance plan and discuss evidence that variable pay improves
performance results.
Identify the different forms of short term pay-for-performance plans, including merit pay,
merit bonuses, individual spot and incentive plans as well as the advantages and
disadvantages of these plans.
Discern the differences between types of individual incentive plans and team incentive
plans, including large group plans, gain-sharing and profit-sharing plans, and
earnings-at-risk plans along with their advantages and disadvantages.
Discuss the various long-term incentive plans, including employee stock ownership
plans, performance plans, broad-based option plans, and combination plans.
Lecture Outline: Summary of Key Chapter Points
I. What Is a Pay-For-Performance Plan?
Many different compensation practices are lumped under the name
pay-for-performance, for example, incentive plans, variable pay plans,
compensation at risk, earnings at risk, success sharing, risk sharing, and others.
The major thing all these names have in common is a shift in thinking about
compensation.
People used to think of pay as primarily an entitlement. If an employee went to
work and did well enough to avoid being fired, the employee was entitled to the same
size check as everyone else doing the same job.
Pay-for-performance plans signal a movement away from entitlement toward pay
that varies with some measure of individual or organizational performance.
Many of the surveys on pay-for-performance tend to omit the starting point of all
these plans, merit pay.
oMerit pay is still a pay-for-performance plan used for more than three-quarters of all
exempt, clerical, and administrative employees.
oIn comparison, variable pay of some form (individual or group incentive pay) is
offered by 95 percent of all companies, up from 51 percent in 1991
oExhibit 10.1 illustrates the wide variety of variable-pay plans in use today.
oWhat used to be primarily a compensation tool for top management is gradually
becoming more prevalent for lower-level employees, too.
oExhibit 10.2 indicates that variable pay is commanding a larger share of total
compensation for all employee groups.
The greater interest in variable pay can be traced to two trends:
oThe 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.
oToday’s fast-paced business environment means employees 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 with a speed that is unparalleled.
Failure to move quickly means market share goes to competitors. 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.
II. Does Variable Pay Improve Performance Results? The General Evidence
Pay-for-performance plans, those that introduce variability into the level of pay an
employee receive, seem to have a positive impact on performance if they are designed
well.
Too often the plans have too small a payout for the work expected, unattainable
(or too easy) goals, outdated or inaccurate metrics, or even too many metrics making it
difficult to determine what is important.
III. Specific Pay-For-Performance Plans: Short Term
A. Merit Pay
A merit pay system links increases in base pay (called merit increases) to how
highly employees are rated on a performance evaluation.
At the end of a performance year, an employee is evaluated, usually by the
direct supervisor.
The performance rating determines the size of the increase added into base
pay.
In effect, what the employee does in a certain year in terms of
performance is rewarded every year the employee remains with the employer.
Increasingly, merit pay is under attack. Not only is it expensive, but many argue it
does not achieve the desired goal of improving employee and corporate
performance.
In a thorough review of merit pay literature, though, Heneman concludes that merit
pay does have a small, but significant, impact on performance.
High performance ratings are nearly always statistically related to high
merit increases and the reverse holds too.
Departments and strategic business units with better merit pay programs
have higher subsequent performance. And removal of merit pay appears to
result in lower subsequent performance, as well as lower satisfaction among top
performers.
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. This
sorting leaves a residual workforce that is more productive and more responsive
to merit rewards.
If merit pay is to live up to its potential, it must be managed better. This requires a
complete overhaul of the way raises are allocated: 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.
B. Merit Bonuses aka Lump-Sum Bonuses
Merit bonuses are thought to be a substitute for merit pay.
Based on employee or company performance, employees receive an end-of-year
bonus that does not build into the base pay.
Because employees must earn this increase every year, it is viewed as less of an
entitlement than merit pay.
Exhibit 10.3 indicates merit bonuses can be considerably less expensive than merit
pay over the long run.
It is no surprise that cost-conscious firms report switching to merit bonuses.
Employees are not particularly fond of merit bonuses. The intent of merit bonuses is
to cause shock waves in an entitlement culture. By giving merit bonuses for several
year, a company is essentially freezing base pay.
C. Individual Spot Awards
Technically, spot awards should fall under pay-for-performance plans. About 35
percent of companies use spot awards.
An impressive 74 percent of companies in one survey reported that these awards
were either highly or moderately effective.
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.
Larger companies may have a formal mechanism for this recognition, and perhaps
some guidelines on the size of the spot award. Smaller companies may be more
casual about recognition and more subjective about deciding the size of the award.
D. Individual Incentive Plans
These plans differ from the merit and spot awards 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. On a more suspect note, reports indicate a large part of
the income for some doctors is linked to incentives given by the pharmaceutical
industry.
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.
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 10.5.
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.
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 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.
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.
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 10.5 , there are four general categories of
plans:
oCell 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.
Cell 2: Two relatively common plans set standards based on time per unit
and tie incentives directly to level of output:
Standard hour plans—this is a generic term for plans setting the incentive
rate based on completion of a task in some expected time period. These are
more practical than straight piecework plans for long-cycle operations and
jobs that are non-repetitive and require numerous skills for completion.
Bedeaux plans—provide a variation on straight piecework and standard
hour plans. Instead of timing an entire task, a Bedeaux plan requires division
of task into simple 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.
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 plans provide
different piece rates, depending on the level of production relative to the
standard.
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.
Merrick system—operates in the same way, except that three piecework
rates are set:
High—for production exceeding 100 percent of standard
Medium—for production between 83 and 100 percent of standard
Low—for production less than 83 percent of standard
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 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.
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 pre-established 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.
E. Individual Incentive Plans: Advantages and Disadvantages
Incentive plans can lead to unexpected and undesired behaviors.
Employees and managers end up in a conflict because the incentive system often
focuses only on one small part of what it takes for the company to be successful.
Employees, being rational, do more of what the incentive system pays for.
Exhibit 10.7 outlines some of the other problems, as well as advantages, with
individual incentive plans.
F. Individual Incentive Plans: Examples
Even though incentive systems are less popular than they used to be, there are still
notable successes. 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 dollars into
employee health reimbursement accounts for participating in various activities such
as smoking cessation programs or running in ironman contests.
Perhaps the longest-running success with individual incentives, going back to
before World War I, belongs to a company called Lincoln Electric.
Exhibit 10.8 describes the compensation package for factory jobs at Lincoln
Electric. All the pieces of the compensation and reward package fit together. Both
culture and the performance review system support the different pay components.