Chapter 12: Incentive Plans and Executive Compensation
Chapter 12
Variable Pay and Executive Compensation
Learning Objectives
After students read this chapter, they should be able to:
• Define variable pay and identify three elements of successful pay-for-
performance plans.
• Discuss three types of individual incentives.
Chapter Overview
This chapter deals with variable pay (individual incentives, sales compensation,
group/team incentives, organizational incentives), sales compensation, and executive
compensation.
An increasing number of employers feel traditional pay systems fail to link pay with
performance. However, to develop a successful pay-for-performance plan the
organization must address the following:
• Does the plan fit the organization?
Chapter 12: Incentive Plans and Executive Compensation
these types of incentives. Individual incentives encourage workers to achieve
individualized goals. Typical individual incentive plans include piece-rate systems,
bonuses, and special incentive programs such as performance awards, recognition
The chapter next looks at organizational incentives such as profit sharing and
employee stock plans such as employee stock ownership plans (ESOPs). A separate
section of the chapter describes sales compensation plans that often emphasize
commissions. The types of sales compensation plans and the sales compensation
challenges are explored.
Chapter Outline
Chapter 12: Incentive Plans and Executive Compensation
Variable pay is compensation that is tied to performance. Better performance leads to
more pay. The performance considered may be an individual’s, the performance of a group
(a team or even a whole plant), or the performance of an entire organization.
I. Variable Pay: Incentives for Performance
Variable pay plans attempt to provide tangible rewards, or incentives, to employees for
performance beyond normal expectations. The philosophical foundation of variable pay
rests on three basic assumptions:
• Some people or groups contribute more to organizational success than others.
HR Headline: Variable Pay “Clawbacks”
Executives and sometimes lower level managers as well may receive variable pay based
on how well they or the company has done in a given year. However, those payments
may have resulted from wrongdoing or financial misstatement. Rules aimed at
recovering variable pay go back at least a decade and more recently in the Sarbanes–
Oxley Act and the Dodd-Frank financial overhaul, the types of situations in which that
money can be “clawed back” have been expanded.
Chapter 12: Incentive Plans and Executive Compensation
Pay for performance has a different set of assumptions than does a more traditional
compensation system, in which differences in length of service is the primary
differentiating factor. The assumptions for a pay system based on seniority are as follows:
• Time spent each day is the best measure of contribution.
Yet there is evidence that variable pay broadly available to most employees does improve
company performance. Not every person wants to have their pay contingent on their
performance, however, so there is “self selection” where possible with different incentive
plans attracting different people with different characteristics such as willingness to take
risks, and gender. Figure 12-1 shows examples of a wide variety of possible incentives for
employees.
A. Successful Variable Pay
Employers adopt variable pay for many reasons. Some of these reasons include the
following:
• Link strategic business goals and employee performance
As economic conditions have changed in industries and among employers, the use of
variable pay incentives has changed as well. Under variable pay programs, employees
are provided a greater share of the gains or declines in organizational performance
Combating Variable Pay Complexity
One factor that can clearly lead to failure of a variable pay plan is having an
incentive plan that is too complex for employees and management to understand. If
Chapter 12: Incentive Plans and Executive Compensation
the plan is too complicated to follow, the focus may not be on successful
performance. Some factors that contribute to the success of incentive plans are as
follows:
• Develop clear, understandable plans that are continually communicated
Does the Plan Fit the Organization?
The success of any variable pay program relies on its consistency with the culture of
the organization. When it comes to variable pay-for-performance plans, one size does
not fit all. A plan that has worked well for one company will not necessarily work
well for another.
Does the Plan Reward Appropriate Actions?
Variable pay systems should be tied as much as possible to desired performance.
Employees must see a direct relationship between their efforts and their financial and
nonfinancial rewards. Performance measures need to have appropriate emphasis and
Is the Plan Administered Properly?
A variable pay plan may be complex or simple, but it will be successful only if
employees understand what they have to do to be rewarded. The more complicated a
Chapter 12: Incentive Plans and Executive Compensation
criteria. Managers also need to be able to explain clearly what future performance
targets need to be met and what the rewards will be.
B. Global Variable Pay
Variable pay is expanding in global firms, as well as among foreign-country employers.
For firms with operations in multiple countries, having widely spread incentives
C. Three Categories of Variable Pay
HR Perspective: Ideas on China, Incentives, and Discipline
The following is adapted from the thoughts and experiences expressed in Human
Resource Executive by Peter Cappelli, a Human Resources professor at the Wharton
School.
Are claw back arrangements “punishment”? Probably. Yet several studies show that
this approach significantly affects motivation and does not cost more than traditional
incentive plans. However, giving people bonuses before they have earned them seems
odd from an American perspective.
Chapter 12: Incentive Plans and Executive Compensation
Variable pay plans can be classified into three categories—individual, group/team, and
organizational. There are advantages and disadvantages associated with using each type.
Organizational incentives reward people according to the performance results of the
entire organization. This approach assumes that all employees working together can
generate improved organizational results that lead to better financial performance.
Figure 12-3 shows some of the different incentive plans that fall under each category of
variable pay.
II. Individual Incentives
Individual incentive systems tie personal effort to additional rewards for the individual
employee. Conditions necessary to use individual incentive plans are as follows:
• Individual performance must be identifiable.
A. Piece-Rate Systems
The most basic individual incentive systems are piece-rate systems. Under a straight
piece-rate system, wages are determined by multiplying the number of units produced
(such as garments sewn or service calls handled) by the piece rate for one unit.
Chapter 12: Incentive Plans and Executive Compensation
jobs. In some instances, the cost of determining and maintaining the standards may be
greater than the benefits derived.
B. Bonuses
Individual employees may receive additional compensation in the form of a bonus,
which is a one-time payment that does not become part of the employee’s base pay.
Individual bonuses are used at all levels in firms and are a popular short-term incentive.
Massive “Kinked” Bonuses
A very large all or nothing bonus is called a massive kinked bonus. This kind of
bonus raises questions of motivating potential.
“Spot” Bonuses
Other Bonuses
Bonuses can be given for almost anything noteworthy, but some more common ones
are referral bonuses (given for referring someone who is later hired), and hiring
Chapter 12: Incentive Plans and Executive Compensation
C. Nonmonetary Incentives
Numerous nonmonetary incentive programs can be used to reward individuals ranging
from one-time contests for meeting performance targets to awards for performance over
time. Although such special programs can be developed for groups and for entire
organizations, they often focus on rewarding individuals. Figure 12-4 shows several of
the purposes for which nonmonetary incentives are used.
HR Perspective: Signing Bonuses on Wall Street
Signing bonuses are common in professional athletics, as well as on Wall Street for
successful brokers who are willing to change firms. Securities firms hired many brokers
away from competitors during the last economic downturn, but some of these star
financial advisors who were promised six- and seven-figure bonuses to jump ship failed
to generate profits to cover their bonuses. The deals look especially bad in hindsight
because brokerage firms were willing to pay excessive sums. However, some firms
decided they wanted their signing bonus money back because of performance issues and
turnover.
Chapter 12: Incentive Plans and Executive Compensation
home kitchen equipment and other noncash items.
Recognition Awards
Another type of program recognizes individual employees for their work.
Recognition awards often work best when given to acknowledge specific efforts and
Service Awards
Another type of reward given to individual employees is the service award. Although
service awards often may be portrayed as rewarding performance over many years,
D. Commissions
A commission is a percentage of the money taken in on sales, usually given in addition
to a salary to an agent or sales person. As such, a commission represents a potential
incentive for employees who qualify. Tips can be similar, even though they are paid by
the customer rather than the employer.
Chapter 12: Incentive Plans and Executive Compensation
III. Group/Team Incentives
The use of groups/teams in organizations has implications for incentive compensation.
Although the use of groups/teams has increased substantially in the past few years, the
question of how to compensate group members equitably remains a significant challenge.
Firms provide rewards for work groups or teams for several reasons (Figure 12-5).
A. Design of Group/Team Variable Pay
In designing group/team variable pay, organizations must consider certain issues. The
Distribution of Group/Team Incentives
HR Perspective: How Dropping Commissions Affected Sales in a Car Dealership
Performance based individual compensation that includes commissions increases
employees’ incentives to work. What would happen if an employer changed away from
a strongly performance based pay system to one with a larger salary component and less
incentive?
The change to a less performance related pay system had the greatest impact on highly
productive employees. It resulted in those employees leaving and being replaced with
poorer performers who were attracted to the new compensation system with the more
certain guaranteed salary it offered. The company was able to change its sales mix and
in the short run did not suffer great revenue loss although overall sales dropped.
Chapter 12: Incentive Plans and Executive Compensation
The two primary ways for distributing those rewards are as follows:
Timing of Group/Team Incentives
How often group/team incentives are paid out is another important consideration.
Choices seen in firms with group/team incentives are monthly, quarterly,
semiannually, and annually, although the most common period used is annually.
However, shorter time periods increase the likelihood that employees will see a link
between their efforts and the performance results that trigger award payouts.
Who Makes Decisions about Group/Team Incentive Amounts?
B. Group/Team Incentive Challenges
This difference between rewarding team members equally and rewarding them
equitably triggers many of the problems associated with group/team incentives.
Rewards distributed in equal amounts to all members may be perceived as “unfair” by
employees who work harder, have more capabilities, or perform more difficult jobs.
Chapter 12: Incentive Plans and Executive Compensation
C. Types of Group/Team Incentives
Group/team reward systems can use different ways of compensating the group. The two
most common types of group/team incentives are team results and gainsharing.
Group/Team Results
Results to be measured may include group production, cost savings, or quality
improvement. Those results may be rewarded with cash bonuses, group awards, or
some other incentive.
Gainsharing
The system of sharing with employees greater-than-expected gains in profits and/or
productivity is gainsharing. Also called teamsharing or goalsharing, the focus is to
D. Group/Team Incentives and Information Sharing
Chapter 12: Incentive Plans and Executive Compensation
Gainsharing programs provide money to be used as a cash bonus for employees on the
IV. Organizational Incentives
An organizational incentive system compensates all employees according to how well the
organization as a whole performs during the year. The basic concept behind organizational
A. Profit Sharing
As the name implies, profit sharing distributes some portion of organizational profits
to employees. The primary objectives of profit-sharing plans can include the following:
• Increase organizational performance
• Attract or retain employees
• Improve product/service quality
• Enhance employee morale
Drawbacks of Profit-Sharing Plans
When used throughout an organization, including with lower-level workers, profit-
sharing plans can have some drawbacks. First, employees must trust that
management will disclose accurate financial and profit information. The definition
Chapter 12: Incentive Plans and Executive Compensation
improved. Profits may vary a great deal from year to year, resulting in windfalls or
losses beyond the employees’ control. Payoffs are generally far removed by time
from employees’ individual efforts; therefore, higher rewards may not be obviously
linked to better performance.
B. Employee Stock Plans
Organizational incentive plans can use stock ownership in the organization to reward
employees. The goal of these plans is to get employees to think and act like “owners.”
Employee Stock Ownership Plans
Firms in many industries have an employee stock ownership plan (ESOP), which
HR Perspective: Profit sharing and Information
The employees at the Canadian packaging manufacturer Great Little Box Company all
know how well the business is doing. The management discusses business results in
monthly meetings with all 213 employees. This “open book management” is tied to the
company’s profit sharing strategy.