10 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
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
Chapter Ten: Pay-For-Performance Plans 10 – 2
Lecture Outline: Overview of Major Topics
I. What Is a Pay-for-Performance Plan?
A. How Widely Used is Pay-for-Performance (PFP)?
B. The Important Role of Promotion in Pay-for-Performance
II. Pay-for-Performance: Merit Pay Plans
III. Pay-For-Performance: Short-Term Incentive Plans (Individual-Based)
A. Merit Bonuses aka Lump-Sum Bonuses
IV. Pay-for-Performance: Short-Term Incentive Plans (Team-Based)
A. Comparing Group and Individual Incentive Plans
B. Large Group Incentive Plans
C. Gain-Sharing Plans
V. Pay-for-Performance: Long-Term Incentive Plans
A. Employee Stock Ownership Plans (ESOPs)
B. Performance Plans (Performance Share and Performance Unit)
C. Broad-Based Option Plans (BBOPs)
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 the
advantages and disadvantages of these plans.
10 – 3 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
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-
• People used to think of pay as primarily an entitlement.
o 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
A. 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.
o 99% of organizations surveyed use some form of short-term incentive plan for
• The greater interest in variable pay can be traced to two trends:
o 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
o Second, today’s fast-paced business environment means employees must be willing
to adjust what they do and how they do it.
Chapter Ten: Pay-For-Performance Plans 10 – 4
▪ There are new technologies, new work processes, and new work
relationships.
• Other evidence points to the very strong overall reliance on pay-for-performance (PFP),
including variable pay, especially in private sector organizations.
o The typical U.S. private sector company relies especially heavily on PFP and the
percentage of private sector organizations using two or more PFP plans is probably
close to 100%.
• 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.
• 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.
o Almost all (97%) of short-term incentive plans base payouts to some degree on
10 – 5 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
• 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.
o Exhibit 10.3 shows that the lowest job levels, where most employees are, receive,
B. The Important Role of Promotion in Pay for Performance
• Merit pay is widely used by organizations and for all types of employees.
o The average merit pay increase is about 3% per year.
▪ At that rate, it would take an employee about 23 years to double their
• Given that promotion is based importantly on performance, it means that 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.
II. Pay-For-Performance: Merit Pay Plans
• A merit pay system links increases in base pay (called merit increases) to how highly
employees are rated on a performance evaluation. (Covered in Chapter 11)
o 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).
Chapter Ten: Pay-For-Performance Plans 10 – 6
▪ An employee in that same salary range with a salary of $67,000 would have a
▪ The first employee (with the compa-ratio of .88) would receive a 7% merit
increase, resulting in a new salary of $56,710.
▪ The second employee (with the compa-ratio of 1.12) would receive a merit
increase of 3%, resulting in a new salary of $69,010.
• Exhibit 10.4 provides an example of a merit increase grid.
• 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% merit increase on average,
compare to, for example, a 2.6% merit increase for an employee in the middle
performance category.
o It also shows that about 7% of employees receive the highest rating and about
• At the end of a performance year, an employee is evaluated, usually by the direct
supervisor.
o A key feature of a merit pay increase is that, unlike variable pay programs, the
• Year after year, there are concerns about merit pay.
o One concern is that is increases fixed compensation costs over time.
▪ One response has been to use merit bonuses and/or other forms of variable
pay plans.
o Another concern is that merit pay becomes costly if too many high performance
ratings are awarded.
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▪ Additionally, the strength of merit pay differentials will be greatly
underestimated if the role of performance in promotions and resulting salary
• While it is difficult to study and document the effects of merit pay plans on
performance, the evidence that does exist is positive.
o When broadly considering the theory and evidence on pay-for-performance plans,
• Keep in mind the idea of incentive and sorting effects, first introduced in Chapter 1.
o Most discussion of merit pay focuses on incentive effects: how does merit pay
• If merit pay is to live up to its potential, it must be managed better.
o This requires a complete overhaul of the way raises are allocated: improving the
accuracy of performance ratings, allocating enough merit money to truly reward
III. Pay-For-Performance: Short-Term Incentive Plans (Individual-Based)
A. 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.
o Because employees must earn this increase every year, it is viewed as less of an
• Exhibit 10.6 indicates merit bonuses can be considerably less expensive than merit
pay over the long run.
o Notice how quickly base pay rises under a merit pay plan.
Chapter Ten: Pay-For-Performance Plans 10 – 8
o It is no surprise that cost-conscious firms report switching to merit bonuses.
▪ Consider the bonus system developed by Prometric Thomson Learning call
B. Individual Spot Awards
• Spot awards are seen by many organizations as being effective.
o Usually 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.
o After the fact, someone alerts top management to the exceptional performance.
C. 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.
• All incentive plans have one common feature: an established standard against which
worker performance is compared to determine the magnitude of the incentive pay.
o For individual incentive systems, this standard is compared against individual
worker performance.
• A number of different individual incentive plans exist.
o Their differences can be reduced to variation along two dimensions and can be
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arise because tasks have different cycles of operation.
o Short-cycle tasks, those that are completed in a relatively short period of time,
• The second dimension on which individual incentive systems vary is the specified
relationship between production level and wages.
o The first alternative is to tie wages to output on a one-to-one basis, so that
• 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:
o 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
o 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
▪ 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
o 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
Chapter Ten: Pay-For-Performance Plans 10 – 10
production relative to the standard.
▪ Merrick system—operates in the same way, except that three piecework
rates are set:
• High—for production exceeding 100% of standard
• Medium—for production between 83 and 100% of standard
• Low—for production less than 83% of standard
▪ Exhibit 10.9 compares these two plans.
o 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 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
• Consequently, workers’ earnings increase faster than production
whenever standard time is met or exceeded.
D. Individual Incentive Plans: Returns (but, Also Risks)
• Individual incentive plans receive much attention but they are not widely used.
o One estimate is that less than 7% of U.S. employees are covered by individual
incentive plans and almost half of those are in sales occupations.
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o Outside of sales, less than 4% of employees work under such plans.
o There is strong evidence that individual incentives, on average, have substantial
positive effects on performance.
• Besides not fitting many jobs in the economy, another reason for their limited use is
that things can go wrong, sometimes spectacularly wrong with such plans.
o Incentive plans can lead to unexpected, and undesired, behaviors.
o A common problem is 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.
▪ Employees, being rational, do more of what the incentive system pays for.
o Exhibit 10.10 outlines some of the general potential problems, as well as
advantages, with individual incentive plans.
E. Individual Incentive Plans: Examples
• Even though incentive systems are less popular than they used to be, there are still
notable successes.
• One of today’s biggest success stories is the merger of individual incentives with
efforts to reduce health care costs.
o For example, Jet Blue deposits $400 into employee health reimbursement
• Perhaps the longest-running success with individual incentives, going back to
before World War I, belongs to a company called Lincoln Electric.
o In Exhibit 10.11, the compensation package for factory jobs at Lincoln Electric
IV. Pay-For-Performance: Short-Term Incentive Plans (Team-Based)
Chapter Ten: Pay-For-Performance Plans 10 – 12
• When we move away from the individual incentive systems and start focusing on
people working together, we shift to team or group incentive plans.
o A standard is established against which worker performance (in this case, team
performance) is compared to determine the magnitude of the incentive pay.
o The standard might be an expected level of operating income for a division.
o Or the measure might be more unusual.
• Despite an explosion of interest in teams and team compensation, many of the reports
from the front lines are not encouraging.
o Failures of team incentive schemes can be attributed to at least five causes:
▪ One of the problems with team compensation is that teams come in many
varieties (full-time teams, part-time, cross-departmental, temporary, etc.).
• With so many varieties of teams, it is hard to argue for one consistent type
of compensation plan.
• Maybe the answer is to look at different compensation approaches for
different types of teams. Perhaps the best illustration is from Xerox.
o 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.
▪ A second problem with rewarding teams is called the “level problem.”
• If teams are defined at the very broad level—the whole organization being
an extreme example—much of the motivational impact of incentives can
be lost.
• Conversely, if teams get too small, other problems arise.
o 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.
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o Teams hoard star performers, refusing to allow transfers even for the
greater good of the company.
o Teams are reluctant to take on new employees for fear that time lost to
training will hurt the team.
o Finally, bickering arises when awards are given.
• Because teams have different performance objectives, it is difficult
to equalize for difficulty when assigning rewards.
▪ The last three major problems with team compensation involve the three Cs:
• Complexity—some plans are simply too complex.
o With a good line of sight as it’s called, employees can see a clear link
between their effort and the rewards they receive.
• Control—some companies factor uncontrollable elements into the process
of setting performance standards.
o Experts assert that this ability to foretell sources of problems and
adjust for them is a key element in building a team pay plan.
• Communications—team-based pay plans simply are not well
communicated.
o Employees asked to explain their plans often flounder because more
effort has been devoted to designing the plan than to deciding how to
• 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:
o Productivity improvements (38% of plans)
• Exhibit 10.12 summarizes some of these measures.
o As Exhibit 10.12 suggests, the range of performance measures for different types of
Chapter Ten: Pay-For-Performance Plans 10 – 14
• Historically, financial measures have been the most widely used performance indicator
for group incentive plans.
• As Exhibit 10.14 illustrates, we need to decide which type of group incentive plan best
fits our objectives.
o Management should even ask if an incentive plan is appropriate.
A. Comparing Group and Individual Incentive Plans
• In this era of heightened concern about productivity, the authors are frequently
asked if setting up incentive plans really boosts performance. The answer is yes.
• The authors are also asked which is better in a specific situation—group or
individual incentive plans.
• As 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.
o When forced to choose a plan with greater productivity “pep,” experts agree that
individual incentive plans have better potential for—and probably better track
records in—delivering higher productivity.
o Group plans can suffer from what is called the free rider problem.
▪ According to this concept, certain team members do not carry their share of
the work load.
• Research on free riders suggests that the problem can be lessened through use of
good performance measurement techniques.
o Specifically, free riders have a harder time loafing when there are clear
performance standards.
B. Large Group Incentive Plans