Human Resources Chapter 10 Risk Sharing Base Pay Reduced Some Amount Relative The Level That Would

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10 – 15 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich

• When we get beyond a small work team and try to incentivize large groups, there

are generally two types of plans:

C. Gain-Sharing Plans

• Gain sharing looks at cost components of the income ledger and identifies savings

over which employees have more impact.

o For example, reduced scrap, lower labor costs, reduced utility costs.

• Studies of gain sharing report positive results and the empirical evidence appears

quite favorable.

• Gain-sharing plans can lead to the sorting effect and changing to group plans may

lead to turnover.

• The following issues are key elements in designing a gain-sharing plan:

o Strength of reinforcement

▪ What role should base pay assume relative to incentive pay?

o Productivity standards

▪ What standard will be used to calculate whether employees will receive an

incentive payment?

▪ 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?

▪ One of the major problems with historical standards is that changing

environmental conditions can render a standard ineffective.

• Care must be taken to ensure that the link between performance and

Chapter Ten: Pay-For-Performance Plans 10 – 16

o Sharing the gains split between management and workers

▪ Part of the plan must address the relative cuts between management and

o Scope of the formula

▪ Formulas can vary in the scope of inclusions for both the labor inputs in the

• For example, with the push for greater quality management,

organizations could measure retention of customers or some other

o Exercise great care with such alternative measures, though, to ensure that the

behaviors reinforced actually affect the desired bottom-line goal.

o Perceived fairness of the formula

o Ease of administration

▪ Sophisticated plans with involved calculations of profits or costs can

o Production variability

▪ One of the major sources of problems in group incentive plans is failure to

set targets properly.

▪ One alternative would be to set standards that are relative to industry

performance.

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Education.

• The obvious advantage of this strategy is that economic and other

external factors hit all firms in the industry equally hard.

• Exhibit 10.16 illustrates three different formulas that can be used as a basis for gain-

sharing plans.

Scanlon Plan

▪ These 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

• In practice, the $50,000 bonus in Exhibit 10.17 is not all distributed to

the workforce.

Rucker Plan

▪ It 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 the total wage bill.

Chapter Ten: Pay-For-Performance Plans 10 – 18

Education.

workforce should be .45 X $94,444 = $42,500.

• The savings are distributed as an incentive bonus according to a formula

similar to the Scanlon formula – 75% of the bonus is distributed to

workers immediately and 25% is kept as an emergency fund to cover

poor months with excess distributed at the end of the year.

Implementation of the Scanlon/Rucker Plans

▪ Two major components are vital to the implementation and success of a

Rucker or Scanlon plan.

• A productivity norm

o Development of a productivity norm requires both effective

measurement of base-year data and acceptance by workers and

management of this standard for calculating bonus incentives.

• Effective worker committees/productivity committees/bonus committees

o The primary function of these committees is to evaluate employee

and management suggestions for ways to improve productivity

and/or cut costs.

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, they give

▪ 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.

• Rucker plans tie incentives to a wide variety of savings, not just the

10 – 19 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich

Education.

labor savings focused on in Scanlon plans.

• This greater flexibility may 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.

▪ First, a standard is developed that identifies the expected hours required to

produce an acceptable level of output.

▪ This standard comes either from time-and-motion studies conducted by

D. Profit-Sharing Plans

• Despite moderately 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.

• On the downside, most employees do not feel their jobs have a direct impact on

profits.

• The trend in recent variable-pay design is to combine the best of gain-sharing and

profit-sharing plans.

E. Earnings-at-Risk Plans

Chapter Ten: Pay-For-Performance Plans 10 – 20

• Management probably should not separate earnings-at-risk plans as a distinct

category. In fact, any incentive plan could be an at-risk plan.

• Incentive plans falls into one of two categories:

o Success sharing

▪ Employee base wages are constant and variable pay adds on during

• These plans shift part of the risk of doing business from the company to the

employee.

o The company hedges against the devastating effects of a bad year by

F. Group Incentive Plans: Advantages and Disadvantages

• Group pay-for-performance plans are gaining popularity in today’s team-based

environment.

o One factor with intriguing implications suggests that group-based plans,

particularly gain-sharing plans, cause organizations to evolve into learning

G. Group Incentive Plans: Examples

• All incentive plans can be described by common features:

o The size of the group that participates in the plan

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• Exhibit 10.19 illustrates some of the more interesting components of plans for

leading companies.

V. Pay-For-performance: Long-Term Incentive Plans

• Exhibit 10.20 shows different types of long-term incentives and their definitions.

o 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.

• 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.

• All this talk about stock options neglects the biggest change in recent memory.

o As of June 2005, companies were required to report stock options as an expense.

o Prior to this date, they were, (wrongly) viewed as a free good under old accounting

rules.

A. 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.

• Despite some high-profile adoptions, ESOPs do not make sense as an incentive.

o The effects are generally long-term—how an employee performs today

• Why then do about 6,000 companies have ESOPs covering more than 14

million employees with holdings of over $1.3 trillion in the stock’s of their

companies?

• 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.

Chapter Ten: Pay-For-Performance Plans 10 – 22

o ESOPs have little impact on productivity or profit.

B. Performance Plans (Performance Share and Performance Unit)

• Performance plans typically feature corporate performance objectives for a time

C. Broad-Based Option Plans (BBOPs)

• Broad-based option plans (BBOPs) are stock grants: a company gives

employees shares of stock over a designated time period.

• The strength of BBOPs is versatility.

• BBOPs have been a growing trend.

o Colliding with this trend is increasing shareholder pushback against equity

D. Combination Plans: Mixing Individual and Group

• It’s not uncommon for companies to use both individual and group incentives.

o The goal is to both motivate individual behavior and to insure that

• These combination programs start with the 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)

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o These plans specify that payouts only occur after the company reaches a

VI. Does Variable Pay Improve Performance Results? The General Evidence

• Pay-for-performance plans, those that introduce variability into the level of pay an

VI. Your Turn: Comparing Airlines

Summary of Case

This case compares the wage and profit sharing plans for two airlines, American Airlines and

Learning Objective

Most of the Your Turns in earlier chapters asked students to apply their knowledge of a specific

chapter by answering real world questions. The authors move a bit further here asking students

to make deductions about the two companies based on wage figures.

Teaching Guideline

You may want to have students complete this assignment outside of class. You also could

review the information during class and break into groups or initiate a class discussion answering

the questions.

Discussion Case Questions

1. What would you deduce these two airlines believe about the importance of base wages

relative to variable pay (profit sharing)?

American has not profit sharing. We can deduce, absent any other information, they either

don’t believe in profit sharing, or they don’t think it is appropriate for pilots. The negative

Education.

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?

5. Do you have any predictions about attraction and retention for each company?

6. Does the external environment influence any of your answers?

10 – 25 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich

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Yes! The huge profit sharing payout is attributable almost solely to lower gas prices,

something pilots can’t affect. So the connect between behavior and outcome is non–

existent. Expect movement over to American when gas prices return to normal, or when

Delta renegotiates the performance standard to take into account falling gas prices.

Answers to Review Questions

1. As VP of HR at Pilsner Roofing, the eleventh largest roofing company in the world,

you are experiencing turnover problems with the employees who actually install roofs

(roofers) General Manager Roy Cranston has asked you to fix the problem. While your

primary emphasis might be on having a competitive base pay, you need to decide if

there is anything you can do in the incentive department. Before you can make these

decisions, what information would you like about (a) pay (base + incentive) at major

competitors, (b) the nature of the turnover, and (c) next year’s labor budget?

Pay (base + incentive) rates for similar jobs at major competitors in the local market are

needed. Regional data may also be required; this depends on the geographic location of

In revamping the compensation program, the first step is to convene a meeting of the

involved managers and supervisors to gather their inputs regarding the objectives of the pay

program—what do the managers and supervisors want? Obviously, they want lower

turnover. Other matters need to be addressed. Should employees work in teams? Is an

incentive plan appropriate? If so, what type of performance measures should be established?

Should the incentive plan emphasize short-term or long-term performance or both?

For this case, the following assumptions are made:

• Employees will not work in teams.

• The primary focus will be on implementing a short-term individual incentive plan.

Education.

2. How is an earnings-at-risk plan different from an ordinary gain-sharing or profit

sharing plan? How might earnings-at-risk plans affect attraction and retention of

employees? How does the 2008–2010 recession affect the viability of earnings at risk

plans?

In an earnings-at-risk plan, employee base wages can be affected either positively or

negatively. If a company has a successful year, employees receive their base pay and a

predetermined amount of variable pay. However, if a company does poorly, base pay is

3. You own Falzer’s Tool Coating Company, a high-tech firm specializing in the coating

of cutting tools (e.g., drill bits, cutting blades) to provide longer life before

resharpening is needed. You are concerned that the competition continues to develop

new coating methods and new applications of coating in different industries. You want

to create a work environment where employees offer more new product ideas, and

suggest new industries where these ideas might be applied. What type of compensation

plan will you recommend? What are some of the problems you need to be aware of?

The recommended compensation plan is based on management setting objectives that are

viewed as both fair and consistent with employee needs. This type of plan should foster and

incorporate employee suggestions that focus on meeting the established objectives. To

Education.

4. Why do the new accounting standards make stock options less popular?

As of June 2005, companies were required to report stock options as an expense. 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. For

example, a CEO issued with 500,000 shares with a vesting period of five years, can purchase

5. You are the teacher in a class where team projects account for 25 percent of course

grades. Each student is assigned to a team and that team is responsible for all team

assignments. Students comes to you and complain bitterly about one of their members

who does absolutely nothing. You know this will affect your teacher ratings if you

don’t do something about it. What should you do?

Chapter Ten: Pay-For-Performance Plans 10 – 28

You have several choices:

a. explain to students this is like the real world where “free–riders” exist everywhere. Tell

them to apply social pressure to the one individual or tell them to “divorce themselves” from

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

1. Employees of Walgreens feel that Walgreens 401(k) plan, called the Walgreens Profit-

Sharing Plan, is the best benefit Walgreens offers.

2. To qualify for the plan, employees should have:

3. The plan allows the employees to contribute up to 50% of their annual salary to the Profit-

Sharing Plan, up to the IRS limit.

4. The company matches the first 2% of the employee’s contributions with a guaranteed match