Pay-for- Pay-for- PerformancePerformance

PlansPlansCHAPTER TENCHAPTER TEN

JENNIFER NEOSHIA BONNIEJENNIFER NEOSHIA BONNIE

What is a Pay-for Performance What is a Pay-for Performance Plan?Plan?

This is a movement away This is a movement away from entitlement and a from entitlement and a movement toward pay movement toward pay that varies with some that varies with some measure of individual or measure of individual or organizational organizational performance.performance.

Words you will hear when you Words you will hear when you think of Performance Planthink of Performance Plan

Does Variable Pay Improve Does Variable Pay Improve Performance Results?Performance Results?

The general evidence has shown The general evidence has shown those that introduce variability into those that introduce variability into

the level of pay receive, seem to have the level of pay receive, seem to have a positive impact on performance if a positive impact on performance if

designed well.designed well.

Specific Pay-for-Performance Specific Pay-for-Performance Plans: Plans:

Short TermShort Term

MERIT PAYMERIT PAY

LUMP-SUM BONUSESLUMP-SUM BONUSES

INDIVIDUAL SPOT AWARDSINDIVIDUAL SPOT AWARDS

SHORT TERM – cont’dSHORT TERM – cont’d• INDIVIDUAL INCENTIVE PLANSINDIVIDUAL INCENTIVE PLANS

• INDIVIDUAL INCENTIVE PLANS: Advantages and INDIVIDUAL INCENTIVE PLANS: Advantages and DisadvantagesDisadvantages

• INDIVIDUAL INCENTIVE PLANS: ExamplesINDIVIDUAL INCENTIVE PLANS: Examples

MERIT PAYMERIT PAY• A system linking increases in base pay to performance A system linking increases in base pay to performance

evaluations.evaluations.

• The performance rating determines the percentage of The performance rating determines the percentage of increase to the base pay.increase to the base pay.

• Competitive, high performing employees benefit most Competitive, high performing employees benefit most from merit pay. from merit pay.

A merit pay system links increases in base pay (called merit increases) to how highly employees are rated on a subjective performance evaluation. Consider the following typical merit pay setup:

Well Above Above Below Well Below Average Average Average Average Average

Performance rating 1 2 3 4 5

Merit pay increase 6% 5% 4% 3% 0%

At the end of a performance year, the employee is evaluated, usually by the direct supervisor.

The performance rating, 1 to 5 in the above example, determines the size of the increase added into base pay. This last point is important. In effect, what you do this year in terms of performance is rewarded every year you remain with your employer.

By building into base pay, the dollar amount, just like the Energizer bunny, keeps on going! With compounding, this can amount to tens of thousands of dollars over an employee’s work career.

LUMP-SUM LUMP-SUM BONUSESBONUSES

•DOES NOT AFFECT BASE PAY.DOES NOT AFFECT BASE PAY.•BASED ON EMPLOYEE OR COMPANY PERFORMANCE BASED ON EMPLOYEE OR COMPANY PERFORMANCE AND PAID AS AN END-OF YEAR BONUS EVERY YEAR AS AND PAID AS AN END-OF YEAR BONUS EVERY YEAR AS IT IS EARNED.IT IS EARNED.

INDIVIDUAL SPOT INDIVIDUAL SPOT AWARDSAWARDS

• Someone alerts top management to exceptional performance……Someone alerts top management to exceptional performance……

INDIVIDUAL INCENTIVE PLANSINDIVIDUAL INCENTIVE PLANSAdvantagesAdvantages

•Substantial impact raising productivity, lowering Substantial impact raising productivity, lowering production costs and increasing earners of workers.production costs and increasing earners of workers.

•Requires less direct supervision.Requires less direct supervision.

•Systems of payment by results enable more accurate Systems of payment by results enable more accurate estimation of labor costs than payment by time.estimation of labor costs than payment by time.

INDIVIDUAL INCENTIVE PLANSINDIVIDUAL INCENTIVE PLANSDISADVANTAGESDISADVANTAGES

•Greater conflict may emerge between employees Greater conflict may emerge between employees seeking to maximize output and managers concerned seeking to maximize output and managers concerned with deteriorating quality levels.with deteriorating quality levels.•Employees concerned about impact on production Employees concerned about impact on production standards may resist attempts to introduce new standards may resist attempts to introduce new technology.technology.•Reduced willingness of employees to suggest new Reduced willingness of employees to suggest new production methods fearing subsequent increases in production methods fearing subsequent increases in production standards.production standards.

INDIVIDUAL INCENTIVE INDIVIDUAL INCENTIVE PLANSPLANS

DisadvantagesDisadvantages•Increased complaints on poorly maintained equipment, Increased complaints on poorly maintained equipment, hinders employee efforts to earn larger incentives.hinders employee efforts to earn larger incentives.•Increased turnover among new employees discouraged Increased turnover among new employees discouraged by the unwillingness of experienced workers to by the unwillingness of experienced workers to cooperate in OJT.cooperate in OJT.•Elevated levels of mistrust between workers and Elevated levels of mistrust between workers and management.management.

INDIVIDUAL INCENTIVE INDIVIDUAL INCENTIVE PLANSPLANS

EXAMPLE – Exhibit 10.10 Lincoln Electric’s EXAMPLE – Exhibit 10.10 Lincoln Electric’s Compensation PlanCompensation Plan

•Description of culture Description of culture Reservoir of trust. Long history of employment stability even during Reservoir of trust. Long history of employment stability even during severesevere

economic downturns. Employees with 3+ years seniority are economic downturns. Employees with 3+ years seniority are guaranteedguaranteed

(on 1-year renewable basis) at least 75 percent full-time work for that (on 1-year renewable basis) at least 75 percent full-time work for that year. Inyear. In

exchange, employees agree to flexible assignment across jobs.exchange, employees agree to flexible assignment across jobs.

•Base wages Base wages Market rate determined. Time study department sets piece rate so that Market rate determined. Time study department sets piece rate so that averageaverage

worker can earn market rate.worker can earn market rate.

INDIVIDUAL INCENTIVE PLANSINDIVIDUAL INCENTIVE PLANS• BonusBonus Board of directors sets year-end bonus pool as function of company Board of directors sets year-end bonus pool as function of company

(short term) performance. Employee’s share in pool is function of semiannual performance(short term) performance. Employee’s share in pool is function of semiannual performance

review (see below).review (see below).

• IncentiveIncentive Employees share in long-term company successes/failures in form of Employees share in long-term company successes/failures in form of employeeemployee

(long term) stock ownership plan (ESOP). Employees now own 28 percent of outstanding(long term) stock ownership plan (ESOP). Employees now own 28 percent of outstanding

stock shares.stock shares.

• Performance review Performance review Employees rated on four factors: (1) dependability, (2) quality, (3) output, (4) Employees rated on four factors: (1) dependability, (2) quality, (3) output, (4) ideasideas

and cooperation in comparison to others in department. To ensure against and cooperation in comparison to others in department. To ensure against rating rating

inflation, the average score in department cannot exceed 100.inflation, the average score in department cannot exceed 100.

Team Incentive Plans: Types

• -When we move away from individual incentive systems and start focusing on people working together, we shift to group incentive plans.• -It might be a work group or a department. Or it might

focus on a division of the whole company.• -With the focus on groups, now we are concerned about

group performance in comparison against some standard, or level, of expected performance.

Comparing Group and Individual Incentive Plans

-Setting up incentive plans really boost performance?

-Which is better: group or individual incentive plans?

Large Group Incentive Plans •When we get beyond a small work team and try to incentivize large groups, there are generally two types of plans. •Gain-Sharing plans use operating measures to gauge performance•Profit sharing plans use financial measures•Earnings-at-Risk plans uses success sharing and risk sharing

Gain-Sharing PlansEmployees earn bonuses tied to unit-wide performance as

measured by a predetermined, gain sharing formula.Key Elements in Designing a Gain-Sharing Plan

-Strength of reinforcement-Productivity standards

-Sharing the gains-Scope of the formula

-Perceived fairness of the formula-Ease of administration-Production variability

Types of Gain-Sharing Plans

• -Rucker Plan: Ratio is calculated that expresses value of production required for each dollar of total wage bill• -Scanlon Plan: Designed to lower labor costs without

lowering level of a firm’s activity. Incentives are derived as a function of ratio between labor costs and sales value of production (SVOP)• -Improshare (Improved productivity through sharing):

Standard is developed that identifies expected hours required to produce an acceptable level of output. Any savings arising from production of agreed-upon output in fewer than expected hours is shared by firm and workers.

Profit-Sharing Plans

• Predetermined index of profitability

Employees may not feel their jobs directly impact profits• The trend in recent variable-pay design is to combine

the best of gain-sharing and profit sharing plans

-the plan must self funding

-along with having the financial incentive, employees feel they have a measure of control

Earnings-at-Risk Plans

• -Success sharing plan: employee base pay is constant• -Risk sharing plan: employee base pay varies

Group Incentive Plans: Advantages and Disadvantages

Advantages1.Positive impact on organization and individual performance of about 5 to 10 percent per year.

2.Easier to develop performance measures than it is for individual plans.

3.Signals that cooperation, both within and across groups, is a desired behavior.

4.Teamwork meets with enthusiastic support from most employees.

5.May increase participation of employees in decision-making process.

Group Incentive Plans: Advantages and Disadvantages

Disadvantages1.Line-of-sight may be lessened, that is employees may find it more difficult to see how their individual performance affects their incentive payouts.

2.May lead to increased turnover among top individual performers who are discouraged because they must share with lesser contributors.

3.Increases compensation risk to employees because of lower income stability. May influence some applicants to apply for jobs in firms where base pay is a larger compensation component.

Group Incentive Plans: Examples

All incentive plans can be described by common features:

1.the size of group that participates in the plan

2.the standard against which performance is compared

3.the payout schedule

Explosive Interest in Long-term Incentive Plans

Long-term incentives 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 is spurred in part by a desire to motivate longer-term value creations

Long-Term Incentive Plans•Employee Stock Ownership Plans (ESOPs)•Performance Plans (Performance Share and Performance Unit)•Broad-Based Option Plans (BBOPs)•Combination Plans: Mixing individual and Group

ConclusionConclusion • Pay-for-performance plans can work. But the design Pay-for-performance plans can work. But the design

and effective administration of these plans is key to and effective administration of these plans is key to their success. Having a good idea is not enough. The their success. Having a good idea is not enough. The good idea must be followed up by sound practices that good idea must be followed up by sound practices that recognize rewards can, if used properly, shape recognize rewards can, if used properly, shape employee behavior.employee behavior.