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Module
5

Pay-for-Performance Plans

McGraw-Hill/Irw i n © 2002 by T he McGraw-Hill Compa nies, Inc. All rights res erved.
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Learning Objectives
After studying Chapter , students should be able to:
1.Discuss reasons for adopting variable pay-for-
performance plans.
2.Explain the types of individual pay-for-performance
plans.
3.Explain the types of team/group incentive plans.
4.Discuss and explain why an employer might choose a
group rather than an individual incentive system.
5.Explain the differences between short term and long term
pay-for-performance plans.
6.Discuss the difficulties of adopting variable pay-for-
performance plans and how they can be overcome.
 What Behaviors Do Employers Care
About?
Employers want employees to perform in ways that
lead to better organizational performance.
Organizational strategy is the guiding force that
determines what kinds of employee behaviors are
needed
Exhibit 9.1: The Cascading Link
between Organization Strategy
Employee Behavior
 Exhibit 9.2: The Big Picture, or
Compensation Can't Do It Alone!
 What Behaviors Do Employers Care
About? (cont.)
Behaviors that compensation needs to reinforce
- Compensation should be sufficiently attractive
to make recruiting and hiring good potential
employees possible (attraction)
- Need to make sure the good employees stay
with the company (retention)
- Need to find ways to motivate employees to
perform well on their jobs—to take their
knowledge and abilities and apply them in ways
that contribute to organizational performance
 What Behaviors Do Employers Care
About? (cont.)
Performance measurement
Need to accurately measure performance to
tell if compensation efforts are working
Performance management
 What Motivates Employees?

In the simplest sense, motivation involves three

elements:
1. What is important to a person?
2. Offering it in exchange for some
3. Desired behavior
 Do Employees Perform Better on
Their Jobs Because of Pay?
Not clear if performance of individuals can
be increased by tying it to pay
If the incentive depends on individual
performance, applicants find the company more
attractive
Team-based incentives, in contrast, are less
attractive
A number of recent studies provide strong
evidence that pay for performance has a direct
and, at times, substantial impact on firm
performance
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Pay for performance plans signal a

movement away from entitlements.

Pay will vary with some measure of

individual, team, or organizational
performance.
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Purposes of Pay-for-Performance

Attain strategic goals

Reinforce organizational norms
Motivate performance at the individual, group,
and organizational levels
Recognize differential employee contributions
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Use of Different Variable Pay Plan Types

Percent of Companies With Each Type
Of Plan
Type of Plan 1996 1997 1998 1999
Special Recognition Plans 44 43 51 59

Stock Option Plans 21 25 46 43

Individual Incentive Plans 17 23 35 39

Cash Profit Sharing 22 20 22 23

Gain-Sharing Plans 16 18 20 18

Team Awards 13 13 17 15
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Performance Pay Obstacles

Difficulties
in specifying and measuring job
performance

Problems in identifying valued rewards

Difficulties in linking rewards to job performance

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Short Term Pay-for-Performance Plans


◆ Merit Pay

◆ Lump-Sum Bonuses

◆ Individual Spot Awards

◆ Individual Incentives
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Difficulties in Rewarding Performance

with Merit Base Pay Increases

Economi cs
Lack of flexibility
Permanence
Individual focus
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Individual Incentives

Under a system of individual incentives, all

or a portion of an individual’s pay is tied
to their performance.
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Individual Incentive Plans

Method of Rate Determination
Units of production Time period per unit of
per time period production
(1) (2)

Straight piecework Standard hour plan

Pay constant function of plan
production level Bedeaux plan
(3) (4)
Relationship between production Taylor differential Halsey 50 - 50 method
level and pay piece rate system
Rowan plan
Pay varies as function of Merrick multiple piece
production level
Gantt plan
rate system
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Advantages of Individualized Incentive Plans

Substantial contribution to:
raise productivity
lower production costs
increase earnings of workers
Less direct supervision is required to maintain
reasonable levels of output than under payment by time.
Systems of payment by results (if accompanied by
improved organizational and work measurement) enable
labor costs to be estimated more accurately than under
payment by time.
This helps costing and budgetary control.
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Disadvantages of Individualized Incentive Plans

Greater conflict may emerge between employees seeking

to maximize output and managers concerned about
deteriorating quality levels.
Attempts to introduce new technology may be resisted
by employees concerned about the impact on production
standards.
Reduced willingness of employees to suggest new
production methods for fear of subsequent increases in
production standards.
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Disadvantages of Individualized Incentive Plans

(continued)

Increased complaints that equipment is poorly

maintained, hindering employee efforts to earn larger
incentives.
Increased turnover among new employees
discouraged by the unwillingness of experienced
workers to cooperate in on-the-job training.
Elevated levels of mistrust between workers and
management.
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Team / Group Incentive Plans

Gain-Sharing Plans
Profit Sharing Plans
Earnings-at-Risk Plans

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Group Incentives

 Improve Organizational Performance

 Organizational Measures
 Measured Periodically

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Sample Group/Team Performance Measures

Customer-Focused Measures Financially-Focused Measures
Time to Market Measures Value Creation
On time delivery Revenue growth
Cycle time Resource yields
New product introductions Profit margins
Customer Satisfaction Economic value added
Measures Shareholder Return
Market share Return on invested capital
Customer satisfaction Return on sales / earnings
Customer growth and Earnings per share
retention Growth in profitability
Account penetration
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Sample Group/Team Performance Measures

(continued)

Capability-Focused Measures Internal Process-Focused

Human Resources Measures
Capabilities Resource Utilization
 Employee satisfaction  Budget-to-actual expenses
 Turnover rates  Cost allocation ratios
 Total recruitment costs  Reliability / rework
 Rate of progress on  Accuracy / error rates
developmental plans  Safety rates
 Promotability index Change Effectiveness
 Staffing mix/head-count ratio
 Program implementation
Other Asset Capabilities  Teamwork effectiveness
 Patents and copyrights  Service / quality index
 Distribution systems
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Different Types of Variable Pay Plans

Cash Profit
Stock Ownership
Sharing
or Options

Balanced Scorecard

Productivity /
Gain-
Team / Sharing
Group
Incentive
s
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Gain-Sharing Plans
Under gain-sharing plans, employees
earn bonuses tied to unit-wide
performance as measured by a
predetermined, gainsharing formula.
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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
Production variability
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Primary Types of Gain-Sharing Plans

Scanlon Plan
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 sales value of production
(SVOP).
SVOP includes sales revenue and the value of goods in
inventory.
Rucker Plan
A ratio is calculated that expresses the value of
production required for each dollar of total wage bill.
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Primary Types of Gain-Sharing Plans

(continued)
Implementation of Scanlon / Rucker Plans
There are two major components vital to
implementation and success:
1. A productivity norm
2. Development of effective worker committees
Improshare
A standard is developed which identifies the
expected hours required to produce an acceptable level
of output.
Any savings arising from production of the agreed-
upon output in fewer than the expected hours is shared
by the firm and by the worker.
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Three Gain-Sharing Formulas

Scanlon Plan Rucker Plan Improshare
(single ratio
volume)
Numerator of Payroll costs Labor cost Actual hours
ratio (input worked
factor)
Denominator of Net sales (plus Value added Total standard
or
ratio (outcome minus value hours
factor) inventories)
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Small Group Incentives

Small group incentive systems are similar to

gainsharing plans; but in this case, the bonus
employees receive is based on the performance
of a small group instead of an entire department,
division, or plant.
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Profit-Sharing Plans

Employees receive an annual bonus or

shares in the company based upon
company-wide performance.
Employees are either paid in cash, or their
earnings are deferred into a retirement plan.
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Advantages of Group Incentive Plans

Positive impact on organization and individual

performance of about 5 – 10 percent per year.
Easier to develop performance measures than for
individual plans.
Signals that cooperation, both within and across
groups, is a desired behavior.
Teamwork meets with enthusiastic support from
most employees.
May increase participation of employees in
decision making process.
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 10 - 27

Disadvantages of Group Incentive Plans

Line of sight may be lessened.
Employees may find it more difficult to see how their
individual performance affects their incentive payouts.
May lead to increased turnover among top
individual performers who are discouraged
because they must share with lesser contributors.
Increases compensation risk to employees
because of lower income stability.

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Example of Group Incentives: GE

Information Systems
A team-based incentive with links to individual
payouts
Team and individual performance goals are set
If the team hits its goals, the team members earn
their incentive only if they hit their individual
goals.
The team incentive is 12% to 15% of monthly
base pay.
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Example of Group Incentives:

Corning Glass
A gain-sharing program (goal sharing) where
75% of the payout is based on unit objectives
such as:
qualitymeasures
customer satisfaction measures
production targets

The remainder is based on Corning’s return on

equity (ROE)
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Example of Group Incentives:

3-M
Operates with an earnings-at-risk plan
Base pay is fixed at 80% of market
Employees have a set of objectives to meet
for pay to move to 100% of market
Additionally, there is a modest profit
sharing component
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Long-Term Incentive Plans

Employee Stock Ownership

Plans (ESOPs)

Performance Plans
(Performance Share and
Performance Unit)

Broad-Based Option Plans

(BBOP)
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Long-Term Incentives and Their

Risk/Reward Tradeoffs
Level One: Low Level Two: Medium
Risk/Reward Risk/Reward
Time-based  Time-vested stock
restricted stock option
Performance –  Performance –
accelerated vested restricted
restricted stock stock
Stock purchase plan  Performance –
accelerated stock
option
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Long-Term Incentives and Their

Risk/Reward Tradeoffs
Level Three: High
Risk/Reward
 Premium-priced
stock option
 Indexed stock option
 Performance –
vested stock option
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Conditions for Effective Variable

Pay-for-Performance Plans
Plan is clearly communicated
Plan is understood
Rewards are easy to calculate
Employees participate in administering
the plan
Employees believe they are being treated
fairly
Employees believe they can trust the
company and that they have security
Rewards are awarded as soon as possible
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The Serious Implications of Variable

Pay-for-Performance (1 of 2)
When a substantial portion of pay is tied
to performance, that portion becomes
variable - can go up or down - based upon
individual, group, or company
performance.
This change is significant.
The nature of authority relationships and
status in the organization might change.
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The Serious Implications of Variable

Pay-for-Performance (2 of 2)
Employees will demand, and the
operation of the systems themselves
might require, increased sharing of
information.
Finally, variable pay-for-performance
systems will create heightened pressure
for performance and cost containment
within the organization.
This pressure will come not just from
managers, but from employees
themselves.
 Compensation of Special Groups:
Who Are Special Groups?
Corporate directors, General managers, VP’s, Presidents
etc.
Specific groups receive special treatment in the form of...
 Add -on packages not received by other employees
 Compensation components entirely unique in
organization
Characteristics of special groups–
 Tend to be strategically (or politically) important
to firm
 Positions tend to have built in conflict
 Components of an Executive
Compensation Package:
 Base salary
 Short-term (annual) incentives or bonuses
 Long-term incentives and capital appreciation
plans
 Executive benefits
 Perquisites
 Popular Perks Offered to Executives:
 Company car
 Financial counseling
 Company plane
 Income tax preparation
 First-class air travel
 Country club membership
 Luncheon club membership
 Estate planning
 Personal liability insurance
 Spouse travel
 Chauffeur service
 Reserved parking
 Executive dining room
 Home security system
 Car phone
 Financial seminars
 Loans at low / no interest
 Legal counseling
 Compensation Strategies For Special
Groups:
1. Use Metrics as the Basis for Incentive
Compensation(Metrics based Strategy)
2. Effectively Communicate to Ensure
Understanding(Communication strategy)
3. Benchmark Compensation
Levels(Benchmarking Strategy)
4. Value Company Equity Regularly(Value
Addition Strategy)
5. Include Both Short and Long-Term
Incentives(Incentives Strategy)