12
Pay for Performance
CATHY C. DURHAM AND KATHRYN M. BARTOL
Our principle is pay for performance. This principle involves providing monetary rewards through carefully designed compensation systems that base pay on measured performance within the control of participants. It also includes incorporating appropriate concerns for procedural and distributive justice. In most situations, properly designed pay-for-performance systems will lead to better performance results.
Well-designed pay-for-performance systems make major contributions to performance through two main mechanisms. First, they positively influence the motivation to perform. Second, they impact the attraction and retention patterns of organizations (i.e., who joins and who remains), thereby affecting the caliber of individuals available to perform.
A number of different pay delivery plans qualify as pay-for-performance systems, although they vary widely with respect to how closely they tie pay to performance. Pay-for-performance systems can deliver monetary rewards at the individual, small group, and/or division or organizational level. Evidence suggests that pay for performance at each of these levels can positively impact performance.
Individual level
At the individual level, there are three major types of pay-for-performance systems: traditional incentive systems, variable pay configurations, and merit pay plans. Traditional incentive plans include piece-rate plans and sales commissions. With piece-rate incentive plans, an employee is paid a specified rate for each unit produced or each service provided. Mitchell, Lewin, and Lawler (1990) estimate that proper use of piece-rate plans leads to performance gains in the 10-15% range. Based on their review of the literature, Locke, Feren, McCaleb, Shaw, and Denny (1980) concluded that the median productivity improvement from piece-rate plans is 30%. A meta-analysis involving mainly piece-rate pay found that financial incentives are associated with higher performance in terms of quantity and also found no detrimental impact on quality (Jenkins, Mitra, Gupta, and Shaw, 1998). The other traditional incentive, the commission, is a sales incentive that is typically expressed as a percentage of sales dollars, a percentage of gross profit margins, or some dollar amount for each unit sold (Colletti and Cichelli, 1993). The available research indicates that salespeople tend to prefer commissions over other forms of reward (Lopez, Hopkins, and Raymond, 2006) and can be effectively motivated by them (e.g., Banker, Lee, Potter, and Srinivasan, 1996; Ford, Walker, and Churchhill, 1985; Harrison, Virick, and William, 1996).
The second major type of individual level pay-for-performance plan, variable pay, is performance-related compensation that does not permanently increase base pay and that must be re-earned to be received again. Because base pay tends to move up more slowly with variable pay plans, the amount of bonus that can be earned needs to be substantial to make up for the fact that part of the pay is “at risk” (Schuster and Zingheim, 1996). The risk stems from the possibility that desired performance might not be achieved and therefore the pay not earned. The piece-rate and commission pay plans discussed above actually constitute forms of variable pay, albeit forms in which a greater proportion of pay is typically tied to performance than is the case with newer forms of variable pay. According to a Hewitt survey of Fortune 1000 companies, a growing number of employers are moving to variable pay: The portion of US companies offering one or more variable pay plans rose from 51% in 1991 to 78% in 2005 (Dean, 2006). Research suggests that variable pay plans are useful in boosting performance (e.g., Chung and Vickery, 1976; Lee, 1988; Smilko and Van Neck, 2004; Yukl and Latham, 1975).
A form of variable pay that is currently popular is a lump-sum bonus for achieving particular goals. Locke (2004) identifies four methods of linking bonuses to goals: assigning stretch goals and paying bonuses only if the goals are achieved, having multiple goal levels and corresponding bonuses that increase as higher goals are met, offering bonuses that grow incrementally as performance improves (with no upper limit), and setting specific, challenging goals but making decisions about bonuses after the fact so that contextual factors can be taken into account. Locke notes that each choice has its pros and cons. For example, bonuses paid only when stretch goals are met, although highly motivating, might also encourage employees to take shortcuts or cheat. Also, they could be discouraging for those who approach but do not reach the goals. Having either multiple or continuous goal and bonus levels (which are similar to piece-rate pay plus goals) may be less likely to result in cheating or gaming, but it is unclear whether such approaches can motivate the highest levels of performance. Setting goals but determining pay after the fact, while accounting for situational factors, requires bosses to understand the full context of employees’ performance more than they often can do. Nonetheless, this method has been the approach of choice at both Microsoft (Shaw, 2004) and General Electric (Kerr and Landauer, 2004). Lacking comparative research to guide choices, Locke highlights the need for more experimental studies about how best to link bonuses to goals.
The third major type of individual level pay-for-performance plan, merit pay, rewards individuals for past work behaviors and outcomes by adding dollar amounts to their base pay. Merit pay is the most widely used pay system in US organizations (Bretz, Milkovich, and Read, 1992; O’Dell, 1987). Milkovich and Newman (2008) report that 90% of US firms reward employees through merit pay. Based on a review of 25 studies, Heneman (1992) concludes that merit pay plans appear to be moderately effective in influencing performance. Taking a longer-term view, Harris, Gilbreath, and Sunday (1998) provide evidence that the connection between merit pay and performance may be greater than short-term studies can detect because the cumulative effects of various types of merit pay adjustments linked to performance, such as those related to promotions, can be substantial.
Team level
In addition to pay for performance at the individual level, there is considerable interest in pay-for-performance plans focused on small groups or teams (Parker, McAdams, and Zielinski, 2000). Such pay plans provide monetary rewards based on the measured performance of the group or team. Small work groups or teams are official (designated or recognized by management) multi-person work units composed of individuals who operate interdependently in the performance of tasks that affect others associated within the organization (Guzzo and Dickson, 1996; Hackman, 1987). One survey found that almost 70% of Fortune 1000 companies are using some type of work group or team incentives (Lawler, Mohrman, and Ledford, 1995). Usage in smaller organizations may be less, with one survey showing that 35% of the 140 companies responding, most of which had 2000 or less employees, reported using team rewards (McClurg, 2001). Evidence suggests that performance gains can be associated with the use of monetary rewards for groups (Cotton and Cook, 1982; Gomez-Mejia and Balkin, 1989; Quigley, Tesluk, Locke, and Bartol, 2007; Wageman and Baker, 1997), but that the results are likely to be heavily influenced by situational factors (Balkin and Montemayor, 2000; DeMatteo, Eby, and Sundstrom, 1998; Lawler, 2003). Increased interest in team pay is also emerging in the executive suite, particularly with respect to top management teams (Devers, Cannella, Reilly, and Yoder, 2007).
Organizational level
At the organizational level, three pay systems that potentially link pay and performance are gainsharing, profit sharing, and stock options. Gainsharing is a compensation plan in which an organization shares with employees a portion of the added earnings obtained through their collective increases in productivity (Henderson, 1997) or the achievement of other goals, such as customer satisfaction with quality (Gerhart and Rynes, 2003). Such plans usually involve a significant portion of an organization’s employees and possibly all. In large organizations, plans may apply to plants, divisions, or other significant subsystems of the organization. In recent years, gainsharing has been growing in popularity, extending its reach beyond traditional industrial settings to other realms such as health care (Jain and Roble, 2008; Patel, 2006). The available evidence on gainsharing indicates that such plans have generally led to gains in productivity (Welbourne and Gomez-Mejia, 1995), as well as to other positive outcomes, such as decreases in absenteeism and the number of grievances (Arthur and Jelf, 1999).
The second type of organizational level pay system aimed at performance is profit sharing, which provides payments to employees based on the profitability of the business. Payments can be made through current distribution plans (paid in cash), deferred plans (paid toward retirement), or a combination of both, although most companies establish deferred plans because of the associated tax advantages. According to one estimate, more than 60% of Fortune 1000 companies have profit sharing plans (Lawler et al., 1995). Data supporting the performance effects of profit sharing plans is somewhat unclear. Kruse (1993) found that productivity growth in firms using profit sharing was 3.5-5.0% higher than in firms that did not use profit sharing. However, Kim (1998) found that profit sharing companies tend to have higher labor costs than other companies, thereby erasing any advantage of profit sharing. There are some weaknesses inherent in profit sharing plans as a direct means of boosting performance. One is that it can be somewhat difficult to establish a clear connection (sometimes referred to as “line of sight”) between individual actions and impact on profits, especially in large organizations. Evidence for this is Kruse’s (1993) finding that annual productivity growth was greater in smaller profit sharing companies than in larger ones (11-17% productivity growth in companies having fewer than 775 employees, versus 0.0-6.9% in companies having 775 or more). Another weakness is that accounting and financial management practices and other factors outside employees’ control can also impact the bottom line. Finally, the deferred nature of many of these plans may not provide strong valence with respect to motivating performance. Indeed, Kruse (1993) found that productivity growth was higher for plans paying cash rewards than for those making deferred payments.
A third type of organizational level reward system is employee stock ownership. One study of Fortune 1000 companies showed that 71% had stock ownership programs of some type (Lawler et al., 1995). During the 1990s, the most rapidly growing approach was via stock options, which give employees the right to purchase a specific amount of stock at a designated price over a specified time period (Brandes, Dharwadkar, Lemesis, and Heisler, 2003). The basic rationale is that employees will be more concerned about the long-term success of the organization and increase their efforts if they can reap the benefits as reflected in the rising price of the organization’s stock. Additionally, extending ownership can both attract new talent and enhance perceptions of fairness (and thus retention) in current employees. In 2000, a study of 490 organizations reported that companies with stock option plans that were broadly dispersed (beyond the executive level) performed better and had higher average compensation levels than companies without broad-based plans, and also that increases in productivity seemed to counterbalance any dilution of earnings per share that occurred when the options were exercised (Sesil, Kroumova, Kruse, and Blasi, 2000).
Since 2000, however, conditions have changed radically. In a much-debated ruling in 2005, the Financial Accounting Standards Board required companies to recognize stock options as a cost on their income statements in the year they were awarded rather than merely list them in the footnotes - a change that diluted earnings per share in the year options were granted and rendered options less attractive to many employers (Deshmukh, Howe, and Luft, 2008). Further, the value of options plummeted early in the decade and then again beginning in 2007, when a crisis in the mortgage markets ultimately led to the historic “Wall Street bailout” by the US government in 2008 and to widespread fear of a steep global recession. When an option is “underwater” (when its exercise price exceeds the current market price), the value is neutralized and employees’ anticipated wealth - along with any motivational potential that might have existed in holding the option - evaporates (Delves, 2001). And, even in times of rising stock prices, the effect may be less than hoped for. One study found that when stock prices have risen above the option price, lower-level employees tend to exercise their options shortly after vesting, a factor that may truncate some of the longer-term motivational potential of the incentive (Huddart and Lang, 1996).
Overall effects
There is some debate regarding whether there are best practices that are applicable to most organizations (Gerhart, Trevor, and Graham, 1996; Huselid, 1995), or whether it is important to match pay systems to particular strategies (Montemayor, 1994; Youndt, Snell, Dean, and Lepak, 1996). The weight of evidence seems to be shifting toward the strategy argument (e.g., Shaw, Gupta, and Delery, 2001; Yanador and Marler, 2006), but more research needs to be done on how best to align pay systems with strategy to ultimately enhance organizational performance (Gerhart, 2000).
The direct impact of pay plans on performance is not the only effect to consider. Growing evidence suggests that there are indirect pay plan effects stemming from influences on attraction and retention patterns in organizations. For example, several studies support the notion that the level of compensation influences attraction to organizations (e.g., Saks, Wiesner, and Summers, 1996; Schwoerer and Rosen, 1989; Williams and Dreher, 1992). Moreover, individuals appear to be more attracted to organizations in which the pay system rewards individual rather than group performance and for job outcomes rather than acquiring new skills (Cable and Judge, 1994; Highhouse, Steierwalt, Bachiochi, Elder, and Fisher, 1999). Individuals may also be more attracted to organizations that offer fixed pay, rather than variable pay, unless there is sufficient upside potential to balance the pay risk (Bartol and Locke, 2000).
Pay for performance can also have a positive effect on retention. Research indicates positive relationships between employee perceptions of pay for performance and both pay satisfaction (Heneman, Greenberger, and Strasser, 1988; Huber, Seybolt, and Venemon, 1992; Williams, McDaniel, and Nguyen, 2006) and job satisfaction (Kopelman, 1976), factors that are related to intention to leave and turnover (Chapter 7). General level of pay is also a factor encouraging retention (Batt, 2002). There is some evidence that profit sharing is an important determinant of organizational commitment (Florkowski and Schuster, 1992; Coyle-Shapiro, Morrow, Richardson, and Dunn, 2002), which has been shown to be related to lower turnover. Based on a meta-analysis, Williams and Livingstone (1994) argue that pay-for-performance systems encourage better performers to remain with the organization while inducing poorer performers to leave. One caveat is that a high degree of pay dispersion, in which pay is much higher for relatively few employees at the top of the pay structure than for others, can lead to higher probabilities of turnover among managers (Bloom and Michel, 2002). These negative effects seem to be lessened when pay levels generally are high (Brown, Sturman, and Simmering, 2003).
Interestingly, due to the flexibility and control over labor costs that it provides, variable pay may also reduce turnover. By having more money allocated to bonuses or other forms of variable pay, an organization can shrink its payroll costs during downturns rather than downsize. Gerhart and Trevor (1996) provide evidence that variable pay plans lessen organizational employment variability, allowing for greater employment stability for employees and their organizations.
Define performance
First, it is essential to identify explicitly what performance is desired. Clearly defining performance, however, requires looking beyond individual jobs and thinking strategically about the organization as a whole. It means developing a business model based on what drives the business (e.g., customer satisfaction), after which goals can be set at the various levels of the organization and determinations made about what will be rewarded. Without a business model (or with the wrong one), management risks setting goals and rewarding employees for the wrong things - and finding its employees doing those wrong things very efficiently, to the organization’s detriment. Focusing on what drives the business leads to the setting of appropriate performance goals for individual employees at all organizational levels. Then, the act of tying incentives to the achievement of those goals will have not only motivational but also informational value, because people will receive a clear message about what specific behaviors and/or outcomes are expected via communications about the reward system. A temptation to resist is that of defining performance in terms of job aspects that are easily quantifiable, thereby ignoring job dimensions that may be critically important but difficult to measure. This can lead an organization to fall into the trap of “rewarding A while hoping for B” (Kerr, 1995). For pay for performance to be effective, strategically important job dimensions - even hard-to-measure ones - must be identified, communicated, assessed, and rewarded.
Communicate
Because it is impossible to be motivated by incentives one does not grasp, it is critically important not only to design a pay plan that is understandable but also to communicate both clearly and frequently how the program works and what employees must do to bring about the results that will trigger a payout. Communication also implies providing feedback along the way about progress toward targets (Smilko and Van Neck, 2004). Young, Burgess, and White (2007) describe the effects of a failure to communicate in a pay-for-quality project for physicians. Participants found the rules complicated, failed to fully understand the plan, and were not sufficiently engaged by meager attempts to explain it. Thus, although 75% of those eligible received a bonus payment in the first year, very few knew whether they had received their payment or, if they did, realized that it was for their performance on the program’s quality measures. Some physicians were so unaware of the financial rewards available to them that they discarded, unopened, the mail that included their bonus checks.
Ensure competence
Employees must have the appropriate knowledge, skills and abilities (KSAs), and self-efficacy (Chapter 10) to perform at the desired level. Instituting pay for performance is a futile exercise if employees are unable to perform at the level required to receive the reward. Hiring people who are efficacious and who possess (or can readily obtain through training) the relevant KSAs is essential.
Make pay systems commensurate with employees’ values
Pay for performance will only work if the rewards being offered are valued and the amount is viewed as sufficient, given what employees are being asked to accomplish. Employers can generally assume that money is a value to their employees, both practically and symbolically. Some employees, however, may not value the incremental gain being offered for high-level performance if the amount is viewed as paltry and thus not worth the additional effort. Further, a pay system can fail if it is perceived as undermining employees’ other values. For example, individuals may be uninterested in obtaining even a substantial amount of additional pay if they believe that achieving performance goals means sacrificing greater personal values, such as time to pursue their own interests (e.g., family life), a low-stress work environment, or a commitment to high-quality work or to standards of ethical behavior.
Use non-financial motivators too
Most employers assume that money is an effective motivator because it enables employees to buy things that they want or need. Also, money is important from a justice standpoint, giving high performers what is due them for their exceptional contributions to the organization’s success. Nonetheless, exclusive reliance on financial incentives would be an unwise policy because it would ignore other important sources of work motivation. Non-monetary motivators include a diverse assortment of activities, such as providing interesting and important work assignments (Chapter 6), engendering commitment to the realization of a vision (or to a visionary leader; Chapter 20), assigning challenging goals in conjunction with ongoing performance feedback (Chapter 9), granting autonomy regarding how a job is accomplished (Chapter 11), providing public and/or private recognition for outstanding contributions (Chapter 13), or simply enabling one to do work that one loves.
Use money in conjunction with intrinsic motivation
Amabile (1993) argues that it is possible to achieve “motivational synergy” by encouraging both intrinsic and extrinsic motivation (see Chapter 26). She posits that intrinsic motivation arises from the value of the work itself to the person. It can be fostered through such measures as matching employees to tasks on the basis of their skills and interests, designing work to be optimally challenging, and bringing together diverse individuals in high-performing work teams. Amabile further suggests that, when creativity is particularly important, it may be best to hold off heavily emphasizing extrinsic motivators during the problem presentation and idea generation stages when intrinsic motivation appears to be most important. Extrinsic factors may be particularly helpful during the sometimes-difficult validation and implementation stages. A meta-analytic study (Eisenberger and Cameron, 1996) and a set of laboratory and field studies (Eisenberger, Rhoades, and Cameron, 1999) also indicated that tangible rewards can enhance, rather than undermine, the effects of intrinsic motivation. Some (e.g., Ryan and Deci, 2000), however, contest this view.
Target the appropriate organizational level
Performance-based pay must be at the appropriate level. Increasingly, firms are rewarding performance at the group and/or organizational levels rather than at the individual level alone, in hopes of boosting organizational performance through enhanced information sharing, group decision making, and teamwork (Bartol and Hagmann, 1992; Parker et al., 2000). Lawler (1971) argues that the distinction between individual and group pay plans is important because individual and group plans are viewed differently by employees and have different effects. A key decision for management, then, concerns whether incentive pay should be based on individual or group performance. Further, if the organization chooses to reward group performance, decisions must be made about what constitutes a “group” for performance-measurement purposes. For example, will group-based pay be based on the performance of a team, a work unit, a division, or the entire organization?
There has been little actual research to offer guidance regarding the level of performance to which incentives should be tied, although several views have been advanced by compensation experts (e.g., Gomez-Mejia and Balkin, 1992; Mitchell et al., 1990; Montemayor, 1994). Key factors that should be considered when making this important decision include:• Nature of the task. Pay for performance at the individual level is considered most appropriate when the work is designed for individuals, where the need for integration with others is negligible, where group performance means only the sum of members’ individual performances, or where the work is simple, repetitive, and stable. For sequential teams that perform various tasks in a predetermined order, so that group performance cannot exceed that of the lowest individual member, it has been recommended that base pay be skill based, and team incentives be team bonuses with payouts distributed as a percentage of base pay. Alternatively, group-based incentive programs, through which all members receive equal shares of a team bonus, are generally considered appropriate when teams are composed of individuals from the same organizational level, when members have complementary roles and must depend upon each other and interact intensively to accomplish their work, so that group performance is enhanced by cooperation, and when the nature of the technology and workflows allow for the identification of distinct groups that are relatively independent of one another. Emerging research (Beersma, Hollenbeck, Humphrey, Moon, Conlon, and Ilgen, 2003) suggests that, when highly interdependent teams have members who are high in extraversion and high in agreeableness, they produce more accurate work under a cooperative reward system than teams with members who are relatively low on these personality dimensions. The increased accuracy, which was found to be due largely to the greater sharing of information (Chapters 17 and 18), came at the expense of speed. The decrement in speed was also related to a tendency for free riding by the lowest performer under the cooperative reward scheme. In contrast, a competitive reward system led to greater speed, but lower accuracy, regardless of the personalities of members. When the work is highly interdependent and a cooperative reward system is in place, it may be helpful to select individuals who are high on extraversion and agreeableness. Some coaching of the team (Chapter 15) may help the group develop norms that discourage free riding (Hackman and Wageman, 2005), thus enabling accurate work with less decrement in speed.
• Ability to measure performance. Good performance measures are critically important in any pay-for-performance plan. Pfeffer (1998) argues that performance can often be more reliably assessed at aggregate than at individual levels. He concludes that individual incentive pay should be replaced by collective rewards based on organizational or subunit performance that highlight the interdependence among organizational members. Although many are unwilling to go as far as Pfeffer in discounting the potential value of individual incentives, most agree that group incentives are a suitable alternative when the identification of individual contributors is difficult due to the nature of the task. For gainsharing plans in particular, it is not only necessary that there be good performance measures for the unit or plant, but also that there be a reliable performance history in order to develop a gainsharing formula. When group performance is rewarded with gainsharing, however, it is nonetheless important, particularly in Western cultures, to provide a means for identifying individual contributions to the group effort (e.g., through peer evaluations), so that members keep in mind their accountability at both the individual and group levels.
• Organizational culture. Group incentive plans are best suited to situations in which the organizational culture emphasizes group achievements (Chapter 33). Group incentives work best when free riding is unlikely (e.g., because members hold each other accountable or because employees are professionals who possess high intrinsic motivation). If a corporate culture is strongly individualistic and competitive, group plans such as team incentives will likely encounter considerable resistance from organizational members accustomed to focusing on individual accomplishments and/or may lead to lower levels of cooperative behavior (Hill, Bartol, Tesluk, and Langa, 2009).
• Management’s purpose. Group incentives are recommended in situations in which there is a need to align the interests of multiple individuals into a common goal, or when management wishes to foster entrepreneurship at the group level. At the organizational level, profit sharing is often used to communicate the importance of the firm’s financial performance to employees, heightening their awareness of the overall financial performance of the organization by making a portion of their pay vary with it. This is thought to be most motivating when employees believe that they can substantially influence the profit measure, such as in smaller organizations and those in which the means by which profits are achieved are well understood.
Some have proposed mixed models, whereby incentive pay is based partially on individual measures of performance and partially on group measures. Wageman (1995), however, found that teams having mixed forms of reward (i.e., rewards based on both individual and group performance), mixed tasks (i.e., some tasks performed solely by individuals and some by interdependent groups), or both, had lower performance than those with task and pay designs that were clearly either individual level or team level. She proposes that mixed tasks and rewards may lead to inferior performance by adding a group element to what is primarily an individual task, thereby undermining attention to the task. It also may be more difficult to develop supporting norms for cooperation in the team (Quigley et al., 2007). In addition, teams executing mixed tasks may need more time to adjust because of the greater complexity of tasks that have both individual and group performance components. In fact, one study (Johnson, Hollenbeck, Humphrey, Ilgen, Jundt, and Meyer, 2006) has shown that it even may be more difficult for a team to shift from a competitive to a cooperative reward structure than from cooperative to a competitive one. When a competitive reward structure was shifted to a cooperative one, team members seem to engage in “cutthroat cooperation” in which team members retained much of their competitive behavior within the new reward systems intended to foster cooperation. Another complicating factor is that some workers may prefer individual pay over team-based pay (Cable and Judge, 1994; Haines and Taggar, 2006; Shaw, Duffy, and Stark, 2001). The question remains, then, how best (or when) to mix individual- and group-based incentive plans.
Make pay commensurate with the level of risk employees are required to bear
Risk refers to uncertainty about outcomes (Sitkin and Pablo, 1992), and, by definition, pay-for-performance systems involve uncertain outcomes for employees. Employees tend to be risk-averse concerning pay because they have no way of minimizing their income risk through diversification, as investors are able to do with their stock portfolios.
At least four factors can affect employees’ perceptions concerning the riskiness of a pay-for-performance plan. First is the proportion of employee pay that is performance based. Although the average percentage of variable pay in the USA is only 5%, the proportion ranges widely, from 0 to 70% (and even to 100% for salespersons; Gomez-Mejia and Balkin, 1992). The higher the proportion of variable pay, the more risk the employee must bear, in a tradeoff between income security and the potential for higher earnings (Gomez-Mejia, Balkin, and Cardy, 1998). At some point the level of risk may be perceived as so great that it would be unacceptable to the majority of employees, regardless of the potential for high pay. The second factor that influences employees’ perceptions of risk is their self-efficacy (Chapter 10) that they can achieve the performance goals on which pay is contingent. Those who are confident of their ability to perform at a high level should perceive contingent pay as less risky than those who are less confident of their ability. Third, to the extent that the performance measure on which pay is based is influenced by factors outside individual employees’ control (e.g., technology or macroeconomic factors affecting profits or stock prices), perceived risk for the employee is increased. For example, CEOs run the risk of losing income (and even employment) if the companies for which they are responsible are unsuccessful - whatever the cause. A fourth factor affecting employee perceptions of risk is the amount of time between performance and the receipt of rewards. Because the future is uncertain, deferred rewards involve more risk than immediate ones. For employees to accept a pay system offering long-term rewards, they must be willing to delay gratification in the hopes of greater (but uncertain) future returns. Research by Shelley (1993) indicates that managers may expect to be compensated for the loss of immediate compensation by the payment of a premium that is far in excess of the amount the time value of money would imply - a finding that is probably true of non-managerial employees as well.
It does not make sense for an employer to offer to pay employees more unless the employer will actually get more in the bargain. When, therefore, might it be unwise (or even counterproductive) to offer incentives?
When employees are learning
In learning situations, when employees are attempting to “get up to speed” on a new task, offering performance-based pay may frustrate more than it motivates. Performance failures that are a natural part of learning may be exaggerated in the learner’s mind because of failure not only to perform the task but also to obtain the monetary reward. Thus, it is unwise to pay for performance until employees are able to perform at the desired level.
When the employer can monitor
Agency theory (Jensen and Meckling, 1976) suggests that financial incentives are unnecessary when employers can easily monitor employees’ behavior (e.g., by direct observation or through information systems) and give them ongoing direction and feedback. In such situations, employees’ awareness that they are being monitored may obviate paying for performance.
When other motivators are sufficient or compensatory
Some people value other aspects of their jobs more than they value pay - factors such as interesting work, autonomy, desirable location, benefits that meet their needs, or having a boss they love working for. Such individuals will often accept lower pay in order to have what is more important to them in their jobs.
When the company is unionized
Union contracts constrain an employer’s pay policies, and thus under collective bargaining agreements it may be impossible to pay for performance, especially at the individual level. When incentives are included in a union contract, they are usually group incentives, because group pay is viewed as encouraging cohesion rather than competition among members.
Paying for individual performance
True Value Company. Kelly and Hounsell (2007) provide an example of a highly successful individual level pay-for-performance plan at the True Value Company (previously TruServe Corporation), which since 2000 has offered a voluntary plan called “simplified gainsharing” (although not gainsharing in the traditional sense) at its regional distribution centers. The incentive relies on a comparison of the actual performance of individual warehouse workers against predetermined expectations based on historical averages and/ or engineered labor standards. Workers who perform above expectations are rewarded in the following month by an increase in their hourly pay rate for the entire month. As long as an employee’s performance level is maintained (and there is no reduction in quality or safety), the rate increase continues. The addition to pay is funded from the savings resulting from productivity gains, the employee’s share of which is approximately one third and the company’s two thirds. Although there is no cap on savings to be shared, there is a provision under which management and employees can agree to increase performance expectation levels as processes become more refined (Kelley and Hounsell, 2007). Highly productive employees appreciate that their individual contributions are recognized, that rewards are immediate rather than deferred, and that the plan prevents poor performers from sharing the rewards of top performers (O’Reilly, 2006). Reported benefits to True Value have been a reduction in the number of employees needed to handle a consistent volume of warehouse activity, decreased turnover, increased quality, and savings of several millions of dollars annually (Kelly and Hounsell, 2007).
Countrywide Financial. Countrywide Financial, rescued from financial ruin through acquisition by Bank of America in 2008, provides an example of the perils of rewarding the wrong things. Morgenson (2007) describes how Countrywide “effectively” used individual incentives to promote the strategic (albeit short-sighted, ethically problematic, and ultimately disastrous) goals of management during the recent mortgage lending boom. Because subprime loans were so lucrative, Countrywide’s commission structure rewarded sales representatives for making extremely risky loans that imposed heavy burdens on borrowers. Incentives included: paying proportionately larger commissions for subprime loans (0.50%) than for loans of higher quality (0.20%), which led brokers and sales representatives to move borrowers possessing good credit (and thus qualified for prime loans) into the subprime category; adding an extra 1% of the loan’s value to the sales commission when a three-year prepayment penalty was added, which encouraged locking borrowers into high-cost loans after the initial “teaser” interest rate was reset; and offering an additional 0.25% commission when the borrower added a home equity line of credit, which promoted more borrowing by cash-strapped mortgagees. Its commission plan supported Countrywide’s position as one of the most aggressive home lenders in the USA and contributed to its role in triggering the global economic crisis of 2008.
Paying for team performance
Children’s Hospital of Boston. The accounts receivables (AR) department of Children’s Hospital in Boston developed a team-based incentive program that led to a greatly reduced billing cycle and aided cash flow for the hospital (Cadrain, 2003). The department had installed a new billing system that was not working as intended, causing problems for employees and leading to low morale in the department. The time to receive payments after bills were sent out was stretching beyond 100 days and hospital officials were becoming concerned about cash flow. To help improve employee morale and shorten the billing cycle, hospital executives set up an incentive plan aimed at establishing a line of sight that allowed employees to focus on the connections between number of days a bill spends in AR and the quarterly cash flow of the hospital. Team members were provided with three possible goals stated in terms of number of days an unpaid bill remained in AR: threshold, target, and optimal. Each goal had a dollar amount attached to it with a provision for a quarterly payment of $500, $1000, or $1500, respectively. Within 30 days of the end of each quarter, each team member would receive a part of the payment prorated to reflect the number of scheduled hours the team member worked, and a progress celebration was held. Once the team members understood the connection between their work and the cash flow at the hospital as well as how their efforts could increase their personal cash flow, they began working closely as a team to follow up with patients, insurers, or the medical records people. By the end of the plan’s first fiscal year, employees had succeeded in reducing the average number of days a bill was in AR from 100 to 75.8. Shortly after, they reached the middle 60s. The plan had an added bonus for the hospital because turnover in the AR department plummeted.
Hewlett-Packard. Beer and Cannon (2004) provide an example of team-based incentives having unforeseen negative consequences. With the intention of supporting a move to self-managed teams, managers at the San Diego site of Hewlett-Packard (HP) introduced a team pay-for-performance system. The purposes were to motivate teams to achieve specific goals related to improvement, production, and quality. There were three levels of team performance pay. Ninety percent of teams were expected to reach a Level 1 payout, with 50% at Level 2, and 10-15% at Level 3. For Level 3, members of the work team were given between $150 and $200 extra at the end of the following month. There was also a skill-based pay component, which allowed employees to achieve a higher base pay for increasing skill levels as certified by “subject matter experts;” this was instead of receiving merit raise increases. The program went well for the first six months as most teams reached Levels 2 and 3. However, the plan paid out more than expected and managers sought to raise the performance standards, much to the chagrin of the employees. It also became apparent that some factors, such as delays in shipments of parts or mechanical breakdowns, could interfere with teams meeting goals, but were beyond their control. Another unexpected outcome was that high performing teams did not want to allow anyone who might lower their performance to join the team, causing some teams to be composed of mainly low performers. Mobility between teams, which could help learning transfer, also became very limited. Finally, a majority of the employees did not like the additional pressure of taking tests for the skill-based pay. After about a year, one of the largest divisions at the site dropped the pay plan because managers grew weary of having to continually rework the pay plan, and because employee surveys indicated that employees preferred to change back to the standard pay system at HP. When the change back to the standard system was announced, the employees staged a party to convey their gratitude. The rest of the site eventually dropped the system when a major manufacturing reorganization was instituted.
Paying for organizational performance
Handelsbanken. Swedish-based Handelsbanken provides an example of profit sharing used effectively to reward performance and instill loyalty among employees (Hope and Fraser, 2003). The bank’s stated goal has long been to consistently realize higher profitability than comparable banks, and in 1973 then-CEO Jan Wallander established Octogonen, a foundation through which Handelsbanken shares with employees the “extra profits” made possible through their efforts. Employees are rewarded when company profits exceed the average profits of comparable banks, and every year but one since 1973 the board has allocated a portion of profits to Octogonen. Each full-time employee in the bank’s home markets receives an equal part of that year’s allocated amount, regardless of position or salary. (As noted in Chapter 33, Sweden is an egalitarian culture, where equal allotments, regardless of rank, are likely to be more acceptable than in individualistic countries such as the USA, where formula-based allocations (e.g., a fixed percentage of salary) are more common.) Distributions are deferred until retirement at age 60. Since Octogonen’s beginning, Handelsbanken has performed well, and the profit sharing system has paid out significant amounts of money. The plan, in conjunction with other employee-friendly human resource management practices, is thought to be an incentive for staff to remain with the company (Hammarström, 2007; Handelsbanken, 2007). In recent surveys, 82% of Handelsbanken staff reported believing they could make a valuable contribution to the bank’s success (Times Online, 2007), and 86% reported that they would not leave, even if they had another job offer (Times Online, 2008).
American Federation of Government Employees. Miller and Schuster (1995) describe the failure of a gainsharing plan at a federally owned and operated industrial complex whose main mission was the maintenance, repair, and rebuilding of military equipment. The complex employed 4800 civilian workers, including several levels of management who ultimately reported to military offices. A local of the American Federation of Government Employees represented almost 60% of the hourly personnel. The gainsharing plan was developed in response to an order from an off-site military commander who wished to increase hourly productivity. The plan was designed by senior managers with no input from line personnel, union leadership, or gainsharing consultants. A total of 460 employees were involved in the gainsharing plan, which was initiated as a 15-month pilot program. The plan base and payout levels differed for various units and, although computed monthly, were distributed quarterly. The formula design apparently was flawed, and quickly caused feelings of inequity and dissatisfaction across units. The top departments in terms of monetary gain and payout earned did not register actual productivity gains, while several departments that did show productivity gains actually received lower payouts. Middle managers particularly were frustrated by their lack of input into the plan design. Both managers and production employees viewed the fact that the plan was labeled a pilot program as evidence that there was actually little commitment to it by upper management. Consensus also developed among participants that the quarterly period for payout was too long. Ultimately, few if any gains in productivity materialized and the plan was eventually discontinued, but not before it seriously damaged an effectively functioning quality program that it partially overlapped.
Global pay
Cisco Systems. Organizations with international operations are presented with some unique challenges when they attempt to pay for performance at the organizational (and thus global) level. Nonetheless, multinational firms are increasingly instituting global pay in an attempt to attract skilled workers and create organizational cultures in which employees feel part of the same company regardless of their location. Cisco Systems, a maker of Internet equipment, has 65,000 employees worldwide, with about one third operating outside of the USA (Cisco, 2008). The company sets base pay at the 65th percentile in every labor market and offers variable pay that brings total remuneration to the 75th percentile (Hansen, 2005). Cisco Systems’ global strategy includes the use of stock options and a stock purchase plan, but its commitment to doing so has meant that the company has had to work hard to ensure that pay is understood, accepted, and deployed to the benefit rather than to the detriment of workers worldwide. Problems it has encountered include (Gross and Winterup, 1999): regulations in China and Russia that limit the ability of citizens to hold securities in foreign companies and differing tax regulations across countries within Europe, including taxing stock options when they are received rather than when they are exercised or severely taxing any profit if stock options are sold within the first five years. Differences in per capita income have also caused some adjustments in some countries to avoid having individuals receive such huge capital gains that they would be able to take early retirement in only a few years. These examples illustrate the importance of staying abreast of labor markets and changing laws wherever a company has operations, but Cisco Systems is convinced that doing so is worth the effort because it enables the firm to recruit and retain superior employees worldwide. The company considers its employees the company’s best asset and, as a result, places heavy emphasis on a broad set of benefits and a culture that focuses on “nurturing and developing this talent to its full potential” (Cisco, 2004). Cisco frequently appears on various rankings of best places to work (Cisco, 2008; Gerdes, 2008).
CONCLUSION
Paying for performance works - when done right. It communicates what factors are most important to the company’s success and focuses employees’ attention and effort on those factors. It is fair, because it pays more to those who contribute more. In turn, it attracts individuals who can perform at high levels and, by recognizing and rewarding them for doing so, makes them want to remain.
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Analyzing the pay system at your job
1. Think about your current job (or a job you’ve held in the past). Circle the types of pay you receive in this job:Non-performance-based pay: Salary Hourly pay
Individual level: Piece-rate Sales commission Other variable pay Merit pay
Team level: Team-based pay
Organizational level: Gainsharing Profit sharing Stock ownership (or options)
2. Use a scale from 0 to 4 to answer (a)-(c) below. (Circle your ratings.) a. How well does the pay plan contribute to your motivation to perform at a high level?Performance: Not at all motivating 0 1 2 3 4 Extremely motivating
b. How well does the pay plan contribute to your motivation to collaborate with or help fellow employees accomplish their work goals?Collaboration: Not at all motivating 0 1 2 3 4 Extremely motivating
c. How well does the pay plan contribute to your motivation to remain with the organization?Retention: Not at all motivating 0 1 2 3 4 Extremely motivating
3. What (if any) aspects of the plan are demotivating or demoralizing to you?
4. (a) What is one change your employer could make to the pay system that would enhance your motivation to perform well and stay with the organization? (b) What potential pitfalls or risks (to you, your fellow employees, or the organization) would be associated with this proposed change?
Bank of America
In 2005, Bank of America unveiled a new profit sharing program, Rewarding Success, which links cash bonuses for 85% of its employees - those whose cash compensation is less than $100,000 and those not paid exclusively by commission or variable pay - to corporate performance goals. Aims of the program included: attracting and retaining employees, motivating performance, and creating a sense of shared destiny, especially after the bank’s merger with FleetBoston in 2004 (Davis, 2005; Ruiz, 2005). When the company meets or exceeds annual business targets, all eligible employees receive equal bonuses, which they can take as cash or defer in whole or part to their 401(k) accounts (Bank of America, 2008). The minimum per-employee payout when the earnings trigger is reached is $500, and employee bonuses rise with bank earnings to a potential maximum of $3000. The bank originally considered offering equity as part of the new program, but a survey of employees showed that they preferred cash. Also, because companies would have to begin expensing stock options on their grant date beginning in 2006, the choice of cash over stock options was considered wise (Davis, 2005).
Davis (2008) reports that in 2006, eligible employees received bonuses of $1175, and in 2007 they received $1820. However, after lower-than-expected earnings in 2007 due to deteriorating credit quality and capital market difficulties, Bank of America informed employees that it would not pay bonuses under the program. Commented a company spokeswoman: “It’s disappointing to all of us.” Given the crisis in US financial markets in 2008, future bonus payments are uncertain at best. What is your assessment of the Rewarding Success program, from both the bank’s and the employees’ perspectives? What recommendations would you make to Bank of America?