pay_OKk

Individual

Group

Organizational

Performance-related payObjectives

• Describe three theories that explain the dynamics of performance-related pay.

• Identify a number of performance-related pay programs.

• List the major factors to consider in matching the pay strategy to the organisation’s strategy.

• Describe the way the rewards of managers and executives can be tied to company performance.

• Explain the importance of process issues, such as communication, in compensation management.

Three theories to explain the effects of compensation

Reinforcement theory: proposed by BF Skinner. It states that individual’s behaviour is a function of its consequences. It is based on “law of effect”, i.e, individual’s behaviour with positive consequences tends to be repeated & vice-a-versa.

Expectancy theory: proposed by Victor Vroom states that employee’s motivation is an outcome of how much an individual wants a reward (Valence).

Agency theory: Agency relationships occur when the principals hire the agent to perform a service on the principals' behalf.

Performance-related pay programs

Merit pay Incentive pay Profit-sharing Ownership Gainsharing Skill-based

Merit pay

Incentive pay

Profit sharing

Ownership

Gain sharing

Categories of pay system

PersonAgeSeniority/experienceQualificationsCompetenceBehaviour/traits AttitudesKnowledgeSkills

PerformanceIndividualCommissionPieceworkIndividual performance-related pay/merit bonus

GroupProfit-sharingGain-sharingTeam bonuses

Pay setting, composition and progression

The pros and cons of performance pay

Arguments for:

It is right that those who perform better receive higher rewards than those who perform less well.

Linking pay to performance improves motivation and hence performance.

Performance-linked pay can send strong messages about what behaviour is expected.

The pros and cons of performance pay

Arguments against:

Pay is not a motivator.It demotivates staff who do not benefit.It ruptures relationships and team work.It represents a diversion from managing staff

performance properly.It discourages risk-taking.It undermines the intrinsic interest in the work.

Kohn (1993)

Operational problems

The setting of appropriate performance measures.

The evaluation of performance

The linking of performance outcomes to pay

The performance management system

Objectives:To communicate a shared visionTo define expectationsTo ensure that employees are aware of what

constitutes high performance and its achievementTo enhance motivation, engagement and commitmentTo enable employees to monitor their own

performance and encourage dialogue with their manager about how performance can be improved

Armstrong and Baron (2005)

The balanced scorecard•It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results.

Balanced Scorecard holds four different perspectives from which a company's activity can be evaluated:

•Financial perspective - return on investment, shareholder value•Customer perspective - customer satisfaction, our corporate image?•Process perspective - in what processes should we excel to succeed?•Innovation perspective - how will we go on from lessons learned and sustain our ability to change and improve?

The balanced scorecard

The performance management cycle

Planning the meeting at which the objectives are agreed

Tracking progress with the plan

Annual appraisal

Rating of individual performance

Types of performance pay progression

Through the award of additional merit-related increments on top of traditional service-based progression

Through all incremental progression being related to performance (rather than to service or competency)

Through ‘all merit’ annual pay increases where the range of increase relates to individual performance rating.

Competency-based pay

‘A payment system that relates salary progression or a cash bonus to the display of “competencies” by individual employees. Systems originate in the identification of competency, understood as the key attributes and behaviours of employees that underlie good performance in a particular organisation or job.’

Heery and Noon (2001)

Competence or competency?

Competence refers to the areas of work in which an employee is competent (measurable skills).

Competency is a wider concept and refers to the behaviours that underpin competent performance (ie an assessment of the employee’s attitudes and behaviour).

Woodruff (1991)

The advantages of competency-based pay

It focuses attention on the need for improved competence.

It encourages employees to develop competence.

It facilitates lateral career moves.It encourages staff to take an interest in their

own career development.It helps to integrate role and generic

competences with organisational core competences.

Armstrong 2001

Two levels of competence are identified in the occupational psychology literature – trait-based (linked to individual personality) and not trait-based.

Most managers are unable to distinguish between these two levels.

Managers lack the skills to evaluate complex issues like human behaviour, and there is a risk of gender and ethnic stereotyping.

•The disadvantages of competency-based pay

Skills-based pay

‘Skills-based pay is an input-based payment system in which employees receive increases in pay for undergoing training and adding to their range or depth of skills.’

Heery and Noon (2001)

Thompson and Milsome (2001) concluded that skills-based pay was rare in the UK. But the 2008 CIPD Reward survey found that 38% of organisations were using it.

Pay for contribution

Paying for how results are achieved as well as the results themselves

Paying for skills and competencies supporting the future success of the individual, not just immediate results

Rewarding a combination of organisation, team and individual performance, rather than concentrating on the last of these

Using a wide variety of forms of rewardTaking a long-term approach, incorporating a mix

of HR systems and processesAddressing all aspects of reward strategy

Armstrong and Brown (1999)

Market-based comparisonsOrganisations in the immediate locality

Organisations in the same industrial sector

Influential firms within the wider economy

Different comparators used for different levels of staff

IDS (2004)

The pros and cons of market-based pay

It can assist with employee retention, especially in tight labour markets.

It enables resources to be targeted at those most difficult to recruit and retain.

But if the market is static, there is no progression, leading to demotivation.

There are also issues around internal equity, transparency and the lack of specialised data to benchmark.

Compensatory payments

Location allowances (eg London allowances)

Overtime or unsocial hours premium payments

Shift premiums

On-call and call-out pay

Annual pay increases are usually linked to performance appraisal ratings.

Merit increase grid combines an employee’s performance rating with his/her position in a pay range, to determine the size and frequency of his/her pay increases.

Develop employee confidence and trust in performance appraisal.

Establish job-related performance criteria.

Separate merit pay from regular pay.

Distinguish merit raises from cost-of-living raises.

Withhold merit payments when performance declines.

Depends on reliable and accepted performance measures.Cause poor relationships between supervisors and their subordinates, and among subordinates.Not suitable for work depending on collaboration and cooperation.Setting the total available bonus pool is an arbitrary decision by top management and can cause dissatisfaction.How to define behavior that will be rewarded? is a tough question.

Types of Incentive Plans

Individual incentive/recognition programs

Sales compensation programs

Team/group-based variable pay programs

Organization-wide incentive programs

Executive incentive compensation programs

Types of Pay-for-performance Plans Individual-based plans

Individual-based plansIndividual-based plans• Merit payMerit pay• Bonus programsBonus programs• Lump-sum paymentsLump-sum payments

Advantages Advantages • Rewarded performance is likely to be repeated – expectancy theory • Financial incentives can shape an individual's goals• Help the firm achieve individual equity• Fit in with an individualistic culture

DisadvantagesDisadvantages• May promote single-mindedness• Employees do not believe pay and performance are linked• They may work against achieving quality goals, and they may

promote inflexibility.

Types of Pay-for-performance Plans Individual-Based Plans

Conditions under which individual-based plans are Conditions under which individual-based plans are most likely to succeedmost likely to succeed• When the contributions of individual employees can be When the contributions of individual employees can be

accurately isolatedaccurately isolated• When the job demands autonomyWhen the job demands autonomy• When cooperation is less critical to successful When cooperation is less critical to successful

performance or when competition is to be encouraged performance or when competition is to be encouraged

Types of Pay-for-performance Plans Sales Compensation Programs

Salary plan• Straight salaries

• Best for: prospecting (finding new clients), account servicing, training customer’s sales force, or participating in national and local trade shows.

Commission plan• Pay is only a percentage of sales

• Keeps sales costs proportionate to sales revenues.

• May cause a neglect of non-selling duties.

• Can create wide variation in salesperson’s income.

• Likelihood of sales success may linked to external factors rather than to salesperson’s performance.

• Can increase turnover of salespeople.

Types of Pay-for-performance Plans Sales Compensation Programs

Combination plan• Pay is a combination of salary and commissions, usually with a

sizable salary component.

• Plan gives salespeople a floor (safety net) to their earnings.

• Salary component covers company-specified service activities.

• Plans tend to become complicated, and misunderstandings can result.

Commission-plus-drawing-account plan• Commissions are paid but a draw on future earnings helps the

salesperson to get through low sales periods.

Commission-plus-bonus plan• Pay is mostly based on commissions.• Small bonuses are paid for directed activities like selling slow-

moving items.

Types of Pay-for-performance Plans Team-based Plans

Team-based plans attempt to support other efforts to increase the flexibility of the work force within a firm.

These plans normally reward all team members equally based on group outcomes.

Advantages• Foster group cohesiveness • Facilitate performance measurement

Disadvantages • Possible lack of fit with individualistic cultural values• Free-riding effect• Social pressures to limit performance• Difficulties in identifying meaningful groups• Inter-group competition leading to a decline in overall

performance.

Types of Pay-for-performance Plans Team-based Plans

Conditions under which team-based plans are Conditions under which team-based plans are most likely to succeed-most likely to succeed-

• When work tasks are so intertwined it is When work tasks are so intertwined it is difficult to single out who did whatdifficult to single out who did what

• When the firm’s organization facilitates the When the firm’s organization facilitates the implementation of team-based incentivesimplementation of team-based incentives

• When the objective is to foster When the objective is to foster entrepreneurship in self-managed work entrepreneurship in self-managed work groupsgroups

Advantages and Disadvantages

Types of Pay-for-performance Plans Plant-wide Plans

Plant-wide plans • Generally referred to as gainsharing programs because they return a

portion of the company's cost savings to the workers, usually in the form of a lump-sum bonus.

Conditions to be consideredConditions to be considered• Firm sizeFirm size• TechnologyTechnology• Historical performanceHistorical performance• Corporate cultureCorporate culture• Stability of the product marketStability of the product market

Three major types:• Scanlon Plan

• Rewards labor savings, most appropriate for companies that have a "high touch labor" content

• Rucker Plan• Most appropriate for organizations that want to improve other variables, such as

scrap reduction or energy consumption, in addition to labor.• Improshare

• easiest of the gainsharing plans to understand and install

Types of Pay-for-performance Plans Plant-wide Plans

Advantages • eliciting active employee input• increasing the level of cooperation• fewer measurement difficulties• improved quality

Disadvantages • protection of low performers• problems with the criteria used to trigger rewards• management-labor conflict

Types of Pay-for-performance Plans Corporate-wide Plans

Corporate-wide Plans • macro type of incentive program and is based on the entire corporation's performance

Differences between Corporate-wide Plan and Gainsharing• no attempt is made to reward workers for productivity improvements• they are very mechanistic• they may used to fund retirement programs although there are exceptions

Profit-sharing plans• Cash plans

• Employees receive cash shares of the firm’s profits at regular intervals.• The Lincoln incentive system

• Profits are distributed to employees based on their individual merit rating. • Deferred profit-sharing plans

• A predetermined portion of profits is placed in each employee’s account under a trustee’s supervision.

Employee stock ownership plans (ESOPs)• A corporation annually contributes its own stock—or cash (with a limit of 15% of

compensation) to be used to purchase the stock—to a trust established for the employees.

• The trust holds the stock in individual employee accounts and distributes it to employees upon separation from the firm if the employee has worked long enough to earn ownership of the stock.


Advantages Advantages • Financial flexibility for the firm• Increased employee commitment• Tax advantages

DisadvantagesDisadvantages • Risk for employees• Limited effect on productivity• Long-run financial difficulties.


Conditions favoring corporate-wide Conditions favoring corporate-wide plansplans

• Firm sizeFirm size

• Interdependence of different parts Interdependence of different parts of the businessof the business

• Market conditionsMarket conditions

• The presence of other incentivesThe presence of other incentives

Designing Pay-for-performance Plans Managers and Executives

Annual bonus

• Plans that are designed to motivate short-term performance of managers and are tied to company profitability.

• Eligibility basis: job level, base salary, and impact on profitability

• Fund size basis : nondeductible formula (net income) or deductible formula (profitability)

• Individual awards: personal performance/contribution


Stock option

• The right to purchase a specific number of shares of company stock at a specific price during a specific period of time.

• Nonqualified stock option

• Indexed option

• Premium priced option

• Options have no value (go “underwater”) if the price of the stock drops below the option’s strike price (the option’s stock purchase price).


Other plans• Guaranteed loans to directors

• Loans provided to buy company stock.• A highly risky and now frowned upon practice Key employee

program

• Golden parachutes• Payments companies make to departing executives in

connection with a change in ownership or control of a company.

• Performance plans• Plans whose payment or value is contingent on financial

performance measured against objectives set at the start of a multi-year period


Creating an Executive Compensation Plan• Define the strategic context for the executive compensation

program.• Shape each component of the package to focus the

manager on achieve the firm’s strategic goals.• Create a stock option plan to meet the needs of the

executives and the company and its strategy.• Check the executive compensation plan for compliance with

all legal and regulatory requirements and for tax effectiveness.

• Install a process for reviewing and evaluating the executive compensation plan whenever a major business change occurs.

Key Strategic Pay Questions

Why Incentive Plans Fail

Performance pay can’t replace good management.

You get what you pay for.

“Pay is not a motivator.”

Rewards punish.

Rewards rupture relationships.

Rewards can have unintended consequences.

Rewards may undermine responsiveness.

Rewards undermine intrinsic motivation.

Implementing Effective Incentive Plans

Ask: Is effort clearly instrumental in obtaining the reward?

Link the incentive with your strategy.Make sure effort and rewards are directly related.Make the plan easy for employees to understand.Set effective standards.View the standard as a contract with your employees.Get employees’ support for the plan.Use good measurement systems.Emphasize long-term as well as short-term success.Adopt a comprehensive, commitment-oriented approach.

HR Activities that Build Commitment

Clarifying and communicating the goals and mission of the organization.

Guaranteeing organizational justice.

Creating a sense of community by emphasizing teamwork and encouraging employees to interact.

Supporting employee development by emphasizing promotion from within, developmental activities, and career-enhancing activities.

Generally committing to “people-first values.”

Straight piece-work

Payment of a uniform price / unit of production.

Forms:

Money piecework

Time piecework

Sales Commissions

Basic commission on sales volume

One-third of salary

Satisfy all the criteria listed for bonus schemes

Gainsharing A form of group compensation based on group or plant performance (rather than organisation-wide profits) that does not become part of the employee’s base salary.

Group incentivesTend to measure performance in terms of physical output.

Profit Sharing

Any procedure by which an employer pays, or makes available to all regular employees, in addition to their base pay, current or deferred sums based upon the profits of the enterprise.

Challenges:

Agreement over division of profits between company and employees.

Possibility of no payout due to financial condition of company.

OwnershipStock option

An employee ownership plan that gives employees the opportunity to buy the company’s stock at a previously fixed price.

Employee stock ownership plan (ESOP). An employee ownership plan that provides

employers certain tax and financial advantages when stock is granted to employees.

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