Pay-for-Performance Plan

WHAT IS PAY-FOR-PERFORMANCE-PLAN Pay-for-performance plans signal a movement away from entitlement.sometimes a very slow movement toward pay that varies with some measure of individual or organizational performance. Many of the surveys on pay for performance tend to omit the grandfather of all these plans, merit pay.

Percent of companies with plan Type of Plan 1996 1998 1999 2002 2007

Special Recognition plans 44 Stock option plans 21 Individual incentive plans 17 Cash profit sharing 22 Gain sharing plans 16 Team awards 13

51 46 35 22 20 17

59 43 39 23 18 15

34 40 38 18 11 8

72 49 16 10 32

The greater interest in variable pay probably can be traced to two friends: 1. The increasing competition from foreign producers forces American firms to cut costs and/or increase productivity. 2. Todays fast-paced business environment means that workers must be willing to adjust what they do and how they do it.

DOES VARIABLE PAY IMPROVE PERFORMANCE RESULTS? THE GENERAL EVIDENCE Pay-for-Performance plans, those that introduce variability into the level of pay you receive, seem to have a positive impact on performance if designed well. Notice that we have qualified our statement that variable-pay plans can be effective if they are designed well.

SPECIFIC PAY-FOR-PERFORMANCE PLANS: SHORT TERM MERIT PAY

A merit pay system links increases in base pay (called merit increases)to how highly employees are rated on a performance evaluation.
Well Above Above Average Average Average 1 2 3 Below Well Below Average Average 4 5

Performance Rating Merit pay increase

5%

4%

3%

1%

0%

At the end of the 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. Increasingly, merit pay is under attack. Not only is it expensive, but many argue it doesnt achieve the desired goal: improving employee and corporate performance. In a thorough interview of merit pay literature, though, Heneman concludes that merit pay does have a small, but significant, impact on performance.

High performance ratings are nearly always statistically related to high merit increases and the reverse holds too. Departments and strategic business units with better merit pay programs have higher subsequent performance. And removal of merit pay appears to result in lower subsequent performance, as well as lower satisfaction among top performance. A final argument for merit pay centers on the sorting effect we discuss throughout our sections on variable pay impacts.

Lump-Sum Bonuses Lump-sum bonuses (or awards) are thought to be substitute for merit pay. Based on employee or company performance, employees receive an end-of-year bonus that does not build into base pay.
Individual Spot Awards Technically, spot awards should fall under pay-for-performance plans. About 35 percent of all companies use spot awards. And an impressive 74 percent of companies in one survey reported that these awards were either highly of moderately effective.

Individual Incentive Plans these plans differ from the merit and lump sum payments because they offer a promise of pay for some objective, pre established level of performance. When this reverse incentive plan (penalty for poor performance rather than reward for good) was implemented, vehicle damage dropped 70%. This is but one of many studies showing pretty conclusive evidence that individual incentive plans increase performance substiantially.

All incentive plans have one common feature: an established standard against which worker performance is compared to determine the magnitude of the incentive pay. For individual incentive systems, this standards is compared against individual worker performance.
1. The first dimension on which incentive system vary is in the method of rate determination. Plans set up a rate based either on units of production per time period or on time period per unit of production. On the surface, this distinction may

appear trivial, but, in fact, the deviations arise because tasks have different cycles of operation. Short-cycle tasks, those that are completed in a relatively short period of time, typically have as a standard a designated number of units to be produced in a given time period. 2. The second dimension on which individual incentive systems vary is the specified relationship between production level and wages.

there are four general categories of plans: 1. Cell 1: the most frequently implemented incentive system is a straight piece work system. Rate determination is base on units of production per time period and wages vary directly as a function of production level. the major advantages of these types of system:
it is easily understood by workers and perhaps consequently, is more readily accepted than some of the other incentive systems.

2. Cell 2 To relatively common plans set standards base on time per unit and tie incentives directly to level of output. a. standard hour plans is a generic term for plans setting the incentive rate base on completion of a task in some expected time period. b. Bedeaux plans 3. A beadeaux plan provides a variation on straight piecework and standard hour plans. Instead of timing an entire task, a bedeaux plan requires division of a task into simple action and determination of the task required by an average skilled worker to complete its action.

4. Cell 3 the two plans included in Cell 3 provide for variable incentives as a function units of production per time period: a. Taylor plan establishes two piece work rates. One rate goes into effect when a worker exceeds the published standards for a given time period. A second rate is established for production below standard in this rate is lower than the regular wage.

b. Merrick system operates in the same way except that 3 piecework rates are set: 1. high for production exceeding 100 percent of standard. 2. medium for production between 83 and 100 percent of standard. 3. low for production less than 83 percent of standard. 5. Cell 4: the three plans included in cell 4 provide for variable incentives linked to a standard expressed as a time period per unit of production.

The Halsey 50-50 method derives its name fro the shared split between worker and employer of any savings in direct cost. The Rowan plan is similar to the Halsey plan in that an employer and employee both share in savings resulting from work completed in less than standard time. The Gantt plan differs from both the Halsey and the Rowan plans in that the standard time for a task is purposely set at a level requiring high effort to complete.

INDIVIDUAL INCENTIVES PLAN: ADVANTAGES AND DISADVANTAGES This is a common problem with incentive plans: Employees and managers end up in conflict because the incentive system often focuses only on one small part of what it takes for the company to be successful. Employees, being rational, do more of what the incentive system pays for.

ADVANTAGES AND DISADVANTAGES OF INDIVIDUAL INCENTIVE PLANS Advantages

1. Substantial impact that raises productivity, lower production costs, and increases earnings of workers. 2. Less direct supervision is required to maintain reasonable levels of output under payment by time. 3. In most cases, systems of payment by results, if accompanied by improved organizational and work measurement, enable labor costs to be estimated more accurate than under payment by time. This helps costing and budgetary control.

Disadvantages
1. Greater conflict may emerge between employees seeking to maximize output and managers concerns about deteriorating quality levels. 2. Attempts to introduce new technology may be resisted by employees concerned about the impact on production standards. 3. Reduce willingness of employees to suggest new production methods for fear of subsequent increases in production standards. 4. Increased complaints that is equipment is poorly maintained, hindering employee efforts to earn larger incentives.

5. Increased turnover among new employees discourage by the unwillingness of experience workers to cooperate in onthe-job training. 6. Elevated levels of mistrust between workers and management.

INDIVIDUAL INCENTIVE PLANS: EXAMPLES

Even though incentive systems are less popular than they used to be, there are still notable successes. Most sales positions have some part of pay based on commissions, a form of individual incentive. Perhaps the longest-running success with individual incentive, going back to before World War I, belongs to a company called Lincoln Electric.

TEAMS INCENTIVE PLANS: TYPES

When we move away from individual incentive systems and start focusing on people working together, we shift to group incentive plans. A standard is established against which worker performance (in this case, team performance) is compared to determined the magnitude of incentive pay. Whit the focus on groups, now we are concerned about group performance in comparison against some standard, or level, of expected performance. The standard might be an expected level of operating income for a division.

Failures of team incentive schemes can be attributed to at least five causes

1. First, one of the problems with team compensation is that teams come with any varieties. There are even full-time teams that are temporary. (e.g., cross-functional teams pulled together to help ease the transition into a partnership or join venture). 2. A seconds rewarding teams is called level problem. If we define teams at the very broad level --- the whole organization being an extreme example --- much of the motivational impact of incentives can be lost.

3. The last three major problems with team compensation involve the three Cs: complexity, control, and communications. Some plans are simply too complex. Xeroxs Houston facility had a gain sharing plan for teams that required understanding a three dimensional performance matrix. The second C is control. Praxair, a worldwide provider of gases (including oxygen) extracted by the atmosphere, works hard to make sure all its team pay comes from performance measures under the control of the team.

The final C is a similar factor in compensation successes and failures: communication. Team-based pay plans simply are not well communicated. Employees asked to explain their plans often flounder because more effort has been devoted to designing the plan than to deciding how to explain it.

LARGE GROUP INCENTIVE PLAN

When we get beyond a small work team and try to incentive large groups, there are generally two types of plans. Gain-sharing plans use operating measures to gauge performance. Profit sharing plans use financial measures. GAIN-SHARING PLANS Employees share in the gains in these types of group incentives plans. With profit-sharing plans (surprise) the sharing involves some forms of profit.

The following issues are key elements in designing a gainsharing plan:

1. Strength of reinforcement: What role should base pay assume relative to incentive pay? Incentive pay tends to encourage only those behaviors that are rewarded. 2. Productivity standards: What standard will be used to calculate whether employees will receive an incentive payout? 3. Sharing the gains split between the management and workers: Part of the plans must address the relative cuts between management and workers of any profit or savings generated. 4. Scope of the formula: Formulas can vary in the scope of inclusions for both the labor inputs in the numerator and the and the productivity outcomes of the denominator.

5. Great care must be exercised with such alternative measures, though, to ensure that the behaviors reinforced actually affect the desired bottom-line goal. 6. Perceived fairness of the formula: One way to ensure the plan is perceived as fair is to let employees vote on whether implementation should go forward. This union participation in program design are two elements in plan success. 7. Ease of administration: Sophisticated plans with involved calculations of profit or costs can become too complex for existing company information systems. 8. Production variability: One of the major sources of problems in group incentive plans is failure to set targets properly.

Scanlon Plan Scanlon plans are designed to lower labor costs without lowering the level of a firms activity. Incentives are derived as a function of the ratio between labor costs and sales value of production (SVOP). The SVOP includes sales revenue and the value of goods and inventory. Rucker Plan The Rucker plans involves a somewhat more complex formula than a Scanlon plan for determining worker incentive bonuses.

Implementation of the Scanlon/Rucker Plan To major components are vital to the implementation and success of a Rucker or Scanlon plan: (1) a productivity norm and (2) effective worker committees. Development of a productivity norm requires both effective measurement of base-year data and acceptance by workers and management of this standard for calculating bonus incentives. The second ingredient of Scanlon/Rucker plans is a series of worker committees (also known as productivity committees or bonus committees). This primary function of these committees is to evaluate employee and management suggestions for ways to improve productivity and/or cut costs.

Similarities and Contrasts Between Scanlon and Rucker Plans Scanlon and Rucker plans differ from individual incentives plan in their primary focus. Individual incentives plans focus primarily on using wage incentives to motivate higher performance through increase effort. While this is certainly a goal of the Scanlon/Rucker plans, it is not the major focus of attention.

Improshare Improshare (Improved Productivity through Sharing) is a gain-sharing plan that has proved easy to administer and to communicate. Profit-Share Plans Productivity was much higher in plans where payouts were that year than in plans were payment was deferred. Also, these plans worked much better in smaller (less than 775 employees) companies.

Earnings-at-Risk Plans We probably shouldn't separate earningsat-risk plans as a distinct category. In successsharing plans, employee base wages are constant and variable pay adds on during successful years. If the company does well, you receive a predetermined amount of variable pay. If the company does poorly, you simply forgo any variable pay --- there is no reduction in your base pay, though. In a risksharing plan, base pay is reduced by some amount relative to the level that would be offered in a success-sharing plan.

Group Incentives Plans: Advantages and Disadvantages Group for pay-for-performance plans are gaining popularity while individual plans are stable or declining in interest. Apparently the suggestions employees are encouraged to make (how to do things better in the company) gradually evolve from first order learning experiences of a more routine variety (maintenance of existing ways of doing things) into suggestions that exhibit second-order learning characteristics --- suggestions that help the organization break out of existing patterns of behavior and explore different ways of thinking and behaving.

Advantages 1. Positive impact on organizations and individual performance of about 5 to 10 percent per year. 2. Easier to develop performance measures that 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.

Disadvantages 1. 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 describe by common features: (1) the size of the group that participates in the plan. (2) the standards against which performance is compared, and (3) the payout schedule. Explosive Interest in Long-Term Incentives Plan Long-term incentives (LTIs) focus on performance beyond the one-year line used as the cutoff for short-term incentive plans. Recent explosive growth in long-term plans appears to be spurred in part by a desire to motivate long-term value creation.

Employees Stock Ownership Plans (ESOPs) Some companies believe that employees can be linked to the success or failure of a company in yet another way --- though employee stock ownership plans. At places like PepsiCo, Lincoln Electric, DuPont, Coca-Cola, and others, the goal is to increase employee involvement in the organizations, and hopefully this will influence performance. Performance Plans (Performance Share and Performance Unit) Performance plans typically feature cooperate performance objectives for a time three years in the future. They are driven by financial earnings or return measures, and they pay out for meeting or exceeding specific goals.

Broad-Based Option Plans (BBOPs) The latest trend in long-term incentives, and probably the component of compensation generating the most discussion in recent years, is broad-based option plans. BBPOs are stock giants: The company gives employees shares of stock over a designated time period. The strength of BBPOs is their versatility. Depending on the way they are distributed to employees, they can either reinforce a strong emphasis on performance or inspire greater commitment and retention of employees.

Combination Plans: Mixing Individual and Group Its not uncommon for companies to use both individual behavior and to insure that employees work together, where needed, to promote team and corporate goals. These combination programs start with standard individual (e.g., profit, operating income). Self-funding plan, often favored by CEOs who dont like to make payouts when the company loses money. These plans specify that payouts only occur after the company reaches a certain profit target.