Chapter 10
Pay-for-
Performance:
Incentive
Rewards
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Learning Outcomes
After studying this chapter, you should be able to
1. Implement a strategic incentive program.
2. Detect when and what types of individual incentives are
appropriate.
3. Differentiate how gains may be shared with employees
under different group incentive plans like the Scanlon
plan and improshare gainsharing systems.
4. Differentiate between profit sharing plans and explain
advantages and disadvantages of these programs as an
alternative to individual and group incentive systems.
5. Understand how to apply different incentive systems
designed for professionals and executives.
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Figure 10.1: Types of Incentive Plans
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10.1 Strategic Reasons
for Incentive Plans
Variable pay – Tying pay to some measure of individual, group, or
organizational performance
Variable pay programs consist of bonuses, incentives, or recognition for
good work.
Variable pay is more flexible than fixed pay (salaries, hourly wages), as
variable pay is attached to fixed costs that allow flexibility to increase,
decrease, or maintain future payments to employees as business
conditions warrant.
Most HR managers see variable pay as strategic because it allows the
organization to align its employees’ interests and outcomes with those of
the organization.
Variable pay not only motivates employees to do what the organization
wants them to do, but it also ensures that employees feel the
organization is fair and responsive to their individual contributions.
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Figure 10.2:
Pay-for-Performance Philosophy
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10.1a Incentive Plans as Links to
Organizational Objectives
By meshing compensation and organizational
objectives, managers believe that employees will
assume “ownership” of their jobs, thereby
improving their effort and overall job
performance.
Incentive pay is highly valued as a compensation
strategy to attract and retain top-performing
employees.
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Figure 10.3: Advantages of
Incentive Pay Programs
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10.1b Requirements for a
Successful Incentive Plan
For an incentive plan to succeed, employees must be able to see a
clear connection between the incentive payments they receive and
their job performance.
Management should guard against incentive payments being seen
as an entitlement.
Instead, these payments should be viewed as a reward that must be
earned through effort.
A successful incentive plan should:
Identify important organizational metrics that encourage employee
behavior
Involve employees
Have simple and understandable payout formulas
Establish a clear link between performance and payout
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10.2 Setting Performance Measures
When setting performance measures, as a
manager, you will need to:
Be able to distinguish between individual contributions
and those made by a group
Be able to avoid biases based on who you like and
dislike, different personalities, and political agendas
Distinguish how much one group contributed over
another group, even if the work they do is highly
interdependent
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Figure 10.4:
Measurement DOs and DON’T’s
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10.3 Administering Incentive Plans
To achieve their full benefit, incentive plans must be
carefully thought out, implemented, and maintained.
A cardinal rule is that thorough planning must be
combined with a “proceed with caution” approach.
Three of the more important points are:
1. Allowing incentive payments to become pay guarantees defeats
the motivational intent of the incentive.
Poor performance must go unrewarded.
2. Annual salary budgets must be large enough to reward and
reinforce exceptional performance.
3. The overhead costs associated with plan implementation and
administration must be determined.
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10.4 Individual Incentive Plans
Incentive payments may be determined by:
The number of units produced
Achievement of specific performance goals
Productivity improvements in the organization as a
whole
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10.4a Piecework
Straight piecework – An incentive plan under which employees
receive a certain rate for each unit produced
Differential piece rate – A compensation rate under which
employees whose production exceeds the standard amount of
output receive a higher rate for all of their work than the rate paid to
those who do not exceed the standard amount
Piecework: The Drawbacks
Despite their advantages, piecework systems have a number of
disadvantages that offset their usefulness.
They may not always be an effective motivator.
Piecework incentive systems can work against an organizational culture
promoting creativity or problem-solving because these goals can infringe
on an employee’s time and productivity and, therefore, total pay earned.
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10.4b Standard Hour Plan
Standard hour plan – An incentive plan that
sets rates based on the completion of a job in a
predetermined standard time
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10.4c Bonuses
Bonus – An incentive payment that is
supplemental to the base wage
Spot bonus – An unplanned bonus given for
employee’s effort unrelated to an established
performance measure
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10.4d Merit Pay (slide 1 of 2)
A merit pay program (merit raise) links an
increase in base pay to how successfully an
employee performs his or her job.
Unlike bonuses, once merit increases are given
they become part of base pay, regardless of
future performance.
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Figure 10.5: Merit Pay
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10.4d Merit Pay (slide 2 of 2)
Problems with Merit Raises
Possible problems with merit pay plans:
Money available for merit increases may be inadequate to satisfactorily
raise all employees’ base pay.
Managers may have no guidance in how to define and measure
performance; there may be vagueness regarding merit award criteria.
Employees may not believe that their compensation is tied to effort and
performance; they may be unable to differentiate merit pay and other
types of pay increases.
Employees and their managers may hold different views of the factors
that contribute to job success.
Merit pay plans may create feelings of pay inequity.
Merit guidelines – Guidelines for awarding merit raises that are tied
to performance objectives
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Figure 10.6: Employee Incentives Should
Align with Organizational Objectives
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10.4f Sales Incentives
Types of Sales Incentive Plans
Straight salary plan – A compensation plan that permits
salespeople to be paid for performing various duties that are not
reflected immediately in their sales volume
Straight commission plan – A compensation plan based on a
percentage of sales
Combined salary and commission plan – A compensation plan
that includes a straight salary and a commission
Salary plus bonus plan – A compensation plan that pays a salary
plus a bonus achieved by reaching targeted sales goals
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10.5 Group Incentive Plans
The emphasis on cost reduction and productivity has led
many organizations to implement a variety of group
incentive plans.
Group plans enable employees to share in the benefits
of improved efficiency realized by major organizational
units or various individual work teams.
Group plans encourage a cooperative—rather than
individualistic—spirit among all employees and reward
them for their total contribution to the organization.
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10.5a Team Compensation
Team incentive plan – A compensation plan in which all team
members receive an incentive bonus payment when production or
service standards are met or exceeded
When team compensation is decided upon, organizations typically
use the three-step approach to establishing team incentive payments.
1. They set performance measures upon which incentive payments are
based.
2. The size of the incentive bonus is determined.
3. A payout formula is established and fully explained to employees.
Problems associated with team compensation:
The perception by individual team members that “their” efforts contribute
little to team success or to the attainment of the incentive reward
The “free-rider” effect
Complex payout formulas or insufficient payout rewards
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10.5b Gainsharing Incentive Plans
Gainsharing plans – Programs under which both employees and the
organization share financial gains according to a predetermined formula that
reflects improved productivity and profitability
The Scanlon Plan
Scanlon plan – A bonus incentive using employee and management
committees to gain cost-reduction improvements
The philosophy behind the Scanlon plan is that employees should offer
ideas and suggestions to improve productivity and, in turn, be rewarded for
their constructive efforts.
Improshare
Improshare – A gainsharing program under which bonuses are based on
the overall productivity of the work team
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Figure 10.7:
Scanlon Plan Suggestion Process
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10.6 Enterprise Incentive Plans
Enterprise incentive plans differ from individual and group incentive
plans in that all organizational members participate in the plan’s
compensation payout.
Enterprise incentive plans reward employees on the basis of the
success of the organization over an extended time period—normally
a year, but the period can be longer.
Common enterprise incentive plans include:
Profit sharing
Stock options
Employee stock ownership plans (ESOPs) – Stock plans in which an
organization contributes shares of its stock to an established trust for the
purpose of stock purchases by its employees
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10.6a Profit Sharing Plans (slide 1 of 3)
Profit sharing – Any procedure by which an employer
pays, or makes available to all regular employees,
special current or deferred sums based on the
organization’s profits
Profit sharing plans are intended to give employees the
opportunity to increase their earnings by contributing to
the growth of their organization’s profits.
Rather than just increasing rates of production, these
contributions may be directed toward:
Improving product quality
Reducing operating costs
Improving work methods
Building goodwill
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10.6a Profit Sharing Plans (slide 2 of 3)
Variations in Profit Sharing Plans
The amount shared with employees may range from 5 to
50 percent of the net profit.
In most plans, however, about 20 to 25 percent of the net profit is
shared.
Profit distributions may be made to all employees on an
equal basis, or they may be based on regular salaries or
some formula that takes into account seniority and/or
merit.
Payments may be disbursed in cash, deferred, or a
combination of the two forms of payments.
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10.6a Profit Sharing Plans (slide 3 of 3)
Weaknesses of Profit Sharing Plans
In spite of their potential advantages, profit sharing plans
are also prone to certain weaknesses.
Losses may occur during years when employee contributions
have been at a maximum.
The fact that profit sharing payments are made only once a year
or deferred until retirement may reduce their motivational value.
If a plan fails to pay off for several years in a row, this can have
an adverse effect on productivity and employee morale.
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10.6b Stock Options
Stock option plans grant to employees the right
to purchase a specific number of shares of the
company’s stock at a guaranteed price (the
option price) during a designated time period.
By allowing employees to purchase stock, the
organization hopes they will increase their productivity,
assume a partnership role in the organization, and
thus cause the stock price to rise.
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10.6c Employee Stock
Ownership Plans (slide 1 of 2)
An ESOP is an employer established trust that qualifies as a tax-exempt
employee trust under Section 401(a) of the Internal Revenue Code.
Under an ESOP, employees do not actually buy shares; instead, the
company contributes its own shares to the plan, contributes cash to buy its
own stock, or, most commonly, has the plan borrow money to buy stock,
with the company repaying the loan.
Advantages of Employee Stock Ownership Plans
Employers can provide retirement benefits for their employees at relatively
low cost because stock contributions are in effect subsidized by the federal
government.
ESOPs can increase employees’ pride of ownership in the organization,
providing an incentive for them to increase productivity and help the
organization prosper and grow.
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10.6c Employee Stock
Ownership Plans (slide 2 of 2)
Problems with Employee Stock Ownership Plans
A major problem with privately held companies is their potential
inability to pay back the stock of employees when they retire.
When large organizations suffer financial difficulties and the value of
the companies’ stocks falls, so does the value of the employees’
retirement plans.
The more retirement income comes from these plans, the more
dependent a pensioner becomes on the price of company stock.
Unlike traditional pension plans, ESOP contributions are not
guaranteed by the federally established Pension Benefit Guaranty
Corporation.
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10.7 Incentives for
Professional Employees
Offering incentives to employees conducting
more specified tasks does not work for
employees whose work is ambiguous, complex,
and requires creative thought.
For professional employees, where the task is
complex and the solution is not easy to figure out, it is
important to motivate employees to be more creative.
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Figure 10.8: Things to Consider
When Managing Professionals
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10.8a The Executive Pay Package
Executive compensation plans consist of five basic
components:
1. Base salary
Executive base salaries represent between 30 and 40 percent of total
annual compensation.
2. Short-term incentives
Annual bonuses represent the main element of executive short-term
incentives.
3. Long-term incentives
Stock options are the primary long-term incentive offered to executives.
4. Benefits
5. Perks
Perquisites – Special nonmonetary benefits given to executives
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Figure 10.9:
Types of Long-Term Incentive Plans
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Figure 10.10: CEO Pay
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10.8c Executive
Compensation Reform
Several important changes will impact future executive
compensation.
The Internal Revenue Service (IRS) always looks for tax code violations
in connection with hefty executive pay packages.
The Securities and Exchange Commission has disclosure rules that
require companies listed on the New York Stock Exchange and
NASDAQ to disclose the true size of their executive pay packages.
The Financial Accounting Standards Board (FASB) requires that stock
options be recognized as an expense on income statements.
The Dodd–Frank Wall Street Reform and Consumer Protection Act
requires companies to disclose the median total compensation of all its
employees in comparison to the total CEO compensation and gives
shareholders of a company “say on pay,” which means that voting
shareholders of a company must ultimately approve of its executive
salaries.
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