Paul L. Schumann, Ph.D.

Professor of Management MGMT 440: Human Resource Management

2008 by Paul L. Schumann. All rights reserved.

Outline

What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay Incentive Pay Systems

Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation
2

What Is Incentive Pay?

Incentive pay links pay (as a reward) to performance The idea of incentive pay is to create incentives for employees to improve their job performance by linking employee pay to employee job performance Incentive pay is also called:

Pay for performance Performance-based pay systems Performance-based reward systems

The reward for performance doesnt have to be pay Pay is one possible reward, not the only possible reward
3

Why Use Incentive Pay?

We want to use pay (and other rewards) to align the goals

of each employee with the goals of the organization

This way, when employees work toward their own goals, they

are also working toward the organizations goals

If incentive pay works to enhance employee motivation,

then the advantages include:

Increased employee productivity & job performance Increased retention of high performers

Because high performers get more pay than low performers

Increased ability of the organization to achieve its objectives Lower costs

4

Does Incentive Pay Work?

Expectancy theory gives us the answer: Yes, incentive pay will motivate employees to improve their job performance, but only if 3 conditions are simultaneously satisfied:

High valence: employees must believe that the amount of the reward (incentive pay) is large enough to be valued High instrumentality: employees must believe that there is a strong link between their job performance and their rewards High expectancy: employees must believe that there is a strong link between their effort and their job performance

Effort Performance Rewards

5

Does Incentive Pay Work?

Expectancy theory (more) What can go wrong?

Effort Performance Rewards Low valences: the reward (the amount of the incentive pay increase) is too small to be valued Example: Supervisor tells a salesperson If you double your sales from $1-million to $2-million, Ill reward you with a pay increase from $50,000 a year to $50,100 a year. Example: Suppose the budget allows for pay increases up to 4% when inflation is 3%: if all the employees get a 3% pay increase (for inflation), then the employees with the best job performance might only get an additional 1%

On a $50,000 salary, 1% is only $500 for exceptional performance

6

Does Incentive Pay Work?

Expectancy theory (more) What can go wrong? (more)

Effort Performance Rewards Poor instrumentality perceptions Example: The supervisor gives everyone the same pay increase regardless of differences in job performance Example: The supervisor does a poor job of evaluating employee job performance Example: The supervisor plays favorites and gives the biggest pay increase to the employee who is the supervisors golfing buddy even though that employee has poor job performance
7

Does Incentive Pay Work?

Expectancy theory (more) What can go wrong? (more)

Effort Performance Rewards Poor expectancy perceptions Example: The employees believe that they are already working as hard as they can Example: The employees believe that there are barriers to improved job performance that are outside of their control

Does Incentive Pay Work?

Expectancy theory (more) Effort Performance Rewards

Summary: For incentive pay to work: we need to make the incentive pay increase large enough that employees want to put forth the effort to go after the incentive and we need to show employees that there is a strong link between their job performance and receiving the incentive pay increase and we need to show employees how, through their efforts, that they can successfully improve their job performance Put another way, employees need to believe: If they work at it, theyll achieve their goals, and theyll get the promised reward
9

Drawbacks of Incentive Pay

Incentive pay is more work to administer Across-the-board pay increases are easy to administer We can make mistakes Example: Link pay to the wrong measures of job performance

Unions typically oppose many types of incentive pay Fear of discrimination or favoritism by supervisors in job performance evaluations, especially for subjective measures of job performance

Unions prefer objective factors, such as across-the-board pay increases or the use of seniority

Incentive pay creates competition among workers, which weakens

worker solidarity (solidarity is necessary for union success) Unions might agree to group-based objective incentives

Example: Profit-sharing bonus

10

Incentive Pay Systems

Piece-rate: pay is a set amount per piece of production Straight piece-rate: pay is entirely on a piece-rate basis

Example: Production job

Market pay = $12 per hour Average hourly production target = 60 pieces per hour Piece-rate = $12/60 = $0.20 per piece 50 pieces 50 $0.20 = $10.00 (below market pay) 60 pieces 60 $0.20 = $12.00 (market pay) 70 pieces 70 $0.20 = $14.00 (above market pay) 80 pieces 80 $0.20 = $16.00 (above market pay)

Base pay plus piece-rate

Example: Production job

$12 per hour plus $0.20 per piece for production over 60 pieces in an hour 70 pieces $12 + [(70 60) $0.20] = $12 + [10 $0.20] = $14.00
11

Incentive Pay Systems

Taylor Plan: piece-rate with differential rates Example: Production job with 2 piece rates

Production standard = 60 pieces per hour Piece-rate #1 = $0.20 per piece if production is less than 125% of the production standard (1.25 60 = 75 pieces per hour) 60 pieces 60 $0.20 = $12.00 (market pay) 70 pieces 70 $0.20 = $14.00 Piece-rate #2 = $0.25 per piece on production over 60 pieces if production equals or exceeds 125% of the production standard (1.25 60 = 75 pieces per hour) 80 pieces (60 $0.20) + [(80 60) $0.25)] = $17.00 Recall the straight piece-rate ($0.20) paid $16 for 80 pieces

Note this makes the reward for exceeding 75 pieces bigger (increased valence), which strengthens the motivational force
12

Incentive Pay Systems

Standard hour plan: piece-rate where the standard is set in

terms of time (instead of units produced)

Method: For a job title, make a list of possible tasks For each task, establish a standard length of time that it should take to complete the task Base pay on the standard times, not actual clock times Example: Auto mechanic Market pay = $20 per hour Task: balance & rotate 4 tires Standard = 30 minutes = 0.50 hours Pay for task = $20 per hour 0.50 hours = $10.00 (no matter how long it actually takes the mechanic to do the task) Mechanic takes 15 minutes or 60 minutes Pay = $10
13

Incentive Pay Systems

Sales commissions: salespersons pay is a percentage of

his or her sales

Straight commission: pay is entirely on commission

Example: Market pay = $50,000 Sales target = $1,000,000 Commission rate = 50,000/1,000,000 = 0.05 = 5.0% Sells $900,000 Pay = $45,000 (below market) Sells $1,000,000 Pay = $50,000 (market) Base pay plus commission

14

Incentive Pay Systems

Merit pay: the employees annual pay increase is based on

the employees job performance in the previous year

We evaluate the employees job performance by using the

organizations performance appraisal system

Measure the relevant results & behaviors of the employee Objective measures of employee job performance: production measures, sales measures, personnel data, performance tests, business unit performance measures Subjective measures of employee job performance: rating scales to subjectively measure multiple aspects of job performance Management By Objectives (MBO)

We use our evaluation of the employees job performance to

decide his or her annual pay increase

15

Incentive Pay Systems

Merit pay (more) Example: Company uses the following 5-point rating scale to evaluate the employees overall job performance and to award the corresponding annual merit pay increase:

5 = Excellent = 4.0% pay increase 4 = Very Satisfactory = 3.0% pay increase 3 = Satisfactory = 2.0% pay increase 2 = Unsatisfactory = no pay increase 1 = Very unsatisfactory = no pay increase

Merit pay might be combined with a forced distribution Merit pay is widely used in the US Merit pay is used at all organizational levels
16

Incentive Pay Systems

Merit pay (more) Potential difficulties of merit pay

Supervisors can make mistakes in evaluating employee job performance & in assigning merit pay increases The mistakes weaken the instrumentality perceptions Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system The mistakes create perceptions of inequity (unfairness) If employees feel underpaid, they may reduce their contributions (reduce their effort)
17

Incentive Pay Systems

Merit pay (more) Potential difficulties of merit pay (more)

The annual merit pay increase can come months after specific instances of good performance Rewards are more effective when they are received immediately after the desired behavior or result The delay in receiving the reward will weaken the employees instrumentality perceptions

Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system

18

Incentive Pay Systems

Merit pay (more) Potential difficulties of merit pay (more)

Differences in merit pay increases may be too small to be meaningful Example: Current pay = $50,000; Suppose: Top performers: 4% merit increase $2,000 pay increase Middle performers: 2% merit increase $1,000 pay increase Some middle performers may believe that the extra $1,000 per year isnt worth the extra effort required to become a top performer

At 2,000 annual work hours, the $1,000 difference works out to an extra $0.50 per hour when theyre making over $25 per hour

Result is low valences Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system
19

Incentive Pay Systems

Merit pay (more) Potential difficulties of merit pay (more)

Merit pay budgets can vary from year to year Result is that the same job performance may get different rewards depending on whether its a good year or a bad year If the same job performance is rewarded differently from one year to another, then:

It weakens the instrumentality perceptions

Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system

It create perceptions of inequity (unfairness)

If good-performing employees feel under-rewarded in the bad years when merit pay increases are smaller, then employees may reduce their contributions (reduce their effort), especially in the bad years
20

Incentive Pay Systems

Merit pay (more) Potential difficulties of merit pay (more)

Merit pay increases become part of the employees base pay in future years, even if the employees job performance isnt so good in the future years We end up continuing to reward the employee in the future for job performance that might have been years in the past Example:

2005 new hire pay = $50,000 at end of 2005, performance rating = 5 merit pay increase = 4% ($2,000) 2006 pay = $52,000 at end of 2006, performance rating = 3 merit pay increase = 2% ($1,040) 2007 pay = $53,040 at end of 2007, performance rating = 1 no merit pay increase 2008 pay = $53,040 the employee is still being rewarded in 2008 (and beyond) for performance in 2005 & 2006

This weakens the instrumentality perceptions Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system

21

Incentive Pay Systems

Bonus: employee receives a one-time lump-sum payment for meeting a performance goal Performance goal might be:

Individual employees performance goal

Example: Salespersons goal is to achieve at least $2-million in sales Example: Companys goal is to achieve earnings-per-share of at least $3.15

Organizations performance goal

The bonus amount does not become part of the employees base pay Example: 2005 new hire pay = $50,000 at end of 2005, performance rating = 5 bonus = $2,000 total pay = $52,000 2006 pay = $50,000 at end of 2006, performance rating = 3 bonus = $1,000 total pay = $51,000 2007 pay = $50,000 at end of 2007, performance rating = 1 bonus = $0 total pay = $50,000 2008 pay = $50,000 This strengthens the instrumentality perceptions Effort Performance Rewards Increases the motivational effectiveness of the incentive pay system

22

Incentive Pay Systems

Skill-based pay (pay-for-knowledge): pay is based on work-

related skills, not seniority or job performance

Example: New hire receives initial training to perform the entry-level job and is paid at the entry-level rate As the employee completes training and becomes qualified to perform additional jobs, the employee is rewarded with pay increases The employee is typically paid at the pay rate associated with the highest paid job for which the employee has been qualified regardless of which job the employee actually performs on any given day Creates incentives for employees to complete training, learn

new skills, & become qualified to do additional jobs Creates a flexible workforce

23

Incentive Pay Systems

Profit sharing: some of the companys profits are shared with the

employees

Ties each employees pay to the profits of the business

Purpose: alignment of employees goals with companys goals

Strengthens the employees stake in the companys profitability

Example:

Company establishes a minimum profit level as a goal If actual profits exceed the goal, a percentage of the excess is divided up among the employees Current distribution plans (cash plans): profit sharing paid as a bonus in the form of cash or shares of the companys stock Deferred payout plans: profit sharing paid as a bonus into a trust fund to be distributed to employees at some time in the future (such as when the employee retires, becomes disabled, or dies) Combination plans
24

Types of profit sharing plans:

Incentive Pay Systems

Gain sharing: when employees make a suggestion that

improves the organization, a percentage of the organizations gain from the suggestion is shared with the employees who made the suggestion
Example: Employees make suggestions Management reviews the submitted suggestions, determines the improvement (gain) from each suggestion, and decides which suggestions to implement A percentage of the gain from a suggestion is shared with the employees who made the suggestion Types of gain sharing: Scanlon Plan, Rucker Plan,

Improshare, & Winsharing

See Fisher, Schoenfeldt, & Shaw (2006), Table 12.5, p. 553, for a comparison of the types of gain sharing
25

Incentive Pay Systems

Employee Stock Ownership Plan (ESOP): the company

facilitates employees owning stock in the company

Methods of distributing stock to employees:

As a bonus directly to employees Example: for every 2 shares an employee buys, the company gives the employee 1 share Example: employees can buy shares for 85% of the current stock market price

26

Incentive Pay Systems

Executive compensation If the goal of executive compensation is to create a pay system in which what is in the best interest of the stockholders also brings the greatest reward to the executives, then the pay of executives should:

Be tied to the performance of the company through incentive pay systems such as bonus plans for the achievement of shortrun goals (such as profits) And use the granting of shares of stock in the company or stock options for the creation of long-run incentives

27

Outline

What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay Incentive Pay Systems

Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation
28