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68 Int. J. Human Resources Development and Management, Vol. 6, No.

1, 2006

Variable pay: its impact on motivation


and organisation performance

Mary Jo Ducharme*
Human Resources Management,
School of Administrative Studies, York University,
Toronto, Ontario, Canada
E-mail: ducharme@yorku.ca
*Corresponding author

Mark Podolsky
DeGroote School of Business,
McMaster University, Hamilton, Ontario, Canada
E-mail: podolsmg@mcmaster.ca

Abstract: Variable pay is commonly associated with many positive individual


and organisation level outcomes, and yet the literature suggests that variable
pay plans in general are failing to provide individual performance results.
Improved organisation level measures may be more attributable to the inherent
financial changes that accompany variable pay plans than to human resources
principles. It is suggested that the true strategic advantage that can be derived
from motivating employees through variable pay has yet to be fully realised or
measured. Implications for theoretical and empirical study are discussed.

Keywords: variable pay; performance; organisation performance; motivation;


reinforcement theory; pay-for-performance; incentive compensation; firm
performance.

Reference to this paper should be made as follows: Ducharme, M.J. and


Podolsky, M. (2006) ‘Variable pay: its impact on motivation and organisation
performance’, Int. J. Human Resources Development and Management, Vol. 6,
No. 1, pp.68–76.

Biographical notes: Mary Jo Ducharme is an Assistant Professor of Human


Resources Management in the School of Administrative Studies at York
University. Her research interests cover a wide variety of topics in HR,
including pay expectations, reward systems, and performance management.
She earned her PhD in Industrial/Organisational Psychology at the University
of Guelph.

Mark Podolsky is a PhD student at the Degroote School of Business, McMaster


University. His research interests include compensation and performance
measurement, and measuring the effectiveness of HR practices. He is currently
on leave from the compensation team at TD Bank, where he focused on the
merit program for TD as well as incentive compensation programs for the
Marketing, IT, HR, and Wealth Management groups. Prior to receiving his
MBA from Wilfrid Laurier University in 2001, he was a professional musician
and the Personnel Manager for the Kitchener-Waterloo Symphony.

Copyright © 2006 Inderscience Enterprises Ltd.


Variable pay: its impact on motivation and organisation performance 69

1 Introduction

Performance-based variable compensation has become a fixture in the organisational


landscape. With purported advantages ranging from increased firm performance,
employee motivation, pay satisfaction, and job satisfaction to reduced absenteeism and
turnover (Heneman, 1992), it is no surprise that 78% of North American organisations
and an increasing number of organisations globally have implemented variable pay plans
(Hansen, 2005). However, little empirical evidence exists that clearly demonstrates
whether variable pay plans have the ability to motivate employees to perform better or in
greater harmony with organisational goals. It is possible that by transferring a portion of
the fixed costs of compensation to variable costs, organisations can reap a host of rewards
that have nothing to do with human resource principles, and that it is these benefits that
may be the driving force behind the widespread increase in variable compensation plans.
Organisations that are able to effectively use variable pay to motivate employees are
likely in the minority, and it is those organisations that are in a position to derive a
strategic benefit from variable pay.
Variable pay is a type of pay-for-performance compensation plan where one-time
lump-sum payments based on performance are added to pay (Agarwal, 1999). This type
of compensation plan has become very popular, and its global usage has dramatically
increased over the past decade (Hansen, 2005; McClenahen and Purdum, 2004;
Smilko and van Neck, 2004). Why has this type of compensation plan become so popular
that most organisations worldwide are implementing some form of variable pay (Towers
Perrin Monitor, 2004)? Two reasons are frequently sited in the literature:
• there is a widespread assumption that variable pay leads to motivation and increased
performance (Agarwal, 1999; Heneman et al., 2002)
• variable pay reduces fixed operating costs by transforming a portion of fixed
compensation costs to a variable cost, and by reducing total compensation costs in
periods of poor organisational performance (Agarwal, 1999).
Variable pay comes in many forms, but the main factors that distinguish the different
types include:
• whether the payment is added to base salary or is a one-time payment
• the performance aspects that determine the payment.
Heneman (1992) refers to merit pay as a form of performance pay that is based on
individual performance and added to base salary. These features differentiate merit pay
from other performance incentives such as profit sharing, gainsharing, or team incentives,
which frequently have some form of group or organisational performance influence in
addition to measures of individual performance, and must be re-earned every
performance period. When referring to variable pay or incentive compensation plans in
this paper, we are discussing the type that uses a group or organisational performance
influence, and that must be re-earned.
70 M.J. Ducharme and M. Podolsky

2 Does variable pay motivate performance?

Much of the foundation of variable pay is based on aspects of what has come to be
known in the compensation literature as reinforcement theory (Heneman, 1992), which
has been thoroughly described by authors such as Skinner (1948). Briefly, the operant
conditioning aspect of this theory purports that a behaviour will increase in frequency if it
is followed by a pleasant outcome (positive and negative reinforcement). Conversely,
a behaviour will decrease in frequency if it is followed by an unpleasant outcome
(positive and negative punishment). There are two tenants of operant conditioning and
they are both of particular relevance to this discussion:
• the outcome must be contingent on the behaviour, meaning that the reward
presentation clearly depends on the execution of the proper behaviour. If the reward
is presented occasionally without the proper behaviour the contingency is weakened
• the reward must be contiguous or presented immediately following the proper
behaviour (Skinner, 1948). Motivation decreases when there is a lengthy delay
between the target behaviour and the reward.
These principles gave rise to the use of variable pay as a motivational tool, and
compensation professionals refer to them collectively as line of sight. However, it would
appear, based on the research and published case study evidence that variable pay plans
in general are failing to provide individual performance results (Brown, 2002; Beer and
Katz, 2003; Budman, 1997). Furthermore, many variable pay designs are moving away
from the principles of reinforcement theory, thereby blocking this line of sight. Many
compensation plans are:
• designed so that the pay-off is long-term (three to five years), which violates the
principle of contiguity
• complex in design and involving so many variables that the employee is not able
to easily see the connection or contingency between their behaviour and the reward
• often based to some degree on organisational performance, which has little to do
with the individual behaviours of most employees.
While reinforcement theory has been shown to be very effective in shaping behaviour
and motivating behaviour change in other settings, based on these violations of its
principles, it would not be effective in motivating individual performance. Indeed, while
many site the value of variable pay in terms of its motivating capacity, there is very little
empirical evidence that demonstrates that this is the case. Hiltrop (1996) points out that
while the HR practices that are theoretically or empirically associated with firm
performance vary within the literature, variable pay emerges as one of the most
frequently mentioned successful practices. Empirical studies have linked variable pay
plans with firm-level measures of success, including productivity measures such as
sales or units per worker, accounting-based measures such as ROA and gross rate
of return on capital, and market-based measures such as stock price and Tobin’s Q
(Banker et al., 1996; Delaney and Huselid, 1996; Huselid, 1995; Lazear, 2000). However,
few studies have attempted to determine whether variable pay has a motivating effect on
the individual. Based on reinforcement theory, one can predict that those variable pay
plans that make clear the line of sight between one’s individual performance and one’s
Variable pay: its impact on motivation and organisation performance 71

reward package will motivate individual performance. To date, however, there is no


direct evidence that variable pay has an effect on motivation.
Based on reinforcement theory, the root notion of variable pay should motivate
performance. However, many variable pay plans are complex, long-term, and based on
organisational performance; all factors which would decrease the contingency or line of
sight between an individual’s performance and reward. If one or more of these factors are
included in a variable pay plan, reinforcement theory would predict that the plan would
not be as motivating. Thus, since many variable pay plans do include one or more of
these factors (complexity, long-term pay-offs or organisational-level targets), it is not
surprising that evidence to support a link between variable pay and individual
performance is scant.

3 The role of variable pay in enhancing firm performance

Taking a pragmatic view of variable pay from the perspective of the organisation,
there are benefits brought by the use of performance-based variable pay plans that are
totally independent of HR considerations. For example, even when holding total
compensation costs constant, a firm’s operating leverage is lowered by the introduction
of a variable pay plan (Burke and Terry, 2004; Gerhart and Trevor, 1996). Operating
leverage is measured as the percentage of fixed costs to total (fixed plus variable)
costs (Horngren et al., 1999). It is an indication of a firm’s risk in that the income of
organisations with lower levels of operating leverage (those with more variable costs)
is less responsive to changes in revenues than the income of organisations with higher
levels of operating leverage (as shown in Figure 1).

Figure 1 Income comparison of high fixed versus high variable costs


72 M.J. Ducharme and M. Podolsky

Lower volatility in income leads to lower firm-level risk (β), which in turn is a key
determinant of a firm’s required rate of return. A lower β is associated with a lower
required rate of return, which affects a firm’s total cost of acquiring capital. All else
equal, a lower cost of capital can lead to a higher firm valuation for investors and analysts
who use common firm valuation tools such as the discounted dividends model,
discounted abnormal earnings, and discounted cash flow analysis (Palepu et al., 2000).
Thus, a higher level of variable costs has the effect of decreasing the variability of
income. This has a meaningful impact on the firm and on the common methods by which
firm values and stock price expectations are set. By simply converting a portion of the
same overall level of compensation costs from all fixed to a blend of fixed and variable
costs, an organisation lowers its own measure of operational leverage and potentially
lowers its measure of beta. Both measures are of interest to investors and analysts
in that for two otherwise identical firms, the one with lower operating leverage and lower
β should be worth more.
Another benefit of higher levels of organisational performance-based variable
compensation is that a larger portion of the total payroll will increase or decrease with
organisation performance. This leaves the organisation better able to meet its payroll in
any competitive environment, and can function as a more stable employer by not having
to terminate or lay-off employees in response to short-term economic conditions. This
can have positive reputation and cost-saving implications for the firm (Gerhart and
Trevor, 1996).

4 Converting fixed costs to variable costs

A recent Hewitt survey showed that base salary costs have risen at a remarkably slow
pace since 2003, and may continue to do so over the foreseeable future (Hansen, 2005).
The survey further reveals that organisations are spending more on variable pay
programs. One possible explanation is that firms are maintaining market-competitive
pay rates by changing the total compensation mix to carry a stronger weighting of
variable pay. This implies that firms may be increasingly converting fixed costs
to variable costs not by reducing base salaries outright, but by reducing the proportion of
base salary in total compensation through the application of market increases to the
variable component of total compensation.
When payout levels and operating leverage are reduced through variable pay tied to
organisational level measures of performance, the firm benefits from improvements in
many of the most important measures of success. For example, where compensation costs
comprise a relatively small proportion of expenses, the cash savings from reducing
incentive payouts can have a noticeable impact on measures of business risk, efficiency,
and profitability ratios such as net profit margin, ROE, and earnings per share, and
growth ratios such as price/earnings. The effect of decreasing variable pay costs in
low-performing years increases as compensation costs comprise a larger proportion of
total expenses.
Variable pay: its impact on motivation and organisation performance 73

5 Variable pay as a means of transferring risk

In short, many of the indicators of firm performance, measures that are used to compare
competitor firms within and across industries, are noticeably improved by implementing
performance-based variable pay plans that reduce payouts in periods of poor firm
performance. These improvements can have the appearance of a strategic advantage.
However, this advantage is achieved through the transfer of risk from the firm to the
employee. The question of how much risk the employee is willing to take has not yet
been addressed in the research on variable pay, and could be another variable that
impacts the motivational ability of variable pay. Bloom and Milkovich (1998) found
support for their hypothesis that higher levels of business risk are associated negatively
with the use of variable pay. As their measure of business risk included variability in
income stream, it is possible that their results were demonstrating the above-mentioned
phenomenon; that the use of variable pay decreases organisational business risk.
In a study that measures business risk differently, Stroh et al. (1996) found that managers
in higher risk organisations receive a higher proportion of their income in the form of
variable pay than managers in lower risk organisations. Their findings also show that
employees in higher risk firms do not receive higher overall compensation than
employees in lower risk firms, which indicates that organisations receive a no-cost
benefit by off-laying a portion of business risk on employees.
The discussion about variable pay improving measures of firm performance, and of
decreasing business risk raises the question that if the mere presence of variable pay can
increase measures of firm performance, how are the intended benefits of variable pay,
such as motivation and increased individual performance being measured, and what role
do these attributes play in the relationship between variable pay and firm performance?

6 Conclusions

Variable pay as an organisational compensation practice is on the rise. Based largely on


anecdotal evidence of its motivational properties, and based on concrete evidence of its
power to reduce fixed costs, organisations globally are implementing variable pay plans
in an effort to remain current in their compensation practices.
It has become commonplace in the literature to refer to the motivational aspects of
variable pay plans, despite the dearth of concrete evidence of its success in this area. This
assertion, in combination with the other aspects of variable pay, such as the
transformation of fixed costs and business risk associated with its implementation, we
believe is misleading, or even deleterious to human resources management in several
ways.
First, while there is a possibility that well-designed variable pay plans do have a
positive impact on individual performance, this remains to be demonstrated. More
research is needed to determine how HR can utilise variable pay to realise performance
improvements. Currently, the designers of compensation plans are presented with a
confusing variety of approaches to variable pay, and not much research on which to base
their decisions. Given its other financial benefits, it is likely that variable pay plan usage
will continue to increase. Unless more research and direction to increase the efficacy of
variable pay plans is forthcoming, organisations will be missing out on an opportunity to
74 M.J. Ducharme and M. Podolsky

gain true strategic advantage. This missed opportunity will be due to organisational
human resource practices.
Second, we hope that it has been demonstrated how the financial benefits of the
implementation of a variable pay plan transfers risk to the employee resulting in lower
organisation-led turnover, and the appearance of better organisational performance. It is
possible that there is confusion regarding the role that variable pay plays in successful
organisational performance. In years when financial performance is weak, organisations
that utilise variable pay transfer a portion of the financial decrement on to their
employees (i.e., in a bad year, they pay out less to employees), thereby buffering the
impact of a bad performance year. Also, the decreased volatility of income due to lower
operating leverage can lead to higher stock price expectations from analysts and
investors. Several studies have been reported in the literature indicating that following the
implementation of a new variable pay plan, organisational performance increased and
turnover decreased (Gerhart and Trevor, 1996; Milkovich and Milkovich, 1992).
We believe that these findings have added to the assumption that variable pay motivates
individual performance which in turn increases organisational performance, when it is
entirely possible that individual motivation has little to do with the improved
organisational performance noted in organisations that implement variable pay plans.
HR managers need to be aware that there are other financial factors involved.
Improvements in certain measures of organisational performance do not necessarily
indicate that they have designed an effective variable plan which motivates performance.

7 Directions for practice and research

Based on reinforcement theory, variable pay should motivate performance. However,


current compensation practices make it unlikely that the principles of reinforcement
theory enter into variable pay plan design. Variable pay plans that are complex, have
long-term pay outs, and are based on organisational performance would not be very
effective in motivating performance. More research is required to determine if variable
pay plans affect performance, and if so, what aspects of the design of these plans make
them more likely to be successful in this way. Confusing the issue, several different
theoretical approaches to variable pay have been well developed such as expectancy
theory (Vroom, 1964), justice theory (Greenberg, 1987), and reinforcement theory
(Skinner, 1948), among others. Research could help to determine which theoretical
approach is most appropriate.
While agency theory predicts that employees are risk-averse, and will therefore
require an inducement to forego straight base salary for a mix of base salary and variable
pay, research does not find evidence that employees receive additional compensation
for taking on the increased risk associated with variable pay (Stroh et al., 1996).
The implication from agency theory is that employees would not choose a variable pay
plan over straight salary unless paid to do so. Recent trends indicate that base salary
comprises a smaller portion of total pay (Hansen, 2005), and yet there remains little
research or evidence to indicate the effect of increased risk on employee attitudes and
behaviours as they pertain to variable pay, the degree to which employees will be willing
to accept the risk associated with all variable pay plans, or the degree to which managers
are willing to expose employees to such pay risk.
Variable pay: its impact on motivation and organisation performance 75

Reinforcement theory suggests that it is possible, however, to leverage the


organisational benefits brought about by moving payroll costs from a fixed to a variable
amount to include increased employee performance. By moving toward simpler
compensation plans that increase line-of-sight, and minimising the impact and
importance of distal performance measures such as organisation-level performance on
which employees could not expect to have any direct impact, practitioners could remove
many of the barriers that may be preventing variable pay plans from motivating as they
could.
The lack of evidence of the link between variable pay, motivation, and organisational
performance may be partly attributable to the multi-level nature of these issues. Research
must move beyond the relation between pay and organisation-level performance to focus
more on the contextual nature of variable pay plans, such as the types of plans being
used, the degree of organisational support for the plans through feedback and attention to
justice issues, and the degree of employee acceptance of the variable pay plans. This
requires that information be gathered at the organisation level, the unit or team level, and
at the employee level. Klein and Kozlowski (2000) suggest that individual-level
perceptions can be averaged to represent higher-level group, subunit, or organisational
phenomena when people in groups and subunits are exposed to common features, events,
and processes. By capturing and aggregating employee attitudes towards variable pay
plans, motivation, and work, team-level attitudes, and organisational or business-unit
level information about the use of and support for variable pay, researchers can gather
information at all relevant levels of study. The relation between aggregated motivation
levels and measures of unit-level and organisation-level performance could clarify the
link between the use of variable pay and organisation-level performance. Furthermore,
this method would avoid the potential measurement issue of attributing a financial
statements effect (the transformation of fixed costs to variable costs) with a human
resources management effect (increased performance through motivation) by measuring
the relation between motivation and performance rather than variable pay and
performance.
The intent of this paper is not to cast doubt on the motivational capabilities of
variable pay, but to bring attention to the issue that some of the benefits that are currently
associated with variable pay plans in the literature may have little to do with human
resource principles. By employing multi-level models and measures of the motivational
effects of variable pay plans, both researchers and practitioners can develop an enhanced
understanding of the impact that variable pay has on the individual, and how that
individual response is translated into an organisational or team-level effect. Those
organisations that are able to capture and demonstrate the motivational influence of
variable pay will be able to extract the full benefit from their compensation system, and
will be in a position to demonstrate a true strategic human resource advantage.

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