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
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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
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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

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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

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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.

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
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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
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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

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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 is widely used in the US Merit pay is used at all organizational levels

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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)
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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

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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
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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

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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

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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

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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)

Types of profit sharing plans:

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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
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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 Into a trust (such as the companys 401(k) pension plan) Company contributes shares of stock into the trust Shares in the trust are allocated to individual employee accounts Employees become vested over time (cliff after 5 years, or graded over 3 to 7 years) When an employee leaves the company (e.g., retirement), they receive the current market value of their vested shares in the trust
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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

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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
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