Pay for performance compensation management

ABSTRACT

Compensation is an integral part of human resource management which helps in motivating the

employees and improving organizational effectiveness. All organizations pay according to some

underlying philosophy about jobs and the people who do them.

Compensation management is more than providing a paycheck and cost of living increases. In

many organizations, employee performance relative to organizational goals serves as the basis

for compensation. The compensation systems have changed from traditional ones to strategic

compensation systems. Whether brought on by economic difficulties, changes in technology or

other business factors, compensation remains a human resources challenge.

Pay-for-performance has become increasingly popular. Companies use compensation to reward

and boost the morale of high-performing employees.

The pay-for-performance works best because there are no comparisons, no complaints, and

better results.

Biju Chandramohan AIT

INTRODUCTION

A major goal of any compensation program should be to motivate employees to perform their

best. This goal gained importance in the United States when organizations realized they were in

danger of losing markets to foreign competitors. Many programs were launched to elicit

employee cooperation and increased effort on the job, in order to make American products better

and more competitive. These programs go under a number of names, such as variable pay, merit

pay, alternative pay, incentive systems and pay-for-performance. Merit pay was introduced

based upon making pay increases within pay grades contingent upon performance. This form of

pay goes beyond pay increases within the pay grade to set up a new form of pay; a bonus based

upon a measure of performance.

Paying for performance is not ordinarily as complete a wage structure as paying basically for the

job or possibly competencies can be. Instead paying for performance is integrated within or

added to wage structures primarily based upon performance criteria. With merit pay,

performance becomes the standard by which the employee moves upward within the pay grade

for the job. In most variable pay plans performance is a factor that leads to an addition to base

pay or base pay is lowered to make room in the compensation budget for a performance reward.

DESIRABILITY

The idea of relating pay to performance is highly attractive to most managers – so much so that

almost all organizations claim that they have pay for performance at least in the form of a merit

pay system. But there is a great deal of evidence that pay for performance is not easy to

implement, not always desirable, and not as prevalent as the surveys would indicate.

Both management and employees agree that tying pay to performance is desirable. Studies do

show that managerial employees feel that their level of performance should be the most

important variable in establishing the amount of a pay increase. While not all groups of

employees rank performance that highly, to most employees performance is a significant

indicator of how much pay they should receive.

Organizations clearly perceive that pay for performance is important. Most organizations

surveyed claim that they do connect pay with performance in setting pay rates for employees.


Furthermore, the practice is spreading to more employee groups. Whereas managers have always

worked under merit pay systems, the emphasis for other employee groups has usually been

equity. But more and more emphasis on performance is extending to such nontraditional groups

as teachers.

Despite its obvious appeal, not all aspects of pay for performance are desirable. First of all, a

focus on performance often conflicts with the compensation goal of equity: in a pay-for-

performance system, employees in the same work group doing the same work may be earning

greatly different pay rates. Feelings of inequity can always arise in this situation, especially if the

program is not well designed and communicated or where people do not perceive performance as

a proper variable by which to set pay.

A second reason that pay-for-performance may not be desirable stems from the first one. The

program implicitly or explicitly puts people in competition with each other. Yet what is needed

for the work of the organizational unit to be accomplished is cooperation. Where everyone has to

work together, differential pay can have a divisive effect that may produce lower and not higher

performance for the group as a whole. This may explain why first-line supervisors are often not

as enthusiastic about pay-for-performance as higher-level managers.

A third reason that pay-for-performance may not be desirable is administrative. As will be seen

in this chapter, pay-for-performance takes managerial time and effort and must be designed and

administered carefully. Failure to put forth the managerial and staff effort required will lead to a

program that does not in fact tie pay to performance and will make employees distrust

management.

This leads to the fourth and last reason that pay-for-performance may not be desirable – lack of

trust. Pay-for-performance most often relies on the judgments of managers about the level of

performance of employees. Unless employees trust the judgment of the manager and perceive

that it is in fact their performance that is being rewarded, there is a good possibility that they will

see the program as manipulation of employees by management. The problem is that trust cannot

be entirely created by the compensation program.


PREREQUISITES

A pay-for-performance program requires a compatible organizational situation if it is to succeed.

To examine the feasibility of having pay-for- performance, it is useful to review the three

components of expectancy theory.

Valence

The first part of expectancy theory says that people must feel that the reward being offered – in

this case money – is important in satisfying their needs. Although an argument can be made that

money is the most universal instrument for need satisfaction, it is clear that its value to different

people is different. A pay-for-performance program is going to work best where pay is highly

valent to the people covered by it. This valence cannot be assumed, it must be determined by

research.

As an example, a researcher was called in to a company where a group of women seemed unable

to meet production standards despite the attractiveness of the incentives provided. He discovered

that this was a group of traditional women who believed they should not make more money than

their husbands and felt guilty about not being at home when their children got out of school. The

researcher suggested to management that the women be allowed to go home as soon as they had

met their standard for the day. The suggestion was accepted and the productivity of the group

improved immediately. These workers were not completely motivated by money. Lawler

suggests that programs such as pay for performance be installed only in units where the

employees clearly have a high need for money. In circumstances where management wants the

motivational force of pay-for-performance, then it is useful to select people who clearly have a

need for money.

The Performance-Reward Connection

It should be obvious that for pay-for-performance to work there must be a connection between

pay and performance. This is easy to say but very difficult to achieve. Organizations are complex

social systems whose members are subject to many influences on their performance at any one


time. To isolate a simple pay-performance connection is not possible. A number of problems

increase the complexity of the connection.

First of all, any compensation program tries to achieve a number of things at the same time, and

these goals are not always consistent. Second, even if the program does make the connection, the

employees must perceive the connection. Secrecy in pay is a factor that leads employees to guess

at this connection, usually inaccurately. The connection is not always a comfortable one to

employees, who may therefore try to assume it does not exist. Third, pay-for-performance is

only as good as performance appraisal – the system that defines "good" performance. A

perception that the performance-appraisal system is biased or does not appraise actual

performance destroys the connection for the employee. Performance appraisal will be discussed

later in this text.

A serious complication is that management and employees may not agree on the performance

level of the latter. Meyer studied a number of occupational groups and found that people tend to

rate their performance higher than does management. Specifically, he found that over 95 percent

of his respondents rated their performance above average; and 68 percent thought they were in

the top 25 percent in performance. If we compare such findings with the assumption of pay-for-

performance – that performance is a normal distribution – then we can see that a great many

employees are not going to perceive that their pay is related to their performance.

The Performance-Effort Connection

Employees must perceive that their effort leads to performance. A pay-for-performance program

assumes that performance varies among employees and that this difference is observable. But in

many jobs, variation is impossible or is so little that it is unrealistic to try to measure it for pay

purposes. Even if there are differences, measuring them or attributing them to the effort of the

employee may be difficult. For instance, the efforts of an individual in a group project may not

be able to be divorced from the efforts of the other members of the group. The employee may

not feel he or she controls the important measures of performance. Teachers, for example, realize

that for them the important measure is student learning, but they feel only minimal control over

that variable.


The main point is that pay-for-performance is not a solution for all motivation and performance

problems in organizations. It can be very effective where the requirements of expectancy theory

can be met. But in many circumstances its application is likely to lead to frustration and other

problems within the organization.

Defining Performance

The first two definitions of performance in the dictionary are: (1) The execution of an action, and

(2) something accomplished. In terms of an employee this would suggest that performance has to

do with what the employee accomplishes and what actions or behaviors go into creating the

accomplishment. From this, performance criteria may fall into three categories: inputs, activities

and outcomes.

Inputs

An input is what the person brings to the job. This includes the employee's knowledge, skills,

abilities and effort. A pay for knowledge plan may define performance as developing or

increasing knowledge, skills or ability, but this plan must specify exactly what is to be learned or

improved. Effort is controllable by the employee and may be a good performance factor if it can

be measured and known to lead to a desired outcome. (Note the bias toward outcomes in this

statement.)

A real problem is when the performance definition is a personal characteristic. It is common to

have such factors in performance appraisal. But the employee who is told that he/she rates low

on such a factor feels personally attacked and rated down on something that is hard to change at

best.

Behaviors

Behaviors focus on what the employee does at the job. They measure the way the job is done.

Again, the thought behind this is if the employee does the job correctly, then the desired outcome

will occur. The advantage of defining performance as a behavior is that it is more observable

than other criteria. Doing the job the way it needs to be done is very important in organizations


where work must be coordinated between employees. Some performance appraisal techniques,

such as BARS (to be discussed later), focus clearly on this definition of performance.

Outcomes

This is what usually comes to mind when the word performance is used. Outcomes are the

productivity measure of the employee, group or organization. As an example, in a conversation

with the woman who ran the Faculty Club, she said that she had four waiters and one of them

could handle more than twice the tables of any of the other three. That one waiter was clearly

more productive. Why don’t we just use outcomes as the measure of performance in all cases?

There are three reasons:

Identifying and measuring desired outcomes can be very difficult for many jobs.

The outcome may be achieved but in ways that are unacceptable. A sales person who sells a

large quantity of goods to a customer with poor credit creates more problems than the value of

the sales.

How one goes about doing the job may also be important. A bank teller who treats customers

politely is valuable to the bank, but this is not an outcome of doing the job.

Differential Performance

Differential performance is assumed to occur in organizations. It is usually desired but is also

restricted by the way jobs are designed. Assembly-line jobs are often designed so that variation

in performance is impossible or irrelevant to the desired outcomes. Variation in performance

where tight coordination of activities is necessary creates trouble and does not necessarily

increase productivity. On the other hand, jobs such as sales, engineering, and management have

a great deal of latitude in their effects on outcomes.

There is also an intermediate position between these two extremes that may be very common in

organizations. Most raters can identify those few employees who are doing an outstanding job.

Likewise, they can identify those few who are doing very poorly. But most performance-

appraisal systems ask that performance distinctions be made among all employees. It is very

likely that not only is making distinctions in the middle of the performance scale very difficult,

but also that the differences are so small as to not warrant differentiation.


Differential performance is not just an ideal; it is a fact. Some people are capable of producing

two or three times what others are, and the best as much as five or six times more than the worst.

These findings indicate that the reward system of organizations could create much higher levels

of performance and therefore productivity in employees, if it were clear to the employees that

they would be rewarded for the increased productivity. But it should be kept in mind that not all

jobs permit differences in performance and not all organizations require or desire them.

The preceding comments assume that good performance means higher output. This is certainly

an important definition of good performance, but it is not the only one. How the job is done may

also be very important. The organization may wish to reward a series of behaviors as well as the

productivity of the employee. A focus strictly on the outcomes of work, such as sales volume,

allows the organization to pay directly for those outcomes. This type of payment system – a

variable system. If the organization wishes to focus on more than just outcomes or finds it

difficult to measure the outcomes, then performance appraisal comes into play and the pay-for-

performance programs discussed here are appropriate. The distinction between these two

systems can also be seen as that between measurement and appraisal.

Program Development

A merit pay system is a particular method for determining the movement of employees within a

pay range. The goal of the program is to match employee performance levels with position in the

pay range over time.


Figure 1. The Concept of Merit Pay

Movement upward in the rate range occurs only if the employee's wage rate is lower in the pay

range than his or her performance is on the performance scale. Employees whose wage rate

exceeds their performance standing receive no increase. Merit Pay allows the organization to

move high performers upward in the rate range very fast by giving large increases to these

employees. It also allows movement downward in the rate range if the employee's performance

level goes down by freezing the wage rate at the current level.

A merit pay program requires the use of an open rate range, a good performance appraisal

system, and a guide chart for pay increases.

Open Rate Range

A pay-for-performance program relies on an open rate range. Such a rate range defines only the

minimum, the maximum, and the midpoint of the range. This rate range needs to be broad

enough so that it is possible to give large pay increases to good performers. Movement within

the pay grade is determined strictly by the performance of the employee, and the position of the

employee within the range is maintained only by good performance over time. Having reached a

particular point in the range, the employee may slip back the next time the pay structure is

adjusted if his or her performance is not as good as in the present period.


The starting point for determining a pay increase is the position of each employee in the rate

range after a pay structure adjustment has been made.

Figure 2. Pay structural adjustment in a pay-for-performance system

In this illustration there are three employees: A, B, and C. Before the structure adjustment, A

was between the first and second quartiles, B was just above the midpoint, and C was at the top

of the pay grade. After the adjustment A is at the bottom of the pay grade, B is in the second

quartile, and C is between the third and fourth quartiles. It is the newly adjusted positions that

are the starting points for determining the pay increases for the next period.

Performance-Appraisal Rank

It must be possible to place each employee upon a distribution of performance. This distribution

is assumed to be divisible into segments such as quartiles, and each individual can be identified

as being within a particular segment. This system does not allow for everyone being rated high

or low; it assumes that there is an even spread of performance – a normal distribution. If this

distribution does not appear in the ratings, spreading out the ratings along the continuum will

develop it.

Guide Chart

Rate range and performance rank are combined in a guide chart,


Figure 3. Example of a Pay-for-Performance Guide Chart

The horizontal dimension of this chart is the present position of an employee in the rate range.

The vertical dimension is the performance ranking of the employee. Each employee can be

placed in a box on the guide chart if these two dimensions are known about him or her.

The boxes in a guide chart indicate the appropriate percentage of increase that should be given to

any employee in the current period. The amounts are determined by the budgetary process and

the amount of adjustment that has been made in the wage structure. As an example, suppose that

the wage structure adjustment illustrated in figure 2 was 6 percent. If employee C's performance

during the period just ended was outstanding, then we would want to move his/her wage rate

again to the top of the rate range, a 6 percent increase. If B's performance was below average, no

increase would be called for. Finally, if A's performance was outstanding, then a maximum

increase should be granted: 12 percent according to figure 3. Note that even this increase would

probably not fully equate A's salary with his/her current performance. A continued high level of

performance would lead to larger increases and a matching of performance rating and position in

the rate range. In general, then, employees whose combination of wage rate and performance

places them on the left upper portion of figure 3 will receive above-average increases, while

those in the lower-right areas will receive small increases or no increase.


The example in figure 3 is a simple one: it varies only the amount of the pay increase with

performance and the place in the rate range. Rather than having a set percentage increase, as

illustrated here, each of the boxes could have a range, say 11 to 14 percent, so that finer

adjustments could be made for those close to the boundaries of the boxes. Even more movement

for good performers and less for poor performers can be allowed by altering the time period

between adjustments, such as giving increases to good performers every six months while

granting lower performers increases every eighteen months. Such alterations allow the top

percentages to not appear so large and the percentages at the bottom to appear larger than they

are in reality.

Comparative Study of 2 MNCs: Organization A following Pay for performance and

Organization B, pay based on experience

The pay-for-performance of Organization A is very well designed pay structure which takes into

consideration the quality of work done, the quantity of work done, independence, punctuality,

and personal development. All these factors are measured in an unbiased manner and most of

measurement is system generated. Although this organization was part of the BPO industry

which faces high attrition rates, it was found that the attrition rate in this organization was below

4%. The organization also sets industry’s best standards when it comes to quality.

On the other hand Organization B, paid its employees more on the basis of experience and the

employees of this company were highly dissatisfied, and the attrition rate in this organization

was more than 20%, and most of employees were not motivated enough nor were the employees

happy with salary structure of this organization.

Conclusion:

Pay for performance compensation structures not only account for individual, but also account

for the working environment and performance of the team as well. This can be a valuable

benefit, as knowing that compensation increases will be based on the performance of the team

will coerce employees to operate as a cohesive unit in order to reach a common goal.


Pay for performance, or P4P is a system in which employees attain increased levels of

compensation if their team, department, or company reaches specified targets. P4P has been

implemented as a motivational tactic and with an eye to persuade employees to work harder and

benefit the company while at the same time providing an added benefit for themselves.

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