AMA Summer 2009 Session 18 1. What Is Incentive Pay? Linking pay to job performance Also known as: Pay for performance Performance-based pay systems Performance-based

AMA Summer 2009 Session 18 1

What Is Incentive Pay? Linking pay to job performance Also known as: Pay for performance Performance-based pay systems Performance-based reward systems Pay is one possible reward, not the only possible reward 2

MEANS OF COMPENSATION Four basic parts of executive compensation packages: Base salary. Allowances. Incentives. Perquisites.

Compensation System Components

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 20025 Variable Pay (payment by output) Straight Salary (payment by input) depends on measure of what comes out Amount of time spent has no relevance Problem: Output not always easy to measure Examples: Agricultural workers: piece rates A salesperson on straight commission Compensation of top executives Time/ effort related Compensation Independent of output consideration Problem: Input not always easy to measure Wage per work hour Monthly salaries Annual salaries Payment by Input Vs. Payment by Output

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 20026 Measuring Performance Objective Performance Measure: Easily observable and quantifiable, e.g. parts produced, hours worked Subjective Performance Measures: Based on personal opinion of a supervisor, customer, peers, etc. Type of evaluat. Database objectivesubjective Outputrevenue, dividendcustomer satisfaction Inputtimequalification

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 20027 BasisVariables for output-based pay Quantity of production pieces, weight, size/height Quality of production Rejects, grade, customers satisfaction, targets Input reduction Reduction in raw material, energy, work time Capacity utilization slack-, repair- and waiting periods Be on schedule Timeliness vis vis internal /external customers Value of the firm stock price, economic value added Different Variables as Basis of Output- Pay

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 20028 Advantages of output-based pay Selection effectMotivation effect efficient workers with a high productivity will join the firm/stay inefficient workers with a low productivity will not join/leave the firm output-based pay motivates workers to put forth more effort Output-Based Pay Source: www.kone.fi

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 20029 World BookBritannica Offered compensation schemevariable pay: W = $ 100. xfixed salary: W = $ 500 Labor costs of 10 sets; Cost per set $ 1,000 $ 100 per set$ 500 $ 50 per set What type of salesperson will stay with the firm? high productive sp. x 5 low productive sp. x 5 Labor costs of 3 sets; Cost per set $ 300 $ 100 per set$ 500 $ 166,67 per set Selection Effect: An Example of Compensating Salespeople

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200210 500 A (World Book) B (Britannica) W... Weekly Pay x... Number of encyclopedia 5 3 30 0 Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will stay at Britannica Selection Effect: An Example of Compensating Salespeople (cont.)

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200211 Variable pay Straight salary Doesnt depend on exogenous factors low-risk form of compensation Workers are insured against volatilities Firm provides the insurance for risks Lower compensation level Can not participate in good economic development Weaker incentives Depends on effort and exogenous risks risky form of compensation Firm should smooth out exogenous risks from workers compensation Firm should bear exogenous risks but endogenous risks should remain with workers Trade-off: More risk,higher compensation Opportunity: share economic development Stronger incentives Disadvantages of Output-Based Pay

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200212 Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to count Appropriate compensation schemes could solve this problem Example: Typists compensation Errors p. pagePrice p. pageMinutes p. pageRevenue per hour 0$ 820$ 24 1$ 715$ 28 2$ 512$ 25 3$ 310$ 18 4$ 09 5 8 Compensation Schemes Balancing Quantity and Quality

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200213 Hourly wages Monthly salaryAnnual salary Input-based pay Production workers Top Management Managerial workers High correlation between effort and time invested Time input as a pretty good indicator for effort Low correlation between effort and work time Time input = bad measure for effort overinvestment in easy (pleasant) tasks Undefined set of tasks (goal), discretion over work Importance of other incentives to motivate for effort (long-term, e.g. stock options) Using the Appropriate Time Unit

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200214 Forms of Incentive Pay Rewards can consist of anything that employees value E.g Piece rates and commissions Bonuses Days off Promotion Training Stock ownership Health care plan Housing Education for kids Retirement Plan Party

Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A.Beijing, Sept. 200215 Criticism to Incentive Compensation Money does not motivate It is difficult to design effective incentive schemes Incentives certainly entail costs The major problem is to design incentive schemes where the benefits exceed the costs

Why Use Incentive Pay? To align employees goals 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 16

Does Incentive Pay Work? Expectancy theory gives us the answer: Yes, it can motivate employees to improve their job performance, if 3 conditions are simultaneously met : 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 17

Does Incentive Pay Work? What can go wrong? Effort Performance Rewards Low valences: the reward 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 18

Does Incentive Pay Work? 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 even though that employee has poor job performance 19

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 20

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 21

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 22

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 23

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) Sells $1,000,000 Pay = $55,000 (above market) Base pay plus commission 24

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 25

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 26

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) 27

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 28

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 29

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 30

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 31

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 Organizations performance goal Example: Companys goal is to achieve earnings-per-share of at least $3.15 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 32

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 33

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 Types of profit sharing plans: 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 34

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 35

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 36

Incentive Pay - Executive Compensation Aligning with organizational objectivereate 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 short- run 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 37

Documents

AMA Summer 2009 Session 18 1. What Is Incentive Pay? Linking pay to job performance Also known as: Pay for performance Performance-based pay systems Performance-based