Pay for Performance

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Chapter 10Pay-for-Performance Plans

Milkovich/Newman: Compensation, Ninth EditionMcGraw-Hill/IrwinCopyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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STRATEGICPOLICIESTECHNIQUESSTRATEGICOBJECTIVES

EFFICIENCY Performance Quality Customers Stockholders CostsFAIRNESSCOMPLIANCE

ALIGNMENTCOMPETITIVENESSCONTRIBUTIONADMINISTRATIONWork Descriptions Evaluation/ INTERNAL Analysis Certification STRUCTUREMarket Surveys Policy PAY Definitions Lines STRUCTURESeniority Performance Merit INCENTIVE Based Based Guidelines PROGRAMSPlanning Budgeting Communication EVALUATION

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Employee performance depends on three general factors:Employee performance = f (S,K,M)where:S = Skill and ability to perform taskK = Knowledge of facts, rules, principles, and proceduresM = Motivation to perform

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What Behaviors Do EmployersCare About?How do we get good employment prospects to join our company?How do we retain these good employees once they join?How do we get employees to develop skills for current and future jobs?How do we get employees to perform well on their current job?

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What Motivates Employees?In the simplest sense, motivation involves three elements:1. what is important to a person, and2. offering it in exchange for something 3. desired behavior

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Components of a Total Reward System

1. CompensationWages, Commissions and Bonuses 2.. BenefitsVacations, Health Insurance 3. Social InteractionFriendly Workplace 4. SecurityStable, Consistent Position and Rewards 5. Status / RecognitionRespect, Prominence Due to Work 6. Work VarietyOpportunity to Experience Different Things 7. WorkloadRight Amount of Work (not too much, not too little) 8. Work ImportanceIs Work Valued by Society 9. Authority / Control / AutonomyAbility to Influence Others; Control Own Destiny10. AdvancementChance to Get Ahead11. FeedbackReceive Information Helping to Improve Performance12. Work ConditionsHazard Free13. Development OpportunityTraining to Learn New Knowledge / Skills / Abilities

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See text, Exhibit 9.3 on page 289

WageComponentsCost of LivingIncreaseBase PayMerit PayLump SumBonusIndividualIncentiveSuccessSharing PlansGain SharingProfit SharingRiskSharing Plans

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See Exhibit 9.3, pages 289-290 in the text

The Fit Between People and RewardsPerson CharacteristicsPreferred Reward CharacteristicsMaterialisticRelatively more concerned about pay levelLow Self-EsteemLow self-esteem individuals want large, decentralized organization with little pay for performanceRisk TakersWant more pay based on performanceIndividualists(I control my destiny)Want pay plans based on individual performance, not group performance

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See Text page 294

Pay for performance plans signal a movement away from entitlements

Pay will vary with some measure of individual, team, or organizational performanceWhat Is Pay-for-Performance?

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Overview: Pay-for-Performance PlansUse of Different Variable- Pay-Plan TypesBase vs. Variable Pay

Increasing interest in variable payCompetition from foreign competitorsFast-paced business environment

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Exhibit 10.1: Use of DifferentVariable-Pay-Plan Types

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11See Exhibit 10.1, page 309

Exhibit 10.2: Base vs. Variable Pay

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Specific Pay-for-Performance Plans: Short Term Merit Pay Lump-Sum Bonuses Individual Spot Awards Individual Incentive Plans

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Merit PayA merit pay system links increases in base pay to how highly employees are rated on a subjective performance evaluationIssuesExpensiveDoesnt achieve the desired goal: improving employee and corporate performanceVery small impact on performance.

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Managing Merit PayImprove accuracy of performance ratingsAllocate enough merit money to truly reward performanceMake sure size of merit increase differentiates across performance levels

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Lump-Sum BonusesIncreasingly used substitute for merit payEmployees receive an end year bonus that does not built into base payViewed as less of an entitlement than merit pay because it must be earned by employees.Less expensive than merit pay over the long run

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Exhibit 10.3: Relative Cost Comparisons

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Individual Spot AwardsViewed as highly or moderately effectiveTypically awarded for exceptional performanceSpecial projectsExceptional performance

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Exhibit 10.4: Customer Service Bonus Scheme

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Overview: Individual Incentive PlansOffer a promise of pay for some objective, pre-established level of performance eg Cellular One car phone installationCommon feature - An established standard against which employee performance is compared to determine magnitude of incentive pay

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Individual Incentive Plans: TypesDimension on which incentive systems vary Method of rate determinationSpecified relationship between production level and wages

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Exhibit 10.5: Individual Incentive Plans

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Straight Piecework SystemRate determination is based on units of production per time period, and wages vary directly as a function of production level.Easily understood by the worker and readily accepted by them.

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Standard Hour PlanIt is a plan setting for the incentive rate based on completion of a task in some expected time period. Eg automobile repair shopIt is practical than straight piecework plans for long-cycle and jobs that are non repetitive and require numerous skills for completion.

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Bedeaux PlanThis plan requires division of a task into simple actions and determination of the time required by an average skilled worker to complete the action.

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Taylor PlanThis plan provides for variable incentives as a function of units of production per time period.It provides for different piece rates, depending on the level of production relative to the standard.

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Taylor PlanIt establishes two plans One rate goes into effect when a worker exceeds the published standard for a given period of time.This rate is set higher than the regular wage incentive level.

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Taylor PlanA second rate is established for production below standard, and this rate is lower than the regular wage

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Merrick PlanIn this plan there is three piecework rates:High- for production exceeding 100 percent of standardMedium for production between 83 percent and 100 percentLow for production less than 83 percent

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Halsey 50-50 PlanThis method derives its name from the shared split between worker and employer of any savings in direct cost..An allowed time is fixed for the completion of a work and if work is completed within the standard time the savings is allocated between the worker and employer 50-50 proportion

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Rowan PlanPlan same as Halsey but workers bonus increases as the time required to complete the work decreases.

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Gantt PlanThe standard time for a task is purposely set at a level requiring high effort to complete.Worker failing to complete the task in the standard time is guaranteed a pre-established wage.If task completed, earnings are payed at 120 % of the time saved.Hence workers earnings increase faster than production whenever standard time is met .

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Advantages ofIndividualized Incentive PlansSubstantial contribution to:Productivity raiseLower production costsWorkers earningsReduces direct supervision to maintain reasonable output levelsEnables labor costs to be estimated more accurately Helps costing and budgetary control

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Conflicts may emerge between employees and managersIntroduction of new technology may be resisted by employees Reduced willingness of employees to suggest new production methods Increased complaints of poor maintenance, hindering employee efforts to earn larger incentivesDisadvantages ofIndividualized Incentive Plans

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Increased turnover among new employees discouraged by the unwillingness of experienced workers to cooperate in on-the-job trainingElevated levels of mistrust between workers and management

(cont.)

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Team Incentive PlansGroup Incentive Plans focus on people working together.A Standard is established against which group performance is compared to determine the magnitude of the incentive pay.Team Incentive plans improved customer satisfaction, raised sales performance and lowered turnover rates.

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Team Incentives Improve organizational performance Use organizational measures Measured periodically

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Team Compensation: Issues and ProblemsMany varieties of teamsLevel problemComplexityControlCommunication

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Company rewarding systemCompany set team performance standards based on :Productivity improvementCustomer satisfaction measuresFinancial performanceQuality of goods and services etc

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Gain-Sharing PlansEmployees earn bonuses tied to unit-wide performance as measured by a predetermined, gain sharing formula

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ContGain sharing looks at cost components of income ledger and identifies savings like:Reduced scrapLower labour costReduced utility cost etc

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How does Gain sharing work? A Company shares productivity gains with the workforce. Workers voluntarily participate in management to accept responsibility for major reforms. This type of pay is based on factors directly under a workers control (i.e., productivity or costs). Gains are measured and distributions are made frequently through a predetermined formula. Because this pay is only implemented when gains are achieved and gain sharing plans do not adversely affect company costs.

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Example of Gain sharing formulasCalculate gain in hours The actual hours worked minus the expected hours (for the given level of output) equals the gain in hours.

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When does Gain sharing work best Works best when company performance levels can be easily quantified. Employee involvement significantly enhances the effectiveness of incentive pay. When used simultaneously, productivity gains from combining these techniques can exceed gains achieved separately.

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Key Elements in Designinga Gain-Sharing PlanStrength of reinforcement Productivity standardsSharing the gainsScope of the formulaPerceived fairness of the formulaEase of administrationProduction variability(setting targets)

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Types of Gain-Sharing PlansScanlon PlanRatio is calculated that expresses value of production required for each rupee of total wage billDesigned to lower labor costs without lowering level of a firms activityIncentives are derived as a function of ratio between labor costs and sales value of production (SVOP)SVOP includes sales revenue and value of goods in inventory

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Types of Gain-Sharing PlansImplementation of Scanlon/Rucker PlansTwo major components are vital to implementation and successProductivity normEffective worker committees

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Exhibit 10.15: Examples of a Scanlon Plan

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Types of Gain-Sharing Plans (cont.)Improshare (Improved productivity through sharing)Standard is developed that identifies expected hours required to produce an acceptable level of outputStandard fixed by time and motion study by industrial engineers.Any savings arising from production of agreed-upon output in fewer than expected hours is shared by firm and workers

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Profit-Sharing Plans An incentive based compensation program to award employees a percentage of the company's profits. Profit sharing work best When company earnings are relatively stable (or steadily increasing).

Predetermined index of profitabilityEmployees may not feel their jobs directly impact profits

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How does Profit sharing work? The company contributes a portion of its pre-tax profits to a pool that will be distributed among eligible employees. The amount distributed to each employee may be weighted by the employee's base salary so that employees with higher base salaries receive a slightly higher amount of the shared pool of profits. Generally this is done on an annual basis.

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ContThe trend in recent variable-pay design is to combine the best of gain-sharing and profit-sharing plansThe plan must be self fundingAlong with having the financial incentive, employees feel they have a measure of control Eg. Airline give incentive based on reduction in lost baggage.

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Earnings-at-Risk PlansSuccess sharing planEmployee base pay is constantVariable pay increases in successful years No reduction in base pay and no variable pay in poorly-performing yearsRisk sharing planEmployee base pay variesBase pay often reduced in poor performance yearsShifts part of risk of doing business from company to employee

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Exhibit 10.16: Group Incentive Plans:Advantages and Disadvantages

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Example of GroupIncentive Plan - GE Information SystemsA team-based incentive with links to individual payoutsTeam and individual performance goals are setIf team hits its goals, team members earn their incentive only if they also hit their individual goalsTeam incentive is 12% to 15% of monthly base pay

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Example of GroupIncentive Plan - Corning GlassA gain-sharing program (goal sharing) where 75% of payout is based on unit objectives such as:Quality measuresCustomer satisfaction measuresProduction targetsRemainder is based on Cornings return on equity (ROE)

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Example of GroupIncentive Plan - 3-MOperates with an earnings-at-risk planBase pay fixed at 80% of marketEmployees have a set of objectives to meet for pay to move to 100% of marketAdditionally, there is a modest profit sharing component

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Example of GroupIncentive Plan - SaturnEarnings-at-risk plan where base pay is 93% of marketEmployees meet individual objectives to capture at-risk componentAll team members must meet objectives for any to get at-risk moneyA profit sharing component is based on corporate profits

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Example of GroupIncentive Plan - Du Pont FibersEarnings-at-risk where employees receive reduced pay increases over 5 years, resulting in 6% lower base payIf department meets annual profit goal, employees collect all 6 percentVariable payout ranges from 0 (reach less than 80% of goal) to 12% (150% of goal)

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Group Incentive Plans: ExamplesAll incentive plans can be described by common featuresThe size of the group that participates in the planThe standard against which performance is comparedThe payout schedule

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Explosive Interest in Long-term Incentive PlansLong-term incentives (LTIs) focus on performance beyond the one-year time line used as the cutoff for short-term incentive plansRecent explosive growth in long term plans is spurred in part by a desire to motivate longer-term value creation

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Long-Term Incentive Plans

Employee Stock Ownership Plans (ESOPs)Performance Plans (Performance Share and Performance Unit)Broad-Based Option Plans (BBOPs)

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Employee Stock Ownership Plan (ESOP) An ESOP is a defined contribution employee benefit plan that allows employees to become owners of stock in the company they work for. It is an equity based deferred compensation plan. Several features make ESOPs unique as compared to other employee benefit plans.

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How does ESOP work?The ESOP operates through a trust, setup by the company, that accepts tax deductible contributions from the company to purchase company stock. The contributions made by the company are distributed to individual employee accounts within the trust.

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ContThe amount of stock each individual receives may vary according to pre-established formulas based on salary, service, or position. The employees may cash out after vesting in the program or when they leave the company. The amount they may cash out may depend on requirements.

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ContWhen an ESOP employee who has at least ten years of participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25% of the value. This option continues until age sixty, at which time the employee has a one-time option to diversify up to 50% of his/her account.

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ContEmployees receive the vested portion of their accounts at either termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.

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Companies offering ESOPsPepsiCoDuPontCoca-ColaMicrosoft etc

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Overall Effectiveness of Alternative Reward PlansType of Plan% of companies reporting significant business result impactGainsharing30Team/small group incentive31Individual incentive20Project incentive29

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See Exhibit 9.7, page 300 in text

Types of Variable Pay Plans: Advantages and Disadvantages

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70See Exhibit 10.11, pages 320-322 for discussion details

Types of Variable Pay Plans: Advantages and Disadvantages-cont

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The Choice BetweenIndividual and Group Plans

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THANK YOU!!

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Documents

Pay for Performance