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Human Resource Management

INCENTIVE COMPENSATIONINCENTIVE COMPENSATION

Chapter 13

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Incentive Compensation?

Compensation that is linked to performance by rewarding employees for actual results achieved instead of seniority or hours worked.

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Why Introduce Incentive Compensation?

• To promote employee identification with the organization’s objectives. Many organisations attempt to link the achievement of company objectives to employee rewards. This builds employee commitment. (profit-sharing)

• To encourage individual, team or business unit performance which makes the incentive reward dependent on specific work outcomes that the employee, or the work group, directly affect. (commission, piece-rates)

• To control fixed compensation costs. One way of controlling compensation costs is to designate a portion of pay as ‘at risk’ if predetermined business unit, team or individual objectives are not achieved.

• To increase remuneration competitiveness.

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1. Bonus versus Incentive1. Bonus versus Incentive

• A bonus is determined and given after the job is done and it makes no guarantee that future work or effort will be rewarded similarly.

• Where a bonus is reactive, an incentive is proactive.

• An incentive provides a very direct message to an employee: ‘If you achieve this level of performance, you will receive this amount of reward.’

Types of Plans

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2. Pay-for-performance Link2. Pay-for-performance Link

• Incentive-type plans aim to strengthen the perceived link between pay and performance.

• The relationship between pay and performance is especially effective when it is based on those aspects of the work that are under the individual employee’s direct control and influence - if you sell or produce more, you earn more!

• This establishes an immediate relationship between results and rewards.

Types of Plans

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3. Variable And ‘At-risk’ Pay3. Variable And ‘At-risk’ Pay

• Any pay system that provides a bonus or incentive is a variable pay system.

• The amount of the bonus or incentive varies and cannot be predetermined.

• Other systems are based on the notion of some portion of pay being ‘at-risk’ against specified levels of performance.

• A clear principle is that the employee must have the opportunity to earn more than the target amount.

Types of Plans

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4. Individual Incentive Plans

• The organisation must emphasise individual contribution as distinct from team or work group effort.

• The job must be designed to allow each employee to work independently and with autonomy and discretion.

There are 3 criteria for setting performance objectives:

• Internal benchmark (within the organisation)

• External benchmark (outside the organisation)

• Strategic business objectives - performance is measured against the strategic business objectives set for the organisation.

Types of Plans

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Individual Incentive Plans: Advantages Provide a clear link between individual pay and work contribution

Discriminate in favour of high performers Can have significant impact on key performance indicators

such as productivity, quality and sales Link total compensation costs to organisational objectives

Individual Incentive Plans: Disadvantages May encourage individualism and non-productive competition Require comprehensive and credible systems of individual

performance measurement Can sometimes end up paying for performance that would have

been achieved without an incentive plan May leave the organisation no better off if improvements from

one employee are offset by another's poor performance

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Key principles in the design of individual incentive plans

• Identified source of funding• Performance tracking and management systems• Frequent reward• Pay-for-performance• Periodic review

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Small Group Incentive Plans

• An important aspect of small group incentives is their ability to increase flexibility in job assignment by focusing on team accomplishments rather than individual ones.

• This promotes a strong group perspective rather than an individual focus.

• The performance objectives of work groups are similar to those of individual incentive plans and relate to financial, productivity and other specific targets.

• The key difference is the deliberate encouragement of a group or team ethos.

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Gain-sharing• Gain-sharing is a small group incentive system that

shares the productivity improvements gains with the employees who make the improvement.

• Gainsharing plans operate in addition to the normal wage structure.

• The aim is to create a work climate in which employees benefit financially from increased productivity.

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Gainsharing Plans• The Scanlon plan defines productivity as ‘payroll costs per

dollar of net sales’. • The financial gain (productivity increase) comes from

achieving the same/better production levels for the period with lower payroll costs than in the agreed baseline data.

• A typical Scanlon plan split is 75 per cent to employees and 25 per cent to the organisation.

• Rucker plans calculate their gains on a value-added formula. • Improshare plans measure gains on the basis of comparing

the standard hours for production (based on industrial engineering calculations) against actual hours taken in production.

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Paying for Quality and Customer Service

• Each team member shares equally in the incentive pool as predetermined targets in quality or customer service are met.

• The approach is to link pay and quality through specifically designed work-team incentive systems.

• The TQM emphasis on team performance provides the basis for an incentive pay system.

• Incentive payments can be linked to key quality performance indicators - such as a reduction in defects and scrap - and key customer service performance indicators - such as a reduction in customer complaints.

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Incentive Pay for Project TeamsIncentive Pay for Project Teams• The key performance measures for project work

are competition on time and within budget. • This allows the overall task to be divided into

‘milestones’ that define specific time frames and budgets for each stage of the project.

• The milestone events required to meet the timing schedule are identified.

• Management must determine when the group bonuses will be paid (usually when the various groups in the project team meet their schedules).

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Advantages of Small Group Incentive Plans•Encourage and reinforce team work by linking rewards to group performance• Increase peer pressure on poor performers to improve• Allow greater use and flexibility of team members• Provide clear link between group performance and reward• Can be easily designed and administered once key performance indicators are identified

•Reduce emphasis on individual performance

•Allow poor performers to be carried by the group

•Can sometimes end up paying for performance that would have been achieved without an incentive plan

Disadvantages of Small Group Incentive Plans

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Large Group Incentive Plans

• Many organisations choose to introduce variable pay systems that cover all employees.

• These organisation-wide plans often work in addition to individual or small-group incentives.

• Such plans are typically based on one or two broad performance indicators such as achievement of a budget or profit.

• Large group incentives usually take the form of a bonus plan, an incentive plan or an ‘at-risk’ incentive.

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Advantages of Large Group Incentive Plans• Encourage employee identification with organisation-wide

objectives

• Control part of remuneration costs if rewards are contingent on meeting objectives

• Promote positive organisational image

Disadvantages • Have a long ‘line of sight’ because only a few employees can

directly influence the end result

• May leave high performers feeling that their contribution is overlooked

• Allow poor performers to be ‘carried’ by the overall effort

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Recognition Programs• A form of individual or work group incentive that is

usually outside the normal remuneration system.• Recognition programs use various forms of reward,

including cash, merchandise, travel, time off with pay, plaques and certificates.

Suitable to apply when:• a reward process is required for a short-term goal or activity• the organisation decides to introduce a process for

recognising any outstanding contribution by an individual employee or work group

• the organisation has a strong team orientation and wishes to keep the focus on work group performance and team incentives while still recognising the specific contribution of individual employees.

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Advantages of Recognition Programs• Ensure that recognition is immediate and separate from the normal

reward system

• Have added psychological value related to peer recognition

• Allow awards to be highly individualised symbols of accomplishment

• Mean that the winning of the award often has greater value than the actual cash value of the award

Disadvantages of Recognition Programs• Can involve high administrative costs and time

• Have the danger of ‘repeat’ winners: Winning the same prize year after year may not contribute to motivation for the employee.

• May be seen as favouritism if the system allows for repeat winners.

• May lead top performers to lose interest if the system does not allow for repeat winners.

• Lead employees to lose motivation if they feel they cannot ever win.

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Design of Incentive Pay: Focus on Strategic Business Objectives

• The first step in designing an effective incentive pay system is to define the required performance criteria.

• The aim is to provide as direct a ‘line of sight’ as possible for all employees included in the incentive system.

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Design of Incentive Pay: Develop a Comprehensive Reward Framework

• The incentive system needs to be integrated into a total reward framework.

• It is necessary at the design stage to address the issue of base pay and how it fits with the incentive system.

• What should the total target pay (that is, base pay plus incentives) be for each employee? Should there be just one incentive system?

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Design of Incentive Pay: Ensure Reinforcement of Desired Behaviours

• The performance objectives need to be clearly specified.

• The nature of the contribution - whether individual or group - must be defined.

• The frequency of payment must be such that it continually reinforces the organisation’s message.

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Design of Incentive Pay: Funding

There are two ways to fund incentive payments:

• First, the amount can be provided from the increased profits or decreased costs arising from the achievement of the objectives.

• Alternatively, the payments can be an additional expense to the organisation.

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Design of Incentive Pay: ‘Fit’ with Organisational Culture

• Performance-based remuneration will be most effective when it reinforces the existing organisational culture and management style.

• Such reinforcement requires giving consideration to such issues as centralisation/decentralisation, the degree of employees’ control or autonomy over their work and other characteristics of the organisation.