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Pay-for-Performance Plan
WHAT IS PAY-FOR-PERFORMANCE-PLAN
Pay-for-performance plans signal a
movement away from entitlement….sometimesa very slow movement toward pay that varieswith some measure of individual ororganizational performance.
Many of the surveys on pay forperformance tend to omit the grandfather of allthese plans, merit pay.
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Percent of companies with plan
Type of Plan 1996 1998 1999 2002 2007
Special Recognition plans 44 51 59 34 72Stock option plans 21 46 43 40
Individual incentive plans 17 35 39 38 49
Cash profit sharing 22 22 23 18 16Gain sharing plans 16 20 18 11 10
Team awards 13 17 15 8 32
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The greater interest in variable pay probably
can be traced to two friends:
1. The increasing competition from foreign
producers forces American firms to cut costsand/or increase productivity.
2. Today’s fast-paced business environment
means that workers must be willing to adjustwhat they do and how they do it.
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DOES VARIABLE PAY IMPROVE PERFORMANCE
RESULTS? THE GENERAL EVIDENCE
Pay-for-Performance plans, those that introduce
variability into the level of pay you receive, seem
to have a positive impact on performance if
designed well. Notice that we have qualified our
statement that variable-pay plans can be
effective if they are designed well.
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SPECIFIC PAY-FOR-PERFORMANCE PLANS: SHORTTERM MERIT PAY
A merit pay system links increases in base pay
(called merit increases)to how highly employees are
rated on a performance evaluation.
Well Above Above Below Well Below
Average Average Average Average Average
Performance 1 2 3 4 5Rating
Merit pay 5% 4% 3% 1% 0%
increase
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At the end of the performance year, the
employee is evaluated, usually by the direct
supervisor. The performance rating, 1 to 5 in theabove example, determines the size of the
increase added into base pay. This last point is
important.
Increasingly, merit pay is under attack. Not only is it
expensive, but many argue it doesn’t achieve the
desired goal: improving employee and corporate
performance. In a thorough interview of merit payliterature, though, Heneman concludes that merit
pay does have a small, but significant, impact on
performance.
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High performance ratings are nearly always
statistically related to high merit increases and
the reverse holds too. Departments andstrategic business units with better merit pay
programs have higher subsequent
performance. And removal of merit payappears to result in lower subsequent
performance, as well as lower satisfaction
among top performance. A final argument for
merit pay centers on the sorting effect we
discuss throughout our sections on variable
pay impacts.
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Lump-Sum Bonuses
Lump-sum bonuses (or awards) are thoughtto be substitute for merit pay. Based onemployee or company performance, employeesreceive an end-of-year bonus that does not buildinto base pay.
Individual Spot Awards
Technically, spot awards should fall underpay-for-performance plans. About 35 percent of all companies use spot awards. And animpressive 74 percent of companies in onesurvey reported that these awards were eitherhighly of moderately effective.
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Individual Incentive Plans
these plans differ from the merit and lump
sum payments because they offer a promiseof pay for some objective, pre establishedlevel of performance.
When this reverse incentive plan (penaltyfor poor performance rather than reward forgood) was implemented, vehicle damagedropped 70%. This is but one of many studies
showing pretty conclusive evidence thatindividual incentive plans increaseperformance substiantially.
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All incentive plans have one common feature:
an established standard against which worker
performance is compared to determine themagnitude of the incentive pay. For individual
incentive systems, this standards is compared
against individual worker performance.
1. The first dimension on which incentive system
vary is in the method of rate determination. Plans
set up a rate based either on units of production
per time period or on time period per unit of
production. On the surface, this distinction may
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appear trivial, but, in fact, the deviations arise
because tasks have different cycles of
operation. Short-cycle tasks, those that arecompleted in a relatively short period of time,
typically have as a standard a designated
number of units to be produced in a giventime period.
2. The second dimension on which individual
incentive systems vary is the specifiedrelationship between production level and
wages.
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there are four general categories of plans:
1. Cell 1: the most frequently implemented
incentive system is a straight piece work
system. Rate determination is base on units of
production per time period and wages vary
directly as a function of production level.
the major advantages of these types of
system:
it is easily understood by workers and perhapsconsequently, is more readily accepted than some
of the other incentive systems.
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2. Cell 2
To relatively common plans set standards base on time
per unit and tie incentives directly to level of output.a. standard hour plans – is a generic term for plans
setting the incentive rate base on completion of a task
in some expected time period.
b. Bedeaux plans
3. A beadeaux plan provides a variation on straight
piecework and standard hour plans. Instead of timing
an entire task, a bedeaux plan requires division of a
task into simple action and determination of the task
required by an average skilled worker to complete its
action.
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4. Cell 3
the two plans included in Cell 3 provide for
variable incentives as a function units of production per time period:
a. Taylor plan – establishes two piece work rates.
One rate goes into effect when a worker exceeds
the published standards for a given time period. A
second rate is established for production below
standard in this rate is lower than the regular
wage.
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b. Merrick system – operates in the same wayexcept that 3 piecework rates are set:
1. high for production exceeding 100percent of standard.
2. medium for production between 83 and
100 percent of standard.3. low for production less than 83 percent
of standard.
5. Cell 4: the three plans included in cell 4provide for variable incentives linked to astandard expressed as a time period per unitof production.
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The Halsey 50-50 method derives its name
fro the shared split between worker and
employer of any savings in direct cost.The Rowan plan is similar to the Halsey
plan in that an employer and employee both
share in savings resulting from workcompleted in less than standard time.
The Gantt plan differs from both the
Halsey and the Rowan plans in that thestandard time for a task is purposely set at a
level requiring high effort to complete.
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INDIVIDUAL INCENTIVES PLAN: ADVANTAGES AND
DISADVANTAGES
This is a common problem with incentive plans:
• Employees and managers end up in conflict
because the incentive system often focuses only
on one small part of what it takes for the company
to be successful.
• Employees, being rational, do more of what theincentive system pays for.
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ADVANTAGES AND DISADVANTAGES OF
INDIVIDUAL INCENTIVE PLANS
Advantages
1. Substantial impact that raises productivity, lower
production costs, and increases earnings of workers.2. Less direct supervision is required to maintain
reasonable levels of output under payment by time.
3. In most cases, systems of payment by results, if
accompanied by improved organizational and workmeasurement, enable labor costs to be estimated
more accurate than under payment by time. This
helps costing and budgetary control.
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Disadvantages
1. Greater conflict may emerge between employeesseeking to maximize output and managers concernsabout deteriorating quality levels.
2. Attempts to introduce new technology may beresisted by employees concerned about the impacton production standards.
3. Reduce willingness of employees to suggest newproduction methods for fear of subsequent increasesin production standards.
4. Increased complaints that is equipment is poorlymaintained, hindering employee efforts to earn largerincentives.
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5. Increased turnover among new
employees discourage by the unwillingness
of experience workers to cooperate in on-the-job training.
6. Elevated levels of mistrust between
workers and management.
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INDIVIDUAL INCENTIVE PLANS: EXAMPLES
Even though incentive systems are less popularthan they used to be, there are still notable
successes. Most sales positions have some part of
pay based on commissions, a form of individual
incentive. Perhaps the longest-running success
with individual incentive, going back to before
World War I, belongs to a company called Lincoln
Electric.
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TEAMS INCENTIVE PLANS: TYPES
When we move away from individualincentive systems and start focusing on peopleworking together, we shift to group incentiveplans. A standard is established against whichworker performance (in this case, teamperformance) is compared to determined themagnitude of incentive pay. Whit the focus ongroups, now we are concerned about groupperformance in comparison against some
standard, or level, of expected performance. Thestandard might be an expected level of operatingincome for a division.
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Failures of team incentive schemes can beattributed to at least five causes
1. First, one of the problems with teamcompensation is that teams come with anyvarieties. There are even full-time teams thatare temporary. (e.g., cross-functional teamspulled together to help ease the transition into apartnership or join venture).
2. A seconds rewarding teams is called “levelproblem”. If we define teams at the very broad
level --- the whole organization being anextreme example --- much of the motivationalimpact of incentives can be lost.
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3. The last three major problems with team
compensation involve the three Cs: complexity,
control, and communications.Some plans are simply too complex. Xerox’s
Houston facility had a gain sharing plan for teams
that required understanding a three dimensionalperformance matrix.
The second C is control. Praxair, a worldwide
provider of gases (including oxygen) extracted by
the atmosphere, works hard to make sure all its
team pay comes from performance measures
under the control of the team.
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The final C is a similar factor in
compensation successes and failures:
communication. Team-based pay plans simplyare not well communicated. Employees asked
to explain their plans often flounder because
more effort has been devoted to designing theplan than to deciding how to explain it.
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LARGE GROUP INCENTIVE PLAN
When we get beyond a small work team andtry to incentive large groups, there are generallytwo types of plans. Gain-sharing plans useoperating measures to gauge performance. Profitsharing plans use financial measures.
GAIN-SHARING PLANS
Employees share in the gains in these types of group incentives plans. With profit-sharingplans (surprise) the sharing involves someforms of profit.
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The following issues are key elements in designing a gain-sharing plan:
1. Strength of reinforcement: What role should base payassume relative to incentive pay? Incentive pay tends toencourage only those behaviors that are rewarded.
2. Productivity standards: What standard will be used to
calculate whether employees will receive an incentivepayout?
3. Sharing the gains split between the management andworkers: Part of the plans must address the relative cutsbetween management and workers of any profit or
savings generated.4. Scope of the formula: Formulas can vary in the scope of
inclusions for both the labor inputs in the numerator andthe and the productivity outcomes of the denominator.
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5. Great care must be exercised with such alternativemeasures, though, to ensure that the behaviorsreinforced actually affect the desired bottom-line
goal.6. Perceived fairness of the formula: One way to ensure
the plan is perceived as fair is to let employees voteon whether implementation should go forward. Thisunion participation in program design are twoelements in plan success.
7. Ease of administration: Sophisticated plans withinvolved calculations of profit or costs can becometoo complex for existing company information
systems.8. Production variability: One of the major sources of
problems in group incentive plans is failure to settargets properly.
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Scanlon Plan Scanlon plans are designed to lower labor
costs without lowering the level of a firm’sactivity. Incentives are derived as a function of the ratio between labor costs and sales valueof production (SVOP). The SVOP includessales revenue and the value of goods andinventory.
Rucker Plan
The Rucker plans involves a somewhatmore complex formula than a Scanlon plan fordetermining worker incentive bonuses.
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Implementation of the Scanlon/Rucker Plan
To major components are vital to the
implementation and success of a Rucker or Scanlonplan: (1) a productivity norm and (2) effective workercommittees. Development of a productivity normrequires both effective measurement of base-year dataand acceptance by workers and management of this
standard for calculating bonus incentives.
The second ingredient of Scanlon/Rucker plans is aseries of worker committees (also known asproductivity committees or bonus committees). This
primary function of these committees is to evaluateemployee and management suggestions for ways toimprove productivity and/or cut costs.
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Similarities and Contrasts Between Scanlon
and Rucker Plans
Scanlon and Rucker plans differ from
individual incentives plan in their primary
focus. Individual incentives plans focus
primarily on using wage incentives to motivatehigher performance through increase effort.
While this is certainly a goal of the
Scanlon/Rucker plans, it is not the major focusof attention.
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Improshare
Improshare (Improved Productivity
through Sharing) is a gain-sharing plan thathas proved easy to administer and tocommunicate.
Profit-Share Plans
Productivity was much higher in plans
where payouts were that year than in planswere payment was deferred. Also, these plansworked much better in smaller (less than 775employees) companies.
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Earnings-at-Risk Plans
We probably shouldn't separate earnings-
at-risk plans as a distinct category. In success-sharing plans, employee base wages areconstant and variable pay adds on duringsuccessful years. If the company does well,
you receive a predetermined amount of variable pay. If the company does poorly, yousimply forgo any variable pay --- there is noreduction in your base pay, though. In a risk-sharing plan, base pay is reduced by someamount relative to the level that would beoffered in a success-sharing plan.
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Group Incentives Plans: Advantages andDisadvantages
Group for pay-for-performance plans aregaining popularity while individual plans arestable or declining in interest. Apparently thesuggestions employees are encouraged to make(how to do things better in the company)
gradually evolve from first order learningexperiences of a more routine variety(maintenance of existing ways of doing things)into suggestions that exhibit second-order
learning characteristics --- suggestions that helpthe organization break out of existing patterns of behavior and explore different ways of thinkingand behaving.
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Advantages
1. Positive impact on organizations and
individual performance of about 5 to 10percent per year.
2. Easier to develop performance measures thatit is for individual plans.
3. Signals that cooperation, both within andacross groups, is a desired behavior.
4. Teamwork meets with enthusiastic support
from most employees.
5. May increase participation of employees indecision making process.
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Disadvantages
1. Line-of-sight may be lessened, that is employees
may find it more difficult to see how theirindividual performance affects their incentivepayouts.
2. May lead to increased turnover among top
individual performers who are discouragedbecause they must share with lessercontributors.
3. Increases compensation risk to employeesbecause of lower income stability. May influencesome applicants to apply for jobs in firms wherebase pay is a larger compensation component.
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Group Incentive Plans: Examples
All incentive plans, can be describe by common
features: (1) the size of the group thatparticipates in the plan. (2) the standards againstwhich performance is compared, and (3) thepayout schedule.
Explosive Interest in Long-Term Incentives Plan
Long-term incentives (LTIs) focus on performancebeyond the one-year line used as the cutoff forshort-term incentive plans. Recent explosivegrowth in long-term plans appears to be spurredin part by a desire to motivate long-term valuecreation.
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Employees Stock Ownership Plans (ESOPs)
Some companies believe that employees can belinked to the success or failure of a company in yet
another way --- though employee stock ownershipplans. At places like PepsiCo, Lincoln Electric, DuPont,Coca-Cola, and others, the goal is to increase employeeinvolvement in the organizations, and hopefully this
will influence performance.Performance Plans (Performance Share and
Performance Unit)
Performance plans typically feature cooperate
performance objectives for a time three years in thefuture. They are driven by financial earnings or returnmeasures, and they pay out for meeting or exceedingspecific goals.
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Broad-Based Option Plans (BBOPs)
The latest trend in long-term incentives,
and probably the component of compensationgenerating the most discussion in recent
years, is broad-based option plans. BBPOs are
stock giants: The company gives employeesshares of stock over a designated time period.
The strength of BBPOs is their versatility.
Depending on the way they are distributed to
employees, they can either reinforce a strong
emphasis on performance or inspire greater
commitment and retention of employees.
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Combination Plans: Mixing Individual and
Group
It’s not uncommon for companies to useboth individual behavior and to insure thatemployees work together, where needed, topromote team and corporate goals. Thesecombination programs start with standardindividual (e.g., profit, operating income).
Self-funding plan, often favored by CEOs
who don’t like to make payouts when thecompany loses money. These plans specifythat payouts only occur after the companyreaches a certain profit target.