mgmt440 t11 incentive compensation

8/3/2019 Mgmt440 t11 Incentive Compensation

1/28

Paul L. Schumann, Ph.D.

Professor of Management

MGMT 440: Human Resource Management

1 2008 by Paul L. Schumann. All rights reserved.


2/28

Outline What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay

Incentive Pay Systems Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay

Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation

2


3/28

What Is Incentive Pay? Incentive pay links pay (as a reward) to performance

The idea of incentive pay is to create incentives foremployees to improve their job performance by linkingemployee pay to employee job performance

Incentive pay is also called:

Pay for performance

Performance-based pay systems

Performance-based reward systems

The reward for performance doesnt have to be pay

Pay is one possible reward, not the only possible reward

3


4/28

Why Use Incentive Pay? We want to use pay (and other rewards) to align the goals

of each employee 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

4


5/28

Does Incentive Pay Work? Expectancy theory gives us the answer:

Yes, incentive pay will motivate employees to improvetheir job performance, but only if 3 conditions aresimultaneously satisfied:

High valence: employees must believe that the amount of thereward (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

5


6/28


7/28

Does Incentive Pay Work? Expectancy theory (more)

What can go wrong? (more)


Poor instrumentality perceptions

Example: The supervisor gives everyone the same payincrease 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 who is the supervisorsgolfing buddy even though that employee has poor jobperformance

7


8/28


What can go wrong? (more)


Poor expectancy perceptions

Example: The employees believe that they are alreadyworking as hard as they can

Example: The employees believe that there are barriers to

improved job performance that are outside of their control

8


9/28



Summary: For incentive pay to work:

we need to make the incentive pay increase large enough thatemployees want to put forth the effort to go after the incentive

and we need to show employees that there is a strong linkbetween their job performance and receiving the incentive pay

increase and we need to show employees how, through their efforts,

that they can successfully improve their job performance

Put another way, employees need to believe: If they work at it,theyll achieve their goals, and theyll get the promised reward

9


10/28

Drawbacks of Incentive Pay Incentive pay is more work to administer

Across-the-board pay increases are easy to administer

We can make mistakes Example: Link pay to the wrong measures of job performance

Example: Sears Auto Centers

Unions typically oppose many types of incentive pay Fear of discrimination or favoritism by supervisors in job

performance evaluations, especially for subjective measures of jobperformance

Unions prefer objective factors, such as across-the-board pay increasesor the use of seniority

Incentive pay creates competition among workers, which weakensworker solidarity (solidarity is necessary for union success)

Unions might agree to group-based objective incentives Example: Profit-sharing bonus

10


11/28

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

11


12/28

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 theproduction 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 ifproduction 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

12


13/28

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

13


14/28

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

14


15/28

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: productionmeasures, sales measures, personnel data, performance tests,business unit performance measures

Subjective measures of employee job performance: rating scales tosubjectively measure multiple aspects of job performance

Management By Objectives (MBO)

We use our evaluation of the employees job performance todecide his or her annual pay increase

15


16/28

Incentive Pay Systems Merit pay (more)

Example: Company uses the following 5-point rating scale toevaluate 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

16


17/28


Potential difficulties of merit pay

Supervisors can make mistakes in evaluating employee jobperformance & in assigning merit pay increases

The mistakes weaken the instrumentality perceptions


Reduces the motivational effectiveness of the incentive pay

system The mistakes create perceptions of inequity (unfairness)

If employees feel underpaid, they may reduce theircontributions (reduce their effort)

17


18/28


Potential difficulties of merit pay (more)

The annual merit pay increase can come months after specificinstances of good performance

Rewards are more effective when they are receivedimmediately 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 paysystem

18


19/28


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 topperformer 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

19


20/28


Potential difficulties of merit pay (more) Merit pay budgets can vary from year to year

Result is that the same job performance may get differentrewards depending on whether its a good year or a bad year

If the same job performance is rewarded differently fromone 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 reducetheir contributions (reduce their effort), especially in the bad years

20


21/28


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 = 5merit pay increase = 4% ($2,000)

2006 pay = $52,000 at end of 2006, performance rating = 3merit payincrease = 2% ($1,040)

2007 pay = $53,040 at end of 2007, performance rating = 1 no merit payincrease

2008 pay = $53,040 the employee is still being rewarded in 2008 (andbeyond) for performance in 2005 & 2006

This weakens the instrumentality perceptions Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system

21


22/28

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 = $1,000total 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

22


23/28

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 andis paid at the entry-level rate

As the employee completes training and becomes qualified toperform additional jobs, the employee is rewarded with payincreases 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 anygiven day

Creates incentives for employees to complete training, learnnew skills, & become qualified to do additional jobs

Creates a flexible workforce

23


24/28

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 theemployee retires, becomes disabled, or dies)

Combination plans

24


25/28

Incentive Pay Systems Gain sharing: when employees make a suggestion that

improves the organization, a percentage of theorganizations gain from the suggestion is shared with theemployees who made the suggestion Example:

Employees make suggestions Management reviews the submitted suggestions, determines the

improvement (gain) from each suggestion, and decides whichsuggestions to implement

A percentage of the gain from a suggestion is shared with theemployees 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

25


26/28

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

26


27/28

Incentive Pay Systems Executive compensation

If the goal of executive compensation is to create a paysystem in which what is in the best interest of the

stockholders also brings the greatest reward to theexecutives, then the pay of executives should:

Be tied to the performance of the company through incentivepay 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

27


28/28

Outline What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay

Incentive Pay Systems Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation

28

mgmt440 t11 incentive compensation

Documents