Chapter 12

Pay for Performance and Financial Incentives

Part Four | Compensation

Copyright 2011 Pearson Education, Inc. publishing as Prentice Hall PowerPoint Presentation by Charlie Cook The University of West Alabama

WHERE WE ARE NOW

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LEARNING OUTCOMES
1. Explain how you would apply five motivation theories in formulating an incentive plan. 2. Discuss the main incentives for individual employees. 3. Discuss the pros and cons of commissions versus straight pay incentives for salespeople. 4. Describe the main incentives for managers and executives. 5. Name and define the most popular organizationwide variable pay plans. 6. Outline the steps in designing effective incentive plans.

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Motivation, Performance, and Pay

Incentives
Financial rewards paid to workers whose production exceeds a

predetermined standard.

Frederick Taylor
Popularized scientific management and the use of financial

incentives in the late 1800s.

Systematic soldiering Fair days work

Linking Pay and Performance

Understanding the motivational

bases of incentive plans

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The Hierarchy of Needs

Maslows Hierarchy of Needs:
Physiological (food, water, warmth) Security (a secure income, knowing one has a job) Social (friendships and camaraderie) Self-esteem (respect) Self-actualization (becoming a whole person)

Maslows prepotency process principle:

People are motivated first to satisfy each lower-order need

and then, in sequence, each of the higher-level needs.

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Herzbergs HygieneMotivator Theory

Hygienes (extrinsic job factors)
Satisfy lower-level needs Inadequate working conditions, salary, and incentive pay can

cause dissatisfaction and prevent satisfaction.

Motivators (intrinsic job factors)

Satisfy higher-level needs Job enrichment (challenging job, feedback, and recognition)

addresses higher-level (achievement, self-actualization) needs.

Premise:
The best way to motivate someone is to organize the job so that

doing it provides feedback and challenge that helps satisfy the persons higher-level needs.

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Demotivators and Edward Deci

Intrinsically motivated behaviors are motivated by the individuals underlying need for competence and selfdetermination.
Offering an extrinsic reward for an intrinsically-motivated act

can conflict with the acting individuals internal sense of responsibility.

Some behaviors are best motivated by job challenge and

recognition, others by financial rewards.

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Victor Vrooms Expectancy Theory

Motivation is a function of:
Expectancy: the belief that effort will lead to performance. Instrumentality: the connection between performance and

the appropriate reward.

Valence: the value the person places on the reward.

Motivation = (E x I x V)
If any factor (E, I, or V) is zero, then there is no motivation

to work toward the reward.

Employee confidence building and training, accurate

appraisals, and knowledge of workers desired rewards can increase employee motivation.

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Behavior Modification / Reinforcement Theory

B. F. Skinners Principles
To understand behavior one must understand

the consequences of that behavior.

Behavior that leads to a positive consequence (reward)

tends to be repeated, while behavior that leads to a negative consequence (punishment) tends not to be repeated.
Behavior can be changed by providing properly scheduled

rewards (or punishments).

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Incentive Pay Terminology

Pay-for-Performance Plan
Ties employees pay to the employees performance

Variable Pay Plan

Is an incentive plan that ties a group or teams pay to some

measure of the firms (or the facilitys) overall profitability Example: profit-sharing plans May include incentive plans for individual employees

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Employee Incentives and the Law

FLSA Wage Calculations and Incentive Payments
Bonuses included in overtime calculations:

Those promised to newly hired employees

Those provided for in union contracts or other agreements

Those announced to induce employees to work more productively, steadily, rapidly, or efficiently or to induce them to remain with the firm Christmas and gift bonuses not based on hours worked. Bonuses so substantial that employees dont consider them a part of their wages

Bonuses excluded from overtime calculations:

Purely discretionary bonuses in which the employer retains discretion over how much, if anything, to pay

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Types of Employee Incentive Plans

Individual Employee Incentive and Recognition Programs Sales Compensation Programs

Pay-for-Performance Plans

Team/Group-based Variable Pay Programs Organizationwide Incentive Programs Executive Incentive Compensation Programs

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Individual Incentive Plans

Piecework Plans
The worker is paid a sum (piece rate)

for each unit he or she produces.

Straight piecework
Standard hour plan

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Pros and Cons of Piecework

Easily understandable, equitable, and powerful incentives Employee resistance to changes in standards or work processes affecting output Quality problems caused by an overriding output focus Possibility of violating minimum wage standards Employee dissatisfaction when incentives either cannot be earned or are withdrawn
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Individual Incentive Plans (contd)

Merit Pay
Is a permanent cumulative salary increase the firm awards

to an individual employee based on his or her individual performance

Can detract from performance if awarded across the board Becomes permanent ongoing reward for past performance

Merit Pay Options

Give annual lump-sum merit raises that do not make the

raise part of an employees base salary.

Tie merit awards to both individual and organizational

performance.

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TABLE 121

Merit Award Determination Matrix (an Example)

Company Performance (Weight = 0.50) Employee Performance Rating (Weight = .50) Outstanding Excellent Good Marginal Unacceptable

Outstanding
1.00 0.90 0.80

Excellent
0.90 0.80 0.70

Good
0.80 0.70 0.60

Marginal
0.70 0.60 0.50

Unacceptable
0.00 0.00 0.00

To determine the dollar value of each employees incentive award: (1) multiply the employees annual, straight-time wage or salary as of June 30 times his or her maximum incentive award and (2) multiply the resultant product by the appropriate percentage figure from this table. Example: if an employee had an annual salary of $20,000 on June 30 and a maximum incentive award of 7% and if her performance and the organizations performance were both excellent, the employees award would be $1,120 ($20,000 0.07 0.80 = $1,120).

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Incentives for Professional Employees

Professional Employees
Are those whose work involves the application

of learned knowledge to the solution of the employers problems.

Lawyers, doctors, economists, and engineers

Possible Incentives
Bonuses, stock options and grants, profit sharing Better vacations, more flexible work hours Improved pension plans Equipment for home offices

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Nonfinancial and Recognition Awards

Effects of Recognition-Based Awards
Recognition has a positive impact on performance,

either alone or in conjunction with financial rewards.

Day-to-day recognition from supervisors, peers, and

team members is important.

Ways to Use Recognition

Social recognition Performance-based recognition Performance feedback

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FIGURE 121

Social Recognition and Related Positive Reinforcement Managers Can Use

Challenging work assignments Freedom to choose own work activity Having fun built into work

Being provided with ample encouragement Being allowed to set own goals Compliments Expression of appreciation in front of others Note of thanks

More of preferred task

Role as bosss stand-in when he or she is away Role in presentations to top management Job rotation Encouragement of learning and continuous improvement

Employee-of-the-month award
Special commendation Bigger desk Bigger office or cubicle

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Online and IT-Supported Awards

Information Technology and Incentives
Enterprise incentive management (EIM)

Software that automates planning, calculation, modeling, and management of incentive compensation plans Enabling companies to align their employees with corporate strategy and goals

Online Award Programs

Programs offered by online incentives firms that

improve and expedite the awards process

Broader range of awards More immediate rewards

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Incentives for Salespeople

Salary Plan
Straight salaries

Best for: prospecting (finding new clients), account servicing, training customers sales force, or participating in national and local trade shows

Commission Plan
Pay is a percentage of sales results.

Keeps sales costs proportionate to sales revenues May cause a neglect of nonselling duties Can create wide variation in salespersons income Likelihood of sales success may be linked to external factors rather than to salespersons performance Can increase turnover of salespeople
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Incentives for Salespeople (contd)

Combination Plan
Pay is a combination of salary and

commissions, usually with a sizable salary component.

Plan gives salespeople a floor

(safety net) to their earnings.

Salary component covers company-

specified service activities.

Plans tend to become complicated,

and misunderstandings can result.

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Specialized Commission Plans

Commission-plus-Drawing-Account Plan
Commissions are paid but a draw on future

earnings helps the salesperson to get through low sales periods.

Commission-plus-Bonus Plan
Pay is mostly based on commissions. Small bonuses (spiffs) are paid for directed

activities like selling add-ons or slow-moving items.

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Maximizing Sales Force Results: Setting Sales Quotas

Should quotas be locked in for a period of time? Have quotas been communicated to the sales force within one month of the start of the period? Does the sales force know exactly how its quotas are set? Do you combine bottom-up information (like account forecasts) with top-down requirements (like the company business plan)? Do 60% to 70% of the sales force generally hit their quota? Do high performers hit their targets consistently? Do low performers show improvement over time? Are quotas stable through the performance period? Are returns and debookings reasonably low? Has your firm generally avoided compensation-related lawsuits? Is 10% of the sales force achieving higher performance than previously? Is 5% to 10% of the sales force achieving below-quota performance and receiving coaching?
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Incentives for Managers and Executives

Executive Total Reward Package
Base salary (cash) Short-term incentives (bonuses) Long-term incentives (e.g., stock options)

Sarbanes-Oxley Act of 2002

Makes executives and the board of directors

personally liable for violating their fiduciary responsibilities to their shareholders.

Requires the CEO and CFO to repay bonuses,

incentives, or equity-based compensation received following issuance of a financial statement that the firm must restate.

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Short- and Long-Term Incentives

Short-Term Incentives: The Annual Bonus
Plans intended to motivate short-term performance

of managers and tied to company profitability. Issues in awarding bonuses Eligibility basis Fund size basis Individual performance award Long-term incentives Stock options Performance shares Indexed options Premium price options Stock appreciation rights Perks
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TABLE 122

Multiplier Approach to Determining Annual Bonus

Companys Performance (Based on Sales Targets, Weight = 0.50) Individual Performance (Based on Appraisal, Weight = .50) Excellent Good Fair Poor Excellent 1.00 0.80 0.00 0.00 Good 0.90 0.70 0.00 0.00 Fair 0.80 0.60 0.00 0.00 Poor 0.70 0.50 0.00 0.00

Note: To determine the dollar amount of a managers award, multiply the maximum possible (target) bonus by the appropriate factor in the matrix.

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Creating an Executive Compensation Plan

1. Define the strategic context for the executive compensation program. 2. Shape each component of the package to focus the manager on achieving the firms strategic goals. 3. Check the executive compensation plan for compliance with all legal and regulatory requirements and for tax effectiveness. 4. Install a process for reviewing and evaluating the executive compensation plan whenever a major business change occurs.

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Team/Group Incentive Plans

Team (or Group) Incentive Plans
Incentives are based on teams performance.

How to Design Team Incentives

Set individual work standards. Set work standards for each team member

and then calculate each members output.

Members are paid based on one of three formulas:

All receive the same pay earned by the highest producer. All receive the same pay earned by the lowest producer. All receive the same pay equal to the average pay earned by the group.

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Pros and Cons of Team Incentives

Pros
Reinforces team planning and problem solving Helps ensure collaboration

Encourages a sense of cooperation

Encourages rapid training of new members

Cons
Pay is not proportionate to an individuals effort Rewards free riders

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Organizationwide Incentive Plans

Profit-Sharing Plans
Current profit-sharing (cash) plans

Employees receive cash shares of the firms profits at regular intervals. A predetermined portion of profits based on the employees contribution to the firms profits is placed in each employees retirement account under a trustees supervision. Employees income taxes on the distributions are deferred, often until the employee retires.

Deferred profit-sharing plans

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Gainsharing Plans

Scanlon Plan Components

Philosophy of cooperation

Identity

Competence

Involvement system

Benefits sharing formula

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Implementing a Gainsharing Plan

1. Establish general plan objectives. 2. Choose specific performance measures.

3. Decide on a funding formula.

4. Decide on a method for dividing and distributing the employees share of the gains.

5. Choose the form of payment.

6. Decide how often to pay bonuses. 7. Develop the involvement system.

8. Implement the plan.

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At-Risk Variable Pay Plans

Put some portion of the employees weekly pay at risk.
If employees meet or exceed

their goals, they earn incentives.

If they fail to meet their goals, they

forego some of the pay they would normally have earned.

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Organizationwide Incentive Plans (contd)

Employee Stock Ownership Plan (ESOP)
A firm annually contributes its own stockor cash

(with a limit of 15% of compensation) to be used to purchase the stockto a trust established for the employees.
The trust holds the stock in individual employee

accounts and distributes it to employees upon separation from the firm if the employee has worked long enough to earn ownership of the stock.

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Advantages of ESOPs
For the Company
Can take a tax deduction equal to the fair market value

of the shares transferred to the ESOP trustee Gets an income tax deduction for dividends paid on ESOP-owned stock Can borrow against ESOP in trust and then repay the loan in pretax rather than after-tax dollars

For the Employees

Develop a sense of ownership in and commitment to the firm. Do not pay taxes on ESOP earnings until they receive

a distribution.

For the Shareholders of Closely-Held Corporations

Can place assets into an ESOP trust which will allow them to

purchase other marketable securities to diversify their holdings

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Implementing an Effective Incentive Plan

1. Ask: Does it make sense to use an incentive here? 2. Link the incentive with your strategy. 3. Make sure the program is motivational. 4. Set complete standards. 5. Be scientific in analyzing the effects of the plan.

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Why Incentive Plans Fail

Performance pay cant replace good management. You get what you pay for.

Pay is not a motivator.

Rewards punish. Rewards rupture relationships.

Rewards can have unintended consequences.

Rewards may undermine responsiveness. Rewards undermine intrinsic motivation.

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TABLE 123

Express Auto Compensation System

Responsibility of Team Persuade buyer to purchase a car. Help close the sale; persuade customer to use company finance plan. Inspect cars delivered from factory, clean, and make minor adjustments. Provide factory warranty service, maintenance, and repair. Primary liaison between customer and sales force, finance, and mechanics Current Compensation Method Very small salary (minimum wage) with commissions. Commission rate increases with every 20 cars sold per month. Salary, plus bonus for each $10,000 financed with the company

Express Auto Team 1. Sales force

2. Finance office

3. Detailing

Piecework paid on the number of cars detailed per day. Small hourly wage, plus bonus based on (1) number of cars completed per day and (2) finishing each car faster than the standard estimated time to repair Minimum wage

4. Mechanics

5. Receptionists/ phone service personnel

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KEY TERMS
financial incentives fair days work scientific management movement merit pay (merit raise) annual bonus

expectancy instrumentality valence behavior modification variable pay piecework straight piecework standard hour plan

stock option golden parachutes team (or group) incentive plan organizationwide incentive plans profit-sharing plan Scanlon plan gainsharing plan at-risk variable pay plans employee stock ownership plan (ESOP)

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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