BUS 681 Week 2 Assignment

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4 Incentive Pay

Learning Objectives

When you �inish studying this chapter, you should be able to:

4-1. Explore the incentive pay approach. 4-2. Describe the differences between incentive pay methods and traditional pay methods.

4-3. Summarize �ive types of individual incentive pay plans. 4-4. Explain two types of group incentive plans.

4-5. Discuss two types of company-wide incentive plans. 4-6. Summarize considerations when designing incentive pay programs.

CHAPTER WARM-UP!

If your professor has assigned this, go to the Assignments section of mymanagementlab.com (http://mymanagementlab.com) to complete the Chapter Warm-Up! and see what you already know. After reading the chapter, you’ll have a chance to take the Chapter Quiz! and see what you’ve learned.

As we will discuss momentarily, incentive pay places some portion of employee compensation at risk. When employees, groups of employees, or entire companies fail to meet preestablished performance standards (e.g., annual sales), they forfeit some or all of their compensation. Expert incentive pay consultants argue that a critical element of successful incentive pay plans is the provision of regular, honest communication to employees. We will explore this issue and several others related to effective incentive pay design.

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4.1 EXPLORING INCENTIVE PAY

4-1 Explore the incentive pay approach.

Incentive pay (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss212) or variable pay (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss462) rewards employees for partially or completely attaining a predetermined work objective. Incentive or variable pay is de�ined as compensation, other than base wages or salaries that �luctuate according to employees’ attainment of some standard, such as a preestablished formula, individual or group goals, or company earnings.1 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end1)

Effective incentive pay systems are based on three assumptions:2

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end2)

Individual employees and work teams differ in how much they contribute to the company, both in what they do as well as in how well they do it.

The company’s overall performance depends to a large degree on the performance of individuals and groups within the company.

To attract, retain, and motivate high performers and to be fair to all employees, a company needs to reward employees on the basis of their relative performance.

Much like seniority and merit pay approaches, incentive pay augments employees’ base pay, but incentive pay appears as a one-time payment. Employees usually receive a combination of recurring base pay and incentive pay, with base pay representing the greater portion of core compensation. More employees are presently eligible for incentive pay than ever before, as companies seek to control costs and motivate personnel continually to strive for exemplary performance. Companies increasingly recognize the importance of applying incentive pay programs to various kinds of employees as well, including production workers, technical employees, and service workers.

Some companies use incentive pay extensively. Lincoln Electric Company, a manufacturer of welding machines and motors, is renowned for its use of incentive pay plans. At Lincoln Electric, production employees receive recurring base pay as well as incentive pay. The company determines incentive pay awards according to �ive performance criteria: quality, output, dependability, cooperation, and ideas. The company has awarded incentive payments every year since 1934, through prosperous and poor economic times. In 2014, the average pro�it sharing payment per employee was $33,984.3

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end3) Coupled with average base pay, total core compensation for Lincoln employees was $82,903. Over the past 10 years, Lincoln’s pro�it- sharing payments averaged approximately 40 percent of annual salary.4

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end4) Similarly, Southwest Airlines has distributed pro�it-sharing payments to employees every year for the past 40 years.5

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end5) In 2014, Southwest

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announced that it would share $228 million in pro�its.6

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end6)

Companies generally institute incentive pay programs to control payroll costs or to motivate employee productivity. Companies can control costs by replacing annual merit or seniority increases or �ixed salaries with incentive plans that award pay raises only when the company enjoys an offsetting rise in productivity, pro�its, or some other measure of business success. Well-developed incentive programs base pay on performance, so employees control their own compensation levels. Companies can choose incentives to further business objectives. For example, the management of H. Lee Mof�itt Cancer Center and Research Institute at the University of South Florida continually strives to improve patient care as well as control costs. Mof�itt’s incentives are usually tied to net income or operating surplus, quality of care measures, patient satisfaction scores, and operating ef�iciencies.

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4.2 CONTRASTING INCENTIVE PAY WITH TRADITIONAL PAY

4-2 Describe the differences between incentive pay methods and traditional pay methods.

In traditional pay plans, employees receive compensation based on a �ixed hourly pay rate or annual salary. Some companies use incentive pay programs that replace all or a portion of base pay in order to control payroll expenditures and to link pay to performance. Since 1998, there has been a 47 percent increase in the use of incentive pay programs. Companies use incentive pay programs in varying degrees for different kinds of positions.7

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end7) Nowadays, most companies use a mix of traditional and incentive pay methods. The mix has steadily changed. In 1998, traditional pay increases totaled 4.2 percent of payroll while incentive pay increases amounted to 8.0 percent. In 2014, the amounts were 2.9 percent and 12.7 percent, respectively.8

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end8)

As we discussed in Chapter 3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch03#ch03) , employees under traditional pay structures earn raises according to their length of service in the organization or to supervisors’ subjective appraisals of employees’ job performance. Again, both merit pay raises and seniority pay raises are permanent increases to base pay. Annual merit pay increase amounts usually total no more than a small percentage of base pay (approximately 3 percent), but the dollar impact represents a signi�icant cost to employers over time. Table 4-1 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec2#ch04tab01) shows the contrast in rate of compensation increase between a traditional merit compensation plan and an incentive plan.

Companies use incentive pay to reward individual employees, teams of employees, or whole companies based on their performance. Incentive pay plans are not limited solely to production or nonsupervisory workers. Many incentive plans apply to such categories of employees as sales professionals, managers, and executives. Management typically relies on business objectives to determine incentive pay levels such as company pro�its and sales growth. Management then communicates these planned incentive levels and performance goals to managers. Although merit pay performance standards aim to be measurable and objective, incentive levels tend to be based on even more objective criteria, such as quantity of items an employee produces per production period or market indicators of a company’s performance (e.g., an increase in market share for the �iscal year). Moreover, supervisors communicate the incentive award amounts in advance that correspond to objective performance levels. On the other hand, supervisors generally do not communicate the merit award amounts until after they offer subjective assessments of employees’ performance.

TABLE 4-1 Permanent Annual Merit Increases versus Incentive Awards: A Comparison

(At the end of 2015, John Smith earned an annual salary of $35,000.)

Total Salary under

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Cost of Increase (Total Current Salary—2015 Annual Salary equals

$35,000) Permanent Merit Increase

(Percent Increase × Previous Year Annual Salary) + Previous

Annual Salary ($)

Incentive Award ($) (Percent Increase × 2015 Salary) + Fixed Base Pay

($35,000) ($)Year

Increase Amount (%)

Permanent Merit

Increase ($)

Incentive Award ($)

2016 3 1,050 1,050 36,050 36,050

2017 5 2,853 1,750 37,853 36,750

2018 4 4,367 1,400 39,367 36,400

2019 7 7,122 2,450 42,122 37,450

2020 6 9,649 2,100 44,649 37,100

Incentive pay plans can be broadly classi�ied into three categories:

Individual incentive plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss218) . These plans reward employees whose work is performed independently. Some companies have piecework plans, typically for their production employees. Under piecework plans, an employee’s compensation depends on the number of units she or he produces over a given period.

Group incentive plans. These plans promote supportive, collaborative behavior among employees. Group incentives work well in manufacturing and service delivery environments that rely on interdependent teams. In gain sharing programs, group improvements in productivity, cost savings, or product quality are shared by employees within the group.

Company-wide incentive plans. These plans tie employee compensation to a company’s performance over a short time frame, usually from a one-month period to a �ive-year period.

Table 4-2 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#ch04tab02) lists common performance measures used in individual, group, and company-wide incentive plans9

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end9) .

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4.3 INDIVIDUAL INCENTIVES

4-3 Summarize �ive types of individual incentive pay plans.

Individual incentive pay plans are most appropriate under three conditions. First, employees’ performance can be measured objectively. Examples of objective performance measures include:

Number of units produced—an automobile parts production worker’s completion of a turn signal lighting assembly

Sales amount—a Mary Kay Cosmetics sales professional’s monthly sales revenue

Reduction in error rate—a word processor’s reduction in typing errors

Second, individual incentive plans are appropriate when employees have suf�icient control over work outcomes. Factors such as frequent equipment breakdowns and delays in receipt of raw materials limit employees’ ability to control their performance levels. Employees are not likely to be diligent when they encounter interference: Chances are good that employees who previously experienced interference will expect to encounter interference in the future. Employees’ resistance threatens pro�its because companies will �ind it dif�icult to motivate people to work hard when problem factors are not present.

TABLE 4-2 Typical Performance Measures for Individual, Group, and Company-wide Incentive Plans

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Individual Incentive Plans Quantity of work output Quality of work output Monthly sales Work safety record Work attendance

Group Incentive Plans Customer satisfaction Labor cost savings (through gain sharing plans) Materials cost savings Services cost savings (e.g., utilities)

Company-wide Incentive Plans Operational Measures:

Customer satisfaction Operational ef�iciency Service/quality Safety/occupational injury

Financial Measures: Revenue Earnings per company stock share

Operating income Revenue growth

Note: Measures such as safety records and customer satisfaction can be measured on an individual, group, or company-wide basis according to a company’s objectives.

Third, individual incentive plans are appropriate when they do not create a level of unhealthy competition among workers that ultimately leads to poor quality. For example, a company may create unhealthy competition when it limits the number of incentive awards to only 10 percent of the employees who have demonstrated the highest levels of performance. If the company judges performance according to volume, then employees may sacri�ice quality as they compete against each other to outmatch quantity. In addition, under an incentive plan that rewards quantity of output, those employees who meet or exceed the highest standard established by their employer may be subject to intimidation by workers whose work falls below the standard.10

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end10) Unions may use these intimidation tactics to prevent plan standards from being raised.

De�ining Individual Incentives

Individual incentive plans reward employees for meeting such work-related performance standards as quality, productivity, customer satisfaction, safety, or attendance. Any one of these standards by itself or in combination may be used. A company ultimately should employ the standards that represent work that an employee actually performs. For instance, take the case of telemarketers. Customer satisfaction and sales volume measures indicate telemarketers’ performance. Tardiness would not be as relevant unless absenteeism was a general management problem.

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Managers should also choose factors that are within the individual employee’s control when they create individual performance standards. Furthermore, employees must know about standards and potential awards before the performance period starts. When designed and implemented well, individual incentive plans reward employees based on results for which they are directly responsible. The end result should be that excellent performers receive higher incentive awards than poor performers.

Types of Individual Incentive Plans

There are �ive common types of individual incentive plans:

Piecework plans

Management incentive plans

Behavioral encouragement plans

Referral plans

Spot bonuses

PIECEWORK PLANS

Companies generally use one of two piecework plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss337) .11

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end11) The �irst, which is typically found in manufacturing settings, rewards employees based on their individual hourly production against an objective output standard and are determined by the pace at which manufacturing equipment operates. For each hour, workers receive piecework incentives for every item produced over the designated production standard. Workers also receive a guaranteed hourly pay rate regardless of whether they meet the designated production standard. Table 4-3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#ch04tab03) illustrates the calculation of a piecework incentive.

Companies use piecework plans when the time to produce a unit is relatively short, usually less than 15 minutes, and the cycle repeats continuously. Piecework plans are usually found in such manufacturing industries as textiles and apparel.

Quality is also an important consideration. Companies do not reward employees for producing defective products. In the apparel industry, manufacturers attempt to minimize defect rates because they cannot sell defective clothing for the same price as nondefective clothing. Selling defective clothing at a lower price reduces company pro�its.

TABLE 4-3 Calculation of a Piecework Award for a Garment Worker

Piecework standard: 15 stitched garments per hour Hourly base pay rate awarded to employees when the standard is not met: $4.50 per hour That is, workers receive $4.50 per hour worked regardless of whether they meet the piecework standard of 15 stitched garments per hour. Piecework incentive award: $0.75 per garment stitched per hour above the piecework standard

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Guaranteed Hourly Base Pay

($) Piecework Award (No. of Garments Stitched above the Piecework Standard × Piecework Incentive Award)

Total Hourly Earnings ($)

First hour

4.50 10 garments × $0.75/garment = $7.50 12.00

Second hour

4.50 Fewer than 15 stitched garments, thus piecework award equals $0

4.50

The second type of piecework incentive plan establishes individual performance standards that include both objective and subjective criteria. Units produced represent an objective standard. Overall work quality is a subjective criterion that is based on supervisors’ interpretations and judgments. For example, supervisors may judge customer service representatives’ performance to be higher when sales professionals emphasize the bene�its of purchasing extended product warranties than when sales professionals merely mention the availability and price of extended product warranties.

Economists argue that there are two advantages to companies of using piecework plans in manufacturing settings known as the incentive effect (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss211) and sorting effect (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss419) .12

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end12) The incentive effect refers to a worker’s willingness to work diligently to produce more quality output than simply attending work without putting in the effort. To put this simply, employees earn much less under the piecework system than they would under a standard hourly pay system. Whereas employees are certainly expected to perform without an incentive (piece rate), research shows that incentives often are associated with higher employee performance.

The sorting effect addresses an employee’s choice to stay versus leave his or her employer for another job, presumably one without an incentive pay contingency. Speci�ically, a hardworking, highly skilled employee is likely to choose to remain employed under an incentive system because both diligence and skill presumably contribute to higher quantity and quality of output—thus, higher pay.

MANAGEMENT INCENTIVE PLANS

Management incentive plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss264) award bonuses to managers when they meet or exceed objectives based on sales, pro�it, production, or other measures for their division, department, or unit. Management incentive plans differ from piecework plans in that piecework plans base rewards on the attainment of one speci�ic objective, and management incentive plans often require multiple complex objectives. For example, management incentive plans reward managers for increasing market share or reducing their budgets without compromising the quality and quantity of output. The best-known management incentive plan is management by objectives (MBO).13

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end13) In Chapter 3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch03#ch03) , MBO was presented as an outcome-oriented performance appraisal technique for merit pay systems. When MBO is used as part of merit pay systems, superiors make subjective assessments of managers’ performance, and they use these assessments to determine permanent merit pay increases. When used as part of incentive

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programs, superiors communicate the amount of incentive pay managers will receive based on the attainment of speci�ic goals.

TABLE 4-4 A Sample Behavioral Encouragement Plan that Rewards Employee Attendance

At the end of each 3-month period, employees with exemplary attendance records will receive monetary incentive awards according to the following schedule. Note that the number of days absent does not refer to such company-approved absences as vacation, personal illness, jury duty, bereavement leave, military duty, scheduled holidays, and educational leave.

Number of Days Absent Monetary Incentive Award ($)

0 (perfect attendance) 250

1 200

2 100

3 50

4 25

BEHAVIORAL ENCOURAGEMENT PLANS

Under behavioral encouragement plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss24) , employees receive payments for speci�ic behavioral accomplishments (e.g., good attendance or safety records). For example, companies usually award monetary bonuses to employees who have exemplary attendance records for a speci�ied period. When behavioral encouragement plans are applied to safety records, workers earn awards for lower personal injury or accident rates associated with the improper use of heavy equipment or hazardous chemicals. Table 4-4 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#ch04tab04) contains an illustration of a sample behavioral encouragement plan that rewards employees for excellent attendance. Employees can earn $250 for perfect attendance during a three-month period. With perfect attendance for an entire year, employees can earn $1,000. Behavioral encouragement plans have the potential to save companies substantially more money than the cost of these awards. For example, frequent absenteeism in a company’s workforce could disrupt production goals and quality. Customers may respond by choosing to make purchases for better quality products from other companies. Loss of customer bases will have a negative impact on pro�itability and reputation that prompts prospective customers to choose alternate sources to purchase products.

REFERRAL PLANS

Employees may receive monetary bonuses under referral plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss371) for referring new customers or recruiting successful job applicants. Companies commonly rely on referral bonuses to enhance recruitment of highly quali�ied employees, particularly when the supply of highly quali�ied individuals is low, or the company is experiencing explosive growth. HubSpot, the developer of inbound marketing software, recently experienced growth in excess of 80 percent.14

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end14) The company relies heavily on the work of talented software engineers and designers. In response to this substantial growth,

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HubSpot offered a $30,000 bonus to employees whose referral was hired as a software engineer or designer. This program expands eligibility to any individual regardless of employment status.

A successful referral usually means that companies award bonuses only if hired referrals remain employed with the company in good standing beyond a designated period, often at least 30 days. Referral plans rely on the idea that current employees’ familiarity with company culture should enable them to identify viable candidates for job openings more ef�iciently than employment agencies could because agents are probably less familiar with client companies’ cultures. Employees are likely to make only those referrals they truly believe are worthwhile because their personal reputations are at stake.

SPOT BONUSES

Many organizations today are providing spot bonuses for critical areas and talents. Spot bonuses (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss422) are relatively small monetary gifts provided to employees for outstanding work or effort during a reasonably short period of time. If an employee’s performance has been exceptional, the employer may reward the worker with a one-time bonus with an amount as low as $50. For certain professional jobs it is not unheard of for a highly productive worker to receive $5,000 shortly after a noteworthy achievement.

Advantages of Individual Incentive Pay Programs

There are three key advantages of individual incentive pay plans. First, individual incentive plans can promote the relationship between pay and performance. As discussed in Chapter 1 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch01#ch01) , employees in the United States are highly motivated by earning money. Employees strive for excellence when they expect to earn incentive awards commensurate with their job performance.

Second, individual incentive plans promote an equitable distribution of compensation within companies (i.e., the amount employees earn depends on their job performance). The better they perform, the more they earn. Equitable pay ultimately enables companies to retain the best performers. Paying better performers more money sends a signal that the company appropriately values positive job performance.

A third advantage of individual incentive plans is their compatibility with such individualistic cultures as the United States. Because U.S. employees are socialized to make individual contributions and be recognized for them, the national culture of the United States probably enhances the motivational value of individual incentive programs.

Disadvantages of Individual Incentive Pay Programs

Although individual incentive plans can prove effective in certain settings, these programs also have serious limitations. Supervisors, human resource (HR) managers, and compensation professionals should know about three potential problems with individual incentive plans.

First, individual incentive plans possess the potential to promote in�lexibility. Because supervisors determine employee performance levels, workers under individual incentive plans become dependent on supervisors for setting work goals. If employees become highly pro�icient performers, they are not likely to increase their performance beyond their reward compensation. For example, let’s assume that management de�ines the maximum incentive award as $500 per month, which is awarded to employees whose productivity rates 15 percent above the performance standard. Employees who produce more

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than 15 percent above the production standard will not receive additional incentive pay beyond the $500. With this design, employees would not be motivated to further improve their performance.

Second, with merit pay systems, supervisors must develop and maintain comprehensive performance measures to properly grant incentive awards. Individual incentive programs pose measurement problems when management implements improved work methods or equipment. When such changes occur, it will take some time for employees to become pro�icient performers. Thus, it will be dif�icult for companies to determine equitable incentive awards, which may lead to employees’ resistance to the new methods.

A third limitation of individual incentive plans is that they may encourage undesirable workplace behavior when these plans reward only one or a subset of dimensions that constitute employees’ total job performance. Let’s assume that an incentive plan rewards employees for quantity of output. If employees’ jobs address such various dimensions as quantity of output, quality, and customer satisfaction, employees may focus on the one dimension—in this case, quantity of output—that leads to incentive pay and thereby neglect the other dimensions.

Our focus has been on �inancial incentive awards. Companies may provide non�inancial incentives to employees, including companies such as hotels that operate in a low-paying industry. Hotel chain Joie de Vivre Hospitality does just that. Several times a year, employees are given the opportunity to stay in any of the company’s hotels at no charge and to take full advantage of the amenities. By assuming the customer role, Joie de Vivre Hospitality employees can improve job performance because they gain a better understanding of their guests’ needs.

WATCH IT!

If your professor has assigned this, go to the Assignments section of mymangementlab.com (http://mymangementlab.com) to complete the video exercise titled Joie de Vivre Hospitality: Pay for Performance and Financial Incentives.

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4.4 GROUP INCENTIVES

4-4 Explain two types of group incentive plans.

U.S. employers are increasingly using teams to get work done. Two main changes in the business environment have led to an increased use of teams in the workplace.15

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end15) First, in the 1980s, many more Japanese companies were conducting business in the United States, particularly in the automobile industry. A common feature of Japanese companies was the use of teams, which contributed to superior product quality. Second, team-based job design promotes innovation in the workplace.16

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end16) At Newell Rubbermaid, a manufacturer of such plastic household products as snap-together furniture and storage boxes, product innovation has become the rule since the implementation of project teams. Team members represent various cross-functional areas, including research and development (R&D), marketing, �inance, and manufacturing. Rubbermaid attributes the rush on innovation to the cross-fertilization of ideas that has resulted from the work of these diverse teams.17

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end17)

Companies that use work teams need to change individualistic compensation practices so that groups are rewarded for their behavior together.18

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end18) Team-based pay plans should accordingly emphasize cooperation between and within teams, compensate employees for additional responsibilities they often must assume in their roles as members of a team, and encourage team members to attain predetermined objectives for the team.19

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end19) Merit, seniority, or individual incentives do not encourage team behaviors and may potentially limit team effectiveness. Experts suggest that traditional pay programs will undermine the ability of teams to function effectively.20 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end20) Both merit- and seniority-based pay emphasize hierarchy among employees, which is incompatible with the very concept of a team.

Team-based organizational structures encourage team members to learn new skills and assume broader responsibility than is expected of them under traditional pay structures that are geared toward individuals. Rather than following speci�ic orders from a supervisor, employees who work in teams must initiate plans for achieving their team’s production. A pay plan for teams usually emphasizes cooperation and rewards its members for the additional responsibilities they must take on, as well as the skills and knowledge they must acquire. Chapter 5 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch05#ch05) will show how skill- and knowledge-based pay plans can address these additional responsibilities.

De�ining Group Incentives

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Group incentive programs (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss184) reward employees for their collective performance, rather than for each employee’s individual performance. Group incentive programs are most effective when all group members have some impact on achieving the goal, even though individual contributions might not be equal. Boeing utilizes a team-based approach to manufacture its model 777 jumbo jet. More than 200 cross-functional teams contribute to the construction of each jet, and the contribution of each individual is clearly not equal. Installing such interior trim features as upholstery is not nearly as essential to the airworthiness of each jet as are the jobs of ensuring the aerodynamic integrity of each aircraft.

Well-designed group incentive plans ultimately reinforce teamwork, cultivate loyalty to the company, and increase productivity. For instance, the Morning Star Company, which processes tomato production, is based almost entirely on self-management principles: “We envision an organization of self-managing professionals who initiate communication and coordination of their activities with fellow colleagues, customers, suppliers, and fellow industry participants, absent directives from others.”21

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end21) Annually, each employee negotiates a Colleague Letter of Understanding with other employees who are most affected by his or her work.22 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end22) Morning Star leadership believes that voluntary agreements among individuals can produce effective coordination.

Types of Group Incentive Plans

Companies use two major types of group incentive plans:

Team-based or small-group incentive plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss443) . A small group of employees shares a �inancial reward when a speci�ic objective is met.

Gain sharing plans. A group of employees, generally a department or work unit, is rewarded for productivity gains.

TEAM-BASED OR SMALL-GROUP INCENTIVE PLANS

Team-based incentives are similar to individual incentives with one exception. Each group member receives a �inancial reward for the attainment of a group goal. There are many kinds of team incentive programs. Most companies de�ine these programs based on the type of team:23

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end23)

Work (process) teams refer to organizational units that perform the work of the organization on an ongoing basis. Membership is relatively permanent, and members work full time in the team. Customer service teams and assembly teams on production lines represent excellent examples of work teams. Work teams are effective when individuals are cross-trained to perform team members’ work when they are absent. The goal is to maintain consistency in performance quality (e.g., addressing customer concerns promptly even when one or more team members are absent) and output (e.g., in the case of assembly teams). Team members ultimately engage in performance sharing rather than focusing exclusively on one set of tasks. The knowledge and skill sets required to contribute effectively to the work of a process team can be acquired with the assistance of person-focused pay, which we discuss in Chapter 5 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch05#ch05) .

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Project teams consist of a group of people assigned to complete a one-time project. Members usually have well-de�ined roles and may work on speci�ic phases of the project, either full time or in addition to other work responsibilities of the team. Project teams usually work across such functions as engineering, product development, and marketing to ensure that the �inal product meets company speci�ications in terms of cost, quality, and responsiveness to market demands (e.g., Toyota’s hybrid vehicles). Many individuals collaborated to ensure the production of cars that rely less on fossil fuels, demonstrate excellent gas mileage, and offer the same driving experience that people have come to expect of gasoline- powered automobiles.

Parallel teams, or task forces, include employees assigned to work on a speci�ic task in addition to normal work duties. The modi�ier parallel indicates that an employee works on the team task while continuing to work on normal duties. Also, parallel teams or task forces operate on a temporary basis until their work culminates in a recommendation to top management. Task forces are used to evaluate existing systems and processes, to select new technology, and to improve existing products. There is some evidence that team interactions on complex tasks are likely to in�luence creativity more than individual efforts, and group incentive plans may foster creativity. This especially seems to be the case when incentive compensation is truly an add-on, and independent of employees’ regular base pay.24

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end24)

Teams or groups may ultimately receive incentive pay based on such criteria as customer satisfaction (i.e., customer service quality), safety records, quality, and production records. Although these criteria apply to other categories of incentive programs as well (individual, company-wide, and group plans), companies allocate awards to each worker based on the group’s attainment of predetermined performance standards.

Human resource managers must devise methods for allocating incentives to team members. Although the team-based reward is generated by the performance of the team, the incentive payments are typically distributed to members of the team individually. Human resource experts allocate rewards in one of three ways:

Equal incentive payments to all team members.

Differential incentive payments to team members based on their contribution to the team’s performance.

Differential payments determined by a ratio of each team member’s base pay to the total base pay of the group.

The �irst method—the equal incentives payment approach—reinforces cooperation among team members except when team members perceive differences in members’ contributions or performance. The second method—the differential incentive payments approach—distributes rewards based to some extent on individual performance. Differential approaches obviously can hinder cooperative behavior. Some employees may focus on their own performance rather than on the group’s performance because they wish to maximize their income. As a compromise, companies may base part of the incentive on individual performance, with the remainder based on the team’s performance. The third disbursement method—differential payments by ratio of base pay—rewards each group member in proportion to her or his base pay. This approach assumes that employees with higher base pay contribute more to the company and so should be rewarded in accord with that worth.

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GAIN SHARING PLANS

Gain sharing (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss171) describes group incentive systems that provide participating employees with an incentive payment based on improved company performance for increased productivity, increased customer satisfaction, lower costs, or better safety records.25

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end25) Gain sharing was developed so that all employees could bene�it �inancially from productivity improvements resulting from the suggestion system. In addition to serving as a compensation tool, most gain sharing re�lects a management philosophy that emphasizes employee involvement. The use of gain sharing is most appropriate where workplace technology does not constrain productivity improvements. For example, assembly line workers’ abilities to improve productivity may be limited. Increasing the speed of the conveyor belts may compromise workers’ safety.

Most gain sharing programs have three components:26

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end26)

Leadership philosophy

Employee involvement systems

Bonus

The �irst component—leadership philosophy—refers to a cooperative organizational climate that promotes high levels of trust, open communication, and participation. The second component— employee involvement systems—drives organizational productivity improvements. Employee involvement systems use broadly based suggestion systems. Anyone can make suggestions to a committee made up of both hourly and management employees who oversee the suggestion implementation. This involvement system also may include other innovative employee involvement practices (e.g., problem-solving task forces).

The bonus is the third component of a gain sharing plan. A company awards gain sharing bonuses when its actual productivity exceeds its targeted productivity level. The gain sharing bonuses are usually based on a formula that measures productivity that employees perceive as fair and the employer believes will result in improvements in company performance. Employees typically receive gain sharing bonuses on a monthly basis. Most bonuses range between 5 and 10 percent of an employee’s base annual pay. A noteworthy exception to this norm is AmeriSteel. On average, AmeriSteel’s gain sharing plan pays out between 35 and 45 percent of base pay.

Although many accounts of gain sharing use can be found in the practitioner and scholarly literature, no one has completed a comprehensive, soundly designed investigation of the effectiveness of gain sharing programs.27 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end27) Meanwhile, gain sharing programs’ success has been attributed to company cultures that support cooperation among employees.28 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end28) Some gain sharing attempts have failed. Such organizational, external environmental and �inancial information factors, including poor communications within and across departments, highly competitive product markets, and variable corporate pro�its over time can inhibit effective gain sharing programs.29

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end29) Poor communications will

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sti�le the creativity needed to improve the ef�iciency of work processes when employees focus exclusively on their own work. Highly competitive product markets often require companies to make frequent changes to their production methods, as in the automobile industry, where such changes occur each year with the introduction of new models. When companies make frequent or sudden changes, employees must have time to learn the new processes well before they can offer productive suggestions. Companies that experience variable pro�its from year to year most likely do not use gain sharing because management sets aside as much excess cash as possible in reserve for periods when pro�its are down and excess cash is scarce.

The Scanlon, Rucker, and Improshare gain sharing plans are the most common forms used in companies, and they were also the �irst types of gain sharing plans developed and used by employers. These plans were adopted wholesale in the early days of gain sharing. Employers today generally modify one of these traditional plans to meet their needs or adopt hybrid plans.

THE SCANLON PLAN

Joseph Scanlon �irst developed the gain sharing concept in 1935 as an employee involvement system without a pay element.30 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end30) The hallmark of the Scanlon plan (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss394) is its emphasis on employee involvement. Scanlon believed that employees will exercise self-direction and self-control if they are committed to company objectives and that employees will accept and seek out responsibility if given the opportunity.31 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end31) Current Scanlon plans include monetary rewards to employees for productivity improvements. Scanlon plans assume that companies will be able to offer higher pay to workers, generate increased pro�its for stockholders, and lower prices for consumers. The Scanlon plan is a generic term referring to any gain sharing plan that has characteristics common to the original gain sharing plan devised by Scanlon. Scanlon plans have the following three components:32

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end32)

An emphasis on teamwork to reduce costs, assisted by management-supplied information on production concerns.

Suggestion systems that route cost-saving ideas from the workforce through a labor– management committee that evaluates and acts on accepted suggestions.

A monetary reward based on productivity improvements to encourage employee involvement.

Scanlon plan employee involvement systems include a formal suggestion program structured at two levels. Production-level committees, usually including a department foreman or supervisor and at least one elected worker, communicate the suggestion program and its reward features to workers. Production committee members encourage and assist workers in making suggestions and formally record suggestions for consideration. Production committees may also reject suggestions that are not feasible, but they must provide a written explanation of the reasons for the rejection to the worker who made the suggestion. Providing the written rationale under this circumstance is key to helping employees understand why the suggestions are not feasible and, thus, workers are not discouraged from making suggestions in the future. After employees’ suggestions have been fully implemented, they typically receive bonuses on a monthly basis.

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The production committee forwards appropriate suggestions to a company-wide screening committee, which also includes worker representatives. This committee reviews suggestions referred by the production committees, serves as a communications link between management and employees, and reviews the company’s performance each month.

Actual gain sharing formulas are designed to suit the individual needs of the company.33

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end33) Formulas are usually based on the ratio between labor costs and sales value of production (SVOP) (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss391) .34

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end34) The SVOP is the sum of sales revenue plus the value of goods in inventory.

Smaller Scanlon ratios indicate that labor costs are lower relative to SVOP. Companies de�initely strive for lower ratios, as Table 4-5 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#ch04tab05) illustrates. In addition, Table 4-5 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#ch04tab05) shows the calculation for a bonus distribution under a Scanlon plan.

THE RUCKER PLAN

Similar to Scanlon’s plan, the Rucker plan (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss384) was developed by Allan W. Rucker in 1933. Both the Scanlon and Rucker plans emphasize employee involvement and provide monetary incentives to encourage employee participation. The main difference lies in the formula used to measure productivity. Rucker plans use a value-added formula (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss461) to measure productivity. Value added is the difference between the value of the sales price of a product and the value of materials purchased to make the product. The following example illustrates the concept of value added based on the sequence of events that eventually lead to selling bread to consumers. These events include growing the wheat, milling the wheat, adding the wheat to other ingredients to make bread, and selling the bread to consumers.

A farmer grows the wheat and sells it to a miller; the added value is the difference in the income the farmer receives for the wheat and the costs incurred for purchasing seed, fertilizer, fuel, and other supplies. The miller, in turn, buys the wheat from the farmer, mills it, and then sells it to a bakery. The difference in the cost of buying the wheat and the price it is sold for to the baker is the amount of “value” the miller “adds” in the milling processes. The same process is repeated by the baker, as the �lour that was milled by the miller is mixed with other ingredients, baked, and sold as bread either to the consumer or to a retailer who in turn sells it to the consumer. The baker “adds value” by blending in the other ingredients to the �lour and baking the bread. If the bread is sold to the consumer through a retailer, then the retailer also “adds value” by buying the bread from the bakery, transporting it to a store convenient for the consumer, displaying the bread, and selling it. The total of all the added values from each step along the way equals the total contribution to the overall economy from the chain of events.35

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end35)

TABLE 4-5 Illustration of a Scanlon Plan

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For the period 2012–2014, the labor costs of XYZ Manufacturing Company have averaged $44,000,000 per year. During the same 3-year period, the sales value of XYZ’s production (SVOP) averaged $83,000,000 per year. (As an aside, of the $83,000,000, $65,000,000 represents sales revenue and $18,000,000 represents the value of goods held in inventory.) The Scanlon ratio for XYZ Manufacturing Company is:

$44,000,000/$83,000,000 = 0.53 The ratio of 0.53 is the base line or standard. Any bene�its that result from an improvement in production methods produce results. Labor cost savings are shared with workers. In other words, when improvements lead to a Scanlon ratio that is lower than the standard of 0.53, employees will receive gain sharing bonuses. The operating information for XYZ Manufacturing Company for March 2015 was as follows:

The Scanlon ratio, based on March 2015 information was

The Scanlon ratio for March 2015 was less than the standard of 0.53. In order for there to be a payout, labor costs for March 2015 must be less than $3,816,000 (i.e., 0.53 × $7,200,000); $3,816,000 represents allowable labor costs for March 2015 based on the Scanlon standard established for XYZ Manufacturing. In summary, the allowable labor costs for March 2015 were $3,816,000. The actual labor costs were $3,100,000. Thus, the savings $716,000 ($3,816,000–$3,100,000) is available for distribution as a bonus.

The following ratio is used to determine whether bonuses will be awarded under a Rucker plan:

In contrast to the Scanlon ratio, companies prefer a larger Rucker ratio. A larger Rucker ratio indicates that the value added is greater than total employment costs. Table 4-6 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#ch04tab06) illustrates the calculation for bonus distribution under the Rucker plan.

Invented by Mitchell Fein in 1973, Improshare (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss210) —Improved Productivity through Sharing—measures productivity physically rather than in terms of dollar savings like those used in the Scanlon and Rucker plans. These programs aim to produce more products with fewer labor hours. Under Improshare, the emphasis is on providing employees with an incentive to �inish products. The Improshare bonus is based on a labor hour ratio formula (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss245) . A standard is determined by analyzing historical accounting data to �ind the number of labor hours needed to complete a product. Productivity is then measured as a ratio of standard labor hours and actual labor hours. Unlike the Rucker and Scanlon plans, employee participation is not a feature, and workers receive bonuses on a weekly basis.

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In summary, the Scanlon, Rucker, and Improshare plans are among the best-known kinds of gain sharing programs that are used by companies. Although the principle underlying these different plans is the same (i.e., a group incentive system that provides all or most employees a bonus payment based on improved performance), they each rest on slightly different assumptions.

Advantages of Group Incentives

The use of group incentive plans has two advantages for companies. First, companies can more easily develop performance measures for group incentive plans than they can for individual incentive plans. There are obviously fewer groups in a company than individuals. Thus, companies generally use fewer resources (e.g., staff time) to develop performance measures. In addition, judging the quality of the �inal product makes the most sense because companies must deliver high-quality products to maintain competitiveness. During the late 1970s and early 1980s, U.S. automobile manufacturers lost substantial market share to foreign automobile manufacturers because foreign automakers marketed automobiles of substantially higher quality than U.S. automakers. The trend did not change until U.S. automakers manufactured high-quality vehicles on a consistent basis.

TABLE 4-6 Illustration of a Rucker Plan

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Calculating the Standard: For the 2012 – 2015 period, ABC Manufacturing Company generated average net sales of $7,500,000. The company paid $3,200,000 for materials, $250,000 for sundry supplies, and $225,000 for such services as liability insurance, basic maintenance, and utilities. On the basis of these data, average value added was $3,825,000 (i.e., net sales – costs of materials, supplies, and services rendered), for this example, $7,500,000 – ($3,200,000 + $250,000 + $225,000). For the same period, average total employment costs were $2,400,000, which includes hourly wages for nonexempt workers, annual salaries for exempt employees, payroll taxes, and all bene�it costs. Based on the Rucker formula, the ratio of value added to total employment costs was 1.59 ($3,825,000/$2,400,000). If there are to be bonuses at the end of 2016, each dollar attributed to employment costs must be accompanied by creating at least $1.59 of value added.

The Rucker ratio, based on this information, was:

Applying the Standard to a 2016 Performance: The operating information for ABC Manufacturing Company for 2016 was as follows:

The Rucker ratio, based on 2016 data, was:

This Rucker ratio for 2016 was less than the standard of 1.59. In order for there to be a payout, value added for 2016 must be more than the standard, which would be $1,065,300 (1.59 × $670,000). However, based on the Rucker ratio obtained for this month (1.07), value added was only $716,900 (1.07 × $670,000). Therefore, employees of ABC Manufacturing will not receive any gain sharing bonuses based on 2016 performance.

Greater group cohesion is the second advantage associated with group incentive plans.36

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end36) Cohesive groups usually work more effectively toward achieving common goals than do individual group members focusing on the speci�ic tasks for which they are responsible. Working collaboratively is undoubtedly in group members’ best interests in order to maximize their incentive awards.

Disadvantages of Group Incentives

The main disadvantage of group incentive compensation is employee turnover. Companies’ implementation of group incentive programs may lead to turnover because of the free-rider effect (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss169) . Some employees may make fewer contributions to the group goals because they possess lower ability, skills, or experience than other group members. In some groups, members may deliberately choose to put forth less effort, particularly when each group member receives the same incentive compensation regardless

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of individual contributions to the group goals. In any case, the free-rider effect initially leads to feelings of inequity among those who make the greatest contributions to the attainment of the group goal. Over time, members who make the greatest contributions are likely to leave.

Group members may feel uncomfortable with the fact that other members’ performance in�luences their compensation level. Exemplary performers are more likely to feel this way when other group members are not contributing equally to the attainment of group goals. The lower performance of a few group members may lead to lower earnings for all members of the group. Discomfort with group incentive plans is likely to be heightened where incentive compensation represents the lion’s share of core compensation.

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4.5 COMPANY-WIDE INCENTIVES

4-5 Discuss two types of company-wide incentive plans.

The use of company-wide incentive plans can be traced to the nineteenth century. Companies instituted pro�it sharing programs to ease workers’ dissatisfaction with low pay and to change their beliefs that company management paid workers substandard wages while earning substantial pro�its. Quite simply, management believed that workers would be less likely to challenge managerial practices if they received a share of company pro�its.

De�ining Company-wide Incentives

Company-wide incentive plans reward employees when the company exceeds minimum acceptable performance standards (e.g., pro�its or the overall value of the company based on its stock price). As competitive pressures on companies increased, management sought methods to improve employee productivity. Companies presently use company-wide incentive programs to motivate employees to work harder for increased pro�its or increased company value to owners. Advocates of company-wide incentive plans believe that well-designed programs make workers’ and owners’ goals more compatible as workers strive toward increasing company pro�its or value.

Types of Company-wide Incentive Plans

Companies use two major types of company-wide incentive plans:

Pro�it sharing plans. Employees earn a �inancial reward when their company’s pro�it objective is met.

Employee stock option plans. Companies grant employees the right to purchase shares of company stock.

PROFIT SHARING PLANS

Pro�it sharing plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss357) pay a portion of company pro�its to employees, separate from base pay, cost-of-living adjustments, or permanent merit pay increases. Two basic kinds of pro�it sharing plans are used widely today. First, current pro�it sharing (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss92) plans award cash to employees, typically on a quarterly or annual basis. Current pro�it sharing represents a form of short-term incentive because of the frequency of payout potential. Second, deferred pro�it sharing (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss97) plans place cash awards in trust accounts for employees. These trusts are set aside on employees’ behalf as a source of retirement income, and can also be considered a long-term incentive. Aircraft manufacturer Boeing offers current pro�it sharing plans to all employee groups, except for ones that are represented by labor unions. Under the plan, nonmanagement employees can earn from 1 to 20 days of regular pay.37 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end37) In 2015,

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nonmanagement employees were granted 12.5 days’ extra pay.38

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end38) Management employees received awards that ranged from 12.5 to 22.5 of their salaries.

Calculating Pro�it Sharing Awards

HR professionals determine the pool of pro�it sharing money with any of three possible formulas. A �ixed �irst-dollar-of-pro�its formula uses a speci�ic percentage of annual pro�its, contingent upon the successful attainment of a company goal. For instance, a company might establish that the pro�it sharing fund will equal 7 percent of corporate pro�its; however, payment is contingent on a speci�ied reduction in scrap rates.

Second, companies may use a graduated �irst-dollar-of-pro�its formula instead of a �ixed percentage. For example, a company may choose to share 3 percent of the �irst $8 million of pro�its and 6 percent of the pro�its in excess of that level. Graduated formulas motivate employees to strive for extraordinary pro�it targets by sharing even more of the incremental gain.

Third, pro�itability threshold formulas fund pro�it sharing pools only if pro�its exceed a predetermined minimum level but fall below some established maximum level. Companies establish minimums to guarantee a return to shareholders before they distribute pro�its to employees. They establish maximums because they attribute any pro�its beyond this level to factors other than employee productivity or creativity (e.g., technological innovation).

After management selects a funding formula for the pro�it sharing pool, they must consider how to distribute pool money among employees. Companies usually make distributions in one of three ways: equal payments to all employees, proportional payments to employees based on annual salary, and proportional payments to employees based on their contribution to pro�its. Equal payments to all employees re�lect a belief that all employees should share equally in the company’s gain in order to promote cooperation among employees; however, employee contributions to pro�its probably vary. Most employers accordingly divide the pro�it sharing pool among employees based on a differential basis.

Companies may disburse pro�its based on proportional payments to employees based on their annual salaries. As we will detail in Chapters 6 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch06#ch06) and 7 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch07#ch07) , salary levels vary based on both internal and external factors; in general, the higher the salary, the more value the company assigns to a job. Higher-paying jobs presumably indicate more potential to in�luence a company’s competitive position. For any given job, pay will differ according to performance or seniority. Chapter 3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch03#ch03) notes that higher performance levels and seniority result in greater worth.

Still another approach is to disburse pro�its as proportional payments to employees based on their contribution to pro�its. Some companies measure employee contributions to pro�it based on job performance; however, this approach is not very feasible because it is dif�icult to isolate each employee’s contributions to pro�its. For example, how does a secretary’s performance (based on answering telephones, greeting visitors, and typing memos) directly contribute to company performance?

Advantages of Pro�it Sharing Plans

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The use of a pro�it sharing plan has two main advantages, one for employees and the other for companies. When properly designed, pro�it sharing plans enable employees to share in companies’ fortunes. As employees bene�it from pro�it sharing plans, they will be more likely to work productively to promote pro�its. The upshot of enhanced employee productivity obviously is greater pro�its for companies that use pro�it sharing plans.

Companies that use pro�it sharing programs gain greater �inancial �lexibility. As we discussed, monetary payouts to employees vary with pro�it levels. During economic downturns, payout levels are signi�icantly lower than they are during economic boom periods. This feature of pro�it sharing plans enables companies to use limited cash reserves where needed (e.g., for R&D activities).

Disadvantages of Pro�it Sharing Plans

There are two main disadvantages associated with pro�it sharing plans. The �irst one directly affects employees; the second affects companies. Pro�it sharing plans may undermine the economic security of employees, particularly if pro�it sharing represents a sizable portion of direct compensation. Because company pro�its vary from year to year, so do employees’ earnings. Thus, employees will �ind it dif�icult to predict their earnings, which will affect their saving and buying behavior. If there is signi�icant variability in earnings, a company’s excellent performers are likely to leave for employment with competitors. The turnover of excellent performers certainly represents a signi�icant disadvantage to companies.

Employers also �ind pro�it sharing programs to be problematic under certain conditions. Pro�it sharing plans may fail to motivate employees because they do not see a direct link between their efforts and corporate pro�its. Hourly employees in particular may have trouble seeing this connection because their efforts appear to be several steps removed from the company’s performance. For instance, an assembly line worker who installs interior trim (e.g., carpeting and seats) in automobiles may not �ind any connection between his or her efforts and the level of company pro�its because interior trim represents just one of many steps in the production of automobiles.

EMPLOYEE STOCK OPTION PLANS

Employee stock option plans (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss130) represent a long-term company-wide incentive plan that provide employees with stock options. Under these plans, companies grant employees the right to purchase shares of company stock. Company stock (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss57) represents total equity of a company. Company stock shares (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss58) represent equity segments of equal value. Equity interest increases positively with the number of stock shares. Stock options (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/bm01#bm01goss428) describe an employee’s right to purchase company stock. Employees do not actually own stock until they exercise the stock option rights. This is done by purchasing stock at a designated price after a company- chosen time period lapses, usually no more than 10 years. Employee stock options provide an incentive to work productively, with the expectation that collective employee productivity will increase the value of company stock over time. Employees earn monetary compensation when they sell the stock at a higher price than they originally paid for it.

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4.6 DESIGNING INCENTIVE PAY PROGRAMS

4-6 Summarize considerations when designing incentive pay programs.

When designing an incentive pay plan, HR professionals and line managers should consider �ive key factors:

Whether the plan should be based on group or individual employee performance.

The level of risk employees will be willing to accept in their overall compensation package.

Whether incentive pay should replace or complement traditional pay.

The criteria by which performance should be judged.

The time horizon for goals—long term, short term, or a combination of both.

Group Versus Individual Incentives

Companies considering various design alternatives should choose a design that �its the structure of the company. Group incentive programs are most suitable where the nature of the work is interdependent and the contributions of individual employees are dif�icult to measure. In such situations, companies require cooperative behavior among their employees. Companies may be able to encourage team behavior by linking compensation to the achievement of department or division goals and eliminating from the pay determination process such factors that are outside the group’s control as the late delivery of raw materials by an independent vendor.

On the other hand, individual incentive plans reward employees for meeting or surpassing such predetermined individual goals as production or sales quotas. The attainment of individual goals should be well within employees’ grasp as is the case for group incentives. Moreover, goals for individual incentive programs should be based on independent work rather than interdependent work. For example, it would be appropriate to base an employee’s incentive on typing accuracy because the work can be performed independently and there are few external constraints on an employee’s ability to complete such work. At the group level, it would be reasonable to provide incentives to the individual members of a sales team. In the case of computer hardware and networks, the sale and implementation of these products involve a team of marketing professionals and technical experts who depend on the others’ expertise to identify the appropriate con�iguration of hardware and networking equipment (i.e., meeting the client’s needs) and to install the equipment in the client’s company successfully.

Level of Risk

Careful consideration should be given to the level of risk employees are willing to accept. As mentioned previously, incentive pay may complement base salary or may be used in place of all or a portion of base salary. The level of risk clearly increases as incentive pay represents a greater proportion of total core compensation. The level of risk tends to be greater among higher-level employees than among those who are at the lower levels of a company’s job structure. It is reasonable to infer that the attainment of a

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�irst-line supervisor’s goal of maintaining a packing department’s level of productivity above a predetermined level is less risky than the achievement of a sales manager’s goal of increasing market share by 10 percent in a market where the competition is already quite stiff. Apart from an employee’s rank, the level of risk chosen should depend on the extent to which employees control the attainment of the desired goal. The adoption of incentive pay programs makes the most sense when participants have a reasonable degree of control over the attainment of the plan’s goals. Incentive programs logically are bound to fail when the goals are simply out of reach because they are too dif�icult or because extraneous factors are hampering employees’ efforts to meet goals.

Complementing or Replacing Base Pay

When complementing base pay, a company awards incentive pay in addition to an employee’s base pay and bene�its. On the other hand, companies may reduce base pay by placing the reduced portion at risk in an incentive plan. For instance, if a company grants its employees 10 percent raises each year, the company could, instead, grant its employees a 4 percent cost-of-living increase and use the remaining 6 percent as incentive by awarding none of it to below-average performers, only half of it to employees whose performance is average, and the entire 6 percent to employees whose performance is above average. In this scenario, the 6 percent that was expected by the employees to become part of their base pay is no longer a guarantee because that potential salary has been placed at risk. By introducing risk into the pay program, employees have the potential to earn more than the 6 percent because poor performers will receive less, leaving more to be distributed to exemplary performers.

Companies in such cyclical industries as retail sales could bene�it by including an incentive component in the core compensation programs they offer to employees. During slow business periods, the use of regular merit pay programs that add permanent increments to base pay can create budget problems. If incentive pay were used instead of permanent merit raises, then the level of expenditure on compensation would vary with levels of business activity. In effect, the use of incentive pay can lower payroll costs during lean periods and enhance the level of rewards when business activity picks up.

Performance Criteria

As seen in the discussion of performance appraisal in Chapter 3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch03#ch03) , the measures used to appraise employee performance obviously should be quanti�iable and accessible. For incentive pay programs, common measures of employee performance are company pro�its, sales revenue, and number of units produced by a business unit. The measures chosen preferably should relate to the company’s competitive strategy. For instance, if a company is attempting to enhance quality, its incentive plan would probably reward employees on the basis of customer satisfaction with quality.

In reality, more than one performance measure may be relevant. In such instances, a company is likely to employ all of the measures as a basis for awarding incentives. The weighting scheme would re�lect the relative importance of each performance criterion to the company’s competitive strategy [e.g., company performance (10 percent), unit performance (40 percent), and individual performance (50 percent), incorporating all of the organizational levels]. An employee clearly would receive an incentive even if company or departmental performance was poor. In effect, the relative weights are indicative of the degree of risk to an employee that is inherent in these plans. Compared with the previous example, the following plan would be quite risky: 50 percent company performance, 35 percent departmental performance, and 15 percent individual performance. Employees’ earnings would depend mainly on

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company and departmental performance over which they possess less control than they do over their own performance.

Time Horizon: Short Term versus Long Term

A key feature of incentive pay plans is the time orientation. There are no de�initive standards to distinguish between short term and long term. A general rule of thumb is that short-term goals generally can be achieved in �ive years or less and that long-term goals may require even longer. Most companies offer one or more short-term plans.39

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end39) Among the most popular plans are spot awards, pro�it sharing, and team-based incentives.

On the other hand, incentive programs for professionals and executives also have a long-term orientation. Stock option plans are among the most commonly used.40

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec11#ch04end40) For instance, rewarding an engineer’s innovation in product design requires a long-term orientation because it takes an extended amount of time to move through the series of steps required to bring the innovation to the marketplace (e.g., patent approval, manufacturing, and market distribution). The incentives that executives receive are based on a long-term horizon because their success is matched against the endurance of a company over time.

COMPENSATION IN ACTION

The use of incentive pay by an employer can be an effective way to tie individual or team performance to compensation. Many of the items in the Action Checklist are critical to the proper formation and administration of an incentive pay program (i.e., accurate criteria and measurement along with ongoing and honest performance discussions). Once this critical foundation is established, line managers and HR and compensation specialists must ensure that the plan is understood by employees and they can see the link between their performance and the portion of pay at risk.

Action checklist for line managers and HR—establishing an incentive pay program

HR takes the lead

Work with compensation specialists on your team to benchmark industry competitors to identify whether individual, group, or company-wide programs are being used (to stay current with trends and ensure that the best people are retained).

Work with line managers, based on the chosen program (individual, group, or company- wide), to choose which types of plan are utilized.

Hold roundtable discussions with employees to gather feedback on the proposed program and to identify potential areas where additional buy-in may be necessary.

Line managers take the lead

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Work with HR to identify the desired behavior(s) you want to tie to incentives—ensuring that the focus on these behaviors does not come at the expense of other desired outcomes.

Seek the education of HR to understand limitations of the chosen plan and how to overcome some of the potential pitfalls; plan should be monitored and/or tailored if these obstacles lead to the wrong behaviors being rewarded.

Provide proper information to HR so that a communication plan is created for rollout and implementation of the program—HR will form frequently asked questions (FAQs) and talking points that detail rationale for the change.

END OF CHAPTER REVIEW

MyManagementLab Go to mymanagementlab.com (http://mymanagementlab.com) to complete the problems marked with this icon .

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Summary

Learning Objective 1: Incentive pay or variable pay is de�ined as compensation, other than base wages or salaries, which �luctuates according to employees’ attainment of some standard, such as a preestablished formula, individual or group goals, or company earnings.

Learning Objective 2: In traditional pay plans, employees receive compensation based on a �ixed hourly pay rate or annual salary. Annual raises are added to base pay according to seniority or a supervisor’s evaluation of past performance. In incentive plans, employees receive one-time payments that correspond to the level of performance attainment based on objective goals.

Learning Objective 3: Individual incentive plans reward employees whose work is performed independently and can be quanti�ied objectively such as by sales volume or number of units produced.

Learning Objective 4: Group incentive plans promote supportive, collaborative behavior among employees. In general, members of a group or team receive the same incentive award for the group’s performance.

Learning Objective 5: Company-wide incentive plans tie employee compensation to a company’s performance over a relatively short time frame, not uncommonly, from three months to �ive years.

Learning Objective 6: Compensation professionals give consideration to at least �ive important factors when designing effective incentive pay plans. These include: (a) group versus individual incentives, (b) level of risk, (c) compensating or replacing base pay, (d) performance criteria, and (e) short- or long- term time horizon.

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Key Terms incentive pay 77 (ch04.xhtml#page_77) variable pay 77 (ch04.xhtml#page_77) piecework plans 81

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_81) incentive effect 82

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_82) sorting effect 82

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_82) management incentive plans 82

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_82) behavioral encouragement plans 82

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_82) referral plans 83

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_83) spot bonuses 83

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#page_83) group incentive programs 85

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_85) team-based incentives 85

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_85) gain sharing 86

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_86) Scanlon plan 87

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_87) sales value of production (SVOP) 88

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_88) Rucker plan 88

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_88) value-added formula 88

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_88) Improshare 89

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_89) labor hour ratio formula 89

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_89) free-rider effect 90

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_90) pro�it sharing plans 91

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_91) current pro�it sharing 91

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_91) deferred pro�it sharing 91

(http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec4#page_91)

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employee stock option plans 93 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec5#page_93)

company stock 93 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec5#page_93)

company stock shares 93 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec5#page_93)

stock options 93 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec5#page_93)

MyManagementLab CHAPTER QUIZ! If your professor has assigned this, go to the Assignments section of mymanagementlab.com (http://mymanagementlab.com) to complete the Chapter Quiz! and see what you’ve learned.

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Discussion Questions 4-1. Indicate whether you agree or disagree with the following statement: “Individual incentive

plans are less preferable than group incentives and company-wide incentives.” Explain your answer.

4-2. There is currently a tendency among business professionals to endorse the use of incentive pay plans. Identify two jobs for which individual incentive pay is appropriate and two jobs for which individual incentive pay is inappropriate. Be sure to include your justi�ication.

4-3. Critics of pro�it sharing plans maintain that these plans do not motivate employees to perform at higher levels. Under what conditions are pro�it sharing plans not likely to motivate employees?

4-4. Unlike individual incentive programs, group and company-wide incentive programs reward individuals based on group (e.g., cost savings in a department) and company-wide (e.g., pro�its) performance standards, respectively. Under group and company-wide incentive programs, it is possible for poor performers to bene�it without making substantial contributions to group or company goals. What can companies do to ensure that poor performers do not bene�it?

4-5. Opponents of incentive pay programs argue that these programs manipulate employees more than seniority and merit pay programs. Discuss your views of this statement.

CASE Individual or Team Reward?

An additional Supplemental Case can be found on MyManagementLab.

Jack Hopson has been making wood furniture for more than 10 years. He recently joined Metropolitan Furniture and has some ideas for Sally Boston, the company’s CEO. Jack likes working for Sally because she is very open to employee suggestions and is serious about making the company a success. Metropolitan is currently paying Jack a competitive hourly pay rate for him to build various designs of tables and chairs. However, Jack thinks that an incentive pay plan might convince him and his coworkers to put forth more effort.

At Jack’s previous employer, a competing furniture maker, Jack was paid on a piece-rate pay plan. The company paid Jack a designated payment for every chair or table that he completed. Jack felt this plan provided him an incentive to work harder to build the furniture pieces. Sally likes Jack’s idea; however, Sally is concerned about how such a plan would affect the employees’ need to work together as a team.

While the workers at Metropolitan build most furniture pieces individually, they often need to pitch in and work as a team. Each worker receives individual assignments, but as a delivery date approaches for a preordered furniture set due to a customer, the workers must help each other complete certain pieces of the set to ensure on-time delivery. A reputation for on-time delivery differentiates Metropolitan from its competitors. Several companies that compete against Metropolitan have a reputation of late deliveries,

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which gives Metropolitan a competitive edge. Because their promise of on-time delivery is such a high priority, Sally is concerned that a piece-rate pay plan may prevent employees from working together to complete furniture sets.

Sally agrees with Jack that an incentive pay plan would help boost productivity, but she thinks that a team-based incentive pay plan may be a better approach. She has considered offering a team-based plan that provides a bonus payment when each set of furniture is completed in time for scheduled delivery. However, after hearing from Jack about the success of the piece-rate pay plan at his previous employer, she is unsure of which path to take.

Questions:

4-6. What are some advantages of offering a piece-rate pay plan to the furniture builders at Metropolitan Furniture?

4-7. What are some advantages of offering a team-based incentive pay plan?

4-8. What do you think Sally should do?

Crunch the Numbers! Calculating Piecework Pay Awards

An additional Crunch the Numbers! exercise can be found on mymanagementlab.com (http://mymanagementlab.com) .

Table 4-3 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch04lev1sec3#ch04tab03) illustrates the calculation of a piecework award for a garment worker who has completed two hours of service. Over the course of a six-hour shift, his productivity varies:

First hour: 10 garments above the hourly standard

Second hour: no garments above the hourly standard

Third hour: 15 garments above the hourly standard

Fourth hour: 13 garments above the hourly standard

Fifth hour: 9 garments above the hourly standard

Sixth hour: 3 garments above the hourly standard

Questions:

4-9. Calculate the worker’s total earnings for his shift.

4-10. How many dollars did the garment worker earn in incentive payments? 4-11. On the following day, the garment worker completed a six-hour shift, but did not exceed the

standard at any time during this shift. How much did he earn for the day?

MyManagementLab

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Go to mymanagementlab.com (http://mymanagementlab.com) for Auto-graded writing questions as well as the following Assisted-graded writing questions:

4-12. How can incentive pay systems, when properly applied, contribute to companies meeting the goals of lowest cost and differentiation strategies?

4-13. Considering our discussion of employee roles in strategic compensation (Chapter 1 (http://content.thuzelearning.com/books/Martocchio.7916.16.1/sections/ch01#ch01) ), how can companies explain employees’ contributions to company pro�its? How would the conversation go with administrative staff members compared to sales professionals?

4-14. MyManagementLab Only – comprehensive writing assignment for this chapter.

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Performance. Cincinnati, OH: South-Western. 3. Kinchen, D. M. (2014). Lincoln Electric Celebrates 81 Uninterrupted Years of Paying Employee Pro�it-

Sharing Bonus (December 13). Available: https://davidkinchen.�iles.wordpress.com (https://davidkinchen.�iles.wordpress.com) , accessed February 5, 2015.

4. Lincoln Electric. (2015). I Choose Lincoln…. Available: www.lincolnelectric.com (http://www.lincolnelectric.com) , accessed February 5, 2015.

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8. Abosch, K. (2014). Making the most of your variable pay program. Workspan (November): 30–34. 9. WorldatWork and Deloitte Consulting LLP (2014). Incentive Pay Practices Survey: Publicly Traded

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10. Dulles, F. R., & Dubofsky, M. (1984). Labor in America: A History (4th ed.). Arlington Heights, IL: Harlan Davidson.

11. Peck, Variable Pay. 12. Lazear, E. P. (1998). Personnel Economics for Managers. New York: John Wiley & Sons. 13. Drucker, P. (1954). The Practice of Management. New York: Harper. 14. Fleishman, H. (2013). HubSpot launches $30,000 referral program for developers and designers.

(HubSpot Company News). Available: http://www.hubspot.com/company-news/ (http://www.hubspot.com/company-news/) , accessed December 3, 2014.

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19. Kanin-Lovers, J., & Cameron, M. (1993). Team-based reward systems. Journal of Compensation and Bene�its, January–February, pp. 55–60.

20. Schuster, J. R., & Zingheim, P. K. (1993). Building pay environments to facilitate high-performance teams. ACA Journal, 2, pp. 40–51.

21. “Our Vision” in the “Morning Star Collegue Guidelines” Used by permission from The Morning Star Company.

22. Hamel, G. (2011). First, let’s �ire all the managers. Harvard Business Review (December). Available: http://www.hbr.org (http://www.hbr.org) , accessed January 31, 2015.

23. Greene, R. J. (2007). Team incentives. In D. Scott (Ed.), Incentive Pay: Creating a Competitive Advantage. Phoenix, AZ: WorldatWork Press.

24. Silverman, R. E. (2014). How to pay employees for great ideas. The Wall Street Journal (December 4). Available: http://www.wsj.com (http://www.wsj.com) , accessed December 10, 2014.

25. Belcher, J. G., Jr. (1994). Gain sharing and variable pay: The state of the art. Compensation & Bene�its Review, May–June, pp. 50–60.

26. Doyle, R. J. (1983). Gain Sharing and Productivity. New York: American Management Association. 27. Peck, Variable Pay. 28. Milkovich, G. T., & Newman, J. M. (1993). Compensation (4th ed.). Homewood, IL: Irwin. 29. Ross, T. (1990). Why gain sharing sometimes fails. In B. Graham-Moore & T. Ross (Eds.), Gain Sharing:

Plans for Improving Performance (pp. 100–115). Washington, DC: Bureau of National Affairs. 30. Schuster, M. H. (2013). Gainsharing: Research and practice. WorldatWork Journal (Second Quarter):

30–39. 31. Lesiur, F. G. (Ed.). (1958). The Scanlon Plan: A Frontier in Labor–Management Cooperation. Cambridge,

MA: MIT Press. 32. Bullock, R. J., & Lawler, E. E., III. (1984). Gain sharing: A few questions and fewer answers. Human

Resource Management, 23, pp. 18–20. 33. Smith, B. T. (1986). The Scanlon Plan revisited: A way to a competitive tomorrow. Production

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