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Human Resource Management

Fifteenth Edition

Chapter 12

Pay for Performance and Financial Incentives

Where are we Now … Chapter 12 Pay for Performance and Financial Incentives

Incentives are important in any pay plan. The main purpose of this chapter is to explain how managers use incentives to motivate employees. The main topics we’ll discuss are money’s role in motivation, individual employee incentive and recognition programs, incentives for salespeople, incentives for managers and executives, team and organization-wide incentive plans, and incentives and employee engagement.

Learning Objectives (1 of 2)

12-1. Explain how you would apply four motivation theories in formulating an incentive plan.

12-2. Discuss the main incentives for individual employees.

12-3. Discuss the pros and cons of commissions versus straight pay for salespeople.

After studying this chapter, you will be able to:

12-1. Explain how you would apply four motivation theories in formulating an incentive plan.

12-2. Discuss the main incentives for individual employees.

12-3. Discuss the pros and cons of commissions versus straight pay for salespeople.

Learning Objectives (2 of 2)

12-4. Describe the main incentives for managers and executives.

12-5. Name and describe the most popular organization-wide incentive plans.

12-6. Explain how to use incentives to improve employee engagement.

After studying this chapter, you will also be able to:

12-4. Describe the main incentives for managers and executives.

12-5. Name and describe the most popular organization-wide incentive plans.

12-6. Explain how to use incentives to improve employee engagement.

I. Explain how you would apply four motivation theories in formulating an incentive plan.

What is the motivation behind incentive plans? Let’s take a look at this objective.

Money and Motivation

Frederick Taylor was an American mechanical engineer who sought to improve industrial efficiencies. He made three major contributions in the late 1800s. First, he defined a fair’s day work using standards of output. Second, he is known as the father of the scientific management approach. This approach emphasized improvement of work methods. Finally, he recognized the use of financial incentives for those whose output exceeded standards.

Incentive Pay Terminology

Pay-for Performance

Variable Pay

Profit Sharing

Managers often use two terms synonymously with incentive plans. Traditionally, all incentive plans are pay-for-performance plans. They all tie employees’ pay to the employees’ performance. Variable pay is more specific: It is usually an incentive plan that ties a group or team’s pay to some measure of the firm’s (or the unit’s) overall profitability; profit-sharing plans (discussed later) are one example. However, confusing as it may be, some experts use the term variable pay to include incentive plans for individual employees.

Linking Strategy, Performance, and Incentive Pay

In any case, incentive pay—tying workers’ pay to their performance—is widely popular. The problem is that linking pay to performance is easier said than done.

As logical as it seems to link pay to performance, about 83% of companies with such programs say their programs are, at best, somewhat successful. One study found that just 28% of the 2,600 U.S. workers it surveyed said their companies’ incentive plans motivated them. “Employees don’t see a strong connection between pay and performance, and their performance is not particularly influenced by the company’s incentive plan,” said one expert. Equally problematical is the fact that some incentives incentivize the wrong behavior.

Another big reason for incentive plans’ often dismal results is the fact that incentives that may motivate some people won’t motivate others. Compensation experts therefore argue that managers should understand the motivational bases of incentive plans. We’ll review some motivation background next, and then go on to explain various incentive plans.

Motivation and Incentives

Theories that have relevance to designing incentive plans

Motivators and Fredrick Herzberg

Demotivators and Edward Deci

Expectancy Theory and Victory Vroom

Behavior Modification / Reinforcement and B.F. Skinner

Several motivation theories have particular relevance to designing incentive plans.

MOTIVATORS AND FREDERICK HERZBERG – Frederick Herzberg said the best way to motivate someone is to organize the job so that doing it provides the challenge and recognition we all need to help satisfy “higher-level” needs for things like accomplishment and recognition. These needs are relatively insatiable, says Herzberg, so challenging work provides a sort of built-in motivation generator. Doing things to satisfy a worker’s “lower-level” needs for things like better pay and working conditions just keeps the person from becoming dissatisfied. Herzberg says the factors (“hygiene's”) that satisfy lower-level needs are different from those (“motivators”) that satisfy or partially satisfy higher-level needs.

DEMOTIVATORS AND EDWARD DECI – Psychologist Edward Deci’s work highlights another potential downside to relying too heavily on extrinsic rewards: They may backfire. Deci found that extrinsic rewards could at times actually detract from the person’s intrinsic motivation. The point may be stated thusly: Be cautious in devising incentive pay for highly motivated employees, lest you inadvertently demean and detract from the desire they have to do the job out of a sense of responsibility.

EXPECTANCY THEORY AND VICTOR VROOM – In general, people won’t pursue rewards they find unattractive, or where the odds of success are very low. Psychologist Victor Vroom’s expectancy motivation theory echoes these commonsense observations. He says a person’s motivation to exert some level of effort depends on three things:

the person’s expectancy (in terms of probability) that his or her effort will lead to performance; instrumentality, or the perceived connection (if any) between successful performance and actually obtaining the rewards; and valence, which represents the perceived value the person attaches to the reward.

Behavior Modification/Reinforcement AND B. F. SKINNER – Using incentives also assumes the manager understands how consequences affect behavior. Psychologist B. F. Skinner’s findings are useful here. Managers apply Skinner’s principles by using behavior modification. Behavior modification means changing behavior through rewards or punishments that are contingent on performance. For managers, behavior modification boils down to two main principles. First, that behavior that appears to lead to a positive consequence (reward) tends to be repeated, whereas behavior that appears to lead to a negative consequence (punishment) tends not to be repeated; and second, that managers can therefore get someone to change his or her behavior by providing the properly scheduled rewards (or punishment).

Know Your Employment Law

Employee Incentives

and the Law

Let’s take a look…

KNOW YOUR EMPLOYMENT LAW

Employee Incentives and the Law

Various laws affect incentive pay. Under the Fair Labor Standards Act, if the incentive the worker receives is in the form of a prize or cash award, the employer generally must include the value of that award when calculating the worker’s overtime pay for that pay period. So, unless you structure the incentive bonuses properly, the bonus itself becomes part of the week’s wages. For example, suppose someone who earns $10 per hour for a 40-hour week also earns, in one week, performance incentive pay (a performance bonus) of $80 for the week, or $480 total pay for the week. Further, assume she also works 2 hours overtime that week. The overtime rate for each of the 2 hours she works overtime is not simply 1.5 times her regular $10-per-hour pay. Instead, it is 1.5 times $12 per hour. Why? Because with her performance bonus she earned $480 for the 40-hour week, and $480 divided by 40 hours is $12 per hour. Therefore she actually earned in total that week $480 plus the overtime pay of $12 per hour for the two extra hours, or $480 + $24 = $504 total for the week.

Certain bonuses are excludable from overtime pay calculations. For example, Christmas and gift bonuses that are not based on hours worked, or are so substantial that employees don’t consider them a part of their wages, do not have to be included in overtime pay calculations. Similarly, purely discretionary bonuses in which the employer retains discretion over how much if anything to pay are excludable.

However, other types of incentive pay must be included. Under the Fair Labor Standards Act (FLSA), bonuses to include in overtime pay computations include those promised to newly hired employees; those provided for in union contracts or other agreements; and those announced to induce employees to work more productively or efficiently or to induce them to remain with the company. Such bonuses would include many of those we turn to next, such as individual and group production bonuses.

II. Discuss the main incentives for individual employees.

Several incentive plans are particularly suited for use with individual employees. Let’s learn about these…

Individual Employee Incentive and Recognition Programs

Piecework plans

Straight piecework

Standard hour plans

Pros and Cons

Piecework is the oldest and still most popular individual incentive plan. Piecework involves paying the worker a specified amount for each piece or unit he/she produces.

Straight piecework entails a strict proportionality between results and rewards regardless of output. It is an incentive plan in which a person is paid a sum for each item he or she makes or sells with a strict proportionality between results and rewards.

Standard hour plan, the worker is paid a basic hourly rate but is paid an extra percentage of his or her rate for production exceeding the stand per hour or per day. Similar to piecework payment but based on a percent.

Advantages and Disadvantages:

Piecework incentive plans have several advantages. They are simple to calculate and easily understood by employees. Piecework plans appear equitable in principle, and their incentive value can be powerful since they tie pay directly to performance.

Piecework also has disadvantages. The main one is its unsavory reputation, based on some employers’ habit of arbitrarily raising production standards whenever they found their workers earning “excessive” wages. A more subtle disadvantage is that since piece rates are quoted on a per piece basis, in worker’s minds, the production standard (in pieces per hour) becomes tied inseparably to the amount of money earned. Piecework systems thus risk engendering rigidity. When the employer tries to revise production standards, resistance ensues. Employees become preoccupied with producing the number of units needed. They can become less focused on quality and may resist switching jobs (since doing so could reduce productivity). Attempts to introduce new processes may more likely fail, insofar as they require adjusting engineered standards. Equipment maintenance tends to decline as employees focus on maximizing quantity.

Merit Pay as an Incentive

Merit pay as an incentive

Differential pay increases

Merit pay options

Merit pay or a merit raise is any salary increase the firm awards to an employee based on his/her individual performance. Merit plan effectiveness depends on truly differentiating among employees.

Two adaptations of merit pay plans are popular. One awards merit raises in a lump sum once a year and does not make the raise part of the employee’s salary. The other adaptation ties merit awards to both individual and organizational performance.

Incentive for Professional Employees

Professional employees are those whose work involves the application of learned knowledge to the solution of the employer’s problems, such as lawyers and engineers. Making incentive pay decisions for professional employees is challenging. For one thing, firms usually pay professionals well anyway. For another, they’re already driven by the desire to produce high-caliber work.

However, it is unrealistic to assume that people like Google engineers work only for professional gratification. Few firms, therefore, work harder to maintain competitive incentives for professionals.

Dual-career ladders are another way to manage professionals’ pay. At many employers, higher pay requires rerouting from, say, engineering into management. However, not all professionals want management. Therefore, many employers institute one path for managers, and another for technical experts, allowing the latter to earn higher pay without switching to management.

Non-financial and Recognition-Base Awards

Social Recognition

Performance Feedback

Employers often supplement financial incentives with various nonfinancial and recognition-based awards. The term recognition program usually refers to formal programs, such as employee-of-the-month programs.

Social recognition program generally refers to informal manager–employee exchanges such as praise, approval, or expressions of appreciation for a job well done.

Performance feedback means providing quantitative or qualitative information on task performance so as to change or maintain performance; showing workers a graph of how their performance is trending is an example.

Trends Shaping HR: Digital and Social Media (1 of 2)

Recognition Programs

Let’s take a look…

Trends Shaping HR: Digital and Social Media

Employers are bulking up their recognition programs with digital support. For example, Baudville, a workplace recognition vendor, offers an e-card service called ePraise. Employers use this to tell employees they’re appreciated. Intuit shifted its employee recognition, years of service, patent awards, and wellness awards programs to Globoforce, an online awards vendor. This “allowed us to build efficiencies and improved effectiveness” into the programs, says Intuit’s vice president of performance, rewards, and workplace. Management consultant Hewitt Associates uses www.bravanta.com to help its managers more easily recognize exceptional employee service with special awards. Other recognition sites include www.premierechoiceaward.com/secure/home.asp, and www.giveanything.com. Various new apps let employees showcase their awards, contributions, and praise from coworkers. For example, go to http://quickbooks.intuit.com/r/, and key “7 mobile apps for recognizing and rewarding employees” into the search box, and click “search.” Apps also enable employees to praise each other. For example, one lets employees “give recognition by picking out a badge and typing in a quick note to thank the people who matter most . . . .” Others let users post the positive feedback they receive to their LinkedIn profiles. Mobile technology is also changing how employers incentivize front-line service people. For example, pay for a $4.00 espresso in some New York coffeehouses with a credit card and the iPad screen will ask how big a tip you want to leave—from $1.00 to $3.00.

Improving Performance: HR Tools for Line Managers and Small Businesses

Financial Incentives for Motivation

Let’s talk about it…

Improving Performance: HR Tools for Line Managers and Small Businesses

The supervisor should not rely just on the employer’s financial incentive plans for motivating subordinates. Those plans may not be complete, plus there are simply too many opportunities to motivate employees every day to let those opportunities pass. What to do?

First, the best option for motivating an employee is also the simplest—make sure the employee has a doable goal and that he or she agrees with it. It makes little sense to try to motivate employees with financial incentives if they don’t know their goals or don’t agree with them. Psychologist Edwin Locke and his colleagues have consistently found that specific, challenging goals lead to higher task performance than do specific, unchallenging goals; vague goals; or no goals.

Second, recognizing an employee’s contribution is a powerful motivation tool. Studies (and theories like those of Herzberg) show that recognition has a positive impact on performance, either alone or in combination with financial rewards. For example, in one study, combining financial rewards with recognition produced a 30% performance improvement in service firms, almost twice the effect of using each reward alone. Third, use social recognition (such as compliments) as positive reinforcement on a day-to-day basis. Figure 12-1 on the next slide presents a list.

Talk About it (Discussion): You have decided to verify that recognition does in fact improve performance. To that end, you will use an honest observation to praise someone’s performance today. What was the effect of your experiment?

List of Recognition

FIGURE 12-1 Social Recognition and Related Positive Reinforcement Managers Can Use

Challenging work assignments Freedom to choose own work activity Having fun built into work More of preferred task Role as boss’s stand-in when he or she is away Role in presentations to top management Job rotation Encouragement of learning and continuous improvement

Being provided with ample encouragement Being allowed to set own goals Compliments Expression of appreciation in front of others Note of thanks Employee-of-the-month award Special commendation Bigger desk Bigger office or cubicle

Source: Based on Bob Nelson, 1001 Ways to Reward Employees (New York: Workman Pub, 1994), p. 19; Sunny C. L. Fong and Margaret A. Shaffer, "The Dimensionality and Determinants of Pay Satisfaction: A Cross-Cultural Investigation of a Group Incentive Plan," International Journal of Human Resource Management 14, no. 4 (June 2003), p. 559 (22).

Job Design

Although not usually considered an “incentive,” job design (discussed in Chapter 4) can significantly impact employee motivation and retention. A study by Harvard Business School researchers concluded that job design is a primary driver of employee engagement. A study by Sibson Consulting concluded that job responsibility and feedback were the fifth- and seventh-most important drivers of employee engagement.

A study by Towers Watson concluded that challenging work ranked as the seventh most important driver for attracting employees. Job design is thus a useful part of an employer’s total rewards program.

Next The Strategic Context feature illustrates how employers combine incentives to boost profits.

Improving Performance: The Strategic Context

The Fast-Food Chain

Let’s talk about it…

Improving Performance: The Strategic Context

The Fast-Food Chain

The heart of just about any fast-food chain’s strategy is to control performance: One chain wanted to know, “Can financial and nonfinancial incentives boost performance in our fast-food chain?” Two researchers studied the impact of financial and nonfinancial incentives on business performance in 21 stores of a fast-food franchise in the Midwest. The researchers compared performance over time in stores that did and did not use financial and nonfinancial incentives. Each store had about 25 workers and two managers. The researchers trained the managers to identify measurable employee behaviors that were currently deficient but that could influence store performance. Example behaviors included “keeping both hands moving at the drive-through window” and “repeating the customer’s order back to him or her.” Then the researchers instituted financial and nonfinancial incentive plans. They measured store performance in terms of gross profitability (revenue minus expenses), drive-through time, and employee turnover.

Financial Incentives

Some employees in some of the stores received financial incentives for exhibiting the desired behaviors. The financial incentives consisted of lump-sum bonuses in the workers’ paychecks. For example, if the manager observed a work team exhibiting up to 50 behaviors (such as “working during idle time”) during the observation period, he or she added $25 to the paychecks of all store employees that period; 50 to 100 behaviors added $50 per paycheck, and more than 100 behaviors added $75 per paycheck. Payouts eventually rose over time as the employees learned to enact the behaviors they were to exhibit.

Nonfinancial Incentives

The researchers trained the managers in some stores to use nonfinancial incentives such as feedback and recognition. For example, for performance feedback managers maintained charts showing the drive through times at the end of each day. They placed the charts by the time clocks. Thus, these store employees could keep track of their store’s performance on measures like drive-through times. The researchers also trained managers to administer recognition to employees. For instance, “I noticed that today the drive-through times were really good.”

Results

Both the financial and nonfinancial incentives improved employee and store performance. For example, store profits rose 30% for those units where managers used financial rewards. Store profits rose 36% for those units where managers used nonfinancial rewards. During the same 9-month period, drive-through times decreased 19% for the financial incentives group, and 25% for the nonfinancial incentives groups. Turnover improved 13% for the financial incentives group, and 10% for the nonfinancial incentives group.

Implications for Managers

Here is what these findings mean for managers designing incentive plans:

1. Link the incentive to behavior that is crucial for achieving strategic goals. For example, this chain wanted to boost store performance and profits. Incentivizing employees to work faster and smarter accomplished that.

2. The point of an incentive is to motivate the person to work better. Therefore, it makes more sense to use an incentive plan when (1) motivation (not ability) is the problem; (2) when the employee’s effort and results are directly related; and (3) when the employee can actually control the results you plan to incentivize. Put another way, make sure there is a clear link between the person’s effort and performance and between the performance and reward, that the incentive is attractive to the employee, and that the employee has the skills to do the job.

3. Don’t just rely on material rewards. Support the incentive plan with performance feedback (as in the form of performance graphs) and with recognition.

4. Set complete standards. For example, don’t just pay for “repeating the customer’s order” if speed is important too.

5. Be scientific. As in this study, gather evidence and analyze the effects of the incentive plan over time.

Talk About it (Discussion): The dean has asked you to design an incentive plan for your professor. How would you apply what you learned in this feature to do so?

III. Discuss the pros and cons of commissions versus straight pay for salespeople.

Now we is examine the pros and cons of commission versus straight pay for sales people.

Incentives for Salespeople

Align how to measure and reward

Align with Strategic Goals

As one survey said, “the performance metrics given to the sales team must drive behaviors that will help the company’s … strategy to be successful.” Unfortunately, the same survey also found that “30% of respondents believe their sales compensation program rewarded the right behaviors ‘not well’ or ‘very poorly.’”

Employers are therefore moving to align (1) how they measure and reward their salespeople with (2) their firms’ strategic goals.

Types of Sales Incentive Plans

Salary plan

Commission plan

Combination plan

Sales compensation plans may focus on salary, commissions, or some combination to drive sales objectives.

Salary Plan

Some firms pay salespeople fixed salaries (perhaps with occasional incentives in the form of bonuses, sales contest prizes, and the like). Straight salary makes sense when the main task involves prospecting (finding new clients) or account servicing. The straight salary approach also makes it easier to switch salespersons’ territories, and it can foster sales staff loyalty. The main disadvantage, of course, is that straight salary may demotivate potentially high-performing salespeople.

Commission Plan

Straight commission plans pay salespeople for results, and only for results. Commission plans tend to attract high-performing salespeople who see that effort clearly produces rewards. Sales costs are proportionate to sales rather than fixed, and the company’s fixed sales costs are thus lower. Such plans are easy to understand and compute. However, problems abound. In poorly designed plans, salespeople may focus on making the sale, and neglect non-selling duties such as servicing small accounts and pushing hard-to-sell items. Wide variations in pay may occur; this can make some feel the plan is inequitable. Misjudging sales potential can lead to excessively high commissions and to the need to cut commission rates.

Combination Plan

Most companies pay salespeople a combination of salary and commissions, usually with a sizable salary component. An incentive mix of about 70% base salary / 30% incentive seems typical; this cushions the salesperson’s downside risk (of earning nothing), while limiting the risk that the commissions could get out of hand from the firm’s point of view. Combination plans have pros and cons. They give salespeople a floor to their earnings, let the company specify what services the salary component is for (such as servicing current accounts), and still provide an incentive for superior performance. Combination plans also tend to become complicated, and misunderstandings can result. This might not be a problem with a simple salary-plus-commission plan, but most plans are not so simple.

Maximizing Sales Force Results

Set Effective Quotas

Distinguish Among Performers

In setting sales quotas and commission rates, the goal is to motivate sales activity but avoid excessive commissions. Unfortunately, the tendency to set commission rates informally often reduces plans’ effectiveness.

Setting effective quotas is an art. Questions to ask include: Are quotas communicated to the sales force within 1 month of the start of the period? Does the sales force know how their quotas are set? Do you combine bottom-up information (like account forecasts) with top-down requirements (like the company business goals)? Are returns and de-bookings reasonably low?

Distinguishing among performers is also important.

Sales Incentives in Action

Car salespersons’ compensation ranges from 100% commission to a small base salary with commission accounting for most of total compensation. Traditionally, the car salesperson’s commission is based on a percentage of the difference between the dealer’s invoice cost and the amount the car is sold for, minus an amount to cover the “pack” or dealer overhead (the pack being perhaps $300 for a new car to $800 for a used car, and rising for pricier cars).

This approach encourages the salesperson to hold firm on the retail price, and to push “after-sale products” like floor mats and side moldings. There may also be extra incentives to sell packages such as rustproofing. For selling slow-moving vehicles, the salesperson may get a “spiff”—an extra incentive bonus over commission. And there are bonuses, such as Salesperson of the Month (perhaps $300 for most cars sold).

Commission plans like these still dominate, but not as much. Many dealers are substituting salary plus bonus plans for commissions. This reflects the growing emphasis on “one price no hassle” pricing. But in either case, the pay plan’s aim is to produce the salesperson behaviors the dealership needs to support its strategic aims.

Trends Shaping HR: Digital and Social Media (2 of 2)

Commission Sales

Let’s take a look…

Trends Shaping HR: Digital and Social Media

Somewhat astonishingly, given the amount of money employers pay out in commissions, about 60% of employers track sales performance and sales commissions much as they did decades ago, using spreadsheets. But to maximize performance, the sales manager typically needs evidence, such as: Do the salespeople know how we measure and reward performance? And, does our commission plan maximize sales of our most profitable products? Spreadsheets don’t easily support such analyses. For example, with more than 1,000 sales representatives, First Tennessee Bank had problems managing its sales incentive programs. Bank employees had to enter by hand sales information for each of the 1,000 sales reps onto Excel spreadsheets. The process “had begun to spiral out of control.” Switching to an enterprise incentive management (EIM) software system solved the problem. Many employers therefore use such EIM software to track and control sales commissions. Several vendors supply these. For example, Oracle Sales Cloud enables management to easily create scorecard metrics such as number of prospecting calls and sales contracts, and to monitor these in real-time on the system’s dashboards. Users can also gamify the sales incentive process with Oracle Sales Cloud, by creating rewards such as points or badges based on each salesperson’s performance.

IV. Describe the main incentives for managers and executives.

Now let’s examine incentives for managers and executives.

Incentives for Managers and Executives

Short-term Incentives

Long-term incentives

Managers play a crucial role in divisional and company-wide profitability, and employers therefore put considerable thought into how to reward them. Most managers get short-term and long-term incentives in addition to salary. Of firms offering short-term incentive plans, virtually all—96% in one study—provided those incentives in cash. For those offering long-term incentives, about 48% offer them as stock options. The options aim to reward management for long-term growth in shareholder value.

Strategy and the Executive’s Long-Term and Total Rewards Package

Sarbanes-Oxley Act

Short-term incentives and the Annual bonus

Eligibility

Fund size

Individual awards

Stock options

Ethics

Whether consolidating operations or pursuing growth, firms can’t fully implement most strategies in just 1 or 2 years. Therefore, the long-term signals you send managers via their long-term incentives can determine whether the firm’s strategy succeeds. The executives’ reward components—base salary, short- and long-term incentives, and benefits—must align with each other and with the company’s strategic aims. Each pay component should help focus the manager’s attention on the behaviors required to achieve the company’s strategic goals. Using multiple, strategy-based performance criteria for incentivizing executives is best. Criteria include financial performance, number of strategic goals met, employee productivity measures, customer satisfaction surveys, and employee morale surveys.

One expert estimates that the typical CEO’s salary accounts for about one-fifth of his or her pay. A bonus based on explicit performance standards accounts for another fifth, and long-term incentive awards such as stock options and long-term performance plans account for the remaining three-fifths. Ideally, the plan’s performance standards should include a combination of market benchmarks (such as performance against competitors) as well as business performance standards (such as earnings per share growth).

The Sarbanes-Oxley Act of 2002 affects how employers formulate their executive incentive programs. Congress passed Sarbanes-Oxley to inject a higher level of responsibility into executives’ and board members’ decisions. It makes them personally liable for violating their fiduciary responsibilities to their shareholders. The act also requires CEOs and CFOs of a public company to repay any bonuses, incentives, or equity-based compensation received from the company during the 12-month period following the issuance of a financial statement that the company must restate due to material noncompliance with a financial reporting requirement stemming from misconduct.

Eligibility – Employers first decide eligibility. Traditionally, most based annual bonus eligibility on job level/title, base salary, and/or officer status. Some simply based eligibility on job level, job title, or salary. Recently, more employers are offering a broader range of employee annual incentive plans “… in which both executives and other employees participate.”

Fund Size – Second, one must determine how big the annual bonus fund should be. Most employers (33% in one survey) traditionally use the sum of targets approach. This means they estimate the likely bonus for each eligible (“target”) employee, and total these to arrive at the bonus pool’s size.

The Individual Awards – Finally, one must decide the actual individual awards. Typically, the employer sets a target bonus (as well as maximum bonus, perhaps double the target bonus) for each eligible position. The actual bonus then reflects the manager’s performance.

Stock Options – A stock option is the right to purchase a specific number of shares of company stock at a specific price during a specific period. The executive thus hopes to profit by exercising his or her option to buy the shares in the future but at today’s price.

Ethics and Incentives – Anyone designing a long-term incentive plan should keep in mind the management truism “People put their efforts where they know they’ll be rewarded.” The problem is that simplistic incentives that focus on just one factor (such as cost-cutting) may inadvertently encourage managers to ignore other important factors (such as long-term investment). Similarly, in the absence of strong ethical standards, incentives may breed unethical behavior.

Improving Performance: HR Practices Around the Globe

International HR – Stock options

Let’s talk about it…

Improving Performance: HR Practices Around the Globe

“International human resource management” is important because cultural, political, legal, and economic differences mean that employees in one country often react differently to an HR practice than would employees in other countries. For example, until January 2006, China basically prohibited publicly listed companies from offering stock incentive plans to their managers. At that point better economic conditions and an evolving political philosophy led to new regulations. Soon Chinese-listed companies were permitting such plans.

A recent study focused on those 42 companies. It sought to determine how the new incentive plans affected company performance. To understand the findings it’s important to know that managing in China still has unique characteristics. For example, prior to becoming publicly listed firms, the big firms were usually owned by the government. Furthermore, the government may well continue to retain certain ownership control rights even after the firms go on the stock market. In such cases, the goals of the owners and the management may diverge. For example, government owners might want to maximize employment, rather than profitability. The question is, given such cultural and political realities, do management stock option plans in China translate into improved company performance, as they often do in the United States?

The researchers compared the performance of the 42 Chinese companies that did adopt management stock-option plans with a control group of firms without such plans. One thing they found was that the stock-option plans did improve firm performance in companies controlled by private shareholders, but not in companies controlled by the government. In the latter, goals such as maximizing employment may have outweighed boosting profits, thus limiting managers’ profit-boosting efforts. The findings highlight why managing globally is challenging. In this case, a stock option plan that might improve financial performance in the United States might fail in China, where the government owners’ goals may well differ from the desire of managers to boost profits.

Source: Based on Robert Boylan, Maggie Foley, and Yu-Jun Lian, “Are Equity Incentives Effective in Chinese Listed Firms? New Evidence from Propensity Score Matching (PSN),” International Journal of Business Strategy 10, no. 3 (September 2010).

Talk About it (Discussion): Given these findings, would it make sense for managers in government-controlled companies to receive stock options tied to something other than profitability, such as “no employees lose their jobs in this company”? Why?

Some Other Executive Incentives

Companies also offer other executive incentives. Some incentivize executives to stay with the firm. This is especially important when executives might flee because another company is stalking the firm with intentions to buy it. Golden parachutes are extraordinary (large) payments companies make to executives in connection with a change in company ownership or control. Some firms use loans as incentives, for example by guaranteeing large loans to directors and officers to buy company stock.

V. Name and describe the most popular organization-wide incentive plans.

Up to this point we’ve focused on individual employee incentives such as piecework, commissions, and executive bonuses. Let’s now look at incentives for teams, and for all employees company-wide.

Team and Organization-Wide Incentive Plans (1 of 2)

How Designing Team Incentives

Evidence-Based HR: Inequities That Undercut Team Incentives

How to Design Team Incentives

Firms increasingly rely on teams to manage their work. They therefore need incentive plans that encourage teamwork and focus teams on performance. Team (or group) incentive plans pay incentives to the team based on the team’s performance.

While most employers just use experience to estimate what the team goal or standard should be (“20 total labor hours per car”), others carefully engineer their production standards. Occasionally, the employer may want to pay team members according to some other formula. For instance, instead of paying each team member based on how well the team as a whole does, pay everyone based on how well the best team member does.

Team incentives often make sense. They reinforce team planning and problem solving, and can help ensure cooperation. Team incentives also facilitate training, since each member has an interest in getting new members up to speed fast. The main disadvantage is the demotivating effects of free rider workers who share in the team-based pay but who don’t put their hearts into it.

Evidence-Based HR: Inequities That Undercut Team Incentives

Although about 85% of large employers reportedly use some type of group- or team-based incentives, studies suggest that team incentives are often counterproductive. Many employers take the team incentive idea to the next logical level and institute incentive plans in which all or most employees participate. Organization-wide incentive plans are plans in which all or most employees can participate, and which generally tie the reward to some measure of company-wide performance. Also called variable pay plans, we’ll look at them next.

Organizational – Wide Plans

Profit-sharing plans

Scanlon plans

Other Gainsharing Plans

At-Risk Pay Plans

Employee Stock Ownership Plans

Organizational-Wide Incentive Plans – again are plans in which all or most employees can participate, and which generally tie the reward to some measure of company-wide performance. Also called variable pay plans.

Here we examine a few:

Profit-sharing plans – Plans in which all or most employees receive a share of the firm’s annual profits. There are several types of profit-sharing plans. With current profit-sharing or cash plans, employees share in a portion of the employer’s profits quarterly or annually. With deferred profit-sharing plans, the employer puts cash awards into trust accounts for the employees’ retirement.

Scanlon plan – An incentive plan developed in 1937 by Joseph Scanlon and is designed to encourage cooperation, involvement, and sharing of benefits.

Other Gainsharing Plans – The Scanlon plan is one early version of today’s gainsharing plans. Gainsharing is an incentive plan that engages many or all employees in a common effort to achieve a company’s productivity objectives, with any resulting cost-savings gains shared among employees and the company. In addition to the Scanlon plan, other popular gainsharing plans include the Lincoln, Rucker, and Impro share plans.

At-risk pay plan – Plan that puts some portion of employees’ normal pay at risk if they don’t meet their goals, in return for possibly obtaining a much larger bonus if they exceed their goals.

Employee stock ownership plans (ESOPs) – Company-wide plans in which the employer contributes shares of its own stock (or cash to be used to purchase such stock) to a trust established to purchase shares of the firm’s stock for employees. The firm generally makes these contributions annually in proportion to total employee compensation, with a limit of 15% of compensation. The trust holds the stock in individual employee accounts. It then distributes the stock to employees upon retirement (or other separation from service), assuming the person has worked long enough to earn ownership of the stock.

Team and Organization-Wide Incentive Plans (2 of 2)

Profit-sharing plans

Scanlon plans

Other gain-sharing plans

At-risk pay plans

Employee stock ownership plans

Profit-sharing plans involve employees receiving a share of the company’s annual profits.

A Scanlon Plan is an incentive plan developed in 1937 by Joseph Scanlon. The basic features of the plan include: philosophy of cooperation, identity, competence, involvement system, and sharing of benefits formula.

Other gain-sharing plans are incentive plans that engage many or all employees in a common effort to achieve a company’s productivity objectives.

At-risk pay plans put some portion of the employee’s weekly pay at risk, subject to the firm meeting its financial goals.

Employee stock ownership plans (ESOP) are company-wide plans in which a firm contributes shares of its own stock (or cash to purchase the stock) to a trust. The trust is established to purchase shares of the firm’s stock for employees.

Incentive Plans in Practice: Nucor

The production incentive plan at Nucor steel also has a:

Department manager incentive plan

Professional and clerical bonus plan

Senior officer incentive plan

Nucor Corp. is the largest steel producer in the United States. It also has the highest productivity and lowest labor cost per ton. Employees can earn bonuses of 100% or more of base salary, and all Nucor employees participate in one of four performance-based incentive plans. With the production incentive plan, operating and maintenance employees and supervisors get weekly bonuses based on their work groups’ productivity. The department manager incentive plan pays department managers annual incentive bonuses based mostly on the ratio of net income to dollars of assets employed for their division. With the professional and clerical bonus plan, employees who are not in one of the two previous plans get bonuses based on their divisions’ net income return on assets. Finally, under the senior officer incentive plan, Nucor senior managers (whose base salaries are lower than those in comparable firms) get bonuses based on Nucor’s annual overall percentage of net income to stockholders equity. Nucor also divides 10% of its operating profits yearly among all employees (except senior officers). Depending on company performance, this may be from 1% to over 20% of an employee’s pay.

V. Explain how to use incentives to improve employee engagement.

Lastly, we need to examine how to use incentives to improve employee engagement.

Employee Engagement Guide for Managers

Incentives and Engagement

Measure the extent to which supervisors are encouraging their subordinates to be engaged

Use incentives to reward supervisors for improving employee engagement

A survey provides some insights into the role of incentive pay in fostering employee engagement. Of approximately 6,300 compensations professionals the researchers solicited, 736 responded to the survey. Here’s what the researchers found:

First, although the compensation professionals believed that total rewards programs can influence employee engagement, many of them did not specifically include employee engagement as one of the goals of their compensation plans.

Second, they concluded that the most direct ways to encourage employee engagement with incentives are (1) to measure the extent to which supervisors are encouraging their subordinates to be engaged, and (2) to use incentives to reward supervisors for improving employee engagement.

Third, even more important than the rewards themselves, getting employees involved in developing the rewards programs was the “gold standard” for building employee cooperation and commitment.

So in brief: Make improving employee engagement a formal target of your compensation plan; appraise and incentivize your supervisors partly based on whether they take steps to improve their subordinates’ engagement; and if possible, let employees participate in devising the compensation plan.

Chapter 12 Review

What you should now know….

In review of Chapter 12, you should now be able to:

12-1. Explain how you would apply four motivation theories in formulating an incentive plan.

12-2. Discuss the main incentives for individual employees.

12-3. Discuss the pros and cons of commissions versus straight pay for salespeople.

12-4. Describe the main incentives for managers and executives.

12-5. Name and describe the most popular organization-wide incentive plans.

12-6. Explain how to use incentives to improve employee engagement.