1. Incentive Compensation
AMA Summer 2009
Session 18

2. What Is Incentive Pay? Linking pay to job performance Also known as:
Pay for performance
Performance-based pay systems
Performance-based reward systems
Pay is one possible reward, not the only possible reward

3. MEANS OF COMPENSATION
Four basic parts of executive compensation packages:
Base salary.
Allowances.
Incentives.
Perquisites.

4. Compensation System Components

5. Payment by Input Vs. Payment by Output
Variable Pay
(payment by output)
Straight Salary
(payment by input)
depends on measure of what comes out
Amount of time spent has no relevance
Problem:  Output not always easy to measure
Time/ effort related Compensation
Independent of output consideration
Problem:  Input not always easy to measure
Examples:
Agricultural workers: piece rates
A salesperson on straight commission
Compensation of top executives
Wage per work hour
Monthly salaries
Annual salaries
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

6. Measuring Performance
Objective Performance Measure:
Easily observable and quantifiable, e.g. parts produced, hours worked
Subjective Performance Measures:
Based on personal opinion of a supervisor, customer, peers, etc.
Type of evaluat.
Database
objective
subjective
Output
revenue, dividend
customer satisfaction
Input
time
qualification
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

7. Variables for output-based pay
Different Variables as Basis of Output- Pay
Basis
Variables for output-based pay
Quantity of production
pieces, weight, size/height
Quality of production
Rejects, grade, customer‘s satisfaction, targets
Input reduction
Reduction in raw material, energy, work time
Capacity utilization
slack-, repair- and waiting periods
Be on schedule
Timeliness vis à vis internal /external customers
Value of the firm
stock price, economic value added
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

8. Output-Based Pay Advantages of output-based pay Selection effect
Motivation effect
efficient workers with a high productivity will join the firm/stay
inefficient workers with a low productivity will not join/leave the firm
output-based pay motivates workers to put forth more effort
Source:
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

9. Selection Effect: An Example of Compensating Salespeople
World Book
Britannica
Offered compensation scheme
variable pay: W = $ x
fixed salary: W = $ 500
Labor costs of 10 sets; Cost per set
$ 1,000  $ 100 per set
$ 500  $ 50 per set
What type of salesperson will stay with the firm?
high productive sp. x  5
low productive sp. x  5
Labor costs of 3 sets; Cost per set
$ 300  $ 100 per set
$ 500  $ 166,67 per set
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

10. Selection Effect: An Example of Compensating Salespeople (cont.)
W ...Weekly Pay
A (World Book)
500
B (Britannica)
300 3 5
x ... Number of encyclopedia
 Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will stay at Britannica
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

11. Disadvantages of Output-Based Pay
Variable pay
Straight salary
Depends on effort and exogenous risks – risky form of compensation
 Firm should smooth out exogenous risks from workers‘ compensation
Firm should bear exogenous risks but endogenous risks should remain with workers
Trade-off: More risk,higher compensation
Opportunity: share economic development
Stronger incentives
Doesn‘t depend on exogenous factors – low-risk form of compensation
 Workers are insured against volatilities
 Firm provides the insurance for risks
Lower compensation level
Can not participate in good economic
development
Weaker incentives
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

12. Balancing Quantity and Quality
Compensation Schemes
Balancing Quantity and Quality
Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to ‚count‘
 Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page
Price p. page
Minutes p. page
Revenue per hour
$ 8 20
$ 24 1
$ 7 15
$ 28 2
$ 5 12
$ 25 3
$ 3 10
$ 18 4
$ 0 9 5 8
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

13. Using the Appropriate Time Unit
Input-based pay
Hourly wages
Monthly salary
Annual salary
Production workers
Managerial workers
Top Management
Low correlation between effort and work time
Time input = bad measure for effort  overinvestment in easy (pleasant) tasks
Undefined set of tasks (goal), discretion over work
Importance of other incen- tives to motivate for effort (long-term, e.g. stock options)
High correlation between effort and time invested
Time input as a pretty good indicator for effort
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

14. Forms of Incentive Pay
Rewards can consist of anything that employees value
E.g
Piece rates and commissions
Bonuses
Days off
Promotion
Training
Stock ownership
Health care plan
Housing
Education for kids
Retirement Plan
Party
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

15. Criticism to Incentive Compensation
Money does not motivate
It is difficult to design effective incentive schemes
Incentives certainly entail costs
The major problem is to design incentive schemes where the benefits exceed the costs
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002

16. Why Use Incentive Pay?
To align employees goals with the goals of the organization
This way, when employees work toward their own goals, they are also working toward the organization’s goals
If incentive pay works to enhance employee motivation, then the advantages include:
Increased employee productivity & job performance
Increased retention of high performers
Because high performers get more pay than low performers
Increased ability of the organization to achieve its objectives
Lower costs

17. Does Incentive Pay Work?
Expectancy theory gives us the answer:
Yes, it can motivate employees to improve their job performance, if 3 conditions are simultaneously met :
High valence: employees must believe that the amount of the reward (incentive pay) is large enough to be valued
High instrumentality: employees must believe that there is a strong link between their job performance and their rewards
High expectancy: employees must believe that there is a strong link between their effort and their job performance
Effort  Performance  Rewards

18. Does Incentive Pay Work?
What can go wrong?
Effort  Performance  Rewards
Low valences: the reward is too small to be valued
Example: Supervisor tells a salesperson “If you double your sales from $1-million to $2-million, I’ll reward you with a pay increase from $50,000 a year to $50,100 a year.”
Example: Suppose the budget allows for pay increases up to 4% when inflation is 3%: if all the employees get a 3% pay increase (for inflation), then the employees with the best job performance might only get an additional 1%
On a $50,000 salary, 1% is only $500 for exceptional performance

19. Does Incentive Pay Work?
What can go wrong? (more)
Effort  Performance  Rewards
Poor instrumentality perceptions
Example: The supervisor gives everyone the same pay increase regardless of differences in job performance
Example: The supervisor does a poor job of evaluating employee job performance
Example: The supervisor plays favorites and gives the biggest pay increase to the employee even though that employee has poor job performance

20. Does Incentive Pay Work?
Expectancy theory (more)
What can go wrong? (more)
Effort  Performance  Rewards
Poor expectancy perceptions
Example: The employees believe that they are already working as hard as they can
Example: The employees believe that there are barriers to improved job performance that are outside of their control

21. Incentive Pay Systems
Piece-rate: pay is a set amount per piece of production
Straight piece-rate: pay is entirely on a piece-rate basis
Example: Production job
Market pay = $12 per hour
Average hourly production target = 60 pieces per hour
Piece-rate = $12/60 = $0.20 per piece
50 pieces → 50 × $0.20 = $10.00 (below market pay)
60 pieces → 60 × $0.20 = $12.00 (market pay)
70 pieces → 70 × $0.20 = $14.00 (above market pay)
80 pieces → 80 × $0.20 = $16.00 (above market pay)
Base pay plus piece-rate
$12 per hour plus $0.20 per piece for production over 60 pieces in an hour
70 pieces → $12 + [(70 − 60) × $0.20] = $12 + [10 × $0.20] = $14.00

22. Incentive Pay Systems Taylor Plan: piece-rate with differential rates
Example: Production job with 2 piece rates
Production standard = 60 pieces per hour
Piece-rate #1 = $0.20 per piece if production is less than 125% of the production standard (1.25 × 60 = 75 pieces per hour)
60 pieces → 60 × $0.20 = $12.00 (market pay)
70 pieces → 70 × $0.20 = $14.00
Piece-rate #2 = $0.25 per piece on production over 60 pieces if production equals or exceeds 125% of the production standard (1.25 × 60 = 75 pieces per hour)
80 pieces → (60 × $0.20) + [(80 − 60) × $0.25)] = $17.00
Recall the straight piece-rate ($0.20) paid $16 for 80 pieces
Note this makes the reward for exceeding 75 pieces bigger (increased valence), which strengthens the motivational force

23. Incentive Pay Systems
Standard hour plan: piece-rate where the standard is set in terms of time (instead of units produced)
Method:
For a job title, make a list of possible tasks
For each task, establish a standard length of time that it should take to complete the task
Base pay on the standard times, not actual clock times
Example: Auto mechanic
Market pay = $20 per hour
Task: balance & rotate 4 tires
Standard = 30 minutes = 0.50 hours
Pay for task = $20 per hour × 0.50 hours = $10.00 (no matter how long it actually takes the mechanic to do the task)
Mechanic takes 15 minutes or 60 minutes → Pay = $10

24. Incentive Pay Systems
Sales commissions: salesperson’s pay is a percentage of his or her sales
Straight commission: pay is entirely on commission
Example:
Market pay = $50,000
Sales target = $1,000,000
Commission rate = 50,000/1,000,000 = 0.05 = 5.0%
Sells $900,000 → Pay = $45,000 (below market)
Sells $1,000,000 → Pay = $50,000 (market)
Sells $1,000,000 → Pay = $55,000 (above market)
Base pay plus commission

25. Incentive Pay Systems
Merit pay: the employee’s annual pay increase is based on the employee’s job performance in the previous year
We evaluate the employee’s job performance by using the organization’s performance appraisal system
Measure the relevant results & behaviors of the employee
Objective measures of employee job performance: production measures, sales measures, personnel data, performance tests, business unit performance measures
Subjective measures of employee job performance: rating scales to subjectively measure multiple aspects of job performance
Management By Objectives (MBO)
We use our evaluation of the employee’s job performance to decide his or her annual pay increase

26. Incentive Pay Systems Merit pay (more)
Example: Company uses the following 5-point rating scale to evaluate the employee’s overall job performance and to award the corresponding annual merit pay increase:
5 = Excellent = 4.0% pay increase
4 = Very Satisfactory = 3.0% pay increase
3 = Satisfactory = 2.0% pay increase
2 = Unsatisfactory = no pay increase
1 = Very unsatisfactory = no pay increase
Merit pay might be combined with a forced distribution
Merit pay is widely used in the US
Merit pay is used at all organizational levels

27. Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay
Supervisors can make mistakes in evaluating employee job performance & in assigning merit pay increases
The mistakes weaken the instrumentality perceptions
Effort  Performance  Rewards
Reduces the motivational effectiveness of the incentive pay system
The mistakes create perceptions of inequity (unfairness)
If employees feel underpaid, they may reduce their contributions (reduce their effort)

28. Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more)
The annual merit pay increase can come months after specific instances of good performance
Rewards are more effective when they are received immediately after the desired behavior or result
The delay in receiving the reward will weaken the employees’ instrumentality perceptions
Effort  Performance  Rewards
Reduces the motivational effectiveness of the incentive pay system

29. Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more)
Differences in merit pay increases may be too small to be meaningful
Example: Current pay = $50,000; Suppose:
Top performers: 4% merit increase → $2,000 pay increase
Middle performers: 2% merit increase → $1,000 pay increase
Some middle performers may believe that the extra $1,000 per year isn’t worth the extra effort required to become a top performer
At 2,000 annual work hours, the $1,000 difference works out to an extra $0.50 per hour when they’re making over $25 per hour
Result is low valences
Effort  Performance  Rewards
Reduces the motivational effectiveness of the incentive pay system

30. Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more)
Merit pay budgets can vary from year to year
Result is that the same job performance may get different rewards depending on whether it’s a good year or a bad year
If the same job performance is rewarded differently from one year to another, then:
It weakens the instrumentality perceptions
Effort  Performance  Rewards
Reduces the motivational effectiveness of the incentive pay system
It create perceptions of inequity (unfairness)
If good-performing employees feel under-rewarded in the bad years when merit pay increases are smaller, then employees may reduce their contributions (reduce their effort), especially in the bad years

31. Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more)
Merit pay increases become part of the employee’s base pay in future years, even if the employee’s job performance isn’t so good in the future years
We end up continuing to reward the employee in the future for job performance that might have been years in the past
Example:
2005 → new hire → pay = $50,000 → at end of 2005, performance rating = 5 → merit pay increase = 4% ($2,000)
2006 → pay = $52,000 → at end of 2006, performance rating = 3 → merit pay increase = 2% ($1,040)
2007 → pay = $53,040 → at end of 2007, performance rating = 1 → no merit pay increase
2008 → pay = $53,040 → the employee is still being rewarded in 2008 (and beyond) for performance in 2005 & 2006
This weakens the instrumentality perceptions
Effort  Performance  Rewards
Reduces the motivational effectiveness of the incentive pay system

32. Incentive Pay Systems
Bonus: employee receives a one-time lump-sum payment for meeting a performance goal
Performance goal might be:
Individual employee’s performance goal
Example: Salesperson’s goal is to achieve at least $2-million in sales
Organization’s performance goal
Example: Company’s goal is to achieve earnings-per-share of at least $3.15
The bonus amount does not become part of the employee’s base pay
Example:
2005 → new hire → pay = $50,000 → at end of 2005, performance rating = 5 → bonus = $2,000 → total pay = $52,000
2006 → pay = $50,000 → at end of 2006, performance rating = 3 → bonus = $1,000 → total pay = $51,000
2007 → pay = $50,000 → at end of 2007, performance rating = 1 → bonus = $0 → total pay = $50,000
2008 → pay = $50,000
This strengthens the instrumentality perceptions
Effort  Performance  Rewards
Increases the motivational effectiveness of the incentive pay system

33. Incentive Pay Systems
Skill-based pay (pay-for-knowledge): pay is based on work-related skills, not seniority or job performance
Example:
New hire receives initial training to perform the entry-level job and is paid at the entry-level rate
As the employee completes training and becomes qualified to perform additional jobs, the employee is rewarded with pay increases
The employee is typically paid at the pay rate associated with the highest paid job for which the employee has been qualified regardless of which job the employee actually performs on any given day
Creates incentives for employees to complete training, learn new skills, & become qualified to do additional jobs
Creates a flexible workforce

34. Incentive Pay Systems
Profit sharing: some of the company’s profits are shared with the employees
Ties each employee’s pay to the profits of the business
Purpose: alignment of employee’s goals with company’s goals
Strengthens the employees’ stake in the company’s profitability
Example:
Company establishes a minimum profit level as a goal
If actual profits exceed the goal, a percentage of the excess is divided up among the employees
Types of profit sharing plans:
Current distribution plans (cash plans): profit sharing paid as a bonus in the form of cash or shares of the company’s stock
Deferred payout plans: profit sharing paid as a bonus into a trust fund to be distributed to employees at some time in the future (such as when the employee retires, becomes disabled, or dies)
Combination plans

35. Incentive Pay Systems
Gain sharing: when employees make a suggestion that improves the organization, a percentage of the organization’s gain from the suggestion is shared with the employees who made the suggestion
Example:
Employees make suggestions
Management reviews the submitted suggestions, determines the improvement (gain) from each suggestion, and decides which suggestions to implement
A percentage of the gain from a suggestion is shared with the employees who made the suggestion
Types of gain sharing: Scanlon Plan, Rucker Plan, Improshare, & Winsharing
See Fisher, Schoenfeldt, & Shaw (2006), Table 12.5, p. 553, for a comparison of the types of gain sharing

36. Incentive Pay Systems
Employee Stock Ownership Plan (ESOP): the company facilitates employees owning stock in the company
Methods of distributing stock to employees:
As a bonus directly to employees
Example: for every 2 shares an employee buys, the company gives the employee 1 share
Example: employees can buy shares for 85% of the current stock market price
Into a trust (such as the company’s 401(k) pension plan)
Company contributes shares of stock into the trust
Shares in the trust are allocated to individual employee accounts
Employees become vested over time (cliff after 5 years, or graded over 3 to 7 years)
When an employee leaves the company (e.g., retirement), they receive the current market value of their vested shares in the trust

37. Incentive Pay - Executive Compensation
Aligning with organizational objectivereate a pay system in which what is in the best interest of the stockholders also brings the greatest reward to the executives, then the pay of executives should:
Be tied to the performance of the company through incentive pay systems such as bonus plans for the achievement of short-run goals (such as profits)
And use the granting of shares of stock in the company or stock options for the creation of long-run incentives