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8/3/2019 Mgmt440 t11 Incentive Compensation
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Paul L. Schumann, Ph.D.
Professor of Management
MGMT 440: Human Resource Management
1 2008 by Paul L. Schumann. All rights reserved.
8/3/2019 Mgmt440 t11 Incentive Compensation
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Outline What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay
Incentive Pay Systems Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay
Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation
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What Is Incentive Pay? Incentive pay links pay (as a reward) to performance
The idea of incentive pay is to create incentives foremployees to improve their job performance by linkingemployee pay to employee job performance
Incentive pay is also called:
Pay for performance
Performance-based pay systems
Performance-based reward systems
The reward for performance doesnt have to be pay
Pay is one possible reward, not the only possible reward
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Why Use Incentive Pay? We want to use pay (and other rewards) to align the goals
of each employee with the goals of the organization
This way, when employees work toward their own goals, they
are also working toward the organizations goals
If incentive pay works to enhance employee motivation,then the advantages include:
Increased employee productivity & job performance
Increased retention of high performers Because high performers get more pay than low performers
Increased ability of the organization to achieve its objectives
Lower costs
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Does Incentive Pay Work? Expectancy theory gives us the answer:
Yes, incentive pay will motivate employees to improvetheir job performance, but only if 3 conditions aresimultaneously satisfied:
High valence: employees must believe that the amount of thereward (incentive pay) is large enough to be valued
High instrumentality: employees must believe that there is a
strong link between their job performance and their rewards High expectancy: employees must believe that there is a
strong link between their effort and their job performance
Effort Performance Rewards
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Does Incentive Pay Work? Expectancy theory (more)
What can go wrong? (more)
Effort Performance Rewards
Poor instrumentality perceptions
Example: The supervisor gives everyone the same payincrease regardless of differences in job performance
Example: The supervisor does a poor job of evaluating
employee job performance Example: The supervisor plays favorites and gives the
biggest pay increase to the employee who is the supervisorsgolfing buddy even though that employee has poor jobperformance
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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 alreadyworking as hard as they can
Example: The employees believe that there are barriers to
improved job performance that are outside of their control
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Does Incentive Pay Work? Expectancy theory (more)
Effort Performance Rewards
Summary: For incentive pay to work:
we need to make the incentive pay increase large enough thatemployees want to put forth the effort to go after the incentive
and we need to show employees that there is a strong linkbetween their job performance and receiving the incentive pay
increase and we need to show employees how, through their efforts,
that they can successfully improve their job performance
Put another way, employees need to believe: If they work at it,theyll achieve their goals, and theyll get the promised reward
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Drawbacks of Incentive Pay Incentive pay is more work to administer
Across-the-board pay increases are easy to administer
We can make mistakes Example: Link pay to the wrong measures of job performance
Example: Sears Auto Centers
Unions typically oppose many types of incentive pay Fear of discrimination or favoritism by supervisors in job
performance evaluations, especially for subjective measures of jobperformance
Unions prefer objective factors, such as across-the-board pay increasesor the use of seniority
Incentive pay creates competition among workers, which weakensworker solidarity (solidarity is necessary for union success)
Unions might agree to group-based objective incentives Example: Profit-sharing bonus
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Incentive Pay Systems Piece-rate: pay is a set amount per piece of production
Straight piece-rate: pay is entirely on a piece-rate basis Example: Production job
Market pay = $12 per hour
Average hourly production target = 60 pieces per hour
Piece-rate = $12/60 = $0.20 per piece
50 pieces 50 $0.20 = $10.00 (below market pay)
60 pieces 60 $0.20 = $12.00 (market pay)
70 pieces 70 $0.20 = $14.00 (above market pay)
80 pieces 80 $0.20 = $16.00 (above market pay) Base pay plus piece-rate
Example: Production job $12 per hour plus $0.20 per piece for production over 60 pieces in an hour
70 pieces$12 + [(70 60) $0.20] = $12 + [10 $0.20] = $14.00
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Incentive Pay Systems Taylor Plan: piece-rate with differential rates
Example: Production job with 2 piece rates Production standard = 60 pieces per hour
Piece-rate #1 = $0.20 per piece if production is less than 125% of theproduction standard (1.25 60 = 75 pieces per hour)
60 pieces 60 $0.20 = $12.00 (market pay)
70 pieces 70 $0.20 = $14.00
Piece-rate #2 = $0.25 per piece on production over 60 pieces ifproduction equals or exceeds 125% of the production standard (1.25 60 = 75 pieces per hour) 80 pieces (60 $0.20) + [(80 60) $0.25)] = $17.00
Recall the straight piece-rate ($0.20) paid $16 for 80 pieces Note this makes the reward for exceeding 75 pieces bigger
(increased valence), which strengthens the motivational force
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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
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Incentive Pay Systems Sales commissions:salespersons pay is a percentage of
his or her sales
Straight commission: pay is entirely on commission
Example:
Market pay = $50,000
Sales target = $1,000,000
Commission rate = 50,000/1,000,000 = 0.05 = 5.0%
Sells $900,000 Pay = $45,000 (below market)
Sells $1,000,000 Pay = $50,000 (market)
Sells $1,000,000 Pay = $55,000 (above market)
Base pay plus commission
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Incentive Pay Systems Merit pay: the employees annual pay increase is based on
the employees job performance in the previous year We evaluate the employees job performance by using the
organizations performance appraisal system Measure the relevant results & behaviors of the employee
Objective measures of employee job performance: productionmeasures, sales measures, personnel data, performance tests,business unit performance measures
Subjective measures of employee job performance: rating scales tosubjectively measure multiple aspects of job performance
Management By Objectives (MBO)
We use our evaluation of the employees job performance todecide his or her annual pay increase
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Incentive Pay Systems Merit pay (more)
Example: Company uses the following 5-point rating scale toevaluate the employees overall job performance and to award
the corresponding annual merit pay increase: 5 = Excellent = 4.0% pay increase
4 = Very Satisfactory = 3.0% pay increase
3 = Satisfactory = 2.0% pay increase
2 = Unsatisfactory = no pay increase
1 = Very unsatisfactory = no pay increase Merit pay might be combined with a forced distribution
Merit pay is widely used in the US
Merit pay is used at all organizational levels
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Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay
Supervisors can make mistakes in evaluating employee jobperformance & 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 theircontributions (reduce their effort)
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Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more)
The annual merit pay increase can come months after specificinstances of good performance
Rewards are more effective when they are receivedimmediately after the desired behavior or result
The delay in receiving the reward will weaken the
employees instrumentality perceptions Effort Performance Rewards
Reduces the motivational effectiveness of the incentive paysystem
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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 isnt worth the extra effort required to become a topperformer At 2,000 annual work hours, the $1,000 difference works out to an
extra $0.50 per hour when theyre making over $25 per hour Result is low valences
Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay
system
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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 differentrewards depending on whether its a good year or a bad year
If the same job performance is rewarded differently fromone year to another, then: It weakens the instrumentality perceptions
Effort
Performance
Rewards Reduces the motivational effectiveness of the incentive pay system
It create perceptions of inequity (unfairness) If good-performing employees feel under-rewarded in the bad years
when merit pay increases are smaller, then employees may reducetheir contributions (reduce their effort), especially in the bad years
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Incentive Pay Systems Merit pay (more)
Potential difficulties of merit pay (more) Merit pay increases become part of the employees base pay in future years, even if
the employees job performance isnt so good in the future years We end up continuing to reward the employee in the future for job
performance that might have been years in the past Example:
2005 new hire pay = $50,000 at end of 2005, performance rating = 5merit pay increase = 4% ($2,000)
2006 pay = $52,000 at end of 2006, performance rating = 3merit payincrease = 2% ($1,040)
2007 pay = $53,040 at end of 2007, performance rating = 1 no merit payincrease
2008 pay = $53,040 the employee is still being rewarded in 2008 (andbeyond) for performance in 2005 & 2006
This weakens the instrumentality perceptions Effort Performance Rewards Reduces the motivational effectiveness of the incentive pay system
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Incentive Pay Systems Bonus: employee receives a one-time lump-sum payment for meeting a
performance goal Performance goal might be:
Individual employees performance goal Example: Salespersons goal is to achieve at least $2-million in sales
Organizations performance goal Example: Companys goal is to achieve earnings-per-share of at least $3.15
The bonus amount does not become part of the employees base pay Example:
2005 new hire pay = $50,000 at end of 2005, performance rating = 5 bonus =$2,000 total pay = $52,000
2006 pay = $50,000 at end of 2006, performance rating = 3 bonus = $1,000total pay = $51,000
2007 pay = $50,000 at end of 2007, performance rating = 1 bonus = $0 total pay= $50,000
2008 pay = $50,000 This strengthens the instrumentality perceptions
Effort Performance Rewards Increases the motivational effectiveness of the incentive pay system
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Incentive Pay Systems Skill-based pay (pay-for-knowledge): pay is based on work-
related skills, not seniority or job performance Example:
New hire receives initial training to perform the entry-level job andis paid at the entry-level rate
As the employee completes training and becomes qualified toperform additional jobs, the employee is rewarded with payincreases The employee is typically paid at the pay rate associated with the
highest paid job for which the employee has been qualified
regardless of which job the employee actually performs on anygiven day
Creates incentives for employees to complete training, learnnew skills, & become qualified to do additional jobs
Creates a flexible workforce
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Incentive Pay Systems Profit sharing:some of the companys profits are shared with the
employees Ties each employees pay to the profits of the business
Purpose: alignment of employees goals with companys goals
Strengthens the employees stake in the companys profitability Example:
Company establishes a minimum profit level as a goal If actual profits exceed the goal, a percentage of the excess is divided up
among the employees
Types of profit sharing plans: Current distribution plans (cash plans): profit sharing paid as a bonus in
the form of cash or shares of the companys stock Deferred payout plans: profit sharing paid as a bonus into a trust fund to
be distributed to employees at some time in the future (such as when theemployee retires, becomes disabled, or dies)
Combination plans
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Incentive Pay Systems Gain sharing: when employees make a suggestion that
improves the organization, a percentage of theorganizations gain from the suggestion is shared with theemployees who made the suggestion Example:
Employees make suggestions Management reviews the submitted suggestions, determines the
improvement (gain) from each suggestion, and decides whichsuggestions to implement
A percentage of the gain from a suggestion is shared with theemployees who made the suggestion
Types of gain sharing: Scanlon Plan, Rucker Plan,Improshare, & Winsharing See Fisher, Schoenfeldt, & Shaw (2006), Table 12.5, p. 553, for a
comparison of the types of gain sharing
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Incentive Pay Systems Employee Stock Ownership Plan (ESOP): the company
facilitates employees owning stock in the company Methods of distributing stock to employees:
As a bonus directly to employees Example: for every 2 shares an employee buys, the company gives
the employee 1 share Example: employees can buy shares for 85% of the current stock
market price Into a trust (such as the companys 401(k) pension plan)
Company contributes shares of stock into the trust Shares in the trust are allocated to individual employee accounts Employees become vested over time (cliff after 5 years, or graded
over 3 to 7 years) When an employee leaves the company (e.g., retirement), they
receive the current market value of their vested shares in the trust
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Incentive Pay Systems Executive compensation
If the goal of executive compensation is to create a paysystem in which what is in the best interest of the
stockholders also brings the greatest reward to theexecutives, then the pay of executives should:
Be tied to the performance of the company through incentivepay systems such as bonus plans for the achievement of short-
run goals (such as profits) And use the granting of shares of stock in the company or
stock options for the creation of long-run incentives
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Outline What Is Incentive Pay? Why Use Incentive Pay? Does Incentive Pay Work? Drawbacks of Incentive Pay
Incentive Pay Systems Piece-Rate Taylor Plan Standard Hour Plan Commissions Merit Pay Bonuses Skill-Based Pay Profit Sharing Gain Sharing Plans Employee Stock Ownership Plans (ESOPs) Executive Compensation
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