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Pay for performance can be a part of total rewards. As discussed in the previous chapter, more employers are moving toward systems providing base pay for performance using matrixes and other means, rather than just giving all workers a standard percentage increase in pay. If the question is whether people work harder because pay is tied to performance, the answer is yes.

Tying pay to performance holds a promise that both employers and employees find attractive. For employees, it can mean more pay; for employers, it can mean more output per employee and therefore more productivity. However, it is much more difficult to design a successful variable pay or special incentive system than to simply pay employees a set hourly wage or salary.

Variable pay programs are very popular, with more than 80% of organizations using them, according to a World at Work annual survey. The most widely used of these programs involve awards based on individual, unit, and organizational performance and success.’ Common types of variable pay programs are based on factors such as sales, customer service, productivity, attendance, safety, and executive incentives.


Variable pay is compensation linked to individual, group team, and/or organizational performance. Variable pay plans attempt to provide tangible rewards, traditionally known as incentives, to employees for performance beyond normal expectations. The philosophical foundation of incentives rests on several basic assumptions:

Some jobs contribute more to organizational success than others.

Some people perform better and are more productive than others.

Employees who perform better should receive more compensation.

Many employees’ total compensation should be tied directly to performance and results.

Pay for performance has a different philosophical base than does a more traditional compensation system, in which differences in job responsibilities are recognized through different amounts of base pay. In many organizations, length of service is a primary differentiating factor. However, giving additional rewards to some people and not others is seen as potentially divisive and as hampering employees’ working together. This is why many labor unions oppose pay-for-performance programs. In contrast, high-performing workers expect extra rewards for outstanding performance that increases organizational results.

Incentives can take many forms. For example, they can include simple praise, “recognition and reward” programs that award trips and merchandise, bonuses for performance accomplishments, and rewards for successful results for the company. A variety of possibilities are discussed later in this chapter. A successful plan will include a combination of different types of incentives.

Variable pay Compensation linked to individual, group/ team, and/or organizational performance.

Developing Successful Pay-for-Performance Plans

Employers adopt variable pay or incentive plans for a number of reasons. Key reasons that many employers adopt these plans are as follows:

Link strategic business goals and employee performance

Enhance organizational results and reward employees financially for their contributions


Incentive Plans and Executive Compensation



Recognize different levels of employee performance through different rewards

Achieve HR objectives, such as increasing retention, reducing turnover, recognizing training, and rewarding safety

As economic conditions have changed in industries and among employers, the use of variable pay incentives has changed as well. Under variable pay programs, employees can have a greater sharing of the gains or declines in organizational performance results. Even in organizations where the number of staff members has been reduced, such as investment firms, employers are switching from base pay to variable compensation means.’

Variable pay plans can be considered successful if they meet the objectives the organization had for them when they were initiated and if they work with the organizational culture and the financial resources of the organization. Both financial and nonfinancial rewards for performance are important in pay- for-performance plans. The manner in which targets are set and measured is important.” Three elements that affect the success of variable pay systems are discussed next. These are highlighted in Figure 12-1.

Does the Plan Fit the Organizational The success of any incentive pay program relies on its consistency with the culture of the organization.’ For example, if an organization is autocratic and adheres to traditional rules and procedures, an incentive system that rewards flexibility and teamwork is likely to fail. In such a case, the incentive plan has been “planted” in the wrong growing environment.

When it comes to variable pay-for-performance plans, one size does not fit all.” A plan that has worked well for one company will not necessarily work well for another. For instance, in professional service firms, performance measures such as client progress and productivity, new business development revenues, client satisfaction, and profit contributions are typically linked to pay-for-performance programs.’ These measures might not work as well in a different industry. For an incentive plan to work, it must be linked to the objectives of the organization, its financial resources, and its desired performance results. However, when these criteria are met, many employers find that

Effective Variable Pay Plans

Does the plan fit with business

strategies and culture? ‘-


Are the appropriate actions rewarded?


Is the plan administered properly?




Awarding Points for Staff Efforts

One incentive that is widely used is award points. For taking certain actions or accomplishing designated results, the individual employees can get point-based incentive awards in addition to their pay. Examples from different industries illustrate the potential effectiveness of using this type of incentive.

One of the staffing concerns in hospitals is staffing certain work shifts. Instead of using independent contract persons to cover some shifts, some health care facilities are using award points and other incentives to encourage employees to be the extra shift workers. For example, at a Hawaiian hospital, employees who request night shifts or 8-hour days get awarded extra award points in addition to their pay. The employees can use their points for gasoline cards, tuition benefits, gift cards, and other awards. The impact of this system

for the hospital is that about 70% of the firm’s unfilled shift hours are being covered by employees who get the award-point incentives. Over an extended period of time, more than 100,000 extra shift hours by workers were aligned with the awards.

Similar programs have been used in other industries.

For instance, one airline used point-based awards to reward customer service personnel for getting more fees on overweight checked passenger bags. Also, the airline employees received such awards for community service, nonprofit volunteer activities, and other behaviors.

Different types of incentive systems have grown in usage in numerous other firms, industries, and organizational settings. This discussion illustrates how custom tailoring incentives can reward employees for desired actions.”

variable pay plans make performance results a higher priority than just how employees behave in their jobs, thus contributing to positive organizational results.

Does the Plan Reward Appropriate Actions? Variable pay systems should be tied as much as possible to desired performance. Employees must see a direct relationship between their efforts and their financial and nonfinancial rewards, as the HR Perspective illustrates.

Because people tend to produce what is measured and rewarded, organizations must make sure that what is being rewarded is clearly linked to what is needed. For instance, in a highly innovative firm, incentives may be very motivating for managers, given economic and other organizational performance impacts.” Performance measures need to give appropriate emphasis and weights for calculating incentives in order for the programs to be effective. If incentive measures are manipulated or inappropriate, the variable pay systems ma y not be as effective.’?

Use of multiple measures helps to ensure that important performance dimensions are not omitted. For example, assume a hotel reservation center wants to set incentives for employees to increase productivity by lowering the time they spend on each call. If that reduction is the only measure, the quality of customer service and the number of reservations made might drop as employees rush callers in order to reduce talk time. Therefore, the center should consider basing rewards on multiple measures, such as talk time, reservations booked, and the results of customer satisfaction surveys.

Linking pay to performance may not always be appropriate. For instance, if the output cannot be measured objectively, management may not be able


incentive Plans and Executive Compensation




to correctly reward the higher performers with more pay. Managers may not even be able to accurately identify the higher performers. For example, in an office where tasks are to provide permits for building renovations, individual contributions may not be identifiable or appropriate.

Is the Plan Administered Properly? A variable pay plan may be complex or simple, but it will be successful only if employees understand what they have to do to be rewarded. The more complicated a plan is the more difficult it will be to communicate it meaningfully to employees. Experts generally recommend that a variable pay plan include several performance criteria. But having multiple areas of focus should not overly complicate the calculations necessary for employees to determine their own incentive amounts. Managers also need to be able to explain clearly what future performance targets need to be met and what the rewards will be.

Global Variable Pay

Variable pay is expanding in global firms, as well as among foreign-country employers. In Europe, Asia, and Latin America, more than 80% of manage- ment professionals and general staff are eligible for broad-based variable pay plans. Many programs are similar to those at U.S.-based companies, but global programs must accommodate cultural, legal, and economic differences.’! For firms with operations in multiple countries, having widely spread incentives requires that local managers be trained to control the reward programs and that the different choices in the programs are beneficial for success.”

Although administering any incentive plan can be difficult, global incentive programs can be especially complex. A company may have an overarching strategy, such as growing market share or increasing the bottom line, but that strategy frequently works out to different goals in different geographical regions. Also, laws and regulations differ from one country to the next. For example, in Latin America, there are mandatory profit-sharing regulations, so variable pay must reflect that. Countries such as China and India use individual incentives more widely than do the United States and Europe. However, to attract and retain expatriates, who are persons from one country working in another one, both salaries and incentives must be considered.

Metrics for Variable Pay Plans

Firms in the United States are spending significant amounts on variable pay plans as incentives. For instance, according to one survey, incentive expenditures in one year totaled $46 billion. Interestingly, more than $30 billion was paid on incentive merchandise and about $13 billion was spent on travel incentives. With such incentive expenditures increasing each year, it is crucial that the results of variable pay plans be measured to determine the success of the programs.’:’

Various metrics can be used, depending on the nature of the plan and the goals set for it. Figure 12-2 shows some examples of different metrics that can be used to evaluate variable play plans.

A common metric for incentive plans is return on investment (ROI). One firm, Leapfrog Group, has developed an ROI Estimator for its hospital pay- for-performance plan on health care activities, such as heart bypass, angioplasty, and others.” To illustrate a general ROI example, suppose a company decides that using a program to provide rewards in the form of lottery drawing






Metric Options for Variable Pay Plans



Actual change vs. planned


Revenue growth

Return on investment

Average employee productivity change

Increase in market share

Customer acquisition rate

Growth of existing customer sales

Customer satisfaction

Employee satisfaction

Turnover costs

Absenteeism cost

Workers’ comp claims

Accident rates

chances each month for employees who were not absent during the month will reduce absenteeism. An ROI metric would look at the dollar value of the improvement minus the cost of the program divided by the total cost. So if the value of the reduction in absenteeism was $100,000 per year, and the program cost $85,000, calculations would be (100,000 – 85,000) -:- 85,000, for just over a 17% return on the investment.

Other metrics also can be used to evaluate programs for management decision making. Regardless of the variable pay plan, employers should gather and evaluate data to determine if the expenditures are justified by increased organizational operating performance.” If the measures and analyses show positive results, the nature of the plan is truly a pay-for-performance one. If not, the plan should be changed to one that is more likely to be successful.

Successes and Failures of Variable Pay Plans

Even though variable pay has grown in popularity, some attempts at incentives have succeeded while others have not. Incentives do work, but they are not a panacea because their success depends on multiple factors. 16 The positive view that many employers have of variable pay is not shared by all workers. If individuals see incentives as desirable, they are likely to put forth the extra effort to attain the performance objectives that trigger the incentive payouts. But not all employees believe that they are rewarded when doing a good job, and not all employees are motivated by their employers’ incentive plans.

Some employees prefer increases in their pay over noncash incentives, but noncash incentives do motivate some workers to perform better than cash rewards do. In addition, a research study concluded that the incentives employees say they desire may not be ones that actually lead to higher performance results. 17

One factor that can lead to failure of a variable pay plan is having an incentive plan that is too complex for employees and management to understand. If the plan is too complicated to follow, the focus may not be on successful performance, employee misunderstanding and miscommunications can occur, and lower performance may be the result. 18

Given these dynamics and the complexity of these plans, providing a variable pay plan that will be successful requires significant, continuing efforts.” Some factors that contribute to the success of incentive plans are as follows:


incentive Plans and Executive Compensation


Develop clear, understandable plans that are continually communicated.

Use realistic performance measures.

Keep the plans current and linked to organizational objectives.

Clearly link performance results to payouts that truly recognize performance differences.

Identify variable pay incentives separately from base pay.

Three Categories of Variable Pay

The incentives offered in variable pay plans can be classified into three categories: individual, group/team, and organizational. There are advantages and disadvantages to each.

Individual incentives are given to reward the effort and performance of individuals. Some common means of providing individual variable pay are piece- rate systems, sales commissions, and individual bonuses. Others include special recognition rewards such as trips or merchandise. However, with individual incentives, employees may focus on what is best for them personally, which may inhibit the performance of other individuals with whom they are competing. For this reason, in some situations, group team incentives may be more appropriate.

When an organization rewards an entire group team for its performance, cooperation among the members may increase. The most common group/team incentives are gain sharing or goal sharing plans, in which the employees on a team that meets certain goals, as measured against performance targets, share in the gains. Often such programs focus on quality improvement, cost reduction, and other measurable results.

Organizational incentives reward people according to the performance results of the entire organization. This approach assumes that all employees working together can generate improved organizational results that lead to better financial performance. These programs often share some of the financial gains made by the firm with employees through payments calculated as a percentage of the employ- ees’ base pay. The most prevalent forms of organization-

wide incentives are profit-sharing plans and employee stock plans.

Figure 12-3 shows some of the programs that fall under each type of incentive or variable pay plan. These programs are discussed in the following sections.


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Categories of Variable Pay Plans




Piece-rate systems


Special incentive programs (trips, merchandise, awards)

Sales compensation

Group team results


Quality improvement

Cost reduction

Profit sharing

Employee stock plans

Executive stock options

Deferred compensation





Individual incentive systems tie personal effort to additional rewards. Conditions necessary for the use of individual incentive plans are as follows:

Individual performance must be identified. The performance of each individual must be measured and identified because each employee has job responsibilities and tasks that can be separated from those of other employees.

Individual competitiveness must be desired. Because individuals generally pursue the incentives for themselves, competition among employees often occurs. Therefore, independent competition in which some individuals “win” and others do not must be something the employer can tolerate.

Individualism must be stressed in the organizational culture. The culture of the organization must be one that emphasizes individual growth, achievements, and rewards. If an organization emphasizes teamwork and cooperation, then individual incentives may be counterproductive.

Piece-Rate Systems

The most basic individual incentive systems are piece-rate systems. Under straight piece-rate system, wages are determined by multiplying the number of units produced (such as garments sewn or service calls handled) by the piece rate for one unit. Because the cost is the same for each unit, the wage for each employee is easy to figure, and labor costs can be accurately predicted.

A differential piece-rate system pays employees one piece-rate wage for units produced up to a standard output and a higher piece-rate wage for units produced over the standard. Managers often determine the quotas or standards by using time and motion studies. For example, assume that the standard quota for a worker is set at 300 units per day and the standard rate is 14 cents per unit. However, for all units over the standard, the employee receives 20 cents per unit. Under this system, the worker who produces 400 units in one day would get $62 (300 X 14¢) + (100 X 20¢). Many possible combinations of straight and differential piece-rate systems can be used, depending on situational factors.

Despite their incentive value, piece-rate systems can be difficult to apply because determining standards is a complex and costly process for many types of jobs. In some instances, the cost of determining and maintaining the standards may be greater than the benefits derived. Also, jobs in which individuals have limited control over output or in which high standards of quality are necessary may be unsuited to piecework unless quality can be measured.


Straight piece-rate system Pay system in which wages are determined by multiplying the number of units produced by the piece rate for one unit.

Bonus One-time payment that does not become pa rt of the employee’s base pay.

Individual employees may receive additional compensation in the form of a bonus, which is a one-time payment that does not become part of the employee’s base pay. Individual bonuses are used at all levels in some firms and are the most popular short-term incentive plan.

A bonus can recognize performance by an employee, a team, or the organization as a whole. When performance results are good, bonuses go up. When performance results are not met, bonuses go down. Most employers base part of an employee’s bonus on individual performance and part on


Incentive Plans and Executive Compensation



company results, as appropriate. Numerous CEOs receive bonuses based on specific results.”

Bonuses also can be used to reward employees for contributing new ideas, developing skills, or obtaining professional certifications. When helpful skills or certifications are acquired by an employee, a pay increase or a one-time bonus may follow. For example, a financial services firm provides the equivalent of two weeks’ pay to employees who master job-relevant computer skills. Another firm gives one week of additional pay to members of the HR staff who obtain professional certifications such as Professional in Human Resources (PHR), Senior Professional in Human Resources (SPHR), or Certified Compensation Professional (CCP).

“Spot” Bonuses A unique type of bonus used is a “spot” bonus, so called because it can be awarded at any time. Spot bonuses are given for a number of reasons, perhaps for extra time worked, extra efforts, or an especially demanding project. For instance, a spot bonus may be given to an information technology employee who installed a computer software upgrade that required extensive time and effort.

Often, spot bonuses are given in cash, although some firms provide man- agers with gift cards, travel vouchers, or other noncash rewards. Noncash rewards vary in types and levels, but they need to be immediately visible and useful to be seen as desirable by individuals.” The keys to successful use of spot bonuses are to keep the amounts reasonable and to provide them only for exceptional performance accomplishments. The downside to their use is that they can create jealousy and resentment in other employees who feel that they deserved a spot bonus but did not get one.

Special Incentive Programs

Numerous special incentive programs can be used to reward individuals, ranging from one-time contests for meeting performance targets to awards for performance over time. For instance, safe-driving awards are given to truck drivers with no accidents or violations on their records during a year. Although special programs can be developed for groups and for entire organizations, they often focus on rewarding individuals. Special incentives are used for several purposes, as noted in Figure 12-4.

Purposes of Special Incentives

“TRIGGERS” FOR SPECIAL INCENTIVES + Recognize performance efforts

+ Expand customer service

+ Increase sales

+ Encourage employee teamwork + Increase employee morale

+ Enhance employee loyalty/retention + Improve safety/attendance


+ Performance

+ Recognition

+ Service




Performance Awards Cash, merchandise, gift certificates, and travel are the most frequently used incentive rewards for significant performance. Cash is still highly valued by many employees because they can decide how to spend it. However, noncash incentives may be stronger motivators, based on a study that considered awards such as vacation cruises, home kitchen equipment, groceries, and other noncash items. For instance, travel awards appeal to many U.S. employees, particularly trips to popular destinations such as Disney World, Las Vegas, Hawaii, and international locations. These examples indicate that many employees appreciate the “trophy” value of such awards as much as the actual monetary value.

Recognition Awards Another type of program recognizes individual employees for their performance. For instance, many organizations in industries such as hotels, restaurants, and retailers have established “employee of the month” and “employee of the year” awards. Hotels often use favorable guest comment cards as the basis for providing recognition awards to front desk representatives, housekeepers, and other hourly employees.

Recognition awards often work best when given to acknowledge specific efforts and activities that the organization has targeted as important. Global employers may use recognition awards that reflect cultural differences in various countries. The criteria for selecting award winners may be determined subjectively in some situations. However, formally identified criteria provide greater objectivity and are more likely to be seen as rewarding performance rather than as favoritism. When giving recognition awards, organizations should use specific examples to describe clearly how those receiving the awards were selected.

Service Awards Another type of reward given to individual employees is the service award. Although service awards often are portrayed as rewarding performance over a number of years, in reality the programs in most firms recognize length of service (e.g., 1, 3, 5, or 10 years) more than employees’ actual performance. Many of these awards increase in value as the length of service increases, and often they are made as dollar amounts rather than as gifts.

Some firms give recipients gift cards to retail or restaurant locations, while others let qualifying employees select items from a range of merchandise choices (e.g., cameras, watches, and other items). Different firms offer employ- ees of certain lengths of service special trips to resorts or social events. The overall goal of these awards is to give appreciation to employees for service.


The use of groups/teams in organizations has implications for incentive compensation. Although the use of groups/teams has increased substantially in the past few years, the question of how to compensate their members equitably remains a significant challenge. Many firms provide rewards for work groups or teams in different ways and for several reasons, as Figure 12-5 notes.

Team incentives can take the form of either cash bonuses for the team or items other than money, such as merchandise or trips. But group incentive situations may place social pressure on members of the group. Everyone in the group succeeds or fails. Therefore, some argue that team incentives should be given to team members equally, although not everyone agrees.


Incentive Plans and Executive Compensation



Teams and Variable Pay Plan Results


Improves productivity

Ties pay to team performance

Improves customer service or production quality

Increases employee retention

Design of Group/Team Incentive Plans

In designing group team incentive plans, organizations must consider a number of issues. The main concerns are how and when to distribute the incentives, and who will make decisions about the incentive amounts.

Distribution of Group Team Incentives Several decisions about how to distribute and allocate group team rewards must be made. The two primary ways for distributing those rewards are as follows:

Same-size reward for each member: All members receive the same payout, regardless of job level, current pay, seniority, or individual performance differences.

Different-size reward for each member: Employers vary individual rewards depending on such factors as contribution to group team results, current pay, years of experience, and skill levels of jobs performed.

Generally, more organizations use the first approach. The combination of

equal team member award payouts and individual pay differences rewards performance by making the group team incentive equal while also recognizing that individual differences exist and are important to many employees. The size of the group team incentive can be determined either by using a percent- age of base pay for the individuals or the group/team as a whole, or by offering a specific dollar amount. For example, one firm pays members individual base rates that reflect years of experience and any additional training that they have. Additionally, the group/team reward is distributed to all as a flat dollar amount.

Timing of Group Team Incentives How often group/team incen

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