Pay for Performance: Implementation of Individual ...

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Pay for Performance: Implementation of Individual and Group Plans Steven H. Appelbaum and Barbara T. Shapiro Concordia University, Montreal, Quebec, Canada "Following the 1982 recession more and more companies looked towards pay for performance to increase bottom-line results and obtain productivity gains"[1]. General pay increases slowly gave place to merit pay and other forms of monetary incentives. A survey of 1,080 Canadian companies, taken between mid-August and mid-September 1990, indicated that "[among] responding companies, 64 per cent will be giving merit-only increases in 1991 (up from 59 per cent in 1989), and 32 per cent will use a general-plus-merit system for distributing increases"[2,3]. It appears that the trend continues to increase. The current issue under examination is: Is pay for performance used effectively? This is the question that each company must ask itself now, as the North American economy is gearing up for the 1991 recession. In this article, the particularities of the two main categories of pay for performance systems (individual and group incentive plans) will be explored, as well as the key factors utilised in determining the outcome of a pay for performance plan, i.e. its implementation. Initially, it will be important briefly to re-examine the two theories supporting the use of pay for performance by organisations.

Journal of Management Development, Vol. 10 No. 7, 1991, pp. 30-40. © MCB University Press, 0262-1711

Equity and Expectancy Theories "Equity theory holds that people want to be fairly or equitably treated by the organisations that employ them, [when] expectancy theory is based on the 'Law of Effect', which states that 'behaviour that is rewarded will be repeated' "[4]. Thus pay for performance may be used to bring perceived "overpaid" performers to increase their performance, and adequately reward the best performers so that they will not feel underpaid. Though it does not guarantee the desired effect on the poorest performer, experience shows that perceived inequity leads to reduction in effort or performance among the best performers, when they decide not to leave the company[4]. Equity theory postulates that people compare their inputs (abilities, effort, experience and education) and their outcomes (pay, promotions and other rewards) with the inputs and outcomes of other people. If an employee believes that her/his ratio of exchange is equal to that of another comparable employee, the situation is perceived as equitable. A perceived imbalance (e.g. a person with similar education and experience receives more pay) is likely to produce feelings of inequity and dissatisfaction[5]. Furthermore, the compensation system, being the most

significant organisational reward system, should be designed to reward superior performance to play efficiently its role as an incentive[4]. According to expectancy theory, employees exert effort when they believe that they can achieve certain performance levels and that they will receive the rewards attached to certain performance levels. An employee's belief that she/he can achieve a certain performance level by exerting some amount of effort is referred to as the effort — performance relationship. The belief that a certain performance level will earn one expected rewards is referred to as the performance — reward relationship. Employers have more control over the performance — reward relationship because they can choose to manage rewards fairly and consistently, thus raising employees' expectancies that performance will result in certain rewards. Currently, a well accepted relationship between performance and satisfaction is that presented in the Porter and Lawler model[6], namely that satisfaction with rewards is one of several factors affecting the amount of effort expended on the job[7]. We know that previous performance and rewards affect the level of effort through job satisfaction. In essence, a dissatisfied employee will probably exert only enough effort to keep her/his job, taking into consideration the fact that individuals differ in their responses to dissatisfaction with rewards. The concept of paying someone extra for performance beyond the normal expectations associated with a particular job or position is still a relatively recent phenomenon[8]. However, pay-for-performance systems, specifically merit pay, have now become so pervasive in their application that few question their validity or efficacy[9]. Although the two concepts of equity theory and expectancy theory dominate the theoretical motivational basis for merit or pay-for-performance systems, there is one other concept which runs counter to these basic assumptions. Although the arguments have not been widely accepted[10], it can be argued that intrinsic rewards, i.e. basic job satisfaction, the challenge associated with a position, or peer recognition, can be even stronger motivators for job performance. These three concepts of equity, expectancy and psychological fulfilment, although slightly different from the other, all acknowledge that a motivator is required in order to maintain or improve an individual's desire to perform better on the job. Almost everyone believes in a pay for performance philosophy; however, the problem each employer faces is to devise a means of tapping the appropriate motivational forces to maximise her/his corporate or institutional goals. Individual Incentive Plans Based on individual performance assessments, these types of plans distribute monetary rewards for performance exceeding normative job standards. The major types of individual plans addressed in the literature are piecework plans and merit plans. These types of systems can function in circumstances where the job is well defined and the performance characteristics are both well delineated and assessable. Research dealing with individual systems[4] further developed these points by citing conditions favouring merit pay. These are:

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•

Individual differences in job performance are great enough to be worth the time and effort that it takes management to measure and relate pay to them. • The pay ranges are wide enough (35 per cent or greater) to allow for significant base-pay differences among employees on the same job. • Management is able validly and reliably to measure individual differences in job performance. • The appraisers are skilful in employee performance planning (setting and communicating expectations) and appraisal. • The organisation's culture supports performance-based pay. • The level of compensation technology in the organisation is reasonably high — the pay structures are equitable and competitive, and management knows how to relate pay to performance. • The levels of trust between managers and those who work for them are high. • The managers have the "will to manage" — that is, the willingness to establish and communicate performance criteria and standards and the willingness to make tough human-resource decisions. When these conditions are fulfilled, it becomes more apparent that individual incentive plans respect the two principles of equity and expectancy by rewarding the best performer and by relating the reward to the effort performed. However, the literature is rife with examples where one or more of these conditions or assumptions are not met. There are numerous situations where differences in job performance are difficult to measure or are not worth the effort. Managerial assessments often include significant subjective components which are difficult to evaluate objectively, for example creativity and interpersonal skills[11]. In small companies or organisations, where the owner or boss has a tight handle on an individual's performance, it may not be worth setting up a formal appraisal system in terms of time or administrative effort[8]. However, it will be more helpful in reaching a decision as to the viability for pay for performance in general or individual and group incentive plans in particular to explore those systems intended to reward top performance. The principal advantage of examining these conditions is to illuminate a direct link between the effort exerted and the reward. However, they are not panaceas and the following criticisms are important to consider in order to balance the opportunities and costs: • • •

they result in a preoccupation with the task at hand and do not relate individual performance to the larger company objectives; incentive pay works against creating a climate of openness, trust, joint problem solving and commitment to organisational objectives; incentive plans can divide the workforce into those supporting the plan and those not in favour of the plan, which may create adversarial relationships.

Furthermore, piecework plans are responsible for producing the following results and criticisms to consider within this enigmatic and dynamic equation: • • •

individual incentives generally focus on the quantity of output and not on cost savings or quality; they violate the logic of co-ordinated and co-operative systems and lead to conflict, defensive work practices and opposition to new work methods and technologies; they encourage people to focus narrowly on a task, to do the task as quickly as possible, and to take few risks.

Moreover, some other critics argue that: (1) often performance cannot be measured precisely enough to justify pay differentials; (2) personal biases such as leniency and halo effect frequently play too large a role in the appraisal process; (3) budget limitations make it difficult to give adequate increases to all who deserve them; (4) there are difficulties in identifying valued rewards; (5) there are difficulties in establishing appropriate contingencies between rewards and performance; (6) the secrecy of pay is related to perceived inequity[10,12,13]. Podsakoff et al.[13], further realising the budget constraints of many merit-pay plans, suggest that organisations select rewards with sufficient magnitude such as: • consider alternatives to rewards currently employed, which permit greater magnitude at lower cost; • utilise rewards that provide visibility for the recipient; • avoid the upward ratcheting effect by using rewards that do not create ongoing, long-term obligations in response to current performance; • increase use of non-monetary rewards where relevant and applicable; • incorporate job-design elements which provide intrinsic rewards as a function of job performance. On the third point, Lawler[14] warns against the use of salary increases rather than bonuses, resulting in the attribution of a reward that becomes an annuity rather than a reward reflecting recent performance. An additional problem of salary increases is that they usually reflect changes in both the market and the merit. The percentage of a salary increase that is merit is therefore masked, impeding the effort — reward link. In spite of these concerns, merit pay remains the most common pay-forperformance system used by companies[15].

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It appears to be worthwhile to work actively towardsfindingways to counteract its undesirable effects. A solution might possibly be to build a reward system including both individual and group incentive forms, since some of the dysfunctional aspects attributed to merit-pay systems have been overcome by the group-incentive plans. Indeed, a principal feature of these plans is that they are designed to instil co-operative behaviour.

34 Group Incentive Plans There are three major categories of group incentive plans: small-group or work units where rewards are allocated on group performance for exceeding predefined standards; productivity improvement plans such as Scanlon, Improshare and Rucker plans; and profit-sharing or share-ownership plans. Group-incentive plans are usually the most appropriate under conditions where direct supervision is not readily feasible, exact measurement of individual work performance is difficult, and where teamwork and co-operation are essential to success. Pay for performance has become an important compensation objective in many organisations[15]. The most popular forms of performance-based reward are lump-sum bonuses (30 per cent) followed by small-group incentive plans (14 per cent), gain sharing (13 per cent) and pay for knowledge (5 per cent). It is clear that many of these plans are inextricably interwoven and quite often difficult to differentiate clearly. Actually many appear to be integrated. With these plans, equity is respected by providing the incentives external to the formal pay structure. In addition, group-incentive pay is normally tied to productivity and/or profits so that, in theory, there is a flexible budget for performance rewards and pay can truly be based upon performance. Furthermore, it has been pointed out that peer recognition is an important reward that group-incentive plans can stimulate more effectively than merit-pay systems. In examining gain sharing, as a group plan, Lawler[16,17] comments that there may be a disadvantage in the fact that there is less direct connection between individual performance and rewards. On the other hand, he sees several advantages in these plans because: •

they do not rely on individual performance;

•

they are jointly developed with the participation of management and employees; they affect everyone in the workforce, from the managers down to the support staff;

• •

they lead to co-operative problem-sharing relationships;

•

there is a greater correlation between organisational profits and individual financial rewards.

In further examining profit sharing, it is expected that this system will encourage teamwork and co-operation, while it is not difficult to understand and administer.

It is a component of a larger Gestalt in which sharing profits, information, responsibility, accountability, and participation in decision making are instrumental in enhancing productivity. It has the capacity to unite the employees in a common goal, the improvement of the firm's competitive position. Profit sharing will be more effective in situations where profits are generated and determined by the employees, not by factors beyond their control. Also it will work only where increased employee concern with profits and increased commitment to produce profits can actually affect the level of profitability. Thus it is unlikely that this system will be effective in capital-intensive industries. It is interesting to note that Lanthier[18] reports in a Canadian study by Peat Marwick Stevenson Kellog that a majority of Canadian employers do not clearly define profit sharing per se but use bonus plans for non-executives. In a survey of 274 employers representing 641,000 employees, about 55 per cent of employers use bonus plans for workers below executive ranks, up from 42 per cent in 1986. Twenty per cent offer profit-sharing plans compared with 12 per cent four years ago. Top-ranking executives receive an average bonus of 24 per cent of their income in a normal year and 35 per cent in a particularly good year. Employees below management level typically receive 5 per cent in a normal year and, in a good year, 9 per cent. The problems encountered with profit-sharing plans are often related to the possible reluctance of the employer to surrender a share of profits, often seeing it as an intrusion into management rights and furthermore as a gift to employees without commensurate benefits of productivity improvement. Also employees could question every expense including R&D, since this has a direct bearing on their bonus. Finally, the delay in feedback, resulting from the time elapsed between the performance and the attribution of the reward, takes away some of the incentive power of the programme. In that sense profit sharing does not provide a direct performance-to-reward link and may even be counterproductive, taking into consideration management's original mission and raison d'être to interweave pay and performance. Implementation How does management decide upon these different plans? Which one should be chosen? The most effective plan is usually custom-designed to fit the organisation's objectives and culture[19]. The objectives must then be clearly defined and communicated in order to have individual and group objectives aligned to those of the company. The company's culture should also encourage the best fit. The optimum plan should permit people to adjust their objectives to meet those of the company where a "win/win" philosophy has been communicated. However, before proclaiming that the organisation has a policy of paying for performance, it may be prudent and essential to engage in a self-audit to determine if the funds available in the "pot" for reward are actually going to be earmarked for that purpose. The organisation could possibly discover that the pay for performance pot has been allocated to other projects such as inflation, correcting inequities, recompense for length of service, and performanceevaluation judgements of future potential as determined by management.

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Others might earmark these funds as a recruitment tool, a control on turnover, or a reward for superior performance[8,10]. Although these are laudable reasons, they would undermine the company's credibility in the employees' opinion if they were said to be pay for performance rewards. As a result, "[the] most important step a company can take is to admit publicly that it has these kinds of objectives and then to design its programme to achieve them"[8]. In this regard, simplicity, openness and direct communications can undermine most management efforts to redistribute the wealth, while forgetting to tell those affected that the rules of the game have been changed unilaterally. It is at this junction that the company's philosophy and mission should be employed to serve as a guide to management in the design of their particular programme. Some questions are needed to serve as a guide for this process: Do they want to be seen as high-paying or simply to be competitive? Is the company's culture based on long-term service or does it rely on fresh blood to stimulate innovation? Do the management want to stimulate innovation while recognising exceptional employee contributions? Is development of an esprit de corps among employees to be encouraged or a spirit of competitiveness promoted among its organisational units[8,20]? The responses to these probing enquiries will be important for the blueprint intended to develop the proper mix in influencing pay for performance. It is suggested that a strong emphasis should be placed on the core values of a company's pay system, matching them to the organisation's culture[16]. These core values should be adhered to and the company should be certain that employees are aware of them. These core values can be identified as follows: • job security; • a comparison of pay levels with those of other organisations; • the major determinants of an individual's pay, i.e. pay for performance or seniority; • individual rights concerning access to information and involvement; • the relationship of pay levels to business success; • the degree to which the system will be egalitarian; • the degree of support the company is willing to provide for learning, personal growth and involvement[16]. It is therefore safe to say that pay structures should be developed to fit the organisation and should be supportive of the culture and types of behaviour required. At the same time, it is also important to consider the firm's environment. As a matter of fact, when a company is in a survival or turnaround mode, management does not always have the time or the interest to focus on individual reward. At the other end of the spectrum, small companies that are experiencing rapid growth usually prefer a profit-sharing system over a reward system to motivate employees[19].

The Structure of a Plan Cummings[21] has suggested that, to be effective, pay for performance must be tailored to the nature of each type of work in the organisation. As shown in Table I, different performance dimensions are inherent in each job and it is strongly suggested that the pay structure be tailored to address each of these dimensions. Furthermore, Scott and Cotter[22] have also suggested the following as major issues that should be considered: • • • • • •

•

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size of the incentive unit; time-span between performance and feedback rewards; selection of performance measures (see Table I); reward amount and distribution (see Table I); programme coverage (Who should be included in the programme?); programme manipulation (Is the programme subject to employee manipulation? Can the employees gain without performing in the desired manner?); programme communication.

Regarding the latter point, according to expectancy theory, employees need to perceive a link between the effort they exert and performance expected and a further link between performance and the desired outcomes. This link between effort, performance, and rewards must be clearly established and communicated a priori to ensure legitimacy. Performance dimensions

Related pay system dimensions

1. Interdependence with other jobs

1.

Team vs individual reward

2. Potential for performance to vary

2.

Size of reward opportunities

3. Individual's control over job outcomes 3.

Risk/reward ratios or degree to which rewards vary based on performance

4. Measurability of performance

4.

Risk/reward ratios or degree to which rewards vary based on performance

5. Time-period over which results are

5.

Frequency of rewards

6. Stability and consistency of the job

6.

Volatility of total compensation and provision to balance possible peaks and valleys (e.g. sales reps draw against commission plans)

7. Importance of job's outcomes to the

7.

Maximum compensation opportunities allowed

achieved

organisation

Table I.

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Further to support and expand upon this issue it is necessary to enumerate certain conditions which must be present for rewards to elicit desired performance[16]: (1) Important rewards can be given and tied to performance. (2) Information can be made public about how rewards are given. (3) Superiors are willing to explain and support the reward system in discussions with their subordinates. (4) Rewards can vary widely, depending on the individual's current performance. (5) Performance can be objectively and inclusively measured. (6) Meaningful performance appraisal sessions can take place. (7) High levels of trust exist or can be developed between superiors and subordinates. As an added note to the last point, objectives set jointly by employees and managers will help to develop the often elusive trust. Moreover, it will demonstrate to the employees involved that their contribution is considered important, and should make it easier for them to understand and accept what is expected on their part. However, it is important to note that this requires both sides to acquire new skills. As Cissell[19] mentions, employees must learn to communicate with one another, problem-solve, and take action to improve productivity; and managers must be prepared to listen and seek ideas from subordinates and effectively coach and reinforce behaviours that will lead to gains. This is a dyadic agreement that needs to be based upon trust for both parties to experience "win/win". The reward systems must be clearly communicated, well understood by those affected and accepted as relevant. As noted by Lawler[16] pay can be an effective motivator only if it is important to people and it is seen to be tied to their performance in ways that are perceived to be credible and direct. Finally, Cissell[19] emphasises the point that all employees should be included in the reward opportunities. Research has supported the fact that it is increasingly important to motivate indirect/support people to improve their productivity. It is vital that management visibly recognise that such people are essential and significantly contribute to the organisation's profitability. Conclusion Organisational strategy and objectives, organisational structure and the environment must be studied before determining the appropriateness of the type of pay-for-performance plan. It is important to determine if success in the organisation requires individual or group efforts. By looking at as many of the factors that should be considered in designing a suitable pay-for-performance plan, it can be seen that there are numerous permutations and combinations that must be considered in designing a suitable reward system. There can be

no one perfect pay-for-performance plan that will work well in all situations and with all players. Individual differences strongly suggest otherwise. While custom tailoring may seem to be the most effective solution in most situations, some organisations are too small to make such an approach practical. Also other companies may see a need to enforce a strong company-wide culture as a reason to pay everyone according to the same system. In this instance they might consider using non-monetary rewards such as merchandise, travel, club memberships, reserved company parking, job variety and autonomy, etc.[9,13,19]. But this supermarket variety may be antagonistic to individuals with unique values working in a complex culture and ultimately prove to be counter-productive to its original intended raison d'être. Paying for performance is a fundamental North American value that is part of the companies' competitive state; each must find the best way to comply with it. The 1990s demand it! References 1. Booth, P.L., "Payment for Performance: The Growing Use of Incentives and Bonus Plans", Report 22-87, The Conference Board of Canada, Ottawa, September 1987. 2.Lendvay-Zwickl, J. and Booth, P., "Compensation Planning Outlook 1988", The Conference Board of Canada, Ottawa, October 1987. 3. Lendvay-Zwickl, J., "Compensation Planning Outlook 1990", The Conference Board of Canada, Ottawa, October 1989. 4. Sullivan, J.F., "The Future of Merit Pay Programs", Compensation and Benefits Review, Vol. 20 No. 3, 1988, pp. 22-30. 5. Adams, J.S., "Inquiry in Social Exchange", in Berkowitz, L. (Ed.), Advances in Experimental Social Psychology, Vol. 2, Academic Press, New York, 1965. 6. Porter, L.W. and Lawler, E.E. III, Managerial Attributes and Performance, Richard D. Irwin and Dorsey Press, Homewood, Illinois, 1968. 7. Steers, R.M. and Rhodes, S.R., "Major Influences on Employee Attendance: A Process Model", Journal of Applied Psychology, August 1978, pp. 391-407. 8. Mandt, E., "Who is Superior and Who's Merely Very Good?", Across the Board, Vol. 21 No. 4, 1984, pp. 16-23. 9. Hammer, W.C., "How to Ruin Motivation with Pay", Compensation and Benefits Review, Vol. 7 No. 3, 1975, pp. 17-27. 10. Geiss, A.A., "Making Merit Pay Work", Personnel, Vol. 64 No. 1, 1987, pp. 52-60. 11. Pearce, J.L. and Perry, J.L., "Federal Merit Pay: A Longitudinal Analysis", Public Administration Review, Vol. 4, July-August 1983, pp. 315-25. 12. Teel, K.S., "Are Merit Raises Really Based on Merit?", Personnel Journal, Vol. 65 No. 3, 1986, pp. 40-5. 13. Podsokoff, P.M., Greene, C.N. and McFillen, J.M., "Obstacles to the Effective Use of Reward Systems", in Dolan, S.L. and Schuler, R.S. (Eds), Canadian Readings in Personnel and Human Resource Management, West Publishing Company, Toronto, 1987, pp. 245-60. 14. Lawler, E.E. III, Pay and Organization Development, Addison-Wesley, Don Mills, Ontario, 1981. 15. McAdams, J.L., "Performance-based Reward System", Canadian Business Review, Vol. 15 No. 1, 1988, pp. 17-19. 16. Lawler, E.E. III, "Pay for Performance: A Motivational Analysis", in Nalbantian, H.R. (Ed.), Incentives, Co-operation and Risk Sharing, 1987.

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17. Lawler, E.E. III, "Pay for Performance: Making It Work", Personnel, Vol. 65 No. 10, 1988, pp. 68-71. 18. Lanthier, J., "Non-executive Bonus Plans Common Survey", Financial Post, 12 October 1989. 19. Cissell, M.J., "Designing Effective Reward Systems", Compensation and Benefits Review, Vol. 19 No. 6, 1987, pp. 49-55. 20. Theriault, R., "Key Issues in Designing Compensation Systems", in Dolan, S.L. and Schuler, R.S. (Eds.), Canadian Readings in Personnel and Human Resource Management, West Publishing Company, Toronto, 1987, pp. 226-44. 21. Cummings, C., "Linking Pay to Performance", Personnel Administrator, Vol. 33 No. 5, 1988, p. 47-52. 22. Scott, K.D. and Cotter, T., "The Team that Works Together Earns Together", Personnel Journal, Vol. 63 No. 3, 1984, pp. 59-67. Bibliography Bullock, R.J. and Lawler, E.E. III, "Gainsharing: A Few Questions, and Fewer Answers", Human Resources Management, Vol. 23 No. 1, 1984, pp. 23-40. Edwards, M.R., "Forgiving Systems: The Key to Effective Merit Appraisals", Supervisory Management, Vol. 30 No. 4, 1985, pp. 12-15. Hathaway, J.W., "How Do Merit Bonuses Fare?", Compensation and Benefits Review, Vol. 18 No. 5, 1986, pp. 50-5. Metz, E.J., "Designing Legally Defensible Performance Appraisal Systems", Training and Development Journal, Vol. 42 No. 7, 1988, pp. 47-51. Wagel, W.H., "A Software Link between Performance Appraisals and Merit Increases", Personnel, Vol. 65 No. 3, 1988, pp. 10-14. Wallace, M.J. and Fay, C.H., Compensation Theory and Practice, Kent Publishing Company, Boston, 1983. Woods, J.G. and Dillion, T., "The Performance Review Approach to Improving Productivity", Personnel, Vol. 62 No. 3, 1985, pp. 20-7.