Lecture 5 Part II (Chapter 13 of textbook) Incentive Compensation

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1 1 Lecture 5 Part II (Chapter 13 of textbook) Incentive Compensation Learning Objectives Explain the concept of incentive compensation and why its use is spreading. Identify the key objectives of incentive compensation plans. Describe the major types of incentive pay systems and their advantages and disadvantages. Understand the role of incentive pay in the overall context of employee rewards. Chapter outline Chapter 13 discusses the different types of incentive programs that organisations might choose to use to motivate their employees. The first two sections examine the use of incentive systems within Australian businesses and why organisations might choose to introduce such a system. Section three describes the different types of incentive programs that are used, and section four identifies a number of key issues that should be considered when designing an effective incentive pay system. Introduction Relating pay to individual performance has never been as significant in Australian compensation practice as it has in the USA. A mix of base salary and performance bonus compensates more than two thirds of US workers. In contrast, only a minority of Australian companies with executive option schemes require some form of performance criteria to be applied before granting options. Many Australians consider that individual-based performance (or incentive) pay strikes at the heart of protectionist and egalitarian values that stress mateship and solidarity. Many public servants, for example, find performance pay divisive and alien to the collective nature of public service work. Consequently, in some departments, all senior staff are given the same performance rating and the same performance pay increase. Three factors have prompted both public and private sector organisations to take an active interest in incentive pay. 1. Australians are coming to appreciate and increasingly demand the opportunity to be rewarded for their individual contribution to an organisation s success. 2. Since the introduction of the structural efficiency and enterprise bargaining principles, the onus is increasingly on individual enterprises to achieve workplace productivity gains. 3. There is an increasing demand for pay structures to provide a more direct link between employee rewards and organisational objectives. HR managers should remember that incentive-based pay is not the prime means for getting employees to work to their fullest capacity. If it is the only motivator, then there are other, different issues at stake for example, a poor work climate, unsuitable management style, faulty job design and a lack of clarity about job duties and responsibilities. Incentive compensation is not a panacea for all the ills of the organisation. Second, the HR manager must remember that performance-based pay systems need to be straightforward in design and simple to communicate. Incentive pay plans most often fail because they are too complex.

2 2 Why introduce incentive compensation? Organisations introduce incentive compensation plans for essentially four reasons. To promote employee identification with the organisation s objectives. To encourage individual, team or business unit performance. To control fixed compensation costs. To increase remuneration competitiveness. Regardless of its reasons for adopting an incentive-based pay system, an organisation will expect to see improvements in performance. Types of plan There is a variety of ways of categorising incentive compensation plans. Ultimately, the choice of plan who it rewards, for what and how depends on the objectives to be achieved, the management processes to be supported and reinforced, and what is likely to be successful within the existing structure and culture of the organisation. Bonus versus incentive - A bonus is a discretionary reward provided after the event. It may be awarded for a well-defined accomplishment or it may simply be given to recognise extra effort or a job well done. A bonus is determined and given after the job is done and it makes no guarantee that future work or effort will be rewarded similarly. Pay-for-performance link - Employees perceive only a weak link between performance and pay. Pay is seen as dependent on non-performance factors such as position and length of service. Variable pay systems and particularly incentive-type plans aim to strengthen the perceived link between pay and performance. Variable and at-risk pay - Any pay system that provides a bonus or incentive is a variable pay system. The bonus or incentive paid for a particular period may or may not be paid the next time period. The amount of the bonus or incentive varies and cannot be predetermined. Individual incentive plans - Individual incentive plans are those that reward the employee for reaching or exceeding specific performance criteria. They can be used only where there are accurate and reliable measures of individual performance. The prime objectives of this type of plan are to increase individual performance and to permit the pay system to actively discriminate in favour of top performers. Small-group incentive plans - Small group incentives are designed to reward work teams, project groups or departments. They can provide a highly effective link between pay and performance. An important aspect of small-group incentives is their ability to increase flexibility in job assignment by focusing on team accomplishments rather than individual ones. This promotes a strong group perspective rather than individual focus. Gainsharing - Gainsharing is a small-group incentive system that shares the productivity improvements with the employees who make the improvement. It is one of the fastest growing pay-for-performance reward systems. The plan involves measuring improvements in performance over some agreed baseline data, calculating the financial impact of any improvements (typically measured in reduced costs) and sharing the financial gain with employees.

3 3 Paying for quality and customer service - Small-group incentives are increasingly being used as a means of rewarding work teams for achievements in quality and customer service. Typically, manufacturing companies focus on product quality while service organisations such as banks and hotels focus on customer service. Each team member shares equally in the incentive pool as predetermined targets in quality or customer service are met. The role of performance measurement and incentives, (particularly individual performance appraisal and individual incentives) is a controversial issue in total quality management (TQM). Incentive pay for project teams - The key performance measures for project work are completion on time and within budget. This usually allows the overall task to be divided into milestones that define specific time frames and budgets for each stage of the project. In this respect, project work is often ideally suited to small-group incentives. Large group (organisation-wide) incentive plans - Many organisations choose to introduce variable pay systems that cover all employees. Such plans are typically based on one or two broad performance indicators such as achievement of a budget or profit. Large-group incentives usually take the form of a bonus plan, an incentive plan or an at-risk incentive. Recognition programs - Recognition programs are a form of individual or work-group incentive that is usually outside the normal remuneration system. Recognition programs use various forms of reward, including cash, merchandise, travel, time off with pay, plaques and certificates. The performance measures vary depending on the purpose of the program. Awards can relate to reaching specific targets for example, achieving shift production quotas or exceeding sales budget. Design and implementation of incentive pay There is a range of issues to be considered when designing and implementing an incentive pay system including: Focus on strategic business objectives Develop a comprehensive reward framework Ensure reinforcement or desired behaviours Funding Fit with organisational culture Summary The act of relating pay to performance is increasing as organisations seek to become more productive. Incentive plans, moreover, are an effective vehicle for management to communicate to employees what is important and what is not. Organisations typically introduce incentive compensation plans to promote employee identification with the organisation s strategic business objectives, to encourage individual, team or business unit performance, to control fixed compensation costs and to increase remuneration competitiveness. Incentive compensation plans can be classified in a variety of ways individual programs, small-group programs, large-group programs and recognition programs. The choice of plan ultimately depends on the objectives to be achieved. Gainsharing, for example, is a small-group incentive system that shares the benefits of productivity improvements with the employees responsible. Types of gainsharing plans include the Scanlon plan, the Rucker plan and Improshare.

4 4 Recognition programs are a form of individual or work-group incentive that is usually outside the standard remuneration system. These programs may include cash, merchandise, travel, time off with pay, plaques and certificates. An organisation, when designing and implementing an incentive plan, needs to consider the performance criteria, development of a integrated reward framework, reinforcement of desired behaviours, funding and fit with the organisation s culture. TERMS TO KNOW at-risk compensation base salary bonus commission contribution-based pay gainsharing incentive incentive compensation individual incentives large-group incentives line of sight merit pay options piece-rates profit sharing recognition programs Rucker plan Scanlon plan small-group incentives total quality management (TQM) variable pay component Some questions for you to discuss: 1.Do you think organisations should introduce incentive compensation? There are essentially four reasons why organisations introduce incentive compensation plans: (a) Promote Employee Identification with the Organisation's Objectives Many organisations attempt to focus employee attention on their objectives by linking the achievement of organisation objectives to employee rewards. This builds employee commitment and gives employees a 'stake' in the overall success of the organisation. Incentive plans designed to build employee commitment in this way include annual bonuses and employee profit sharing. (b) Encourage Individual, Team or Business Unit Performance The aim here is to bring the incentive reward closer to specific work outcomes that the employee, or the work group, can directly affect. (This is often referred to as maintaining a direct 'line of sight' between employee performance and pay.) Sales commissions, production piece-rates, and other such incentives linked to reaching and exceeding agreed targets are examples of this type of variable pay. (c) Control Fixed Compensation Costs One way of controlling compensation costs is to designate a portion of pay as 'at risk' against the achievement of predetermined business unit, team or individual objectives. The organisation thus gears its total compensation costs to meeting its objectives. If the objectives are met, employees receive their full pay, if the objectives are exceeded they receive more, and if the organisation does not meet its objectives, some - or all - of the 'at risk' component is not paid. (d) Increase Remuneration Competitiveness

5 5 Another reason for adopting incentive pay is to increase the competitiveness of the organisation's compensation practices compared with other organisations. This provides a visible signal to employees that the organisation is willing to reward good performance at a significantly higher level than other organisations. Here the aim is to use variable pay to provide employees with the opportunity of earning well above their regular salary levels. 2. What behavioural changes can be brought about by incentive compensation? increased teamwork increased output (performance) reduced staff turnover reduced absenteeism reduced accident rate 3. What are the major objectives of incentive plans? Promote Employee Identification with the Organisation's Objectives Encourage Individual, Team or Business Unit Performance Control Fixed Compensation Costs Increase Remuneration Competitiveness Regardless of which reasons an organisation adopts an incentive-based pay system, it will expect to see improvements in performance. Key performance indicators may be expressed as quantitative measures related to an organisation's financial or operating performance (examples include return on assets managed, revenue growth, share price increase, unit cost of production, stock turnover and lost time due to accidents). Alternatively, many performance-based pay systems reward employees for their performance using qualitative measures (examples include teamwork, employee attitudes and customer satisfaction ratings). As a general rule, senior managers have their performance measured against indicators of the overall financial performance of the business unit or function under their control. This is consistent with the fact that the impact of these jobs is much broader and is thus likely to affect the overall well being of the organisation. Further down the organisation, performance indicators tend to focus more on work group indicators (e.g. team productivity, branch sales) or highly specific personal goals (e.g. number of units produced per shift). 4. What are the characteristics of a successful incentive plan? Provides a clear link between individual or group pay and contribution. Discriminates in favour of high performers can have significant impact on key performance indicators such as productivity, quality and sales. Total compensation costs are linked to organisation objectives, increases peer pressure for improvement on poor performers, encourages employee identification with organisation-wide objectives, controls part of remuneration costs where reward is contingent on meeting objectives 5. What are the advantages and disadvantages of linking rewards to performance? Attitude surveys suggest that employees perceive only a weak link between performance and pay. Pay is instead seen as dependent on non-performance related factors such as

6 6 position and length of service. Variable pay systems and particularly incentive-type plans aim to strengthen the link between pay and performance. The relationship between pay and performance is especially effective when it is based on those aspects of the work that are under the individual employee's direct control and influence. "If you sell or produce more, you earn more!" This establishes an immediate relationship between results and rewards. This relationship between employee control and influence over the end result is referred to as the "line of sight". The more immediate the "line of sight" the employee has, the more likely the incentive plan will generate improved performance. An incentive that rewards a manager for the performance of her or his department has a stronger "line of sight" - or pay-for-performance link - than one that rewards her or him for the overall performance of the organisation. The most successful plans continually emphasise the link between individual performance and reward. Similarly, successful plans pay strictly on the basis of results achieved. In this way, all employees quickly learn that if they meet - or exceed - performance targets, the rewards are there. Conversely, if they do not perform at the required levels, there are no consolation prizes. Advantages and Disadvantages of Individual Incentive Plans Advantages Provides a clear link between individual pay and contribution Discriminates in favour of high performers Can have significant impact on key performance indicators such as productivity, quality and sales Total compensation costs are linked to organisation objectives Disadvantages May encourage individualism and non-productive competition Require comprehensive and credible systems of individual performance measurement - where these are not already in place, they may be expensive to design and introduce Can sometimes end up paying for performance that would have been achieved without an incentive plan Where improvements by one employee are offset by poor performance of another, the organisation is no better off 6. What are some of the considerations involved in using individual, group and organisation-wide incentives? Individual Incentive Plans Individual incentive plans are those that reward the employee for reaching or exceeding specific performance criteria. For this reason, individual incentive plans can only be used where there are accurate and reliable measures of individual performance. The prime objectives of this type of plan are to increase individual performance and permit the pay system to actively discriminate in favour of top performers.

7 7 Two conditions need to be present for individual incentive plans to be successful. Firstly, there is a requirement that the organisation emphasises individual contribution, as distinct from team or work group effort. Secondly, the job must be designed to allow each employee to work independently and with a high degree of autonomy and discretion. Small Group Incentives The essential principles outlined under the individual incentive systems also apply to the reward of small groups (e.g. work teams, project groups, departments). Three changes in the design and management of work have increased the popularity of small group incentives. First, complex technologies and highly competitive business environments have led to greater reliance on specific purpose project teams as a key feature of work in some industries (e.g. information technology, defence). Second, world-wide there has been a consistent process of downsizing in private and public sector organisations which has reduced the levels of management and led to the development of flatter organisation structures that focus on the work team and self management. Third, research and experience has shown that work group effectiveness is strongly correlated with employee involvement, communication and a supportive management style. Large Group (Organisation-wide) Incentive Plans Many organisations choose to introduce variable pay systems that cover all employees. These organisation-wide plans are often additional to individual or small group incentives. Where such plans are introduced, they are typically based on one or two broad performance indicators such as achievement of budget or profit. The principles involved in the design of large group incentives follow the general guidelines applicable for individual and small group incentives. Large group incentives usually take the form of a bonus plan, an incentive plan or an "at-risk" incentive. Most bonus plans make little or no distinction between individual contributions with all employees receiving the same percentage bonus. While bonus plans do allow employees to share in the success of the organisation, and promote a favourable organisation image, there are some consistent criticisms. First, because of their discretionary nature they do little to influence individual performance. Second, where bonuses are paid regularly, they are often seen as a "right" and a form of deferred pay. Third, because they do not differentiate on the basis of performance, high performing employees often feel that their contributions are not sufficiently recognised. 7. How can the effectiveness of an incentive plan be evaluated? Focus on Strategic Objectives. The first step in designing an effective incentive pay system is to define the required performance criteria. Where the overall organisation objectives may be phrased in terms of one or two key indicators (e.g. share price and profit after tax), these may well be the performance criteria for the Chief Executive Officer and the executive team. It is rarely appropriate however, to use such broad performance criteria for middle managers, supervisors and employees. The manufacturing department will impact profit - and therefore, share price - by increasing the productivity of its operations. Thus, the key performance indicators are likely to be drawn from those issues that affect cost and efficiency. Similarly, the sales department will affect profit by increasing the volume of sales and gross profit margins. Performance indicators for sales employees should reflect this.

8 8 Ensure Reinforcement of Desired Behaviours.The aim of an incentive system is to reinforce the organisation objectives and priorities to employees. It is important therefore that this process is clear and unambiguous. Three things are necessary: first, the performance objectives need to be clearly specified; second, the nature of the contribution - whether individual or group - must be defined; and third, the frequency of payment must be such that it continually reinforces the organisation's message. "Fit" with Organisation Culture. Performance-based remuneration will be most effective where it reinforces the existing organisation culture and management style. Consideration should be given to such issues as centralisation/decentralisation, the degree of control or autonomy over the work and other characteristics to ensure that the incentive plan is in harmony with the organisation's culture and management style.