Chapter 4: Incentive Pay Copyright © 2017 Pearson Education, Inc.4-1

Learning Objectives 4-1. Explore the incentive pay approach Describe the differences between incentive pay methods and traditional pay methods Summarize five types of individual incentive pay plans Explain two types of group incentive plans Discuss two types of company-wide incentive plans Summarize considerations when designing incentive pay programs. Copyright © 2017 Pearson Education, Inc.4-2

Incentive Pay  Compensation fluctuates according to:  A preestablished formula  Individual or group goals  Company earnings  Adds to base pay on a nonrecurring basis  Controls costs  Motivates employees through explicit goal setting Copyright © 2017 Pearson Education, Inc.4-3 LO 4-1

Incentive Pay Assumptions Effective incentive pay systems are based on three assumptions:  Individual employees and work teams differ in how much they contribute to the company, both in what they do as well as in how well they do it  The company’s overall performance depends to a large degree on the performance of individuals and groups within the company  To attract, retain, and motivate high performers and to be fair to all employees, a company needs to reward employees on the basis of their relative performance Copyright © 2017 Pearson Education, Inc.4-4 LO 4-1

Contrasting Incentive Pay with Traditional Pay  Traditional pay generally includes an annual salary or hourly wage  Increased periodically on a seniority or merit basis with permanent increase to base pay  Incentive pay generally  Increases base pay on goal attainment with pay increase nonrecurring  Companies use incentive pay to reward individual employees, teams of employees, or whole companies based on their performance Copyright © 2017 Pearson Education, Inc.4-5 LO 4-2

Cost Comparison: Merit Pay vs. Incentive Pay Copyright © 2017 Pearson Education, Inc.4-6 LO 4-2

Incentive Pay Categories  Individual: these plans reward employees whose work is performed independently  Group: these plans promote supportive, collaborative behavior among employees  Company-wide: these plans tie employee compensation to a company’s performance over a short time frame Copyright © 2017 Pearson Education, Inc.4-7 LO 4-2

Incentive Pay Measures Copyright © 2017 Pearson Education, Inc.4-8 LO 4-3

Types of Individual Incentive Plans  Piecework plans: reward workers for every item produced over a designated production standard  Management incentive plans: award bonuses to managers when they meet or exceed objectives based on sales, profit, production, or other measures for their division Copyright © 2017 Pearson Education, Inc.4-9 LO 4-3

Types of Individual Incentive Plans  Behavior encouragement plans: employees receive payments for specific behavioral accomplishments  Referral plans: employees receive bonuses for recruitment of highly qualified employees  Spot bonuses: employees receive small monetary gifts for outstanding work or effort during a reasonably short time period Copyright © 2017 Pearson Education, Inc.4-10 LO 4-3

Piecework Plans  Awards based on individual production vs. objective standards  Awards based on individual performance standards using objective and subjective criteria  Quantity and/or quality goals Copyright © 2017 Pearson Education, Inc.4-11 LO 4-3

Calculation of a Piecework Award for a Garment Worker Copyright © 2017 Pearson Education, Inc.4-12 Guaranteed Hourly Base Pay ($) Piecework Award (No. of Garments Stitched Above the Piecework Standard x Piecework Incentive Award) Total Hourly Earnings ($) First Hour garments x $0.75/garment = $ Second Hour4.50Fewer than 15 stitched garments, thus piecework award equals Piecework standard: 15 stitched garments per hour Hourly base rate awarded to employees when the standard is not met: $4.50 per hour That is, workers receive $4.50 per hour worked regardless of whether they meet the piecework standard of 15 stitched garments per hour. Piecework incentive award: $0.75 per garment stitched per hour above the piecework standard LO 4-3

Individual Incentive Plan Advantages  Helps relate pay to performance  Promotes equitable distribution of compensation  Helps retain best performers  Compatible with America’s individualistic culture Copyright © 2017 Pearson Education, Inc.4-13 LO 4-3

Individual Incentive Plan Disadvantages  May promote inflexibility  Unrealistic standards may hamper employee motivation  Setting performance standards is time consuming  Factors beyond employee’s control may affect outcomes  May promote undesirable behaviors Copyright © 2017 Pearson Education, Inc.4-14 LO 4-3

Group Incentive Plans  Reward employees for their collective performance  Use has increased in industry  Two types:  Team based or small group  Gain sharing Copyright © 2017 Pearson Education, Inc.4-15 LO 4-4

Types of Teams  Work (process) teams: refer to organizational units that perform the work of the organization on an ongoing basis  Ex: Customer service teams, assembly teams on production lines.  Project teams: consist of a group of people assigned to complete a one-time project  Ex: Engineers working on the construction of a bridge.  Parallel teams (task forces): include employees assigned to work on a specific task in addition to normal work duties Copyright © 2017 Pearson Education, Inc.4-16 LO 4-4

Rewards Allocation Methods  Equal incentive payments  Differential payments based on contribution to goals  Differential payments according to base pay Copyright © 2017 Pearson Education, Inc.4-17 LO 4-4

Gain Sharing  Incentives based on company performance in  Increased productivity  Increased customer satisfaction  Lower costs  Better safety records  Based on open leadership  Involves employee participation  Includes bonuses Copyright © 2017 Pearson Education, Inc.4-18 LO 4-4

Advantages of Group Incentives  Companies can more easily develop performance measures for group plans than individual plans  Greater group cohesion Copyright © 2017 Pearson Education, Inc.4-19 LO 4-4

Disadvantages of Group Incentives  May lead to higher employee turnover because of the free-rider effect  Members may feel uncomfortable with the fact that other members’ performance influences their compensation level Copyright © 2017 Pearson Education, Inc.4-20 LO 4-4

Company-Wide Incentive Plans  Rewards employees when company meets performance standards  Two types  Profit sharing plans  Employee stock options Copyright © 2017 Pearson Education, Inc.4-21 LO 4-5

Profit-Sharing Plans  Current profit-sharing plans  Award cash to employees typically on a quarterly or annual basis  Deferred profit-sharing plans  Place cash awards in trust accounts for employees Copyright © 2017 Pearson Education, Inc.4-22 LO 4-5

Profit-Sharing Formulas  Fixed first-dollar-of profits  7% of corporate profits  Graduated first-dollar-of profits  3% of the first $8 million of profits and 6% of the profits in excess of that level  Profitability threshold formula Copyright © 2017 Pearson Education, Inc.4-23 LO 4-5

Distribution Methods  Equal payments  Proportional payments based on annual salary  Proportional payments based on contribution to profits Copyright © 2017 Pearson Education, Inc.4-24 LO 4-5

Advantages and Disadvantages of Profit-Sharing Plans Advantages  Enable employees to share in companies’ profits  Allow companies greater financial flexibility Disadvantages  Can undermine the economic security of employees  May fail to motivate employees if they do not see a direct link between their efforts and profits Copyright © 2017 Pearson Education, Inc.4-25 LO 4-5

Employee Stock Option Plans Companies grant employees right to purchase share of company  Company stock  Company stock shares  Stock options Copyright © 2017 Pearson Education, Inc.4-26 LO 4-5

Incentive Pay Considerations  Based on individual or group performance  Acceptable level of risk  Replace traditional pay  Performance criteria evaluated  Appropriate time horizon Copyright © 2017 Pearson Education, Inc.4-27 LO 4-6