Pay-for-Performance Plans Chapter 10 Pay-for-Performance Plans © 2014 by McGraw-Hill Education.  This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner.  This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 

Learning Objectives What is a pay-for-performance plan? Does variable pay improve performance results? The general evidence Specific pay-for-performance plans: Short term Team incentive plans: Types Explosive interest in long-term incentive plans 10-2

What is Pay-for-Performance? Pay-for-performance: Signals a movement: Away from entitlement Towards a pay that varies with individual or organizational performance Increasing interest in variable pay Competition from foreign competitors Fast-paced business environment 10-3

Specific Pay-for-Performance Plans: Short Term Merit pay Lump-sum bonuses Individual spot awards Individual incentive plans 10-4

Merit Pay Links increases in base pay to: Issues How highly employees are rated on a subjective performance evaluation Issues Expensive Doesn’t achieve the desired goal of: Improving employee and corporate performance 10-5

Managing Merit Pay Improve accuracy of performance ratings Allocate enough money to truly reward performance Increase in merit pay should differentiate across performance levels 10-6

Lump-Sum Bonuses Substitute for merit pay Not built into base pay Viewed as less of an entitlement than merit pay Less expensive than merit pay over the long run 10-7

Exhibit 10.3 - Relative Cost Comparisons 10-8

Individual Spot Awards Viewed as highly or moderately effective Awarded for exceptional performance 10-9

Individual Incentive Plans A promise of pay for some objective, pre-established level of performance Use established standards to: Compare employee performance Determine magnitude of incentive pay Dimensions on which plans vary Method of rate determination Relationship between production and wages 10-10

Exhibit 10.5 - Individual Incentive Plans 10-11

Exhibit 10.6 - The Taylor and Merrick Plans 10-12

Individual Incentive Plans Taylor plan - Two piecework rates Higher than the regular incentive, when production exceeds published standard Lower than regular wage for production below standard Merrick system - Three piecework rates are set High for production exceeding 100 percent of standard 10-13

Individual Incentive Plans Medium for production between 83 and 100 percent of standard Low for production less than 83 percent of standard 10-14

Individual Incentive Plans Halsey 50–50 method For tasks completes in less than the standard time: Savings are allocated 50–50 between the worker and the company Rowan plan A worker’s bonus increases as the time required to complete the task decreases 10-15

Individual Incentive Plans Gantt plan Standard time for a task is purposely set at a level requiring high effort to complete 10-16

Exhibit 10.7 - Advantages and Disadvantages of Individualized Incentive Plans Source: Michael Coates, Psychology and Organizations, Heineman Themes in Psychology (Heineman: Boston, 2001); T. Wilson, “Is It Time to Eliminate the Piece Rate Incentive System?” Compensation and Benefits Review 24(2) (1992), pp. 43–49; Pinhas Schwinger, Wage Incentive Systems (New York: Halsted, 1975). 10-17

Team Incentives Plans Group incentive plan Gain-sharing plan Team performance is measured against a set standard to: Determine the magnitude of incentive pay Gain-sharing plan Pays off for teams defined at the level of a strategic business unit 10-18

Team Incentives Plans Causes for failure Varieties in teams Level problem Complexity Control Communications 10-19

Exhibit 10.9 - A Sampling of Performance Measures 10-20

Types of Variable-Pay Plans: Advantages and Disadvantages Plan type Advantages Disadvantages Cash profit sharing Simple, easily understood Low administrative costs Profit influenced by many factors beyond employee control • May be viewed as an entitlement • Limited motivational impact Stock ownership or options Minimal impact on the financial statements Have powerful impact on employee behavior Tax deferral to employees Indirect pay/performance link Employees may be required to put up money to exercise grants 10-21

Types of Variable-Pay Plans: Advantages and Disadvantages Plan type Advantages Disadvantages Balance Scorecard Communicates organizational priorities If financial targets are not met, there may be a reduced payout Can be complex Productivity/ gain sharing Performance– reward links • Productivity and quality improvements • Knowledge of business increases • Fosters teamwork, cooperation Administratively complicated • Drop-off in quality • Management must open the books • Payouts occur even if company’s financial performance is poor 10-22

Types of Variable-Pay Plans: Advantages and Disadvantages Plan type Advantages Disadvantages Team/group incentives Reinforces teamwork and team identity/ • Stimulates ideas and problem solving • Minimizes distinctions between team members • May better reflect how work is performed May be difficult to isolate impact of team • Not all employees can be placed on a team • Can be administratively complex • May create team competition • Difficult to set equitable targets for all teams 10-23

Exhibit 10.12 - The Choice Between Individual and Group Plans World at Work and Vivient Consulting, 2012. “Private Company Incentive Pay Practice Survey.” Reprinted with permission 10-24

Key Elements in Designing a Gain-Sharing Plan Strength of reinforcement Productivity standards Sharing the gains Scope of the formula Perceived fairness of the formula Ease of administration Production variability 10-25

Exhibit 10.13 - Three Gain-Sharing Formulas Adapted from M. Bazerman and B. Graham-Moore, “PG. Formulas: Developing a Reward Structure to Achieve Organizational Goals,” in B. Graham- Moore and T. Ross, eds., Productivity Gainsharing (Englewood Cliffs, NJ: Prentice-Hall, 1983). 10-26

Gain-Sharing Plans Scanlon plan Rucker plan Designed to lower labor costs without lowering the level of a firm’s activity Incentives are derived: As a function of the ratio between labor costs and sales value of production (SVOP) SVOP includes sales revenue and value of goods in inventory Rucker plan Expresses the value of production required for each dollar of total wage bill 10-27

Gain-Sharing Plans Implementation and success of Rucker or Scanlon plan requires: A productivity norm Effective measurement of base year data Acceptance by workers and management of this standard for calculating bonus Effective worker committees Evaluate employee and management suggestions 10-28

Similarities and Contrasts Between Scanlon and Rucker Plan Differ from individual incentive plans in their primary focus Differences Rucker plans tie incentives to a wide variety of savings Scanlon plans focus on labor savings Due to greater flexibility Rucker plans can be linked with individual incentive plans 10-29

Gain-Sharing Plans Improshare (improved productivity through sharing) Develops standard to: Identify expected hours required to produce an acceptable level of output Savings are shared by firm and workers Easy to administer and to communicate 10-30

Profit-Sharing Plans Focuses on a predetermined index of profitability Company should specify the funding formula 10-31

Earnings-at-Risk Plans Success sharing plan Employee base pay is constant Variable pay increases in successful years No reduction in base pay and no variable pay in poorly-performing years Risk sharing plan Compared to success sharing plan base pay is reduced by some amount 10-32

Exhibit 10.15 - Group Incentive Plans: Advantages and Disadvantages 10-33

Group Incentive Plans Can be described by: The size of the group that participates in the plan The standard against which performance is compared The payout schedule 10-34

Explosive Interest in Long-term Incentive Plans Long-term incentives (LTIs) Focus on performance beyond the one-year time line Growth in long term plans Result of desire to motivate longer-term value creation 10-35

Exhibit 10.17 - Long-Term Incentives and Their Risk/Reward Tradeoffs Source: This was originally published in IOMA’s monthly publication ‘Pay for Performance Report’ and is republished here with the express written permission of Kennedy Information, LLC. Copyright © 2012. Further use of, electronic distribution or reproduction of this material, requires the permission of Kennedy Information, LLC. 10-36

Exhibit 10.17 - Long-Term Incentives and Their Risk/Reward Tradeoffs Source: This was originally published in IOMA’s monthly publication ‘Pay for Performance Report’ and is republished here with the express written permission of Kennedy Information, LLC. Copyright © 2012. Further use of, electronic distribution or reproduction of this material, requires the permission of Kennedy Information, LLC. 10-37

Long-Term Incentive Plans Employee stock ownership plans (ESOPs) Generate long-term effects Foster employee willingness to: Participate in the decision-making process Have little impact on productivity or profit Performance plans (performance share and performance unit) Driven by financial earnings or return measures Pay for meeting or exceeding specific goals 10-38

Long-Term Incentive Plans Broad-based option plans (BBOPs) Are stock grants Are versatile Combination plans Use of both individual and group incentives Self-funding plan Payouts occur only after the company reaches a certain profit target 10-39