Performance Management and Compensation Dr. Jeanne Michalski michalski@uta.edu 1

Pay for Performance Discussion

Linking Pay to Performance U.S. organizations often use “merit” pay to determine employee pay increases Straightforward logic: if pay is made contingent upon performance, then employee motivation to achieve high performance is increased. Founded in motivational theories

Linking Pay to Performance Performance Pay Motivation Improved Performance

Expectancy Theory Motivation = E X I X V Expectancy: The connection between behavior and the outcome Instrumentality: The connection between outcome and a reward Valence: Is the reward something that the individual values? People are motivated by intrinsic and extrinsic rewards they desire. People will only be motivated if outcome is possible. People will only be motivated if outcome is contingent on behavior. People will only be motivated if a reward is attached to the outcome. “Line of sight” is the perceived link between individual behavior and the reward.

Equity Theory Comparison of my input / reward ratio with that of similar others. Merit pay should lead to improved performance because a pay raise is seen as a fair outcome for one’s performance input – the more one contributes to the organization the greater the pay increase

Pay Equity and Motivation The greater the perceived disparity between my input/output ratio and the comparison person’s input/output ratio, the greater my motivation to reduce the inequity.

“Monkeys Demand Equal Pay” A recent study shows brown capuchin monkeys refused to play along when they saw another monkey get a better payoff for performing the same work. The monkeys were trained to trade a granite token for a piece of cumber. When the reward was the same for both monkeys, they took the cucumber 95 percent of the time. But it was a different story when one monkey was given something better -- namely, a grape. Then, the other monkey often pitched a fit -- either throwing the token, refusing to eat the cucumber or giving it to the other monkey. Associated Press 2003

Reinforcement Theory Rewards reinforce performance “what gets rewarded gets repeated” Merit pay should motivate improved performance because the monetary consequences of good performance are made known. The better one’s performance, the greater the pay increase will be.

Goal Setting Theory Behavioral goals vs. Outcome goals Often easier to observe outcomes Gives employee discretion on how to achieve goals Use Outcome Goals When: Workers know how to achieve the goals Workers have the necessary resources

Goal Challenge and Performance High Performance Note: Not to scale Low Performance Easy Moderately Difficult Extremely Difficult

Pay Brings Talent into Organization Job Offer #1 Job Offer #2 Base Salary: $45k/yr. Mgr Quality Great Health Benefits Great Sr. Executive Quality Great Base Salary: $60k/yr. Mgr Quality Poor Health Benefits Great Sr. Executive Quality Fair While compensation is not the only consideration of a job offer there is no substitute for fair pay based on employees role in the firm, the market value of the job and their performance in that position in meeting employee basic needs. Remaining competitive with compensation is critically important Pay can make or break a recruiting effort as it is the most visible and concrete attribute of a job offer. Many attributes are less tangible until person has joined the firm and interacted with colleagues, managers, culture 50000 employees in 59 different org Candidates Value: Compensation and Benefits 4.3 Development and Work Environment 3.85 Work-Life Balance 3.57 Company Environment 3.46 Corporate Leadership Council 2004

Pay Keeps Talent Total Compensation Base Pay

Effect of Compensation on Discretionary Effort Connection - Performance and Raise 10.8% Connection - Performance and Bonus 9.9% Total Compensation Satisfaction 9.1% Base Pay Satisfaction 7.6% Cash Bonus Satisfaction 7.0% Compensation attracts talent and plays a role in retention but has less impact on employee effort. Biggest impact on employee effort had to due with the role of the manager

Pay for Performance Requires Definition of performance How are we going to measure and compare people? Distribution of performance Can we distinguish high and low performers? Decide the increase for each level of performance. How large a difference between high and low performers?

Questions Should low performers be paid an increase? Should average performers be paid an increase? What about cost of living? What about existing difference in pay distribution?

Training for supervisors on how to: An accurate, reliable, and credible performance-appraisal program is the foundation of a successful merit pay program Training for supervisors on how to: Plan performance that links individual efforts with business plans and strategies Measure and evaluate performance fairly and consistently Provide feedback Use merit matrix Communicate assessment of performance and the allocation of rewards to employees

Merit Pay Increases Fundamental feature is an established budget amount not-to-be-exceeded bottom line usually computed as a % of payroll Key decisions: Size of the budget How to allocate to different business units Factors that may influence budgets: Organizational financial results Cost of living/inflation rates Industry trends Cost of labor and the competitive position of the organization’s pay in the marketplace

Merit Pay Policy – Merit Pay Matrix Generally 3 alternatives for issuing merit increases Based only on performance Based on performance and position in range Based on performance and position in range using variable timing

Performance and Base Pay Merit Pay Matrix Performance and Base Pay Performance Rating Fixed Increase Amount Discretionary Increase Amount Outstanding 8 % 6-10% Consistently Exceeds Standards 5% 4-6% Meets 3% 2-4% Does Not Fully Meet 0% 0-2%

Merit Pay Matrix Increase as % of Base Pay Employee Current Pay Rate Increase Percentage Increase Dollars A $25,000 4% $1,000 B $35,000 $1,400 C $45,000 $1,800 Increase as % of $35,000 Midpoint Employee Current Pay Rate Increase Percentage Increase Dollars Effective Increase Percentage A $25,000 4% $1,400 5.6% B $35,000 4.0% C $45,000 3.1%

Advantages of calculating merit increase based only on performance are: Simple to budget Easy to administer Straightforward to communicate

Performance and Position in Range Position in Range Before Increase Merit Pay Matrix Performance and Position in Range Position in Range Before Increase Performance Rating 1st Quartile Or Below 2nd Quartile 3rd Quartile 4th Quartile Outstanding 8-9 % 6-7% 4-5% 3-4% Consistently Exceeds Standards 2-3% Meets ------- Does Not Fully Meet 0-2%

Advantages of merit matrix based on performance and position in range: Reduces the tendency to perpetuate tenure-based pay inequities Likely to be deemed “fair” by the work force because over time, employees with similar performance in same salary grade will tend to be paid comparably

Merit Pay Matrix Performance and Position in Range with Variable Timing Position in Range Before Increase Perf. Rating 1st Quartile Or Below 2nd Quartile 3rd Quartile 4th Quartile Outstanding 8-9 % 6-9 months 6-7% 9-12 months 4-5% 10-12 months 3-4% 12-15 months Consistently Exceeds Standards 8-10 months 2-3% 15-18 months Meets ------- Does Not Fully Meet 0-2%

Advantages of performance and position in range with variable timing: Top performers receive bigger rewards with greater frequency During tight budgets can still give “normal” increase just granted at later interval Disadvantages Much more complicated to administer Difficult to track and maintain budgets

Managing a Merit Pay Plan Simple equation – significant performance yields significant rewards Relies on trust – needs openness and candidness Recent move is to communicate more information about company’s compensation program Needs balance between too little – and too much Employee needs enough information about merit pay plan for it to serve as a performance motivator without breaching their right to privacy or restricting the organization’s ability to exercise management discretion

Communication of Compensation for Merit Pay General information about the performance management process General information about the compensation program (how pay is determined, how jobs are evaluated, salary ranges, etc.) Specific information about merit pay program (budgets, performance rating distributions) Size of the individual’s increase, minimum and maximum raises, and average size of merit increases

Merit Pay Matrix – Example for HW Assignment Performance and Position in Range Position in Range Before Increase Performance Rating 1st Quartile Or Below 2nd Quartile 3rd Quartile 4th Quartile Outstanding 9 % 7% 5% 4% Consistently Exceeds Standards 6.5% 3.5% 3% Meets 2% Does Not Fully Meet 1% -------

Multiply the performance distribution by the range distribution to obtain the percent of employees in each cell. Multiply the increase percentages by the employee distribution for each cell The sum of all cells equals the total merit increase percentage or the merit pool

Performance and Position in Range Position in Range Before Increase Merit Pay Matrix Performance and Position in Range Position in Range Before Increase Performance Rating % of Ees per rating 1st Quartile 2nd Quartile 3rd Quartile 4th Quartile (% Ees per Quartile) 15% 40% 30% Outstanding 5% .15x.05 .40x.05 .30x.05 Consistently Exceeds Standards .15x.15 .40x.15 .30x.15 Meets 77% .15x.77 .40x.77 .30x.77 Does Not Fully Meet 3% .15x.03 .40x.03 .30x.03

Performance and Position in Range Position in Range Before Increase Merit Pay Matrix Performance and Position in Range Position in Range Before Increase Performance Rating % of Ees per rating 1st Quartile 2nd Quartile 3rd Quartile 4th Quartile (% Ees per Quartile) 15% 40% 30% Outstanding 5% 9 % 7% 4% Consistently Exceeds Standards 6.5% 3.5% 3% Meets 77% 2% Does Not Fully Meet 1% -------

Merit Pay Matrix – Example for HW Performance and Position in Range (Position in Range Before Increase) Performance Rating % of Ees per rating 1st Quartile 2nd Quartile 3rd Quartile 4th Quar. (% Ees per Quartile) 15% 40% 30% Outstanding 5% .15x.05x.09 .40x.05x.07 .30x.05x.05 Consistently Exceeds Standards .15x.15x.065 .40x.15x.05 .30x.15x.035 Meets 77% .15x.77x.05 .40x.77x.04 .30x.77x.03 Does Not Fully Meet 3% .15x.03x.01 .40x.03 .30x.03

Costing Exercise Focal Point Increase (Multiple Increases) Your organization has 150 employees in the Engineering department, with an average employee pay of $50,000 annually. The department has a 5% merit budget with an April 1 focal-point review date. Then, due to competitive market pay movement, the company must grant a 4% market equity adjustment on July 1. What is the cost in year 1 of these two increases?  

Costing Exercise Formula and Solution: Eligible payroll x % increase x effective period Eligible payroll = 150 x $50,000 = $7,500,000 Effective period of the merit increase = 9 months (April – December)  $7,500,000 x 5% x 9/12 = $281,250 (cost of the merit increase given in April)

Costing Exercise Formula and Solution continued: After the merit increase, the eligible payroll rises to $7,875,000 since everyone has received a 5% increase ($7.5M x 5%) Effective period of the market increase = 6 months (July – December) $7,875,000 x 4% x 6/12 = $157,500 (cost of the market increase given in July) Adding the two increases together gives a total cost of $438,750 ($281,250 + $157,500)