Pay-for-Performance Plans Chapter 10 Pay-for-Performance Plans

What Is Pay-for-Performance? Pay for performance plans signal a movement away from entitlements. Pay will vary with some measure of individual, team, or organizational performance.

Obstacles to Pay-for-Performance Difficulties in specifying and measuring job performance Problems in identifying valued rewards Difficulties in linking rewards to job performance

Exhibit 10.1: Use of Different Variable-Pay-Plan Types See Exhibit 10.1, page 309

Exhibit 10.2: Base vs. Variable Pay See Exhibit 10.1, page 309

Pay-for-Performance Plans: Short Term Merit Pay Lump-Sum Bonuses Individual Spot Awards Individual Incentive Plans

Exhibit 10.4: Customer Service Bonus Scheme See Exhibit 10.1, page 309

Overview: Individual Incentive Plans All or a portion of an individual’s pay is tied to employee performance Offer a promise of pay for some objective, pre-established level of performance Common feature - An established standard against which employee performance is compared to determine magnitude of incentive pay

Exhibit 10.5: Individual Incentive Plans Method of Rate Determination Units of production per time period Time period per unit of production (1) (2) (4) (3) Straight piecework plan Standard hour plan Bedeaux plan Halsey 50 - 50 method Rowan plan Gantt plan Taylor differential piece-rate system Merrick multiple piece- rate system Pay constant function of production level Pay varies as function of production level Relationship between production level and pay See Exhibit 10.4, page 313

Exhibit 10.9: Advantages of Individualized Incentive Plans Substantial contribution to: Raise productivity, Lower production costs, Increase earnings of workers. Less direct supervision required to maintain reasonable levels of output than under payment by time. Systems of payment by results (if accompanied by improved organizational and work measurement) enable labor costs to be estimated more accurately than under payment by time. Helps costing and budgetary control.

Exhibit 10.9: Disadvantages of Individualized Incentive Plans Greater conflict may emerge between employees seeking to maximize output and managers concerned about deteriorating quality levels. Attempts to introduce new technology may be resisted by employees concerned about impact on production standards. Reduced willingness of employees to suggest new production methods for fear of subsequent increases in production standards. Increased complaints that equipment is poorly maintained, hindering employee efforts to earn larger incentives. Increased turnover among new employees discouraged by unwillingness of experienced workers to cooperate in on-the-job training. Elevated levels of mistrust between workers and management.

Exhibit 10.10: Lincoln Electric’s Compensation System See Exhibit 10.4, page 313

Exhibit 10.11: A Sampling of Performance Measures (1 of 2) Customer-Focused Measures Time to Market Measures On time delivery Cycle time New product introductions Customer Satisfaction Measures Market share Customer satisfaction Customer growth and retention Account penetration Financially-Focused Measures Value Creation Revenue growth Resource yields Profit margins Economic value added Shareholder Return Return on invested capital Return on sales / earnings Earnings per share Growth in profitability

Exhibit 10.11: A Sampling of Performance Measures (2 of 2) Capability-Focused Measures Human Resources Capabilities Employee satisfaction Turnover rates Total recruitment costs Rate of progress on developmental plans Promotability index Staffing mix/head-count ratio Other Asset Capabilities Patents and copyrights Distribution systems Internal Process-Focused Measures Resource Utilization Budget-to-actual expenses Cost allocation ratios Reliability / rework Accuracy / error rates Safety rates Change Effectiveness Program implementation Teamwork effectiveness Service / quality index

Balanced Scorecard Approach Uses a constellation of measures Pinpoints areas of success Indicates areas to improve Categories of measures Financial results Process improvements Customer service Innovation Forces discussions about priorities among different measures Outcome – Objectives with different weights in terms of importance

Exhibit 10.12: Types of Variable Pay Plans: Advantages and Disadvantages Cash Profit Sharing Stock Ownership or Options Balanced Scorecard Productivity / Gain- Sharing Team / Group Incentives See Exhibit 10.11, pages 320-322 for discussion details

Exhibit 10.13: The Choice Between Individual and Group Plans See Exhibit 10.4, page 313

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

Exhibit 10.14: Three Gain-Sharing Formulas Total standard value hours Value added Net sales (plus or minus inventories) Denominator of ratio (output factor) Actual hours worked Labor cost Payroll costs Numerator of ratio (input factor) Improshare Rucker Plan Scanlon Plan (Single ratio volume) See Exhibit 10.12, page 328

Profit-Sharing Plans Focus – Predetermined index of profitability Employees receive annual bonus or shares in company based upon company-wide performance Paid in cash or Deferred into a retirement plan Issue Employees may not feel their jobs directly impact profits

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 Employee base pay varies Base pay often reduced in poor performance years Rewards typically higher than success-sharing plans in high-performance years Shifts part of risk of doing business from company to employee

Exhibit 10.16: Group Incentive Plans: Advantages and Disadvantages Positive impact on performance of about 5-10%/yr. Ease of measurement Cooperation valued Support of teamwork Increases participation in decision-making Disadvantages Line of sight lessened Increased turnover Increases compensation risk to employees

Exhibit 10.17: Example of Group Incentive Plan - GE Information Systems A team-based incentive with links to individual payouts Team and individual performance goals are set If team hits its goals, team members earn their incentive only if they also hit their individual goals Team incentive is 12% to 15% of monthly base pay

Exhibit 10.17: Example of Group Incentive Plan - Corning Glass A gain-sharing program (goal sharing) where 75% of payout is based on unit objectives such as: Quality measures Customer satisfaction measures Production targets Remainder is based on Corning’s return on equity (ROE)

Exhibit 10.17: Example of Group Incentive Plan - 3-M Operates with an earnings-at-risk plan Base pay fixed at 80% of market Employees have a set of objectives to meet for pay to move to 100% of market Additionally, there is a modest profit sharing component

Exhibit 10.17: Example of Group Incentive Plan - Saturn Earnings-at-risk plan where base pay is 93% of market Employees meet individual objectives to capture at-risk component All team members must meet objectives for any to get at-risk money A profit sharing component is based on corporate profits

Exhibit 10.17: Example of Group Incentive Plan - Du Pont Fibers Earnings-at-risk where employees receive reduced pay increases over 5 years, resulting in 6% lower base pay If department meets annual profit goal, employees collect all 6 percent Variable payout ranges from 0 (reach less than 80% of goal) to 12% (150% of goal)

Long-Term Incentive Plans Employee Stock Ownership Plans (ESOPs) Performance Plans (Performance Share and Performance Unit) Broad-Based Option Plans (BBOPs)

Exhibit 10.18: Long-Term Incentives and Their Risk/Reward Tradeoffs Level One: Low Risk/Reward Time-based restricted stock Performance – accelerated restricted stock Stock purchase plan Level Two: Medium Risk/Reward Time-vested stock option Performance-vested restricted stock Performance – accelerated stock option See Exhibit 10.16, page 335

Exhibit 10.18: Long-Term Incentives and Their Risk/Reward Tradeoffs Level Three: High Risk/Reward Premium-priced stock option Indexed stock option Performance-vested stock option

Conditions for Effective Variable Pay-for-Performance Plans Plan is clearly communicated Plan is understood Rewards are easy to calculate Employees participate in administering plan Employees believe they are being treated fairly Employees believe they can trust company and they have security Rewards are awarded as soon as possible after desired performance

Implications of Variable Pay-for-Performance When a substantial portion of pay is tied to performance, that portion becomes variable - can go up or down - based upon individual, group, or company performance Nature of authority relationships and status in organization might change Employees will demand and operation of systems might require increased sharing of information Variable pay-for-performance systems will create heightened pressure for performance and cost containment within organization - pressure will come from managers and employees