1. Performance Management and Compensation
Dr. Jeanne Michalski 1

2. Pay for Performance
Discussion

3. 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

4. Linking Pay to Performance
Performance Pay
Motivation
Improved Performance

5. 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.

6. 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

7. 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.

8. “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

9. 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.

10. 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

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

12. 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
Company Environment
Corporate Leadership Council 2004

13. Pay Keeps Talent
Total Compensation
Base Pay

14. Effect of Compensation on Discretionary Effort
Connection - Performance and Raise 10.8%
Connection - Performance and Bonus 9.9%
Total Compensation Satisfaction %
Base Pay Satisfaction %
Cash Bonus Satisfaction %
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

15. 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?

16. 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?

17. 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

18. 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

19. 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

20. 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%

21. 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%

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

23. 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%

24. 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

25. 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%

26. 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

27. 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

28. 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

29. 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%

30. 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

31. 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

32. 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%

33. 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

36. 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?

37. 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)

38. 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)