Chapter 12

Pay for Performance

and Financial
Incentives

Part Four | Compensation

Copyright 2011 Pearson Education, Inc.
publishing as Prentice Hall

PowerPoint Presentation by Charlie Cook

The University of West Alabama

WHERE WE ARE NOW

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LEARNING OUTCOMES
1. Explain how you would apply five motivation theories in
formulating an incentive plan.
2. Discuss the main incentives for individual employees.
3. Discuss the pros and cons of commissions versus
straight pay incentives for salespeople.
4. Describe the main incentives for managers and
executives.
5. Name and define the most popular organizationwide
variable pay plans.
6. Outline the steps in designing effective incentive plans.

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Motivation, Performance, and Pay

Incentives
Financial rewards paid to workers whose production exceeds a

predetermined standard.

Frederick Taylor
Popularized scientific management and the use of financial

incentives in the late 1800s.

Systematic soldiering

Fair days work

Linking Pay and Performance

Understanding the motivational

bases of incentive plans

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The Hierarchy of Needs

Maslows Hierarchy of Needs:
Physiological (food, water, warmth)
Security (a secure income, knowing one has a job)
Social (friendships and camaraderie)
Self-esteem (respect)
Self-actualization (becoming a whole person)

Maslows prepotency process principle:

People are motivated first to satisfy each lower-order need

and then, in sequence, each of the higher-level needs.

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Herzbergs HygieneMotivator
Theory
Hygienes (extrinsic job factors)
Satisfy lower-level needs
Inadequate working conditions, salary, and incentive pay can

cause dissatisfaction and prevent satisfaction.

Motivators (intrinsic job factors)

Satisfy higher-level needs
Job enrichment (challenging job, feedback, and recognition)

addresses higher-level (achievement, self-actualization) needs.

Premise:
The best way to motivate someone is to organize the job so that

doing it provides feedback and challenge that helps satisfy the

persons higher-level needs.

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Demotivators and Edward Deci

Intrinsically motivated behaviors are motivated by the
individuals underlying need for competence and selfdetermination.
Offering an extrinsic reward for an intrinsically-motivated act

can conflict with the acting individuals internal sense of

responsibility.
Some behaviors are best motivated by job challenge and

recognition, others by financial rewards.

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Victor Vrooms Expectancy Theory

Motivation is a function of:
Expectancy: the belief that effort will lead to performance.
Instrumentality: the connection between performance and

the appropriate reward.

Valence: the value the person places on the reward.

Motivation = (E x I x V)
If any factor (E, I, or V) is zero, then there is no motivation

to work toward the reward.

Employee confidence building and training, accurate

appraisals, and knowledge of workers desired rewards can

increase employee motivation.

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Behavior Modification /
Reinforcement Theory
B. F. Skinners Principles
To understand behavior one must understand

the consequences of that behavior.

Behavior that leads to a positive consequence (reward)

tends to be repeated, while behavior that leads to a negative

consequence (punishment) tends not to be repeated.
Behavior can be changed by providing properly scheduled

rewards (or punishments).

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Incentive Pay Terminology

Pay-for-Performance Plan
Ties employees pay to the employees performance

Variable Pay Plan

Is an incentive plan that ties a group or teams pay to some

measure of the firms (or the facilitys) overall profitability

Example: profit-sharing plans
May include incentive plans for individual employees

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Employee Incentives and the Law

FLSA Wage Calculations and Incentive Payments
Bonuses included in overtime calculations:

Those promised to newly hired employees

Those provided for in union contracts or other agreements

Those announced to induce employees to work more

productively, steadily, rapidly, or efficiently or to induce them
to remain with the firm

Bonuses excluded from overtime calculations:

Christmas and gift bonuses not based on hours worked.

Bonuses so substantial that employees dont consider them

a part of their wages

Purely discretionary bonuses in which the employer retains

discretion over how much, if anything, to pay

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Types of Employee Incentive

Plans
Individual Employee
Incentive and Recognition
Programs
Sales Compensation
Programs

Pay-forPerformance
Plans

Team/Group-based
Variable Pay Programs
Organizationwide
Incentive Programs
Executive Incentive
Compensation Programs

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Individual Incentive Plans

Piecework Plans
The worker is paid a sum (piece rate)

for each unit he or she produces.

Straight piecework

Standard hour plan

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Pros and Cons of Piecework

Easily understandable, equitable,
and powerful incentives
Employee resistance to changes
in standards or work processes
affecting output
Quality problems caused by
an overriding output focus
Possibility of violating minimum
wage standards
Employee dissatisfaction when
incentives either cannot be earned
or are withdrawn
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Individual Incentive Plans (contd)

Merit Pay
Is a permanent cumulative salary increase the firm awards

to an individual employee based on his or her individual

performance
Can detract from performance if awarded across the board
Becomes permanent ongoing reward for past performance

Merit Pay Options

Give annual lump-sum merit raises that do not make the

raise part of an employees base salary.

Tie merit awards to both individual and organizational

performance.

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TABLE 121

Merit Award Determination Matrix (an Example)

Company Performance (Weight = 0.50)

Employee Performance
Rating (Weight = .50)

Outstanding

Excellent

Good

Marginal

Unacceptable

Outstanding

1.00

0.90

0.80

0.70

0.00

Excellent

0.90

0.80

0.70

0.60

0.00

Good

0.80

0.70

0.60

0.50

0.00

Marginal

Unacceptable

To determine the dollar value of each employees incentive award: (1) multiply the
employees annual, straight-time wage or salary as of June 30 times his or her maximum
incentive award and (2) multiply the resultant product by the appropriate percentage figure
from this table.
Example: if an employee had an annual salary of $20,000 on June 30 and a maximum
incentive award of 7% and if her performance and the organizations performance were
both excellent, the employees award would be $1,120 ($20,000 0.07 0.80 = $1,120).

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Incentives for Professional

Employees
Professional Employees
Are those whose work involves the application

of learned knowledge to the solution of the

employers problems.

Lawyers, doctors, economists, and engineers

Possible Incentives
Bonuses, stock options and grants, profit sharing
Better vacations, more flexible work hours
Improved pension plans
Equipment for home offices

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Nonfinancial and Recognition

Awards
Effects of Recognition-Based Awards
Recognition has a positive impact on performance,

either alone or in conjunction with financial rewards.

Day-to-day recognition from supervisors, peers, and

team members is important.

Ways to Use Recognition

Social recognition
Performance-based recognition
Performance feedback

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FIGURE 121

Social Recognition and Related Positive

Reinforcement Managers Can Use

Challenging work assignments

Freedom to choose own work
activity

Being provided with ample

encouragement
Being allowed to set own goals

Having fun built into work

Compliments

More of preferred task

Expression of appreciation in
front of others

Role as bosss stand-in when he

or she is away

Note of thanks

Role in presentations to top

management

Employee-of-the-month award

Job rotation

Bigger desk

Encouragement of learning and

continuous improvement

Bigger office or cubicle

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Special commendation

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Online and IT-Supported Awards

Information Technology and Incentives
Enterprise incentive management (EIM)

Software that automates planning, calculation,

modeling, and management of incentive
compensation plans

Enabling companies to align their employees

with corporate strategy and goals

Online Award Programs

Programs offered by online incentives firms that

improve and expedite the awards process

Broader range of awards

More immediate rewards

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Incentives for Salespeople

Salary Plan
Straight salaries

Best for: prospecting (finding new clients),

account servicing, training customers sales force,
or participating in national and local trade shows

Commission Plan
Pay is a percentage of sales results.

Keeps sales costs proportionate to sales revenues

May cause a neglect of nonselling duties

Can create wide variation in salespersons income

Likelihood of sales success may be linked to external

factors rather than to salespersons performance

Can increase turnover of salespeople

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Incentives for Salespeople (contd)

Combination Plan
Pay is a combination of salary and

commissions, usually with a sizable

salary component.
Plan gives salespeople a floor

(safety net) to their earnings.

Salary component covers company-

specified service activities.

Plans tend to become complicated,

and misunderstandings can result.

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Specialized Commission Plans

Commission-plus-Drawing-Account Plan
Commissions are paid but a draw on future

earnings helps the salesperson to get through

low sales periods.

Commission-plus-Bonus Plan
Pay is mostly based on commissions.
Small bonuses (spiffs) are paid for directed

activities like selling add-ons or slow-moving

items.

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Maximizing Sales Force Results: Setting Sales

Quotas
Should quotas be locked in for a period of time?

Have quotas been communicated to the sales force

within one month of the start of the period?
Does the sales force know exactly how its quotas are set?
Do you combine bottom-up information (like account forecasts)
with top-down requirements (like the company business plan)?
Do 60% to 70% of the sales force generally hit their quota?
Do high performers hit their targets consistently?
Do low performers show improvement over time?
Are quotas stable through the performance period?
Are returns and debookings reasonably low?
Has your firm generally avoided compensation-related lawsuits?
Is 10% of the sales force achieving higher performance than previously?
Is 5% to 10% of the sales force achieving below-quota performance
and receiving coaching?
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Incentives for Managers and

Executives
Executive Total Reward Package
Base salary (cash)
Short-term incentives (bonuses)
Long-term incentives (e.g., stock options)

Sarbanes-Oxley Act of 2002

Makes executives and the board of directors

personally liable for violating their fiduciary

responsibilities to their shareholders.
Requires the CEO and CFO to repay bonuses,

incentives, or equity-based compensation

received following issuance of a financial
statement that the firm must restate.

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Short- and Long-Term Incentives

Short-Term Incentives: The Annual Bonus
Plans intended to motivate short-term performance

of managers and tied to company profitability.

Issues in awarding bonuses
Eligibility basis
Fund size basis
Individual performance award
Long-term incentives
Stock options
Performance shares
Indexed options
Premium price options
Stock appreciation rights
Perks
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TABLE 122

Multiplier Approach to Determining Annual Bonus

Companys Performance (Based on Sales Targets, Weight = 0.50)

Individual Performance
(Based on Appraisal, Weight = .50)

Excellent

Good

Fair

Poor

Excellent

1.00

0.90

0.80

0.70

Good

0.80

0.70

0.60

0.50

Fair

0.00

0.00

0.00

0.00

Poor

0.00

0.00

0.00

0.00

Note: To determine the dollar amount of a managers award, multiply the maximum possible
(target) bonus by the appropriate factor in the matrix.

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Creating an Executive
Compensation
Plan for the executive
1. Define the strategic context
compensation program.
2. Shape each component of the package to focus
the manager on achieving the firms strategic goals.
3. Check the executive compensation plan for
compliance with all legal and regulatory
requirements and for tax effectiveness.
4. Install a process for reviewing and evaluating
the executive compensation plan whenever
a major business change occurs.

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Team/Group Incentive Plans

Team (or Group) Incentive Plans
Incentives are based on teams performance.

How to Design Team Incentives

Set individual work standards.
Set work standards for each team member

and then calculate each members output.

Members are paid based on one of three formulas:

All receive the same pay earned by the highest producer.

All receive the same pay earned by the lowest producer.

All receive the same pay equal to the average pay

earned by the group.

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Pros and Cons of Team Incentives

Pros
Reinforces team planning and problem solving
Helps ensure collaboration
Encourages a sense of cooperation
Encourages rapid training of new members

Cons
Pay is not proportionate to an individuals effort
Rewards free riders

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Organizationwide Incentive Plans

Profit-Sharing Plans
Current profit-sharing (cash) plans

Employees receive cash shares of the firms profits

at regular intervals.

Deferred profit-sharing plans

A predetermined portion of profits based on the

employees contribution to the firms profits is
placed in each employees retirement account
under a trustees supervision.

Employees income taxes on the distributions are

deferred, often until the employee retires.

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Gainsharing Plans

Scanlon Plan
Components

Philosophy
of
cooperation

Identity

Competenc
e

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Involvemen
t system

Benefits
sharing
formula

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Implementing a Gainsharing Plan

1. Establish general plan objectives.
2. Choose specific performance measures.
3. Decide on a funding formula.
4. Decide on a method for dividing and distributing
the employees share of the gains.
5. Choose the form of payment.
6. Decide how often to pay bonuses.
7. Develop the involvement system.
8. Implement the plan.

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At-Risk Variable Pay Plans

Put some portion of the employees
weekly pay at risk.
If employees meet or exceed

their goals, they earn incentives.

If they fail to meet their goals, they

forego some of the pay they would

normally have earned.

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Organizationwide Incentive Plans

(contd)
Employee Stock Ownership Plan (ESOP)
A firm annually contributes its own stockor cash

(with a limit of 15% of compensation) to be used to

purchase the stockto a trust established for the
employees.
The trust holds the stock in individual employee

accounts and distributes it to employees upon

separation from the firm if the employee has worked
long enough to earn ownership of the stock.

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Advantages of ESOPs
For the Company
Can take a tax deduction equal to the fair market value

of the shares transferred to the ESOP trustee

Gets an income tax deduction for dividends paid
on ESOP-owned stock
Can borrow against ESOP in trust and then repay
the loan in pretax rather than after-tax dollars

For the Employees

Develop a sense of ownership in and commitment to the firm.
Do not pay taxes on ESOP earnings until they receive

a distribution.

For the Shareholders of Closely-Held Corporations

Can place assets into an ESOP trust which will allow them to

purchase other marketable securities to diversify their holdings

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Implementing an Effective
Incentive
1. Ask: Does itPlan
make sense to use an incentive here?
2. Link the incentive with your strategy.
3. Make sure the program is motivational.
4. Set complete standards.
5. Be scientific in analyzing the effects of the plan.

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Why Incentive Plans Fail

Performance pay cant replace good management.
You get what you pay for.
Pay is not a motivator.
Rewards punish.
Rewards rupture relationships.
Rewards can have unintended consequences.
Rewards may undermine responsiveness.
Rewards undermine intrinsic motivation.

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TABLE 123

Express Auto Compensation System

Express Auto Team

Responsibility of Team

Current Compensation Method

1. Sales force

Persuade buyer to
purchase a car.

Very small salary (minimum wage) with

commissions. Commission rate increases
with every 20 cars sold per month.

2. Finance office

Help close the sale;

persuade customer to
use company finance
plan.

Salary, plus bonus for each $10,000

financed with the company

3. Detailing

Inspect cars delivered

from factory, clean, and
make minor adjustments.

Piecework paid on the number of cars

detailed per day.

4. Mechanics

Provide factory warranty

service, maintenance,
and repair.

Small hourly wage, plus bonus based on

(1) number of cars completed per day and
(2) finishing each car faster than the
standard estimated time to repair

5. Receptionists/
phone service
personnel

Primary liaison between

customer and sales
force, finance, and
mechanics

Minimum wage

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KEY TERMS
financial incentives

merit pay (merit raise)

fair days work

annual bonus

scientific management movement

stock option

expectancy

golden parachutes

instrumentality

team (or group) incentive plan

valence

organizationwide incentive plans

behavior modification

profit-sharing plan

variable pay

Scanlon plan

piecework

gainsharing plan

straight piecework

at-risk variable pay plans

standard hour plan

employee stock ownership plan (ESOP)

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