CMS 2 Assignment 9: Aligning Strategy, Talent and Rewards: Pay-for-Performance Plans

Pay-for-performance plans that introduce variability into the level of pay workers receive seem to have ...

... a positive impact on performance if designed well.

Identify six disadvantages of individualized incentive plans.

(1) Greater conflict may emerge between employees seeking to maximize output and managers concerned about deteriorating quality levels. (2) Attempts to introduce new technology may be resisted by employees concerned about the impact on production standards. (3) They may reduce willingness of employees to suggest new production methods for fear of subsequent increases in production standards. (4) Increased complaints that equipment is poorly maintained, hindering employee efforts to earn larger incentives (5) Increased turnover among new employees discouraged by the unwillingness of experienced workers to cooperate in on-the-job training (6) Elevated levels of mistrust between workers and management.

Identify three advantages of individualized incentive plans.

(1) They make a substantial contribution to raise productivity, to lower production costs and to increase earnings of workers. (2) Less direct supervision is required to maintain reasonable levels of output than under payment by time. (3) In most cases, systems of payment by results, if accomplished by improved organizational and work measurement, enable labor costs to be estimated more accurately than under payment by time. This helps costing and budgetary control.

Three factors that influence group incentive plans

(1) how large a group participates in the plan (2) what is the standard against which performance is compared (3) what is the payout schedule

Key elements in designing a gain-sharing plan.

(a) Strength of reinforcement (b) Productivity Standards (c) Sharing the gains (d) Scope of the formula (e) Care of execution (f) Perceived fairness of the formula (g) Ease of administration (h) Production variability

Improshare stands for ...

... improved productivity through sharing and is a gain-sharing plan that has proven easy to administer and to communicate. First, a standard is developed which identifies the expected hours required to produce an acceptable level of output. this standard comes either from time and motion studies conducted by an industrial engineer or from a base period measurement of the performance factor. Any savings arising from production of the agreed-upon output in fewer than the expected hours is shared by the firm and by the worker.

Employee stock ownership plans ...

... link employees to the success or failure of the company.

Issues with Scope of the formula in designing a gain-sharing plan.

Formulas can vary in the scope of inclusions for both the labor inputs in the numerator and productivity outcomes in the denominator. Recent innovations in gain-sharing plans largely address broadening the types of productivity standards considered appropriate. Arguing that organizations are complex and require more complex measures, performance measures have expanded beyond traditional financial measures. They may include customer retention, delivery performance, safety, and other factors.

Issues with Ease of administration in designing a gain-sharing plan.

Sophisticated plans with involved calculations of profits or costs can become too complex for existing company information systems. Increased complexities also require more effective communications and higher levels of trust among participants.

Issues with Strength of reinforcement in designing a gain-sharing plan.

What role should base pay assume relative to incentive pay? Incentive pay tends to encourage only those behaviors that are rewarded.

Issues with Sharing the gains in designing a gain-sharing plan.

split between management and workers—Part of the plan must address the relative cuts between management and workers of any profit or savings generated. This also includes discussion of whether an emergency reserve, that is gains withheld from distribution in case of future emergencies, will be established in advance of any sharing of profits.

Earnings-at-risk plans ...

... shift some of the risk of doing business from the company to the employee.

Issues with Care of execution in designing a gain-sharing plan.

Great care must be exercised with such alternative measures, though, to ensure that the behaviors reinforced actually affect the desired bottom-line goal. Getting workers to expend more effort, for example, might not always be the desired behavior. Increased effort may bring unacceptable levels of accidents. It may be preferable to encourage cooperative planning behaviors that result in more efficient work.

Briefly describe lump-sum bonuses.

Lump-sum bonuses are used as a substitute for merit pay. Based on employee or company performance, employees receive an end-of-year bonus that does not build into base pay. Because employees must earn this increase every year, it is viewed as less of an entitlement than merit pay. Lump-sum bonuses also can be considerably less expensive than merit pay over the long run.

Issues with Production variability in designing a gain-sharing plan.

One of the major sources of problems in group incentive plans is failure to set targets properly. At times the problem can be traced to volatility in sales. Large swings in sales and profits, not due to any actions by workers, can cause elation in good times and anger in bad times. A good plan ensures that environmental influences on performance, not controllable by plan participants, should be factored out when identifying incentive levels. One alternative would be to set standards that are relative to industry performance. The obvious advantage of this strategy is that economic and other external factors are likely to impact all firms in the industry in the same way.

What is a rucker plan, another form of a gain-sharing plan?

The Rucker plan involves a somewhat more complex formula than a Scanlon plan for determining worker incentive bonuses. Essentially, a ratio is calculated that expresses the value of production required for each dollar of total wage bill.

Disadvantages of group incentive plans

(1) Line of sight may be lessened, that it, employees may find it more difficult to see how their individual performance affects their incentive payouts. (2) It may lead to increased turnover among top individual performers who are discouraged because they must share with lesser contributors. (3) It increases compensation risk to employees because of lower income stability. It may influence some applicants to apply for jobs in firms where base pay is the larger compensation component.

Issues with Productivity Standards in designing a gain-sharing plan.

What standard will be used to calculate whether employees will receive an incentive payout? Almost all group incentive plans use a historical standard. A historical standard involves choice of a prior year's performance to use for comparison with current performance. But which baseline year should be used? One possible compromise is to use a moving average of several years. One of the major problems with historical standards is the problems that changing environmental conditions can cause. Such problems are particularly insidious during economic swings and for organizations facing volatile economic climates. Care must be taken to ensure that the link between performance and rewards is sustained. This means that environmental influences on performance, those not controllable by plan participants, should be factored out when identifying incentive levels.

Issues with Perceived fairness of the formula in designing a gain-sharing plan.

One way to ensure the plan is perceived as fair is to let employees vote on whether implementation should go forward. This and union participation in program design are two elements in plan success.

Briefly discuss the one feature that all incentive plans have in common.

The feature that all incentive plans have in common is an established standard against which worker performance is compared to determine the magnitude of the incentive pay. For individual incentive systems, this standard is compared against individual worker performance. From this basic foundation, a number of seemingly complex and divergent plans have evolved.

Briefly discuss different types of team incentive plans.

When the focus is on people working together, group incentive plans become relevant. The group might be a work team. It might be a department. Or the focus might be on a division or the whole company. The basic concept is still the same, though. A standard is established against which worker performance, this means the teams, is compared to determine magnitude of the incentive pay. The standard might be an expected level of operating income for a division. Historically, financial measures have been the most widely used performance indicator for large group incentive plans. Top executives express concerns that these measures do a better job of communicating performance to stock analysts than to managers trying to figure out how to improve operating effectiveness. One problem that team incentive plans suffer from is called the "free rider." This problem arises when team members who do not carry their share of the workload still share in the rewards. This problem has caused companies to abandon their team reward plans because top-performing employees become disenchanted. However, good performance measurement techniques and clear standards lessen this problem.

Advantages of group incentive plans

(1) Positive impact on organization and individual performance of about 5-10% per year (2) Easier to develop performance measures than for individual plans (3) Signals that cooperation, both within and across groups, is a desired behavior (4) Teamwork meets with enthusiastic support from most employees. (5) May increase participation of employees in decision-making process.

Identify the problems with team compensation.

(a) There are many types of team compensation. With so many varieties of team compensation, it is hard to argue for one consistent type of compensation plan. (b) A second problem with rewarding teams is called the "level problem." If teams are defined at a very broad level—the whole organization being an extreme example—much of the motivational impact of incentives can be lost. Conversely, if the teams are too small, other problems can arise. Experience has found that small work teams competing for a fixed piece of incentive awards tend to gravitate to behaviors that are clearly unhealthy for overall corporate success. Teams hoard star performers, refusing to allow transfers even for the greater good of the company. Teams are reluctant to take on new employees for fear that time lost to training will hurt the team. Finally, bickering arises when awards are given. (c) The third major problem with team compensation deals with complexity. Some plans are simply too complex. (d) The fourth major problem with team compensation is control. Key to the control issue is the whole question of fairness. Recent research suggests this perception of fairness is crucial. With it, employees feel it is appropriate to monitor all members of the group. Without fairness, employees seem to have less sense of responsibility for the team's outcomes. (e) The final problem with team compensation is a familiar factor in compensation successes and failures. This is communication. Team-based pay plans simply are not well communicated. Employees asked to explain their plans often flounder because more effort is devoted to the mechanics by the design team than to deciding how to explain the plan.

Discuss merit pay as a short-term specific pay-for-performance plan.

A merit pay system links increases in base pay, sometimes called merit increases, to how highly employees are rated on a performance evaluation. Merit pay has come under attack recently. Not only is it expensive, but many argue it doesn't achieve the desired goal, that is, to improve employee and corporate performance. Historically, studies, though, have shown that merit pay does have a small, but significant, impact on performance. For merit pay to live up to its potential, it needs to be managed better. This requires a complete overhaul of the way raises are allocated. The allocation of raises usually means improving the accuracy of performance ratings, allocating enough merit money to truly reward performance and making sure the size of the merit increase differentiates across performance levels. Unless the reward difference is made larger for every increment in performance, it will not act to motivate employees to perform at a higher level.

The greater interest in variable pay probably can be traced to two trends...

First, the increasing competition from foreign producers forces American producers to cut costs and/or increase productivity. Well-designed variable pay plans have a proven track record in motivating better performance and helping cut costs. Second, today's fast-paced business environment means that workers must be willing to adjust what they do and how they do it. There are new technologies, new work processes and new work relationships. All these require workers to adapt in ways and with speed that is unparalleled. Failure to move quickly means market share goes to competitors. If this happens, workers face possible layoffs and terminations. To avoid this scenario, compensation experts are focusing on ways to design reward systems so that the workers will be willing and able to move quickly into new jobs and new ways of performing old jobs.

Identify the various long-term incentives, that is, incentives that focus on performance beyond the one-year time line used as the cutoff for short-term incentive plans, in terms of their risk/reward tradeoffs.

Long-term incentives and their risk/reward trade-offs grouped into three different levels are: Level One: Low risk/reward (a) Time-based restricted stock. An award of shares that actually are received only after the completion of a predefined service period. Employees who terminate employment before the restriction lapses must return their shares to the company. (b) Performance-accelerated restricted stock. Restricted stock granted only after attainment of specified performance objectives. (c) Stock purchase plan. Opportunity to buy shares of a company stock either at prices below market price or with favorable financing. Level Two: Medium risk/reward (a) Time-vested stock option. This is what most stock options are—the right to purchase stock at a specified price for a fixed time period. (b) Performance-vested restricted stock. This is a grant of stock to employees upon attainment of defined performance objective(s). (c) Performance-accelerated stock option. An option with a vesting schedule that can be shortened if specific performance criteria are met. Level Three: High risk/reward (a) Premium-priced stock option. A stock option that has an exercise price about market value at the time of grant. This creates an incentive for employees to create value for the company, see stock prices rise and thus be eligible to purchase the stock. (b) Indexed stock option. An option whose exercise price depends on what peer companies' experiences are with stock prices. If industry stock prices are generally rising, it would be difficult to attribute any similar rise in a specific company to "motivated employees." Therefore, these options require improvements beyond general industry improvement. (c) Performance-vested stock option. One that vests only upon the attainment of a predetermined performance objective.

Explain profit-sharing plans.

Many variable pay plans still require some profit target to be met before any payouts occur. Many variable pay plans have some form of profit "trigger" linked to revenue growth or profit margins or some measure of shareholder return, such as earnings per share or return on capital. Profit sharing continues to be popular because the focus is on the measure that matters most to the most people. This means there must be some index of profitability. When payoffs are linked to these measures, employees spend more time learning about financial measures and the business factors that influence them. On the downside, most employees don't feel their jobs have a direct impact on profits. Strength of the market, global competition, even the way accounting information is entered into the balance sheet, can affect profits and serve to disenchant workers. The trend in recent variable pay design is to combine the best of gain-sharing and profitsharing plans. The company will specify a funding formula for any variable payout that is linked to some profit measure. As experts say, the plan must be self-funding. Dollars going to workers are generated by additional profits gained from operational efficiency. Along with the financial incentive, employees feel they have a measure of control. Such a program combines the need for fiscal responsibility with the chance for workers to affect something they can control.

Describe the meteoric interest in long-term incentive plans.

Meteoric growth in long-term plans appears to be spurred in part by a desire to motivate longer term value creation. Stock ownership is likely to increase internal growth rather than more rapid external diversification. Employee stock ownership plans do not make sense as an incentive because their effects are very long-term and it is too complex to try to figure out how employees can affect a rise in the price of the stock—the central ingredient in the reward component of these plans. Performance plans typically feature corporate performance objectives for a time frame three years in the future. They are driven by financial earnings or return measures and pay out for meeting or exceeding specific goals. The strength of broad-based option plans is their versatility. Depending on how they are distributed, they can either reinforce a strong emphasis on performance, or inspire greater commitment and retention (ownership culture) of employees.

Briefly explain similarities and contrasts between Scanlon and Rucker plans.

Scanlon and Rucker plans differ from individual incentive plans in their primary focus. Individual incentive plans focus primarily on using wage incentives to motivate higher performance through increased effort. While this is certainly a goal of the Scanlon/Rucker plans, it is not the primary focus of attention. Rather, given that increased output is a function of group effort, more attention is focused on organizational behavior variables. The key is to promote faster, more intelligent and more acceptable decisions through participation. This participation is won by developing a group unity in achieving cost savings, a goal that is not stressed and is often stymied, in individual incentive plans. Even though Scanlon and Rucker plans share this common attention to groups and committees through participation as a linking pin, there are two important differences between the two plans. First, Rucker plans tie incentives to a wide variety of savings, not just the labor savings focused on in Scanlon plans. Second, this greater flexibility may help explain why Rucker plans are more amenable to linkages with individual incentive plans.

Describe the characteristics of a scanlon plan, one of the oldest and most widely used gain-sharing plans.

Scanlon plans are 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). The sales value of production includes sales revenue and the value of goods in inventory. In practice, the $50,000 bonus in Exhibit 10.14 on page 355 of the text is not distributed to the workforce. Rather, 25% is distributed to the company, 75% of the remainder is distributed as bonus and 25% of the remainder is withheld and placed in an emergency fund to reimburse the company for any future months when a "negative bonus" is earned. A "negative bonus" is when the actual wage bill is greater than the allowable wage bill. The excess remaining in the emergency pool is distributed to the workers at the end of the year.

What is an individual spot award?

Technically, spot awards (so called because they are supposed to be awarded on the spot) should fall under pay-for-performance plans. About 35% of all companies use spot awards. Usually these payouts are awarded for exceptional performance, often on special projects or for performance that so exceeds expectations as to be deserving of an add-on bonus. The mechanics are simple. After the exceptional work has been performed, someone in the organization alerts top management that it has been done. If the company is large, there may be a formal mechanism for this recognition and perhaps some guidelines on the size of the spot award. Smaller companies may be more casual about recognition and more subjective about deciding the size of the award.

Describe the two dimensions on which individual incentive systems vary.

The first dimension on which incentive systems vary is in the method of rate determination. Plans either set up a rate based on units of production per time period or on time period per unit of production. On the surface, this distinction may seem trivial but, in fact, the deviations arise because tasks have different cycles of operation. Short-cycle tasks, those that are completed in a relatively short period of time, typically have as a standard a designated number of units to be produced in a given time period. For long-cycle tasks, this would not be appropriate. It is entirely possible that only one task or some portion of it may be completed in a day. Consequently, for longer cycle tasks, the standard is typically set in terms of time required to complete one unit of production. Individual incentives are based on whether or not workers complete the task in the designated time period. The second dimension on which individual incentive systems vary is the specified relationship between production level and wages. The first alternative is to tie wages to output on a one-to-one basis, so that wages are some constant function of production. In contrast, some plans vary wages as a function of production level. For example, one common alternative is to provide higher dollar rates for production above the standard than for production below the standard.

How are scanlon/rucker plans implemented?

There are two major components vital to the implementation and success of a Rucker or Scanlon plan. These two components are: (1) a productivity norm and (2) development of effective worker committees. Development of a productivity norm requires both effective measurement of base year data and acceptance by workers and management of this standard for calculating bonus incentives. Effective measurement requires that an organization keep extensive records of historical cost relationships and make them available to workers or union representatives to verify cost accounting figures. Acceptance of these figures, assuming they are accurate, requires that the organization choose a base year that is neither a boom nor a bust year. The base year chosen also should be fairly recent, allaying worker fears that changes in technology or other factors would make the base year unrepresentative of a given operational year. The second ingredient of a Scanlon/Rucker plan is a series of worker committees also known as productivity committees or bonus committees. The primary function of these committees is to evaluate employee and management suggestions for ways to improve productivity and/or cut costs. Operating on a plantwide basis in smaller firms, or a departmental basis in larger firms, these committees have been highly successful in eliciting suggestions from employees. It is this type of climate the Scanlon/Rucker plans foster that is perhaps the most vital element of success. Numerous authorities have pointed out these plans have the best chance for success in companies with competent supervision, cooperative union-management attitudes, strong top-management interest and participation in the development of the program and management open to criticism and willing to discuss different operating strategies.