Mgmt 434 Compensation Ch 10

Merit pay is widely used and the average merit pay increase

o 3% per year. § An average employee would double their salary in about 23 years. § Higher performers will get larger merit pay increases and their salary will increase faster, but it will still take a while. o Salary increases due to promotion are much larger, ranging around 15%. Salary could double every 5 years

Halsey 50-50 method

Individual incentive method that provides for variable incentives as a function of a standard expressed as time period per unit of production. This plan derives its name from the shared split between worker and employer of any savings in direct costs

o There are four general categories of plans. · Types of Individual Incentive Plans

straight piecework system. · Standard hour plans and Bedeaux plans. · Taylor plans and the Merrick system. · The Halsey 50-50 method, the Rowan plan, and the Gantt plan.

§ Two plans provide variable incentives as a function of units of production per time period.

· Taylor plans and the Merrick system.

§ Three plans provide for variable incentives linked to a standard expressed as a time period per unit of production.

· The Halsey 50-50 method, the Rowan plan, and the Gantt plan.

· How Widely Used is PFP?

o 99% of organizations use some form of short-term incentive plan. § The use of variable pay in general has increased. o The greater interest in variable pay can be traced to two trends. § Increasing competition from foreign producers forces U.S. firms to cut costs and/or increase productivity. § Today's fast-paced business environment means employees must be willing to adjust what they do and how they do it.

· Pay-For-Performance: Merit Pay Plans

o A merit pay system links increases in base pay to how highly employees are rated on a performance evaluation. § Most use a merit increase grid to determine merit pay on the basis of performance and also position in the salary range, or grade. · Captured by the compa-ratio - employee salary divided by range midpoint. · Ratios are plugged into the grid to determine size of merit increase. o At the end of a performance year, employees are evaluated. § Merit pay increases, unlike variable pay, is added into base pay. § What the employee does this year is rewarded every year the employee remains with the employer.

Earnings-at-Risk Plans

o Any incentive plan could be an earnings-at-risk plan. o Incentive plans fall into one of two categories. § Success sharing. · Employee base wages are constant and variable pay adds on a predetermined amount in successful years. · If the company does poorly, employees forgo any variable pay. § Risk sharing. · Base pay is reduced by some amount relative to the level that would be offered in a success-sharing plan. o These plans shift part of the risk to the employee. § They may result in decreased satisfaction with pay in general and the process used to set pay - may increase turnover.

· Individual Incentive Plans: Examples

o Even though these plans are less popular, there are still notable successes. § Most sales positions have some part of pay based on commissions, a form of individual incentive. o The biggest success story is the merger of individual incentives with efforts to reduce health care costs. § Companies deposit money into employee health reimbursement accounts for participating in various health incentive programs. o The longest-running success belongs to Lincoln Electric company. § The compensation and the reward package fit together. § Both culture and the performance review system supports the different pay components.

Group Incentive Plans

o Group PFP plans are gaining popularity in team-based companies. o Group-based plans, particularly gain-sharing plans, may cause organizations to evolve into learning organizations. § Employee suggestions evolve from first-order learning experiences into suggestions exhibiting second-order learning characteristics. § Suggestions that help the organization break out of existing patterns of behavior and explore different ways of thinking and behaving. o All group incentive plans have common features. § The size of the group that participates in the plan. § The standard against which performance is compared. § The payout schedule.

Long-Term Incentive Plans

o Growth in such plans is partly due to a desire to motivate longer-term value creation. § There is very little evidence that stock ownership by management leads to better corporate performance. § There is some evidence that stock ownership is likely to increase internal growth, rather than more rapid external diversification. o As of June 2005, companies are required to report stock options as an expense. § Prior, they were viewed as a free good under old accounting rules.

· Gain sharing: Improshare

o Improshare (Improved Productivity through Sharing) is easier to administer and to communicate. o First, a standard is developed identifying the expected hours required to produce an acceptable level of output. § The standard comes either a time-and-motion study or from a base-period measurement of the performance factor. o Any savings arising from production of the output in fewer than expected hours is shared by the firm and the workers. § Gains are split 50-50 between employees and management.

· Comparing Group and Individual Incentive Plans

o Incentive plans boost performance. § Individual incentives yield higher productivity gains, but group incentives often are right when team coordination is the issue. o Type of task, organizational commitment to teams, and the type of work environment may warrant individual or group plans. o Individual incentive plans have better potential for delivering higher productivity. o Group plans can suffer from the free rider problem. § Free riders have a harder time loafing when there are clear performance standards.

· Individual Incentive Plans: Returns and Risks

o Individual incentive plans are not widely used. § Outside of sales, less than 4% of employees work under such plans. o There is strong evidence that individual incentives, on average, have substantial positive effects on performance. o Besides not fitting many jobs in the economy, another reason for their limited use is that things can go wrong. § Incentive plans can lead to unexpected, and undesired, behaviors. § A common problem is employees and managers end up in conflict. · Systems often focus on one small part of what it takes for the company to succeed. · Employees then focus on that one small part.

· What is a Pay-for-Performance Plan?

o Many compensation practices are lumped under pay-for-performance, such as: § Incentive plans, variable pay plans, compensation at risk, earnings at risk, success sharing, risk sharing, and others. o People used to think of pay as primarily entitlement. o Pay-for-performance plans move toward pay that varies with some measure of individual or organizational performance. o Many surveys on pay-for-performance omit the starting point of all these plans, merit pay.

· Concerns About Merit Pay

o Merit pay increases fixed compensation costs over time. § One response is to use merit bonuses or other variable pay plans. o Merit pay becomes costly if too many high-performance ratings are awarded. § Control the number of high ratings and/or improve the accuracy and credibility of performance ratings. o Merit pay differentials are too small to motivate performance. § Use larger differentials and include the role of promotions to strengthen merit pay differentials. o Individual performance is a deficient measure when work is interdependent and requires cooperation to obtain objectives. § Broaden criteria to include cooperation and other factors.

· Evidence for Merit Pay

o PFP plans create an environment that rewards excellence. o Most discussion of merit pay focuses on incentive effects. § How does merit pay influence performance of current employees? o Merit pay may also have significant sorting effect causing employees who do not want pay tied to performance to leave. o For merit pay to live up to its potential, it must be managed. § This requires a complete overhaul of the way raises are allocated. § Unless the reward difference is larger for every increment in performance, many employees will say, "Why bother?".

· Does Variable Pay Improve Performance Results?

o Pay-for-performance plans: § That introduce variability into the level of pay an employee receives. § Seems to have a positive impact on performance if they are designed well. o Too often the plans have: § Too small a payout for the work expected. § Unattainable (or too easy) goals. § Outdated or inaccurate metrics. § Or too many metrics making it difficult to determine what is important.

· Performance and Broad-Based Option Plans

o Performance plans feature corporate performance objectives for a time three years in the future. § Driven by financial earnings or return measures and pay out for meeting or exceeding specific goals. o Broad-based option plans (BBOPs) are stock grants with a firm giving employees shares of stock over a designated time period. § The strength of BBOPs is versatility. § Depending on their distribution, they reinforce performance or inspire greater commitment and retention. § They are a growing trend. § Colliding with this trend is shareholder pushback against equity awards for all but the top 1% of employees.

· Profit Sharing Plans

o Profit sharing continues to be popular due to its focus on a predetermined index of profitability. o On the downside, most employees do not feel their jobs have a direct impact on profits. o The trend in variable-pay design is to combine the best of gain sharing and profit sharing plans. § A funding formula is linked to some profit measure. § The plan must be self-funding. § Dollars given to workers are generated by additional profits gained from operational efficiency. § Along with financial incentive, employees have a sense of control

Long-Term Incentive Plans - Employee Stock Ownership Plans (ESOPs)

o Some companies link employees to success or failure of a company through ESOPs. § The effects are long-term and employee's working harder means nothing at the time. § Management cannot predict what makes stocks rise, a central ingredient in the reward component of ESOPs. o Why use an ESOP? § They foster employee willingness to participate in decision-making. o Impact is modest with little impact on productivity or profit. § Critics argue the plans are not used effectively. § If combined with high goal setting, improved communication, and greater participation, ESOPs may have a positive impact.

· Key Elements in a Gain Sharing Plan

o Strength of reinforcement. § What role should base pay assume relative to incentive pay? o Productivity standards. § Most plans use a historical standard. § Changing conditions can render a standard ineffective. o Sharing the gains between management and workers. § Emergency reserve? o Scope of the formula. § Performance measures have moved beyond financial. o Ensure reinforced behaviors affect the desired goal. o Perceived fairness of the formula. § Increase employee and union participation. o Ease of administration. o Production variability.

· Team Incentive Plans - Measures

o Team performance standards are typically based on: § Productivity improvements. § Customer satisfaction measures. § Financial performance. § Quality of goods and services. o Historically, financial measures have been used. § Increasingly, this is seen more as a means to inform stock analysts than managers trying to improve operating effectiveness. o Decide which type of group incentive plan best fits the objectives. § Firms high on business risk and those with uncertain outcomes are better off not having incentive plans at all.

· Combination Plans: Mixing Individual and Group

o The goal is to motivate individual behavior and insure employees work together to promote team and corporate goals. o Plans start with the standard individual and group measures. o Variable pay level depends on how well individuals perform and how well the company does on its macro measures. o A typical plan might call for a 75-25 split. § 75% of the payout is based on individual performance and 25% on corporate performance. o An alternative might be a self-funding plan. § Triggers specific payouts only after the company reaches a certain profit target.

· The Scanlon and Rucker Gain Sharing Plans

o Two major components are vital to success of either plan. § A productivity norm requires effective measure of the base-year and employee acceptance. § Effective work/productivity/bonus committees whose primary function is to evaluate suggestions for improving productivity and/or cutting costs.

Team Incentive Plans

o When focusing on people working together, we shift to team or group incentive plans. § The established standard measures team performance to determine the magnitude of the incentive pay. o Despite increased interest in teams and team compensation, many reports are not encouraging. § Teams come in many varieties. § The "level problem" creates difficulty equalizing when assigning rewards. § Some plans are simply too complex. § Control and fairness are key issues. § Team-based plans are simply not well communicated.

Broad-based option plans (BBOPs

o are stock grants with a firm giving employees shares of stock over a designated time period. § The strength of BBOPs is versatility. § Depending on their distribution, they reinforce performance or inspire greater commitment and retention. § They are a growing trend. § Colliding with this trend is shareholder pushback against equity awards for all but the top 1% of employees.

· Gain Sharing Plans Scanlon Plan.

§ Incentives derived as a function of the ratio between labor costs and sales value of production (SVOP). § 25% of wage savings goes back to the company and 75% of the remainder is distributed as employee bonuses. § With the remaining 25% placed in an emergency fund.

o The plans differ from individual incentive plans in their focus.

§ Individual plans focus on wage incentives to motivate. § The Scanlon/Rucker plans focus on organizational behavior variables. · The key is participation developed through group unity.

Rowan Plan

An incentive plan that benefits the workers and the organization. The incentive increases as the time to complete tasks decreases.

Straight Piecework definition

An incentive plan under which employees receive a certain rate for each unit produced

Taylor Plan

Originator of the scientific management theory. Uses two piecework rates: one for those who produce below or up to standard and another for those who produce above standard.

straight piecework system.

The implemented

The most common performance basis is a combination of

corporate, unit, and individual objectives.

· Large Group Incentive Plans

o There are two plan types for incentivizing large groups. § Gain sharing plans use operating measures to gauge performance. § Profit sharing plans use financial measures. o Gain sharing identifies areas where employees have some impact on savings - such as reduced scrap. § Studies report positive results. § Can lead to the sorting effect.

Gantt Plan

standard time for a task is purposely set at a level requiring high effort to complete

Gain Sharing Plans - Rucker Plan.

§ A ratio is calculated expressing the value of production required for each dollar of the total wage bill. § Production savings are split similarly to the Scanlon plan, including the emergency fund.

o Two important differences in the Scanlon and Rucker plans.

§ Rucker plans tie incentives to a variety of savings, not just labor. § Rucker plans are more linkable with individual incentive plans.

Standard hour plans

an incentive plan that pays workers extra for work done in less than a preset "standard time"

· PFP: Short-Term Incentive Plans - Spot awards

are given for exceptional performance, often on special projects or for performance exceeding expectation.

Long-term incentive plans are more likely to be used for

officers/executives and other higher job levels.

· PFP: Short-Term Incentive Plans Merit bonuses

o differ from merit pay in that employees receive an end-of-year bonus that does not build into base pay. Over time, these can be considerably less expensive than merit pay.

PFP: Short-Term Incentive Plans - Individual incentive plans

o offer a promise of pay for some objective or pre-established level of performance. § All plans have one common feature: an established standard. § These plans do not work for every job.

· Types of Individual Incentive Plans

o Differences can be reduced to variations along two dimensions. § The way the standard is set and the way wages are tied to output.

Bedeaux Plan

plans set standards based on time per unit and tie incentives directly to level of output.