PERFORMANCE AND COMPENSATION
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Theories of motivation
Before considering how managers and staff should be compensated, it is worth considering what
motivates them. If compensation can contribute to their motivation, the drivers for that motivation
need to be addressed.
A useful starting point is Maslow’s hierarchy of needs. This is a theory in psychology that Abraham
Maslow proposed in his 1943 paper A Theory of Human Motivation. His theory contends that once
humans have met 'basic needs', they seek to satisfy successively 'higher needs' that occupy a set
hierarchy. Maslow based his ideas on studies of high achievers such as Albert Einstein.
The hierarchy of needs can be represented as a pyramid with the more primitive needs at the
bottom. The four lower levels are grouped together as deficiency needs associated with
physiological needs, while the top level is termed growth needs associated with psychological
needs. While deficiency needs must be met, growth needs are continually shaping behaviour. The
basic concept is that the higher needs in this hierarchy only come into focus once all the needs that
are lower down in the pyramid are mainly or entirely satisfied.
An interpretation of Maslow’s hierarchy of needs for compensation strategies could be that
providing a basic salary, which meets basic needs, can only go so far in motivating staff.
But different people are motivated by different things, and another set of ideas that brings this out is
the ‘Theory X’ and ‘Theory Y’ theories of human motivation created and developed by Douglas
McGregor at the MIT Sloan School of Management in the 1960s. They describe two very different
attitudes toward workforce motivation. McGregor felt that companies followed either one or the
other approach.
In Theory X management assumes employees are inherently lazy and will avoid work if they can.
Because of this workers need to be closely supervised and comprehensive systems of controls
developed. A hierarchical structure is needed with narrow span of control at each level. According
to this theory employees will show little ambition without an enticing incentive program and will
avoid responsibility whenever they can.
The implication of Theory X for compensation strategies is that you need financial incentives in
order to get the best out of people.
In Theory Y management assumes employees are ambitious, self-motivated, anxious to accept
greater responsibility, and exercise self-control and self-direction. It is believed that employees
enjoy their mental and physical work activities. It is also believed that employees have the desire
to be imaginative and creative in their jobs if they are given a chance. There is an opportunity for
greater productivity by giving employees the freedom to be their best.
A Theory Y manager believes that, given the right conditions, most people will want to do well at
work and that there is a pool of unused creativity in the workforce. They believe that the satisfaction
of doing a good job is a strong motivation in and of itself. A Theory Y manager will try to remove
the barriers that prevent workers from fully actualizing themselves.
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Types of compensation
It is time now to turn to the different types of compensation and to consider which types are most
appropriate in particular situations and for particular individuals.
Typical elements in a compensation package are as follows.
PERFORMANCE AND COMPENSATION
REVISION NOTES
Base salary
The fixed, recurring portion of the employee’s compensation.
Bonus
Bonuses are additions to pay that are linked to individual or team performance measured against
targets or objective criteria. Employers introduce bonus payments to reward individuals for doing
well. By definition a 'bonus' payment is an extra and not part of basic pay. (EOC definition)
Long-term incentives
LTIs are differentiated from bonuses by the time horizon over which they are available (typically at
least three years) and because they will very likely take the form of grants of shares in the
organisation, subject to certain performance conditions having been met. Share options can be
LTIs, if they are conditional on performance.
Non-cash benefits
These can include both tangible goods or services (eg company car, home computer, health
insurance, study support) and benefits from different ways of working, such as flexi hours, longer
holidays, opportunity to take a sabbatical, etc.
Designing a bonus scheme
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Bonus schemes are established to fulfil a number of key business and HR objectives:

To reward past performance (e.g. productivity, sales or profits).

To motivate employees to achieve targets such as customer service, quality and on-time
delivery.

To encourage change within the organisation.

To signal what the organisation wants to encourage, eg to create a desired workplace
culture of teamwork and good attendance.

To conform with industry norms.

To form part of a wider change in the way that remuneration is structured.

To take advantage of tax legislation (eg in the 1990s there were tax breaks for performance
related pay in the UK).
It is worth defining certain terms that will recur in discussion of bonus schemes.
Factor
The element that drives the amount of bonus. There can be single factors or multiple factors
behind bonuses.
Bonus pool
An amount of money that is set aside from company profits and from which bonuses can be paid.
Typically the pool might be a percentage of the company’s profits. In such a situation the size of
the pool would therefore vary according to how profitable the company had been.
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PERFORMANCE AND COMPENSATION
REVISION NOTES
There are a number of variables in designing a bonus scheme.
A. Operating level
Bonus schemes can operate at any one or any combination of the following levels:
Individual Bonus Scheme
Team Bonus Scheme
Site Bonus Scheme
Corporate Bonus Scheme
In theory a company could operate a scheme at any one or more of these levels. The constraining
factor however, in any bonus scheme, is cost
B. Factors
Bonus schemes can be based on a single factor or a range of factors. Single factor schemes allow
special focus to be put on a key target or business objective. This may be of ongoing importance,
such as profits or productivity, or a matter that needs particular short-term attention. Multi-factor
bonus schemes take in a wide range of factors and may include targets at a corporate level in
conjunction with targets aimed at particular departments or teams. A similar outcome may be
achieved by using a number of single-factor or single-level schemes.
There is a wide range of factors that can form the basis of both single- and multi-factor bonus
schemes. These include:
Productivity and output
Quality
Safety
Cost Management
Financial performance/profits
Sales
Customer Service/satisfaction
Attendance
HR-Related measures
Project Work Targets
Team working
Individual Performance
C. Distribution of the Bonus Pool
Bonuses may be paid as an equal flat rate or as a percentage of salary across a department, site
or company. Payments may be further differentiated in the following ways:
Vary by grade or role
Reflect individual performance
Be based on team performance
D. Frequency of Payments
The frequency of payments varies from weekly to annually and is linked to the objectives and types
of bonus scheme operated. Most companies make payments on an annual basis because they
have linked their bonuses to annual profit targets.
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PERFORMANCE AND COMPENSATION
REVISION NOTES
In some contexts, shorter measurement periods and regular bonus payments may have a greater
motivational impact. Conversely, the longer the bonus period, the more scope there is for making a
significant lump-sum payment that stands out more from basic pay. Interest in a bonus scheme that
measures performance over a longer period can be maintained by communicating progress against
targets to employees on a regular basis. An annual bonus payment can also act as a retention tool,
although there is likely to be a surge of leavers immediately after bonus is paid.
E. Hurdles
Most companies only make payments from their bonus schemes if certain hurdles are overcome:
Minimum targets for all factors – if these minimum targets are not reached then there is no bonus
pay out for these factors
Threshold profit level – most of the bonus schemes fully or partly based on financial measures
include a threshold profit level that must be reached before any payments are made.
Absence triggers – many companies have chosen to use “absence triggers” for bonus payments
e.g. employees at Marks & Spencer Group must have at least 96% attendance, regardless of
whether sales targets are being met, to receive a bonus payment from the scheme.
Management Discretion – organisations often maintain a degree of discretion over the payment of
bonuses e.g. the board might reserve the right not to make bonus payments if a serious lapse,
such as a major health and safety incident occurs on site.
Conclusion
Overriding issues when designing a bonus scheme are as follows.
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The structure of the scheme needs to be kept simple.
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The number of variables, including the factors that will determine how a bonus is
calculated, need to be considered carefully. Too many variables and the scheme will
become over-complicated and will use its motivational effect. Too few, and it may not
achieve the desired result.
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The term of the scheme needs to be considered. If long-term commitment to the
organisation is required, it could set objectives and rewards for the next three years.
Alternatively, if the objective is to get immediate results, a shorter time horizon may be
appropriate.
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A balance of quantitative and qualitative factors may be beneficial for the bonus scheme. If
purely quantitative factors are used, there is no role for the judgment of the assessor about
whether the employee receiving the bonus has done well. If purely qualitative factors are
used, there may be a lack of clarity about what is required.
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Whoever assesses performance against the factors determining the bonus must be, and
be seen to be, impartial and objective. For this reason it is not usually appropriate for an
employee’s immediate boss to have the final say on a bonus.
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There must exist a right of appeal in the case of mistakes.
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PERFORMANCE AND COMPENSATION
REVISION NOTES
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Trends and issues in compensation
Rewards for those at the top are growing disproportionately
It is well known that the gap between the highest earners and the lowest earners has been growing
wider, both in the UK and the US. The rate of increase in earnings for the well paid would appear
to be out of proportion to any commensurate improvement in productivity.
So, to what extent is compensation really related to performance?
A number of factors appear to lie behind this trend:
1. The increasing use of external benchmarks for compensation creates a ratchet effect. Typically,
a major company will use a remuneration committee to determine top directors’ compensation.
The committee will use a criterion such as ‘compensation to be in the top quartile for FTSE 100
Finance Directors’. Most businesses would prefer to see themselves as being ‘in the top quartile’
or ‘better than average’ and set their key people’s pay accordingly. But not everyone can be ‘better
than average’, still less ‘in the top quartile’! Hence the inflation of top people’s pay.
2. Performance related pay is becoming more popular. But it tends to affect remuneration
asymmetrically – in other words, if performance is good, it leads to higher than average pay
increases, but if performance is poor, then people do not suffer a corresponding loss of earnings.
Shareholder opposition to share options
Share options became an increasingly popular way of rewarding senior managers when stock
markets were rising strongly in the 1990s. An option issued with an exercise price of 100p provides
a powerful incentive for a manager to improve the company’s performance and push the share
price above 100p.
Unfortunately, share price performance depends on many other factors behind the performance of
management. In a rising market, even poorly performing managers could benefit. Conversely, in a
falling market, share options lose their incentive effect.
These problems have been exacerbated in some cases by management appearing to rig the issue
of options in such a way that they could not fail to benefit – eg by issuing options at an exercise
price that could easily be achieved.
Shareholders have therefore become increasingly wary of approving share options.
Different issues for different organisations
Although different types of organisation – quoted companies, unquoted companies, not for profit
organisations such as charities and government agencies – are often hunting in the same talent
pool – they will face different compensation issues. Quoted companies face a greater degree of
scrutiny, so will in theory be less inclined to pay senior staff generously. Not for profit organisations
have traditionally paid less than private sector organisations.
Pressure for links to environmental and safety measures
As the ‘Green’ agenda becomes more powerful, there is pressure for compensation to be linked to
environmental and safety measures. This has been seen in the case of BP, where the value of the
company, and hence shareholders’ wealth, has been hit seriously by its poor safety record in the
US.
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