Human Resource
Management
INCENTIVE COMPENSATION
Chapter 13
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Incentive Compensation?
Compensation that is linked to performance by
rewarding employees for actual results achieved
instead of seniority or hours worked.
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Why Introduce Incentive Compensation?
• To promote employee identification with the organization’s
objectives. Many organisations attempt to link the achievement
of company objectives to employee rewards. This builds
employee commitment. (profit-sharing)
• To encourage individual, team or business unit performance
which makes the incentive reward dependent on specific work
outcomes that the employee, or the work group, directly affect.
(commission, piece-rates)
• To control fixed compensation costs. One way of controlling
compensation costs is to designate a portion of pay as ‘at risk’
if predetermined business unit, team or individual objectives
are not achieved.
• To increase remuneration competitiveness.
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Types of Plans
1. Bonus versus Incentive
• A bonus is determined and given after the job is
done and it makes no guarantee that future work
or effort will be rewarded similarly.
• Where a bonus is reactive, an incentive is
proactive.
• An incentive provides a very direct message to an
employee: ‘If you achieve this level of
performance, you will receive this amount of
reward.’
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Types of Plans
2. Pay-for-performance Link
• Incentive-type plans aim to strengthen the
perceived link between pay and performance.
• The relationship between pay and performance is
especially effective when it is based on those
aspects of the work that are under the individual
employee’s direct control and influence - if you
sell or produce more, you earn more!
• This establishes an immediate relationship
between results and rewards.
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Types of Plans
3. Variable And ‘At-risk’ Pay
• Any pay system that provides a bonus or incentive is a
variable pay system.
• The amount of the bonus or incentive varies and cannot
be predetermined.
• Other systems are based on the notion of some portion of
pay being ‘at-risk’ against specified levels of performance.
• A clear principle is that the employee must have the
opportunity to earn more than the target amount.
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Types of Plans
4. Individual Incentive Plans
• The organisation must emphasise individual contribution
as distinct from team or work group effort.
• The job must be designed to allow each employee to work
independently and with autonomy and discretion.
There are 3 criteria for setting performance objectives:
• Internal benchmark (within the organisation)
• External benchmark (outside the organisation)
• Strategic business objectives - performance is measured
against the strategic business objectives set for the
organisation.
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Individual Incentive Plans: Advantages
 Provide a clear link between individual pay and work contribution
 Discriminate in favour of high performers
 Can have significant impact on key performance indicators
such as productivity, quality and sales
 Link total compensation costs to organisational objectives
Individual Incentive Plans: Disadvantages
 May encourage individualism and non-productive competition
 Require comprehensive and credible systems of individual
performance measurement
 Can sometimes end up paying for performance that would have
been achieved without an incentive plan
 May leave the organisation no better off if improvements from
one employee are offset by another's poor performance
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Key principles in the design of
individual incentive plans
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Identified source of funding
Performance tracking and management systems
Frequent reward
Pay-for-performance
Periodic review
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Small Group Incentive Plans
• An important aspect of small group incentives is their
ability to increase flexibility in job assignment by focusing
on team accomplishments rather than individual ones.
• This promotes a strong group perspective rather than an
individual focus.
• The performance objectives of work groups are similar to
those of individual incentive plans and relate to financial,
productivity and other specific targets.
• The key difference is the deliberate encouragement of a
group or team ethos.
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Gain-sharing
• Gain-sharing is a small group incentive system that
shares the productivity improvements gains with the
employees who make the improvement.
• Gainsharing plans operate in addition to the normal
wage structure.
• The aim is to create a work climate in which
employees benefit financially from increased
productivity.
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Gainsharing Plans
• The Scanlon plan defines productivity as ‘payroll costs
per dollar of net sales’.
• The financial gain (productivity increase) comes from
achieving the same/better production levels for the period
with lower payroll costs than in the agreed baseline data.
• A typical Scanlon plan split is 75 per cent to employees
and 25 per cent to the organisation.
• Rucker plans calculate their gains on a value-added
formula.
• Improshare plans measure gains on the basis of
comparing the standard hours for production (based on
industrial engineering calculations) against actual hours
taken in production.
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Paying for Quality and Customer Service
• Each team member shares equally in the incentive pool as
predetermined targets in quality or customer service are
met.
• The approach is to link pay and quality through
specifically designed work-team incentive systems.
• The TQM emphasis on team performance provides the
basis for an incentive pay system.
• Incentive payments can be linked to key quality
performance indicators - such as a reduction in defects and
scrap - and key customer service performance indicators such as a reduction in customer complaints.
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Incentive Pay for Project Teams
• The key performance measures for project work
are competition on time and within budget.
• This allows the overall task to be divided into
‘milestones’ that define specific time frames and
budgets for each stage of the project.
• The milestone events required to meet the
timing schedule are identified.
• Management must determine when the group
bonuses will be paid (usually when the various
groups in the project team meet their schedules).
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Advantages of Small Group Incentive Plans
•Encourage and reinforce team work by linking rewards to group
performance
• Increase peer pressure on poor performers to improve
• Allow greater use and flexibility of team members
• Provide clear link between group performance and reward
• Can be easily designed and administered once key performance
indicators are identified
Disadvantages of Small Group Incentive Plans
•Reduce emphasis on individual performance
•Allow poor performers to be carried by the group
•Can sometimes end up paying for performance that would have
been achieved without an incentive plan
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Large Group Incentive Plans
• Many organisations choose to introduce variable
pay systems that cover all employees.
• These organisation-wide plans often work in
addition to individual or small-group incentives.
• Such plans are typically based on one or two
broad performance indicators such as achievement
of a budget or profit.
• Large group incentives usually take the form of a
bonus plan, an incentive plan or an ‘at-risk’
incentive.
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Advantages of Large Group Incentive Plans
• Encourage employee identification with organisation-wide
objectives
• Control part of remuneration costs if rewards are contingent
on meeting objectives
• Promote positive organisational image
Disadvantages
• Have a long ‘line of sight’ because only a few employees can
directly influence the end result
• May leave high performers feeling that their contribution is
overlooked
• Allow poor performers to be ‘carried’ by the overall effort 17
Recognition Programs
• A form of individual or work group incentive that is
usually outside the normal remuneration system.
• Recognition programs use various forms of reward,
including cash, merchandise, travel, time off with pay,
plaques and certificates.
Suitable to apply when:
• a reward process is required for a short-term goal or activity
• the organisation decides to introduce a process for
recognising any outstanding contribution by an individual
employee or work group
• the organisation has a strong team orientation and wishes to
keep the focus on work group performance and team
incentives while still recognising the specific contribution of
individual employees.
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Advantages of Recognition Programs
• Ensure that recognition is immediate and separate from the normal
reward system
• Have added psychological value related to peer recognition
• Allow awards to be highly individualised symbols of
accomplishment
• Mean that the winning of the award often has greater value than the
actual cash value of the award
Disadvantages of Recognition Programs
• Can involve high administrative costs and time
• Have the danger of ‘repeat’ winners: Winning the same prize year
after year may not contribute to motivation for the employee.
• May be seen as favouritism if the system allows for repeat winners.
• May lead top performers to lose interest if the system does not
allow for repeat winners.
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• Lead employees to lose motivation if they feel they cannot ever win.
Design of Incentive Pay: Focus on
Strategic Business Objectives
• The first step in designing an effective
incentive pay system is to define the
required performance criteria.
• The aim is to provide as direct a ‘line of
sight’ as possible for all employees included
in the incentive system.
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Design of Incentive Pay: Develop a
Comprehensive Reward Framework
• The incentive system needs to be integrated
into a total reward framework.
• It is necessary at the design stage to address
the issue of base pay and how it fits with the
incentive system.
• What should the total target pay (that is, base
pay plus incentives) be for each employee?
Should there be just one incentive system?
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Design of Incentive Pay: Ensure
Reinforcement of Desired Behaviours
• The performance objectives need to be
clearly specified.
• The nature of the contribution - whether
individual or group - must be defined.
• The frequency of payment must be such that
it continually reinforces the organisation’s
message.
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Design of Incentive Pay: Funding
There are two ways to fund incentive payments:
• First, the amount can be provided from the
increased profits or decreased costs arising
from the achievement of the objectives.
• Alternatively, the payments can be an
additional expense to the organisation.
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Design of Incentive Pay: ‘Fit’ with
Organisational Culture
• Performance-based remuneration will be most
effective when it reinforces the existing
organisational culture and management style.
• Such reinforcement requires giving consideration
to such issues as centralisation/decentralisation,
the degree of employees’ control or autonomy
over their work and other characteristics of the
organisation.
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