Paul L. Schumann, Ph.D.
Professor of Management
MGMT 440: Human Resource Management
© 2008 by Paul L. Schumann. All rights reserved.
1
Outline





What Is Incentive Pay?
Why Use Incentive Pay?
Does Incentive Pay Work?
Drawbacks of Incentive Pay
Incentive Pay Systems











Piece-Rate
Taylor Plan
Standard Hour Plan
Commissions
Merit Pay
Bonuses
Skill-Based Pay
Profit Sharing
Gain Sharing Plans
Employee Stock Ownership Plans (ESOPs)
Executive Compensation
2
What Is Incentive Pay?
 Incentive pay links pay (as a reward) to performance
 The idea of incentive pay is to create incentives for
employees to improve their job performance by linking
employee pay to employee job performance
 Incentive pay is also called:



Pay for performance
Performance-based pay systems
Performance-based reward systems
 The reward for performance doesn’t have to be pay
 Pay is one possible reward, not the only possible reward
3
Why Use Incentive Pay?
 We want to use pay (and other rewards) to align the goals
of each employee with the goals of the organization
 This way, when employees work toward their own goals, they
are also working toward the organization’s goals
 If incentive pay works to enhance employee motivation,
then the advantages include:
 Increased employee productivity & job performance
 Increased retention of high performers
 Because high performers get more pay than low performers
 Increased ability of the organization to achieve its objectives
 Lower costs
4
Does Incentive Pay Work?
 Expectancy theory gives us the answer:
 Yes, incentive pay will motivate employees to improve
their job performance, but only if 3 conditions are
simultaneously satisfied:



High valence: employees must believe that the amount of the
reward (incentive pay) is large enough to be valued
High instrumentality: employees must believe that there is a
strong link between their job performance and their rewards
High expectancy: employees must believe that there is a
strong link between their effort and their job performance
 Effort  Performance  Rewards
5
Does Incentive Pay Work?
 Expectancy theory (more)
 What can go wrong?

Effort  Performance  Rewards
 Low valences: the reward (the amount of the incentive pay
increase) is too small to be valued
 Example: Supervisor tells a salesperson “If you double your
sales from $1-million to $2-million, I’ll reward you with a pay
increase from $50,000 a year to $50,100 a year.”
 Example: Suppose the budget allows for pay increases up to
4% when inflation is 3%: if all the employees get a 3% pay
increase (for inflation), then the employees with the best
job performance might only get an additional 1%

On a $50,000 salary, 1% is only $500 for exceptional performance
6
Does Incentive Pay Work?
 Expectancy theory (more)
 What can go wrong? (more)

Effort  Performance  Rewards
 Poor instrumentality perceptions
 Example: The supervisor gives everyone the same pay
increase regardless of differences in job performance
 Example: The supervisor does a poor job of evaluating
employee job performance
 Example: The supervisor plays favorites and gives the
biggest pay increase to the employee who is the supervisor’s
golfing buddy even though that employee has poor job
performance
7
Does Incentive Pay Work?
 Expectancy theory (more)
 What can go wrong? (more)

Effort  Performance  Rewards
 Poor expectancy perceptions
 Example: The employees believe that they are already
working as hard as they can
 Example: The employees believe that there are barriers to
improved job performance that are outside of their control
8
Does Incentive Pay Work?
 Expectancy theory (more)
 Effort  Performance  Rewards


Summary: For incentive pay to work:
 we need to make the incentive pay increase large enough that
employees want to put forth the effort to go after the incentive
 and we need to show employees that there is a strong link
between their job performance and receiving the incentive pay
increase
 and we need to show employees how, through their efforts,
that they can successfully improve their job performance
Put another way, employees need to believe: If they work at it,
they’ll achieve their goals, and they’ll get the promised reward
9
Drawbacks of Incentive Pay
 Incentive pay is more work to administer
 Across-the-board pay increases are easy to administer
 We can make mistakes
 Example: Link pay to the wrong measures of job performance

Example: Sears Auto Centers
 Unions typically oppose many types of incentive pay
 Fear of discrimination or favoritism by supervisors in job
performance evaluations, especially for subjective measures of job
performance

Unions prefer objective factors, such as across-the-board pay increases
or the use of seniority
 Incentive pay creates competition among workers, which weakens
worker solidarity (solidarity is necessary for union success)
 Unions might agree to group-based objective incentives

Example: Profit-sharing bonus
10
Incentive Pay Systems
 Piece-rate: pay is a set amount per piece of production
 Straight piece-rate: pay is entirely on a piece-rate basis

Example: Production job



Market pay = $12 per hour
Average hourly production target = 60 pieces per hour
Piece-rate = $12/60 = $0.20 per piece
 50 pieces → 50 × $0.20 = $10.00 (below market pay)
 60 pieces → 60 × $0.20 = $12.00 (market pay)
 70 pieces → 70 × $0.20 = $14.00 (above market pay)
 80 pieces → 80 × $0.20 = $16.00 (above market pay)
 Base pay plus piece-rate

Example: Production job

$12 per hour plus $0.20 per piece for production over 60 pieces in an hour
 70 pieces → $12 + [(70 − 60) × $0.20] = $12 + [10 × $0.20] = $14.00
11
Incentive Pay Systems
 Taylor Plan: piece-rate with differential rates
 Example: Production job with 2 piece rates



Production standard = 60 pieces per hour
Piece-rate #1 = $0.20 per piece if production is less than 125% of the
production standard (1.25 × 60 = 75 pieces per hour)
 60 pieces → 60 × $0.20 = $12.00 (market pay)
 70 pieces → 70 × $0.20 = $14.00
Piece-rate #2 = $0.25 per piece on production over 60 pieces if
production equals or exceeds 125% of the production standard (1.25 ×
60 = 75 pieces per hour)
 80 pieces → (60 × $0.20) + [(80 − 60) × $0.25)] = $17.00
 Recall the straight piece-rate ($0.20) paid $16 for 80 pieces

Note this makes the reward for exceeding 75 pieces bigger
(increased valence), which strengthens the motivational force
12
Incentive Pay Systems
 Standard hour plan: piece-rate where the standard is set in
terms of time (instead of units produced)
 Method:
 For a job title, make a list of possible tasks
 For each task, establish a standard length of time that it should take
to complete the task
 Base pay on the standard times, not actual clock times
 Example: Auto mechanic
 Market pay = $20 per hour
 Task: balance & rotate 4 tires
 Standard = 30 minutes = 0.50 hours
 Pay for task = $20 per hour × 0.50 hours = $10.00 (no matter how
long it actually takes the mechanic to do the task)
 Mechanic takes 15 minutes or 60 minutes → Pay = $10
13
Incentive Pay Systems
 Sales commissions: salesperson’s pay is a percentage of
his or her sales
 Straight commission: pay is entirely on commission


Example:
 Market pay = $50,000
 Sales target = $1,000,000
 Commission rate = 50,000/1,000,000 = 0.05 = 5.0%
 Sells $900,000 → Pay = $45,000 (below market)
 Sells $1,000,000 → Pay = $50,000 (market)
 Sells $1,000,000 → Pay = $55,000 (above market)
Base pay plus commission
14
Incentive Pay Systems
 Merit pay: the employee’s annual pay increase is based on
the employee’s job performance in the previous year
 We evaluate the employee’s job performance by using the
organization’s performance appraisal system

Measure the relevant results & behaviors of the employee
 Objective measures of employee job performance: production
measures, sales measures, personnel data, performance tests,
business unit performance measures
 Subjective measures of employee job performance: rating scales to
subjectively measure multiple aspects of job performance
 Management By Objectives (MBO)
 We use our evaluation of the employee’s job performance to
decide his or her annual pay increase
15
Incentive Pay Systems
 Merit pay (more)
 Example: Company uses the following 5-point rating scale to
evaluate the employee’s overall job performance and to award
the corresponding annual merit pay increase:





5 = Excellent
= 4.0% pay increase
4 = Very Satisfactory = 3.0% pay increase
3 = Satisfactory
= 2.0% pay increase
2 = Unsatisfactory
= no pay increase
1 = Very unsatisfactory = no pay increase
 Merit pay might be combined with a forced distribution
 Merit pay is widely used in the US
 Merit pay is used at all organizational levels
16
Incentive Pay Systems
 Merit pay (more)
 Potential difficulties of merit pay

Supervisors can make mistakes in evaluating employee job
performance & in assigning merit pay increases
 The mistakes weaken the instrumentality perceptions
 Effort  Performance  Rewards
 Reduces the motivational effectiveness of the incentive pay
system
 The mistakes create perceptions of inequity (unfairness)
 If employees feel underpaid, they may reduce their
contributions (reduce their effort)
17
Incentive Pay Systems
 Merit pay (more)
 Potential difficulties of merit pay (more)

The annual merit pay increase can come months after specific
instances of good performance
 Rewards are more effective when they are received
immediately after the desired behavior or result
 The delay in receiving the reward will weaken the
employees’ instrumentality perceptions
Effort  Performance  Rewards
 Reduces the motivational effectiveness of the incentive pay
system

18
Incentive Pay Systems
 Merit pay (more)
 Potential difficulties of merit pay (more)

Differences in merit pay increases may be too small to be meaningful
 Example: Current pay = $50,000; Suppose:
 Top performers: 4% merit increase → $2,000 pay increase
 Middle performers: 2% merit increase → $1,000 pay increase
 Some middle performers may believe that the extra $1,000 per
year isn’t worth the extra effort required to become a top
performer


At 2,000 annual work hours, the $1,000 difference works out to an
extra $0.50 per hour when they’re making over $25 per hour
Result is low valences
 Effort  Performance  Rewards
 Reduces the motivational effectiveness of the incentive pay
system
19
Incentive Pay Systems
 Merit pay (more)
 Potential difficulties of merit pay (more)

Merit pay budgets can vary from year to year
 Result is that the same job performance may get different
rewards depending on whether it’s a good year or a bad year
 If the same job performance is rewarded differently from
one year to another, then:

It weakens the instrumentality perceptions
Effort  Performance  Rewards
 Reduces the motivational effectiveness of the incentive pay system


It create perceptions of inequity (unfairness)

If good-performing employees feel under-rewarded in the bad years
when merit pay increases are smaller, then employees may reduce
their contributions (reduce their effort), especially in the bad years
20
Incentive Pay Systems
 Merit pay (more)
 Potential difficulties of merit pay (more)

Merit pay increases become part of the employee’s base pay in future years, even if
the employee’s job performance isn’t so good in the future years
 We end up continuing to reward the employee in the future for job
performance that might have been years in the past
 Example:





2005 → new hire → pay = $50,000 → at end of 2005, performance rating = 5 →
merit pay increase = 4% ($2,000)
2006 → pay = $52,000 → at end of 2006, performance rating = 3 → merit pay
increase = 2% ($1,040)
2007 → pay = $53,040 → at end of 2007, performance rating = 1 → no merit pay
increase
2008 → pay = $53,040 → the employee is still being rewarded in 2008 (and
beyond) for performance in 2005 & 2006
This weakens the instrumentality perceptions
 Effort  Performance  Rewards
 Reduces the motivational effectiveness of the incentive pay system
21
Incentive Pay Systems
 Bonus: employee receives a one-time lump-sum payment for meeting a
performance goal
 Performance goal might be:

Individual employee’s performance goal


Example: Salesperson’s goal is to achieve at least $2-million in sales
Organization’s performance goal

Example: Company’s goal is to achieve earnings-per-share of at least $3.15
 The bonus amount does not become part of the employee’s base pay
 Example:
 2005 → new hire → pay = $50,000 → at end of 2005, performance rating = 5 → bonus =
$2,000 → total pay = $52,000
 2006 → pay = $50,000 → at end of 2006, performance rating = 3 → bonus = $1,000 →
total pay = $51,000
 2007 → pay = $50,000 → at end of 2007, performance rating = 1 → bonus = $0 → total pay
= $50,000
 2008 → pay = $50,000
 This strengthens the instrumentality perceptions
 Effort  Performance  Rewards
 Increases the motivational effectiveness of the incentive pay system
22
Incentive Pay Systems
 Skill-based pay (pay-for-knowledge): pay is based on work-
related skills, not seniority or job performance
 Example:
 New hire receives initial training to perform the entry-level job and
is paid at the entry-level rate
 As the employee completes training and becomes qualified to
perform additional jobs, the employee is rewarded with pay
increases
 The employee is typically paid at the pay rate associated with the
highest paid job for which the employee has been qualified
regardless of which job the employee actually performs on any
given day
 Creates incentives for employees to complete training, learn
new skills, & become qualified to do additional jobs
 Creates a flexible workforce
23
Incentive Pay Systems
 Profit sharing: some of the company’s profits are shared with the
employees
 Ties each employee’s pay to the profits of the business

Purpose: alignment of employee’s goals with company’s goals

Strengthens the employees’ stake in the company’s profitability
 Example:


Company establishes a minimum profit level as a goal
If actual profits exceed the goal, a percentage of the excess is divided up
among the employees
 Types of profit sharing plans:



Current distribution plans (cash plans): profit sharing paid as a bonus in
the form of cash or shares of the company’s stock
Deferred payout plans: profit sharing paid as a bonus into a trust fund to
be distributed to employees at some time in the future (such as when the
employee retires, becomes disabled, or dies)
Combination plans
24
Incentive Pay Systems
 Gain sharing: when employees make a suggestion that
improves the organization, a percentage of the
organization’s gain from the suggestion is shared with the
employees who made the suggestion
 Example:
 Employees make suggestions
 Management reviews the submitted suggestions, determines the
improvement (gain) from each suggestion, and decides which
suggestions to implement
 A percentage of the gain from a suggestion is shared with the
employees who made the suggestion
 Types of gain sharing: Scanlon Plan, Rucker Plan,
Improshare, & Winsharing

See Fisher, Schoenfeldt, & Shaw (2006), Table 12.5, p. 553, for a
comparison of the types of gain sharing
25
Incentive Pay Systems
 Employee Stock Ownership Plan (ESOP): the company
facilitates employees owning stock in the company
 Methods of distributing stock to employees:
 As a bonus directly to employees
 Example: for every 2 shares an employee buys, the company gives
the employee 1 share
 Example: employees can buy shares for 85% of the current stock
market price
 Into a trust (such as the company’s 401(k) pension plan)
 Company contributes shares of stock into the trust
 Shares in the trust are allocated to individual employee accounts
 Employees become vested over time (cliff after 5 years, or graded
over 3 to 7 years)
 When an employee leaves the company (e.g., retirement), they
receive the current market value of their vested shares in the trust
26
Incentive Pay Systems
 Executive compensation
 If the goal of executive compensation is to create a pay
system in which what is in the best interest of the
stockholders also brings the greatest reward to the
executives, then the pay of executives should:


Be tied to the performance of the company through incentive
pay systems such as bonus plans for the achievement of shortrun goals (such as profits)
And use the granting of shares of stock in the company or
stock options for the creation of long-run incentives
27
Outline





What Is Incentive Pay?
Why Use Incentive Pay?
Does Incentive Pay Work?
Drawbacks of Incentive Pay
Incentive Pay Systems











Piece-Rate
Taylor Plan
Standard Hour Plan
Commissions
Merit Pay
Bonuses
Skill-Based Pay
Profit Sharing
Gain Sharing Plans
Employee Stock Ownership Plans (ESOPs)
Executive Compensation
28