Pay for Performance and

Financial Incentives
LO1: Motivational Theories
underpinning Incentive Plans
What motivates an
employee the
most?
Money and Motivation
The relationship between money (in other words, incentives) and
motivation was most prominently explained by Fredrick Taylor.

⮚Frederick Taylor’s scientific management

– Popularized scientific management technique to overcome
the problem of “systematic soldiering”.
• Systematic soldiering: the tendency of employees to work at the
slowest pace possible and to produce at the minimum acceptable level.
• Scientific management involved establishing benchmark work standard
(fair days work), attempts to improve work methods in a scientific
manner and providing financial incentives to high performing
employees who exceeded the work standard.
• Scientific Management surmised that:

⮚Incentives
– Financial rewards paid to workers whose production
exceeds a predetermined standard.
Linking Strategy, pay and
performance
⮚ So, Fredrick Taylor first proposed that a clear relationship exists
between money, motivation and consequently performance.

⮚ However, the link between these are not so clear. As many

factors such individual employee’s personality, unfair appraisal
of performance, inaccurate work standards etc. complicate the
link.

⮚ Similarly, individual differences also create ambiguity in the

relationship between money and motivation, as exhibited in the
next slide.
Individual Differences
⮚ Law of individual differences
– The fact that people differ in personality, abilities,
values, and needs.
– Different people react to different incentives in
different ways.
– Managers should be aware of employee needs and
fine-tune the incentives offered to meets their needs.
– Money is not the only motivator.

To better understand the link between money and

motivation, it is important to explore some of the
motivational theories and their implications for
Incentive design.
Motivational theories underpinning
Incentive design

1. Maslow’s Hierarchy of needs Theory

2. Herzberg’s two factor theory
3. Devi’s Theory
4. Vroom’s Expectancy Theory
5. Behavior Modification theory of B F Skinner
1. Abraham Maslow’s Hierarchy of
Needs

– Lower level needs must be satisfied before higher level needs can
be addressed or become of interest to the individual(Prepotency
Process Principle).

HR needs to identify at which stage of the hierarchy an

employee is and then develop an incentive type which will
cater to that need specifically.
2. Herzberg’s Hygiene–Motivator
theory
– Hygienes (extrinsic job factors)
• Inadequate working conditions, salary, and incentive pay can
cause dissatisfaction and prevent satisfaction.
– Motivators (intrinsic job factors)
• Job enrichment (challenging job, feedback and recognition)
addresses higher-level (achievement, self-actualization) needs.
– The best way to motivate someone is to organize the
job so that doing it helps satisfy the person’s higher-
level needs.

The implication of this theory is that, HR should focus

more on motivators to intrinsically motivate an
employee. Relying exclusively on financial incentives
is dangerous and unsustainable.
3. Edward Deci’s Theory

– Offering an extrinsic reward for an

intrinsically-motivated act can conflict with
the acting individual’s internal sense of
responsibility.
– In simpler words, extrinsic rewards can
sometimes detract an employee from
his/her internal motivation.

So, HR should realize that Some behaviors are

best motivated by job challenge and
recognition, others by financial rewards. HR
should therefore design its incentive plan
using a mixture of both and not rely too
4. Vroom’s Expectancy Theory

A person’s motivation to exert some level of

effort is a function of three things:

Employee confidence building and training, accurate appraisals,

and knowledge of workers’ desired rewards can increase
employee motivation.
5. Behavior Reinforcement Theory
⮚ This theory states that an organization
should design it’s incentive plan in such a
way that enables it to modify its employees
behaviors by giving them rewards or
punishments contingent on performance.
LO2: Types of Incentive Plans
Basic Terminology
⮚ Before studying about the incentive types,
some terminologies have to be understood.
These are:

– Pay for performance plans: A plan where

pay is tied with some measure of employee
performance (productivity, behavior, ethics
etc.)
– Variable Pay: Is more specific than “pay for
performance plans”. Here, payment is tied
with a measure of organizational
performance usually profitability.
Types of Incentive Plans
The incentive types can be classified broadly based on
the type of employee to which it is offered. The
classification based on this criteria is as follows:

1.Individual Employee Incentive and Recognition

program/Plans
2.Sales people Incentive Plan
3.Incentives for Teams
4.Incentives for Managers and Executives
Individual Incentive Plans
⮚ Piecework Plans
– The worker is paid a sum (called a piece rate) for each unit
he or she produces.
• Straight piecework: A fixed sum is paid for each unit the
worker produces under an established piece rate standard. The
standard rate is determined using management approximation
of “fair hour wage” and “fair hour productivity” (piece rate=fair
hour wage/fair hour productivity). An incentive may be paid
for exceeding the piece rate standard.
• Guaranteed Piecework: An hourly minimum wage is paid
(regardless of whether standard target is met) and additional
unit based payment is made if production exceeds
predetermined standards.
• Standard hour plan: Workers are paid using piece rate but the
worker also gets a premium equal to the percent by which his
or her work performance exceeds the established standard.
Individual Incentive Plans (cont’d)
⮚ Pro and cons of piecework
– Easily understandable, equitable, and
powerful incentives
– Quality problems caused by an overriding
output focus
– Employee resistance to changes in
standards or work processes affecting
output
– Possibility of violating minimum wage
standards
– Employee dissatisfaction when incentives
either cannot be earned due to external
factors or are withdrawn due to a lack of
need for output
Individual Incentive Plans (cont’d)
⮚ Merit pay
– A permanent cumulative salary increase the
firm awards to an individual employee
based on his or her individual
performance. Unlike Bonuses, Merit pays
become a part of the employees basic
salary.
⮚ There are two adaptations of merit pay
options:
– Annual lump-sum merit raises that do not
make the raise part of an employee’s base
salary. This is infact a bonus.
– Merit awards tied to both individual and
organizational performance.
 Merit Award Determination Matrix
(an example)

To determine the dollar value of each employee’s incentive award: (1) multiply
the employee’s annual, straight-time wage or salary as of June 30 times his or
her maximum incentive award and (2) multiply the resultant product by the
appropriate percentage figure from this table. For example, if an employee had
an annual salary of $20,000 on June 30 and a maximum incentive award of 7%
and if her performance and the organization’s performance were both “excellent,”
the employee’s award would be $1,120: ($20,000 × 0.07 × 0.80 = $1,120).
Table 12–1
 Merit Award Determination Matrix
(an example)

An employee earned an annual salary of taka 600,000 last year. The company
has set the maximum incentive award limit at 10% of the annual salary. During
the year the employee had an individual performance rating of “Outstanding”.
However, the company’s performance was “marginal”.

The company assigns following score to the performance parameters;

Outstanding = 1, excellent = 0.8, good =0.6, marginal= 0.2, poor= 0

While calculating merit award, individual performance is given more importance

and weight of 0.7. The remainder is for organizational performance.

What is the merit award attributable to this employee?

Ans: 45600 tk

Table 12–1
Individual Incentive Plans (cont’d)
⮚ Incentives for professional employees
– Professional employees are those whose
work involves the application of learned
knowledge to the solution of the employer’s
problems.
• Lawyers, doctors, economists, and engineers.
⮚ Possible incentives
– Bonuses, stock options and grants, profit
sharing
– Better vacations, more flexible work hours
– improved pension plans
– Equipment for home offices
– Recognition and self actualization
Individual Incentive Plans (cont’d)
⮚ Non-Financial and
Recognition-based awards
– Recognition has a
positive impact on
performance, either
alone or in conjunction
with financial rewards.
• Combining financial
rewards with nonfinancial
ones produced
performance improvement
in service firms almost
twice the effect of using
each reward alone.
– Day-to-day recognition
from supervisors, peers,
and team members is
important.
Incentives for Salespeople
⮚ Salary plan
– Straight salaries
• A fixed salary is paid per month. There is no connection with the amount of
sales made.
• Best for: prospecting (finding new clients), account servicing, training
customer’s salesforce, or participating in national and local trade shows.
• Makes it easier to switch sales people from one territory to another.
However, high performers might become disgruntled.
⮚ Commission only plan
– Pay is only a percentage of sales
• Keeps sales costs proportionate to sales revenues.
• May cause a neglect of nonselling duties.
• Can create wide variation in salesperson’s income. This might lead to
questioning of appraisal process, unjustly.
• Likelihood of sales success may linked to external factors rather than to
salesperson’s performance. This might be unfair to the sales people.
• Can increase turnover of salespeople.
• Under this plan, Sky is the limit for sales peoples earning potential. At the
same time Abyss is the floor.
Incentives for Salespeople (cont’d)
⮚ Combination plan
– Pay is a combination of salary and
commissions, usually with a sizable salary
component. (Typically, 70%-30%)
– Plan gives salespeople a floor (safety net) to
their earnings.
– Salary component covers company-
specified service activities.
– Plans tend to become complicated, and
misunderstandings can result.
Incentives for Salespeople (cont’d)
Specialized Combination Plans

⮚Commission-plus-drawing-account plan
– Commissions are paid but a draw on future
earnings helps the salesperson to get
through low sales periods.
⮚Commission-plus-bonus plan
– Pay is mostly based on commissions.
– Small bonuses are paid for directed
activities like selling slow-moving items.
Incentives for Managers And
Executives
⮚ The incentive plan for managers and executives is
extremely crucial.

⮚ It should be designed in such a way that it encourages

managers to focus on achieving the strategic goals of the
firms.

⮚ Using multiple, strategy based performance criteria for

determining the incentive of the managers. For example,
criterions could include financial profitability, number of
strategic goals met, employee productivity measures etc.
Short-Term Incentives for Managers
And Executives
⮚ Annual bonus
– Plans that are designed to motivate short-
term performance of managers and are tied
to company profitability. The amount of
bonus that an employee will receive
depends on four factors:
• Eligibility basis: job level, base salary, and impact on
profitability
• Fund size basis : nondeductible formula (net income) or
deductible formula (Operating profit)
• Individual awards: personal performance/contribution
• Formula: The formula used to calculate the bonus
amount
Example of formula: Multiplier Approach to Determining
Annual Bonus

Note: To determine the dollar amount of a manager’s award, multiply the

maximum possible (target) bonus by the appropriate factor in the matrix.

Typically, more weight is placed on company performance whilst determining

the bonus of top level executives. In contrast, individual performance is given
more importance for lower level employees bonus determination.

Table 12–2
Long-Term Incentives for Managers
And Executives
⮚ Stock option
– The right (but not obligation) to purchase a specific
number of shares of company stock at a specific
price (Sx) during a specific period of time (M).
– Options have no value (go “underwater”) if the price
of the stock drops below the option’s strike price (the
option’s stock purchase price).They are valuable
when they are “in the money” (ST > Sx )
– There are many types of stock option plan:
• Plain vanilla stock option
• Indexed option (Strike price varies with market index)
• Premium priced option (strike price is set at a premium)
Long-Term Incentives for Managers
And Executives (cont’d)
⮚ Other plans
– Stock appreciation rights: Executive can benefit from exercising
the stock on maturity date or by taking equivalent amount of cash
or a bit of both.
– Performance contingent stock plan: Managers are given the stocks
only after he/she meets preset performance standards. Helps
avoid problem of awarding mediocre managers.
– (time based) Restricted stock plans: Executives are awarded
shares without any cost. However, the executives are barred from
selling the stock until a certain amount of time matures. This
works like a golden handcuff.
– Phantom stock plans: Instead of shares, employees receive “units”
similar to shares. After some time, executives receive cash amount
equal to any appreciation enjoyed by the phantom units.
⮚ Performance achievement plans
– Plans whose payment or value is contingent on financial
performance measured against objectives set at the start of a
multi-year period. Stocks are directly awarded to employees when
financial targets are met.
Long-Term Incentives for Managers
And Executives (cont’d)
Problems of Stock options plans

1.Might even reward mediocre managers

2.Might lead to corporate scandals
3.Encourages short term risk taking to momentarily
boost profit
4.Encourages poor corporate governance especially
with respect to information dissemination
5.Promotes “shareholder view” of financial management
instead of “stakeholder view”
Other long term management and
Executive Incentives
⮚ Golden parachutes
– Payments companies make to departing
executives in connection with a change in
ownership or control of a company. It is a
defense tactic like “white angel”, “scorched
earth” etc.
⮚ Guaranteed loans to directors
– Loans provided to buy company stock.
– A highly risky and now frowned upon
practice.
Creating an Executive
Compensation Plan
⮚ Define the strategic context for the executive
compensation program.
⮚ Shape each component of the package to focus the
manager on achieve the firm’s strategic goals.
⮚ Create a stock option plan to meet the needs of the
executives and the company and its strategy.
⮚ Check the executive compensation plan for
compliance with all legal and regulatory requirements
and for tax effectiveness.
⮚ Install a process for reviewing and evaluating the
executive compensation plan whenever a major
business change occurs.
Team/Group Incentive Plans
⮚ Team or group incentive plan
– A plan in which a production standard is set
for a specific work group, and its members
are paid incentives if the group exceeds the
production standard.
– It is a very sensitive plan and care must be
taken with regard to how to reward the
team performance. As wrong decisions
could be deadly for the company like in the
case of Levi Strauss US factory.
– Many companies have relied on proper
employee selection, training and peer
pressure to address the problem of “free
rider” in a team incentive system.
How to Design Team Incentives
⮚ Use an engineered production standard based on the
output of the group as a whole.
– All members receive the same pay, based on the
piece rate for the group’s job.
• This group incentive can use the piece rate or standard hour
plan, but the latter is more prevalent.
• Or, All members receive the same pay earned by the highest
producer.
• Or, All members receive the same pay earned by the lowest
producer.

⮚ Tie rewards to goals based on an overall standard of

group performance
– If the firm reaches its goal, the employees share in a
percentage of the improvement (in labor costs
saved).
Types of Team/ Organizationwide Variable
Pay Plans
⮚ Profit-sharing plans
– Cash plans
• Employees receive cash shares of the firm’s profits at
regular intervals. It improves employee commitment.
– Deferred profit-sharing plans
• A predetermined portion of profits is placed in each
employee’s account under a trustee’s supervision. This
plan is beneficial for employees retirement planning. It
basically acts as a pension.
Scanlon Plan
⮚ Scanlon plan (Joseph Scanlon, 1937) : A very progressive plan
renowned for its ability to synchronize firm goals with individual
employee goals. It is based on five pillars/philosophies.
– Philosophy of cooperation
• No “us” and “them” attitudes that inhibit employees from developing a sense of
ownership in the company.
– Identity
• Employees understand the business’s mission and how it operates in terms of
customers, prices, and costs.
– Competence
• The plan depends a high level of competence from employees at all levels.
– Involvement
• Employees must be involved in trying to improve firm performance by suggesting
new ideas and innovations.
– Sharing of benefits formula
• Employees share in 75% of the savings that happened due to their involvement
(i.e reduction in payroll expenses divided by total sales).
Gainsharing Plans
⮚ Gainsharing
– An incentive plan that engages many or all
employees in a common effort to achieve a
company’s productivity objectives.
– Cost-savings gains are shared among
employees and the company.
– So, Scanlon plan was a early version of a
gainsharing plan.
– The Lincoln incentive system is a type of
gainsharing plan.
• Profits are distributed to employees based on their
individual merit rating.
Implementing a Gainsharing Plan
1. Establish general plan objectives.
2. Choose specific performance measures.
3. Decide on a funding formula.
4. Decide on a method for dividing and distributing the
employees’ share of the gains.
5. Choose the form of payment.
6. Decide how often to pay bonuses.
7. Develop the involvement system.
8. Implement the plan.
At-Risk Variable Pay Plans
⮚ At-risk variable pay plans that put some
portion of the employee’s weekly pay at risk.
– If employees meet or exceed their goals,
they earn handsome incentives.
– If they fail to meet their goals, they forgo
some of the pay they would normally have
earned.
⮚ i.e employees might agree to forgo 10% of
their base pay if they fail to meet a
performance target. However, if they do meet
the target then they will get a bonus of 20% of
their base pay.
Organizationwide Variable Pay Plans
(cont’d)
⮚ Employee stock ownership plan (ESOP)
– A corporation annually contributes its own
shares—or cash (with a limit of 15% of
compensation) to be used to purchase the
stock—to a trust established for the
employees.
– The trust holds the stock in individual
employee accounts and distributes it to
employees upon separation from the firm if
the employee has worked long enough to
earn ownership of the stock.
Advantages of ESOPs
⮚ Employees
– ESOPs help employees develop a sense of
ownership in and commitment to the firm,
and help to build teamwork.
– No taxes on ESOPs are due until employees
receive a distribution from the trust, usually
at retirement when their tax rate is lower.
⮚ Shareholders of closely held corporations
– Helps to diversify their assets by placing
their shares of company stock into an ESOP
trust and allowing them to purchase other
marketable securities for themselves in
their place.
Advantages of ESOPs (cont’d)
⮚ The company
– A tax deduction equal to the fair market
value of the shares transferred to the
trustee.
– An income tax deduction for dividends paid
on ESOP-owned stock.
– The Employee Retirement Income Security
Act (ERISA) allows a firm to borrow against
employee stock held in trust and then repay
the loan in pretax rather than after-tax
dollars.
– Firms offering ESOP had higher shareholder
returns than did those not offering ESOPs.
LO3: Guidelines for designing an
effective incentive plan
Why Incentive Plans Fail
⮚ Performance pay can’t replace good management.
⮚ You get what you pay for.
⮚ “Pay is not a motivator.”
⮚ Rewards punish.
⮚ Rewards rupture relationships.
⮚ Rewards can have unintended consequences.
⮚ Rewards may undermine responsiveness.
⮚ Rewards undermine intrinsic motivation.
Implementing Effective Incentive
Plans
⮚ Ask: Is effort clearly instrumental in obtaining the
reward?
⮚ Link the incentive with your strategy.
⮚ Make sure effort and rewards are directly related.
⮚ Make the plan easy for employees to understand.
⮚ Set effective standards.
⮚ View the standard as a contract with your employees.
⮚ Get employees’ support for the plan.
⮚ Use good measurement systems.
⮚ Emphasize long-term as well as short-term success.
⮚ Adopt a comprehensive, commitment-oriented
approach.
Thank You