There are two basic types of “pay-for-performance” plans: individual incentive plans and group incentive plans. Individual incentive plans have been around for many years. They were particularly popular during the height of the scientific management movement over a hundred years ago in the form of piece rate incentive plans. For example, in those early days a person loading iron ingots in a steel mill could earn as much as 7 cents per long ton (2,200 pounds) under an incentive plan. As a result, a highly skilled loader could make 50 percent more money per day than an individual who was being paid a basic day rate.43 So individuals who were willing to work hard and had the necessary stamina could opt for incentive pay that was determined by the amount of iron ore they were able to load each day.
Individual Incentive Pay Plans
Like the piece rate incentive plan of the pioneering scientific managers, today’s individual incentive plans also pay people based on output or even quality. For example, at Woolverton Inn’s hotels, housekeepers are given a 40-item checklist for each room. Those who meet 95 percent of the criteria over six months of random checks receive an extra week’s salary. Most salespeople work under an individual incentive pay plan earning, for example, 10 percent commission on all sales. At Lincoln Electric in Cleveland, Ohio, there is an individual incentive plan in effect that, over the years, has helped some factory work-ers earn more than $100,000 annually.44
Pay for some jobs is based entirely on individual incentives. However, because of the risk factor, in the very turbulent economy of recent years many companies have instituted a combination payment plan in which the individual receives a guaranteed amount of money, regardless of how the person performs. So a salesperson might be paid 10 percent of all sales with a minimum guarantee of $2,000 per month. Another popular approach is to give the person a combination salary/incentive such as $26,000 plus 5 percent of all sales. A third approach is to give the person a “drawing account” against which the indi-vidual can take money and then repay it out of commissions. An example would be a
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salesperson who is paid a flat 10 percent of all sales and can draw against a $25,000 account. If the first couple of months of the year are slow ones, the individual will draw on the account, and then as sales pick up the person will repay the draw from the 10 percent commissions received.
The Use of Bonuses
Another common form of individual incentive pay is bonuses. The signing bonus is one of the biggest incentives for athletes and upper-level managers. For example, Conseco Inc., an insurance company, paid Gary Wendt, a former executive at General Electric, a $45 million bonus for agreeing to join the company for at least five years as its chairman and chief exec-utive officer. Additionally, Conseco also paid Wendt a multimillon dollar bonus at the end of his second year based on the firm’s performance, and a minimum bonus of $2.8 million was to be paid at the end of the fifth year.45Although this bonus package is extremely large, successful managers and individuals who can generate large accounts for a firm can also expect sizable bonuses. For example, the PaineWebber Group recruited a top-producing brokerage team from one of its competitors by offering the group a signing bonus of $5.25 million and an additional $2 million if they bring more customers to PaineWebber.46In the roller-coaster economy, most companies are moving to bonus pay based on performance rather than fixed pay increases. A survey of a wide array of firms found that 10.8 percent use bonuses compared to only 3.8 percent ten years before,47but The Wall Street Journal report at the end of 2008 indicated that pay raises of any kind were likely to sink in the com-ing years.48
The Use of Stock Options
Another form of individual incentive pay is the stock-option plan. This plan is typically used with senior-level managers and gives them the opportunity to buy company stock in the future at a predetermined fixed price. The basic idea behind the plan is that if the exec-utives are successful in their efforts to increase organizational performance, the value of the company’s stock will also rise.49During the boom period several years ago, many firms depended greatly on stock options to lure in and keep top talented managers and entrepre-neurs. However, if these lucrative options were not exercised, when the economy had a meltdown, these stock values in many cases were halved or less. For example, Oracle’s stock was off 57 percent from its high when CEO Lawrence J. Ellison exercised his option and lost more than $2 billion, but he still made $706 million, more than the economy of Grenada and one of the biggest single year payoffs in history.50More recently, there are reports of increasing numbers of firms trying to counteract unprofitable stock options held by top managers by exchanging the options for cash and/or issuing new options with a bet-ter chance of becoming profitable. The organizations doing this feel it is necessary to keep and motivate top talent, but of course the stockholders (and general public) object because nobody makes good their losses when stocks decline.51
Potential Limitations
Although bonuses and stock options remain popular forms of individual pay, there are potential problems yet to be overcome. A general problem inherent in these pay plans may have led to the excesses and ethical breakdowns experienced by too many firms in recent years. For example, as an editor for the Financial Times observed, “If we treat managers as financially self-interested automatons who must be lured by the carrot of stock options and beaten with the stick of corporate governance, that attitude will become self-fulfilling.”52 There is recent research evidence supporting such observations. A study found that the heads (CEOs) of corporations holding stock options leads to high levels of investment
Chapter 4 Organizational Context: Reward Systems 97
outlays and brings about extreme corporate performance (big gains and big losses). The results thus indicate that stock options prompt CEOs to take high-variance risks (not sim-ply larger risks), but importantly it was also found that option-loaded CEOs deliver more big losses than big gains.53
In addition to these underlying problems, another obstacle is that reward systems such as pay for performance are practical only when performance can be easily and objectively measured. In the case of sales, commissions can work well. In more subjective areas such as most staff support jobs and general supervision, they are of limited, if any, value. A sec-ond problem is that individual incentive rewards may encourage only a narrow range of behaviors. For example, a salesperson seeking to increase his or her commission may spend less time listening to the needs of the customer and more time trying to convince the indi-vidual to buy the product or service, regardless of how well it meets the buyer’s needs. Also, there may be considerable differences along customer and industry lines with salespeople operating under the same incentive plan. For example, the New York Times sales force had considerable heterogeneity among clients that resulted in substantial earnings inequity and failure to pay for performance. When the plan was restructured and customized for each area, the sales force perceived the new plan as fairer and more motivational.54
Finally, especially in light of the ethical issues brought out in the recent economic crisis, the pay for performance, unfortunately, does not add the qualifier, pay for performance with integrity. As explained by a recent analysis of executive compensation:
The omission—evident from compensation committee reports in top companies’ proxy statements—is striking. Corporations, after all, face unceasing pressures to make the numbers by bending the rules, and an integrity miss can have catastrophic consequences, including indictments, fines, dismissals, and collapse of market capitalization. Furthermore,
performance with integrity creates the fundamental trust—inside and outside the company—
on which corporate power is based. A board should explicitly base a defined portion of the CEO’s cash compensation and equity grants on his or her success in handling the foundational task of fusing high performance with high integrity at all levels of the company.55
Bonuses are also proving unpopular in some situations such as educational compensa-tion. Delegates to the National Education Association convention, for example, recently rejected the idea of linking job performance to bonuses. One reason is that the association believes that a bonus system will discourage people from teaching lower-ability students or those who have trouble on standardized tests, as bonuses would be tied to how well students perform on these tests.56Finally, individual incentive plans may pit employees against one another that may promote healthy competition, or it may erode trust and teamwork.57One way around this potential problem is to use group incentive plans.
Group Incentive Pay Plans
As Chapter 11 will discuss in detail, there has been a growing trend toward the use of teams. There is increasing evidence that teams and teamwork can lead to higher productiv-ity, better qualproductiv-ity, and higher satisfaction than do individuals working on their own.58As a result, group incentive pay plans have become increasingly popular.59 One of the most common forms of group pay is gain-sharing plans.60These plans are designed to share with the group or team the net gains from productivity improvements. The logic behind these plans is that if everyone works to reduce cost and increase productivity, the organiza-tion will become more efficient and have more money to reward its personnel.
The first step in putting a gain-sharing plan into effect is to determine the costs associ-ated with producing the current output. For example, if a computer manufacturer finds that it costs $30 million to produce 240,000 printers, the cost per printer is $125, and these data will be used as the base for determining productivity improvements. Costs and output are
98 Part One Environmental and Organizational Context
then monitored, while both the workers and the managers are encouraged to generate cost-saving ideas and put more effort into producing more with better quality. Then, at some pre-determined point, such as six months, costs and output are measured and productivity savings are determined. For example, if the firm now finds that it costs $14 million to pro-duce 125,000 printers, the cost per unit is $112. There has been a savings of $13 per printer or $1,625,000. These gain-sharing savings are then passed on to the employees, say, on a 75:25 basis.
A number of organizations use gain-sharing in one form or another. At Owens Corning, for example, the company has instituted a gain-sharing plan designed to reduce costs and increase productivity in the production of fiberglass. Savings in the manufacturing cost per pound are then shared with the employees. In another example, Weyerhaeuser, the giant forest and paper products company, employs what it calls “goalsharing” in its container board packaging and recycling plants. The company’s objective is to enlist the workforce in a major performance improvement initiative designed to achieve world-class performance by reducing waste and controllable costs and increasing plant safety and product quality.
Although the research evidence to date is somewhat mixed and complex, there is definitive evidence that gain-sharing plans can have a significant impact on employee suggestions for improvement.61
Another common group incentive plan is profit sharing. Although these plans can take a number of different forms, typically some portion of the company’s profits is paid into a profit-sharing pool, and this is then distributed to all employees. Sometimes this is given to them immediately or at year-end. Some plans defer the profit share, put it into an escrow account, and invest it for the employee until retirement. To date, research on the impact of profit sharing on performance via improved employee attitudes has been mixed. However, one study of engineering employees did find that favorable perceptions of profit sharing served to increase their organizational commitment (loyalty).62
A third type of group incentive plan is the employee stock ownership plan or ESOP.
Under an ESOP the employees gradually gain a major stake in the ownership of the firm.
The process typically involves the company taking out a loan to buy a portion of its own stock in the open market. Over time, profits are then used to pay off this loan. Meanwhile the employees, based on seniority and/or performance, are given shares of the stock, a key component of their retirement plan. As a result, they eventually become owners of the com-pany. However, because new accounting rules require more oversight, many companies such as Kodak, Aetna, and Time Warner are reducing the number of employees who are eli-gible to receive ownership in their firm as part of the incentives package.63Also, when the media company Tribune recently filed for bankruptcy, it exposed the risks to employees who had bought into the ESOP, especially retirees and those who were promised deferred compensation.64
Potential Limitations
As noted earlier, group incentives plans are becoming increasingly popular. However, they may have a number of shortcomings. One is that they often distribute rewards equally, even though everyone in the group may not be contributing to the same degree. So all of a team or defined group may get a gain-sharing bonus of $2,700, regardless of how much each did to help bring about the productivity increases and/or reduced costs. A second shortcoming is that these rewards may be realized decades later as in the case of an employee’s profit sharing or ESOP that is placed in a retirement account. So their motivational effect on day-to-day performance may, at best, be minimal. A third shortcoming is that if group rewards are distributed regularly, such as quarterly or annually, employees may regard the payments as part of their base salary and come to expect them every year. If the group or firm fails to
Chapter 4 Organizational Context: Reward Systems 99
earn them, as has been the case in recent years, motivation and productivity may suffer because the employees feel they are not being paid a fair compensation.
Realizing that base pay, merit pay, and both individual and group forms of incentive pay all have limitations, organizations are now beginning to rethink their approach to pay as an organizational reward and formulate new approaches that address some of the challenges they are facing in today’s environment.65For example, especially labor-intensive firms such as Marriott Hotels, which annually pays billions to their people, have undergone an exam-ination of their reward systems to align with associates’ needs, improve attraction and retention, enhance productivity, and in general increase the return invested in people.66The result has been the emergence of what are sometimes called “new pay” techniques.