Pay for Performance Compensation Systems

Overview

Pay for Performance Compensation Systems (a.k.a. variable, performance-based, incentive-based, merit pay), are formal compensation systems that are directly tied to organizational or individual performance. Such systems are most effective when based on objective measures of quantity or quality of performance.

Organizational Behavior Modification (OBM) applies concepts of operant conditioning to the management of human resources and performance. Such theories contend that behavior results in consequences, either as reinforcers or punishments. Recognition, feedback and incentives are common forms of reinforcement used in business. But, according to OBM theory, such rewards are only reinforcing to behavior if they cause an increase in the frequency of desired behaviors. Therefore, if pay is to have an impact on work motivation, it must be linked directly to the performance of desired behaviors. (Pinder, 1999).

To link pay to performance, organizations must have a comprehensive, standardized, well-communicated and implemented performance appraisal system that addresses core competencies that “have a proven impact on business” (Wiscombe, 2001). Performance evaluations must be conducted frequently and in a manner that allows performers to alter their behaviors accordingly. Additional resources for performance support, such as training and development, will be required of any organization attempting to implement such a system.

When applied appropriately, pay for performance plans may also reflect or improve the strength of organizational culture. Mayberry’s 1985 study demonstrated that, in organizations where “goals are clear, a work ethic is emphasized, and employees are evaluated and rewarded for their accomplishments” (as cited in Pinder, 1999, p. 75), employees were more motivated to perform. Brethower (1998) provides an interesting analysis of the so-called “Hawthorne effect” wherein performance is thought to improve due to managers paying more attention to performers. While monetary incentives provided to workers cannot fully explain the increased performance, “the pay-for-performance system was important in supporting the other changes. For example, it is unlikely that as many suggestions would have been made without the monetary incentive; it is extremely unlikely that as many suggestions would have been made if the suggestions had been ignore” (p. 58). It is important to recognize that pay alone is not an effective motivator. Coordination with other performance interventions and cultural standards such as feedback, evaluations and increased management support is essential to successful pay for performance plans. Linking performance to rewards may also increase the commitment an employee makes to an organization and job satisfaction. Though research cannot support these intuitive assumptions, there may be indirect influence on performance when employees feel their efforts are valued by an organization.

Implementing a pay for performance compensation plan requires major organizational change and is not without serious challenges. Narrow views of performance outcomes may result in a focus on quantity over quality. Performance appraisal processes that are too subjective, arbitrary, or based on forced ranking systems may lead to dissatisfaction and even litigation if employees experience overt bias or discrimination. When the focus is on individual performance alone, competition against coworkers may hinder efforts at teamwork (Wiscombe, 2001).

Case Studies

Lincoln Electric, Cleveland, Ohio

“Through this well-defined group of incentives, Lincoln encourages and compensates individual initiative and responsibility. Employees work together to reduce costs and improve quality. These individual and cooperative efforts create a more profitable company, the success of which each person shares according to his or her own contribution” (“Working at Lincoln”, 2004).

James Lincoln “believed that employees could work efficiently, enthusiastically, have fun at their jobs, and be loyal and secure” (Hastings, 1996). As CEO, he initiated a piecework pay system, an Employee Advisory Board, and group life insurance for employees in the early 1900s (“Our History”, 2004). Since that time, Lincoln’s incentive performance system has been a “cornerstone” of this industrial organization’s culture (“Working at Lincoln”, 2004). The system has been widely studied and sets a standard for other organizations. Additional features of this pay-for performance system include annual profit-sharing (in place since 1934) and guaranteed employment regardless of the economy (no layoffs since 1948) (“Working at Lincoln”, 2004).

The combination of objective measurement of individual performance with management support of the employees’ value to the organization seems to have paid off, even in times of economic recession and business downsizing and closures. In 1996, Lincoln Electric employees were more than twice as productive as other workers in the same type of business, they were earning almost twice as much as the average U.S. manufacturing worker, and the company was expanding (Hastings, 1996). For more information, see Lincoln Electric's website.

Nucor Corporation, Charlotte, North Carolina

This steel manufacturing company has adopted a performance-based pay system and organizational culture similar to Lincoln Electric. Employees can receive bonuses of over 100 percent their base salary. They have the highest productivity rate and lowest labor costs of any American steel company. In 2000, the average pay for a steel mill worker was $63,000. Needless to say, they also have the highest wages in the industry (Wiscombe, 2001). For more information, see www.nucor.com.

Douglas County Federation of Teachers, Douglas County, Colorado

Traditionally, teachers have been paid according to a combination of years of service and educational level. Taxpayers have voiced a desire for some sort of system that allows teachers to get paid for the quality of their instruction. Teachers have resisted such systems, due to the reliance on measures of student performance for determining merit pay. It is common for teacher’s unions and school districts to be at odds on the issue, resulting in very limited implementation of pay-for-performance plans in public schools.

In 1993, facing major budget problems, teachers and school officials put their differences aside and collaborated on the development a performance-based pay plan. This plan includes base salaries set by education level and “evaluation credits” (Hartman & Weil, 1997). These annual evaluation credits determine if an educator has earned another successful year of service. If an evaluation is unsatisfactory, there is no raise, not even for cost of living adjustment or years of service, and the teacher is ineligible for any of the additional bonus incentives.

The “Group Incentive Plan” provides all eligible teachers with an annual cash bonus if students achieve academic goals as determined by a group incentive board (“Creating a Performance-based Pay Plan”, 2000). The “Outstanding Teacher” program rewards teachers who can demonstrate student performance and personal development through the submission of portfolios, reflective writings, personal development plans, and evaluations from peers, students and parents (Hartman & Weil, 1997). Teachers are rewarded for participation in and application of certain skills valued by the organization. These “Skill Block” rewards require the teachers to demonstrate the impact of their newly acquired skills on students in their classrooms (“Creating a Performance-based Pay Plan”, 2000). Finally, the “Responsibility Pay” plan rewards teachers for participating in activities that normally are not compensated. Such activities are based on the needs of the school and may range from curriculum development to participation on an administrative or school governance committees (“Creating a Performance-based Pay Plan”, 2000; Hartman & Weil, 1997).

Rob Weil, President of the Douglas County Federation of Teachers (DCFT), attributes the improvement in student performance to the overall improvements brought about by the incentive plan: “But it’s not just the pay plan. It’s a combination of that and curriculum development, dedicated teachers and administrators, and other factors” (“Creating a Performance-based Pay Plan”, 2000). For more detailed information on this plan, see the DCFT website.

Consultants/Experts

William B. Abernathy, Ph. D.

Background:

Website: www.abernathyassociates.com

Publications:

Alyce Dickinson, Ph. D.

Background:

Website: www.wmich.edu/psychology/faculty/dickinson.html

Publications:

Edward E. Lawler III, Ph. D.

Background:

Website: www.marshall.usc.edu/ceo/

Publications:

Current Trends

Resources

References

Abernathy, W. B.   (2004).  The sin of wages: Where the conventional pay system has led us, and how to find a way out.  Retrieved October 9, 2004 from http://www.abernathyassociates.com/Article7.htm.

Brethower, D. & Smalley, K.  (1998). Performance-based instruction.  San Francisco: Josey-Bass/Pfieffer.

Creating a performance-based pay plan that works. (2000).  Curriculum review, 39, 9.  HTML full-text retrieved October 9, 2004 from http://80-web4.epnet.com.libproxy.boisestate.edu

Hartman, D. B. & Weil, R. (1997).  Developing a performance pay plan for teachers: A process, not an event.  Retrieved October 9, 2004 from http://www.aft.org/topics/teacher-quality/downloads/perfplan.pdf

Hastings, D. (1996). The role of incentives, profit sharing, and of human resources in the United States.  Canada-United States Law Journal, Vol. 22, p. 135.  HTML full-text retrieved October 9, 2004 from http://80-web4.epnet.com.libproxy.boisestate.edu

Our History – A Century of Excellence, A Future of Innovation. Retrieved October 9, 2004 from www.lincolnelectric.com/corporate/about/history.asp

Pinder, C. C.  (1999). Work motivation in organizational behavior.  Saddle River, NJ: Prentice-Hall.

Wiscombe, J.  (August 2001).  Can pay for performance really work?  [Electronic version].  Workforce, 28-34.

Working at Lincoln.  Retrieved October 9, 2004 from www.lincolnelectric.com/corporate/career/default.asp