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

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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

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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

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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

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Does Incentive Pay Work?

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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

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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

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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

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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

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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

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Incentive Pay Systems

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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

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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

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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

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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

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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)

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Incentive Pay Systems

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Incentive Pay Systems

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Incentive Pay Systems

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Incentive Pay Systems

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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

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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

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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

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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

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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

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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
short-run 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

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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

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