Performance and Compensation

Linking Performance With Compensation

A performance appraisal system is often the link between rewards employees hope to receive and their productivity. The linkage can be thought of as follows:

• Productivity — Performance appraisal — Rewards
  
  
• Performance-based compensation affirms the idea that pay raises should be given for performance accomplishments rather than for seniority.
  
  
• Where a performance-oriented philosophy is followed, organizations do not guarantee additional or increased compensation simply for completing another year of organizational service. Instead, pay and incentives reflect performance differences among employees.
  
  
• Employees who perform well receive larger compensation increase; those who do not perform satisfactorily see little or no increase in compensation. Thus, employees who perform well receive larger compensation increases; those who do not perform satisfactorily see little or no increase in compensation.
  
  Thus, employees who perform satisfactorily, advance in relation to market compensation levels, whereas poor or marginal performers may fall behind. Also, bonuses are determined on the basis of individual, group, and/or organizational performance.

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Traditional Compensation Approach vs. Total Rewards Approach

Traditional Compensation Approach	Total Rewards Approach
Compensation is primarily base pay	Variable pay is added to base
Bonuses/perks are for executives only	Annual/long-term incentives are provided to executives, managers, and employees
Fixed benefits are tied to long tenure	Flexible and portable benefits are offered
Pay grade progression based on organizational promotions.	Knowledge/skill-based broad bands determine pay grades.
Organization – wide standard pay plan exists	Multiple plans consider job family, location and business units

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Performance Related Compensation Design

Employees are the backbone of any organization. Organizational growth and sustainability highly depend on the quality of performance of the employees. Performance management system, therefore, must objectively link the individual level performance of employees with the overall performance of the organizations. Wages or compensation is the most important vehicle of performance management.

Most of the organizations, therefore, embrace the system of performance-linked compensation for its obvious strategic dimension. It facilitates compensation cost optimization, as non-performers do not required to be paid like the performers.

Even with higher payment of compensation to performers, organizations can optimize the compensation cost, as the variables, i.e., the part of compensation payable on performance, need not be paid to the non-performers. Moreover, performance-linked compensation system motivates good performing employees and increases the retention of talents.

Performance management, on the other hand, is an integrated process. It sets objectives, appraises employees, translates objectives into individual key performance areas (KPA), helps in compensation design, and in the process, benefits the organization to achieve its business goals and objectives.

We call it a development tool, as it facilitates performance improvement, career development, and training. Thus performance management involves thinking through various facets of performance, identifying critical dimensions of performance, planning, reviewing, and developing and enhancing performance and related competencies.

It is an ongoing communication process that involves both the managers and the employees:

• To identify and describe essential job functions and relating them to the mission and goals of the organization.
  
  
• To develop realistic and appropriate performance standards.
  
  
• To give and receive feedback about performance.
  
  
• To write and communicate constructive performance appraisals.
  
  
• To plan education and development opportunities to sustain improvement or build on employees’ work performance.

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Benefits of Compensation Based Pay

From compensation management point of view, performance management systems help in achieving following critical goals:

• It helps in recognizing the efforts and contributions of employees ‰ objectively and thereby facilitates in effective job pricing, both through cost optimization and rewarding of talented performers.
  
  
• It facilitates in suitable compensation design, rewarding employees based on the performance linkage.
  
  
• It supports employee motivation (which leads to increased performance), helping employees to receive their performance feedback, understanding their strengths and weaknesses. Employees can develop themselves through self-introspection and thereby feel intrinsically motivated. So also performance- based pay helps in getting extrinsically motivated. Both the motivational constructs lead to improved performance.
  
  
• It facilitates employees to develop their core faculty of goal achievement.

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Performance Related Pay (PRP)

The term performance-related pay (PRP) encompasses several company wide schemes, like employee participation and share ownership schemes, etc. and general linkage with the compensation which the employees get.

PRP schemes are designed and administered based on a view of what the businesses needs are. Firstly, it often fails to deliver because it is not aligned closely to business strategy. Secondly, performance-driven compensation can support constant change and performance improvement, but they can’t deliver these by itself contrary to popular belief. Third, line managers can muddle the process, unless they get the help.

Despite such difficulties in implementing PRP, organizations adopt this.

Areas to be Considered While Implementing PRP in Organizations

Some of the important areas, which deserve attention from the organizations, while they implement PRP are listed below:

• Competition and Cost Control: Performance-related pay enhances corporate performance in a competitive environment. When we link performance and pay together, we also expect employees to behave accordingly.
  
  
• Individualization: Collective relationships in a workplace are a common organizational pursuit to achieve teamwork. PRP is essentially driven by an individualization agenda.
  
  
• Mismatch with the Strategy: Organizations adopt various strategies, depending on their business priorities. A common cost minimization strategy requires different range of behaviours.
  
  
• Monitoring and Evaluation: This is really important and organizations often lack in this. It is not enough to just introduce PRP systems; it is also important to understand how PRP actually benefits the organization. Tracking changes after introduction of PRP through an effective monitoring and evaluation system can do this.
  
  
• Culture: PRP often runs into conflict with the organizational culture. Organizations, which support diversity and pursue principles of equity, may not find it easy to implement, as PRP makes differentiation in pay packages on merit criteria.
  
  
• Use of PRP as an Instrument of Management Control: Many organizations wrongly use PRP as an instrument of management control, pay-roll control, or performance control. But this is not the right approach. In true sense, an effective PRP can help in empowering employees.

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Skill-based Compensation Design

Introducing a skill-based pay system requires several steps to be taken and several issues to be addressed. In designing the Skill-based Compensation/pay, following points should be borne in mind:

• The skills requirements of the enterprise should be analyzed.
  
  
• The availability of resources for training should be ascertained.
  
  
• The jobs to be covered by the scheme should be identified.
  
  
• The individual jobs have to be grouped into ‘job families’ on the basis that in each ‘family’ the skills needs are similar.
  
  
• The skills within each job family and the tasks needed to perform the job should be analyzed.
  
  
• Training modules have to be formulated ‰
  
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• The way in which certification is obtained that the skill has been acquired should be agreed upon.
  
  
• The criterion for extra payment is not acquisition of the skill, but its application.
  
  
• A difficult question is how obsolete skills should be dealt with e.g. through retraining or redundancy.

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Competency-based Pay

Theoretically, in today’s organizations we are more used to the term competency rather than skill. Competency is more holistic, as it aggregates knowledge, skill, and abilities of employees, and even integrates with the behavioural requirements. Instead of paying for the position and the job title, competency-based pay emphasizes on the job accomplishments, much wider than job efficiency (outcome of skill only).

Competency-based pays directly measure knowledge and skills in terms of criticality involved, amount of depth in the job content, and the skills breadth.

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Forms and Types of Performance Linked Reward System/Contingent Pay

There are several types of performance-linked reward schemes. Generally, these are designed to share with or distribute among employees as individuals, groups or collectivity, productivity gains, profit improvement, or the financial gains of the organizational performance.

Such schemes fall into the following broad categories: ‰

• Schemes based on individual or small group performance including piece rates, traditional merit pay, and sales commissions
  
  
• Incentive schemes that relate pay to profit on the basis of a pre-determined formula
  
  
• Bonus schemes based on contribution to productivity profitability according to a with gains sometimes distributed among the individual employees on the basis merit rating.
  
  
• Productivity bargaining
  
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• Long term incentives, Employee’s Stock Option Plans – ESOP
  
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• Competency based pay ‰

Merit Pay or Individual Performance Related Pay

A common method which has long been in existence is pay increase or bonus payment on the basis of performance rating. The merit incentive pay scheme provides another method of recognizing and rewarding differential performance.

This method could particularly be suitable for office staff. The scheme essentially involves the following steps: ‰

• The determination of result-oriented merit rating procedures, ‰ ‰
• The identification of job factors and their relative importance,
• The formulation of a scale of reward, and
• The communication of the basis of monetary reward. ‰‰

Sometimes merit increments and merit awards are also given in recognition of superior performance on the part of individuals. These are poor substitutes for a system of merit incentive pay because of several shortcomings.

Skill Based Pay

Organizations that pursue skill-based compensation programmes reward their employees on attainment of additional knowledge and skills. The underlying philosophy behind this is that on acquiring higher qualifications and skills, knowledge of the employees enhances and, accordingly, it exerts positive impact on their performance.

Some organizations, therefore, motivate their employees to acquire higher knowledge and skill with additional increments or pay rise, as such investment reflects through incremental performance results. With the increased knowledge and skills, employees can also improve their competencies.

To introduce skill-based compensation, at the outset, it is necessary to document the skill requirements for various job components at different job levels, and make it transparent to employees.

Major Obstacles to the Introduction of Skill Based Pay

Although skill-based pay provides multiple benefits, to introduce it, organizations encounter serious problems.

Some of the major obstacles to introduce the skill-based pay can be listed as under: ‰

• Defining skill sets: It is difficult to document the skill sets of a job. Even though organizations can at the outset document skill sets for a well-defined job, it becomes quickly obsolete.
  
  
• Pricing skill sets: This is another major obstacle in introducing skill-based pay. Effective pricing of skill sets is seemingly difficult for the organizations. Often we benchmark with the market pricing, but many organizations may require some unique skill sets for their typical nature of job.
  
  
• Validation of skills: This is also difficult to validate some skill sets. For some jobs, we can use job trial or performance tests to validate the skills and competencies of employees, but for many others, we have to depend on our hunches and subjective assessment.
  
  
• Skill re-certification tests: For some skill sets, it is necessary to ensure that concerned employees are able to sustain their skill, through a periodic skill re-certification programme.
  
  
• Skill obsolescence: Technology changes render change of necessary skill sets. This makes earlier learned skills obsolete, requiring organizations to renew the existing skills through sustained training and development initiatives
  
  
• High cost of training: To introduce skill-based pay, organizations need to locus on employees learning of new activities. Any training and learning initiatives enhance downtime, apart from usual cost of training. Often the benefits accrue fail to recoup the expenses resulting in failure of organizational initiatives. Such possible threat outweighs the benefit of skill-based pay.
  
  
• Increased payroll costs: Often, skill-based pay increases the overall payroll costs. This, however, depends on the nature of the job. If the jobs are simple, employees can quickly learn the skill sets required to perform the job and accordingly can maximize their earnings stepping up production, even when organizations may require curtailing the same.
  
  This problem would be more acute for those organizations whose production planning is market dependent. It would be difficult for such organizations to practice lean management of lean manufacturing.
  
  
• Regulatory bottlenecks: Skill-based pay programmes among others, require organizations to increase the variables, which put the pay at risk. Thus, reduced fixed or basic pay at less than statutory minimum wages may lead to legal complications of average or below average performers who fail to earn the variables for their inability to acquire new skill sets.

Shop Floor Incentive and Bonus Schemes

Incentive of bonus schemes relate to the pay or part of the pay received by the employee to the number of items they produce or processes, the time they take to do a certain amount of work and/or some other aspects of their performance.

They usually provide for pay to fluctuate with performance in the short term, but they can, as in major day work, provide for long-term relationship. They are often referred to as payment by result schemes.

Such schemes are of following types:

• The main types of incentive schemes – individual piece work, work measure individual schemes and measure day work
  
  
• Alternative approaches – high day rates, performance related pay, productivity bonus and the use of other criteria in the bonus schemes.
  
  
• Bonus schemes in different environment
  
  
• Individual Piece Work: In individual or straight piece work a uniform price is paid per unit of production. Operators are therefore rewarded according to the number of pieces they produce or process, so pay is directly proportionate to results.
  
  
• Work Measure Schemes: In a work measure scheme, the job or its component task is timed and the incentive payment is related to performance above the standard time allowed for the job. The amount of incentive pay received depends on the difference between the actual time taken to perform the task and the standard time allowed. If a task is done in less than the standard time, then there is a time saving, which means that the operator’s output will increase.
  
  
• Measure Day Work: In measure day work, the pay of employees is fixed on the understanding that they will maintain a specified level of performance, but pay does not fluctuate in the short term with their performance.

Team Rewards

“Teamwork is the fuel that allows common people to attain uncommon results”.

A group of employees is not necessarily a “team”, but either one can be the basis for variable compensation. The use of work teams in organizations has implications for compensation of the teams and their members. Interestingly, although the use of teams has increased substantially in the past few years, the question of how to equitably compensate the individuals who compose the team remains a significant challenge.

As the following figure notes, organizations establish group or team variable pay plans for a number of reasons. According to several studies about 70% of large firms use work groups or teams in some way. Of those, about 36% say they use group incentives, and 10% say they use team-based pay.

Distributing Team Incentives

Several decisions about methods of distributing and allocating team rewards must be made. The two primary approaches for distributing team rewards are as follows:

• Same size reward for each team member: In this approach, all team members receive the same payout, regardless of job levels, current pay, or seniority.
  
  
• Different size rewards for each team member: Using this approach, employers vary individual rewards based upon such factors as contribution to learn results, current pay, years of experience, and skill levels of jobs performed.

Generally, more organizations use the first approach as an addition to different levels of individual pay. This method is used to reward team performance by making the team incentive equal, while still recognizing that individual pay differences exist and are important to many employees. The size of the team incentive can be determined either by using a percentage of base pay for the individuals or the team as a whole, or by offering a specific dollar amount.

Example: One firm pays team members individual base rates that reflect years of experience and any additional training that team members have. Additionally, the team reward is distributed to all as a flat dollar amount.

Types of Team

There are four types of team that is seen in our working:

• Parallel teams
• Work teams
• Project teams
• Management teams ‰ ‰

• Parallel teams supplement the regular organization structure and perform problem solving and work improvement tasks – examples, quality circles, survey feedback teams, etc.
  
  
• Work teams are responsible for producing a product or providing a service and are self-contained, identifiable, work units that control the processes involved in transforming inputs into measurable outputs. They are found most frequently in manufacturing setting – examples, assembly teams, insurance claim processing teams, etc.
  
  
• Project teams typically involved a diverse group of knowledge workers, such as, design engineers, process engineers, programmers and marketing manager who are brought together to conduct projects for new product development, etc.
  
  
• Management teams are the least frequently used and most poorly understood type of team. There are obvious advantages of a team of well-trained managers.

Team/organization Based Schemes

For designing performance-based compensation, it is imperative to understand the theoretical contexts of various incentives. As the list is long, here we are listing those incentive schemes, which are common for organization.

Barth System

Under this system, there is no minimum guaranteed wage. The formula (considering hourly wage rate of 1) is as follows:

Wage = Std. time 8 hrs × time-taken (6 hrs) × hourly rate 1 = `Rs 7 (approx.)

Bedaux System

This system is also called ‘units’ or ‘points’ system. It has a guaranteed basic rate like the Halsey and Rowan Systems. Under this system each minute of Standard Time is expressed in terms of units or points after a detailed time study. The guaranteed basic wage is paid unto 60 points per hour scored by the worker. Points earned above 60 are paid at 75–100 per cent of the basic wage rate (the standard daily rate for the job which is always higher than the minimum guaranteed wage).

Taylorian System

In this scheme, there are two piece rates: one lower and one higher plus a bonus paid as a percentage of the time rate. Obviously such a system would automatically discourage low production and would be installed where the average performance is well below expectations.

Merrick Differential Piece Rate System

Under this system there are three piece rates:

• Up to, say, 83 per cent of the standard output—a piece-rate + 10 per cent of time rate as bonus.
• Above 83 per cent and up to 100 per cent of standard output— same piece rate + 20 per cent of time rate.
• Above 100 per cent of standard output—same piece rate but no ‰ bonus.

Gantt Task System

This has three stages of payment:

• Below the standard performance, only the minimum guaranteed wage is to be paid.
• At the standard performance, this wage + 20 per cent of the time rate will be paid as bonus. ‰ When the standard is exceeded, higher piece-rate is paid but there is no bonus.
• The main objective of this scheme is to raise the performance up to the standard level which is the task set before the workers.

Emerson Empiric System

Under this system, standard time is established for each job. The efficiency of the worker is determined by dividing the time taken into the standard time. Up to 67 per cent efficiency the worker is paid at this time rate and from this point to 100 per cent, a bonus of 1 per cent is paid for every additional 1 per cent output. At 100 per cent efficiency, a bonus of 20 per cent is paid.

Accelerating Premium System

This provides for a guaranteed minimum wage for output below the standard. For low and average increase in output above the standard small increments in earnings are allowed. Increasingly, large earnings are conceded for the above average output, the increment being different for each 1 per cent increase in output.

Scanlon Plan

The Scanlon plan was designed to involve the workers in making suggestions for reducing the cost of operation and improving the working methods and sharing in the gains of increased productivity. The Rucker plan is similar to the Scanlon plan, the only difference being that in the latter the incentive earnings are calculated on the basis of the ‘value added’ by the manufacturing process.

Halsey Premium Plan

It guarantees a fixed time wage to slow workers and, at the same time, offers extra pay to efficient workers. Extra pay in the form of bonus is given based on the amount of time saved by the worker, which is calculated @ 33½ per cent of the time saved. Thus the cost of labour is reduced because of the percentage premium system.

Rowan Premium Plan

Under this plan, the time saved is expressed as a percentage of the time allowed, and the hourly rate of pay is increased by that percentage of the time allowed, and the hourly rate of pay is increased by that percentage so that total earnings of the worker are the total number of hours multiplied by the increased hourly wages.

While determining performance-based compensation, it is imperative to consider various incentive schemes, and select the appropriate one, keeping pace with the specific nature of work.

Economic Value Added/market Value Added

Companies are using innovative methods to raise their bottom lines and to boost up employees and investors confidence. Economic Value Added (EVA) is the latest in this direction. Economic value added measures the difference between the return on a company’s capital and the cost of that capital.

EVA is the surplus or deficit that remains after levying a charge against after tax operative profits for the opportunity cost of equity and debt. The accounting concept of profit takes into consideration, interest on borrowed capital i.e. debt. The economic value added concept takes into account the economic cost i.e., not only the interest on debt but also the cost of capital invested by shareholders.

EVA is calculated by a combination of three basic factors – net operating profit after taxes, capital and cost of capital. If the EVA is positive, it indicates that the company has created value for shareholders. If the EVA is negative, it signifies contrary.

EVA focuses on thee and helps determine the market value of the company (MVA). EVA is linked to the market value added:

EVA = Total market value less total capital employed.

MVA represents how much wealth a company has created for its investors. (MVA = Discounted present value of future EVA).

A sustained increase in EVA will bring an increase in the market value of a company. This is because continuous improvement in EVA brings continuous increases in shareholder wealth.

EVA incorporates two basic principles of finance into management decision-making.

• The first is that the primary financial objective of any company should be to maximise the wealth of its shareholders.
  
  
• The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital.