Pay for Performance: What does it mean?
Human Resource Management research has long focused on the topic of compensation methods. Over time, HR managers have invented a wide assortment of compensation methods that include, among others, base salaries, bonuses, commissions, piece-rate plans, profit-sharing plans, fringe benefits, etc. One of recent improvements is the pay-for-performance method. Under this system, the supervisor regularly adjusts compensation in accordance with performance. The goal of such compensation plans is usually “to improve the equity of pay practices by providing more compensation to the highest performers” (US Merit Systems Protection Board, n.d.). Employees working in organizations applying pay-for-performance to determine at least a part of their salaries are motivated to put more effort in their work to receive positive assessment from their supervisors in the process of evaluation. At times, the management chooses to base its assessment on the opinion of an employee team. This method improves cooperation and creates good conditions for teamwork.
Pay-for-performance compensation aims to boost productivity by increasing workers’ motivation. However, management scholars have expressed doubt that such improvements are possible with the help of this plan and will create the desired effect. In this paper, we will evaluate the evidence collected from a variety of sources that demonstrates the pros and cons of this compensation method and helps evaluate its effectiveness.
Positive Features of Pay For Performance
Pay for performance is effective in environments where several criteria are met:
- Employees’ motivation has serious effect on performance.
- Employees’ motivation appears inadequate.
- Regular compensation schemes do not convincingly show connection between skills, performance, and pay levels.
This is especially topical in public service environments where officials are regularly confronted with “more highly paid employees, who serve not as role models that one should strive to emulate, but rather as glaring examples of the inequities of the pay program” (Hyde, 2005, p. 3). In some public offices, pay-for-performance methods were used to complement the existing compensation system. Thus, employees began to receive small bonuses. This helped remove the feeling of unfairness that is often generated by inequitable compensation. As of now, employees see a well-established link between their pay and performance.
A pay-for-performance system “also provides a clearer focus on results” (Crum, 2003, p. 60). The organization relying on pay-for-performance can use this tool to communicate to the workforce what is expected of them and what the management emphasizes in their work. In a manufacturing company, the management will probably prefer to connect performance incentives to quality that, in turn, can be evaluated by the proportion of defects. In this case, employees are unlikely to remain insensitive to quality control efforts. Overall, an improvement in quality can be the direct result of applying pay for performance measures (Hyde, 2005, p. 3).
The pay-for-performance system also enhances the control of the manager over the resources available to influence employees (Hyde, 2005, p. 3). When pay for performance is applied, the managers at the middle level of an organization are more likely to make decisions than top managers. In this way, they will receive more control over their employees. Working at lower levels of an organization, middle-level managers can receive greater opportunities to motivate their employees.
The system may come in useful in organizations that traditionally suffer from lower compensation levels that make their salaries not really competitive with other similar positions. In public management, for instance, it “may help agencies retain their most valuable employees and provide a way to compete with the private sector for highly capable talent” (Crum, 2003, p. 60). Pay for performance will help keep the loyalties of skilled and experienced employees with special bonuses. Other, less valuable employees, can be granted the same compensation levels provided they are more easily replaced.
The merits of pay for performance come to the spotlight when compared with other alternatives. Many organizations prefer to reward their skilful and productive employees for their contribution with a pay raise or promotion. However, the problem with permanent changes in the individual’s compensation is exactly its permanent character. Once an employee received a pay raise, the organization cannot lower it again without disastrous consequences for motivation. In this case, the person’s performance will inevitably deteriorate. In comparison, under a pay for performance scheme, employees have to strive for consistently high performance levels. They realize that if they show slack, their pay raise will be forfeited. This is a great advantage to organizations that are willing to “maintain some sort of budget neutrality” (Crum, 2003, p. 61).
Pay For Performance: The Downside of the Method
Although effective in many cases, the implementation of the Pay for Performance compensation method can in many cases lead to insignificant increases in performance, produce no observable change, or even lead to deterioration in productivity and quality of work. This happens despite expectations that employees’ performance will benefit from a new type of incentives that will inspire them to improve their work quality and apply extra effort. Managers usually turn to such incentive policies because they “expect performance standards will outweigh the costs of whatever incentives they put in place” (Lagace, 2003).
On the other hand, the management of Rejuvenation Inc, a Portland, Oregon-based brass fixture manufacturer, abolished their incentive program because they found that “craftsmen were stealing parts from other craftsmen to meet quotas, and workers were pacing the production of fixtures to gobble up overtime, then working like maniacs to achieve production bonuses” (Hays, 2006). In this way, pay-for-performance can create ‘unhealthy’ competition, leading workers to push ahead of each other to grab a larger share of the pie. Since many people are sensitive to changes in their compensation packages, many will be so motivated to demonstrate superior performance that they can turn to unethical measures in order to boost their numbers.
Indeed, introduction of pay-for-performance can lead to dismal results in many cases. U.S. Merit Systems Protection Board (2006) explains it by the fact that “the effectiveness of a pay for performance system can be undermined by flaws in the design, implementation, and operational phases”. The implementation of the Pay for Performance compensation method can also depress creativity and innovation that are not easily assessed with reliable numerical indicators and therefore cannot be translated into pay-for-performance measures. It is important to design appropriate performance measurements against which the success of an employee will be benchmarked. Failure to select appropriate criteria will result in skewing workers’ effort toward certain measures that may not represent the company’s priorities or will represent only some of them. For example, a manufacturing company that chooses to reward employees and management based on the output in their departments will not want to let quality out of the picture.
The problem with pay for performance is also that not all aspects of an employee’s work can be effectively captured in measurable benchmarks. This is true of creativity, ability to build relationships with clients, innovative potential, leadership ability, and many other skills, especially those that produce results over the long term. Failure to link them to compensation will result in situation when employees who perform well on these measures can feel eclipsed by their colleagues who demonstrate more measurable results.
Another assumption underlying pay for performance is that pay is either the most important motivator or one of the most important ones. However, this may not be true for all professions. For example, public service professionals “are motivated by a desire to contribute to the public good and a desire to do a good job” (Crum, 2003, p. 61). Excessive reliance on payment methods can depress their performance instead of stimulating it.
Organizational Evidence: Does It Work in Practice?
The balance of positive and negative factors can take an individual turn in each separate organization. As a result, research demonstrates both positive and negative instances of pay for performance system’s effect on the situation in individual organizations.
A successful example is Eastern Michigan University where “a recently implemented merit pay system was given credit for helping to dramatically improve the performance of the athletic program” (Lowery et al., 1995, p. 475). In the natural gas industry and an R&D company, these projects have successfully been used to improve overall business performance (Lowery et al., 1995, p. 475). The same effect was recorded by the administration of New York City when it added the pay-for-performance component to employee compensation.
However, in many cases research failed to find a reliable connection between merit pay and performance and in others the result was negative. Gratz (2005), evaluating the effects of a pay for performance system implementation within Denver’s Pay for Performance pilot for school teachers, arrives at the conclusion that “test-based pay for performance doesn’t work”. In the project, the teachers’ compensation was linked to the performance of their students on tests measured by test scores. The ultimately inferred ineffectiveness of the method was deemed due to several factors. In the first place, the project faced numerous technical difficulties as it was not that easy to link teachers to students in various databases. On the conceptual level, it was imperative that evaluators “know how much that achievement has changed during the time the students have studied with that teacher”; that is, the tests had to measure student growth, not actual achievement level. This was a challenging task indeed. There was also a debate about the type of assignments that would best evaluate the student’s current level: rubric-driven assignments or a broader range of tasks? In general, it can be concluded that the work of teachers is too complex and involves too many intangibles to allow of an effective use of pay for performance methods.
Harder (1992) shows a different picture, describing the effects of pay for performance methods in an athletic environment. Focusing on professional football and baseball players, he determines that pay for performance seems to boost the achievement of those whose rewards are above the average. For those on the lower end of the scale, such methods generate “less cooperative and more selfish behavior” (Harder, 1992, p. 321). In this way, this method is likely to stimulate the “stars”, but everybody else can be de-motivated as a result of perceived inequity in pay levels. As it happens, many organizations can be in danger of alienating their “B” players with pay for performance, and this is the last what most managers want since it will repel the stable majority that forms the backbone of each organization. This position is compared to “sending the message to the fully-functioning majority of our workforce that they are not valued when in fact exactly opposite is true” (Crum, 2003, p. 63). Harder (1992) states that “linking pay to performance may prevent performance decreases in light of underreward”. It is the feeling of being underrewarded that will produce a negative effect on employees that have not received a significant pay increase under the new system. This means that the effect of the system will be subject to individual variation across different groups of employees. The effect on the whole organization is likely to be driven by the relative weight of drops and rises in performance levels by different groups.
While these cases show the inherent problems with the pay-for-performance model, many programs fail because of flaws in implementation. This is true concerning the Transportation Security Administration. The review issued by an inspector general shows that the TSA “handed out bonuses last year to 76 percent of its executives but to only 3 percent of its rank-and-file employees” (Hyde, 2005, p. 4). This distribution of pay for performance awards creates a situation when the management obviously exploits the HRM tool to improve their position compared to the rest of the employees. It is obvious that transparency of decision-making concerning compensation levels is required to make it work for most of the employees. Inequitable treatment is the expected outcome of such measures, and it can in many cases mask exploitation of authority.
Lowery et al (1995) investigate the results of applying a pay for performance compensation system in a large public utility, evaluating the outcomes through the prism of employee perception. Their survey showed that “only 47% of the public utility’s employees agreed that the pay plan had improved their productivity” and “just 44% of the organization’s employees said that the quality of their work had improved as a result of the plan” (Lowery et al, 1995, p.477). Interestingly, when asked about their individual performance, most employees (70%) reported a self-perceived improvement in performance and most stressed progress in their work habits. Researchers explain why these reports (improvement in performance and work habits against lack of increase in productivity and work quality) by the fact that employees may be dissatisfied with the new compensation plan. Either the plan was not properly implemented, or the nature of the work does not allow of an effective application of pay for performance measures, but in any case self-perception of employees demonstrates that the plan was not as effective as it was hoped to be.
Making Pay for Performance Work: Effective Implementation
The above discussion demonstrates that pay for performance is not a panacea for performance improvement. The results from research are mixed. Some researchers record improvements, while others stress that the method had not met expectations. It appears more likely to have positive effects on ‘stellar’ performer, at the same time depressing the outcomes of the ‘ordinary’ employees. In many cases, implementation was clearly found to be a problem. This means that managers can do a lot to improve the chances of success for pay-for-performance programs.
Factors determining the outcome of the pay for performance measures are “ensuring that employees are provided with meaningful feedback on their performance, ensuring that the work goals of employees are of high quality, and ensuring that employees believe that the rewards of the plan are truly based on their performance, a situation termed “reward contingency” (Lowery et al, 1995, p.477). All these goals should be achieved for a new compensation plan to gain support from employees. Performance should be evaluated in a straightforward, understandable way that has a clear link to compensation increases or decreases. The case of the Transportation Security Administration discussed above clearly illustrates what lack of transparency in determination of compensation levels can do to effectiveness of pay for performance plans.
The pay for performance systems should be set based on clear specification of goals and objectives of the organization. In fact, setting priorities effectively is the key to organizational success. An organization that fails in this first step cannot expect to get any of the other areas to function effectively, including the employee compensation. Managers note that “a compensation system cannot resolve inadequate goals setting; it actually makes it worse” (Bates, 2003). The system should reward the behavior that the company wants from employees, not distribute gifts. That is why an effective pay for performance system would be the one linked effectively to the goals set by the organization.
The systems should also consider the type of culture that already exists and strive to change it in the way that is believed appropriate. This challenge was met by Charles Schwab, a brokerage firm, as it switched to online brokerage. The company had to design a compensation system that would promote team work in a traditionally individualistic brokerage environment. In the end, the company turned to balanced methods, adopting “a system that required an entire branch to hit its target before any branch, group, or team bonuses were awarded” (Day et al, 2002, p. 46). This system combined individual bonuses with a system that emphasized the collective component.
Application of Pay for Performance Systems in Different Types of Organizations
Organizational designs, structures, and cultures can vary dramatically. The impact of these factors on implementation of new compensation methods can hardly be overrated. In fact, it emerges from the research that pay-for-performance systems have to be linked to the specific features of the organization. For some organizations, they are not recommended because their specific features prevent the success of pay for performance compensation no matter how well this system can be designed and implemented.
The approach works best in business companies and departments where selling skills are emphasized. Bates (2003) claims that “establishing performance pay systems has been easiest in organizations or units where job performance and results are easiest to see and quantify, such as in sales”. The reason for success is the easy quantification of outcomes that are conveniently measured in terms of sales volume. In this case, the compensation based on merit also demonstrates a clear connection to organizational goals. As such, it can be meaningfully linked to strategic priorities that include increased sales volume.
However, pay for performance is not just for sales departments. In many cases, it can be connected to performance of employees engaged in other areas as long as measurement and link to organizational goals is possible. It can be successfully applied, for example, “in a customer relations call center, managers can record the number and length of calls handled by each worker or each group of workers and can survey customer satisfaction” (Bates 2003). As long as skills critical to success in crucial areas can be quantified and translated into tangible outcomes, the management’s challenge is only to link these outcomes to compensation levels in a fair and effective manner.
In contrast, pay for performance is likely to fail where a lot of intangibles are involved, such as intellectual contribution, innovation, creativity, emotional response to the client, etc. In the teaching compensation experience in Denver, it was found out that in case of applying pay for performance, “the impulse to narrow the curriculum is heightened, as can be seen in urban schools across the country” (Gratz, 2005, p. 568). The pay for performance can only capture how students do in pre-specified areas; yet this compensation scheme does not reward the teachers who want to broaden learners’ experience beyond the narrow boundaries of the curriculum. Yet this is where many teachers make their special contribution to children’s development, highlighting provocative and intriguing topics that motivate self-directed exploration. Pay for performance will inevitably miss intangibles and is thus hardly applicable in areas where their proportion is high.
Day et al (2002) in McKinsey Quarterly note that the success of pay for performance also depends on the possibility to measure the outcomes of an activity here and now. They state that “corporate incentive schemes encourage managers to concentrate either on executing current tasks or on developing and implementing new business ideas to fuel future growth, but not both” (Day et al, 2002, p. 46). This is why in areas where managers concentrate on current tasks, their aptitude in execution of those can be measured and tied to pay levels. However, when the results of the manager’s actions are likely to come to light only after a few months or years, a workable pay for performance system should be hard to design.
Pay for performance may also prove detrimental in stimulating novices in the department who are bound to be less productive because of their relative inexperience. Being constantly reminded of their lower performance and penalized in terms of pay levels, these individuals may feel frustrated about their performance and compensation. It is a good idea to grant to new employees a grace period during which their performance is appraised under conditions that do not affect their salaries. Organizations and units with a large proportion of new employees may find that they have to rely less on pay for performance or perhaps suspend its implementation till all employees can work on a level playing field.
The ultimate success of pay for performance depends on a variety of factors, including the interplay between the compensation and culture. These two factors exert mutual influence upon each other. Culture is changed and re-shaped with the change of the compensation policy when it begins to embrace a greater pay-for-performance component. However, to be successful, this method should be applied to a cultural environment where it does not clash with currently accepted norms, values, and beliefs.
Zierler et al (1998), assessing the impact of pay for performance when applied to physicians in a hospital, states that some doctors comparing base salary to salary linked to output suggested that physicians that are more economically motivated will leave the entity that provides only base salaries with no incentives, and in this way organisational culture “self-selects” itself. This is also suggested by the administrator who insists that concerning the compensation based on output, “high producers love it and low producers hate it and say it affects quality” (Zierler et al, 1998). These confessions demonstrate that the compensation method selected by the organization will exert influence on culture by driving away those that disagree with it and attracting a different type of people. With all or most professionals, increasing the component of compensation that is based on output relative to the total compensation package will attract high performers and consequently increase the volume of output in an organization. However, the organization also needs to recognize that such a move can be problematic for quality, and if there is no reliable method to account for quality, it should be used with caution.
However, culture, too, can influence the introduction and implementation of compensation methods. The cyclical relationship between culture and pay method is demonstrated in the diagram prepared by the US Merit Systems Protection Board (n.d.): when pay-for-performance is introduced, it gradually changes the culture that, in turn, affects the ease with which the plan is implemented. The aspects of culture that exert influence on the implementation of the plan are communication, including upward and downward communication, and values and behaviours acceptable in the organization. For instance, in a strongly individualistic culture putting pay in dependence on group evaluation may not be as effective. Bates (2003) also notes that “the corporate culture has to accept this kind of reward/risk system” for a pay performance system to succeed.
Pay for performance methods have many advantages as they help focus employees’ attention on desired goals and have the potential to improve their performance. They can also produce many negative effects, depressing employee morale and motivation, repelling employees with average or less-than-average performance, and failing to boost performance that cannot be translated into numbers. At the same time, many problems with pay for performance stem from incorrect implementation or inappropriate design of the program. If these faults are corrected, there is no doubt that this compensation approach can prove more useful in a great variety of organizations. In general, the efficacy of merit-based pay methods should be treated with caution since it has been shown to lead to modest results in many organizations, even if some projects had a great success. In general, the management needs to conduct a thorough audit of the organization’s specific features and arrive at a workable plan for compensation methods, considering all alternatives and organization’s specificity.
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