Performance Based Pay as a Motivational Tool - Essay Example

Performance-based Compensation Plan Benefits and Risks of a Performance-based Compensation System The Benefits Performance-based pay can motivate the employees of an organization to work towards better organizational performance ( Boachie-Mensah 275). This was the conclusion of a study held at a Ghanaian manufacturing company; 81% of the companys employees supported performance-based compensation. However, for that to happen, certain conditions must obtain. First, the system must be deemed fair and based on merit. There must be in place a system against which employee performance is measured and that system must be well-understood by the employees. 87.5% of the interviewed employees of the company demonstrated knowledge of the companys standard of performance. One would suspect that individual performance-based compensation (as opposed to a group performance-based compensation scheme) would have adverse effects on teamwork among employees. However, the study found that that the scheme ran at the company had no adverse effects on teamwork. Performance-based compensation, if well implemented, may lead to increased job satisfaction among the employees of an organization(Ismail, Raffiuddin and Mohamad 83). A study conducted in seventeen GIATMARA centers in Malaysia came to this conclusion. The study was rolled out in two stages. In the first stage, five experienced employees including two supervisors and three support staff were interviewed in depth at the GIATMARA headquarters in Kuala Lumpur. In the second phase of the study, questionnaires were administered to GIATMARA employees. The researchers set out to investigate employee participation in determining their pay and the extent to which the employees perceived their pay as adequate. The study concluded that a well-executed performance-based pay system leads to job satisfaction. A well-implemented performance-based pay system has at least two features: the employees participate in them and consider their pay adequate. Employee participation is achieved by encouraging employees in various job groups to take part in the design and administration of compensation systems. There is some evidence, albeit less compelling, that performance-based compensation could lead to higher employee retention(Dee and Wyckoff 26), presumably because of the job satisfaction that employees derive from these schemes. This was the verdict of a 2013 study by the National Bureau of Economic Research. The study sought to investigate IMPACT, the rather controversial system used by the District of Columbia Public Schools to evaluate and compensate teachers. The system stands out in that it proposes unusually high, individually-targeted teacher incentives. The incentives are pegged to the performance of the teacher as measured using data obtained from various sources as opposed student academic achievement alone. Employee retention would lead to number of benefits to the company, key among them being low employee turnover. Low employee turnover would save the company time and money that would otherwise have been used to hire and train new employees. The Risks Traditionally, boards of directors, investors and executive pay consultants have held that the more the CEO is paid, the more they are motivated to perform. Some organizations have gone as far as allowing their CEOs to own stocks in the company in the belief that the CEO who owns a share of the company is better motivated to safeguard the interests of the company. However, a 2014 study showed that, across the board, the more CEOs are paid, the worse their companies perform over the next three years with respect to stock and accounting performance(Cooper, Gulen and Rau 15). This statement is true for both the highest and lowest paid CEOs. The study involved 1,500 leading firms whose data was supplied by Execucomp. The researchers studied CEO pay and company performance in periods of three years between 1994 and 2013. The study also found that the negative correlation was most pronounced among the top 150 firms by CEO pay(Cooper, Gulen and Rau 16). This finding challenges the popular notion that it is worth compensating a superstar CEO at a premium. While acknowledging that there could be exceptions at individual firms, the researchers reported that examined as a group, the top 10% highest CEOs posted the worst performance. They returned 10% less to the company owners compared to their industry peers. In fact, the higher one goes the pay spectrum the poorer the performance; the top 5% highest paid CEOs performed, on average, 15% worse than their peers. The also concluded that the longer a highly paid CEO stayed at the helm of a company, the poorer the company performed. The explanation for the negative relationship between CEO pay and company performance can be captured in one word: overconfidence(Cooper, Gulen and Rau 22). Highly paid CEOs tend become complacent and question their decisions less. They disregard any disconfirming information because they believe they are right at all times. That attitude tends to result in over-investing company money in bad projects that yield poor returns for investors. The study found that 13% of the bottom 150 CEOS had pursued mergers in the last one year. The average return from those mergers was -0.51%. 19% of the top 150 CEOS too engaged in mergers. On average, their deals yielded a performance of -1.38% over the following three years. Thus, for the top 150 firms, the returns from mergers are almost three times lower than those of the bottom 150. The researchers described this situation as “wasteful spending” that “destroys shareholder value”. Implications for the Company The most important question for our firm is how to rip the benefits of performance-based compensation while avoiding the possibility of declining performance. The solution lies in “claw-back provisions”. In an employee pay contract, there should be a clause that stipulates that if the employee’s performance fails to meet the set standards, the employee loses a share of their compensation. This recommendation will necessitate that the firm defines and puts in place standards against which performance will be measured. For the CEO, besides company-set standards, their performance will be assessed against that of their industry peers as this is the international practice(Albuquerque 81). Components of the New Compensation System A good performance-based compensation (PBC) system comprises the various incentives that will be proffered to employees, a PBC plan, a system for measuring performance, critical success factors (CSFs) and key performance indicators. Incentive payments include lump sum payments, sales commissions, cash bonuses, profit-sharing, stock ownership, deferred compensation and piece rates(de Silva 13). Lump sum payments are a traditional method of payment. Lump sums are not added to the basic pay. Usually, the relationship between lump sum payments and performance and the formula for arriving at the former will be defined beforehand. Sales commissions are rarely an indicator of the performance of a salesperson because sales can be affected by factors other than the effort of the salesperson. These factors include the quality of the product, its pricing relative to competing products, brand recognition and advertising among other factors. Besides sales figures, no other measurement of performance may be necessary in order to arrive at sales commissions. Another traditional means of payment is piece rates where an employee is paid according to the number of pieces of an item produced as opposed to the time taken to complete them. The incentives may be paid in the present or deferred to a future date. Incentive compensation may also be discretionary and targeted at specific individuals and groups or may be rolled out to all employees of the organization. A PBC plan operationalizes the PBC system(Ismail, Raffiuddin and Mohamad 80). Among other things, it states how high performers will be identified and compensated. PBC practitioners strongly recommend the putting in place the system by which performance is measured. For a marketing firm, for instance, the system could be as simple as the total value of the sales made by a salesperson in a given month. However, total sales may not be a good measure of performance as the demand for a product could be determined by several other factors beyond the ability of the salesperson to persuade and convince customers to buy. Whichever, the system for evaluating performance, it should be kept simple and understandable by all the employees of the organization. The evaluation system should make reference to the organization’s goals as closely as possible. The employees of the organization should see the system as being fair. In addition to the system for evaluating performance, a good PBC system embraces the concepts of Critical Success Factors (CSFs) and Key Performance Indicators (KPIs)( Boachie-Mensah 278). CSFs are those factors that the organization must get right in order to achieve its goals. KPIs, on the other hand, are specific measurable activities which, when accomplished, lead to the achievement of the CSFs. For many industries, KPIs and CSFs are time-tested and well-documented. For instance, in a building construction project, the obtaining of a development permit by the physical planner (on behalf of the developer) from the concerned local authority is a KPI. The development permit paves the way for the others professionals involved in the project to proceed with their work. Action Plan The first stage in the plan execution is the determination of the incentives that will be paid to different levels of employees under the new system. This step will follow the adoption of this plan by the Board of Management. A reputable human resource consultancy will be commissioned to undertake the exercise. The world over, the types and levels of compensation adopted by organizations are, to a large extent, influenced by those of industry(Albuquerque 70). Over the years, this has been the practice especially as far as the compensation of top level managers is concerned. However, in the light of the new system, benchmarking will be necessary for all cadres of staff. A consultancy is better placed to undertake the exercise as the company lacks industry-wide data. The company will factor consultancy fees into its budget for the following fiscal year. Upon the determination of the incentives scheme, the company’s HR manager will immediately embark on developing the system for evaluation of performance under the new compensation system. The HR manager will then constitute an in-house team to train staff on the new compensation system and the evaluation system. Simultaneously, the company’s chief executive will develop CSFs and KPIs in line with company goals and objectives (Dee and Wyckoff 24). The performance evaluation system will in turn be informed by the CSFs and KPIs. Next, a pilot phase of the new system will be rolled out and operated for three months. The pilot phase will involve a few employees representing all levels in the organization. The pilot project will be co-managed by the HR and Finance departments. During this period, the HR manager will look out for the weaknesses of the new system and take the necessary remedial measures( Boachie-Mensah 276). Upon the expiry of the three months, the project will be rolled out throughout the organization. Short Note to the Board of Management A performance-based compensation (PSC) system, if well managed, can bring with it several benefits to the organization. Research has shown that PBC can motivate the employees of the organization to work toward better organizational performance and the realization of organizational goals, but only if the employees understand and can identify with those goals, there exists a system for evaluating performance and the employees understand that system and consider it fair. Research has also shown that where employees deem the PBC system to be fair, it can enhance job satisfaction. Job satisfaction leads to higher employee retention, which in turn save the organization time and money in hiring and training new staff. However, there is a catch: research has also demonstrated that the high compensation of CEOs (and top managers) often leads to poorer performance. The company can mitigate this negative relationship between high pay and poor performance by including “claw-back” clauses in pay contacts: he whose performance declines shall have his compensation reduced. The new compensation system comprises a mix of incentive payments, a system for evaluating performance and CSFs and KPIs (these abbreviations are defined under the “Components of the New Compensation System” section. The implementation of the plan will entail four major stages – determining the mix of incentives to be included, developing a performance evaluation system, defining CSFs and KPIs and implementation. All these stages will be implemented by in-house personnel with the exception of the first one that will be outsourced to an HR consultancy. The new compensation scheme is beneficial to the organization and should be adopted. Works Cited Boachie-Mensah, Francis. "Performance-Based Pay as a Motivational Tool for Achieving Organisational Performance: An Exploratory Case Study." International Journal of Business and Management 6.2 (2011): 270-285. Albuquerque, Ana. "Peer firms in relative performance evaluation." Journal of Accounting and Economics 48 (2009): 69-89. Cooper, Michael, Huseyin Gulen and Raghavendra Rau. Performance for pay? The relation between CEO incentive compensation and future stock price performance. Salt Lake City: University of Utah, 2014. de Silva, Sriyan. "An Introduction to Performance and Skill-based Pay Systems." Geneva: International Labour Office, 2010. Dee, Thomas and James Wyckoff. INCENTIVES, SELECTION, AND TEACHER PERFORMANCE: EVIDENCE FROM IMPACT. Cambridge: National Bureau of Economic Research (NBER), 2013. Ismail, Azman, Nurhana Raffiuddin and Mohd Mohamad. "Performance-based Pay as a Determinant of Job Satisfaction: A Study in Malaysia Giatmara Centres." Ideas (Online Journal) (2011): 77-88. Read More