Linking Pay to Employee Performance - Assignment Example

Linking pay to employee performance Introduction Pay is one of the key components in the relationship between employers and employees. It concerns the employees, employers and the government. There are specific reasons why compensation is of interest to all the three parties concerned. To the employer, pay accounts for a significant portion of his total cost of operations; pay can be used to improve employees’ performance and as a result organisational effectiveness, and also has an impact in attracting and retaining an effective workforce. For the employees, compensation has a direct effect on their standard of living and a means to assess the value of their services. For the government, pay levels have an impact on macro-economic factors, such as employment, inflation, purchasing power and socio-economic development.  Even though basic pay makes up a significant portion of the total compensation, the employer is also affected by the benefits offered to the employees, such as fringe benefits, cash and non- cash benefits. In the majority of developed countries and countries with high personal tax rates, the benefits component of executive compensation has been consistently increasing over the past few years (Silva, 1998).  Performance related pay (PRP) “links reward or salary progression to some form of performance rating. This could be part of a performance management or appraisal system, or it could be based on a separate appraisal of performance exclusively for pay purposes.” (Armstrong, 2001). PRP has assumed growing significance in the present times with more and more organisations adopting measures to motivate their workforce. The objective is to drive performance levels by linking employee rewards with organisational goals and objectives (CIPD, 2011).  Benefits and objectives of PRP Pay can have one or more objectives that can be categorised under four heads. The first objective is equity. This can be achieved through various means, such as adjusting income distribution in such a way to reduce the disparity in income levels; bringing the pay levels of the lowest paid employees on par with the rest of the organisation; safeguarding real wages, and ensuring uniform pay for work of equal value. Even differences in pay is made on the basis of skills or performance levels, it is connected to equity (Silva, 1998). The second objective of efficiency has a relationship with the first objective of equity. Efficiency objective comes into play when a part of the pay is linked to employee performance and contribution to the organisation. Macro-economic stability is the third objective. Pay levels have an impact on the employment levels, inflation and purchasing power. Therefore, good and stable pay policies help in contributing towards balanced economic development. Proper allocation of employees in the job market is the fourth objective. This means that employees will take up the job that pays them the best. Employees may be willing to move from one job to another within the same organisation either in the same location or a different location. The movement can also be from one company to another. These job changes are motivated by increased levels of compensation. For instance, employee movement from a low wage area with an adequate supply of labour to a high wage area that has shortage of labour. Employees can also be motivated to acquire new skills when they are aware of the higher pay for additional skills. When the pay levels in the organisation are below the industry standard, it results in higher levels of employee turnover. When the pay is higher than the industry rates, the company is able to attract more candidates for employment (Silva, 1998). Pay and performance may have strong linkages, but to what extent does PRP support the goals and objectives of high performance organisations is a debatable issue. The discussion analyses the key aspects of PRP and its impact of employee performance through an in-depth study of various resources and theoretical evidences put forward by researchers and academicians. Factors determining pay levels and wage structures There are a number of factors that need to be considered while determining the pay levels, including labour laws, minimum wages, trade unions, regulatory stipulations and job contracts with employees. The determinants of compensation include profits, job evaluation, skill set, number of years of experience, cost of living, availability of labour and the negotiating capabilities of the trade unions (Silva, 1998). Even though pay differences take into account skill sets of employees, compensation systems have not been able to use it effectively to motivate employees to acquire new skills and use it in their job. The superior competency of developed nations has not been built on low wages but on the strength of competitive industries. These industries have been able to use continuous improvements in technology, productivity and quality to ensure high compensation and standards of living. Increasingly countries are becoming aware of the fact that low wages cannot sustain superior technology and performance over a longer period of time. As a result, a majority of companies are linking pay increases with performance. This helps them to absorb the increase in labour costs and also motivates the employees to perform better at their job. For instance, countries like Singapore, Japan and Korea have been successful in entering industries based on high value addition, technology and services because they had committed to development of skills of the workforce. These countries understood the fact that higher pay levels are a pre-condition for entering knowledge-based industries. They were able to sustain the pay increases as their investments in training and skill development earned rich dividends in the form of increased productivity and profits (The Economist, 2009). Traditionally, compensation systems for non-executive employees have been driven by standardisation across various industries and within organisations. Prior to liberalisation of economies, employers were mainly competing in the domestic labour market free from foreign competition. The effect of standardisation on performance levels, productivity and employee retention was not significant. But with globalisation and entry of foreign companies, local companies had to compete with companies having high-end technology, more efficient methods of providing goods and services and a global presence (Brown & Heywood, 2002). In the majority of cases, foreign companies are successful in attracting and retaining the best talent by providing compensation at a level that cannot be matched by the local companies. With the rapid growth of globalisation and transformation of planned economies to market economies, governments and businesses have be forced to build new competences in order to be able to sustain and grow in the global market. The objective of a number of developing countries is to link productivity with performance at both the national and organisation levels. They are also aiming at making quality an important component of productivity in order to compete in the global economy. Countries that want to move from manufacturing to high-end technology based industries have to use compensation systems that not only consider differences in skills but also encourage employees to acquire new skills. They need to invest substantially in education, training and skill development of the workforce (Kandula, 2006). Organisations have undergone significant changes in structure, strategies and processes owing to increase in competition but compensation systems have not been updated. It is only in the past few years that compensation is considered a key aspect of organizational change. In terms of measuring performance, the focus has moved from individual performance to group performance and team work. This has created the need for changing to a suitable pay system. In an enterprise, people in different functions may have varied views on pay that may at times be in conflict with each other. For instance, pay may be seen as a cost by top management, as investment by functional managers and by the human resource managers as an effective way to attract and retain the best talent (Unison, 2001). More and more companies are acknowledging the fact that compensation is not merely a cost but can also have a positive impact on performance when used effectively. Successful companies are shifting their focus from individual jobs to groups and processes. This will enable to them to reduce costs, increase adaptability and deliver superior quality of goods and services (Layard, 2011). Types of PRP In the last 15 years, the use of pay systems based on performance has increased significantly. Only private enterprises used performance based compensation systems earlier. This has now changed with more and more public sector enterprises starting to use pay systems based on performance. Performance based compensation systems can relate pay with individual, team or organizational performance. Even though there are a number of pay systems based on performance, they all rely on the assumption that increased pay levels will motivate employees to improve performance (The Economist, 2009). There are a number of performance pay systems, which can either be used individually or be combined. Piecework system is one of the original performance pay systems where a price is determined for each unit of output and workers are paid based on the total number of units they produce. Payments by results method include incentive schemes based on achieving a standard amount of output in a standard amount of time. Bonus earnings can also be linked to the total output of the entire organisation. Merit pay method links the pay and incentives to measurement of individual employees’ contribution to overall performance. In the performance related pay method, specific objectives are set for all employees and the actual performance is compared with the set standard. There is a performance management system in place (Storey, 2007). Competency based pay systems determine pay and bonus earnings based on the assessment of the skill sets of employees, such as communication, problem solving, decision making, leadership, customer service and conflict management. It also assesses their ability to use these skills in fulfilling their job responsibilities. In profit related pay (PRP) method, the bonus and pay levels of employees, mainly senior managers are determined by the profit levels of the enterprise. This is widely used in private companies (Storey, 2007). Effectiveness of PRP and its linkage to employee motivation The effectiveness of all types of PRP is based on the metrics and approach used by management to determine the employee performance levels that form the basis for financial rewards and compensation. The most important steps are determining the goals, periodic appraisal of results, and relating contributions to compensation. There are a number of reasons for companies to use PRP. It enables employers to clearly communicate the organizational goals to employees and link it with performance. PRP helps in motivating employees to improve performance by relating pay levels with achievement of goals. It also enables companies to recognize and reward good performance and assess under performance. It helps in building team spirit. PRP helps in making the compensation system fair and transparent. It helps in enhancing productivity. PRP lends flexibility to the pay system. It can help in solving the problems of employee retention. PRP also facilitates managers to negotiate in an effective way with trade unions (OECD, 2005). The success of compensation systems is based on a number of factors. There are certain limitations in all PRP methods. Research studies have shown that PRP schemes are not as effective as expected in boosting the levels of employee morale and motivation. For instance, in public sector enterprises, cost restrictions may result in the compensation for superior performance not being large enough to motivate employees (Storey, 2007). Inadequate training for managers and ineffective communication with employees has a negative influence on morale. Studies of NHS managers in 1997 and 1998 showed that PRP instead of enhancing performance led to rivalry between employees and reduced motivation levels (Silva, 1998). As PRP systems are based on assessment of individual employees by their managers, bias, favouritism and a lack of objectivity could result in an unfair appraisal that may not give the correct picture of employee performance. This could reduce the motivation levels of the employees. PRP could have a negative influence on individual employees and the organisation by downgrading team work. Employees could be led to believe that it is not performance that determines pay levels but having the right connections (Silva, 1998). Recent studies have shown that there may be discrimination against women in PRP systems. This is because the performance review may be influenced by gender bias. The skill sets of women employees could be subject to undervaluation by their managers. They also get fewer opportunities for training and development. Managers may not be able to correctly identify the training needs of women employees (Silva, 1998). Performance pay methods may work against the creation of fair, transparent and gender free performance appraisal systems for ensuring equitable pay. A study by the Institute of Personnel and Development showed that nearly two-thirds of employers had no mechanisms in place for assessing gender and racial discrimination in their PRP systems (CIPD, 2011). Motivation alone is not enough to improve performance. Employees with high levels of motivation may not be able to perform due to a number of other issues, such as lack of training, ineffective management, inadequate communication and outdated tools and technology. In contrast, employees who are motivated may still perform due to a strict management. Therefore, motivation can have a positive influence on performance only when other issues are resolved (Marsden & Richardson, 1992). Marks and Spencers adopts a well-defined PRP approach that is closely integrated to its performance management systems. The company defines distinctive parameters of performance measurement and evaluation system based on which the financial rewards and compensation benefits are announced to its employees (CIPD, 2007). Theoretical bases for PRP Rewarding an employee with financial compensation is a form of motivation that is intended to increase productivity and encourage others within the organisation to strive harder to reach the specified performance targets. Motivation has been defined as the “driving force that determines the direction and strength of goal-oriented behaviours” (Preker, 2007, p. 240). Performance based pay schemes have failed in many instances to motivate the employees to the desired level of performance. Many explanations have been given for this failure and it is to some extent attributed to the amount of compensation in lieu of the hard work and the management fairness during performance appraisals. Vroom’s expectancy theory and the Adam’s equity theory provide explanation to the fundamental problems faced during the process of deciding the level of compensation. The amount of financial compensation being provided as incentive should meet the extent of hard work required to reach the desired level of performance. This is illustrated clearly in context of Vroom’s (1964) expectancy theory of motivation that claims “motivation is likely only when a clearly perceived relationship exists between performance and outcome and satisfies the need” (Preker, 2007, p. 239). According to this theory the financial motivation works only if the link between effort and reward is clear and the reward is worth the effort. In many organisations the cash rewards or compensation is too small to motivate the staff. Another theory that explains the failure of financial reward compensation schemes in motivating employees relates to the Equity theory put forward by Adam’s in 1965. According to this theory, “people will be better motivated if they think they are being treated fairly and de-motivated if they think they are being treated unfairly” (Preker, 2007, p. 239). The performance related pay systems are based on performance appraisal of the employees by their line managers and most often these appraisals are biased and some degree of favouritism influences the line manager’s opinions. This leads to unfair appraisal and feedback that in turn influences the bonus and pay hikes. In this context it is essential that the management provides tangible yardsticks for measuring performance within the organisation. In certain cases like sales department the number of units sold and amount of sales achieved during a specific period of time forms the base for evaluation. However, workers within an operational environment involving technical processing or administrative functions, make the process of evaluating performance slightly complex. In such cases, the management outlines certain parameters based on which the performance of an employee is assessed. Some of these parameters include quantum of processing done, error rates, and level of innovation applied to get a specific job done. Conclusion An essential ingredient in implementing a successful performance related pay system is the trust in management. Employees need to have complete faith in their managers and the policies adopted by them. This obviously requires “strong management commitment, a top down introduction process, the maintenance of a competitive base salary structure, a valid job evaluation system, a well designed, accurate and trusted appraisal system, a comprehensive and effective communication strategy, regular and systematic training for managers in performance review and feedback and an ongoing monitoring and evaluation process” (Beaumont, 1993, p. 110). The performance related pay system needs to be supported by a thorough understanding of the organizational culture, adequate monitoring and supervision of managers, transparency in communications and suitable growth opportunities to reinforce employee motivation. References 1. Armstrong. M. 2001, A Handbook Of Management Techniques, 3rd ed. London: Kogan Page Limited. 2. Beaumont, P. B. 1993, Human resource management: key concepts and skills, SAGE Publishers. 3. Brown, M. & Heywood, J.S. 2002, Paying for performance: an international comparison, M.E. Sharpe Inc. 4. CIPD 2007, Recruitment, retention and turnover, Annual survey report. 5. CIPD 2011, Performance related pay – factsheet, available from http://www.cipd.co.uk/hr-resources/factsheets/performance-related-pay.aspx 6. Kandula, S.R. 2006, Performance management – strategies, interventions, drivers, Prentice Hall of India. 7. Layard, R. 2011, The case against performance related pay, available from http://www.ft.com/cms/s/0/f2d347bc-6917-11e0-9040-00144feab49a.html#axzz1dvilpWyG 8. Marsden, D. & Richardson, R. 1992, Motivation and performance related pay in the public sector: a case study on the inland revenue, Centre for Economic Performance, London School of Economics, Discussion paper no. 75. 9. OECD 2005, Performance related pay policies for government employees, Organization for Economic Co-operation and Development Publishing. 10. Preker, A. S. 2007, Public Ends, Private Means: Strategic purchasing of health services, World Bank publication. 11. Silva, S. 1998, Performance related and skill-based pay: an introduction, International Labor Office. 12. Storey, J. 2007, Human resource management: a critical text, Thomson Learning. 13. The Economist 2009, Performance related pay, available from http://www.economist.com/node/14301231 14. Unison 2001, Performance related pay – factsheet, Unison Bargaining Support Group report. Read More