Performance-based pay schemes have become more widespread in recent decades. The hope is that such incentive schemes boost firm productivity, revenues, and profits; firstly by incentivising existing employees, and secondly by encouraging the most productive employees to apply for and stay in jobs. But do these employee incentives work?
Performance-Based Pay Defined
With this method of compensation, employees are paid depending on how they perform. This could also be referred to as a compensation pay structure in some cases. There are different types of payment schemes that apply to performance pay systems, which are designed to distribute financial rewards to employees. In contrast with set salaries, performance pay is based on compensating the employee per their individual contribution, not the value of the position itself. In other cases, the employees may be paid based on how many units they produce or perform in some other statistical category.
Performance pay offers a variety of benefits. One of the major advantages of performance-based pay is that it gives employees more reason to work hard and perform better. When an employee knows that he can be compensated more, he is willing to put more time and effort into his job. When you are paid on salary, you can only be motivated by that amount of money for so long. With performance-based competition, employees work harder and it ultimately rewards the company as well.
In addition, management enjoys better employee performance and employee engagement. As long as there is a fair and effective performance review system that is accurately aligned with local salary levels, employees will strive to work hard. Executives will enjoy increased revenue and working capital. Management can use performance pay systems to transition model employees into supervisors. HR administrators can use performance pay to attract potential job applicants and improve employee retention. In the beginning, turnover rates may be slightly higher as low performers leave, but qualified and motivated employees will remain.
This form of compensation also has a few potential drawbacks. For example, when the business suffers for reasons outside of the employee's control, it may be harder to perform well. Sales may not come as easily and it can lead to lower paychecks for the employees. This form of compensation also leads to income gaps in society as a whole. Over the years, performance-based compensation has increased while the gap between wealthy and poor has grown. Part of this is due to the fact that those with this pay structure earn more.
Furthermore, some companies struggle to implement performance pay systems because it is hard to define performance levels and objectively evaluate employees. The performance criteria and measurements may be vague and inadequate. As a result, supervisors favor certain employees over others, which increase collective employee dissatisfaction. When employees cannot understand the performance measures, they may still blame management when they fail to receive wage increases. Sometimes, the objective of performance appraisal systems is to merely identify training needs or promotion suitability. The biggest challenge of performance pay systems is that management must continually observe and document employee performance while also providing feedback, which is very time-consuming.
What does research say?
In a 2010 joint Harvard Business School and Yale School of Management study on whether bonuses boost sales productivity within the sales force of a large office supply company, researchers found that:
- Bonuses do increase productivity.
- Quarterly bonuses increase sales force productivity more than annual bonuses.
- Salespeople tend to give up when they’re far away from reaching a quota, but they don’t slow down once a quota is reached, especially if their firm offers commissions for overachievement.
For non-sales roles, the data is equally compelling. More companies are offering short-term incentives, according to a 2018 report by WorldatWork, which surveyed 325 companies, non-profits, and government organizations. The survey results showed that 96 percent of the responding companies had short-term incentive programs in 2017, up from 94 percent in 2015. Spending on short-term incentives rose to a median of 6 percent of operating profits, up from 5 percent in 2015. In addition, about 66 percent of non-exempt employees were eligible for annual incentives, up from 52 percent. In the survey, 74 percent of respondents said their organization’s annual incentive plan was “moderate to effective” in achieving its objective. That rating, along with the increase in the use of incentives, shows that compensation professionals find them successful.
Incentive pay, which is a variable form of compensation, can benefit employers in other ways as well. “During volatile economic times, the use of variable pay allows a company to reward individuals and teams based on current profits and productivity, without the promise or expectation that such rewards will be offered continuously,” according to a 2014 article in the International Journal of Human Resource Studies. This can be observed in Zimbabwe which is currently experiencing volatility in its economy.
While this arrangement does have many benefits, there are also some downsides, according to a study published in the Human Resource Management Journal. The study looked at three different types of “contingent pay” — performance-related, profit-related and employee stock ownership — and how they affected employee attitudes such as job satisfaction, commitment to the company, and trust in management. Here’s what they found:
Only performance-related pay (in other words, pay based solely on the individual employee’s performance) positively affected all three of these employee attitudes. Pay arrangements related to company profit, or employee stock ownership, either didn’t affect employee attitudes or affected them negatively.
But even performance-related pay isn’t all good. The study reports that although performance-related pay positively influenced workers’ attitudes, it also tended to stress them out to a degree that might negate the beneficial effects. Employees in this type of arrangement are more likely to feel they’re being encouraged to work too hard, which decreases their job satisfaction. Ultimately, the stress can lower their productivity — giving performance-based pay the exact opposite effect that was intended.
Making Performance-Based Pay Work
This doesn’t mean you should write off the idea of performance-based pay altogether — but there is a need to take some precautions to make it work for businesses. Organisations can try these tips:
- Strike a balance. Try setting “stretch goals” — performance goals that aren’t easy to achieve, yet aren’t so difficult that employees feel defeated before they even start. You could also set different bonus levels for different levels of performance so that not everyone feels they have to aim for the highest possible level.
- Make it proportionate. Don’t make employees work incredibly hard for a small reward. It’s important to ensure a balance between employee job demands and the reward, the study says.
- Pay attention. Regularly check in with employees and managers to see how your performance-based pay system is working. Do employees seem stressed and overloaded? Perhaps the bar is set too high.
In conclusion, the available evidence shows that performance-based pay schemes are indeed associated with significantly more productive employees. But the scale of the benefits varies according to the type of scheme. The most effective schemes are those that reward employees for individual effort, rather than group performance.
Milton Jack is a Business Consultant at Industrial Psychology Consultants (Pvt) Ltd, a business management and human resources consulting firm.
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