Step 6_ Pay for Performance.docx

Step 6: Pay for Performance Step 6 of building a compensation plan considers pay for performance, determining the use of pay that varies with some measure of individual or organizational performance, such as merit, incentives, and variable pay. The third and final functional area of building the com...

Step 6: Pay for Performance Step 6 of building a compensation plan considers pay for performance, determining the use of pay that varies with some measure of individual or organizational performance, such as merit, incentives, and variable pay. The third and final functional area of building the compensation plan is compensation management. Compensation management refers to the activities of making your compensation plan work by addressing individual contributions and providing clear communication to employees. Step 6, pay for performance, is part of the third functional area of building a compensation plan, compensation management. In considering pay for performance, you will determine the use of pay that varies with some measure of individual or organizational performance, such as merit, incentives, and variable pay. Compensation typically consists of two forms, base and variable pay. Base pay is the fixed compensation paid to an employee for performing specific job responsibilities. Although base pay is a vital component to any total rewards package, variable pay is also important. Employees may not always see the link between base pay and organizational objectives, whereas variable pay allows employees to see that link and how their actions reflect the organization and the achievement of its goals. It is important for any variable pay plan to align employee performance to organizational objectives and ensure that employees understand the link. Variable pay is compensation that's contingent on the discretion, performance, or results achieved. Also known as pay at risk, variable pay is not guaranteed and the company needs to hit certain objectives for employees to receive variable pay payouts. Also, most variable pay plans have a targeted amount if goals or objectives are reached and a stretch goals if those goals are exceeded. Variable pay is used to drive organizational performance in such ways as focus. It clarifies important tasks employees must perform to contribute to organizational goals and objectives and assists in establishing measures and those objectives. Alignment. It establishes the link between organizational success and individual performance. Motivation. Variable pay establishes the link with how employees actions can make a difference regarding organizational performance. And finally, reinforcement. Acknowledges the desired behavior and results and provides positive reinforcement. Eligibility and variable pay depends on both the organizational compensation philosophy and strategy and the following key decision factors. Is the employee full or part-time? How does that affect his or her contribution? At what organizational level does the employee reside? How does the position affect organizational performance? Should employees who have poor performance ratings be eligible for participation? Does it matter if an employee is eligible for other variable pay plans? What does eligibility mean and when does it begin? The first day of employment, after the probationary period, the beginning of a measurement cycle or some other criteria. Merit pay programs reward employees for achieving certain levels of performance over a predetermined time in the past. The logic for this approach is straightforward. Employees who perform at higher levels should receive greater rewards. With a typical merit pay increase, employees receive a compensation adjustment based on the results of their performance evaluation. The performance ratings they receive are then used to allocate merit pay increases to them. For example, employees with a low rating of one on a five-point rating scale might receive a merit increase of zero percent or maybe one percent. As performance ratings continue to increase, so too does the amount of the merit increase allocated to the employee. The highest level of performers receive the greatest percentage of increase to their base pay. Someone receiving a score of three might be rewarded with three to four percent and someone with a score of five might be rewarded with a five percent or larger increase. A variation of the merit pay increase is the lump sum merit bonus. Like traditional merit pay programs, lump sum bonuses are often based on an employee's level of performance. The primary difference is the lump sum bonus are not rolled into the employee's salaries. They're a one-time payment. That's an important difference. Compared to merit pay plans, bonuses generally cost companies less because the payouts don't increase their labor costs permanently. As we've suggested, merit pay increases and lump sum bonuses reward employees based on their past performance levels. In contrast, piecework incentive plans are more forward-looking because they reward employees for future performance levels. Under a straight piecework plan, employees receive a certain rate of pay for each unit they produce. Calculating a straight piecework plan is very simple. For example, a salesperson might be compensated one dollar for every call they make to a potential customer. The more call the salesperson makes, the more he or she earns. Under a differential piecework plan, the pay an employee receives per unit produced or delivered changes at certain levels of output. Returning to the salesperson example, a company might implement a differential plan in which employees who make more than 10 calls in one hour receive a dollar and 10 cents for those calls compared to one dollar for those failing to meet or exceed 10 calls. Spot awards are an incentive that companies use to encourage their employees to work towards specific outcomes. Managers give the rewards, often cash, to employees on the spot when they exhibit certain behaviors or achieve certain outcomes associated with excellent performance. Spot awards give managers flexibility because they're linked to a variety of employee actions at any given time. Unlike merit raises or lump sum bonuses, they don't depend on performance evaluations over the course of a review period. Under profit sharing plans, company profits are shared with employees. Procedurally, profit sharing can be distributed to employees as cash or can be deferred. Under a deferred profit sharing plan, the incentive money paid to an employee is put into a retirement account for that person. The plan has a tax advantage because the income the employee earns is deferred until he or she retires. And after people retire, their earnings are generally lower and so income withdrawn from the retirement account is taxed a lower rate. To be effective, variable pay plans, no matter what you choose, need to meet several criteria. First, they need to link your firm's strategic objectives. You have to know exactly what you're trying to accomplish with your incentive plan and provide clear direction. You have to have clear standards. Effective incentive plans have clear standards of performance that employees strive to reach. You must sample the full performance domain. That is, effective incentive plans must give employees an incentive to excel in all aspects of their job. The variable pay standards must be attainable. The standards by which incentives are triggered must not only be clear but they have to be attainable. In addition, they need to be easily understood. Incentive plans must be easy to understand. They also must provide meaningful incentives. Incentives must be meaningful to employees. And finally, we need to evaluate incentives regularly. A final criteria for effective incentive plans is that they must be regularly evaluated to ensure that they're actually motivating people to work towards appropriate individual team and organizational goals. Now go consider implementing pay for performance in your compensation plan.