The success of any business or farm ultimately depends on how its employees perform. A basic problem that any owner/manager faces is that employees often have different goals than the owner/manager. For example, the owner/manager wants employees with strong work ethic to take productive actions that increase the profitability of the farm or business while keeping labor costs to a minimum. Employees, on the other hand, often want the highest pay possible, but at the same time, some employees do not always have the interests of the farm or business at hand and therefore may not be the most efficient workers. An intelligently designed pay-for-performance plan can achieve the twin objectives of aligning the interests of the firm and employees, and providing incentives to employees to take productive actions that contribute to the bottom line. A poorly designed compensation scheme, however, can lead to negative unintended consequences, increased labor costs, and ultimately, lower profits. As global competition increases, business risk is higher than ever so that there is more riding on even the simplest actions taken by employees. Thus, intelligently designed compensation plans that increase a worker’s vested interest in productivity while maintaining manageable labor costs can increase a firm’s competitiveness.
This article is the first of a multi-part series covering the basic economic principles of designing optimal pay-for-performance plans – plans that will generate the highest productivity at the lowest labor costs. The design of effective compensation plans has become a science and many business schools and other social scientists devote considerable resources toward the understanding of incentive systems. The purpose of the series is to discuss and illustrate key economic principles developed by business and social science researchers that can help managers design effective pay-for-performance plans and incentive systems. The first part of the series provides an overview of pay-for-performance plans and highlights their impact on productivity using some case studies. Moreover, major research findings by social scientists are summarized. This will lay the groundwork for subsequent parts of this series, which will cover more specific principles and guidelines for designing efficient incentive plans.
Pay-for-performance: Does it Work?
At the heart of any incentive scheme is the method by which monetary compensation is linked to performance. While common sense tells us that people are not motivated only by money (examples of non-monetary rewards include a feeling of pride and self esteem, praise from superiors and co-workers, etc), money is nonetheless a powerful motivator. Even casual observation will tell us that the majority of people in society work because they need to earn money and that they tend to gravitate toward higher paying jobs. It is no accident that demand for slots in our nation’s medical schools, business schools, and law schools far outstrips the supply, as these slots are gateways to the highest paying professions in our society. In addition, even when people value non-monetary rewards, many individuals are willing to substitute non-monetary for monetary rewards, which suggests that money can serve as a general measure of economic value (Baker, Jensen and Murphy).
Our common sense is also verified by numerous research studies that have been undertaken by economists, psychologists and human resource professionals. While a few scholars have argued against pay-for-performance (e.g. Deci; Slater; Kohn), the overwhelming majority of studies show that pay-for-performance plans do improve productivity in many organizations. A common argument against pay-for-performance plans is that explicit monetary rewards can destroy intrinsic motivation. But the large number of studies that show that pay-for-performance plans work, suggests that the eroding of intrinsic motivation argument against pay-for-performance may be specialized to certain types of jobs or certain special situation such as jobs that require a great deal of creativity and latitude.
Ed Lazear, an economist at Stanford University , studied a change in compensation method at Safelite Glass Corporation in Columbus , Ohio . In 1994-95, Safelite changed the compensation method from pure hourly wages to piece rate pay, where glass installers were guaranteed $11 dollars an hour and then can earn addition money depending on number of glass units installed (i.e. pay-for-performance). Lazear examined over 3,000 workers at all Safelite locations over a 19-month period and found the following:
- A switch to a pay-for-performance piece rate system resulted in about a 44% increases in productivity per worker (based on number of units installed per worker per day).
- The output gain can be split into two components: a selection component and an incentive component. The “selection effect” refers to the gain that came from worker turnover where workers either were attracted to the piece rate or left the company because they did not like the piece rate. This selection effect, which is strictly due to a change in composition of workers, had a positive impact on production. In other words, a switch to piece rates also increased the talent level of the installers, which resulted in a 22% increase in productivity. The remaining 22% gain came from increased output for a given worker. In other words, even in the absence of turnover, each worker was incentivized to produce more under the piece rate.
- On average, each worker made 10% more under the piece rate system so some of the cost savings from increased productivity was shared with workers.
Other studies also show that pay-for-performance can be beneficial. For example, M.A. Huselid conducted a study examining the human resources practices of over 3000 companies and concludes that firms that tied pay to performance had annual sales that averaged $27,000 more per employee.
The bottom line is that there is overwhelming evidence in the social sciences literature that pay-for-performance works if it is designed properly. Just as there are success stories, there are horror stories of pay-for-performance plans that went awry because they were not carefully thought out. This series of articles will discuss important principles that can help managers design profit enhancing pay-for-performance plans and avoid implementing “perverse” plans that lead to negative unintended consequences.
Before proceeding, I provide some examples of popular pay-for-performance schemes to add concreteness to the discussion. Common pay-for-performance plans are:
- Merit pay – Raise salary at the end of each year if performance is strong. Some researchers believe merit pay has little impact on performance (Bassett).
- Lump-sum bonuses – A one time bonus (not part of base salary) for good performance. E.g. end of the year bonus. Much less expensive than merit pay because it is not permanently built into the base pay. Thus, it is more efficient than merit pay.
- Piece rate – Pay varies with the number of units produced. Advantage is that it is simple to understand.
- Tournaments – a worker or supplier is awarded a bonus or promotion only if he outperforms another worker or supplier. Only relative performance matters.
Promotions are another way to provide big, discrete rewards for outstanding performers. According to Baker, Jensen and Murphy, promotions serve to (1) match individuals to the jobs for which they are best suited over time, and (2) provide incentives for lower level employees. However, promotions have some problems in that disincentives are created for those who have been passed up because they may perceive their future prospects at the company as being dim. This is particularly problematic if the best performer (therefore one who is most deserving of a promotion) is better suited for her current job because she is the best at it. If she is promoted, she may not be well suited for the new job.
Designing Effective Incentive Systems: Basic Principles
In order to design an effective incentive system, the manager must address some key issues, including the following:
- What objectives does the manager want her employee to pursue?
- How will these objectives be measured and how much transparency is there in the way performance is measured?
- How much control does the employee have over outcome and how risk averse is the employee?
- Will employees work in teams or will they be assessed individually?
- What is the duration of the relationship?
Answers to these questions can help managers avoid major pitfalls when designing incentives. I will address each of these issues in turn in future issues of Ohio Ag Manager. The reader should also keep in mind that the focus of this article is on the economic principles of incentive design, and it does not discuss labor laws or legal issues. Keeping abreast of labor laws is crucial aspect of human resources management and the following OSUE Extension websites provide additional information:
http://www.midamservices.org/maahs/maahswebengine.nsf/homepage
http://ohioagmanager.osu.edu/resources/zoller.pdf
http://ohioline.osu.edu/lines/busi.html#BCDEV