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September 2001
Vol. 10, No. 08,
pp 23, 25, 27.
Workplace Perspectives
Milton Zall
Pluses and minuses of variable pay

opening artInnovations aim to align compensation with performance.

Employers nationwide are searching for inventive ways to tie employees’ pay to performance, while still remaining attractive in a competitive job market. Alternative or “variable” compensation looks like one way to accomplish these objectives and may be the wave of the future.

Variable compensation is becoming a more common method for rewarding employees while linking their performance more closely to the employer’s financial success. Some companies are allowing all levels of employees to participate in these programs. Executives of corporations have long been rewarded with bonuses for increased sales or productivity, the thinking runs, so why not bring this same compensation method to middle management and even onto the shop floor?

Variable pay is an innovative way to bring wages and salaries in line with companies’ market performance. It is really a rather simple concept that’s based on rewarding employees for increased sales or efficiency. Rewarding employees who increase productivity or efficiency provides incentive for other employees who want to share in the bounty. Rather than rewarding every employee with a pay raise or bonus, variable pay rewards the individual worker, or a team of workers, for extraordinary efforts.

Types of Plans
Individual-based plans are the most widely used pay-for-performance plans in industry. Of the individual-based plans commonly used, merit pay is by far the most popular; its use is almost universal. Merit pay consists of an increase in base pay, normally given once a year. Supervisors’ ratings of employee performance are typically used to determine the amount of merit pay granted. Once a merit pay increase is given to an employee, it remains a part of that employee’s base salary for the rest of his or her tenure with the firm.

Team-based pay plans normally reward all team members equally based on group outcomes. These outcomes may be measured objectively or subjectively. The criteria for defining a desirable outcome may be broad or narrow. As is less commonly done in individual-based programs, payments to team members may be made in the form of a cash bonus or in the form of noncash awards such as trips, time off, or luxury items.

Plantwide or company-wide pay-for-performance plans reward all workers in a plant or business unit on the basis of the performance of the entire plant or business unit. Profit and stock prices are generally not meaningful performance measures for a plant or unit because they are the result of the entire corporation’s performance. Most corporations have multiple plants or units, a factor that makes it difficult to attribute financial gains or losses to any single segment of the business. Therefore, the performance indicator most frequently used to distribute rewards at the plant level is plant or business unit efficiency, which is normally measured in terms of labor or material cost savings compared to an earlier period or another plant or business unit.

The broadest type of variable-pay incentive programs—company-wide pay-for-performance plans—reward employees on the basis of the entire corporation’s performance. The most widely used program of this kind is profit sharing. Profit sharing is a company-wide pay-for-performance plan that uses a formula to allocate a portion of declared profits to employees. Typically, profit distributions under a profit-sharing plan are used to fund employee retirement plans.

Unfortunately, there are hazards in using variable compensation to reward nonexempt (hourly) employees. The U.S. Fair Labor Standards Act (FLSA) requires employers to include certain types of variable compensation, such as bonuses, in employees’ regular hourly wage rates. As a result, companies that pay variable compensation to nonexempt employees must often recalculate employees’ regular hourly pay rates by factoring in the variable pay. The recalculation then affects the overtime pay calculations. Employers who are designing variable compensation pro grams that include nonexempt employees must be sure to review their programs for compliance with the FLSA. Failure to do so could cost significantly more in penalties and payment of back wages.

Unspoken Assumptions
Several underlying assumptions are behind the variable-pay concept, which derive from the very nature of the society that we live in and are not necessarily accurate.

  • Money motivates people to work harder.
  • Increased motivation will increase performance.
  • Fair measurement of work performance is possible.

Let’s take a closer look at these assumptions.

Money as a motivator: There is no doubt that money can be a powerful motivator. However, it isn’t always. In a study of welders who went from piecework pay (a particularly pure form of variable pay) to a straight salary, no change in performance was observed. In other words, variable pay didn’t lead to increased motivation. This doesn’t prove anything other than that one can’t blithely assume that money will always be a motivator. In some cases, money is not a motivator. For example, if you love gardening, you will put your heart into it. If you get paid to garden but don’t really like doing it, you’ll do it for the money but probably won’t do as good a job as someone who loves gardening.

Performance measurement: Motivation is clearly linked to performance. However, in many cases motivation is not the problem. The performance problem may be due to lack of skills, poor organization, bad strategy, or a host of other factors. Measuring performance is difficult and the most significant practical problem in a variable-pay system. But paradoxically, precise measurements may lead people to do precisely the wrong thing. For example, two offices will compete rather than cooperate on a job because each is measured on its own profitability.

Even harder to manage is the problem of perception. Even where there are real, perhaps obvious, performance differences, the employee who doesn’t perform well is more likely to attribute his or her low output to favoritism rather than performance.

Survey Findings
Employers probably need to do a better job of mapping individual employee performance and linking it with compensation, according to a recent strategic compensation survey. The survey reports that although linking individual goals to the company’s business goals is the primary objective of short-term incentives, 30% of those surveyed don’t find that these plans are effective in improving organizational performance.

The survey, conducted by the Society for Human Resource Management and Arthur Andersen’s Human Capital Services, provides a comprehensive look at competitive practices with respect to compensation philosophies, salary structures, “broad-banding”, short- and long-term incentives, performance management/appraisal systems, and more. Information was collected from 738 diverse organizations across the United States.

Other findings of this survey:

  • The majority (69%) of companies have short-term incentive (bonus) plans. Relevant reasons for having these plans are to link individual goals to business goals (77%) and to reward superior performance (63%).
  • The most common measures used for annual incentive plans are profit, revenue, individual goal attainment, and customer satisfaction.
  • 74% of public companies have long-term incentive plans. The most prevalent long-term incentives are nonqualified stock options (64%), incentive stock options (47%), and performance-based restricted stock (26%).
  • Competency assessment is valued equally with other performance measures in 41% of the companies, but in almost as many companies (37%), it is considered to be the primary driver of overall assessment.

Another consulting firm, Hewitt Associates LLC, has been monitoring variable-pay plans at a variety of companies—from automobile manufacturers to financial institutions—since 1996. Hewitt’s study found that while 75% of companies felt that their variable-pay plan helped improve business results, only 49% of those polled actually met or exceeded their main objective.

Finally, a study by the Towers Perrin consulting firm indicates that most companies feel their reward programs are not as effective as they would like them to be in helping them shift to a more flexible, less hierarchical culture. It also shows that some recent and highly touted innovations such as the elimination of merit increases, the use of a system called “broad-banding” that reduces promotional opportunities, and competency-based pay have not taken hold.

The Bottom Line
Although variable-pay plans are more popular than ever, they may be working too well in some instances. Frequently, that’s because the plan does not consider worker motivation in a realistic fashion. For example, a building design company implemented an incentive pay plan to encourage its engineers to draft buildings under budget. In response, one engineer simply scaled a building’s walls and ceilings down by six inches. While the engineer saved thousands for the company and received a large cash award, he didn’t necessarily produce the best structure.

To create and implement an efficient variable-pay plan, an employer must make a commitment to define employee expectations in behavioral and measurable terms. This means making goals achievable, profitable, and practical for both the company and its workers. The key to the success of variable compensation is to have something you can measure and understand—something that is linked to creating economic value for the company.

Instead of continually ratcheting up base pay, manufacturing and service companies are adopting and expanding the use of incentive compensation programs, at all levels, to reward outstanding achievement without increasing fixed costs.

Milton Zall is a freelance writer who specializes in taxes, investments, and business issues. He is a certified internal auditor and a registered investment adviser. Send your comments or questions regarding this article to tcaw@acs.org or the Editorial Office 1155 16th St N.W., Washington, DC 20036.

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