Incentive Pay

Chapter Purpose
• How incentive pay and traditional pay systems
differ
• Plans that reward individual behavior
• A variety of plans that reward group behavior
• The most broadly used corporate-wide
incentive programs—profit sharing and
employee stock option plans
• Considerations for designing incentive pay plans
• How individual, group, and gain sharing
incentive plans contribute to differentiation and
lowest cost competitive strategies

Incentive Pay
• Definition
Compensation, other than base wages or salaries,
that fluctuates according to employees'
attainment of some standard such as:
a. Pre-established formula
b. Individual or group goals
c. Company earnings
 Also known as variable pay, rewards employees
for partially or completely attaining a
predetermined work objectives

Incentive Pay
• Effectiveness: Based on these assumptions
a. Individual employees and work teams differ in how much
they contribute to the company, and in how well they do
it
b. The company’s overall performance depends on the
performance of its employees
c. How well it attracts, retrains and motivates high
performers
d. How well it rewards all employees for their relative
performance
• Adds to base pay as a one-time payment
• Usually, employees receive a combination of recurring
base pay and incentive pay, with base pay representing
the greatest portion of core compensation

Incentive Pay
• Designed to:
a. Control costs
i. By replacing annual merit or seniority
increases or fixed salaries
ii. With pay raises based on the company’s rise
in productivity, profits or other measure of
business success
b.Motivate employee productivity

Incentive Pay
• Increased use for:
a. Production workers
b. Technical employees
c. Service workers
d. Professionals
e. Managers
f. Executives
• Employees' earnings potential is increased

Incentive Pay
• Examples: Incentive Program
* Lincoln Electric Company
* Awards based on five performance criteria
• Quality
* Output
• Dependability
* Cooperation
* Ideas
* Job importance based on job evaluation techniques, five criteria
* Skill
* Responsibility
• Mental aptitude
* Physical application
* Working conditions

Incentive Pay
• Examples: Incentive Program
* H. Lee Moffitt Cancer Center and Research
Institute, at the University of South Florida
* Goals are to improve patient care and control
costs
* Incentives tied to the company’s:
* Net income or operating surplus
* Quality of care measures
* Patient satisfaction scores
* Operating efficiencies

Incentive Pay
• Example: Incentive Pay Plan
* Taco Bell Restaurants
* Offer managers biannual bonus based on
attainment of:
* Target profit levels
* Quality of customer service
* Store sales
* These incentives are used to motivate managers;
they know about them ahead of time

Contrasting Incentive Pay with
Traditional Pay
• Traditional pay plans based on
a. Fixed hourly wage or annual salary that is determined
i. Relative worth of positions to the company, or
ii. The going industry rate
b. Raises based on:
i. Seniority
ii. Past performance
iii. Supervisor’s appraisals
iv. Percentage of base pay, currently from 2% to 10%
c. Merit pay performance standards should be:
i. Measurable
ii. Objective

Contrasting Incentive Pay with
Traditional Pay
• Incentive pay
a.Designed to reward employees and teams for
performance
b.Classified into three categories:
i. Individual-incentive plans
ii.Group-incentive plans
iii. Company-incentive plans

Example: Typical Performance
Measures Per Incentive Plan
• Individual-incentive plan
* Quantity of work output
* Quality of work output
* Monthly sales
* Work safety record
* Work attendance
* Group-incentive plan
* Customer satisfaction
* Labor cost savings
* Materials cost savings
* Reduction in accidents
* Services cost savings
* Company-wide-incentive plan
* Company profits
* Cost containment
* Market share
* Sales revenue

Individual Incentives
• Definition
1. A system to reward employees for meeting work-related
performance standards, such as:
a. Quality
b. Productivity
c. Customer satisfaction
d. Safety
e. Attendance
2. Appropriate when:
a. Performance can be measured objectively, such as:
i. Units produced
ii. Sales volume
iii. Reduction in error rate
b. Employees have sufficient control over work outcomes
c. The incentives do not create a level of unhealthy competition
among workers

• Types 0f Individual Plans
1. Piecework plans
2.Management incentive plans
3.Behavior encouragement plans
4.Referral plans

• Individual incentive systems attempt to relate individual effort to
pay.
• Conditions necessary for the use of individual incentive plans are as
follows:
1. Identification of individual performance
 The performance of each individual can be measured and identified
because each employee has job responsibilities and tasks that can
be categorized from those of other employees
2. Independent work
 Individual contributions result from independent work and effort
given by individual employers.
3. Individual competitiveness desired
 independent competition whereby some individuals “win” and
others do not must be desired
4. Individualism stressed in organizational culture:
 The culture of the organization must be one that emphasizes
individual growth, achievements, and rewards

• Piece-Rate Systems
 The most basic individual incentive system is the piece-
rate system, whether of the straight or differential type
• Straight piece-rate system:
 Wages are determined by multiplying the number of
units produced (such as garments sewn or customers
contacted) by the piece rate for one unit.
 The rate per piece does not change regardless of the
number of pieces produced.
 Because the cost is the same for each unit, the wage
for each employee is easy to figure, and labor costs can
be accurately predicted

• A differential piece-rate system
 Pays employees one piece-rate wage for units
produced up to a standard output and a higher piece-
rate wage for units produced over the standard.
 Managers often determine the standards, or quotas, by
using time and motion studies
 For example, assume that the standard quota for a
worker is set at 300 units per day and the standard rate
is 14 cents per unit. For all units over the standard,
however, the employee receives 20 cents per unit

Calculation of Piece Work Award for a
Garment worker
Piecework standard : 15 stitched garments per hour
Hourly base rate awarded to employees when standard is not met: $
4.50 per hour
Piece work incentive award $ 0.75 per garment stitched per hour
above the piecework standard
Guaranteed hourly
base pay
Piecework award
( no. of garments stitched
above the piecework standard
x piecework incentive award0
Total hourly
earnings
First hour $ 4.50 10 garments x $0.75 = $ 7.50 $ 12.00
Second
hour
$ 4.50 Fewer than 15 stitched
garments, piecework award =
$0
$ 4.50

• Management Incentive Plans
 Awards bonuses to managers when they meet or
exceed objectives based on sales, profits, production,
or other measures for their division, department, or
unit
 Differs from piecework plans in that;
a. Piecework plans base rewards on one specific objective
b. Management incentive plans often require multiple
complex objectives
 Is based on superiors communicating the amount of
incentive pay managers can receive if goals are met

• Behavior Encouragement Plans
Awards employees for specific behavioral
accomplishments, such as:
a.Good attendance or
b. Safety records
 Employees are generally informed of
possibilities ahead of time to motivate them
to reach the goals

• Referral Plans
1. Employees awarded bonus for referring new
customers
2. Employees awarded bonus for referring new
employees if the new hires remain employed in
good standing beyond a designated period (e.g.,
30 days)
 Referral plans rely on the idea that current
employees’ familiarity with company’s culture
should enable them to identify viable candidates
more efficiently than other sources
 Employees are likely to make only those
referrals they truly believe are worthwhile
because their personal reputation is at stake

Group Incentive
• Companies that use work teams need to change individualistic
compensation practice so that groups are rewarded for their behavior
together
• Team based pay plans should;
i. Emphasize cooperation between and within teams
ii. Compensate employees for additional responsibilities they often must
assume as members of the team
iii. Encourage team members to attain predetermined objective for the
team
 Merit, seniority, or individual incentives do not encourage team
behaviors and may potentially limit team effectiveness
 Team based organization structures encourages team members to:
a. Learn new skills
b. Assume broader responsibility than is expected of them under
traditional pay structures
c. Employees working in teams must initiate plans for achieving their
teams goals

Why Organizations Establish Team
Based Variable Pay Plans

Group Incentives
• Types of Group Incentive Plans
Companies use two major types of group
incentives
1. Team based or small group incentive plans
 A small group of employees shares a financial
reward when specific objective is met
2. Gains Sharing Plans
 A group of employees, generally a department
or work unit is rewarded for productivity gains

Group Incentives
• Team-Based or Small-Group Incentive plan
 Similar to individual incentives with one exception
 Each group member receives a financial reward for the attainment of a
group goal
 There are many kinds of team incentive programs
 Companies define these programs according to performance criteria
 These criteria may be;
 Customer satisfaction
 Safety records
 Quality
 Production records
 The team based rewards reward is generated by the performance of the
team, incentive payments are distributed to the team members
individually
 Rewards allocated three ways
i. Equal incentive payments to all team members
ii. Differential payments to team members based on their contributions to
the goal
iii. Differential payments determined by a ratio of each team members’ base
pay to the total base pay of the group

Group Incentives
• Team-Based or Small-Group Incentive plan (contd.)
Equal incentive payments to all team members
i. Reinforces cooperation among team members, except
when:
ii. Team members perceive differences in members’
contributions or performance
Differential payments to team members based on their
contributions to the goal:
i. Can hinder cooperative behavior
ii. Can be modified to include both individual and team
incentives
Differential payments determined by a ratio of each team
members’ base pay to the total base pay of the group:
i. Rewards each team member in proportion to their base
pay
ii. Assumes that employees with higher base pay contribute
more to the company, so they should be rewarded
accordingly

Gain sharing plans
• Defined as group incentive systems that provide
employees an incentive based on improved company
performance in areas such as:
i. Increased productivity
ii. Increased customer satisfaction
iii. Lower costs
iv. Better safety records
 Gain sharing was developed so that all employees
could benefit financially from productivity
improvements resulting from suggestion system
 Most appropriate workplace technology does not
constrain productivity improvements

Gain sharing plans
 Most gain sharing programs have three components
I. Leadership philosophy
 Refers to a cooperative organizational climate that promotes high levels
of trust, open communication, and participation
ii. Employee involvement system
 Use broadly based suggestion system
 Any one can make suggestion to committee made up of both hourly and
management employees who oversee the suggestion implementation
iii. Bonus
 A company awards gain sharing bonus when actual productivity exceeds
its targeted productivity level
 Usually gain sharing bonuses are based on a formula that measures
productivity that employee perceives as fair and employer believes will
result in improvements in company performance
 Employees typically receives gain sharing bonus on a monthly basis
 Most bonuses range between 5 and 10 percent of an employee’s base
annual pay
 Gain sharing success has been attributed to company’s culture that
support cooperation among employees

Gain sharing plans
• Three most common forms
i. Scanlon Plan
ii.Rucker Plan
iii. Improshare

Scanlon Plan
• Developed by Joseph Scanlon in 1935
• Scanlon believed that employees will:
i. Exercise self-direction and self-control if they are committed to company
objectives and
ii. That employees will accept and seek out responsibility if given the opportunity
• Did not involve monetary rewards
• Current Scanlon plans include monetary rewards to employees for productivity
improvements
• Assumes that companies will be able to offer higher pay to workers, generate
increased profits and lower prices for consumers
• Scanlon plans the following three components
1. An emphasis on team work to reduce costs, assisted by management supplied
information on production concerns
2. Suggestion system that route cost saving ideas from the workforce through a
labor- management committee that evaluates and acts on accepted suggestions
3. A monetary reward based on productivity improvements to encourage employee
involvement

Scanlon Plan
• Scanlon plan employee involvement system include a formal suggestion
program at two levels
a. Production Level Committee
 Include a department foreman or supervisor and at-least one elected
worker
 Communicate the suggestion program and its reward features to
workers
 Members encourage and assist workers in making suggestions for
consideration
 May also reject suggestions that are not feasible but must provide a
written explanation of the reason for rejection
b. Company wide screening committee
 Also includes worker representative
 Reviews suggestions referred by production committee
 Serves as a communication link between management and employees
 Reviews the company’s performance each month

Scanlon Plan
• Monetary rewards for productivity improvements
Based on a ratio of labor costs and sales value of
production (SVOP)
SVOP is the sum of sales revenue plus the value
of goods in inventory
Scanlon Ratio = Labor Costs/SVOP
Smaller Scanlon ratio indicate that labor cost are
lower relative to SVOP
Companies strive for lower ratios

Scanlon Plan: Illustration
• For the past three years, the labor cost of XYZ
manufacturing company have averaged $ 44,000,000 per
year. During the same 3-year period, the sales value of
XYZ’s production (SVOP) averaged $ 83,000,000 per year (
As an aside, of the $83000,000, $ 65,000,000 represents
sales revenue, and $18,000,000 represents the value of
goods held in inventory.) The Scanlon ratio for XYZ company
is $ 44,000,000/ $83,000,000 = 0.53
• The ratio of 0.53 is the base line. Any benefits resulting
from an improvement, such as an improvement in
production methods that result in a reduction of labor
costs, are shared with workers. In other words, when
improvements lead to Scanlon ratio that is lower than the
standard of 0.53, employees will receive gain sharing
bonuses.

Scanlon Plan: Illustration
• The operating information for XYZ Manufacturing Company
for March 2011 was as follows:
• Total labor cost: $ 3,100,000
• SVOP: $ 7,200,000
 The Scanlon ratio, based on March 2011 information was: $
3,100,000/ 7,200,000 = 0.43
 In order for there to be payout, labor cost for march 2011
must be less than $3,816,000 ( i.e. 0.53 x $7,200,000); $
3,816,000 represents allowable labor costs for March 2003,
based on the Scanlon standard established for XYZ
Manufacturing
 In summary, the allowable costs for March 2011 were $
3816,000. The actual labor costs were $ 3100,000. Thus the
savings $ 716,000 ( $3816,000 – 3,100,000) is available for
distribution as bonus

Rucker Plan
• Developed by Allan W. Rucker, in 1933
Emphasizes employee involvement and provides
monetary incentives
 Uses a value-added formula to measure
productivity, which is the difference between
the value of the sales price and the value of
materials used to make the product
Larger Rucker Ratio indicates that the value
added is greater than the total employment costs
Rucker Ratio = (Value added) – (Costs of
materials, supplies, services rendered)/ Total
employment costs (wages, salaries, payroll taxes,
compensation

Rucker Plan: Illustration
• Last year ABC Company generated net sales of $ 7,500,000. The company
paid $ 3,200,000 for materials, $ 250,000 for sundry supplies, and
$225,000 for such services as liability insurance, basic maintenance, and
utilities. On the basis of these data, value added $3,825,000 (i.e., net sales
– cost of materials, supplies, and services rendered.) For this example: $
7,500,000 – ($ 3,200,000 + 250,000 + 225,000).
• For the same year total employment costs were $2,400,000, which
includes hourly wages for non exempt workers, annual salary for exempt
employees, payroll taxes, and all benefit costs. Based on the Rucker
formula, the ratio of value added to total employment costs was 1.59. this
ratio means that if there are to be bonuses, each dollar attributed to
employment cost must be accompanied by creating at-least $1.59 of value
added.

Rucker Plan: Illustration
• The operating information for ABC manufacturing company
for the month July 2011 was as follows:
• Value added: $ 670,000
• Total Employment Costs: $ 625,000
• The Rucker Ratio, based on July 2003 information was:
$670,000/ 625,000 = 1.07
• The Rucker ratio for July 2011 is less than the standard of
1.59 which was based on historical data. In order for there
to be payout, value added for July 2011 must be more than
the standard, which would be $ 1,065,300 (1.59 x $67,000).
However, based on Rucker ratio obtained for July 2011
(1.07), value added was only $ 716,900. Therefore,
employees of ABC Manufacturing will not receive any gain
sharing bonus for July 2011 performance.

Improshare
• Improved productivity through Sharing (Improshare) Invented by
Mitchell Fein, in 1973
 Measures productivity physically rather than in terms of dollar
savings
 Aims to produce more products with fewer labor hours
 Emphasis on providing employees with an incentive to finish
products
 Improshare bonuses are based on a labor hour ratio formula
 A standard based on historic relationship between the number of
labor hours needed to complete a product is determined
 Productivity is then measured as a ratio of the standard hours
compared to the actual hours it takes to produce the product now
 Unlike the Scanlon and Rucker Plans, employee participation is not
a feature, and workers receive bonuses on a weekly basis

Improshare
• Includes a buy-back provision
 Under this provision, a maximum productivity improvement payout
level is placed on productivity gains
 Any bonus money that generated because of improvements above
maximum level is placed in a reserve
 If productivity improves to the point where maximum is repeatedly
exceeded, the firms buys back the amount of the productivity
improvement over the maximum with one time payment to
employees
 This payment usually is equal to the amount in reserve
 The company is then permitted to adjust the standard so that a new
ceiling can be set at higher levels of productivity
 In unionized settings, management’s discretion may be challenged
by unions when union leadership believes that management is
simply trying to exploit workers by making it more difficult for
them to receive bonuses

Scanlon, Rucker, and Improshare Plans: A comparison of key features
Feature Scanlon Rucker Improshare
Program goals Productivity
improvement
Productivity
Improvement
Productivity
improvement
Basis for savings Labor costs Labor costs plus
raw materials
cost plus
services cost
Completing work
at or sooner than
production
standard
Employee
involvement
Require Required NA
Type of
employee
involvement
Screening and
production
committee
Screening and
production
committees
NA
Bonus payment Monthly Monthly Weekly

How does Gainsharing work
 The typical Gainsharing organization measures performance and
through a pre-determined formula shares the savings with all
employees
 The organization's actual performance is compared to baseline
performance (often a historical standard) to determine the amount
of the gain
 Employees have an opportunity to earn a Gainsharing bonus (if
there is a gain) generally on a monthly or quarterly basis.
 Typical elements of a Gainsharing plan include the following:
 Gains and resulting payouts are self-funded based on savings
generated by improved performance.
 Employees often are involved with the design process.
 A supporting employee involvement system is part of the plan in
order to drive improvement initiatives

Advantages of Gainsharing plans
 Helps companies achieve sustained improvement in key
performance measures
 Rewards only performance improvement
 Payouts are self-funded from savings generated by the plan
 Aligns employees to organization goals
 Fosters a culture of continuous improvement
 Enhances employee focus and awareness
 Increases the feeling of ownership and accountability
 Enhances the level of involvement, teamwork and
cooperation
 Supports other performance improvement efforts and
helps promote positive change

Disadvantages of Gainsharing plans
 Measures are narrower than organization-wide profit and therefore
gains may be paid even though profits may be down.
 Requires a participative management style
 Requires that management openly shares information related to
performance measures
 Employees may question or challenge management decisions that
may adversely impact a gain.
 Increases the level of organizational stress since everyone has more
of a financial stake in the organization's success
 Applies best to and a work environment that requires teamwork
and collaboration rather that individual entrepreneurship
 Paid on the basis of group performance rather than individual merit

Is Gainsharing different from Profit
Sharing?
• Gainsharing and Profit Sharing are similar in that when the company does
better, these improvements are reflected in employees' compensation.
• But beyond this basic similarity there are several important differences.
1. Power to Motivate Rank and File Employees
 Gainsharing is very strong is this regard
 Employees will have an answer to the question, "What do I need to do,
and what do we need to do, to make the gains happen.“
 Profit Sharing does not do a good job of answering these questions for the
rank and file employees
 I may want to increase our profit sharing, but what do I do - today, right
now - to make the profit sharing happen?
2. Costs Included in the Measurements
 Gainsharing differs from Profit Sharing in that Gainsharing focuses on the
most important costs in a company's financials,
 whereas Profit Sharing typically includes all of the line items in a
company's financials

Is Gainsharing different from Profit
Sharing?
3. Frequency of Feedback
 Feedback is much more frequent with Gainsharing systems vs.
Profit Sharing
 This more frequent feedback makes it possible to turn poor
performance around, and thus save the week or the month.
 Profit Sharing usually provides less frequent feedback (on a
quarterly or annual basis).
4. Frequency of Payouts
 Gainsharing systems typically have a (potential) payout on a
monthly basis.
 Profit Sharing systems typically payout (potentially) on an annual
basis
 The more closely rewards are tied to the performance, the greater
the motivational impact of the rewards paid out.

Advantages of Group-Incentive Plans
1. Companies can more easily develop performance
measures for group plans than for individual plans
 Fewer groups in the company than individuals
 Companies generally use fewer resources such as staff
time to develop performance measures
 Judging the quality of final product makes the most
sense because companies must deliver high quality
products to maintain competitiveness
2. Greater group cohesion
 Cohesive groups usually work more effectively toward
achieving common goals than do individuals focusing
on specific tasks for which they are responsible

Disadvantages of Group-Incentive
Plans
1. May lead to higher employee turnover because
of the free-rider effect
 Employee contributions to group vary because
of skill, ability, experience, or motivation
 Most productive employees may leave when
equal rewards are given for unequal
contributions
2. Dissatisfaction may be heightened where
incentive compensation represents the lion’s
share of core compensation

Company-Wide Incentive Plans
• Origins
 Instituted, in the 19th century, as a way for companies to ease
workers’:
a. Dissatisfaction with low pay
b. Belief that company management paid them substandard wages
while earning substantial profits
• Defined as systems that reward employees when the company
exceeds minimally acceptable performance standards such as:
a. Profit
b. Overall value of the company basd on its Stock price
 Companies use company wide incentive programs to motivate
employees to work harder for increased profits or increased
company value to the owners
 Well designed company wide incentive programs make workers’
and owner goals more compatible as workers strive toward
increasing company profits or value

Company-Wide Incentive Plans
• Types of companywide incentive plans
1. Profit sharing plans
 Employees earn a financial reward when
their company’s profit objective is met
2. Employee stock option plans
 Companies grant employees the right to
purchase shares of the company

Profit sharing plans
Pay a portion of company profits to employees, separate from:
a. Base pay
b. Cost-of-living adjustments, or
c. Permanent merit pay increases
• Two basic kinds of profit sharing plans are widely used
a. Current profit sharing plans
 Award cash to employees, typically on a quarterly or annual basis as part
of their core compensation
 Are subject to taxation when earned
b. Deferred profit sharing plans
 Place cash awards in trust accounts for employees for retirement
 Are not taxed until the employee withdraws money from their account,
usually at retirement
 Can withdraw money early, but will be subject to a stiff tax penalty

• Formulas for Calculating Profit Sharing Award
1. Fixed first-dollar-of-profits formula
 Based on a specific percentage of either pre- or post-tax annual profits
 Contingent upon successful attainment of a company goal
 A company might establish that the profit sharing fund will equal to 7%
of corporate profits; payment is contingent on a specified reduction in
scrap rates
2. Graduated first-dollar-of-profits formula
 Based on percentages of pre- or post-tax profits
 The percentage increases as profits increase
 A company may choose to share 3% of the first $ 8 million of profit and
six percent in excess of that level
 Motivates employees to strive for extraordinary profit targets by sharing
even more of the incremental gain with them

• Formulas for Calculating Profit Sharing Award
3. Profitability threshold formulas
 Fund profit sharing pools when profits fall within
pre-determined minimum and maximum levels
 Minimum levels are established to insure a
return for shareholders
 Maximum levels are set with the belief that
profits above these levels are due to reasons
other than employee productivity

• Common distribution methods
1. Equal payments to all employees
 Reflect a belief that all employees should share equally in the
company gain in order to promote cooperation among employees
 Employees contribution to profit varies
2. Proportional payments based on annual salary
 Presumes that higher salaries equate to more contributions to
profit levels
 Since most higher salaries generally relate to higher performance
or seniority
3. Proportional payments based on contribution to profit
 Generally based on performance
 Not widely used, as it may be difficult to quantify each employee’s
contribution

• Profit sharing and core compensation
 Companies can treat profit sharing distribution either as:
a. Compensation awarded in addition to an employees
base pay
 Base pay is set at externally competitive levels which
makes profit sharing tantamount to a bonus
b. Pay at risk
 Base pay is set below the average for competing
employers which creates a sense of risk
 Employees’ earning for the period may be relatively
eager or relatively sizable, compared to what they could
earn elsewhere

• Advantages
1. Enables employees to share in companies’ profits
 More likely to work productively to promote profits
2. Allows companies greater financial flexibility
 Monetary payouts to employees vary with profit
levels
 During economic downturns payout levels are
significantly lower than payouts during economic
boom periods
 This feature of profit sharing plans enables companies
to use limited cash reserves where needed, such as
research and development

• Disadvantages of Profit Sharing Plans
1.Can undermine the economic security of
employees, especially when:
a. Its provided as a pay at risk award
b.It represents a sizable portion of direct
compensation
2.May fail to motivate employees if they do not see
a direct link between their efforts and corporate
profits
3.May lead to high turnover of productive
employees if awards are predominately small

Stock Option Plans
1.General stock compensation plans
2.Employee stock ownership plans (ESOP)
3.Stock compensation plans

Stock Option Plans
• General stock compensation plans
 Companies grant employees the right to purchase shares of
company stock
 Company stock represents total equity of a company
 Company stock shares represent equity segments of equal value
 Equity interest increases positively with the number of stock shares
 Stock options describe an employee’s right to purchase company
stock
 Employees don’t actually own stock until they exercise the stock
option rights
 These rights are exercised by purchasing the stock at a designated
price after a company-chosen time period lapses, generally around
five years
 If employees keep productivity high, stock should be worth more
when sold than when purchase
 Designed to provide employees with the motivation to work more
productively and increase their stocks value

Stock Option Plans
• Employee Stock ownership plans (ESOP)
The stock is place in trust accounts, like the
deferred profit sharing plan
To be used as a source of retirement income
• Stock compensation plans
 A deferred compensation plan for executives
 Designed to create a sense of ownership,
aligning the interests of the executives and
the owners or shareholder

Designing Incentive Pay Programs
• Five Key Considerations
1. Should the plan be based on group or individual
employee performance?
2. What level of risk will the employees be willing to
accept in their overall compensation package?
3. Should the incentive pay replace or complement
traditional pay?
4. What criteria should be used to judge performance?
5. Which time horizon for meeting goals would be most
effective?
a. Long-term
b. Short-term
c. Some combination

Group versus Individual Incentives
• Group incentives are most suitable where:
a. The nature of work is interdependent
b. The contributions of individual employees are difficult to
measure
c. Companies require cooperative behavior among their
employees
d. Encourage team behavior by linking compensation to the
achievement of department or division goals
• Individual incentives
• Reward employees for meeting or surpassing
predetermined individual goals
b. Are most suitable for employees whose work is
independent not interdependent, such as:
i. Meeting production goals
ii. Sales quotas
• Both options require goals that are attainable

Level of Risk
 Increases as incentive pay represents a greater
proportion of total core compensation
 Is usually greater among employees with higher level
jobs
 Should be dependent on the extent to which an
employee controls the attainment of the desired goal
 Logically incentive programs are bound to fail when
goals are out of reach because:
 They are too difficult
 Extraneous factors are hampering employees effort to
meet goals

Complementing or Replacing Base Pay
 When complementing base pay, a company awards incentive pay in
addition to employee’s base pay and fringe compensation
 Alternatively company may reduce base pay by placing the reduced
portion at risk in an incentive plan
 This may increase the potential for high performers to earn more
than they would when risk is not involved
 Companies in cyclical industries such as retail sales could benefit by
including an incentive component in the core compensation
program
 During slow business period, the use of regular merit pay programs
that add permanent increment to base pay can create budget
problems
 If incentive pay were used instead of permanent merit raises, then
level of expenditure on compensation would vary according to
business activity

Performance Criteria
• Measures used to appraise performance
should be quantifiable and accessible
• Measures should include:
a.Company profits
b.Sales revenue or units of production
• Measures should relate to the company’s
competitive strategy
• If more than one measure is relevant, each
should be weighed to reflect its relative
importance to the company’s competitive
strategy

Example: Weighing Performance
Measures
When the amount of employees' incentive pay is
based on:
* Company performance = 10%
* Unit performance = 40%
* Individual performance = 50%
* The level of risk is minimal
* When the amount of employees' incentive pay is
based on:
* Company performance = 50%
* Unit performance = 35%
* Individual performance = 15%
* The level of risk is much higher

Time Horizon: Short-Term versus
Long-Term
• Incentives for lower-level employees are:
a.Usually short-term
b.Goals are within the control of the employees
• Incentives for professionals' and executives'
are generally long-term

Flip Side of the Coin
On the Folly of Rewarding A, While Hoping for B
Article by Steven Kerr that criticized organizational reward
systems for some behaviors while ignoring other
desirable work behaviors
*Case-in-Point: Research Universities
* Award faculty awards based on quality and quantity of
scholarly publications with:
* Pay raises
* Promotions
* Tenure
* Little emphasis on teaching effectiveness
* Universities under pressure from taxpayers and parents
because of lack of emphasis on teaching
* Difficulties in defining and measuring teaching
effectiveness

Linking Incentive Pay with Competitive
Strategy
• Lowest Cost Competitive Strategy
 Demands reduced output costs per employee
a. Individual incentive programs
• Piecework systems, connect core compensation costs
to employee productivity
 Piecework plans are especially effective when:
 They motivate employees to keep up with the
demand for companies products
 Employees’ out put matches market demand, then
company will cover its expenditure on incentive
compensation and generate profit

Strategy
• Lowest Cost Competitive Strategy (contd.)
• Behavioral encouragement plans
 Can be effective when companies suffer:
i. Excessive absenteeism or
ii. Poor safety records
4. Group incentive programs
• Gain sharing programs are appropriate when employee
involvement facilitates productivity enhancements
 When improvements result from:
i. More efficient ways to conduct work and
ii. Enhanced employee motivation that comes from greater
participation in workplace matters
• Current profit sharing plans may not be appropriate if the
employees do not perceive a link between their work
contributions and company

Strategy
• Differentiation Competitive Strategy
 Mandate employee roles that display:
a. Creativity
b. Open minds to novel ways of approaching work, and
c. Promote risk taking
 Companies hold a longer term focus with regard to the attainment
of pre-established objectives
 Team-based incentives and gain sharing systems are the most
appropriate because they:
a. Promote interaction among coworkers
b. Provide some degree of autonomy to devise the best way to
achieve the objective set by the management
 Piecework plans and current profit sharing plans are inappropriate
a. Piecework plans focus on increasing employees' productivity on
existing jobs, not on encouraging employees to offer creative ideas
that may lead to product or service differentiation
b. Profit sharing plans may be ineffective if employees see no link
between job performance and profit

Incentive Pay

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