Productivity linked wage systems
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The Productivity Linked Wage System (PLWS) theory addresses how to motivate employees through effective compensation contracts. It discusses incentive problems that arise from misaligned interests between employers and employees. PLWS proposes using a mix of fixed salaries and variable pay linked to measurable outputs to both insure workers against risks and incentivize better performance. Key elements include output-based pay to select more productive workers, and using the appropriate measurement metrics and time units for different job types.
Productivity linked wage systems
- 1. Productivity Linked Wage System The theory in PLWS
- 2. Outline 1. Incentive Problem 2. Compensation Contracts 3. Output-Based Pay 4. Input-Based Pay 5. Incentive Pay Source: www.msn.de PLWS Theory 2
- 3. 1. Incentive Problem Coordination and Motivation Problem Task Coordination Motivation Who does what, Individual How do I get somebody when,... to perfom a task, improve the quality,... Allocation of Input Distribution of => Incentive Problem Resources Output Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51 PLWS Theory 3
- 4. 1. Incentive Problem Why do Incentive Problems Exist? Why do Incentive problems exist? • Employee and employer have different interests – Employer would want the employee to take actions that maximize the profit of the firms, but the employee might rather like spending his time with his/her family or play golf – All actions of the employee cannot be monitored and/or controlled by contracts (risk for the employer) – Employers have to compensate employees for doing undesirable tasks PLWS Theory 4
- 5. 1. Incentive Problem How can Incentive Problems be Solved? • Incentive Problems can be solved through effective compensation contracts • Compensation contracts have two functions – Motivate employees – Share risk more efficiently Source: www.euro.fi PLWS Theory 5
- 6. 2. Compensation Contracts Compensation Contracts Variable Pay Fixed Salary Payment by Output Payment by Input Objective Subjective Objective Subjective Performance Performance Performance Performance Measures Measures Measures Measures PLWS Theory 6
- 7. 2. Compensation Contracts Payment by Input versus Payment by Output Variable Pay Straight Salary (payment by output) (payment by input) • Compensation depends on measure • Compensation depends on the amount of what comes out of time or effort spent on an activity • Amount of time spent on work does • Independent of output consideration not affect workers‘ compensation Problem: Problem: ⇒ Input also not always easy to measure ⇒ Output not always easy to measure • Time at work as a proxy in order to assess worker‘s effort Examples: Examples: • Agricultural workers: piece rates p. tray • Wage per work hour • A salesperson on straight commission • Monthly salaries • Compensation of top executives by • Annual salaries stocks or stock options PLWS Theory 7
- 8. 2. Compensation Contracts How can the Performance of an Employee be Measured? •Objective Performance Measure: – Measure that is easily observable and quantifiable, e.g. parts produced, hours worked etc. •Subjective Performance Measures: – An evaluation which is based on personal opinion of a supervisor, customer, peers, etc. Type of evaluat. objective subjective Database Output revenue, dividend customer satisfaction Input time qualification PLWS Theory 8
- 9. 2. Compensation Contracts Examples of Different Variables as a Basis of Output-Related Pay Basis Variables for output-based pay Quantity of production pieces, weight, size/height Rejects, grade, customer‘s satisfaction, Quality of production individual targets Reduction of input factors: raw material, Input reduction energy, work time Capacity utilization slack-, repair- and waiting periods Timeliness vis à vis internal and external Be on schedule customers Value of the firm stock price, economic value added PLWS Theory 9
- 10. 3. Output-Based Pay Advantages of output-based pay Selection effect Motivation effect • efficient workers with a high • output-based pay motivates workers productivity will join the firm/stay to put forth more effort • inefficient workers with a low productivity will not join/leave the firm Source: www.kone.fi PLWS Theory 10
- 11. 3. Output-Based Pay Selection Effect: An Example of Compensating Salespeople World Book Britannica Offered compensation scheme variable pay: W = $ 100 . fixed salary: W = $ 500 Labor costs of 10 sets; Cost per x $ 1,000 ⇒ $ 100 per set $ 500 ⇒ $ 50 per set set type of salesperson What high productive sp. low productive sp. will stay with the firm? x ≥ 5 x ≤ 5 Labor costs of 3 sets; Cost per set $ 300 ⇒ $ 100 per set $ 500 ⇒ $ 166,67 per set PLWS Theory 11
- 12. 3. Output-Based Pay Selection Effect: An Example of Compensating Salespeople (cont.) W ...Weekly A (World Book) Pay 500 B (Britannica) 300 3 5 x ... Number of encyclopedia ⇒ Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will stay at Britannica PLWS Theory 12
- 13. 3. Output-Based Pay Disadvantages of Output-Based Pay • Disadvantage of piecework: Variations of output can be beyond the worker‘s control Variable pay Straight salary • Variable pay depends on invested effort • Fixed salary doesn‘t depend on exoge- and exogenous risks – risky form of nous factors – low-risk form of compensation compensation ⇒ Firm should smooth out exogenous risks ⇒ Workers are insured against volatilities from workers‘ compensation ⇒ Firm provides the insurance for risks ⇒ Firm should bear exogenous risks but endogenous risks should remain with workers • Trade-off: More risk⇔higher compensation • Lower compensation level • Opportunity: participate in good economic • Can not participate in good economic development development • Stronger incentives • Weaker incentives PLWS Theory 13
- 14. 3. Output-Based Pay Risk in Output-Based Pay • The firm should bear the largest portion of risk because of risk pooling abilities • Workers with a high average compensation should bear more risks than workers with a low average compensation. Source: www.kone.fi PLWS Theory 14
- 15. 4. Input-Based Pay • In spite of all the advantages of output-based schemes: A large proportion of workforce is paid by input • Compensation depends on the amount of time or effort spent on an activity • Independent of output consideration ⇒ Time at work as a proxy to assess worker‘s effort Source: www.euro.fi Examples: wage per work hour, monthly salaries, annual salaries PLWS Theory 15
- 16. 4. Input-Based Pay Benefits of Input-Based Pay Problems of output-based pay solved by time-based (input-based) pay • Finding the right output measure • Costs of measurement • Overemphasizing quantity, reduction of quality • Risk aversion of workers • Promoting long-run performance However, in many cases output-based schemes could be used if only they were designed correctly! PLWS Theory 16
- 17. Compensation Schemes Balancing Quantity and Quality • Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to ‚count‘ ⇒ Appropriate compensation schemes could solve this problem Example: Typist‘s compensation Errors p. page Price p. page Minutes p. page Revenue per hour 0 $8 20 $ 24 1 $7 15 $ 28 2 $5 12 $ 25 3 $3 10 $ 18 4 $0 9 $0 5 $0 8 $0 PLWS Theory 17
- 18. 4. Input-Based Pay Using the Appropriate Time Unit Input-based pay Hourly wages Monthly salary Annual salary • Production workers • Managerial workers • Top Management • Clerical workers Tasks: experienced and Tasks: less experienced and Tasks: not experienced and easy to prescribe not easy to prescribe difficult to prescribe; often to be defined by top manager • High correlation between • Low correlation between • Undefined set of tasks (goal), effort and time invested effort and work time discretion over work • Time input as a pretty • Time input = bad measure for • Importance of other incen- good indicator for effort effort ⇒ overinvestment in tives to motivate for effort easy (pleasant) tasks (long-term, e.g. stock options) PLWS Theory 18
- 19. 5. Incentive Pay Optimal Level of Variable Pay • Since employees do not diversify their risk – Large exogenous risks should be born by owners Fixed salary • However, employees are motivated by pay for performance Variable Pay Part of the pay should be fixed and part variable PLWS Theory 19
- 20. 5. Incentive Pay Forms of Incentive Pay • Rewards do not need to be monetary, they can consist of anything that employees value • E.g Piece rates and commissions Housing Bonuses Education for kids Parking spots Retirement Plan Days off Party Promotion Training Stock ownership Health care plan PLWS Theory 20
- 21. 5. Incentive Pay Criticism to Incentive Compensation • Often heard critics to incentive compensation: – Money does not motivate – It is difficult to design effective incentive schemes • Incentives certainly entail costs • The major problem is to design incentive schemes where the benefits exceed the costs PLWS Theory 21