Reliance on traditional merit increases to base pay as a way of rewarding strong employee performance has steadily eroded in recent years, largely because these programs have little or no direct tie to the bottom line. Instead, performance based rewards have become virtually synonymous with incentives. Companies are rapidly developing group award programs aimed at rewarding team, department or even company performance, or some combination of the three.
Many companies have had little choice. In today's labor market, fierce competition for talent and candidates' expectations for some form of an incentive opportunity have placed organizations without some type of performance-based rewards at a distinct disadvantage in recruiting and retaining key employees.
As a result, many companies have shifted the focus of their pay philosophies to include incentives. Some have also redefined their compensation strategies to allow for total cash compensation-base pay plus incentives --that is higher than the average pay in a defined marketplace. These organizations now set base salary at competitive levels and allow performance-based rewards programs to raise the total cash compensation levels even higher. The rationale is that higher compensation is justified because it will reflect superior performance driven by performance-based rewards payouts.
By taking a broader view of performance to include the aggregate results of a collection of individual efforts, organizations have been able to use incentive programs to translate business strategy down through the ranks. Effective use of incentives demonstrates that compensation programs are more than systems for rewarding employees competitively; they communicate management expectations by impacting individual paychecks.
CASE IN POINT
A company that we'll call Big Foods, a food ingredient manufacturer, decided to change its long-held business strategy of emphasizing profitability in favor of a strategy designed to increase market share. By diversifying its product lines and venturing into new markets, Big Foods believed it could substantially increase growth and eventually profitability once it achieved economies of scale. However, the company quickly realized that it had to change its short-term incentive plan, which rewarded sales people based on a percent of gross margin of all product lines.
Under this plan, sales people were rewarded for all products they sold individually and also received a percentage of their territory's gross margin. Consequently, most focused on selling those mature product lines that had the highest gross margins. Big Foods quickly realized that the incentive plan was helping it maximize profitability, but it was not helping Big Foods gain market share with new product offerings that were critical to the company's new long-term strategy. Clearly, the incentive plan had to change to reflect the new business strategy.
To communicate this change in strategy more effectively, Big Foods revised the incentive plan and tied the incentive award to the number of units sold rather than gross margin dollars. Big Foods also divided its products into three categories: Develop, Maintain and Harvest. Those products in the Develop category had the highest per unit incentive, while those in the Maintain and Harvest categories had a lower and lowest per unit incentive, respectively. With the new incentive plan in place, top management was able to clearly communicate what kind of performance it wanted and was willing to pay for.
As Big Foods' experience illustrates, performance-based rewards can be powerful tools to effect and reinforce change in an organization. If what gets rewarded is indeed what gets done, companies need to make sure that their performance-based rewards programs are aligned with the overall business strategy. Any disconnect between the two may undermine a company's ability to achieve its goals. To prevent that, companies must understand the seven key steps to successful performance-based rewards Programs:
1. DEVELOP CLEAR EXPECTA1TIONS. Before they can develop effective performance-based rewards, senior management must know what it expects of employees and be able to articulate those expectations through clearly defined goals. Because overall organizational goals may not apply to all employees, it is important to break down broad organization goals into specific goals for each division, department, group and, sometimes, individual employees. Big Foods understood this need and communicated its priorities to its sales force by providing the highest per unit incentive products in its Develop category.
2. CREATE A CLEAR LINE OF SIGHT. Employees must see that their direct efforts will impact the results that management wants. No one wants to be held accountable for something they cannot directly effect. With the proper training and direction, the more experienced sales people in Big Foods were quickly able to redirect their sales efforts to increase market share in the Develop product lines in order to earn worthwhile incentive payouts.
3. SET ACHIEVABLE GOALS. Performance-based rewards must be tied to either individual or group goals that have a reasonable chance of being achieved. If the goals are such a stretch that most employees believe that they cannot be attained, the program is doomed from the outset. Few will be motivated to try to achieve such goals; others will become discouraged early on. On the other hand, goals should not be so easy that incentives are paid for results that would have otherwise been achieved through normal effort. To prevent either of these scenarios, Big Foods trained employees to sell its new products and to recognize the characteristics of the customers most likely to buy them. Through the training program, management communicated to the sales force the potential of the new products and convinced them of the probability of success.
4.ESTABLISH A CREDEBLE MEASUREMENT SYSTEM. Sales incentive plans, like the one developed by Big Foods, are among the easiest performance-based rewards programs to establish because sales can be measured quantitatively. In all types of performance-based rewards programs, it is essential to provide quantitative measures of results. The less quantifiable the measurement, the greater the role of subjective judgment in deciding rewards, and the greater the potential for dispute and participant dissatisfaction. If performance-based rewards are to succeed, participants must have faith in the fairness of the measurement system. In addition, the calculation of the measurement should be understood and agreed upon by both management and participants at the beginning of the performance period.
In many cases, the performance of staff professionals is measured using Management by Objectives, which includes both quantitative and qualitative goals. In these situations, a company must rigorously establish qualitative measures that do not leave too much of an employee's performance to supervisory discretion. When much of the appraisal is subject to judgment, the credibility of the performance-based program is at risk. Employees are concerned that management can manipulate the results to reward those they favor instead of those whose performance is outstanding.
Employees need to believe not only that the goals against which theyare measured and rewarded are achievable, but that they are capable of achieving those goals. Have employees been adequately trained in the skills that they need for superior performance? Do employees have the information they need to make intelligent decisions? Are employees empowered to make decisions on their own? Are other departments cooperating and providing these employees with information on a timely basis? In short, is the entire system geared to maximum productivity, communication and cooperation? If the answers to these questions are no, companies must be prepared to see the incentive system backfire and result in more stagnation, resentment and mistrust of management.
To avoid this, Big Foods segmented the marketplace based on its new product categories (Develop, Maintain and Harvest) and provided employees with the latest market research. Big Foods also focused its more seasoned sales people on the Develop products while assigning the less experienced sales people to the Maintain and Harvest product lines. This approach not only freed the experienced sales people to devote more time to the new products, it provided a better training opportunity to less experienced personnel. Although the Maintain and Harvest products had lower per unit incentives, these products were easier to sell in an already established marketplace.
6. MAKE REWARDS MEANINGFUL. Researchers in the fieldof compensation have long held that, for incentives to be truly effective, the actual reward must be significant--that is, 15% to 20% of base pay. Big Foods set its annual target awards at 25% of base pay for achieving goal; however, the award could increase to as much as 40% of base pay for superior performance. This was a significant increase over the old plan which had a maximum award of 30% of base pay. Performance-based rewards programs that provide marginal rewards-that is, less than 10% of base pay-are rarely motivational enough to change behavior and are probably not worth the trouble and expense involved in implementation.
7. MAKE PAYOUTS IMMEDIATE. There should be as little time as possible between employee performance and therelated payout. Employees need to "feel" the impact of their efforts by quickly experiencing the results.
Many performance-based rewards programs are based on full-year performance results because it makes sense from a management point of view. After all, company performance is most often judged on annual results. However, for the connection between performance and reward to be truly motivational, companies should strive for a much shorter time frame for incentive payouts whenever possible for example, on a quarterly or semiannual (as Big Foods has chosen to do) basis. This is particularly important in companies developing incentives for lower-level, nonexempt employees. The time from performance to payout for this population should be as short as possible. Unlike exempt employees who tend to be accustomed to annual incentive systems, nonexempt employees often live from paycheck to paycheck and need to see an immediate connection between their efforts and their rewards.
These seven steps should guide every performance-based rewards program from gainsharing plans that reward production workers for minimizing production costs to stock-based programs that reward executives for increasing shareholder value. No matter what type of performance-based rewards program a company adopts, these steps must be completed and reviewed periodically to ensure that the program is achieving its objectives.
THOMAS J. HACKETT and DONALD G. McDERM0TT are members ofD.G. McDermott Associates, LLC, a humanresources and compensation consulting firmbased in Red Bank, NJ. Both have served onthe faculty of the Workat Work.