Individual-based plans have four major advantages:

• ▪ Performance that is rewarded is likely to be repeated A widely accepted theory of motivation, known as expectancy theory , explains why higher pay leads to higher performance. People tend to do those things that are rewarded. Money is an important reward to most people, so individuals tend to improve their work performance when a strong performance–pay linkage exists.43

• ▪ Individuals are goal oriented and financial incentives can shape an individual’s goals over time A pay incentive plan can help make employees’ behavior consistent with the organization’s goals.44 For instance, if an automobile dealer has a sales employee who sells a lot of cars, but whose customers rarely return to the dealership, the dealer might implement a pay incentive plan that gives a higher sales commission for cars sold to repeat buyers. This plan would encourage the sales staff to please the customer rather than just sell the car.

• ▪ Assessing the performance of each employee individually helps the firm achieve individual equity An organization must provide rewards in proportion to individual efforts. Individual-based plans do exactly this. If individuals are not rewarded, high performers may leave the firm or reduce their performance level to make it consistent with the payment they are receiving.

• ▪ Individual-based plans fit in with an individualistic culture National cultures vary in the emphasis they place on individual achievement versus group achievement (see Chapter 17). The United States is at the top of the list in valuing individualism, and U.S. workers expect to be rewarded for their personal accomplishments and contributions.

In contrast to U.S. firms, the Japanese do not tend to reward individual performance but economic pressures seem to be moving the Japanese toward a more “American” model. In a recent survey, 70 percent of Japanese leaders said they plan to cut wages and that only top performers may be able to keep (or exceed) their prior earnings.45

Many of the pitfalls of pay-for-performance programs are most evident at the individual level. Two particular dangers are that individual plans may (1) create competition and destroy cooperation among peers and (2) sour working relationships between subordinates and supervisors. And because many managers believe that below-average raises are demoralizing to employees and discourage better performance, they tend to equalize the percentage increases among employees, regardless of individual performance. This, of course, defeats the very purpose of an incentive plan.

Other disadvantages of individual-based plans include the following:

• ▪ Tying pay to goals may promote single-mindedness Linking financial incentives to the achievement of goals may lead to a narrow focus and the avoidance of important tasks, either because goals are difficult to set for these tasks or because their accomplishment is difficult to measure at the individual level. For instance, if a grocery store sets a goal of happy and satisfied customers, it would be extremely difficult to link achievement of this goal to individual employees.

• ▪ Many employees do not believe that pay and performance are linked Although practically all organizations claim to reward individual performance, it is difficult for employees to determine to what extent their companies really do so. So it should come as no surprise that many surveys over the past three decades have found that up to 80 percent of employees do not see a connection between personal contributions and pay raises.46 The beliefs underlying this perception, many of which have proved to be very resistant to change, are summarized in Figure 11.2.

  • • Performance appraisal is inherently subjective, with supervisors evaluating subordinates according to their own preconceived biases.

  • • Regardless of the appraisal form used, supervisors tend to manipulate the ratings.

  • • Merit systems emphasize individual rather than group goals, and this may lead to dysfunctional conflict in the organization.

  • • To maintain an effective working relationship with all subordinates and prevent interpersonal conflict within the team, the supervisor may be reluctant to single out individuals for special recognition with pay.

  • • The use of a specified time period (normally one year) for the performance evaluation encourages a short-term orientation at the expense of long-term goals.

  • • Employees try to defend their ego by ignoring negative performance feedback, blaming the organization for their problems.

  • • Supervisors and employees seldom agree on the evaluation, leading to interpersonal confrontations.

  • • Supervisors often do not know how to justify a particular pay raise recommendation to an employee.

  • • Increments in financial rewards are spaced in such a way that their reinforcement value for work behaviors is questionable. For example, becoming twice as productive now has little perceived effect on pay when the employee must wait a whole year for a performance review.

  • • Individual merit pay systems are less appropriate for the service sector, where many people in the United States work. In knowledge-based jobs (such as “administrative assistant”), it is even difficult to specify what the desired product is.

  • • Supervisors typically control a rather limited amount of compensation, so merit pay differentials are normally quite small and, therefore, of questionable value.

  • • A number of bureaucratic factors that influence the size and frequency of merit pay (for example, position in salary range, pay relationships within the unit and between units, and budgetary limitations) have little to do with employee performance.

  • • Performance appraisals are designed for multiple purposes (training and development, selection, work planning, compensation, and so forth). When a system is used to accomplish so many objectives, it is questionable whether it can accomplish any of them well. It is difficult for the supervisor to play the role of counselor or adviser and evaluator at the same time.

• ▪ Individual pay plans may work against achieving quality goals Individuals rewarded for meeting production goals often sacrifice product quality. Individual-based plans also work against quality programs that emphasize teamwork because they generally do not reward employees for helping other workers or coordinating work with other departments.

• ▪ Individual-based programs promote inflexibility in some organizations Because supervisors generally control the rewards, individual-based pay-for-performance plans promote dependence on supervisors. Thus, they prop up traditional organizational structures, which make them particularly ineffective for firms trying to take a team approach to work.

Despite the challenges they present to managers, rewards based on individual performance can be highly motivating, usually under the following conditions:

• ▪ When the contributions of individual employees can be accurately isolated Identifying any one person’s contributions is easier for some jobs than for others. For instance, a strong individual incentive system can work well with salespeople because it is relatively easy to measure their accomplishments. In contrast, research scientists in industry are generally not offered individual-based performance incentives because they typically work so closely together that individual contributions are hard to identify.

• ▪ When the job demands autonomy The more independently employees work, the more it makes sense to assess and reward the performance of each individual. The performance of managers of individual stores in a large retail chain like Gap can be rated fairly easily, whereas the performance of the HR director in a large company is much more difficult to assess.

• ▪ When cooperation is less critical to successful performance or when competition is to be encouraged Practically all jobs require some cooperation, but the less cooperation needed, the more successful an individual-based pay program will be. For example, less employee cooperation is expected of a stockbroker than of a pilot in an Air Force squadron.

When properly designed, team-based incentives have two major advantages:

• ▪ They foster group cohesiveness To the extent that team members have the same goals and objectives, work closely with one another, and depend on one another for the group’s overall performance, team-based incentives can motivate group members to behave and think as a unit rather than as competing individuals. In this situation, each worker is more likely to act in a way that benefits the entire group.50

• ▪ They aid performance measurement A number of studies have shown that performance can be measured more accurately and reliably for an entire team than for individuals.51 This is true because less precise measurement is required when an individual’s performance does not need to be identified and evaluated in relation to others in a group.

Managers need to be aware of potential pitfalls with team-based plans. This may account for the limited adoption of these types of incentives, which are used by firms about a third as often as individual-based incentives.52 The disadvantages are as follows:

• ▪ Possible lack of fit with individualistic cultural values Because most U.S. workers expect to be recognized for their personal contributions, they may not react well to an incentive system in which individual efforts take a back seat to the group effort, with all team members rewarded equally. On the other side of the coin, individual incentives are likely to fail in societies with a collective orientation. In a striking display of cultural insensitivity, many U.S. companies have introduced high-risk individual incentives to their Japanese subsidiaries. These plans have generally failed.53

• ▪ The free-riding effect In any group, some individuals put in more effort than others. In addition, ability levels differ from one person to the next. Those who contribute little to the team—either because of low effort or limited ability—are free riders. 54

  When all team members (including free riders) are rewarded equally for a group outcome, there are likely to be complaints of unfairness. The result may be conflict rather than the cooperation the plan was intended to foster, with supervisors having to step in to judge who is contributing what.55

  To minimize the free-riding effect, some companies have been adjusting pay incentives to encourage individual performance within teams. W. L. Gore, the maker of Gore-Tex fabric, has its 4,000-plus employees evaluate fellow team members each year to individualize team-based incentives (each team member receives a payment according to his or her personal contributions as assessed by peers).56

• ▪ Social pressures to limit performance Although group cohesiveness may motivate all team members to increase their effort and work to their full potential, it can also dampen team productivity. When commercial airline pilots want to express a grievance, for instance, they sometimes agree among themselves to fly “by the book.” This means that they follow every rule without exception, leading to an overall work slowdown. Group dynamics may also encourage team members to try to beat the game—cheating to get the reward, for instance—as a way to get back at management.57

• ▪ Difficulties in identifying meaningful groups Before they decide how to distribute rewards based on team performance, managers must define a team. Coming up with a definition can be tricky, because various groups may be highly interdependent, making it difficult to identify which ones did what. Also, a person may be a member of more than one team, and teams may change members frequently.

• ▪ Intergroup competition leading to a decline in overall performance A team may become so focused on maximizing its own performance that it ends up competing with other teams. The results can be quite undesirable. For instance, the manufacturing group may produce more units than the marketing group can possibly sell, or the marketing group may make sales commitments that manufacturing is hard pressed to meet on schedule.58

Although managers need to be aware of the potential disadvantages of team-based plans, they should also be on the lookout for situations conducive to their successful use. Such plans are likely to be successful under the following circumstances:

• ▪ When work tasks are so intertwined that it is difficult to single out who did what This is often the case in research and development labs, where scientists and engineers work in teams. It is also the case with firefighter crews and police units, which often think of themselves as one indivisible entity.

• ▪ When the firm’s organization facilitates the implementation of team-based incentives Team-based incentives are appropriate when:

  1. There are few levels in the hierarchy, and teams of individuals at the same level are expected to complete most of their work with little dependence on supervisors or upper management Both public- and private-sector organizations that have had to lay off workers to maintain efficiency and profitability have found that teamwork becomes a necessity. For instance, when the city of Hampton, Virginia, underwent a massive downsizing and restructuring that resulted in the loss of several layers of supervision, it had to redesign its work processes. The city created self-managed teams and incorporated team-based pay into a multilayered pay-for-performance plan.59 At W. L. Gore, which, as noted earlier, uses a lot of team-based incentives, the firm’s culture is highly supportive of the practice. American scientist Bill Gore, who founded the company with his wife Vievi in 1958, believed that a nonhierarchical environment allows creative individuals to flourish and work collaboratively. Hence, almost 55 years later (in addition to team incentives), W. L. Gore does not have job descriptions, titles, or managers, just leaders.60

  2. Technology allows for the separation of work into relatively self-contained or independent groups This can be done more easily in a service unit (such as a telephone repair crew) than in a large manufacturing operation (such as a traditional automobile assembly line).

  3. Employees are committed to their work and are intrinsically motivated Such workers are less likely to shirk responsibility at the expense of the group, so free riding is not a serious concern. Intrinsic motivation is often found in not-for-profit organizations, whose employees are emotionally committed to the organization’s cause.

  4. The organization needs to insist on group goals In some organizations, this is a paramount need. For example, high-tech firms often find that their research scientists have their own research agendas and professional objectives—which are frequently incompatible with those of the firm or even their peers. Team-based incentives can focus such independent-minded employees’ efforts on a common goal.61

  5. Team-based incentives can help blend employees with diverse backgrounds and perspectives and focus their efforts on goals important to the organization At Intel, for instance, “customer-focused teamwork” is now the firm’s mantra. Long-dominant hardware engineers are learning to work more closely with marketers and software engineers, and their incentives are tied directly to how well they cooperate with each other.62

• ▪ When the objective is to foster entrepreneurship in self-managed work groups Sometimes, to encourage innovation and risk taking within employee groups, a firm will give certain groups extensive autonomy to perform their task or achieve certain objectives. This practice is often referred to as intrapreneuring (a term coined by Gifford Pinchot, who published a book with that title in 1985).63 In an intrapreneuring environment, management often uses team-based incentives as a hands-off control mechanism that allows each group to assume the risk of success or failure, as entrepreneurs do.

Figure 11.3 summarizes the advantages and disadvantages of individual- and team-based pay-for-performance plans.

The primary rationale for gainsharing programs can be traced to the early work of Douglas McGregor,64 a colleague and collaborator of Joseph Scanlon, founder of the Scanlon Plan. According to McGregor, a firm can be more productive if it follows a participative approach to management—that is, if it assumes that workers are intrinsically motivated, can show the company better ways of doing things if given the chance, and enjoy being team players.

In contrast to individual-based incentive plans, gainsharing does not embrace the idea that pay incentives motivate people to produce more. Rather, gainsharing suggests that cost savings result from treating employees better and involving them intimately in the firm’s management. The underlying philosophy is that competition between individuals and teams should be avoided, that all workers should be encouraged to use their talents for the plant’s common good, that employees are willing and able to contribute good ideas, and that the financial gains generated when those ideas are implemented should be shared with employees.

Gainsharing plans can provide a vehicle to elicit active employee input and improve the production process. They can also increase the level of cooperation across workers and teams by giving everyone a common goal. In addition, gainsharing plans are subject to fewer measurement difficulties than individual- or team-based incentives. Because gainsharing plans do not require managers to sort out the specific contributions of individuals or interdependent teams, it is easier both to formulate bonus calculations and to achieve worker acceptance of these plans.65

Like all other pay-for-performance plans, plantwide gainsharing programs may suffer from a number of difficulties, among them:

• ▪ Protection of low performers The free-rider problem can be very serious in plants where rewards are spread across a large number of employees. Because so many people work together in a plant, it is less likely that peer pressure will be used to bring low performers into the fold.

• ▪ Problems with the criteria used to trigger rewards Although the formulas used to calculate bonuses in gainsharing plans are generally straightforward, four problems may arise. First, once the formula is determined, employees may expect it to remain the same forever. A too-rigid formula can become a management straitjacket, but managers may not want to risk employee unrest by changing it. Second, improving cost savings will not necessarily improve profitability, because the latter depends on many uncontrollable factors (such as consumer demand). For example, an automobile production facility can operate at high efficiency, but if it is producing a car that is in low demand, that plant’s financial performance will not look good. Third, when gainsharing is first instituted, it is easier for inefficient than for efficient plants or business units to post a gain. This occurs because opportunities for dramatic labor-cost savings are much higher in the less-efficient units.66 Thus, gainsharing programs may seem to penalize already efficient units, which can be demoralizing to those who work in them. Fourth, there may be only a few labor-saving opportunities in a plant. If these are quickly exhausted, further gains will be difficult to achieve.

• ▪ Management–labor conflict Many managers feel threatened by the concept of employee participation. When the gainsharing program is installed, they may be reluctant to give up their authority to committees, thus creating conflict and jeopardizing the program’s credibility. In addition, only hourly workers are included in many gainsharing plans. The exclusion of salaried employees may foster hard feelings among them.

A number of factors affect the successful implementation of gainsharing programs.67 These are:

• ▪ Firm size Gainsharing is more likely to work well in small-to-midsize plants, where employees can see a connection between their efforts and the unit’s performance.

• ▪ Technology When technology limits improvements in efficiency, gainsharing is less likely to be successful.

• ▪ Historical performance If the firm has multiple plants with varying levels of efficiency, the plan must take this variance into account so that efficient plants are not penalized and inefficient plants rewarded. It is difficult to do this where there are scanty historical records. In these cases, past data are insufficient for establishing reliable future performance standards, making it difficult to implement a gainsharing program.

• ▪ Corporate culture Gainsharing is less likely to be successful in firms with a traditional hierarchy of authority, heavy dependence on supervisors, and a value system that is antagonistic to employee participation. Gainsharing can be used effectively in a firm that is making the transition from a more autocratic to a more participative management style, but it probably cannot lead the charge as a stand-alone program.

• ▪ Stability of the product market Gainsharing is most appropriate in situations where the demand for the firm’s product or service is relatively stable. Under these circumstances, historical data may be used to forecast future sales reliably. When demand is unstable, the formulas used to calculate bonuses may prove unreliable and force management to change the formula, which is likely to lead to employee dissatisfaction.

Corporatewide pay-for-performance plans have distinct advantages, several of which are economic rather than motivational. These are:

• ▪ Financial flexibility for the firm Both profit sharing and ESOPs are variable compensation plans: Their cost to the firm is automatically adjusted downward during economic downturns. This feature allows the firm to retain a larger workforce during a recession. In addition, these plans allow employers to offer lower base compensation in exchange for company stock or a profit-sharing arrangement. This feature gives the firm “float,” the flexibility to direct scarce cash where it is most needed. ESOPs may also be used to save a foundering company—one whose cash is running out or is facing a hostile takeover bid. Weirton Steel, Hyatt Clark, Polaroid, and Chevron have effectively used ESOPs for this purpose.76

• ▪ Increased employee commitment Employees who are entitled to profit sharing and ESOPs are more likely to identify themselves with the business and increase their commitment to it. Many consider the sharing of profits between the firm’s owners and workers as a just distribution of income in a capitalistic society.

• ▪ Tax advantages Both profit sharing plans and ESOPs enjoy special tax privileges. In essence, they allow the firm to provide benefits (discussed in detail in Chapter 12) that are subsidized in part by the federal government. Although these types of plans are sometimes blamed for the loss of enormous amounts in tax revenues, it can be argued that they let firms that cannot afford to pay employees high salaries grow and prosper, thereby creating more jobs and tax revenues in the long run. Apple Inc., Sun Microsystems (now part of Oracle Corporation), Quantum Corporation, and Microsoft might not be around today were it not for tax-subsidized ESOPs and profit-sharing plans.

Like all other pay-for-performance programs, corporatewide plans have their drawbacks:

• ▪ Employees may be at considerable risk Under profit-sharing or ESOP plans, workers’ financial well-being may be threatened by factors beyond their control. Often workers are not fully aware of how much risk they face because the factors affecting profits or stock prices can be very complex. The more that long-term employees become reliant on these programs for savings (for their children’s college tuition, their own retirement, or some other purpose), the more vulnerable they are to the firm’s fate.

  Many employees of Fortune 500 firms saw their life savings take a huge fall after the bull market turned into a bear market late in 2008, with the Dow dropping more than 30 percent. Others have seen a windfall in 2013 as the market picked up steam. As the Enron case and its aftermath traveled through the legal and legislative process, it became evident that employers can subject employees to great financial risk when (1) they impose restrictions that prohibit employees from selling or diversifying their company stock until a certain age, or (2) when they allow employees to bet 100 percent of their long-term savings on their company stock. Among entrepreneurial firms, the risk can be huge: Many of these firms do not survive past five years, so the stock employees own may not be worth the paper it is printed on.77 Unfortunately many employees are not fully aware of the risks, or perhaps they don’t want to recognize the risk in these programs and focus instead on the possibility of high returns. The ethical thing for employers to do is to keep insisting on the fact that losses are a distinct possibility when it comes to employees holding company stocks (although this might be difficult to do given that most firms that institute stock-based programs believe that they are good for both employees and the company).

• ▪ High exposure to macroeconomic forces Related to the prior point, most companies have switched over the years from fixed pensions to 401(k) accounts, which are largely funded through profit sharing (see Chapter 12). Because these are unsecured investments, retirees and those approaching retirement age risk losing big chunks of their savings in a single day’s trading, as many experienced in recent years.78

• ▪ Limited effect on productivity Because the connection between individual goal achievement and firm performance is small and difficult to measure, corporatewide programs are not likely to improve productivity. However, they should reduce turnover if seniority strongly affects how much an employee is entitled to under the plan.

• ▪ Long-run financial difficulties Both profit sharing and ESOPs often appear painless to the company in the short run, either because funds are not paid out to employees until retirement or because employees are paid in “paper” (company stock). As noted earlier, firms are now required to expense this “paper money,” but they may still trim the option expenses in a number of ways. This illusion may induce managers to be more generous with these types of compensation than they should be, leaving future management generations with less cash available, lower profits to distribute to investors, and a firm that has decreased in value.

A number of factors influence the successful implementation of corporatewide pay-for-performance plans:

• ▪ Firm size Although they may be used at firms of any size, profit sharing and ESOPs are the plans of choice for larger organizations, in which gainsharing is less appropriate.79

• ▪ Interdependence of different parts of the business Corporations with multiple interdependent plants or business units often find corporatewide plans most suitable because it is difficult to isolate the financial performance of any given segment of the corporation.

• ▪ Market conditions Unlike gainsharing, which requires relatively stable sales levels, profit-sharing and ESOP programs are attractive to firms facing highly cyclical ups and downs in the demand for their product. The structuring of these incentives helps the firm cut costs during downturns. (This is why these programs are often called “shock absorbers.”) Employees (except those who are closer to retirement) are not immediately affected by these fluctuations in short-term earnings because most profit-sharing benefits are deferred until retirement.

• ▪ The presence of other incentives Because corporatewide pay-for-performance plans are unlikely to have much motivational impact on individuals and teams within the firm, they should not be used on their own. When used in conjunction with other incentives (for example, individual and team bonuses), corporatewide programs can promote greater commitment to the organization by creating common goals and a sense of partnership among managers and workers.

Figure 11.4 summarizes the conditions that favor individual, team, plantwide, and corporatewide pay-for-performance plans.