Choosing a compensation policy is one of the most crucial decisions a business owner can make. In recent years, some employers have moved toward a pay-for-performance model, which provides financial rewards for employees who meet and exceed performance standards. Over time, analysts have observed both advantages and drawbacks to this method of determining employee pay.
What is Pay for Performance?
A pay-for-performance system rewards employees with additional compensation for their job performance. Some companies institute performance-based compensation in order to encourage employees to take ownership of their responsibilities and to improve overall job performance. Within some companies, certain bonuses could be based on employees maintaining health insurance, maintaining good standing with their credit or improving their overall credit scores.
The Cons of Pay for Performance
According to a study performed by the American Management Association and the Management Toolbox, some roles may be vulnerable to abuse in a performance-based compensation model. Managers often allot bonuses to stars within their own departments to improve morale and overall performance among their teams. However, if compensation is misallocated, it could be viewed as a lack of fairness within the company or as a form of favoritism toward the most valued employees.
Performance-Based Compensation Systems Can Be Misunderstood
A study performed by the consulting firm O’Connor & Associates found that many workers misunderstood their performance-based compensation systems. Some workers associated performance-based pay with management bonuses and incentives, which drives some to worse performance. Only 28% of the employees surveyed knew how performance-based compensation affects compensation.
Pros of Performance-Based Compensation
One of the main advantages to a performance-based compensation model is an increase in employee morale. Workers who are feel rewarded for their dedication and hard work tend to stay longer with a company. Many employees also find it favorable to work for their own interests instead of a company’s, and performance-based pay always makes workers feel as though they have a stake in the company by improving the bottom line.
While profitability is often a career goal, many employees who earn more than minimum wage feel overly compensated when their pay is based on performance. In many ways, a performance-based compensation model provides nearly limitless opportunities for compensation because companies can select different benchmarks to base compensation on and can evaluate employee performance on a wide range of factors.
A performance-based compensation system lowers the overall cost of hiring and training new employees because employers can compensate the employees in addition to the fixed cost of hiring outside sources for temporary labor.
If evaluating the success of a compensation program, analysts typically judge the cost effectiveness of hiring new employees. An ability to balance hiring while maintaining the profitability of a company is very desirable in a performance-based compensation model. When designing a performance-based compensation system, consider factors that directly affect both hiring and maintaining the productivity of the new employees.
A performance-based compensation model takes the responsibility of raising an employee’s performance and compensating them for their work off the shoulders of the employer. When a performance-based compensation system is incorporated, employers can focus on creating a better work environment for their employees. Employers can shift their focus from the day-to-day details of running a company to developing long-term strategies for growth.
Control over the compensation system is an extremely valuable benefit of a performance-based compensation model. For employers, it can take fewer than five years to recirculate capital through an employee’s compensation. By estimating the cost of hiring, hiring and training new employees, as well as their productivity after succumbing new hires, a company can have a great deal of control over its position in the market concerning performance-based compensation.
In some cases, companies may base profits from a performance-based compensation system on the customer satisfaction ratings for their products at the end of a fiscal year.This is only true if a company sells its products directly to the public or to businesses.
When using a performance-based compensation system, companies can balance an employee’s performance with additional benefits such as equipment, automobiles, vehicles and capital investment. They can also use the money to subsidize private education, training and even early retirement. By offering these types of benefits to employees, a company can reduce its overall cost and can offer its employees the chance to advance their careers.
A performance-based compensation model also allows employers to provide accelerated pay increases. A performance-based compensation model can allow employers to increase an employee’s pay by 20% or more. This approach has been proven to increase the overall performance of employees, and they are more likely to increase their overall level of ownership and dedication while working.
In a performance-based compensation system, workers are also more likely to stay within a company. When employees are compensated based on merit, they are less likely to move between companies for a pay increase. This is only true to the extent that it does not conflict with other employee policies that prohibit or control employee mobility. Companies should ensure that severance policies and employee agreements do not conflict with a performance-based compensation model.
How to Structure a Pay for Performance System
A performance-based compensation system provides many opportunities for constructing a unique and effective pay-for-performance system. When designing a system, it is best to seek advice from legal counsel or a certified public accountant. Consultants can assist companies in making strategic decisions on how to structure their system, as well as determining the best strategies for compensating employees in performance-based compensation systems.
When structuring a performance-based compensation system, an employer should consider the following benefits:
- Establishing a performance-based compensation incentive plan that rewards employees for the achievement of clear goals.
- Offering the employees a range of different incentives to steer their efforts toward the achievement of goals.
- Offering incentives in an environment that provides real and achievable reasons for achieving the stated goals.
Some businesses may offer sales commissions as part of a performance-based compensation system. These commissions may be paid out to employees who meet the desired threshold for sales volume. While this benefit may help to eliminate competition between key employees, it can also create an aggressive and disincentive environment for sales staff.
Companies can also use performance-based compensation to recruit innovative employees by offering cash prizes for achieving innovative milestones.
If a company has produced prior work that did not receive positive attention, it is possible to retroactively pay employees for work that has been created by them in the past. This approach can encourage employees to align their performance with goals that are more realistic and achievable.
If a company expects to conduct a merger or acquisition, the company can seek the advice of benefits professionals to decide how their pay-for-performance system will work in a new organization.
To motivate workers to create plans and develop a compensation system that will be beneficial to the company, the company should:
Provide a primer on how a pay-for-performance system can motivate and benefit the employee. Employees should also know how the compensation system works in their company.
Allow employees to explain how compensation should be managed. A professional can then respond with a variety of options for establishing a performance-based compensation system.
Design a compensation system that fits the needs of the company and the employee.
Ensure that the compensation structure aligns with the company’s overall strategy and goals.
When an employee is overpaid, they may be as demoralized as they would be if they were underpaid.
If an employer has a shareholder that is a recognized expert in an industry, they may choose to have them serve as a director of the board of directors. This will provide the company with the innovative expertise that is often absent when using a stock market to raise capital.
When a business uses a pay-for-performance system, it must also factor in the compensation-to-performance ratio. When this ratio is aligned properly, it will motivate employees to meet their target benchmarks, and it will not impede on their opportunity to become innovative and creative. A company should also create economic incentives that will benefit the shareholders and the employees.
How to Determine the Salary Range to Use for an Employee
In some cases, employers will determine the salary range for an employee by using the following formula:
[Base Salary]  x [(Number of Years of Experience)] [# of Employees]
When workers do not report profits that are equal to the company’s target benchmarks, a performance-based compensation plan can help the company to ascertain whether the problem is with management or with the worker. In order to determine which of these two party’s is responsible for the failure to meet the target benchmark, a company must take a closer look at the whole compensation process. If certain employees are compensating at a higher rate than others, then the problem may be with the employee, not the management. This information can then be used to draft a strategy for increasing the overall profitability of the company.
In order to determine which employees will be eligible for a performance-based compensation system, companies can operate a number of different criteria. For example, they can:
- Employ individuals who have passed a probation period.
- Target senior-level employees who have greater job stability and experience.
- Target new employees who may not have yet discovered the optimum ways to interact with customers.
Doc. Dev. Inc., a company that develops employer-specific software, offers the following resource for evaluating the effectiveness of an employee:
Workplace testing is an excellent way to evaluate the employee who is not meeting your company’s benchmark for performance. This process can also be used to determine what kind of employee work styles are best suited for your organization. It provides the employer with an opportunity to compare employees to each other. Workplace testing can provide the employer with the factors and characteristics that are most important for employees to be successful in their jobs with the company.
Contests are effective ways of encouraging and engaging employees who are otherwise disengaged from the company. These contests are often used as part of a promotional strategy for companies that are seeking to generate interest in their products and services among employees. A company can also make use of contests to consider employees’ interests and to promote their higher-level employees. Contests are also easy to carry out and they are relatively inexpensive to operate.
An incentive-pay plan offers employees the potential for additional benefits. In order to encourage workers to achieve their goals, the company should offer employees in incentive-pay plans the following kind of benefits:
- A range of incentives based on various achievements
- A stronger reason to work for the company
- An easier opportunity to earn bonus funds
When a company has a successful incentive-pay plan, they will also have the financial resources to handle projects, fires, and emergencies that are especially costly.
When an employee has not achieved a goal, an incentive-pay plan can provide the company with the opportunity to track the employee’s productivity and behavior. A company can choose to reward those employees who have met their goals, or they can offer a slate of options to the employee, so that they can appeal to the others in the company to improve their performance.