Remuneration: Lifting the curtain on HR’s dark art (part 3)

Sheshaya Surtani has been informing us on the dark art of HR, remuneration.  This is Sheshaya’s third post in her series of four.  More of Sheshaya’s writing can be found here.

Part 3: Show should we pay? Option 2: Pay related to performance (PRP)

As a starting point, we must bear in mind that PRP is a rather delicate set of motivational tools that can be powerfully effective in one setting and dysfunctional in another. This post provides key theories and empirical evidence on PRP. It provides background information on PRP, its plus points as a payment measure along with its key drawbacks in implementation.

  • Defining PRP: key considerations 
    • What is being assessed? ( e.g. individual, group or organisation performance)
    • How is it being assessed? ( e.g. subjective evaluation or concrete result)
    • How is it being rewarded? (e.g. incorporate into the base salary or re-earned every year)
  • What is the goal of PRP? It affects organisations through two main channels: 
    • Sorting effect( i.e. identify and attract the most competent employees
    • Incentive effect (i.e. elicit greater levels of effort , correct attitude and higher job performance)
  •  When to implement PRP?

Ideally, PRP should be implemented when the benefits outweigh the costs. It is highly applicable when:

  • Input/effort monitoring is costly and difficult
  • Output is easily measured
  • Tasks are clear/repetitive
  • Team production is considered relatively unimportant
  • Low levels of intrinsic motivation
  • Individualist organisation culture
  • Limited trade union influence

Job types which fit into this category are: factory workers, call centre staff, post officers and sales persons. Jobs in which PRP poses adverse reactions and risks are: teaching, doctors, nurses, CEO’s and investment bankers.

  •  Why might PRP be beneficial?

Important theories from psychology to bear in mind in relation to this topic:

-Reinforcement Theory (Skinner)
both positive and negative reinforcement have the effect on increasing the probability that a particular behaviour will be learnt and repeated.

Agency theory
the interests of principal (the superior) and the agent (the subordinate) are said to diverge. PRP incentivises agents and is believe to align interests with the principal. Management must make sure the employee doesn’t shirk by close monitoring and offering incentive pay.

Vroom’s Expectancy theory
Motivation is a function of valence, instrumentality and expectancy

-Valence (i.e. personal goals- relative to pay): How much you value the rewards

-Instrumentality
(i.e. performance- reward relative to pay): The belief that a person will receive reward if performance expectations are met. Key factors associated are trust, control and work related policies.

-Expectancy (i.e. effort- performance relative to pay): The belief that one’s effort will result in desired performance. It is based on skills, self-efficacy, and past experience.

Goal setting theory (Latham and Loche)
(Goals should be SMART. note they should be well defined, as these lead to higher performance. Simply stating “do your best” will not work to elicit specific forms of behaviour- it is important that the person knows what exactly is expected of them.

Empirical evidence:  Study on USA logging industry among 3 types of supervisors. Results found productivity was superior for the supervisor who sets specific production goals.

 

  • Empirical evidence of the effects of PRP on performance

There is not much evidence to prove that PRP enhances individual performance per say, yet lots of evidence has been found on whether workplaces that use PRP often perform better than those who don’t.

It is often difficult to obtain a pure measure of performance (i.e. one that relates to the specific individual only, and is not affected by external factors. For instance tying in the pay of CEO’s to share prices will entice more effort and align interests, but share prices are also affected by many other external factors beyond the control of the CEO and it is thus problematic and difficult to measure.

Fernie and Metcalf- study on computer telephony and PRP on jockeys in Britain
There are many possibilities for moral hazard in horse racing. This can be overcome either by monitoring or incentive pay. The study compares jockeys who receive PRP vs those that get a large retainer not related to performance. Results find that huge retainer fees don’t work as well as PRP contracts. It is not what you pay, it is how you pay it and that is what gets the result.

Lazear Safelite study
the study is based on a windshield company which switched from hourly wages to a piece pay rate (i.e.  The number of coin shields installed), combined with minimum hour wage guarantee. Results found that productivity was enhanced by 44%. The study shows significant accountability for the incentive effect and sorting effect. Moving to the piece rate pay structure improved recruitment and retention of high quality workers.
However, in the same case note that it was very difficult to obtain pure performance measures.

Important evaluation:
PRP should be used in conjunction with the “five factor analysis” used in performance management systems. This payment system worked compatibly with Safelite because the five factors (i.e. strategy, technology, culture, workforce and environment) fit very well together. In evaluating this study as a whole, noting the extent to which organisations face differing five factors in their respective contexts, we should treat the success of the Safelite with a pinch of salt. The implementation of a PRP structure worked well because it fit in smoothly with the conditions of “when to implement PRP”. In reality any other company of a different context, could expect very different (sometimes adverse) consequences of adopting a scheme like that of Safelite.

  • Why might PRP be problematic? / Why does PRP fail?

Key theories to consider in this context:

Herzberg’s two factor theory
Motivation factors (certain factors lead to positive satisfaction)
Hygiene factors (if absent, leads to demotivation).This theory suggests that psychological incentives reap much higher benefits than pay.

-Adam’s Equity Theory
Employees seek to maintain equity between the inputs that they bring to a job and the outcomes they receive comparing against perceived inputs and outputs of others.- i.e. employees believe that they ought to be paid according to their contribution to the organisation.

Self Determination Theory
Relates to the importance of intrinsic motivation in driving human behaviour. The presence of extrinsic rewards “crowds out” intrinsic motivation. Performance can increase with payments, but motivation cannot. One must bear in mind that if incentives are perceived too strongly it can lead to “cheating” i.e. excessive risk taking by financiers in the lead up to the financial crisis. According to Stiglitz, “incentive pay in the financial industry, rewards short-term gains, but protects managers from the pain of longer-term negative profits, since the consequences of excessive leverage often become apparent only over extended time periods. Moreover, incentive compensation spurs predatory behaviour, hinders innovation, results in the deterioration of product quality and encourages deceptive accounting procedures.”

In conclusion: PRP does not truly aim at motivation. Companies must design payment systems depending on budget formulation. The use of merit pay increases grid guidelines. Institutional isomorphism in turn suggests that we must use a “contingency approach” and align this with key business strategies.

– Historically, empirical evidence showed a significant relationship between PRP and productivity. It is critical to note that this has not always been the case. The work of Lawler has found the weak link between pay and performance. The link between variable pay and productivity and performance is unclear a priori.

-Firstly the employer incurs costs through the introduction and maintenance of variable pay which might outweigh its potential benefits (Freeman and Kleiner, 2005; Levine and Tyson, 1990).

-Second, variable pay has the potential to demotivate workers. (Brown and Nolan, 1988). Employees may perceive the pay/performance link to be unfair if, for instance, performance is measured with error or employees have not been consulted about the criteria governing the scheme (Marsden, 2004).

-The issue with PRP systems is that they incentivise the wrong behaviour (e.g. individual risk taking). Most jobs nowadays are service-based and focus on the knowledge economy. The degree of physical outputs measured in sectors like manufacturing and call centres, has greatly reduced.

-PRP emphasises work performed by individuals, and consequently lacks focus on teamwork. Most jobs now require interdependence and teamwork based environments
-Empirical evidence: focus on employees individual contributions of individual employees can be destructive in cases where individuals are unfairly penalised for deficiencies in the system, rather than behaviour that they can control. It undermines team work and cooperation thus acting as a disincentive. (Deming). Note that even in the case of group based pay plans, employers have to deal with the “free rider problem” in relation to shirking.

So should we reward top performers with PRP and low performers with others? –What about equity concerns in this context? This poses a trade-off as cooperation and teamwork without ability do not work!

-Other issues associated with PRP:

  • The subjective nature of PM can lead to favouritism and adverse effects on employees fairness perceptions. C.f Organisational Justice Theory (Greenberg)
  • Hay group results have found that less than half of the managers/ professionals believe that high performers are rewarded more than the low performers.
  • Weakens employee’s perception on the link between performance and rewards.
  • Adverse effect on instrumentality component of expectancy theory.

Finally, coming back to the starting point of this post, “PRP is a rather delicate set of motivational tools that can be powerfully effective in one setting and dysfunctional in another.”- I hope that by this point, you have gained a greater understanding of why this is the case. To sum up take a look at the final part of this blog series: “Conclusion-the bottom line about the compensation arena”.

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