Improving Employee Productivity With Performance-Based Pay

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Published: 25th May 2010
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Between 2007 and 2008, in the midst of what former Federal Reserve Chairman Alan Greenspan called "by far" the worst financial crisis in the U.S. history, American CEOs were not exactly destitute.

In fact, according to a survey of 2,700 public companies by independent research firm the Corporate Library, as the stock market plummeted by 37 percent and 2.6 million Americans became unemployed, median annual compensation for CEOs declined barely by a miniscule 0.08 percent. But wait, that's not all: Three quarters of the surveyed CEOs actually received a raise, proving that executive compensation is recession-proof!

All that brings up a very important question as to why executives are receiving disproportionately high compensation when their companies are losing money and laying off workers? This also begs another related question: What compensation model should be applied to employees and executives to boost both long-term and short-term performance?

An overview of compensation models

Before we tackle these questions, let's look at the three commonly used compensation models:

Seniority Pay awards additional increases in pay based on how long a person has worked on the job. Seniority generally warrants a permanent increase in base pay for past time on the job.

Merit Pay awards additional increases in pay based on an individual employee's job performance. Generally speaking, it is also a permanent increase in base pay for past performance.

Incentive Pay is a compensation that changes based on individual or group/company standard. Although an employee may receive base pay as with the seniority or merit system, with incentive pay it is a one-time payment that will vary from year to year, based on either individual or group performance.

A question you may be asking yourself is: Which of the above compensation models is most appropriate to increase a firm's productivity?

Most effective approach

The best decision for profit-motivated organizations (as opposed to non-profits) is to implement a hybrid approach combining all three compensation models: seniority and merit pay system's permanent increase with incentive pay based on performance.

How do you calculate the incentive pay? I suggest that you use permanent ratio increases - as is the case with seniority and merit pay systems - but they should only be paid out when the group/company achieves it goals. This hybrid approach has two effects:

It creates a permanent increase in individual pay - as long as the group reaches its goals.

It encourages individual effort, while also promoting collaboration and innovation among the group because everyone is working toward a common goal and benefiting from achieving that goal.

Performance-based pay

The above approach may not retroactively modify the exorbitant payouts made to CEOs of many companies, but it does create a more equitable compensation system which fuels individual and team performance.

And by the way, some companies - such as BMW - have already started to tie performance to pay. According to a study conducted in March 2009 by the Institute for Corporate Productivity (i4cp), an increasing number of companies are paying closer attention to their pay-for-performance systems.

If this is the beginning of a trend, then there is no doubt that in the future more and more companies will adopt some type of incentive pay system for all workers in order to increase employee motivation. And increased motivation will eventually translate into improved performance.

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