RSM Resources

During the past several years, traditional annual pay raises and holiday bonuses have begun to disappear as U.S. companies opt for pay-for-performance (PFP) compensation plans.

A recent study of 1,000 companies revealed that:

• 78 percent have PFP compensation plans of some sort.
• Only 41 percent give holiday bonuses, a decrease of more than 10 percent in the past five years — and more than half of the companies that still give bonuses do so in the form of food rather than cash.
• The 2005 budget allotment for PFP increased nearly 2 percent among the companies surveyed to 11.4 percent of their total compensation budget.

Why are all these companies moving to PFP plans? For the same reasons your company should make the switch (if you haven’t already), says compensation expert Rob Heneman. They simply work.

"The research evidence is very clear," says Heneman, a professor of management and human resources at The Ohio State University Fisher College of Business. "When it comes to motivating people and making them more productive, pay for performance is the most powerful HR management intervention tool we have."

PFP plans can be more effective than providing employees with additional training and more fruitful than going to extraordinary lengths to hire the best people in the first place, Heneman says. Good PFP plans can increase individual productivity by 30 percent or more. Furthermore, they help match employee goals with a company’s overall strategic goals and communicate to them what really matters within the organization. That doesn’t mean,however, that any old PFP plan will do. In fact, the wrong kind fail or even demoralize employees.

Although it seems obvious, Heneman says, a common mistake in creating PFP plans is to enter the process without first projecting the cost and determining where the money will come from. Some studies have shown that PFP plans must provide a minimum 4 to 5 percent increase over base salary in order to be meaningful to a manufacturing employee, for example. In general, Heneman thinks that truly effective PFP plans must offer somewhat higher increases — 7 to 8 percent. At any rate, you need to figure out if your available resources before you begin.

The next step is to determine how a PFP plan might work in your organization.

"If you want a pay-for-performance plan that works — both for your employees and for your business — you must align the interests of the employees with those of the company," Heneman says. "That means, for starters, you need to revisit your business strategy. Make sure you have well-established and clearly articulated goals and objectives."

As you re-examine your basic business strategy, one of your primary goals is to zero in on the business drivers at every level of your company, from senior management, through middle management, down to the individual employee. Ideally, you want to design a comprehensive PFP plan that addresses everything from your strategic objectives, through operating and departmental objectives, down to individual objectives. Doing so sets the stage for a PFP plan that closely aligns with your business strategy and enables all employees to meet company expectations and contribute to overall success.

After you’ve aligned your PFP plan with business strategy, determine what to measure and how to measure it. A common downfall of PFP plans is to tie incentive pay to things over which employees have no control. For example, suppose that A-to-Z Widgets Co. (a hypothetical manufacturing company) wants to increase revenue by 10 percent and profitability by 5percent. If A-to-Z Widgets plans to divvy up incentive pay based solely on increasing sales, production-line workers may object. They don’t directly impact sales, and they certainly can’t see how you can effectively measure their performance and reward them accordingly. At this stage, Heneman recommends you begin to involve your employees in designing the PFP plan.

"The only time I’ve seen a lot of problems crop up around pay-for-performance plans is when management enters into the process with a preconceived set of notions about what constitutes high performance and how it should be measured," Henemansays. "The employees end up feeling like the whole plan was imposed on them from on high or shoved down their throats."

When approached collaboratively, however, employees often receive PFP plans with open arms. Even labor unions — historically resistant to merit pay — have welcomed new PFP plans when they helped create them, Heneman says.

As you work with your employees to develop your PFP plan, make sure you include enough details to give employees a good picture of exactly what actions they can take to become strong performers and how such performance benefits the company. If production-line workers from A-to-Z Widgets, for example, know that one way to meet plan is to reduce scrap by 15 percent, then they’ve got performance they can measure. That kind of alignment and transparency makes sense to employees and creates a high level of "buy-in," an essential criterion for a successful PFP plan, Heneman says.

Even good ideas need a chance to take root. Before initiating a new PFP plan, Heneman recommends laying the groundwork necessary for it to flourish.

"You can’t just dump a PFP plan on a group of employees that have no experience with it," Heneman says. "But you can develop a culture that’s supportive of incentive pay in as little as nine months to a year."

Communication is key. If you tell employees precisely what you’re going to measure and then train them accordingly, you’re creating a culture that will support your PFP plan.

Once launched, a well-designed PFP plan becomes a very powerful vehicle for ongoing communication of organization values. It enables management to guide employees every day of the year. The end result? Not only are your employees working really hard, they’re focusing onthe right things so that your business — and your bottom line — can flourish along with your PFP plan.