Discuss the basic requirements for successful implementation of incentive programs.

Chapter ObjectivesAfter studying this chapter, you should be able to • Discuss the basic requirements for successful implementation of incentive programs. • Identify the types of and reasons for implementing individual incentive plans. • Explain why merit raises may fail to motivate employees adequately and discuss ways to increase their motivational value. • Indicate the advantage of each of the principal methods used to compensate salespeople. • Differentiate how gains may be shared with employees under the Scanlon and Improshare gainsharing systems. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Chapter Objectives(cont’d)After studying this chapter, you should be able to • Differentiate between profit sharing plans and explain advantages and disadvantages of these programs. • Describe the main types of ESOP plans and discuss the advantages of ESOP to employers and employees. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Strategic Reasons for Incentive Plans • Variable Pay • Tying pay to some measure of individual, group, or organizational performance. • Incentive Pay Programs • Establish a performance “threshold” to qualify for incentive payments. • Emphasize a shared focus on organizational objectives. • Create shared commitment in that every individual contributes to organizational performance and success. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentive Plans as Links toOrganizational Objectives • Incentive Plan Purposes • Encourage employees to assume “ownership” of their jobs, thereby improving effort and job performance. • Motivate employees to expend more effort than under hourly and/or seniority-based compensation systems. • Support a compensation strategy to attract and retain top-performing employees. • Incentive Plan Effectiveness • There is evidence of a relationship between incentive plans and improved organizational performance. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Advantages of Incentive Pay Programs FIGURE10.2 • Incentives focus employee efforts on specific performance targets. They provide real motivation that produces important employee and organizational gains. • Incentive payouts are variable costs linked to the achievement of results. Base salaries are fixed costs largely unrelated to output. • Incentive compensation is directly related to operating performance. If performance objectives (quantity and/or quality) are met, incentives are paid. If objectives are not achieved, incentives are withheld. • Incentives foster teamwork and unit cohesiveness when payments to individuals are based on team results. • Incentives are a way to distribute success among those responsible for producing that success. • Incentives are a means to reward or attract top performers when salary budgets are low. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Do Incentive Plans Work? • Successful Plans • Use important organizational metrics by which to measure employee performance • Find the right incentive payout. Payout formulas should be simple and understandable. • Are continuously communicated to employees to establish a clear link between performance and payout. • Effectively measure employee output and reward exceptional employee performance © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Do Incentive Plans Work? • Why Incentive Plans Fail: • They fail to meet employee expectations for pay gains. • There is confusion about incentive payment calculations due to poor design and implementation of the plan. • Employees do not have the capability to change their performance levels. • The organization environment does not support plan. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

1 Setting Performance Measures—The Keys Both large and small organizations have established performance measures to improve operational success while rewarding employees for their performance outcomes. Establishing meaningful performance measures is one of the important and difficult challenges facing management today. Before managers or supervisors develop and implement organizational measures, they should consider the following guidelines. • Performance measures—at all organizational levels—must be consistent with the strategic goals of the organization. • Define the intent of performance measures and champion the cause relentlessly. • Involve employees. • Consider the organization’s culture and workforce demographics when designing performance measures. • Widely communicate the importance of performance measures. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Administering Incentive Plans • Incentive systems are effective: • When incentives are based on actual differences in individual, team, or organizational performance and not seen as entitlements. • When annual incentive budgets are large enough to reward and reinforce exceptional performance. • When overhead costs associated with plan implementation and administration are properly considered beforehand and are controllable. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Employee Opposition to Incentive Plans • Production standards are set unfairly. • Incentive plans are really “work speedup.” • Incentive plans create competition among workers. • Increased earnings result in tougher standards. • Payout formulas are complex and difficult to understand. • Incentive plans cause friction between employees and management. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Successful Incentive Plans • Employees have a desire for an incentive plan. • Employees are encouraged to participate. • Employees see a clear connection between the incentive payments they receive and their job performance. • Employees are committed to meeting the standards. • Standards are challenging but achievable. • Payout formulas are simple and understandable. • Payouts are a separate, distinct part of compensation. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Effective Incentive Plan Administration • Grant incentives based on individual performance differences. • Have the financial resources to reward performance. • Set clearly defined, accepted, and challenging yet achievable performance standards. • Use an easily understood payout formula • Keep administrative costs reasonable. • Do not “ratchet up” performance standards. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Individual Incentive Plans • Straight Piecework • An incentive plan under which employees receive a certain rate for each unit produced. • Differential Piece Rate • A compensation rate under which employees whose production exceeds the standard amount of output receive a higher rate for all of their work than the rate paid to those who do not exceed the standard amount. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

60 minutes (per hour) 5 units per hour = 12 minutes (standard time per unit) $12.75 (hourly rate) $2.55 per unit = 5 units (per hour) Computing the Piece Rate © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Piecework: The Drawbacks • Problems with piecework systems: • Is not always an effective motivator • Piecework standards can be difficult to develop. • Individual contributions can be difficult measure. • Not easily applied to work that is highly mechanized with little employee control over output. • Piecework may conflict with organizational culture (teamwork) and/or group norms (“rate busting”). • When quality is more important than quantity. • When technology changes are frequent. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Individual Incentive Plans (cont’d) • Standard Hour Plan • An incentive plan that sets pay rates based on the completion of a job in a predetermined “standard time.” • If employees finish the work in less than the expected time, their pay is still based on the standard time for the job multiplied by their hourly rate. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Individual Incentive Plans (cont’d) • Bonus • Incentive payment that is supplemental to the base wage for cost reduction, quality improvement, or other performance criteria. • Spot bonus • Unplanned bonus given for employee effort unrelated to an established performance measure. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Merit Pay • Merit Pay Program (Merit Raise) • Links an increase in base pay to how successfully an employee achieved some objective performance standard. • Merit Guidelines • Guidelines for awarding merit raises that are tied to performance objectives. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Problems with Merit Raises • Money for merit increases may be inadequate to satisfactorily raise all employees’ base pay. • Managers may have no guidance in how to define and measure performance; there may be vagueness regarding merit award criteria. • Employees may not believe that their compensation is tied to effort and performance; they may be unable to differentiate between merit pay and other types of pay increases. • Employees and their managers may hold different views of the factors that contribute to job success. • Merit pay plans may create feelings of pay inequity. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Motivation Through Merit Raises • Develop employee confidence and trust in performance appraisal. • Establish job-related performance criteria. • Separate merit pay from regular pay. • Distinguish merit raises from cost-of-living raises. • Withhold merit payments when performance declines. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Lump-Sum Merit Pay • Lump-Sum Merit Program • Program under which employees receive a year-end merit payment, which is not added to base pay. • Advantages: • Provides financial control by maintaining annual salary expenses and not escalating base salary levels. • Contains employee benefit costs for levels of benefits normally calculated from current salary levels. • Provides a clear link between pay and performance. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentive Awards and Recognition • Awards • Often used to recognize productivity gains, special contributions or achievements, and service to the organization. • Employees feel appreciated when employers tie awards to performance and deliver awards in a timely, sincere and specific way. • Noncash Incentive Awards • Are most effective as motivators when the award is combined with a meaningful employee recognition program. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

2 Customize Your Noncash Incentive Awards Compensation specialists recognize that a successful noncash incentive program will offer employees a wide selection of awards—awards that appeal to a diverse workforce and the uniqueness of individual employees. “One-size-fits-all” is not the approach to take. What appeals to younger employees may not be attractive to older employees. For example, one marketing firm characterizes recognition and rewards based on generations as follows: Traditionalists (61+). These individuals are less likely to spend money on themselves. Attractive awards include entertainment venues, vacations, and technology items. They also appreciate health and wellness opportunities. Boomers (41–60). Personal recognition is important. These individuals want to feel appreciated for their work contributions and are likely to change jobs if they feel under valued or go unrecognized. Boomers favor incentive rewards in the areas of travel, luxury gifts, health and wellness options, and personalized plaques and awards. Generation X (25–41). This group values a balanced lifestyle of work and play. Generation X employees value gadgets and high-tech items along with flexible schedules and discretionary time off. A flexible “day-off-work” would appeal to this group. Generation Y (14–25). These employees desire immediate performance feedback. Employee-of-the-Month programs appeal to these employees as do “spot” recognition plans. Gift cards, gift certificates to “trendy” stores, and movie tickets are appropriate as rewards for the immediate recognition of performance. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentive Plans for Salespersons • Straight Salary Plan • Compensation plan that permits salespeople to be paid for performing various duties that are not reflected immediately in their sales volume. • Advantages: • Encourages building customer relationships. • Provides compensation during periods of poor sales. • Disadvantage: • May not provide sufficient motivation for maximizing sales volume. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentive Plans for Salespersons • Straight Commission Plan • Compensation plan based upon a percentage of sales. • Drawis a cash advance that must be paid back as commissions are earned. • Disadvantages: • Emphasis is on sales volume rather than on profits. • Customer service after the sale is neglected. • Earnings tend to fluctuate widely between good and poor periods of business. • Temptation to grant price concessions to get sales. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentive Plans for Salespersons • Combined Salary and Commission Plan • A compensation plan that includes a straight salary and a commission component (“leverage”). • Advantages: • Combines the advantages of straight salary and straight commission forms of compensation. • Offers greater design flexibility • Can be used to develop the most favorable ratio of selling expense to sales. • Motivates sales force to achieve specific company marketing objectives in addition to sales volume. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Incentives for Professional Employees Managerial and Executive Incentives Bonuses and merit increases Double-track wage systems Performance incentive bonuses Profit sharing and stock ownership Executive perquisites (perks) © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Executive Compensation • The Executive Pay Package • Base salary • Short-term incentives or bonuses • Long-term incentives or stock plans • Benefits • Perquisites (perks) © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Executive Compensation • Justifications • Large financial incentives reward superior performance. • Business competition is pressure-filled and demanding. • Good executive talent is in great demand. • Effective executives create shareholder value. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Executive Compensation: Ethics and Accountability • Incentive payments are excessive compared with return to stockholders. • Time periods for judging and rewarding performance are too short. • Quarterly earnings growth is emphasized at the expense of research and development. • Emphasis is placed upon equaling or exceeding executive salary survey averages. • Benefits do not relate closely to individual performance. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Executive Compensation Reform • Current Reform Measures • The Internal Revenue Service (IRS) is looking for tax-code violations in executive pay packages and will make executive pay a part of corporate audits. • The Securities and Exchange Commission issued pay disclosure rules which require companies listed on the New York Stock Exchange and NASDAQ to disclose the true size of their top executive pay packages. • The Financial Accounting Standards Board (FASB) now requires that stock options be recognized as an expense on income statements. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Executive Compensation Reform (cont’d) • Other Reform Measures: • The adoption of performance formulas that peg executive compensation to organizational benchmarks other than stock price • Shareholder resolutions that allow shareholders the right to vote on executive pay packages • Greater accountability by compensation committees to justify large executive pay awards or severance or retirement packages © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Group Incentive Plans • Team Incentive Plans • Compensation plans where all team members receive an incentive bonus payment when production or service standards are met or exceeded. • Establishing Team Incentive Payments • Set performance measures upon which incentive payments are based • Determine the size of the incentive bonus. • Create a payout formula and fully explain to employees how payouts will be distributed. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

4 Lessons Learned: Designing Effective Team Incentives Will your team incentive program be successful? While there are no exact keys to success, team compensation specialists cite the following as important components of a meaningful team incentive plan. • Are organizational members—employees and managers—predisposed to a team incentive reward system? Is there a “cultural readiness” for team compensation? If change is indicated, what information needs to be given to all organizational employees? • Enlist total employee and managerial support for the incentive effort. While top management support is critical, without the encouragement of employees and middle- and lower-level managers (those directly involved in the program implementation), team incentive programs invariably fail. • When developing new programs, include representatives from all groups affected by the incentive effort—labor, management, employees. Inclusion, not exclusion, serves to build trust and understanding of the program’s intent and its overall importance to organizational success. • Establish effective, fair, and precise measurement standards. Selected performance measures should be key indicators of organizational success. Do not attempt to measure everything. Employees should be able to directly influence the performance measures selected. Furthermore, performance measures should be challenging but realistic and obtainable. Standards must encourage increased effort without becoming entitlements. • Incentive payout formulas must be seen as fair, be easy for employees to calculate, offer payouts on a frequent basis, and be large enough to encourage future employee effort. The goal is to create a pay-for-performance environment. When standards are not met, explain why the reward was not earned. • Determine how incentive rewards will be distributed. Will team members receive equal dollar awards, or will team members receive differential payments based on such factors as seniority, skill levels, rates of pay, member contributions, and so forth? • Communicate, communicate, communicate. Constantly champion the benefits of the incentive awards to employees and their contribution to organizational success. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Team Incentive Plans (cont’d) • Advantages • Team incentives support group planning and problem solving, thereby building a team culture. • The contributions of individual employees depend on group cooperation. • Team incentives can broaden the scope of the contribution that employees are motivated to make. • Team bonuses tend to reduce employee jealousies and complaints over “tight” or “loose” individual standards. • Team incentives encourage cross-training and the acquiring of new interpersonal competencies. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Team Incentive Plans (cont’d) • Disadvantages • Individual team members may perceive that “their” efforts contribute little to team success or to the attainment of the incentive bonus. • Intergroup social problems—pressure to limit performance and the “free-ride” effect may arise. • Complex payout formulas can be difficult for team members to understand. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Group Incentive Plans (cont’d) • Gainsharing Plans • Programs under which both employees and the organization share the financial gains according to a predetermined formula that reflects improved productivity and profitability. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Gainsharing Incentive Plans Scanlon Plan Rewards come from employee participation in improving productivity and reducing costs. Rucker Plan (SOP) Shared rewards come from the difference between labor costs and sales value of production. Improshare Gainsharing based on increases in productivity of the standard hour output of work teams. Earnings-at-risk Encourages employees to achieve higher output and quality standards by placing a portion of their base salary at risk of loss. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Enterprise Incentive Plans • Profit Sharing • Any procedure by which an employer pays, or makes available to all regular employees, in addition to their base pay, current or deferred sums based upon the profits of the enterprise. • Challenges: • Agreement over the percentages of shared of profits and the forms of distribution (cash or deferred) of profits between company and employees • Annual variations and possibility of no payout due to financial condition of company • Maintaining motivational connection of profit-sharing to performance of employees © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Enterprise Incentive Plans (cont’d) • Stock Options • Granting employees the right to purchase a specific number of shares of the company’s stock at a guaranteed price (the option price) during a designated time period. • The value of an option is subject to stock market conditions at the time that option is exercised. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

5 Employee Stock Option Plans What Is a Stock Option? A stock option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the “grant” price and is usually the market price at the time the options are granted. Employees who have been granted stock options hope that the share price will go up and that they will be able to “cash in” by exercising (purchasing) the stock at the lower grant price and then selling the stock at the current market price. How Stock Option Plans Work Here is an example of a typical employee stock option plan. An employee is granted the option to purchase 1,000 shares of the company’s stock at the current market price of $5 per share (the “grant” price). The employee can exercise the option at $5 per share—typically the exercise price will be equal to the price when the options are granted. Plans allow employees to exercise their options after a certain number of years or when the company’s stock reaches a certain price. If the price of the stock increases to $20 per share, for example, the employee may exercise his or her options to buy 1,000 shares at $5 per share and then sell the stock at the current market price of $20 per share. Companies sometimes revalue the price at which the options can be exercised. This may happen, for example, when a company’s stock price has fallen below the original exercise price. Companies revalue the exercise price as a way to retain their employees. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Enterprise Incentive Plans (cont’d) • Employee Stock Ownership Plans (ESOPs) • Stock plans in which an organization contributes shares of its stock to an established trust for the purpose of stock purchases by its employees. • The employer establishes an ESOP trust that qualifies as a tax-exempt employee trust under Section 401(a) of the Internal Revenue Code • Stock bonus plans are funded by direct employer contributions of its stock or cash to purchase its stock. • Leveraged plans are funded by employer borrowing to purchase its stock for the ESOP. © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Rewards and Risks of ESOPS Employee Stock Ownership Plans Advantages Disadvantages Retirement benefits Liquidity and value Pride of ownership Single funding basis Deferred taxes Not insured © 2010 South-Western, a part of Cengage Learning. All rights reserved.

bonus combined salary and commission plan differential piece rate employee stock ownership plans (ESOPs) gainsharing plans Improshare lump sum merit program merit guidelines perquisites profit sharing salary plus bonus plan Scanlon Plan spot bonus standard hour plan straight commission plan straight piecework straight salary plan team incentive plan variable pay © 2010 South-Western, a part of Cengage Learning. All rights reserved.

Discuss the basic requirements for successful implementation of incentive programs.