Pay for Performance is a compensation strategy that uses salary, bonuses, or other benefits to directly incentivize employee performance. Employee Performance is generally measured by pre-defined metrics or qualitative evaluations (performance appraisals).
What is Pay for Performance in Business?
It can be stated in simple terms that Pay for Performance is a governance tool that attempts to motivate employees by giving financial rewards for higher performance.
Companies that use a Pay for Performance strategy attempt to reward and give a financial benefit to their top performing employees.
A well designed Pay for Performance system makes a genuine effort to give incentives to all its employees, not just their top performers.
However, it is undeniable that the relationship between performance and pay is a complex one.
Pay for Performance is not a new term in the world of management and is referred to as Merit pay systems.
Pay for Performance is a long established practice that emphasizes employee performance as a key factor in determining compensation.
Merit pay has been a popular concept since the 1960s, when legislation in many labor-friendly states prohibited employers from resorting to seniority as a qualification for wage increases.
But exactly how is pay for performance measured?
There are numerous ways in which employers can design their own measure of performance,
Measures of Performance
Individual Performance Measurement Evaluations were introduced in the late 1980s by Frederick Herzberg. The idea was that it was possible to measure employee performance in such a way that the most significant factors could be separated from the less significant factors.
The above figure shows an Individual Performance Measurement Evaluation.
Individual Performance Measurement Evaluations are sometimes called Job Descriptions. They list the employee’s job duties and goals. The degree of difficulty of the job is also an important consideration.
This information is then used as the basis for performance evaluations. This means that employees are evaluated on the basis of how much they have achieved and not just actual time worked.
Another example of performance measurement is the Individual Performance Appraisals.
Organizational Performance Measurement evaluations are generally used to evaluate and measure the performance of a company.
People within the organization can increase efficiency in their jobs by calculating statistical data about the operations and processes undertaken by the company, and utilizing computer-based models to find the patterns among the data.
The above picture of Organizational Performance Measurement Evaluation is an example of a company that transfers the data it has gathered into an employee performance appraisal metric.
The data gathered from the above process is then used to evaluate employee performance and is used to adjust compensation, salary, and benefits.
But when is Pay for Performance used?
Pay for Performance is used to address problems such as:
When the most productive workers displace the least productive workers, pay for performance can help to promote their retention and provide them with additional compensation, thus minimizing staff turnover and improving productivity;
The issue of employee motivation and retention is fundamental to the effectiveness of any company. It can be stated that Pay for Performance is seen as one of the best ways to retain and motivate employees;
Employees who know that their performance can lead to bigger and better things are more motivated and try harder.
Pay for Performance strategies are credited with boosting productivity levels.
The opposite is not true. Incentives also motivate existing employees to perform better.
Therefore, of course, if poor performers are not fired, and are kept on, management simply adds to its costs.
The benefits of incentives to companies are:
- Higher employee productivity;
- A reduced labor turnover rate;
- Improved efficiency;
- Developing employee skills;
- Motivating employees to achieve;
- An increased rate of return on fixed assets.
These are the most effective arguments for Pay for Performance.
You should however take note that the benefits of the Pay for Performance strategy alone are not enough, and, management must make sure that they enjoy these benefits.
When should Pay for Performance be used?
The Pay for Performance strategy can be used in almost any business operation.
The only requirement is that one can identify some performance measures, and can find a way to reward performance.
The primary user of the Pay for Performance strategy is the individual company, when it is used to adjust pay for employees.
The big three questions that management should ask are:
Do you have the employee skills and performance data to manage a pay-for-performance system? Do you have the resources to implement a pay-for-performance system? Do you have the support and cooperation of your employees?
Further explanation of the reasons why Pay for Performance may not be the right choice for management are:
Employees may be suspicious by a sudden change in their benefits package. For example, just because the company installed a Pay for Performance program, it doesn’t mean that the employees will be interested in the idea of obtaining greater compensation;
A hostile or uncooperative workforce could make a Pay for Performance strategy ineffective;
If management delays in rewarding the best performers or in making necessary adjustments, the Pay for Performance strategy may become a source of frustration for those who are not receiving rewards.
Pay for Performance strategies are used because they are an efficient way to motivate and retain employees.
They make a genuine effort to reward all workers, not just their top performers.
Management should have a genuine interest in what all employees of the company can do, and finding out what motivates them.
What is the link between Pay for Performance and the paycheck?
The paycheck is the total income that employees receive from a given period of employment.
To know how much someone is paid, the company has to know and understand the employee’s pay structure.
The more employees know about their own pay structure, the more they can understand and appreciate what their total income is going to look like.
Take for example a consultant who charges $250 per hour. If he works for two hours each Monday on a project for a company, then it is easy to understand that he earned $500 for that week.
However, what if he worked on that project for that company for 25 minutes instead of two hours? In that case, he earned $5,000 for that week.
Now, what the employee who charged $250 per hour earned $5,000 for a 25-minute day of work. That can be a lot more money than the employee realizes to be honest.
Take another example of an employee who has eight hours of work and earns $150 for that day. In this case, that employee can look to the paycheck and see that the total wages were $1,200, but he or she is still working eight hours.
What is the difference of $150 between what the employee thought that they were earning and what they are actually earning? That difference might put the employee in a different mindset.
Another example is an employee who earns $9.00 an hour. Performing the arithmetic, the employee sees that they earned $72.00 for a 12-hour day. In this case, the employee earned a standard rate of pay for an employee who is earning minimum wage, or maybe slightly above.
However, that $72.00 does not include any type of bonuses or incentives. Therefore, the employee who earned $72.00 for a 12-hour day of work in reality, has only earned $61.28 not including any type of bonuses or incentives.
To ensure that an employee can understand what an hourly wage really represents, the employee must have a basic knowledge of the employee’s pay structure, and the reasons behind why an employee is charged what they are being charged for and the benefits behind those charges.