Incentive Pay: Is It Right For You?
by Deborah Rechnitz, CMA CMC

From the Management Strategies Column published monthly in American Drycleaners Magazine

Incentive pay is a concept which is not new to business and not even new to many drycleaner owners.  Recently, it is gaining more and more popularity, at least with business owners.  In fact, sixty percent of companies surveyed last year by the compensation experts Hewitt Associates had at least one broad-based results-sharing program, up from 51 percent in 1990.

What is incentive pay?  Incentive pay is a pay practice that places a portion of an employee's pay increase at risk.  There are several advantages to these types of pay systems.  First, if used properly, incentives are much more cost effective than wage and salary increases.  For instance, only if volume goes up does the pay increase.  This also allows the plan to be self-funding in that employees earn more only when they produce value-added results. 

Another advantage is that there is no permanent addition to the base pay.  The pay must be re-earned every year. In fact sometimes pay is re-earned every paycheck or even every hour, depending on the plan design. 

Such plans also seem to solve a number of problems: sagging moral, stagnant productivity, and so-so quality.  And yet, staff and management agree that after several years, these plans fail to perform as expected.

Are they really that good?  When something comes along that sounds too good to be true, it usually is.  Incentive plan results are being constantly surveyed throughout the United States.  What do people say about these plans?  The most common gripe is that "everyone feels good when you put something extra in their paycheck, but when it's not there, they feel you've taken it away."  This is often called entitlement creep.  The incentive plan actually becomes a de-motivation plan.

The second problem is that only a minority of employees actually change their behavior in response to incentive pay plans - and those that do, all too often, they maximize their compensation at the expense of the company. 

Successful plans, at best, achieve modest, short-term success.  For some, that's good enough.  Successful plans, on average, had a one-time 4 to 5 percent productivity increase within a year.  We'd all like that.  However, after the first year, there is generally no increase or an actual decrease in productivity.   

What's the major reason for incentive pay's checkered track record?  Management is often less than candid with themselves and their employees about their plans' true objectives.  There are three basic reasons to introduce an incentive pay program. 

1) to focus or change employee behavior,

2) to share company profits, or

3) to replace fixed costs with variable costs. 

Not surprisingly, management often proclaims their goal is to motivate and reward employees or to share profits, when in reality the true objective is to cut costs.

How do you design a successful plan?  It is dangerous to generalize about incentive pay.  There are a wide variety of programs in use today.  Among the most popular are spot awards, often non-financial or for very modest sums designed to recognize individual achievement; individual performance bonuses, small group or team awards, gainsharing plans in which management and employees in a business unit split gains achieved through cost reduction or increased productivity; and company wide cash profit sharing in which all employees share equally.  Each type of plan achieves a different objective. 

Individual incentive plans are the most effective at more closely linking pay to performance.  Small group incentives foster team work and reward organizational changes.  Gainsharing is effective at increasing productivity but doesn't necessarily reward teamwork.  Profit sharing is helpful as a recruiting device, but is not an effective way to link employee pay to performance.  While each type of plan is better at achieving some goals than others achieve, none is a surefire blueprint to success, regardless of the goal. 

Each plan must be customized so that the financial incentive reinforces and supports the corporate culture.  It should not drive it. 

What Every Plan Needs.  The more specific the objectives and the greater the employee's control in achieving them, the better for the health of an incentive plan.

The Right Performance Measures.  It is critical to identify quality goals as well as quantity goals.  Without quality standards, the productivity results may skyrocket, but if the quality suffers, sales will ultimately fall.  The quantity standards must also be quantifiable by the employees.  They can not be complex gyrations produced by your office staff, but rather easy to understand and calculate by the person performing the work.

Challenging Goals.  If takes some courage to set goals that are difficult, but achievable.  If everyone can reach these goals, then entitlement creep occurs. 

Goals Employees Feel They Can Reach.  A good plan should recognize there might be no direct line of sight between an overall corporate measure and individual performance.  Ideally, you should have an incentive fund with multiple components, say a split of 33/33/33 - a piece for overall corporate results, a piece for team or unit performance, and a piece for individual performance.  The individual or team goal must be controllable by these individuals.  You can not hold someone responsible for items that they have no control over.

Goals That Reflect Corporate Culture.  A company sends a message about what's valued.  Plans that work best are in sync with the organization's underlying philosophy.

Clear Communication About The Downside.  Virtually all incentive pay plans shift risk to employees - a fact management tends to downplay.  Employees need to understand this at the outset.  The plan won't pay if results are insufficient.  Part of the definition of variable pay is that it varies.

Employee Input.  Often the most successful plans are those that involve the employee in the design and implementation of the plan. 

Consistent Messages.  Plans are often introduced with warm messages from management about the company and employees having a shared destiny.  This message is often inconsistent with what employees see in the business or perceive about the business.

Realistic Expectations.  It is important to calculate the real cost of the plan, to rewrite the rules, to communicate the plan, and to wait for it to take its full effect.

Significant Rewards.  Any goal must return an adequate amount of reward for the perceived work required.  For most employees, this means that the amount of the reward must be a significant, after tax impact on the paycheck.

The Root of the Problem Any incentive plan requires constant monitoring and updating.  It is a misconception that you can let a plan sit for years.  In addition, these plans are expected to be panaceas - to solve all of the employee-related issues, which currently exist.  THEY ARE NOT REPLACEMENTS FOR MANAGEMENT.  The incentive plan is just a tool to help you manage.  If you don't know how to manage, it won't help you.  A fundamental problem with incentive compensation plans is that they are built on a cultural fault line that runs from the bottom of the company all the way to the top.  If management talks of getting employees to shift from an "entitlement" mentality to an "entrepreneurial" mentality - but has not yet made that transition itself, there is a mixed message being sent to the employees.  After all, companies no longer offer cradle-to-grave employment; they want loyalty but no longer pay more for seniority.  They want employees to act as if they own the company, but they pay based on the speed of each piece produced.  These incentive pay programs become manipulative, not empowering. 

Employees can ask more questions when their money is at stake, but management must encourage it.  Ideas must be treated with dignity.  Questions require answers and dialogue must occur.  At the end of the day, it may be a more important part of the plan to have the dialogue than the money.

There is a critical caveat which anyone considering incentive systems must be aware of.  There is a key distinction between what's important to people and what motivates them.  You may be preoccupied with money, but more money can never motivate you to do a good job.  We can not forget that people are motivated when they like what they're doing and feel appreciated.  This is not to say that incentive compensation does not drive employee behavior.  It does, but if we pay people well and treat them fairly, it will increase your opportunity for success, no matter how you structure the plan.

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