Why Pay for Performance Only Works in Theory

Why Pay for Performance Only Works in Theory

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Why Pay for Performance Only Works in Theory

In this short paper I will explain why the statement “The introduction of individual pay for performance contributes to an improvement in a company's (financial) performance” is to my opinion not valid. Before we can jump into a reflection on the statement, two questions arise that will be discussed as an introduction “What is pay for performance?” and “Why is pay for performance considered as a system that might contribute to a company’s performance?”

What is pay for performance?
Pay for performance is a motivation concept in human resources, in which employees receive compensation for their work based on the level of reaching certain targets (individually or with their team, department or company). The term is often referred to when one is addressing the topic of variable pay based on performances. Although not generally recognised, the term pay for performance should, to my opinion, include as well, aside of variable pay, fixed pay and intrinsic rewards.
According to Dreher and Dougherty most current pay systems are not related to performance but only to circumstances and skills and competencies: ‘Most pay structures can be labelled job based pay (…). Some firms introduced a new pay system toward a skill- or competency based pay. In these systems employees are given pay increases as they acquire additional skills or competencies, not as they move to a job in a higher pay range’ .

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Ideally we should include intrinsic rewards in the discussion as well. 'Employees receive both intrinsic and extrinsic rewards for performance. Intrinsic rewards are self-granted and consist of intangibles such as a sense of accomplishment and achievement. Extrinsic rewards are tangible outcomes such as pay and public recognition’ . The value of intrinsic rewards is often neglected, without reason as according to some research: “extrinsic rewards can lose their motivating properties over time and may undermine intrinsic motivation” . And “some research shows that workers value interesting work and recognition more than money” .

Why is pay for performance considered as a system that might contribute to a company’s performance?
One of the objectives of Human Resource management in general is to align the human resources of the company with its strategy and with specific circumstances. “What better way to drive people to work harder and more efficiently, you may ask, than to offer them a special carrot: more money for hitting specific company targets? ” Pay for performance is a performance appraisal system that motivates employees to perform activities in line with the company targets, and rewards employees that meet the specific targets. On the one hand the system stimulates performance in line with company strategy, but on the other hand when targets are not met, the company saves money. The system ‘puts some of the risk of doing business from the firms to the employees ’.

Several underlying unspoken assumptions are behind the pay for performance concept, which derive from the very nature of the society that we live in and are not necessarily accurate.
- Money motivates people to work harder.
- Increased motivation will increase performance.
- Fair measurement of work performance is possible.
Let’s take a closer look at these assumptions.
Money as a motivator: There is no doubt that money can be a powerful motivator. Dreher and Dougherty state that ‘effective merit pay creates a strong connection (instrumentality) between the employees’ level of performance and the subsequent size of their salary increase’ . From the Vroom expectancy Theory we learn: “The strength of a tendency to act in a certain way depends on the strength of expectancy that the act will be followed by a given consequence (or outcome) and on the value or attractiveness of that consequence (or outcome) to the actor ”. Within a pay for performance system the described relation can be considered among the highest. However, money isn’t always the motivator. For example, if you love gardening, you will put your heart into it. If you get paid to garden but don’t really like doing it, you’ll do it for the money but probably won’t do as good a job as someone who loves gardening.
Motivation leads to increased performance: Motivation is clearly linked to performance. However, in many cases motivation is not the problem. The performance problem may be due to lack of skills, poor organization, bad strategy, or a host of other factors.
Performance measurement: Measuring performance is difficult and the most significant practical problem in a variable-pay system. But paradoxically, precise measurements may lead people to do precisely the wrong thing. For example, two offices will compete rather than cooperate on a job because each is measured on its own profitability. Even harder to manage is the problem of perception. Even where there are real, perhaps obvious, performance differences, the employee who doesn’t perform well is more likely to attribute his or her low output to favoritism rather than performance.

Why individual pay for performance won’t contribute to the company performance
Although embraced by a high number of companies in the beginning a large number of them have already abandoned the pay for performance system. Based on the theory, other available resources (e.g. interviews, newspapers, internet, etc.) and personal experiences I identified 8 key reasons why individual pay for performance will not contribute to the company performance (see picture 1).

1. Changing market conditions
In a pay for performance system targets are set based on assumptions on market conditions. In a situation like we see today with ABN-AMRO in the Netherlands where the position of the bank, due to the situation of a possible merger or acquisition has changed dramatically the perspectives on performance criteria like “customer retention” or “customer acquisition”. The example is perhaps a bit dramatic, but the fact is that market conditions change and the pay for performance system is not able to adapt to these changes.

2. Variability in targets
As conditions in the market change, strategies within the company change as well. Changing strategies lead to new targets. Dreher and Dougherty recognise this and comment on it: “performance appraisal should be congruent with the organization’s strategies and circumstances as well as relevant for the work of the particular job classes involved ”. As targets are set on specific moment it doesn’t take into account these fluctuations. Last year a colleague of me had a massive target on a relaunch of a product range in her workplan. During the year, she proposed herself to change priorities as results were not as promising as expected and therefore was it not worth the investment to continue to strive for a successful product launch. When it got down to variable pay she was really dissatisfied on the judgement of the targets as she didn’t get any payout on this subject, while she proposed herself to stop further investments and initiatives.

3. Where does the money come from?
In general companies that implement are not aiming to spend more on wages, but just to spend it different and to distribute the money different amongst employees. About 4 years ago Unilever intended to improve its pay for performance system by increasing the possible pay out of variable pay. Of course this idea got great applause from everybody within the company. The downside of this initiative was a freeze on increases in fixed salary. Personally this felt that I was paying my bonus myself I was therefore dissatisfied instead of extra motivated.

4. History of rewarding
Dreher and Dougherty comment on the principle of profit sharing as following: “Once the profit sharing becomes institutionalized as a permanent, unchanging fixture of the workplace it may have little motivational impact as far as improvement in work performance” . Kreitner et al. explain the relationship between employees’ future effort and reward probabilities which are influenced by past experience with performance and rewards . Within Unilever variable pay will only be paid if Europe meets its targets, I personally experienced that I over performed on all my targets but did not get any extra pay for this performance. This results in an enormous dissatisfaction.

5. Interdependency
Like already mentioned in the “performance management” part of the unspoken assumptions might lead to conflicting situations within the organisation. On the other hand it is hard to think about employees activities that are fully isolated. In general a sales rep is used as an example for who a pay for performance system should work beneficial. But how about a situation in which the service department is doing a lousy or a great job, this does influence for a great deal the possible results of the sales rep.

6. Effective measurement of performances
Key in pay for performance systems is effective measurement of performances. This is unfortunately one of the hardest things in business.
- Merit pay will lose its motivational power if the performance appraisal system is seen as unfair or inaccurate. Merit pay, like any individual-oriented pay-for-performance mechanism, may also inhibit cooperation and instead foster competition among work group members. In addition, because of the use of subjective performance evaluations, some argue that merit pay can harm employees’ self esteem, perceptions of equity, and even their “intrinsic” interest and motivation in their work .
- Drawbacks to results oriented measures are caused by:
- contamination: the performance measure is influenced beyond the employee’s control
- deficiency: adequate measurement of employee performance must cover all the important dimensions of job performance
- motivational concerns: employees will focus their attention on tasks that are measured and rewarded
- Unavailability: there is no easy way to capture important aspects of employee work with objective output measures.
- As “credibility is crucial for maintaining employee morale ” the measures have to be captured with a minimum of measurement errors. This measurement accuracy contributes to the credibility . This sensitivity is often experienced as a strong disadvantage

7. Intrinsic versus extrinsic rewards
Like mentioned in the part “what is pay for performance?” and as illustrated with the example of the gardener, the value of intrinsic rewards is often understated.

8. Narrow-mindedness on targets
The advantage of target setting is that managers can prioritise activities for their employees. But what would expect to happen, when 10 activities are relevant for a specific job and you reward just one or two with a pay for performance? Research shows that “individuals neglected aspects of the job that were not covered in the performance goals ”. Pay for performance leads to an unbalanced set of priorities within a job. Furthermore, Kreitner et al state that “quality suffered when employees were given quantity goals ”.

In this short paper I summarized 8 key reasons why “The introduction of individual pay for performance does not contribute to an improvement in a company's (financial) performance”. Performance appraisal and management is a complex and difficult undertaking, often accompanied by frustration and confusion on the part of managers and employees . It is often experienced as a negative process instead of the intentional positive en stimulating process that should contribute to a company’s performance.

But both Kreitner et al. (“there in no one best way type of reward. Individual differences and need theories tell us that people are motivated by different rewards” ) and Dreher and Dougherty (“there is no one best way to formulate a performance appraisal and performance management system” ) agree on the fact that there is no one best way in performance appraisal. This indicates that for some companies pay for performance could be the best system to implement. Therefore I would like to take the position regarding the statement “No, unless”. If a company is able to turn the 8 key reasons for not implementing “pay for performance”, the system could be beneficial. In all other cases I would advise not to implement pay for performance in a pure form. A derivative of pay for performance, which can come in many different ways, might be the best solution in those cases.
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