Rewarding Performance: Getting The Level Right

Most organizations pay for performance or say they do. In order to do that effectively the first step is defining performance. One of the critical decisions has to do with the level at which performance is defined, measured and rewarded… organization-wide, unit/team or individual?

Every organization is given a report card… by shareholders, investment analysts, employees and prospective investors and employees. Successful organizations generate a high return on the resources they consume, whether they are in the private sector, public sector or not-for-profit sector. This is the most widely accepted definition of effectiveness and success. In the private sector criteria such as profit, ROI, EBITDA, shareholder return, growth, share of market and other financially oriented measures dominate the definition of performance. Public and not-for-profit organizations may use quantitative measures such as expenditures vs. budget but most often define results as providing services. But no matter what definition is selected constituents will measure the organization’s performance.

When deciding how to reward performance at the organizational level there are numerous options. In for-profit organizations management may opt to budget rewards based on the level of organizational performance. If base pay increases are the medium for awards the budget for increases would be tied to results… larger budgets in good years and smaller in bad years. Another alternative is to use Incentive plans that create an award fund that is a percentage of profits over and above an established threshold, with profits below the threshold being reserved for shareholders, to pay them a return on their investment. Management may believe that only executives and managers should share in the fund, based on their more direct and significant impact on organizational results. Or the philosophy might be that all employees contributed in their own way and therefore should share in the spoils. No matter what eligibility criteria are allocation decisions must be made.

Cash performance sharing incentive plans have a long history. Roman Legions had a plan that all should share in the spoils of conquest, with “managers” (Centurions) receiving five times the loot received by the “employees” (Legionnaires). Profit sharing plans, both cash and deferred, often calculate individual awards using the same dollar amounts or the same percentage of current pay for all employees. In some cases the targeted award level varies by organizational level, based on the assumption that those in more responsible positions contribute more than those with lesser responsibilities. There may also be differences in the type of awards. Managers may receive stock or stock options while others may receive cash.

Some organizations insert another level for determining allocation. Divisions, business units, departments or teams may have their performance measured, with the size of the fund allocated to each based on their performance. This approach considers both organizational and unit performance in allocating awards. The figure below outlines the alternative methods of allocating reward funds.

Another decision must be made relative to allocation. Should employees who contribute more receive larger awards than those contributing less? If the organization uses a merit pay system this is the intent, although merit pay results in larger or smaller base pay increases, rather than cash awards. If incentive plans are used the share of the available fund, whether determined at the organization-wide or unit level, is allocated based on relative individual performance. One of the differences between merit pay and incentive plans is often that merit pay is based on how the individual performs a job, while incentive awards are generally for meeting objectives.

When teams are used it poses another question. If performance can only be accurately measured at the team level should any attempt be made to use individual performance as a determinant of awards? A research team may include people from different disciplines, making it difficult to differentiate contribution, especially if no one can produce the desired results without the assistance from the others. A team creating a new product using concurrent design may have people representing Engineering, Finance, Production and Marketing, with all contributing different perspectives. This also make it difficult to compare individual contributions. When culturally diverse teams exist the acceptance of the allocation method may differ across cultural orientations. In individualistic cultures egalitarian allocation may be viewed as inappropriate, while in collectivist cultures differentiating between individuals may be thought to be wrong-headed.

It is critical to address these philosophical issues before deciding how to define, measure and reward performance. An organization can select the organizational or unit or individual level. Alternatively it can deem it appropriate to define performance at the organizational and the unit and the individual level and to make separate reward allocation decisions at each. It depends on the culture… of the organization and the workforce. Getting the level(s) right is critical to the effectiveness of a strategy governing how performance is defined, measured and rewarded.

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