Performance Management &

Strategic Planning

Chapter-3
Performance management and
reward system
 Strategic Reward Systems:
Pay for Performance

Reward Systems consist of the following

elements:
Financial Rewards – Compensation
1. Base Salary
2. Pay Incentives
3. Employee Benefits
Non-financial Rewards
1. Intrinsic Rewards – centers on the work itself
2. Praise, recognition, time off and other rewards
given to the employee by peers or superiors.
 Strategic Reward Systems:
Pay for Performance

Reward Systems in most cases should be

consistent with other HR systems.
The Reward System is a key driver of:
 HR Strategy

 Business Strategy

 Organization Culture
 Strategic Reward Systems:
Need for Consistency with Other HR Systems
Skill-based pay

Training Culture
Overtime
pay rules in
Merit pay reinforces
contract
performance culture
Labor Rewards
Relation
s Performance
Management

Sign-on Bonus
Employment
Merit Pay
 Strategic Reward Systems

Critical Thinking Question:

1. Should pay policies “lead” or “lag” the
development of other HR systems?
 Theoretical Models of Pay and
Performance: Equity theory (Adams, 1963)

Assumptions:
 People develop beliefs about what is a fair reward
for one’s job contribution - an exchange
 People compare their exchanges with their
employer to exchanges with others-insiders and
outsiders called referents
 If an employee believes his treatment is inequitable,
compared to others, he or she will be motivated to
do something about it -- that is, seek justice.
 Theoretical Models of Pay and
Performance: Equity theory (Adams, 1963)

Is/Os versus Ir/Or

 O = Outcomes: the type and amount of
rewards received
 I = Inputs: employee’s contribution to
employer
 R = Referent: comparison person
 S = Subject: the employee who is judging
the fairness of the exchange
Agency Theory

1. Principals = owners or managers who delegate

responsibilities
2. Agents = managers or employees who manage
firm assets for owners or other principals.
3. Information asymmetry = managers or other
agents have greater access to strategic
information than principals, who are not willing
to bear the cost of directly monitoring the
agents due to steep agency costs.
Agency Theory

4. Risk Preferences – principals are risk neutral

and willing to bear greater risks than agents
because their asset wealth is more likely to be
diversified between corporate assets and other
equities/investments. Agents are more risk
averse than principals, because most of their
wealth is concentrated in the firm and received
in the form of pay and opportunities for
promotion.
Agency Theory

7. Incentive alignment – the agency contract will

specify a compensation plan that aligns the
interests of the principal and agent. This agency
contract will be a type of pay for performance plan.
Meeting or exceeding pre-agreed upon financial or
non-financial outcomes triggers various forms of
compensation (individual or group-based) for the
agent. Some agency costs are borne by the
principal in the form of financial incentives for the
agent.
Tournament Theory

4. A high pay differential (such as the CEO

receiving much greater pay than any
subordinates) attracts more “players” to the
tournament.
5. Players must “invest” (work long hours, accept
less pay, show loyalty to their boss) to enter the
tournament – firm captures value from these
players, more than what it gives up to the
“winner” for the prize.
 Controversies that Surround Pay for
Performance Plans

Single Mindedness – “you get what you pay

for” – no more, no less. The activities that are
rewarded get done, to the exclusion of other
activities that are not rewarded. Example: The
dysfunctional behaviors that are observed when
a sales representative is put on straight
commission.
 Controversies that Surround Pay for
Performance Plans
Control – externalities can control the
outcomes, positive or negative. There can be
windfall affects (the bull market improving the
stock value of all stock options) or negative
externalities (a bear market or recession that
lowers the value of all stocks). Employee
performance results may be magnified or
diluted by these effects.
 Controversies that Surround Pay for
Performance Plans

Inflexibility – managers or employees may

resist change of the basis of compensation
because they are comfortable with current
basis for pay and want to avoid risk of taking
reduction in earnings in new system.
 Controversies that Surround Pay for
Performance Plans
Misalignment of incentives – if pay emphasis is
on a goal that is no longer relevant, that goal will
continue to be emphasized until the pay system
places emphasis on a different objective.
For example, managers may emphasize short-term
goals, even if long-term goals are more relevant, until
the pay system recognizes long-term goals to a
greater extent than short-term goals. The reward mix
for complex jobs with several goals must reflect the
relative value of attaining the mix of goals.
Some Suggestions for More Effective Pay
For Performance Plans

Pay and Performance should be Loosely

Coupled – this gives managers more flexibility
to make changes when new situations arise.
Example: a formula with a bonus based on a
moving average of a 3-year historical
performance period. A 3-year period smoothes
out performance over a longer cycle.
Some Suggestions for More Effective Pay
For Performance Plans

It is Necessary to Nurture the Belief that

Performance Makes a Difference – there are
important cultural values that are supported with
pay for performance even if the accuracy of the
performance metrics and the fairness of the pay
allocations fall short of an ideal situation.
Abandoning pay for performance may be more
problematic than having an imperfect pay
system.
 Some Suggestions for More Effective Pay
For Performance Plans

Pay for Performance systems should be

designed to fit each firm’s unique situation –
imitation of other firm’s plans should be avoided