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Chapter 5 –Why Does Performance-Based Pay Work?

Why don’t more firms use performance-based compensation? The main reason is a lack of common sense. Many managers take a wrong, static view of a dynamic process. By static, we mean that bosses tend to look at possibilities as fixed and future profit growth as not changeable.

However, the truth is: “With the right motivation, the possibilities for growth and profit are really endless.”

The historical view was that an employee is only a cost, not an asset.

Traditional managers said that companies have to pay at least a fixed minimum wage to attract workers. Companies did not want to pay much more than the minimum because they wanted to keep prices low and to make adequate returns on capital. Employers saw a ceiling that limited the amount they should pay workers. This historical view put companies in an adversarial relationship with workers. In this view, companies should pay workers in a narrow band above the minimum.

However, this historical view is wrong. The ceiling is not fixed. People who become high performers can generate substantial excess value for their firms. This excess value creates room to pay people more on average. By sharing the excess value with employees, both employees and the firm get more cash flow. Both win. Both get more.

Firms with largely fixed pay packages get fixed performance. They actually discourage high performance. Why should an employee work their butts off? With largely fixed compensation, the intelligent employee has little interest in huge effort.

Many readers will have observed that the high-performer group has the highest turnover rate in most companies. Fixed pay systems encourage the low-performers to stay by offering average compensation, and encourage high-performers to leave by offering the same average compensation.

However, performance-based pay systems that vary pay by performance make average and high-performers happier. For average and high-performers, performance-based pay systems reduce their tendency to conduct job searches and turnover. Performance-based pay systems also make low performers less happy and more likely to job search (low performers are paid less than average).

Variable pay systems shift turnover from the high-performer group to the low-performer group—where it should be. Variable pay systems encourage low performers to quit and take jobs at competitors that offer an “average pay” system.

We explain this powerful effect with example of Five Guys. If a Five Guys location has a shift person who continually makes errors while taking the customer orders, the shop has a business problem. Customers are unhappy when Five Guys serves up the hamburger with the wrong toppings.

In most other fast-food companies, the problem continues because employees have no interest in fixing the problem. The other fast food companies only can afford to pay market wages because bad operational problems limit their financial performance.

However, at Five Guys, the problem gets fixed. Why? First, secret shoppers make the problem very apparent. Second, shift workers have an incentive to instruct the error-prone worker and (if the errors continue) pressure the inept worker to leave.

What happens when the bad worker fixes the order-taking problem or leaves?   At Five Guys, the secret shoppers start awarding more compensation to the shift. The high-performing employees get more money. The Five Guys location does better.

Sometimes, the low-performing employee finds a job at another company (perhaps the fast-food joint across the street who now has a worse workforce).

This example makes clear the fact that fixed pay schemes lead to high-performing employees “giving” money to low-performing employees. If a company pays everybody at a location the average wage, the company pays low-performers more than they are worth, and the company pays high-performers less than they are worth.

Fixed pay plane siphon money from high-performers and give money to low-performers. This is not good.

Famous business leaders like Andy Grove of Intel say that most companies waste 10-20% of their labor costs on people who add no value and or destroy value. The approach of some (Intel, for example) is to fire the bottom 10% of staff each year. This is hard to implement for most companies, unpleasant for most managers, and a real hardship for fired employees. It is far easier to pay low performers much less than average, and thus encourage them to find another job.

In addition, when a company has a performance-based pay package, it is very clear what the company wants. The plan makes it very clear how helping the company is in the interest of employees. A well-designed pay-for-performance plan is a very effective communication tool for companies. A good plan also aligns the interests of the company and employees. It helps employees understand what they have to do to help the company and how to make more money.

The result is that all employees spend more time and effort on the things that really matter to the company, increasing the company’s cash flow and value.

A pay-for-performance plan also helps firms avoid layoffs in recessions. In a study of over 12,000 firms, researchers confirmed that firms introducing more Eat-What-You-Kill pay plans enjoy more employment stability, particularly during severe business conditions.

Lastly and surprisingly, a pay-for-performance company is a happy company.

With a good pay-for-performance system, employee satisfaction also goes up for employees overall. Studies have shown that well-administered pay-for-performance systems that are clear and fair lead to increased employee satisfaction, higher productivity, decreased lateness, less theft, less time spent job searching, and less turnover.

In a statistical study of 40,000 employees at hundreds of locations, the National Bureau of Economic Research (Blasi, et al.) found that companies with Eat What You Kill policies (their term was “Shared Capitalism”) had a long list of positive characteristics:

  1. Would turn down another job for more pay to stay with this company
  2. Not likely to search for a new job
  3. Lower days absent
  4. Co-workers work hard
  5. Proud to be working for the company
  6. Co-workers have enough interest in the company to get involved
  7. Co-workers generally encourage each other make extra effort
  8. More loyal to company
  9. Willing to work harder to help company
  10. Higher frequency of employee suggestions

That is quite a list! The authors found that all of these results were highly statistically significant (95%+ significance).

Would you enjoy your work more if your company had these characteristics?

Employers and employees thus gain at least seven ways:

  • High performers stay
  • More average performers are encouraged to be high performers
  • Low performers move up to average or leave
  • More employee effort is spent on the things that matter to the company
  • Employees are paid more
  • Employees become happier and do better jobs
  • Everybody pulls together

With a well-designed compensation plan, these effects add up to create more cash than is needed to deploy the new incentives. Thus, paying more to employees with incentive pay is self-funding.

More broadly, a properly constructed plan will create both above-competitor company profit performance and above-industry pay packages for employees. A well-constructed pay plan is win/win for both companies and employees.

We now give a good example of how this works.


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