25 Types of Incentives system

Pragya Dheer

Learning outcome:-

Incentives schemes are also known as payment by results. The three factors which favour the payment of Wage incentives to employees are: (i) the employees must be rewarded for their additional efforts in the job; (ii) The payment facilitates the earning of the higher wages as an inducement for additional efforts; (iii)   It improves productivity & organisational profitability. The fairness of the outcome (reward) of an incentive scheme determine its ability to win the employee’s compensation with the scheme.

However, the type of scheme is a critical factor in determining the quantum of reward available to the employees. Therefore, an organisation must be prudent in choosing incentive schemes as the nature of a scheme has a direct bearing on its outcome. However, the organisation must invariably ensure that the incentive schemes are classified into three categories.

25.1. Types of Incentive Compensation

There are various types of incentive systems which can be divided into three categories described below:

Fig. 25.1. Types of Incentive Compensation

25.1.1. Individual Incentives:

Individual incentive plan is the oldest form of compensation, in which the employee is paid for units produced. Individual incentive plans pay off for individual performance. When individual productivity is measureable, individual incentives are most successful in boosting performance through a fairly direct link between performance & rewards.

These include the following:

25.1.1. Piece Rate system:

The piece rate in the oldest & most common incentive plan. The earliest approach was called straight piece work. In this approach, a worker was paid per unit of production. It is very common in factories around the world. It is based on paying only for what is actually produced. A simple piece rate approach often results in production variability that can disrupt the flow of product to customers. Piece rate system is easy to understand. It is useful in labour incentive industries.

The prerequisites for the implementation of this scheme are:

(i) The skill levels required in production must be similar;

(ii) Productvion should be expressible in units or numbers;

(iii) Production stoppage for which the employee is not responsible should be compensated adequately. The formula for computing the earning is:

Wage Earning = no. of units produced x the piece rate per unit

25.1.1.2. Differential Rate:

Taylor developed the differential rate system as a response to the variation potential in piece rate systems. Taylor’s differential rate had two piece rates; one for performing below standard & a higher rate for meeting or exceeding the standard, thus encouraging workers to at least meet the standard.

However, the major limitations of the differential piece rate system are: (i) It may be difficult to set accurate & agreeable standards of production; (ii) This method may result in the employees cutting corners in their bid to produce faster: (iii) It may create tensions & rivalry between the slow & the fast performance; (iv) The employees may complain of unfairness in the standard setting when they are not able to achieve it.

25.1.1.3. Standard Hourly Rates:

Standard hourly rates differ from piece rate systems is that the production standard is expressed in time units. Using job analysis, the standard time for given task is established & the organisation the sets a fairly hourly wage rate. The standard rate for any task is the wage rate times standard. In some standard hourly plans, the rates varies with output.

25.1.1.4. Production Bonus Systems:

Under these systems an employee is paid an hourly rate plus a bonus when the employee exceeds the standard. The bonus usually equal approximately 50% of labour savings. It is also called time saving bonus. In Japan, all employees receive semiannual production bonuses in December & June.

25.1.1.5. Commissions:

This is incentive plan is usually found in sales jobs. This reward system allows the salesperson to receive a % of his gross receipt (example, 5% of all sales). About 75% of the salespeople work on a commission paid is typically a percentage of the price of the item. Sometimes a salesman is paid small salary & a commission or bonus when he exceeds the budgeted sales goals.

  http://www.prosalesguy.ca/should-salespeople-be-paid-commission-or-salary/

Merits:-

• Commission payments offer a very clear link between pay & worker performance
• Commission plans are easy to administer
• They justify between there is no subjective elements & rewards are purely a function of performance.
• Commissions provide sufficient incentive without adding too much to product cost.
• Because commissions can be highly variable over time, some firms protect salespeople from low sales periods by using a draw-plus commission system.

    25.1.1.6. Bonuses:

To give bonus is a popular trend in compensation. It is one-time lump-sum payment given for meeting a performance goal. Bonuses can be based on objective goal attainment or a subjective rating. In some organisations all employees share in the bonus awards if organisational goals are met whereas in others the size of the bonus is tied to each individual’s performance. Bonuses also can be based on individual or group based measures.

http://blog.turbotax.intuit.com/tax-tips/the-tax-implications-of-receiving-a-holiday-bonus-4419/

Merits:

• Bonuses involve lower risk to the employer because the employer does not make a permanent financial commitment
• Bonus can be offered for a valuable cost-saving suggestion. Thus it promotes creativity.
• It does not add permanently to be base wage & can be given based on either rated or non-rated output measures.
• It helps the employer control cost & improve employee satisfaction.
• Because bonuses arrive in one lump-sum, they may feel to the employees like more money than a comparable-sized raise.
• It is based partly on organisational performance.

On the other hand, if bonuses cannot be paid, it tends to hurt morale.

25.1.1.7. Awards:

Awards like bonuses are on time rewards but tend to be given in the form of a tangible prize. Such as a paid vacation, a television set, or a dinner for two at a fancy restaurant.

25.1.1.8. Merit Pay:

The most widely used for managing individual performance is merit pay. It consists of an increase in base pay, normally given once a year. Supervisors rating of employee’s performance are typically used to determine the amount of merit pay granted. Once a merit pay increase is given to an employee, it remains a part of that employee’s base salary for the rest of his future with the firm (except under extreme conditions, such as general wage cut or a demotion).

Merit pay is based on the rated performance in a previous time period, or a reward based on how well an employee has done the job.

In practice, merit pay system fail to reward superior performance because of the following problems:

(i)   Employees fails to make the connection between pay & performance.

(ii)  The secrecy of the reward is perceived by other employees as inequality.

(iii) The size of the merit pay has little effect on performance.

(iv) Merit pay is not always viewed as meaningful.

(v)  It depends on the reward to produce an effect rather than planning & designing the effect at the outset.

(vi) Merit pay is always based on the supervisor’s subjective evaluation, so employees may perceive a weak line between performance & pay.

(vii) Merit increases are usually awarded annually, so they do not immediately follow the specific instances of good performance that the organisation wishes to reinforce.

For the merit pay to work & become successful, the following requirements are needed:

(i)   Job should be well designed & the performance criteria are both well delineated & assessable.

(ii)  There should be a high level of trust in the management.

(iii) There should be a correct job evaluation system & wage structure.

(iv) There should be job specific & results-based criteria to reduce subjective bias.

(v)  There should be accurate performance appraisals.

(vi) The time should be minimized between the performance appraisal & pay increase, to maximize reinforcement principle.

(vii) Managers should be trained in the correct use of the compensation system.

(viii) There should be proper feedback during performance appraisal session to ensure that employees are aware of expected performance.

25.1.1.9. People-Based Pay:

Compensation designs are changing to meet the environmental challenges of the 21st century. In place of bureaucratic job-based approach, new designs are people based. There are several different variants of people based pay. These are discussed below:

(i)  Skill-based Pay:

This methods sets pay levels on the basis of how many skills employees have or how many jobs they can do. It is a reward system that pays employees on the basis of the work-related skills they posses rather than associating rewards with performance levels or senority.

Under the skill-based system, no one gets a raise, even when promoted, until he has demonstrated proficiency with new skills. It is associated with work teams or self managed work groups.

Merits:-

(i)   It has increased flexibility. Because workers know more than on e job, they can more to provide expertise when & where needed.

(ii) Tying pay increases to skill acquisition creates an incentives for learning, self improvement & performance.

(iii)  It is a creative approach to compensation.

(iv)  It seeks employee involvement through total quality, continuous improvement & similar initiatives.

(v)  It assumes that employees want to grow & improve their job skills.

(vi)  it can be used to replace annual raises.

Demerits:

(i)   It is difficult to design.

(ii)  It does not fit all situations.

(iii) It involves a time consuming process of constructing skill blocks, mapping pay progressions, and assigning monetary values to each skills.

Skill based pay can be successful only if the organisation has a commitment to employee training & development & has something to gain from increased flexibility.

(ii)  Knowledge based pay:

This approach rewards employees for acquiring additional knowledge both within the current job category & in new job categories.

(iii)  Credential-based pay:

This reward system rests on the fact the individual must have a diploma or license or must pass one or more examinations from a third party professional or regulatory agency. Credential based pay is much more cut and dried than skill based or knowledge based pay.

(iv)  Feedback Pay:

This reward approach is based on aligning pay with strategic business objectives & then establishing a direct connection between the jobholder & his part in accomplishing these goals. This design must conform to four principles: (1) It flows directly from the organisation’s strategic business goals; (2) It directly links employee’s actions to these goals; (3) It provides sufficient opportunities for rewards to hold employee’s attention, and (4) it is timely. This method replaces job descriptions with mission statements as a means of directing employees.

(v)  Competency-based Pay:

It is actually a combination of skill based pay, knowledge based pay and credential-based pay. It is often applied to highly educated “knowledge workers”. In addition to skills, knowledge & credentials, competency-based pay includes cognitive or subjective measures not usually considered in evaluating a job.

Advantages of Individual Incentive Plans:

1. Performance that is rewarded is likely to be repeated

2. Individuals are goal-oriented & financial incentives can shape an individual goals over time.

3. Assessing the performance of each employee individually helps the firm achieve individual equity.

4. Individual based plans fit in with an individualistic culture

5. They are widespread in practice.

Disadvantages of Individual Incentive Plans:

1. These create dysfunctional competition and destroy cooperation among peers.

2. Sour relationship between subordinates & supervisors are created.

3. Individual pay plans may work against achieving quality goals.

4. Many employees do not believe that pay & performance are linked.

5. And because many managers believe that below average raises are demoralizing to employees & discourage better performance, they tend to equalize the percentage increases among employees, regardless of individual performance. This of course, defeats the very purpose of an incentive plan.

6.  Individual create inflated perceptions of their own work while deflating the work of others.

7.  Workers are encouraged to “cut corners”. This will affect quality & safety.

Conditions Under which individual Incentive Plan are most likely to succeed:

Individual Incentive work best:

1.  Where clear performance objectives can be set & where tasks are independent.

2.  When the contribution of individual employees can be accurately isolated.

3.  When the job demands autonomy.

4.  When cooperation is less critical to successful performance.

5.  When competition is to be encouraged.

6.  When the supervisor reinforces & supports the system

7.  When quality of work is not especially important.

8.  When most delays in work are under the employee’s control.

25.1.2. Group and Organisationwide Incentives:

These incentives are shared by all members of the organisation. In group incentives, two or more employees can be paid for their combined performance. Group incentives make the most sense where employee’s task are interdependent & thus require cooperation. The goal of organisationwide incentives is to direct the efforts of all employees toward achieving overall organisational effectiveness.

Some major types of group-based & organisationwide incentives are:

25.1.2.1. Profit Sharing:

Profit sharing has received a considerable boost in recent years. Many companies are adopting profit sharing plan as a means of promoting greater productivity to meet world competition. Profit sharing seeks to promote a ‘culture of Ownership’. It develops a sense of belongingness, cooperation & teamwork among all employees. Edwin Flippo writes, “Employee profit-sharing plans constitute one of the more glamorous forms of monetary compensation used in business.”

Profit sharing is a method of industrial remuneration under which an employer undertakes to pay his employees a share in the annual net profits of the enterprise. This share is in addition to regular wages. It is paid on compliance with certain service conditions & qualifications.

Objectives:

1.  To increase productivity

2.  To effect an increase in productive efficiency through reducing costs & increasing output.

3.  To improve employee morale & to reduce labour-management strife.

4.  To provide for employee security in the event of death, retirement or disability.

5.  To constitute a mechanism of employee economic education.

6.  To reduce turnover

7.  To improve public relations.

8.  To maintain peace & harmony between labour & the employer.

9.  To recognize their right for sharing the prosperity of the concern.

10.  To create a congenial atmosphere inside the organisation in which workers feel as partners rather than employers.

11.   To supplement worker’s earnings

12.   To increase the interdependence of labour, management and capital. Employee earnings would adjust quickly to changes in business conditions

13.   To increase awareness and interest in the performance of the organisation.

14.   To encourage long term commitment & loyalty to the company.

15.   To attract & retain employees.

Types of Profit Sharing Plans:

1. Cash Payment Plan: Under this plan, benefits are distributed among participants in cash at least once each year. This is the most popular. The firm simply distributes a percentage of profits (usually 15% to 20%) as profit shares to employees at regular intervals.

2. Deferred Payment Plan: Under this plan, the employees share of profits is held in trust for him to be paid either in installments or as retirement benefits. If the employee is dismissed, the investment amount reverts to him and in the event of his death, it is paid to his right department.

3.   Combination Payment Plan: It is a combination of the cash & differed payment plans. It enables the employee to get some immediate benefits & also to put away something for the future.

Importance of Profit sharing:

1.   Increased Productivity: Profit sharing creates in the worker a genuine desire to work wholeheartedly for the firm.

2.   Improved Industrial Relation: Profit sharing offers a solution to the problems of industrial unrest & strifle. It helps avoid industrial strikes & unrest.

3.  Increased Earnings for workers: The simple effect of profit sharing will be additional earnings for the workers. Thus, it contributes towards the material welfare of the workers.

4.  Stabilisation of Labour Force: Profit sharing is applicable only to those workers who have stayed and worked in organisation for a certain period.

5.  Easy Supervision: Workers take interest and initiatives in the performance of their task if they are given a share in the profits.

6.   Social Justice: Profit sharing scheme helps realize the object of social justice by relating workers’ earnings to the financial position of the company.

7.   Team Spirit: Under profit sharing scheme, both management and workers cooperation and work in a team spirit as their interests are common.

8.  Decrease in Labour Turnover: Workers will prefer to stay in a concern which gives them a share in the profits. It leads to reduction in labour turnover.

9.    Improvement in Standard of Living: the standard of living of workers depends on the wages and income they receive from the concern.

10.   Improved Motivation: When employees are given a share in profits, they feel highly motivated and their morale is raised.

11.   Attracts Talented Workers: The incentive of share in the profits encouraged talented workers to join the organisation.

12.   Other Merits:

i.   It promotes equal partners in industrial enterprises.

ii.  It protects workers’ right to bonus and their due share in productivity.

iii. It fills up the gap between living wage and the actual wage paid.

iv. It improves public relations.

v.  It is a means of drawing labour and management closer together.

Disadvantages:

1. No Distinction between efficient and inefficient workers: All workers covered under this scheme of profit sharing are entitled to an equal share of profit without reference to their efficiency.

2. It kills Personal Initiative: Profit sharing schemes do not make any distinction between good and bad workers.

3. No Immediate Effects: Profit cannot be ascertained every month. The profit share is paid to the worker only at the end of six month or a year.

4. Feeling of Distrust: Profit sharing sometimes may make workers distrustful of management.

5. Opposition by Trade Union: Sometimes trade unions might put up stiff opposition to profit sharing.

6. Employees also oppose: Many employees have not yet acceptable the idea of giving workers a share in net profits.

7. Limited Motivational Impact: Beardwell and Len Holden have made it clear when they state, “the motivational impact is limited as there exists a fragile and vague relationship between individual effort and company profit.”

Pre-requisites for success in Profit Sharing:

1.        A sense of partnership between labour and management should be created.

2.       Satisfactory employer – employee relations should be maintained.

3.       Up – to – date and sound personnel management programme should be formulated.

4.       Congenial supervisory climate should be created.

5.       There should be effective employee communication about the calculation and allocation of profit.

6.       Profit sharing should be a supplementary device to wage incentive plan rather than supplanting it.

7.       There should be a ‘productivity bonus’ side by side with profit bonus.

8.       An effective employee educational plan about profit sharing must be adopted.

25.1.2.2. Gain Sharing:

Gain sharing is becoming a popular approach to motivate higher levels of group productivity. Gain sharing plans generally are based on the assumption that better cooperation among workers and between workers and managers will result in greater effectiveness. Gain sharing is a type of group incentive in which a portion of the gains the organisation realizes from group effort is shared with the group. Many organisations are seeking productivity and quality improvement through gain sharing plans. It is a plantwide ‘pay for performance’ programme in which a portion of the company’s cost savings is returned to workers, usually in the form of a lump – sum bonus.

25.1.2.3. Employee Stock Option Plans:

Many companies use employee stock options plans to compensate, retain and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time.

Employees Stock Options Plans should not be confused with the term “ESOP’s” or “Employee Stock Ownership Plans” which are retirement plans. An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to the plan for the benefit of the company’s employees. Under an employee stock ownership plan (ESOP), employees receive stock in the company. An ESOP is a qualified, defined contribution plans in that the employer makes yearly contributions that accumulate to produce a benefit that is not defined in advance. Technically, an ESOP is a kind of stock bonus plan, or a combination of a stock bonus plan and a money purchase pension plan.

25.1.2.4. Suggestion System:

A suggestion system is a formal method of obtaining employees advice about improvements in organisational effectiveness. It includes some kind of reward based on the successful application of the idea. The key to successful suggestion system is employees’ involvement. Implementation of these programmes have proved quite cost – effective. Suggestion systems can improve employee relations, foster high quality products, reduce costs and increase revenue. In Japan suggestion systems are one of the main practical forms of worker participation schemes.

Figure 25.2. shows how employees benefit from a stock option scheme.

Source: Business Today, January 7 – 21, 1996

Fig.25.2. How to Implement a Stock Option Scheme.

Merits of Organisationwide Incentives:

1.  Financial flexibility for the firm is maintained.

2. Various incentives at the organisation level increases employee commitment.

3. Company has tax advantages as both profit sharing and ESOP’s enjoy special tax privileges.

Demerits:

1. Under profit sharing or ESOP plans, workers’ financial well being may be threatened by factor beyond their control. Hence, employees may be at considerable risk.

2. Because the connection between individual goal achievement and firm performance is small and difficult to measure, organisationwide programmes are not likely to improve productivity.

3. Both profit sharing and ESOPs often appear painless to the company in the short run, but the company may face financial difficulties in the long run.

4. All the organisationwide incentives suffer from a dilution effect. It is hard for employees to see how their efforts results in the organisations’ overall performance.

5. These plans also tend to distribute their payoffs at wide intervals.

6. We should not overlook what happens when organisationwide incentives become both large and recurrent.

25.1.3. Managerial and Executive Incentive Pay:

25.1.3.1. Executive Bonus Plans:

Bonuses play an important role in today’s competitive executive payment programmes. This type of incentive is usually short term (annual) and based on performance. There are almost as many bonus systems as there are companies using this form of executive compensation. In some systems, the annual bonus is tied by formulas to objective measures, such as gross or net profits, earnings, share price or return on investment.

25.1.3.2. Long Term Incentives:

To encourage a longer perspective, many boards of directors are adopting plans of long term incentives for  executives.  Most  executives  receive  long  term incentives, either in the form of equity in the firm (stock based programmes) or a combination of cash awards and stock. Stock options have been a common incentive offered to executives. They generally allow executives to purchase, at some time in the future, a specific amount of the company’s stock at a fixed price. Under the assumption that good management will increase the company’s profitability and therefore, the price of the stock, stock options are viewed as performance – based incentives.

25.1.3.3. Perquisites:

Executives are frequently offered special incentives known as ‘perquisites’. These ‘perks’ are offered to attract and keep good managers and to motivate them to work hard in the organisations’ interests. In addition to the standard benefits offered to all employees, some benefits are reserved for privileged executives. These ‘perks’ are given to supplement the basic benefit package.

www.slideshare.net/vaishali_bansal/perquisites-allowance

Popular perks include the following:

1. Payment of the life insurance premiums.
2. Club memberships
3. Company automobiles and special parking
4. Liberal expense accounts
5. Supplemental disability insurance
6. Supplemental retirement accounts
7. Post retirement consulting contracts
8. Personal financial, tax and legal counseling
9. To pay for vacation travel
10. Low cost loans
11. Personal use of company facilities (eg: airplanes)
12. Chauffer service, concierge service.

    25.1.3.4. Golden Parachute:

This popular benefit was designed by top executives as a means of protecting themselves if a merger took place. These parachutes provides either a severance salary to the departing executive or a guaranteed position in the newly created (merged) organisation.

Summary:

Individual incentive plans include Halsey, Rowan, Emerson, Bedeaux, Taylor, Merrick and Gantt Plans, Priestman, Towne and Scanlon plans are group incentive schemes. Profit sharing helps to improve morale and productivity of employees as well as workers’ income and living standards. It does not have motivational value.