Advantages and Disadvantages of Performance-Related Pay Systems Case Study

Introduction

A performance-related pay system is a remuneration method in which pay progression is based on individual performance (Schuler & Jackson 2008, p. 5). In this system, pay increments and bonuses are normally awarded to employees who are able to meet or exceed pre-agreed objectives or targets.

Thus, it depends on appraisal systems, which help the management to measure employees’ performance. Some of the common performance-related pay schemes include piecework, payment by results, merit pay, and commissions among others.

The idea behind performance-related pay systems is that increased pay can encourage high performance in situations whereby employees can vary their output according to effort (Armstrong 2008, p. 21).

Performance-related pay systems were widely used in the 1980s because they were viewed as the best way to motivate employees and to increase performance. However, the popularity of these systems has significantly reduced in the last decade due to their inability to facilitate high performance and motivation.

It is against this backdrop that this paper discusses the premise that the disadvantages of performance-related pay system exceed its advantages.

Advantages and Disadvantages of Performance-Related Pay Systems

There is little variation in the advantages and disadvantages associated with the various forms or types of performance-related pay systems. Consequently, the merits and demerits of this pay system can be discussed in a general manner.

Advantages

First, performance-related pay systems enable employees to identify a direct link between remuneration and effort (Mathis & Jackson 2011, p. 47). This encourages them to put more effort in their work in order to achieve defined objectives.

According to Piekkola (2005, pp. 619-635), employees are likely to increase their productivity if they believe that their pay will be proportional to the amount of effort that they devote to their work. In most cases, employees will require advanced skills in order to improve their productivity.

Employees who are interested in improving their productivity are likely to be more willing to state their weaknesses in order to benefit from training and development programs. This enables human resource managers to design training programs that address the specific needs of the employees.

Skill acquisition can increase staff costs if the company has to pay for the training and development programs that aim at improving employees’ skills. In situations whereby employees have to pay for their training and development programs, performance-related pay systems tend to benefit the high-income earners.

This is because low-income earners might not afford the training programs that would enable them to improve their skills. In this regard, the low-income earners will not be able to increase their productivity in order to improve their incomes.

The resulting increase in pay disparity can be a source of low morale and productivity. Nonetheless, proponents of performance-related pay systems believe that they encourage skill acquisition (Piekkola 2005, pp. 619-635). This improves the competitiveness of the organization in terms of high efficiency, innovation, and productivity.

Second, performance-related pay systems can lead to cost reduction. According to Mathis and Jackson (2011, p. 98), highly motivated employees do not need close supervision in order to increase their productivity. Motivated employees tend to be proactive and willing to seek assistance from their colleagues.

This negates the need for close supervision, and the costs associated with it. Performance-related pay systems that depend on profits can also lead to a reduction in staff costs.

In particular, when profits decline, the organization’s labor costs will also decline, thereby eliminating the need to lay-off some workers in order to reduce operating costs. In this regard, the organization will avoid costs such as terminal benefits and the legal costs that might arise due to labor lawsuits.

In economies with high unemployment rates, employees are likely to accept a reduction of the portion of their variable pay rather than losing their jobs. However, pay reductions often lead to dissatisfaction among employees, especially, if the reduction in profits is attributed to factors beyond their control.

Marsden (2002, pp. 305-316) asserts that linking remuneration to profits enables employees to identify with the success of the company. Generally, the employees will strive to increase the company’s profits in order to improve their earnings. This strategy requires employees to be familiar with the financial performance of the company.

Thus, it is likely to succeed in listed companies in which financial information is readily available to all employees. However, in private companies employees are often not able to access financial information. In this regard, the management might fail to increase employees’ salaries even if the profits increase.

Similarly, it can be very difficult to convince the employees to accept pay cuts due to a reduction in profits if they are not familiar with the company’s financial performance.

Third, performance-related pay systems can help organizations to reduce staff turnover and absenteeism. This perspective is based on the premise that a remuneration system that links rewards to employees’ effort is likely to improve staff morale or motivation.

According to Dorantes and Mach (2003, pp. 673-698), high motivation is one of the factors that help organizations to reduce staff turnover.

A low staff turnover is beneficial to companies in several ways. To begin with, it reduces the costs associated with replacing employees who leave the company, thereby improving the company’s financial performance. Companies with low staff turnover rates are able to retain their best employees.

In this regard, retaining the best talent is a means of enhancing competitiveness, especially, if the labor market lacks highly skilled personnel. Finally, low staff turnover enables organizations to avoid low productivity. In particular, a reduction in productivity can be avoided by minimizing staff turnover.

In order to realize these benefits, the remuneration must be high enough to motivate the employees to continue working for the company.

In most cases, the variable part of employees’ salaries tends to be a small percentage of their basic pay. Similarly, some employees find it difficult to achieve the targets that would enable them to earn high income.

Under these circumstances, motivating employees through a performance-related pay system can be very difficult. Consequently, the turnover rate will still be a problem. Armstrong (2008, p. 78) asserts that performance-related pay systems help in reducing staff turnover in organizations in which growth opportunities are limited.

Most organizations cannot reward their employees through promotions due to the limited number of high-level positions. In this regard, a payment that corresponds to employees’ effort enables organizations to retain their workers.

Fourth, a performance-related pay system is one of the best ways of introducing change within a company. Concisely, linking financial rewards to performance encourages employees to adopt business cultures that enable them to improve their productivity.

For instance, teamwork is likely to improve in organizations in which performance is measured at both group and individual level. The team members are likely to improve their commitment, cooperation, and productivity if they are aware that their contributions in the team will determine their earnings.

Similarly, customer satisfaction is likely to improve if the employees receive financial rewards for offering excellent services. In this regard, a performance-related pay system is a means of fostering a culture of high productivity by rewarding the best performers (Shelley 1999, pp. 439-454).

The poor performers are expected to emulate the high performers by increasing their productivity. Hence, a performance-related pay system is a means of dealing with underperformance. In the last two decades, teamwork has emerged as one of the best ways of promoting high productivity.

Consequently, most organizations are trying to develop the best team-based remuneration system. The difficulty in developing team-based remuneration is that the system must recognize the success of the team as a whole, as well as, the contributions of its members.

In this regard, some organizations are opting for performance-related pay systems to reward teamwork. This is because the system provides employees with opportunities of higher earnings in a manner that is equitable and consistent with their effort within a team.

Finally, performance-related pay can be an effective system for encouraging workers to pursue the mission and vision of the company. Mission and vision statements are often conceptualized in terms of broad and specific business objectives.

Line managers often use these objectives as guidelines for setting individual targets for their juniors. According to Armstrong (2008, p. 122) aligning employees’ job targets to the objectives of the organization facilitates achievement of the company’s vision.

However, this strategy often fails because mangers do not provide incentives that motivate the employees to achieve the set targets. In this regard, a performance-related pay system facilitates achievement of targets by motivating employees to work hard.

The resulting increase in productivity, leads to the achievement of the organization’s mission and vision. This strategy is likely to succeed if the managers are able to align job targets of their employees to the stated vision of the company.

Disadvantages

Even though performance-related pay systems are likely to improve employees’ motivation and performance, they also have several disadvantages. Some of the disadvantages of the system include the following.

First, the difficulties associated with the measurement of performance limits the application of performance-related pay systems (Randle 1997, pp. 187-200). The system can only be fair if a reliable appraisal procedure is used to assess employees’ performance.

Measuring performance is often a problem in most organizations due to the weaknesses of the available appraisal systems. Most managers find it difficult to measure work in most occupations, especially, if a given task has to be completed by several people.

In this case, it is difficult to determine the employee who is supposed to receive financial rewards. Identifying the right metrics for measuring performance is one of the major challenges that hinder the application of performance-related pay systems.

Appraisal systems often fail because they do not measure the actual effort or performance of the employees. Additionally, some employees fail to understand the criteria for measuring performance.

The challenges associated with measuring performance often lead to conflicts between managers and employees concerning the amount of bonus or salary increments that should be paid. In particular, conflicts are likely to arise if employees’ efforts are equal, but their financial rewards are different.

This leads to low motivation and high dissatisfaction among employees. Similarly, productivity will reduce if employees believe that their contributions to the company cannot be recognized through a fair appraisal system. Linking remuneration to appraisal can limit the benefits of assessing employees’ performance.

Concisely, employees who are underperforming are likely to consider appraisals as a means of punishing them because it leads to a reduction of their salaries. In this regard, employees may become defensive during the appraisals rather than accepting targets that are more challenging.

Additionally, underperforming employees are likely to cover up their weaknesses when their salaries are at stake. Consequently, it will be difficult to identify their training and development needs. As a result, the underperformers will continue to record poor results, thereby reducing the competitiveness of the organization.

Second, the effect of performance-related pay systems on motivation is unclear (Randle 1997, pp. 187-200). While proponents of the system believe that it has positive effects on motivation, its opponents opine that it has little or no contributions to employee motivation.

Financial rewards such as bonuses and commissions are often a small percentage of employees’ pay. Similarly, salary increments are often awarded in small percentages in order to avoid high labor costs.

In this regard, performance-related pay systems fail to motivate employees since the financial reward is not likely to be a true reflection of their effort. Marsden (2002, pp. 305-316) asserts that performance-related pay systems can only facilitate short-term motivational effect.

This is because most organizations find it difficult to sustain salary increments and bonus payment due to profit reductions in their industries. Payment schemes that depend on profits hardly facilitate motivation. This is because financial performance of the company depends on several factors, which employees might not be able to control.

In this regard, reducing employees’ salaries in response to a reduction in profits will lead to low motivation since the poor performance cannot be attributed to their performance.

Performance-related pay systems often fail to improve employees’ commitment due to their “focus on financial rewards rather than developmental needs” (Marsden 2002, pp. 305-316). This is because non-financial rewards such as promotions are also important in the process of improving employees’ commitment to the organization.

In this regard, a performance-related pay can only be effective if it is used to strengthen a motivational system that has non-monetary rewards such as training.

Third, performance-related pay systems often worsen the problem of pay inequality. Since it is not easy to measure individual performance objectively, some employees will always earn more than they deserve while others will receive less.

In socialist communities, an unequal pay system can lead to serious legal battles. Labor suits are not only expensive, but are also likely to tarnish the reputation of the company in the labor market. Performance-related pay systems often weaken trade unions and limit the success of collective bargaining processes (Heery 1997, pp. 430-442).

This is because remuneration decisions are related to individuals rather than groups of employees. For instance, in a piecework pay system employees’ salaries depend on the amount of output that they are able to produce in a given period.

The amount of “salary or wage that employees receive for each unit of output depends on the value of the product” (Armstrong 2008, p. 142). In this regard, trade unions cannot easily negotiate for better pay, especially, if there are little or no improvements in the value of products.

Fourth, performance-related pay systems often fail due to the unavailability of the right mix of rewards. The most common forms of financial rewards include commission, bonus, and salary increment. Some organizations might not be able to use any of these rewards due to poor financial performance (Marsden 2002, pp. 305-316).

In some cases, choosing the right financial reward tends to be difficult. Bonus and commissions are relatively cheaper than salary increments. However, determining the percentage of the bonus or the commission to be paid is often very difficulty. This difficulty is attributed to the complications associated with measuring work.

Employees’ morale is likely to improve significantly if the commission or bonus is high. However, paying commissions or bonuses at a high percentage might not be sustainable due to the competing needs of the organization.

Paying commissions at low rate, on the other hand, might not have any effects on employees’ motivation and performance. Hence, it will not have any impact in the organization.

Fifth, recent research findings indicate that performance-related pay systems can discourage teamwork rather than promoting it (Marsden 2002, pp. 305-316).

The system can be divisive as employees try to achieve their performance targets. In particular, employees are likely to pay little attention to team activities if they are aware of the fact that free rides will benefit from their efforts.

In some cases, employees tend to devote much of their effort to pursuing personal targets at the expense of their teams. In this regard, employees often avoid tasks that require teamwork. This leads to poor performance and low product quality. Competition among employees can also lead to poor teamwork.

Poor performers can opt for unorthodox means such as sabotage in order to reduce the income disparity between them and the high performers within a team. For instance, poor performers can be reluctant to share vital information with excellent performers.

Consequently, the productivity and the earnings of the high performers will decline, thereby reducing the salary disparity in the team.

Divisions can also emerge if the overall objectives of the team limit the ability of its members to improve their achievements. In this context, team members might not be able to agree on the objectives that should adopt.

Finally, implementing performance-related pay systems is often very expensive. The system can only succeed if the company is able to use an effective approach to appraisal. In this regard, the company might have to replace its appraisal system in order to implement a performance-related pay scheme.

Research indicates that introducing a new appraisal system is often expensive and time-consuming (Marsden 2002, pp. 305-316). For instance, the company might incur high costs by conducting research on the best appraisal system to adopt. In some cases, the organization will have to hire external consultants to design a new appraisal system.

Independent or external consultants are often expensive and might fail to understand the appraisal needs of the organization. After adopting the new appraisal system, managers and supervisors must receive adequate training on how to use it. Similarly, the management must create awareness among employees on how the system works.

These trainings increase the cost of implementing the performance-related pay system. Finally, the company must have adequate funds that will enable it to offer financial rewards to its employees. Some pay schemes such as sales commissions can significantly reduce profit margins.

Furthermore, providing financial rewards can be unsustainable during periods of low sales and profitability. It is apparent that a performance-related pay system will fail if the company is not able to keep its promise of rewarding employees through financial compensations.

Conclusion

Performance-related pay is a remuneration system in which employees are paid according to their performance. In this system, financial incentives such as bonuses, commissions, and salary increments are used to reward employees.

The main forms of performance-related pay systems include piecework pay, merit pay, and profit-related pay among others (Schuler & Jackson 2008, p. 13). Proponents of performance-related pay systems believe that they are a means of providing incentives to employees.

These incentives improve employees’ motivation and commitment, thereby encouraging high performance. Additionally, the system is an important control mechanism that enables organizations to influence the behaviors and performance of their employees.

Despite these benefits, the application of performance-related pay system is limited due to the following reasons. First, measuring performance objectively is often a serious challenge in most organizations. Second, it can discourage teamwork as employees focus on their targets.

Third, the ability of the system to enhance motivation is uncertain. Finally, implementing the system is normally expensive. Organizations that intend to use performance-related pay systems should be ready to address these weaknesses.

References

Armstrong, M 2008, Strategic Human resource Management, McGraw-Hill, New York.

Dorantes, C & Mach, T 2003, ‘Performance Pay and Fringe Benefits: Work Incentives or Compensating Wage Differentials?’ International Journal of Manpower, vol. 24 no. 6, pp. 673-698.

Heery, E 1997, ‘Performance-Related Pay and Trade Union Membership’, Employee Relations, vol. 19 no. 5, pp. 430-442.

Marsden, D 2002, ‘The Paradox of Performance-related Pay Systems’, Applied Economics, vol. 34 no. 3, pp. 305-316.

Mathis, R & Jackson, J 2011, Human Resource Management, McGraw-Hill, New York.

Piekkola, H 2005, ‘Performance-Related Pay and Firm Performance in Finland’, International Journal of Manpower, vol. 26 no. 8, pp. 619-635.

Randle, K 1997, ‘Rewarding Failure: Operating a Performance-Related Pay System in Pharmaceutical Research’, Personnel Review, vol. 26 no. 3, pp. 187-200.

Schuler, R & Jackson, S 2008, Strategic Human Resource Management, John Wiley and Sons, New York.

Shelley, S 1999, ‘Diversity of Appraisal and Performance-related Pay Practices in Higher Education’, Personnel Review, vol. 28 no. 6, pp. 439-454.