Financial Incentives

Abstract

Most organizations use financial incentives to motivate their employees to perform at a higher level in support of organizational goals and objectives. On an individual basis, financial incentives include piecework programs, bonuses, promotions, and merit pay raises to encourage consistent above-average performance. On a broader level, financial incentives can be given to all employees according to the profitability of the organization; an act which encourages employees to harbor a vested interest in the organization's success. No matter the type of financial incentive used, it must be tied to performance in order to ensure that the employee is fairly compensated and that the organization reaches the high performance it needs and desires.

Overview

Why Work? Many of us have a love/hate relationship with our jobs. While on some days we can barely drag ourselves out of bed to go to work, on other days the thought of the tasks to be done is so invigorating that we cannot wait to get started. One is truly fortunate if the latter type of mornings outnumber the former. However, all too often this does not seem to be the case. Yet, we still continue to go to work if for no other reason than that we need the paycheck.

Maslow's Hierarchy of Needs. A number of observers have posited various motivations to explain why people work. Although some theorists have tried to reduce motivation to an equation that connects the probability of increased performance with such things as the employee's perceived expectancy of obtaining a reward for doing so, other theorists have posited that different people are motivated by different things such as having one's physical needs met (e.g., food on the table and a roof over one's head), a need for the esteem of others, or some other internal incentive. Abraham Maslow, for example, described a hierarchy of needs ranging from meeting basic physiological needs (e.g., food, clothing, shelter) to safety, belongingness, and esteem needs and eventually self-actualization (see Figure 1). According to this theory, people are motivated by different things depending on where there are on the hierarchy at any given point. For example, a person who has earned a high level position in his/her career and has adequate income for whatever s/he wants to do may be able to focus on self-actualization. However, if that same person loses his/her job or investments, s/he may once again be concerned about meeting basic physiological needs.

Importance of Financial Incentives. Although virtually every organization tries to motivate its employees through financial incentives, these are not seen as motivators in the scientifically used meaning of the word. Rather, at various places on the hierarchy of needs (or other motivation theory), financial incentives give people the means by which they can meet their needs. For example, in Maslow's hierarchy of needs, a person who is out of work and fears losing his/her house could probably be easily motivated to work for a financial reward that would help him/her put food on the table or pay the mortgage. Once such immediate needs have been met, however, money or other financial incentives allow the person to meet his/her safety needs through such things as obtaining a steady job that brings in a sufficient and reliable paycheck, one's belongingness needs by providing a high enough income to allow the person to be identified with other successful people (either at the work place or through other fee-based institutions like country clubs). Money can also be used to help meet one's esteem needs as people look at the situation that money has allowed the person to attain.

No matter the theory, however, most motivation theorists recognize the fact that most people working in organizations both need and expect remuneration. Sometimes financial incentives are required to meet basic physical needs or to have the security of knowing that those needs will continue to be met for the foreseeable future. In other cases, financial incentives in the form of bonuses, raises, or promotions fill a need for recognition from others. However, no matter what motivators an employee has, from the employee's point-of-view, pay is always a consideration. Although job titles and other perquisites can be important motivators, in most cases employees need more from the organization than to know that they are helping it succeed. To motivate employees to perform at a consistently high level, the organization must give them what they want or need. In most cases, this is some kind of financial incentive that, in turn, allows the employee to obtain or work towards the reward that s/he really wants. One of the things that successful organizations do to motivate employees to contribute to the company's high performance is to link the desired performance to rewards.

The truth is that money and other financial incentives are one of the reasons why people in Western culture work. Although many of us could keep ourselves mentally and physically engaged through other activities, if one does not have the financial status to meet one's needs, a job is the most typical solution. Although other perquisites (e.g., a corner office, a more important title) can be used to reward an employee in the workplace, because of the flexibility of financial incentives to meet one's needs, they are one of the most frequently used rewards. However, to be effective in motivating the kind on the job behavior that will most effectively support the business, the financial incentives need to be linked to job performance. Otherwise, rather than reinforcing the type of behavior that supports the organization, the financial incentives can actually reinforce behavior that is contrary to the good of the organization. For example, one of the reasons that the piecework approach to paying assembly line workers has historically been so widely used is because it ties the financial remuneration that the worker receives to the number of widgets that the worker produces. The more widgets (that are within specification) that the worker produces, the more the worker gets paid under this method. However, if workers were only paid for the number of widgets that they completed—whether or not they were within the standards for an acceptable widget—the financial incentive might actually encourage the workers to produce more widgets that were unacceptable, thereby rewarding them for shoddy work and costing the organization money rather than saving it.

Types of Financial Incentive Plans. There are a number of common approaches to financial incentives in business.

Variable Pay Plans. Variable pay incentive plans tie the employee's pay to a predetermined measure of overall profitability for the organization in general or for the specific facility in which the employee works. In profit sharing plans, most of the employees of the organization receive a share of the annual profits of the organization, typically on a one-time, lump sum basis. In profit sharing plans, all employees share in the profitability of the company. Therefore, the more profitable the company is during a given time period, the greater the reward the employee will receive. In theory, therefore, the employee is motivated to do his/her best in order to increase the profitability of the company and, thereby, also increase his/her financial reward. There are several general types of profit sharing plans.

• Under cash plans, a percentage of the profits of the organization (usually 15 to 20 percent) are distributed to workers at regular intervals.
• Under the Lincoln incentive system, employees work in a guaranteed piecework basis and receive a percentage of the total annual profits of the organization based on their merit rating.
• Under deferred profit sharing plans, a predetermined portion of the organization's profits are placed in an account for each employee. These accounts are supervised by a trustee and payment is often deferred until retirement, thereby offering a tax advantage.

However, although profit sharing plans are currently a popular way to provide financial incentives to employees, research on the effectiveness of profit sharing plans—particularly from the point of view of increased profits for the organization—tend to be ambivalent (Dessler, 2005).

Piecework Pay Plans. In addition, there are number of financial incentive programs that are used to motivate employees on an individual basis. Piecework plans are pay systems that are based on the number of items processed by an individual employee during a specified unit of time. This is one of the oldest individual incentive plans, and is still widely used.

• An example of a straight piecework plan would be to pay a worker based on how many widgets the worker produces during an eight hour shift. The more widgets that the worker produces during that time, the more pay the worker receives; a specified amount for each unit s/he completes (e.g., widgets made; sales calls completed).
• Another type of piecework plan is the standard hour plan. Under this type of financial incentive plan, the employee receives a premium that corresponds to the percent by which the employee's performance exceeds the standard. So, for example, if the standard for making widgets is 100 widgets per day and Harvey produces 120 widgets that day, he would receive a 20 percent bonus on top of his standard pay for that day. Although still widely used today, piecework incentive plans have earned a poor reputation in some industries. For example, in the garment industry, workers may be paid based on how many garments they complete. However, in some cases, a worker may not complete sufficient garments during a day in order to meet the minimum-wage standards.

Bonuses, Stock Options, & Profit Sharing. Piecework systems, of course, are difficult to implement for professional or creative employees. It would be unreasonable in most situations, for example, to pay a computer programmer based on the number of lines of code s/he produces per day. A few lines of good code are worth much more to the organization than many lines of poor code. Therefore, many organizations offer professional employees financial incentives in the form of such things as bonuses, stock options, and profit sharing.

Merit Pay. Another financial incentive that is widely used is merit pay. This is an increase in salary that is given to an employee based on the employee's individual performance. Merit pay can be given to an employee on a one time, lump sum basis in the form of a bonus for outstanding work. Merit pay raises for outstanding work, on the other hand, become part of the employee's salary and are given on a continuing basis. For example, at his annual review, Harvey's supervisor might determine that Harvey's work was consistently outstanding enough to warrant a pay raise. This merit raise would be added to Harvey's current base salary to become his new base salary from that point on.

Pay for Performance. Another popular approach for motivating desired behavior in high performing organizations is an approach frequently referred to as "pay for performance." In these plans, employees are rewarded financially for high performance and contributing to the organization's goals. This is true not only for workers at the bottom of the organizational structure as is done in piecework plans, but also all the way up to the chief executive officer. Research performed by the government's General Accounting Office (GAO) has found that there a number of factors that make pay for performance incentive plans successful (U.S. General Accounting Office, 2004).

• First, the GAO found that it is important to use objective competencies to assess the quality of the employee's performance. These should be based on empirical research and directly related to the goals of the organization.
• Second, the GAO found that employee performance ratings should be translated into pay increases or awards so that employees can see a direct, positive consequence for their actions.
• Third, the GAO found that both the employee's current salary and contribution to the organization should be considered when making decisions about compensation, so that rewards for similar contributions are equitable.
• Finally, to be successful and to prevent possible abuse, the GAO found that pay for performance systems should be clear and well-published so that employees know the basis on which decisions are made and what kind of awards are made across the organization.

Applications

Financial Incentives within the Sales Industry. Although financial incentives are used across industries and at all organizational levels, one of the first groups for which financial incentives often springs to mind is sales personnel. Typically, sales personnel are paid a regular salary, on the basis of commission, or some combination of the two plans. In the straight salary approach, the sales person is paid a salary (with occasional incentives) just as is done with most employees. This approach to remunerating sales personnel is particularly appropriate when the salesperson is required to generate leads in addition to making a sale or when the sales job involves customer service in addition to straight sales. Although salary plans are simple to administrate, they have the disadvantage of not linking pay to performance. As a result, members of the sales staff have no particular incentive to become high performing employees. Commission plans, on the other hand, pay sales persons only for results. Under this plan, the salesperson does not receive a regular salary, but is paid only on commission, a set fee or percentage of the sale. However, although commission plans have the advantage of motivating high performance, not every salesperson has the skills and abilities necessary to excel at sales. This can not only lead to dissatisfaction with the plan (and, by extension, the job), but also lead to burnout. Because of the drawbacks of both the straight salary and straight commission approach to remunerating sales employees, most organizations use a plan that is a combination of the two approaches, giving salespersons both a steady salary as well as a commission on any sales made. Most organizations use an 80/20 split between percent of pay coming from base salary and from commissions, although other combinations are also possible.

Defining Criteria for Success. However, although tying the performance of a salesperson to his/her performance makes sense, defining the criteria of success to which financial incentives are attached for a sales job can be a challenging exercise. Two general approaches to linking pay to sales performance have been widely implemented.

Outcome-Based Standards. The first of these is the outcome-based system that focuses on the final outcomes of the sales process (e.g., whether or not a sale was made, total revenues earned by a salesperson in a given period of time). Outcome-based standards tend to be both objective and clear: Either a sales quota was met or it was not. Outcome-based systems tend to be easy to implement because of the relative availability of criteria against which performance can be measured (e.g., number of sales made or dollar volume earned within a given performance assessment period). However, because sales jobs tend to be performed in isolation, it is easy for sales personnel to actually harm the organization while still making a sale (e.g., a salesperson might skimp on customer service and follow-up in order to make another sale or focus on selling more items with a smaller price tag or on items or services that have been proven easier to sell). Outcome-based control systems do not take into account a number of factors that affect the success of a salesperson. Sales often occur over a period of time, particularly when the decision to purchase is a complicated or major one. Further, for many sales personnel, making the sale is only part of the job; the salesperson is also often required to perform customer service not only to make the sale but also after the sale has been made. As a result, it can be difficult to tell whether a salesperson is not doing his/her job well or if s/he is immersed in associated activities that will bear fruit later.

Behavior-Based Standards. Because of the problems with outcome-based control systems arising from the nature of the sales job, many experts argue in favor of a behavior-based rather than an outcome-based control system for sales personnel. Behavior-based systems focus more on the behavior of the sales person rather than his/her final sales. Although these systems better link pay to performance, they also require significantly more monitoring of both the activities and the results of the sales force's efforts. Behavior-based control systems are also more dependent than outcome-based control systems on the knowledge, skills, and abilities that the salesperson brings to the job (e.g., aptitudes, personality traits, general or specific product knowledge), the activities of the sales force (e.g., number of calls made), and the sales strategies employed in trying to make a sale (Anderson & Oliver, 1987). However, although behavior-based control systems overcome a number of the disadvantages associated with outcome-based control systems, they also tend to be complex to develop and implement and more subjective than outcome-based systems. This can lead to employee dissatisfaction and work against the very motivation that it was meant to establish.

Conclusion

Virtually every organization uses some sort of financial incentive to motivate high performance from its employees in support of the organization's goals and objectives. Financial incentives can be as simple as paying the employee for each unit of work performed or as complicated as a package that pays the employee on a combination of salary and reward for either individual or team performance. However, to be effective, financial incentives need to be linked with performance in order to ensure not only that the employee is fairly compensated, but also that the organization is paying for high performance in support of its goals and objectives.

Terms & Concepts

Commission: A set fee or percentage of the sale that is given to a sales representative for convincing a customer to make a purchase.

Control system: The method by which an organization properly compensates its employees; involves supervision, instruction, and appraisal.

Criterion: A dependent or predicted measure that is used to judge the effectiveness of persons, organizations, treatments, or predictors. The ultimate criterion measures effectiveness after all the data are in. Intermediate criteria estimate this value earlier in the process. Immediate criteria estimate this value based on current values.

Empirical: Theories or evidence that are derived from, or based on, observation or experiment.

Hierarchy of needs: A theory of motivation developed by Abraham Maslow. According to Maslow, there are five levels of need: Physiological, safety, belongingness, esteem, and self-actualization. The theory posits that people's behavior is motivated by where they are in the hierarchy. People can move up and down the hierarchy and can also experience needs from several levels at once.

Incentive: An inducement or reward that is used to motivate an employee to perform a desired action or behave in a manner that supports the organization's goals and objectives. A financial incentive is an incentive that is monetary or financial in nature, such as a pay raise, bonus, or stock options.

Merit pay: An increase in salary that is given to an employee based on the employee's individual performance. Merit pay can be given to an employee on a one time, lump sum basis in the form of a bonus for outstanding work. Merit pay raises given for consistent outstanding work, on the other hand, become part of the employee's salary and are given on a continuing basis.

Motivation: The needs and thought process that determine a person's behavior. Motivating factors do not necessarily remain constant, but may change with the individual's current circumstances.

Pay for performance: An incentive plan in which employees are rewarded financially for high performance and contributing to the organization's goals. Pay for performance plans are applicable to all levels within the organization.

Performance assessment: The process of evaluating an employee's work performance and providing feedback on how well s/he is doing (typically against some standard of performance for that job).

Perquisites ("perks"): Something given to the employee in return for work over and above regular pay or compensation. Perks may include such things as health insurance, a company car, or a private office.

Piecework: A pay system that is based on the number of items processed by an individual employee during a specified unit of time.

Reinforcement: An act, process, circumstance, or condition that increases the probability of a person repeating a response.

Self-actualization: The need to live up to one's full and unique potential. Associated with self-actualization are such concepts as wholeness, perfection, or completion; a divestiture of "things" in preference to simplicity, aliveness, goodness, and beauty; and a search for meaning in life. In Maslow's hierarchy of needs, this is the ultimate level of motivator for behavior.

Bibliography

Anderson, E. & Oliver, R. L. (1987). Perspectives on behavior-based versus outcome-based salesforce control systems. Journal of Marketing, 51(4), 76-88. Retrieved February 17, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4996249&site=ehost-live

Dessler, G. (2017). Human resource management (15th ed.). Boston: Pearson.

Ghosh, S. S. (2017). Financial incentives—a potent weapon for higher productivity. International Journal of Productivity & Performance Management, 66(4), 554-571. doi:10.1108/IJPPM-02-2016-0040. Retrieved February 27, 2018, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=122156969&site=ehost-live&scope=site

U.S. General Accounting Office. (2004). Human capital: Implementing pay for performance at selected personnel demonstration projects (GAO-04-83). Retrieved March 27, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18173828&site=ehost-live

Suggested Reading

Atul, M., Gupta, N., & Jenkins, G. D., Jr. (2007). A drop in the bucket: When is a pay raise a pay raise? Journal of Organizational Behavior, 18(2), 117-137. Retrieved March 2, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=12493230&site=ehost-live

Brink, A. G., Hobson, J. L., & Stevens, D. E. (2017). The effect of high power financial incentives on excessive risk-taking behavior: An experimental examination. Journal of Management Accounting Research, 29(1), 13-29. doi:10.2308/jmar-51533. Retrieved February 27, 2018, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=124929583&site=ehost-live&scope=site

Darmon, R. Y. (1987). The impact of incentive compensation on the salesperson's work habits: An economic model. Journal of Personal Selling and Sales Management, 7(1), 21-32. Retrieved March 2, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6652095&site=ehost-live

Kahn, L. M. & Sherer, P. D. (1990). Contingent pay and managerial performance. Industrial and Labor Relations Review, 43(3), 107S-120S. Retrieved March 2, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9603275758&site=ehost-live

Palia, D., Abraham, R. S., & Wang, C.-J. (2008). Founders versus no-founders in large companies: Financial incentives and the call for regulation. Journal of Regulatory Economics, 33(1), 55-86. Retrieved March 2, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27978131&site=ehost-live

Peterson, S. J. & Luthans, F. (2006). The impact of financial and nonfinancial on business-unit outcomes over time. Journal of Applied Psychology, 91(1), 156-165. Retrieved March 2, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19504997&site=ehost-live