REWARD MANAGEMENT

Methods of Pay
It is any form of payment given to employees in return for labour.

There is no doubt that most people are motivated (at least in part) by the financial rewards they gain
from their work. So, getting employee pay right (often referred to as the “remuneration package”) is a
crucial task for a business.

Why is pay important?

It is an important cost for a business (in some “labour-intensive” businesses, payroll costs are over 50%
of total costs)

People feel strongly about it

Pay is the subject of important business legislation (e.g. national minimum wage; equal opportunities)

It helps attract reliable employees with the skills the business needs for success

Pay also helps retain employees – rather than them leave and perhaps join a competitor

Because pay is a complex issue, there are several ways in which businesses determine how much to pay:

Job evaluation / content; this is usually the most important factor. What is involved in the job being
paid? How does it compare with similar jobs?

Fairness – pay needs to be perceived and be seen to match the level of work

Negotiated pay rates – the rate of pay may have been determined elsewhere and the business needs to
ensure that it complies with these rates.

Market rates – another important influence – particularly where there is a standard pattern of supply
and demand in the relevant labour market. If a business tries to pay below the “market rate” then it will
probably have difficulty in recruiting and retaining suitable staff

Individual performance – increasingly, businesses include an element of “performance-related” reward

in their pay structures.

Other Factors Influencing Pay Levels

There are eight factors influencing the determination of wage rates are as follows:

1. Ability to Pay

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2. Demand and Supply

3. Prevailing Market Rates

4. Cost of Living

5. Bargaining of Trade Unions

6. Productivity

7. Government Regulations

8. Cost of Training.

The wage payment is an important factor influencing labour and management relations. Workers
are very much concerned with the rates of wages as their standard of living is connected with the
amount of remuneration they get. Managements, generally, do not come forward to pay higher
wages because cost of production will go up and profits will decrease to the extent.

The following factors also influence the determination of wage rate:

1. Ability to Pay:

The ability of an industry to pay will influence wage rate to be paid, if the concern is running
into losses, then it may not be able to pay higher wage rates. A profitable enterprise may pay
more to attract good workers. During the period of prosperity, workers are paid higher wages
because management wants to share the profits with labour.

2. Demand and Supply:

The labour market conditions or demand and supply forces to operate at the national and local
levels and determine the wage rates. When the demand for a particular type of skilled labour is
more and supply is less than the wages will be more. One the other hand, if supply is more
demand on the other hand, is less then persons will be available at lower wage rates also.

According to Mescon,” the supply and demand compensation criterion is very closely related to
the prevailing pay comparable wage and on-going wage concepts since, in essence to all these
remuneration standards are determined by immediate market forces and factors.

3. Prevailing Market Rates:

No enterprise can ignore prevailing wage rates. The wage rates paid in the industry or other
concerns at the same place will form a base for fixing wage rates. If a unit or concern pays low

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rates then workers leave their jobs whenever they get a job somewhere else. It will not be
possible to retain good workers for long periods.

4. Cost of Living:

In many industries wages are linked to enterprise cost of living which ensures a fair wages to
workers. The wage rates are directly influenced by cost of living of a place. The workers will
accept a wage which may ensure them a minimum standard of living.

Wages will also be adjusted according to price index number. The increase in price index will
erode the purchasing power of workers and they will demand higher wages. When the prices are
stable, then frequent wage increases may not be required

5. Bargaining of Trade Unions:

The wage rates are also influenced by the bargaining power of trade unions. Stronger the trade
union, higher will be the wage rates. The strength of a trade union is judged by its membership,
financial position and type of leadership.

6. Productivity:

Productivity is the contribution of the workers in order to increase output. It also measures the
contribution of other factors of production like machines, materials, and management .Wage
increase is sometimes associated with increase in productivity. Workers may also be offered
additional bonus, etc., if productivity increases beyond a certain level. It is common practice to
issue productivity bonus in industrial units.

7. Government Regulations:

To improve the working conditions of workers, government may pass a legislation for fixing
minimum wages of workers. This may ensure them, a minimum level of living. In under
developed countries bargaining power of labour is weak and employers try to exploit workers by
paying them low wages. In India, Minimum Wages Act, 1948 was passed empower government
to fix minimum wages of workers. Similarly, many other important legislation passed by
government help to improve the wage structure.

8. Cost of Training:

In determining, the wages of the workers, in different occupations, allowances must be made for
all the exercises incurred on training and time devoted for it.

9 Industry

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According to Finkelstein and Hambrck, (1989), companies belonging to different industries
present different wage and salary models. Such reflect industry differences which speak to
capacity to pay. Salaries in the Retail sector are generally low when compared to the
Manufacturing sector. These two sectors represent different value additions making their
capacity to pay different also. What industry you work in can have big impact on how much you
earn. An accountant employed by the public school system, regardless of how hard they work,
isn't going to make a much as an accountant that rises to the level of partner at Ernst & Young.
Likewise, a lawyer working as a public prosecutor isn't going to earn as much as a successful
defense attorney working for a private firm. Even within the same occupation, the industry you
choose to work in will greatly influence your earning potential. If you want to maximize your
earning potential, you'll want to determine which industries offer the best opportunity for your
chosen profession.

10 Working Conditions
Typically, when workers are required to work under hazardous conditions or perform dangerous
tasks they're paid more. Police who volunteer to work in a dangerous section of town, demolision
experts who transport explosives, engineers who handle sensitive chemicals on a routine basis
and heavy machinery operators are all examples of workers who can earn an additional premium
for the risk they assume.

11 Experience
It's been said that there's no substitute for experience - and that's probably true. Experience plays
a large part in how much you can earn as a professional. At the end of the day, you'll earn what
you're worth. A trial lawyer who has proven himself or herself again and again is going to make
much more than young rookie lawyer who has never won a case. Along with experience comes
reputation. Usually, the more experience you have, the better you're reputation will be - assuming
that your good at what you do. As you gain a reputation, there will be more clients, customers,
and employers on your doorstep who will be willing to pay you top dollar for your services.
Typically, top earners within an occupation will have 10+ years of experience.

There are three main factors involved when dealing with pay and these include;

1 Pay level

2 Pay structure

3 Pay Policy

Pay Level
It represent the firm’s average pay relative to what other companies are paying for the same
labour, (Gerhart and Milkovich). Pay level take three forms which are leading, matching, and
lagging.

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An organisation with a policy of leading the market offers higher than average wages of the
relevant labour market.

A policy of lagging the market signifies payment of lower than market average wages of the
relevant labour.

A policy of matching market rate entails payment of rates that are in line with what other
companies employing the same type of labour are paying.

The efficiency wage theory helps to explain how pay levels relate to organisational performance.
Better paying companies also perform better than less paying companies. The point speaks to
the level of employee commitment as a result of the returns paid for their labour. Organisations
with higher pay levels should experience increases in both individual and organisational level
efficiency because they attract, retain, and motivate the best performers. Higher pay levels
generate larger application pools, which allow the organisation to be more selective when hiring
and to retain highly qualified employees. Higher pay may also improve employee and resource
efficiency by reducing employees’ unproductive behaviour. It generates a state of employee
engagement resulting in individual drive for work. An engaged employee does not require an
external push for him or her to do the work. Instead, they take such work as a personal call of
duty.

PAY STRUCTURE
It represents an array of pay rates within the organisation and representing the degree of slope
in the pay policies. Characteristic of a particular pay structure include the number of levels in
the structure, the size of pay differentials between pay levels in the structure, and the rate at
which employees can progress through each level within the structure. Pay structures can
broadly be classified as egalitarian, a term that describes a compressed pay distribution or
hierarchical, showing widely dispersed pay (unequal pay)

The equity theory has been used to investigate the performance effect of organisational pay
structures. The theory holds that employees evaluate “exchange relationship” on the basis of
comparisons of their perceived ratios of inputs and outputs to the perceived ratios of others’
inputs and output. When employees perceive inequity, they respond with a host of potentially
negative reactions in order to restore equity in the exchange relationship. Further, the equity
theory suggests that overly hierarchical pay structures can have disfunctional consequences to
the organisation. As pay structures become too hierarchical, organisational performance tends
to suffer as employee become less cooperative and less inclined towards teamwork.

This however gets worse as the pay structure become hierarchical and pay become a means of

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signifying organisational value, creating feelings of social, psychological, and economic injustice
among employees. Equity theory also holds that an overly egalitarian pay structure generates
similar results as it fails to deal with differential effort of individuals as well as value if the
different jobs to the organisation. Greater levels of knowledge, skills, and abilities should be
associated with higher pay and the reverse is also true.

Equity is looked at from two perspectives;

1 Internal equity, and

2 External equity.

Internal equity
This involves the placement of jobs in a hierarchy based on characteristics such as qualifications,
essential functions, and the skill, knowledge, and ability required by the position. This allocation
of variables are called compensable factors. Jobs are placed in a hierarchy based on these
factors reflecting on similarity or differences in job content. This is achieved through a process
known as job evaluation. Rating processes are classified into two, i.e

1 Whole job, and

2Quantitative.

The point evaluation process, relies on compensable factors to create hierarchy of jobs to justify
differences in pay.

External equity
This involves comparison of the organisation’s wage and benefits offerings to what other
organisations pay for the same skill. In order to achieve competitiveness, organisations often
conduct wage and salary surveys so as to establish whether the company is paying as well as its
competitors. Jobs for surveys are benchmarked especially those common to organisations and
those that are difficult to find replacements.

Individual equity
This refers to the relationship between and among individuals within the organisation. This form
of equity requires that the pay system reflects on the individual performance. As an avenue for
acknowledging individual contributions and guiding supervisors’ pay decisions, an effective
performance management system help to motivate and develop competent staff. Such pay

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systems take the form of merit based pay systems or performance based pay systems.

Structuring the financial package

With so many methods of pay available, how should a business decide to structure the pay package it
offers to employees, and what rate of pay should it use?

The starting point is usually to find out what the “market rate” is. Factors that help determine the market
rate for a job include:

Whether the skills that are required are widely available

The overall level of unemployment in the employment “catchment area”

Whether the job requires specialised (or even highly specialised) skills

There are several ways in which a business can obtain data on market rates and among these include;

1 Local employment agencies & job centres

2 Job adverts

3 Industry associations (who often perform annual surveys of pay in an industry)

4 The next question is – should the business pay MORE or LESS than the market rate? Factors to consider
here include:

5 Does the business need above-average employees (e.g. salesmen with an industry reputation for being
strong performers)

6 Does the business need trained employees or is it prepared to invest in training beginners?

7 Are the skills wanted by the business needed urgently (in which case – the business would probably
want to pay more)

8 Do factors affecting the mobility of labour need to be addressed – e.g. are there transport problems
that need to be solved (e.g. pay for a rail season ticket) or relocation allowances to be offered to
encourage new employees to move home?

9 The third important question is how to structure the remuneration package.

10 Should employees be paid on the basis of time spent working (e.g. time-rates) or the amount they
produce (e.g. piece rates) or some other measure of performance?

11 Should the remuneration package be a combination of approaches (e.g. some basic pay per month +
a commission-related incentive)?

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In deciding the answers to these questions, a business should try to construct a pay structure that is
simple (to help employees understand it), logical and fair

Time-rate pay
Time rates are used when employees are paid for the amount of time they spend at work. This is the
most common method of payment in the UK.

The usual form of time rate is the weekly wage or monthly salary. Usually the time rate is fixed in relation
to a standard working week (e.g. 35 hours per week). The employment contract for a time-rate
employee will also stipulate the amount of paid leave that the employee can take each year (e.g. 5
weeks paid holiday).

Time worked over this standard is known as overtime. Overtime is generally paid at a higher rate than
the standard time-rate – reflecting the element of sacrifice by an employee. However, many employees
who are paid a monthly salary do not get paid overtime. This is usually the case for managerial positions
where it is generally accepted that the hours worked need to be sufficient to fulfil the role required.

The main advantages of time-rate pay are:

1 Time rates are simple for a business to calculate and administer

2 They are suitable for businesses that wish to employ staff to provide general roles (e.g. financial
management, administration, maintenance) where employee productivity is not easy to measure

3 It is easy to understand from an employee’s perspective

4 The employee can budget personal finance with some certainty

5 Makes it easier for the employer to plan and budget for employee costs (e.g. payroll costs will be a
function of overall headcount rather than estimated output)

The main disadvantages of time-rate pay are:

1 Does little to encourage greater productivity – there is no incentive to achieve greater output

2 Time-rate payroll costs have a tendency to creep upwards (e.g. due to inflation-related pay rises and
employee promotion

Piece-rate pay
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Piece-rate pay gives a payment for each item produced – it is therefore the easiest way for a business to
ensure that employees are paid for the amount of work they do. Piece-rate pay is also sometimes
referred to as a “payment by results system”. Further, the piece rate system is that system of wage
payment in which the workers are paid on the basis of the units of output produced. Piece rate
system does not consider the time spent by the workers. Piece rate system is the method of
remunerating the workers according to the number of unit produced or job completed. It is also
known as payment by result or output. Piece rate system pays wages at a fixed piece rate for each
unit of output produced. The total wages earned by a worker is calculated by using the following
formula.

Total Wages Earned= Total units of outputs produced x Wage rate per unit of output.
OR,
Total Wages Earned= Output x Piece Rate

Piece-rate pay encourages effort, but, it is argued, often at the expense of quality. From the employee’s
perspective, there are some problems. What happens if production machinery breaks down? What
happens if there is a problem with the delivery of raw materials that slows production? These factors
are outside of the employee’s control – but could potentially affect their pay. The piece rate pay method
compensates employees a set amount for each unit of work completed. For example, in a manufacturing
setting, an employee receives a set amount for each item he produces, regardless of how fast or slow he
works. This payment method is beneficial for both employees and the company, but the potential
drawbacks may make it less feasible for your business.

The answer to these problems is that piece-rate pay systems tend, in reality, to have two elements:

A basic pay element – this is fixed (time-based)

An output-related element (piece-rate). Often the piece-rate element is only triggered by the business
exceeding a target output in a defined period of time.

ALTERNATIVE PIECE RATE SYSTEMS

1 Halsey Premium Bonus Plan (Halsey Plan and Halsey-Weir Plan): This plan was introduced by
F A Halsey in 1891. It is a simple combination of time and piece rate systems. A worker is paid a
guaranteed base rate and is rewarded when his performance exceeds standard. A standard time is
established in respect of each job or unit. Bonus is paid on the basis of 50% of time saved.

The total wages payable is calculated as under: = (Hourly rate X Time taken) + (50% X Time
saved X Hourly rate)

As a result of increased productivity, conversion cost per unit falls. This is because fixed
overhead gets distributed over larger volume of output. Thus, the firm finds it possible to reward
workers directly in proportion to production. In the case of Halsey Weir plan, the percentage
used is 30 instead of 50.

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2 Rowan Premium Bonus Plan (Variable Sharing plan): A standard time is established in respect
of each job or process. There is a guaranteed base rate. A bonus is paid on the basis of time saved
computed as a proportion of the time taken which the time saved bears to the standard time. The
total wages payable is calculated as under: = (hourly rate x time taken) + ( time saved x time
taken) x hourly rate time allowed

3 Taylor Differential Piece Rate Method: This system was introduced by F. W. Taylor, the father
of Scientific Management. The main features of this incentive plan are as follows: a. Day wages
are not guaranteed, i.e. it does not assure any minimum amount of wages to workers. b. A
standard time for each job is set very carefully after time and motion studies. c. Two piece rates
are set for each job- the lower rate and the higher rate. The lower piece rate is payable where a
worker takes a longer time than the standard time to complete the work. Higher rate is payable
when a worker completes the work within the standard time. In other words, lower piece rate is
payable to inefficient workers and higher piece rate is payable to efficient workers. It will be
seen that there is a great difference between the wages of an efficient and an inefficient worker.

Problem 1

You are presented with the following information by Olympia Engineering Company related to
the first week of December 1999. The firm employs 5 workers at an early rate of 2. During the
week, they worked for 4 days for a total period of 40 hours each and completed a job for which
the standard time was 48 hours for each worker. Calculate the labour cost under the Halsey
method and Rowan method of incentive plan payments.

Problem 2

A worker is allowed 10 hours to complete a job on daily wages. He takes 6 hours to complete the
job under a scheme of payment by results. His day rate is $6 per hour and piece rate is $3.6. The
material cost of the product is $40 and the overheads are charged at 150% of the total direct
wages. Calculate the factory cost of the product under i) Piece work plan ii) Rowan Plan iii)
Halsey plan

Problem 3

From the following particulars calculate wages earned by workers A and B respectively under
Taylors System: Standard time allowed 10 units per hour Normal wage rate $1 per hour
Differential rates to be applied: 90% of piece rate when below standard efficiency 125% of piece
rate when at or above standard production on a day of 8 hours A – 75 units B -85 units

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Advantages

1 Motivation
The opportunity to earn more money motivates some employees to increase productivity. If the
employee increases her work speed, she can complete more units of work in an hour. She could
potentially make more per hour than she would with a standard hourly rate. With an hourly pay
rate, employees know they cannot make any more no matter how hard they work so they may be
less likely to push themselves.

2 Cost Effective
In many work settings, the piece rate pay method is cost effective, since the company is only
paying for work completed. A slower employee may not complete many work units per hour. If
you use a standard hourly wage, he gets paid the same, even if he only completes a fraction of
the work completed by another employee. You may end up paying him less per hour with the
piece rate method if his production is low.

3 Piece rate system pays wages according to the output produced by the workers. It encourages
efficient workers.

4 Piece rate system helps to reduce idle time.

5 Piece rate system gives incentives to the workers to adopt a better method of production for
increasing their production and earning.

6 Piece rate system helps the management to determine the exact labor cost per unit for
submitting quotation.

7 Piece rate system reduces per unit cost of production due to increased volume of production.

8 Piece rate system requires less supervision cost.

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Disadvantages Of Piece Rate System

The following are the notable disadvantages of piece rate system

1 Piece rate system does not help in producing quality output as the workers are concentrated more on
quantity instead of quality.

2 Piece rate system does not help for a uniform flow of production and makes difficult to regulate the
production schedule.

3 It is very difficult to fix an acceptable and reasonable piece rate for each item of output or job.

4 Piece rate system adversely affect the workers' health as well.

5 It requires extra supervision cost for quality output and effective use of materials, tools and
equipment.

Commission
Commission is a payment made to employees based on the value of sales achieved. It can form all or
(more often) part of a pay package. Commission is, therefore, a form of “incentive pay”.

Commission, like piece-rates, is a reward for value of work achieved. In most cases, the employee is paid
a flat percentage of the value of the good or service that is sold.

The rate of commission depends on the selling price and the amount of effort required in making the
sale.

For example, commission rates could range from 5% where the product sells easily (e.g. household
goods sold door-to-door) to 30% where the effort is substantial.

1 The main advantage of commission from an employee’s point-of-view is that it enables high
performing sales people to earn huge amounts.

2 The main advantage to the employer is that the payroll cost is related to the value of business achieved
rather than just the amount produced. After all, businesses exist to sell goods and services for profit –
not just to make things.

However, there are several drawbacks with using commission payments:

1 Sales people may cut corners to make sales (e.g. not explain the product or service in enough detail to
potential customers) – i.e. customers are misled & missold

2 High commission earnings enjoyed by some of the sales team may be resented elsewhere in the
business – particularly if the sales actually depend on a team effort

3 It is difficult to change what proves to be an over-generous commission structure without upsetting

and demoralising the sales team

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4 Once commission payments have been made, the sales force may lose some motivation until they
begin to focus on the next payment (which might be up to 12 months away)

As a result of the above disadvantages, most businesses that use commission as an incentive payment
method offer a basic pay plus a moderate commission level. In this way, if sales and profits justify the
change, the commission rate can always be increased slightly.

Performance related pay

Performance-related pay is a financial reward to employees whose work is considered to have reached a
required standard, and/or above average

Performance related pay is generally used where employee performance cannot be appropriately
measured in terms of output produced or sales achieved.

Whilst the detail of real performance-related schemes varies from business to business, there are several
common features:

Individual performance is reviewed regularly (usually once per year) against agreed objectives or
performance standards. This is the performance appraisal

At the end of the appraisal, employees are categorised into performance groups – which determine what
the reward will be

The method of reward will vary, but traditionally it involves a cash bonus and/or increase in wage rate or
salary

Performance-related pay has grown widely in recent years – particularly in the public sector. This is part
of a movement towards rewarding individual performance which reflects individual circumstances.

There are several problems with performance-related pay:

There may be disputes about how performance is measured and whether an employee has done enough
to be rewarded

Rewarding employees individually does very little to encourage teamwork

There is doubt about whether performance-related pay actually does anything to motivate employees.
This may be because the performance element is usually only a small percentage of total pay

Fringe benefits

Fringe benefits are financial benefits that are not paid out directly in cash (or cash equivalents such as
shares).

Examples of these include:

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Company cars

Discounted season tickets

Health insurance

Pensions

Holiday and other entitlements to take time off work

Childcare provision

Staff uniforms

Staff discounts

Benefits in kind have become a much more popular and widespread form of remuneration. This is partly
because businesses pay less tax on providing them, but also because they cause a business less hassle
and can help to differentiate the remuneration package.

Profit sharing
Profit sharing refers to any system whereby employees receive a proportion of business profits. Profit
sharing is generally accepted as having many advantages, providing that all employees are able to
participate.

Profit sharing
History: Profit sharing certainly is not a new concept. One of the first documented profit
sharing plans in the United States was introduced in 1794 at New Geneva, PA, Glass
Works. At the time the company was recognized by the Secretary of the Treasury under
Presidents Jefferson and Madison as applying “the nation’s fundamental democratic
principles to an industrial operation. However, profit sharing arrangements were far from
prevalent until the end of the Civil War. As America became more industrialized, profit
sharing begin to grow through the 1920’s. Profit Sharing companies held the belief that
sharing profits would unite workers and management in the pursuit of the same
common goal. In addition, profit sharing was offered as a means to discourage
unionization, but after the Depression through the 1930’s many of these profit sharing
plans were discontinued.

After World War II there was a rebirth of profit sharing. Most of these plans were
deferred compensation plans driven by the desire to avoid a tax on excess income that
had been imposed during the war. In other words, companies would place a portion of
the profits aside to fund employee retirement plans. This was especially popular among
private, “family” owned companies that saw employees as an extended family. The
concept was also one of “common fate.” In good times a family would be able to share

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more, in the bad times, less. Employees often spent their entire working career with the
same company. There was mutual loyalty on both the employer’s and employees’
behalf.

In the late 1980’s some companies attempted to deviate from the deferred
compensation nature of Profit Sharing. In other words, Profit Sharing was viewed as
incentive compensation rather than a benefit plan. One of the best documented
examples was at Dupont’s fibers division which employed approximately 20,000 people.
The plan’s designers intended to develop a “program to reward employee contributions,
in the belief that sharing the rewards as well as the risks of the division’s financial
performance would help the business succeed in the market place.” The complex
arrangement focused on “world-wide after-tax operating income and established a
“Compensation Target Rate” and a “Variable Element Rate.”

Basically, DuPont’s new pay concept was that employees would place a portion of their
normal base compensation at risk. In return employees had the opportunity to more
than offset the “at-risk” monies through a year-end bonus. On the other hand, if
profitability was significantly below targeted levels employees would loss the monies “at-
risk.” The plan could yield a bonus of up to 12 % of salary in an exceptional year. In a
bad year an employee could loss as much as 6% of salary. The new “pay-at-risk”
system would enable the company to better manage costs by moving to more of an
“ability to pay” approach. In addition, the thinking was there would be less work force
pressure for base salary adjustments. The theory was that since employees would be
sharing in the profits, they would feel and act more like stakeholders. The result would
lead to changes in behaviors and work habits, resulting in even more profits.

When the plan was rolled out in 1989, DuPont employees saw a modest bonus after the
first year. However, the second year saw rapidly declining profitability. Profits had
declined due to a number of unforeseen business conditions, two of which were the
rapid increase in raw material prices and the erosion in the final product’s selling price.
Profits were “squeezed.” As a result employees lost the portion of their base pay that
was placed at-risk. The employee loss represented approximately 4% of compensation.
DuPont experienced a significant rise in employee discontent. Some felt that they were
“hoodwinked.” A company executive commented, “Employees were not ready for such a
program. Employees felt it was fine when they were getting money back, but thought it
was not fair when no bonus was paid.” As a result the program was quickly abandoned.

The flaw in the “pay-at-risk form of profit sharing” was that employees were asked to put
a portion of their pay in jeopardy over something they had little or no control, profitability.
In addition DuPont is a large, world-wide organization. Obviously the sense of employee
ownership and identity toward a very large corporation often is found to be less than in a
small family-owned company. People have more difficulty trusting the financial data.
Clearly most DuPont employees didn’t like putting their base pay at “risk” in exchange

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for the opportunity to share in the profits. Many would say they “preferred to lose money
at the casino; at least they would have had some fun and excitement in doing so.”

In more recent times, “cash,” profit sharing plans have been installed where no “pay-at-
risk” is involved. These plans are designed to include all employees including hourly
and salaried, non-exempt employees, not just executives and managers. In other
words, all employees have an opportunity to share in the profit pie by having an
opportunity to receive a year-end cash bonus.

Figure 1

When profits are up, “I get more.” If profits are down, there’s no consequence.
Companies that install these plans hope to enable employees to share in the
organization’s success, to motivate workers to improve profits, and in turn to act in the
best interest of the company.

Unfortunately many companies that have a “cash” profit sharing plan find that workers
view the system as an entitlement. People are happy when they get a bonus and are
upset when they don’t. Employees feel that when they receive a profit bonus they
“earned it.” When they don’t, “it’s the company’s fault.” In lean years, the employee
response is too often complaining, whining, and mistrust in the company.

What would the farmer have learned from these experiences?: The clear and
simple issues are that for most organizations Profit Sharing plans provide very little or
no “line-of-sight” in terms of what employees do and what they are paid. The general
employee population has little understanding of how they directly impact a broad
financial measure of profitability. Even those who have an understanding of the financial
data find their efforts insignificant in relationship to key management decisions and
external market conditions. To make matters worse, some may feel that the company
may manipulate the numbers in order to take advantage of tax regulations or influence
the investment community. These feelings are further exaggerated in large multi-
location organizations where employees are distanced from top management. Also
these multi-site organizations may calculate profit company-wide rather than on a
location-by-location basis.

So should the farmer further consider Profit Sharing? It depends on the objective. If the
focus is to share the organization’s success and to reinforce a sense of ownership, then
profit sharing might be the appropriate answer. However, the farmer needs to clearly
understand the result will most likely be in terms of impacting employee attitudes rather

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than driving behaviors. This is especially true in organizations that have an absence of a
high degree of employee involvement.

If Profit Sharing is the route, should it be a compensation system or should it be

designed to be used as a benefit plan, a method to help finance employee retirement
years? In most cases history has demonstrated that the farmer may be better served to
incorporate Profit Sharing into a retirement scheme. In doing so, employees would see
their retirement security grow in tune with the company’s growth and prosperity. In other
words, both employee and employer would share in a “common-fate.” This would
certainly satisfy the objective of sharing in the organization’s success. The plan would
give employees more of a long term outlook and strengthen the sense of identity and
ownership. On the other hand, if the farmer’s objective is to influence not only attitudes
but to change behaviors, in terms of teamwork, involvement, and communications, profit
sharing most likely will be the wrong answer, particularly if the organization has more
than a handful of employees.

Formula For Sharing of Profit Among Employees

The plan must provide a definite formula for allocating the employer contribution
among the participants. There are three different types of allocation formulas:
Compensation to Compensation (Prorata) – This allocation method provide for all
participants to receive an equal percentage of their compensation (up to the total
maximum dollar limit in effect for the year).
Permitted Disparity – This allocation method allows for participants with earnings in
excess of the taxable wage base (the cap on compensation used for paying Social
Security Taxes or FICA) to receive an allocation slightly higher than those with
earnings below the taxable wage base.

Cross-tested (or Tiered) – This allocation method allows for contributions to be

allocated amongst different allocation groups (as defined by the employer) in
varying amounts as long as the allocation meets certain non-discrimination tests.
To take advantage of this method, the employer must contribute a minimum
percentage of compensation (generally 5%) to participants classified as non-highly
compensated employees (NHCEs). Typically, these plans are established to provide
maximum contributions to the owner. Other highly compensated employees
(HCEs) can be limited to a smaller percentage of compensation, depending on the
plan’s “top heavy” status.

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Gainsharing

Figure 2
History – Today many people view Gainsharing strictly as a bonus or group incentive
plan. However, it is much more than a compensation plan. It helps drive a change in the
culture. Employees feel that they are more valued and respected. As a result, people
develop a higher sense of teamwork, ownership, and identity. People are more engaged
which leads to a higher level of performance. There are four relatively simple principles
for understanding why Gainsharing works. All four are incorporated in the strategy used
to install and maintain a successful plan. The four principles address equity, identity,
involvement, and commitment. The four principles are interrelated and mutually
reinforcing.

In order to fully understand the concept, one must examine its roots. The Gainsharing
concept dates back to the 1930's when a labor leader, Joe Scanlon, preached that “the
worker” had much more to offer than a pair of hands. The premise was that the person
closest to the problem often has the best and simplest solution. Moreover, if the worker
is involved in the solution, most likely he or she will make the solution work. Scanlon is
often credited for developing a system that promotes involvement in the workplace
through employee ideas and suggestions.

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 Figure 3

Basically, employee teams are formed to solicit and review suggestions from other
members of the workforce. The teams are permanent groups that meet on a regular
basis to discuss ideas and suggestions. The teams are given limited spending authority
to approve and implement suggestions. Suggestions that are approved by a team, but
are beyond their spending authority, are advanced to a higher level in the organization
for final approval.

The involvement structure not only is intended to encourage participation but also is
meant to enhance two-way communications regarding company goals and objectives.
The idea system helps foster respect and cooperation. In other words, if employees feel
their ideas are listened to, are given prompt feedback, and see their ideas promptly
implemented, they will feel that they are respected.

Unlike a traditional suggestion system, Scanlon’s system does not provide individual
monetary rewards for improvement ideas. The thinking is that the review, investigation,
and implementation of employee’s ideas are truly a collaborative effort. Suggestion
systems that pay individual awards based on the projected savings from the idea

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promote behaviors in which employees may conceal their improvement suggestions
rather than freely share and collaborate with others to advance the idea. Originally the
Scanlon approach didn’t have an employee bonus component. However, a few years
after the plan’s initial implementation, Scanlon devised an organization-wide bonus
formula that provided a more frequent and line-of-sight measurement system than profit
sharing. The idea system and other improvement efforts drove the performance
measures, and in turn gains (savings) generated through the measurement formula are
shared with everyone in the organization. Basically the Scanlon philosophy says, “As
we work together to improve the operations, everyone shares financially in the savings.”

The Scanlon Plan became know as “a frontier in labor-management cooperation.”

Scanlon went on to work at MIT to help other labor leaders and managers. As a result
the Scanlon message gradually began to spread. In the 1950’s Scanlon developed a
group of disciples including Frederick Lesieur and Carl Frost. As companies moved
forward with the concept, interest in academic and government circles grew. One of the
earlier studies was done by the General Accounting Office and was entitled “Productivity
Sharing Programs; Can they Contribute to Productivity Improvement?’ The 1981 study
examined 36 “productivity sharing” firms. The GAO reported that “while productivity
sharing plans are not the panacea for every firm in the solution to the Nation’s economic
problems, they warrant serious consideration by firms as a means “of stimulating
productivity performance, enhancing their competitive advantage, increasing monetary
benefits to their employees, and reducing inflationary pressure.” The report was
published in the hope of encouraging organizations to implement performance-
enhancing tools that better engaged the workforce.

As time passed, the term “Scanlon Plan” evolved to “Gainsharing Plan”. The Scanlon
term mistakenly had become associated with a single bonus formula focused on people
productivity. The “Gainsharing” term became more associated with the use of tailor-
made measures that still focused on the line-of-sight.

Another hallmark study was published in 1992. The study, (one of the most
comprehensive studies up until that time) was sponsored by WorldatWork (Formerly the
American Compensation Association). The group was known as the Consortiums for
Alternative Reward Strategies Research (CARS). The study entitled, “Capitalizing on
Human Assets,” focused on 2,200 organizations with performance-based reward plans.
The findings reported many positive results in both operational performance and
employee attitudes. In addition, the study reported better performance in plans that
used more line-of-sight measures (Gainsharing) than plans using only “a bottom-line’’
profit- sharing measure. In addition the study reported that successful plans lead rather
than support cultural change.

In the mid-1990’s the Total Quality Management movement led to further interest in the
Gainsharing concept. As TQM attempted to involve the workforce, employees began
asking; “What’s in it for me?” Gainsharing was one answer. More recently interest in

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Gainsharing has again surfaced as companies cycle through Lean Manufacturing and
Six/Sigma initiates. An important point is that all of these improvement initiatives are
nothing more than tools to better engage the workforce and to promote involvement.
Simply put, these tools are an extension to what Scanlon had preached in the 1930’s.

Unfortunately many of today’s companies that study Gainsharing see the concept as an
incentive, thinking that if you simply put a carrot in front of people, you will put “fire in
their belly.” These organizations focus on the bonus/incentive side of Gainsharing, and
may lack the understanding and appreciation of the cultural and employee involvement
origins of the concept. They believe that a bonus system lacking employee involvement,
will somehow miraculously lead to a positive result. The problem is that they are putting
the cart in front of the horse, the incentive in front of the involvement.

Line-of-Sight & Measurement

Figure 4

After focusing on the cultural and employee involvement heritage of Gainsharing it is

appropriate to turn to the bonus/incentive side. Basically, to provide Gainsharing’s
incentive an organization measures performance through a pre-determined formula
which, in turn, shares the savings with all employees. The organization’s actual
performance is compared to baseline performance (often a historical standard) to
determine the amount of the gain. The gains and resulting payouts are self-funded
based on savings generated by the measurement formula. Some plans may utilize
broad financial measures that closely resemble profit sharing. However, it is more
common to find Gainsharing companies that utilize more narrow operational measures
such as productivity, quality, customer service, on-time delivery, and spending. Typically
gainsharing plans have multiple measures. In order for a gain to occur, the performance
pie must improve.

As the pie expands, the greater the improvement (gain), and the more financial benefit
for the company and employees. The key point is that there must be an improvement
before any sharing occurs. A critical point is that since gains are typically measured in
relationship to a historical baseline, employees and the organization must change in
order to generate a gain.

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A multi-measure system is commonly used which is referred to as a “family of
measures” approach. Basically the “family of measures” approach uses 3 to 6 drivers of
performance. Examples of measures are listed below.

Examples of Operational Measures

Productivity
Equipment efficiency
Cycle time
Yeild
Shrinkage
Scrap
Rework
Spending
On-time Shipments
RMAs
Fill Rate
PPM Returned
Uptime
Inventory Turns
Inventory Accuracy
Safety
Schedule Attainment
Energy Usage
Customer Complaints
Service Satisfaction
Spending
Credits
Collections

The drivers are measured, and gains and losses are calculated for each respective
measure. The gains and losses are shared for each measure and then aggregated into
an employee distribution pool.

It’s very important to point out that employees do not have 100% control of any
measure. No matter what the measure: productivity, cycle time, yield, spending, or on
time delivery, there are always outside factors that will influence the result. The point is
that employees have more control of operational measures than profitability.

However, unlike Profit Sharing and depending on the Gainsharing plan’s design,
employee payouts can potential occur even during periods of profitability decline.
Companies with this type of Gainsharing model argue that even though profits may be
down, profits would have further declined if not for the savings generated from the

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gainsharing measures. In this example the company is sharing “savings” and not
necessarily “profits.”

Family of measures

Figure 5

Another line-of-sight feature of Gainsharing relates to employee eligibility. All employees

at a site are generally included in the plan, including hourly, salaried, and managers.
The objective is to improve the line of sight by having the plan applied to employees
“housed under the same roof.”

On the other hand, a Profit Sharing plan may exclude lower level or hourly employees,
or profit bonuses may be paid out on a hierarchical basis. In other words the bonus
payout percentage is reduced as the Profit Sharing cascades down the organization.
The end result could divide the workforce and create feelings of inequity rather than
build teamwork and the sense of unity. On the other hand, Gainsharing plans are
designed to distribute gains based on an equal percentage of pay or cents per hour
worked.

Another Gainsharing line-of-sight enhancement is that Gainsharing is always paid in the

form of a cash bonus. Gainsharing’s intent is to be based on the “pay-for-performance”
concept as compared to a “benefit/deferred compensation plan.” In addition the
frequency for possible payout is greater for Gainsharing than Profit Sharing. The payout
of Profit Sharing plans is typically an annual arrangement.

On the other hand, Gainsharing typically has the potential for a monthly or quarterly
payout opportunity. A gain and resulting payout is best described as a score rather than
a bonus. Since everyone in the organization is typically included, the score is a “team
score” as compared to an individual one. The score helps give a common focus for
employees on measures they can influence and control. Therefore, Gainsharing works
best in work environments that require collaboration between individuals, work groups,
and departments.

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Another important feature regarding Gainsharing is that typically a portion of the
employees share is placed in a year-end reserve account that is paid to all the eligible
participants at the end of each plan year. In periods of deficit performance, the
employees’ share of the loss is deducted from the annual reserve account. In other
words, employees will see consequences for worse performance and longer-term
thinking is reinforced. If at the end of the plan year the reserve is negative, a company
will typically absorb the loss and start the next plan year at zero. The reserve concept
helps further develop a sense of employee identity and ownership to the organization.
For example if a company measured scrap and shared 50% of the gain and 50% of the
loss (through the reserve) in a sense employees would own 50% of the financial value
of the scrap. Obviously the sense of ownership would drive many new behaviors.

Unlike Profit Sharing in multi-site operations, Gainsharing is typically site specific. The
measures and resulting gains are specific to the facility rather than gains being
aggregated from multiple locations and in turn distributed across the organization. Again
the concept is to increase controllability and the line-of sight. On the other hand, unlike
group incentives, Gainsharing typically measures across department/units/functions.
The concept is to build cooperation and communications between departments instead
of building silos.

Another distinction between Profit Sharing and Gainsharing relates to the method of
plan design and development. A Profit Sharing plan is typically developed at the top of
the organization. In larger corporations the plan may be designed and developed by
compensation executives who in turn are granted approval from an executive committee
made up of board members.

However, the development of a Gainsharing plan often involves employees in many

aspects of the plan’s design and implementation. Often a cross-functional Design Team
is assembled that mirrors the makeup of the total organization. The Design Team sorts
through a number of issues related to measures, policies, and communication. After
upper management’s approval, the Design Team is responsible for conducting all
employee kick-off and promotional meetings. The objective is a sense of employee
ownership for the plan. In a sense the Design Team members become disciples of the
plan and help lead a process for improvement and change.

So should the farmer consider installing a Gainsharing plan rather than profit sharing?
Again, the same question must be asked. What is the objective? If the farmer’s
objective is to drive organizational change by influencing attitudes and behaviors, then
Gainsharing may be the right answer. However, the farmer needs to have the horse in
front of the cart. He needs to understand that Gainsharing is an employee “involvement
system with teeth.” Simply instituting some type of bonus formula is not enough. A
second question; “Should the farmer consider a broad financial measure of performance
or more narrow operational measures?” All other things being equal, the use of more
narrow, “line-of-sight” measures will more likely yield significant changes in behaviors

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which in turn generate positive results. The use of a broad financial based measure is
much more dependent on the level of employee involvement in the organization at the
time of the plan’s implementation. In other words, “How open is the company’s
communication? How knowledgeable are employees about the business conditions?
What is the level of trust? How much baggage is the organization carrying from its past?
A Gainsharing plan that uses a broad financial measure such as profitability, EBIT, or
ROI may be a success if the organization can answer “yes” to the following questions: Is
their a high level of company commitment to the concept of sharing? Are employees
afforded regular training both in terms of skills and individual development? Is
communication ongoing? Are the financial results openly shared? Does the company
practice open book management? Are managers willing to admit mistakes? Is the
workforce highly engaged? Are people at all levels involved in some decision making?
Do employees have a strong understanding of how they influence profitability? Do
people identity with the business? Does the company demonstrate loyalty to the
workforce? Do employees view themselves as stakeholders? If the answers are” yes”,
then measuring and sharing profits may work. If not, then it’s best to have a plan that
focuses on operational more “line-of-site measures. Otherwise, the organization will find
itself in the same position as the generous, but disappointed farmer.

Gainsharing Profit Sharing

Purpose To drive performance of an
organization by promoting
awareness, alignment, teamwork,
communication and involvement.
Application The plan commonly applies to a
single facility, site, or stand-alone
organization.
Measurement Payout is based on operational
measures (productivity, quality,
spending, service), measures that
improve the ?line of site? in terms of
what employees do and how they are
compensated.
Funding Gains and resulting payouts are self- Payouts are funded through company
funded based on savings generated by profits.
improved performance.
Payment Target Payouts are made only when
performance has improved over a
To share the financial success of the
total organization and encourage
employee identity with company
success.
The plan typically applies
organization-wide; companies with
multiple sites typically measure
organization-wide profitability rather
than the performance of a single site.
Payout is based on a broad financial
measure of the organization’s
profitability.
Payouts are typically made when
there are profits; performance doesn’t

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 historical standard or target. necessary have to show an
improvement.
Employee Typically all employees at a site are Some employee groups may be
Eligibility eligible for plan payments. excluded, such as hourly or union
employees.
Payout Payout is often monthly or quarterly. Payout is typically annual.
Frequency Many plans have a year-end reserve
fund to account for deficit periods.
Form of Payment is cash rather than deferred Historically profit plans were
Payment compensation. Many organizations primarily deferred compensation
pay via separate check to increase plans; organization used profit
visibility. sharing as a pension plan. Today we
see many more cash plans.
Method of Typically employees receive the same The bonus may be a larger % of
Distribution % payout or cents per hour bonus. compensation for higher-level
employees. The % bonus may be less
for lower level employees.
Plan Design & Employees often are involved with There is no employee involvement in
Development the design and implementation the design process.
process.
Communication A supporting employee involvement Since there is little linkage between
and communication system is an what employees do and the bonus,
integral element of Gainsharing and there is an absence of accompanying
helps drive improvement initiatives. employee involvement initiatives.
Pay for Gains are generated only by Profit sharing often is viewed as a
Performance improved performance over a entitlement or employee benefit.
Plan versus predetermined base level of
Entitlement performance. Therefore, Gainsharing
is viewed as a pay-for-performance
initiative.
Impact on Gainsharing reinforces behaviors that Little impact on behaviors since
Behaviors promote improved performance. employees have difficulty linking
Used as a tool to drive cultural and what they do and their bonus. Many
organization change. variables outside of the typical
employee’s control determine
profitability and the bonus amount.
Impact on Heightens the level of employee Influences the sense of employee
Attitudes awareness, helps develop the feeling identity to the organization,
of self worth, builds a senses of particularly for smaller organizations.

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 ownership and identity to the
organization.

Key advantages include:

1 Creates a direct link between pay and performance

2 Creates a sense of team spirit- helps remove ‘them and us’ barrier between managers and workers if
all employees involved

3 May improve employee’s loyalty to company

4 Employees more likely to accept changes in working practices if can see that profits will increase
overall

5 Brings groups of employees to work together toward a common goal (the success/benefit of the
company).

6 Helps employees focus on profitability.

7 The costs of implementing the plan rise and fall with the company's revenues.

8 Enhances commitment to organizational goals.

Disadvantages

1 The pay for each employee moves up or down together (no individual differences for merit or
performance).

2 Focuses only on the goal of profitability (which may be at the expense of quality).

3 For smaller companies, these plans may result in drastic swings in earnings for employees
which the employees may find difficult to manage their personal finances.

4 Adherence to the FLSA requires employers to recalculate each worker's "regular rate" of pay.
To overcome this limitation, employers may restrict this type of compensation to exempt
employees.

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