MASTER OF BUSINESS ADMINISTRATION

SEMESTER 4

DHRM401

COMPENSATION AND BENEFITS

Unit 11

Performance Linked Compensation

Table of Contents

SL No	Topic		Fig No / Table / Graph	SAQ / Activity	Page No
1	Introduction		-	-	3
	1.1	Objectives	-	-	3
2	Performance Management		1	1 , I	4 - 8
	2.1	Objectives of performance management	-	-
	2.2	Process of performance management	-	-
3	Performance Appraisal and Measurement		2, 3, 4, 5, 6, 7	2 , II	9 - 19
	3.1	Formula of Performance linked Compensation	-	-
	3.2	Approaches to performance appraisal	-	-
	3.3	Process of performance appraisal	-	-
	3.4	Methods of performance appraisal	-	-
4	Pay for Performance Plans		8, 9	3,	20 - 27
	4.1	Individual pay plans	-	-
	4.2	Team/Organisation based pay plans	-	-
5	Balancing of Internal and External Equity		10 , 11	4, III	28 - 31
	5.1	Internal equity	-	-
	5.2	External equity	-	-
6	Summary		-	-	32
7	Glossary		-	-	32
8	Terminal Questions		-	-	33
9	Answers		-	-	33 -34
10	Case Study		-	-	35 - 36

1. INTRODUCTION

In the earlier unit, you studied about the concept and elements of managerial remuneration, the approach of rewarding, remuneration ceilings, and benchmarking compensation package as per industry standards, etc. Now you will study the concept of performance linked compensation.

Performance linked compensation is a form of compensation received by an employee from its employer directly related to his/her performance output as specified in the contract of employment. Most of the organisations today work on performance linked compensation as it affects the work quality of employees and organisation as a whole, their willingness to be flexible in working, learning new skills and providing valuable suggestions regarding innovation. It also enables an organisation to attract and retain efficient and talented workforce.

In this unit, you will learn the concepts of performance management, performance appraisal and measurement, pay for performance plans, and how performance linked compensation balances both external and internal equity.

1.1 Objectives:

After studying this unit, you should be able to:

❖ Discuss the concept of performance management

❖ Describe the meaning of performance appraisal and its measurement

❖ Identify the types of pay for performance plans

❖ Explain how performance linked compensation balances both external and internal equity.

2. PERFORMANCE MANAGEMENT

Beer and Ruh, who first coined the phrase performance management in the year 1976, define it as the process of evolving an organisation wide process for improving employees’ performance and linking it with organisation’s goals and objectives.

Now you will understand this concept with the help of a case let:

Case Let

General Electric

There are two ways to motivate people – the carrot and the stick. Competitions – prizes (carrots) for the winners – tend not to work because only the top few who feel the awards within reach tend to try harder. Most of the others, recognising that for them winning is not possible, simply ignore the competition and continue to plod.

Jack Welch of General Electric came up with a solution to this paradox. When he took over GE was profitable, but it had already become relatively stodgy and too comfortable for people who had been there a long time. To affect change, he implemented several strategic initiatives, the most significant of which was a performance matrix. The top 10–15% of employees were rewarded, the middle 70% were compensated adequately, and the remaining 10–15% were targeted for elimination. Everybody shaped up because nobody wanted to be at the bottom. Most people agree that GE improved significantly during Jack Welch’s tenure.

GE and other forward-looking companies started these kinds of changes in the 1980’s. GE made it clear from its compensation strategies that in today’s knowledge-worker business environment, the best form of compensation is performance-based. It gives people immediate and meaningful feedback. The best form of compensation is performance-based, with measurable objectives. The easiest targets to quantify are those based on bookings, shipments and profit. Pay is based on whether or not plans or budgets are met – usually monthly, but quarterly and even annually for top managers.

Source: http://www.jimpinto.com/writings/compensation.html

Now, you can say that performance management is concerned with the way the performance of an organisation or organisational units is managed. It refers to the following set of techniques and procedures:

• Providing information on the contribution of human resources to the strategic objectives of the organisation;

• Forming a framework of techniques to secure maximum achievement of objectives for given inputs;

• Developing and communicating employee performance plans, including the key result areas and indicators of performance;

• Evaluating the performance of each employee on the basis of the performance plan during the period of appraisal; and

• Recognising and rewarding employees whose performance meets or exceeds performance plan.

Example: The performance management system at Wipro aims at giving employees feedback on their performance, identifies their training needs, forms basis for personnel decisions like salary hike, promotions, disciplinary actions, and even provides Wipro the opportunity for its organisational diagnosis and development.

The following definitions will help you analyse the concept of performance management in detail.

According to Hendry, Bradley and Perkins, the authors of Missed, “Performance Management is a systematic approach to improving individual and team performance in order to achieve organisational goals.”

Dr. T.V Rao, the father of Indian HRD, explains performance management as, “thinking through various facets of performance, identifying critical dimensions of performance, planning, reviewing, and developing and enhancing performance and related competencies.”

2.1 Objectives Of Performance Management

The major objectives of performance management are as follows:

• To assist in strategy formulation in order to give shape to the goals and objectives of the organisation,

• To manage the strategy implementation process by monitoring progress,

• To motivate employees in setting up goals that align with organisational strategies,

• To give feedback to employees about individual, team and organisational performance against the expected goals,

• To encourage, reinforce and reward appropriate employee behaviours consistent with organisational goals and objectives,

• To foster a culture of learning and development at all levels and across the organisation,

• To ascertain employee and managerial talents for the purpose of succession planning, and

• To allow a participative management style whereby employees set their own performance objectives so that achieving these objectives becomes their mission.

Example: Dabur India Ltd. has a system of performance management designed for their employees aimed at their performance evaluation, promotion and arrangement of training programs.

2.2 Process Of Performance Management

Figure 11.1: Performance Management Process

The figure 11.1 mentioned above represents that performance management embraces all aspects of the organisation including organisational strategies, environmental responsiveness, business processes, and innovation with employees and managers at the epicentre of the process.

It encompasses the following steps:

• Performance planning entails setting the work related activities in the form of specific job objectives as integrated with the work-unit or department goals.

• Performance analysis entails monitoring of employee’s performance with regard to the agreed performance objectives periodically for the purpose of supporting the employee to perform effectively as per his performance plan.

• Performance appraisal involves formal evaluation of employee’s performance for the purpose of rewards administration and identifying performance deficiencies.

• Performance linked rewards is concerned with administration of compensation revision and career progression of employees.

• Performance development includes creating action plans for improving performance deficiencies.

• Performance feedback and counselling consists of coaching and mentoring for improving employee’s insight into his own performance for further improvement.

3. PERFORMANCE APPRAISAL AND MEASUREMENT

Performance appraisal as a critical part of performance management aims to improve employees performance and analyse their current needs for effective performance, etc. It is an assessment of an employee’s performance measured in terms of:

• Productivity

• Effectiveness

• Quality

• Timeliness

Example: The performance appraisal system at 3i InfoTech involves setting key performance indicators, mid-year reviews, annual reviews to link career to competencies, individual preferences and organisational needs.

According to Mathis and Jackson, the authors of Human Resource Management, 11^thEdition, “performance appraisal is the process of evaluating how employees perform their jobs when compared to a set of standards and then communicating that information to those employees”.

R. Lansbury, the author of Performance management: A process approach defines performance appraisal as, “the process of identifying, evaluating and developing the work performance of employees in the organisation, so that the organisational goals and objectives are more effectively achieved, while at the same time benefiting employees in terms of recognition, receiving feedback, catering for work and offering career guidance”.

3.1 Formula Of Performance Linked Compensation

Performance linked reward systems reduce labour cost, result in increase in real wages and motivate performance. They provide a method of observing cost escalation on account of pay increase and thus, help in sustaining the competitiveness of the organisation.

Employees performance depends on mainly three factors-Skill, Knowledge and Motivation:

Employees performance = f (SKM)

Where;

S = skill & ability to perform task

K = knowledge of facts, rules, principles, and procedures

M = motivation to perform

Performance Measures

“If you cannot measure you cannot improve” – What is not measured is not worth doing – Simple Measurements (Production, Quality, Cost, Delivery, Safety) etc. – profitability gets measured on–

• return on investment

• return on sale

• return on total capital

• return on book quality

• net income by total assets

Performance is essentially what an employee does or does not do. Employee performance common to most jobs includes the following elements:

• Quantity of output

• Quality of output

• Timeliness of output

• Presence at work

• Cooperativeness

Performance measures provide evidence of whether or not the intended result has been achieved and extend to which the jobholder has produced the result. Performance measure becomes the basis of generating feedback information. Performance appraisal is the process of evaluating how well employees perform their jobs when compared to a set of standards, and then communicating that information to those employees. Performance appraisal also is called employee rating, employee evaluation, performance review, performance evaluation, and results appraisal.

Example:

1. Wipro has quarterly based Performance linked compensation which are granted to all on the basis of the contribution of their division towards the profitability of the company. This improves the co-ordination and teamwork of a division.

2. Air India decided to do away with performance-linked incentives (PLI) as part of pay and wage rationalisation exercise. However, the airline has decided to introduce Profit or Productivity Related Pay (PRP) in place of Performance linked Incentives (PLI) for its employees. Thus, the airline has decided to introduce Profit or Productivity Related Pay (PRP) in place of PLI for its employees. However, for payment of flying allowances and some other allowances to pilots, engineers and cabin crews as per the industry standard. Rationalisation of pay and wages was one of the key recommendations, as the cash-strapped national carrier, which got a ` 30,000-crore equity infusion from the government for nine years, had a wage bill of ` 3,200 crore of which around 50 per cent constituted PLI and flying allowances of the employees. PRP would be determined on the achievement of Key Performance Indicators (KPIs) like yield, aircraft utilisation, passenger load factor, on-time performance and revenue achievement and it will be given only after the Company starts making profit.

3.2 Approaches To Performance Appraisal

There are two approaches namely evaluative and development approach to performance appraisal as depicted in figure 11.2.

1. Evaluative approach: This approach focuses on previous year’s performance, which is used to make decisions on compensation revision, promotions, demotions and transfers. It can also be used to determine the efficacy of recruitment and selection.

2. Developmental approach: This approach focuses on employee’s development needs. Manager plays the role of a coach and mentor to reward good performance and give advice on how to improve. It is important to developmental feedback to reinforce individual behaviours.

Source: Compensation Management, 1^st Edition, Tapomoy Deb, Excel Books

Figure 11.2: Approaches to Performance Appraisal

3.3 Process Of Performance Appraisal

There is no single appraisal process which is common in all organisations as it varies due to organisational, cultural and competitive environmental factors. However, any good performance appraisal process consists of the steps as depicted in figure 11.3.

Source: Compensation Management, 1st Edition, Tapomoy Deb, Excel Books

Figure 11.3: Performance Appraisal Process

3.4 Methods Of Performance Appraisal

You can summarise the most commonly used methods of performance appraisal as given some under:

1. Straight ranking: In this method, employees are compared directly against one another identifying the best employee, second best, and so on as shown in figure 11.4:

Company: ABC Ltd. Department: Marketing Marketing executives: Mr. A, Mr. B., Mr. C. Mr. D. and Mr. E.
Mr. Mr. Mr. Mr. Mr.	Compensable factors	Mr. A’s performance	Mr. B’s performance	Mr. C’s performance	Mr. D’s performance	Mr. E’s performance
	Sales target achievement	Great	Great	Great	Great	OK
	Team building	Great	Ok	Great	Great	OK
	Communication	OK	OK	Great	Great	OK
	Interpersonal skill	OK	OK	Great	OK	OK
	Performance rating according to best to worst scale on the basis of the compensable factors: C – The best performer D – Second best performer A – Third best performer B – Fourth best performer E – The worst performer

Source: Compensation Management, 1st Edition, Mousumi S. Bhattacharya and Nilanjan Sen gupta, Excel Books.

Figure 11.4: Straight Ranking

2. Paired comparison ranking: It examines all possible pairs of employees, choosing the better person in each pair. The person chosen first most often is ranked first, and so on. The formula for the number of pairs is [n (n-1)/2] explained in the example as illustrated in figure 11.5 below. This method is easy to use and explain, and is helpful in making promotion and merit-based increment decisions.

Comparison with	Mr. A’s performance	Mr. B’s performance	Mr. C’s performance	Mr. D’s performance	No. of Times Ranked Higher
Mr. A’s performance	x	Better	Better	Better	3
Mr. B’s performance	X	x	Better	Better	2
Mr. C’s performance	x	x	x	Better	1
Mr. D’s performance	X	X	X	X	0

Source: Compensation Management, 1st Edition, Mousumi S. Bhattacharya and Nilanjan Sen gupta, Excel Books

Figure 11.5: Paired Comparison Ranking

3. Graphic rating scales: In this rating system, the rater evaluates an employee on each of the several dimensions along a clearly defined scale. If some characteristics are considered important, the rating on these dimensions can be multiplied by a "weight" before the total is calculated. This method also is easy to develop and use in which more than one performance dimensions can be included and gives the benefit of comparing employee scores. This scale is shown in the figure 11.6 below:

Employee name:		Job title:
Department: Data:		Rate:
	Unsatisfactory	Fair	Satisfactory	Good	Outstanding
• Quantity of work: volume of work under normal working conditions • Quality of work: neatness, thoroughness and accuracy of work. • Knowledge of job: a clear understanding of the factors connected with the job. • Attitude: Exhibits enthusiasm and cooperativeness on the job. • Dependability: Conscientious, thorough, reliable, accurate, with respect to attendance, relief, lunch breaks, etc. • Cooperation: Willingness and ability to work with others to produce desired goals.

Source: Compensation Management, 1st Edition, Mousumi S. Bhattacharya and Nilanjan Sen gupta, Excel Books

Figure 11.6: Graphic Rating Scale

4. Weighted checklists: In this method, a list of job-related characteristics is provided to the rater, who must check the items that are typical of a particular employee. During checklist development, job experts indicate the level of good or poor performance that each behaviour or characteristic represents.

5. Forced-choice system: It is a variation developed to reduce leniency error. From each pair of items, the rater needs to choose one item that is more characteristic of the employee. Only one of the two choices is significantly related to actual job performance.

6. Critical incident technique: The evaluator keeps a record/log on each employee, recording behaviours and performance incidents that are particularly effective or ineffective. This record is then used to evaluate the employee. It is time-consuming and it may be difficult to quantify or structure the incidents into a final evaluation.

7. Behaviourally Anchored Rating Scales (BARS): Some assessment systems use graphic scales on which anchor points are defined in considerable detail, using examples of behaviour that represent particular levels of performance.

A group of knowledgeable employees identifies the important dimensions that make up effective performance. A second group develops critical incidents that represent effective, average, and ineffective behaviour. A third group assigns each critical incident to the characteristic it represents. A fourth group rates the level of performance each incident represents.

The rating scale is pilot-tested in the organisation. The number of people involved makes development slow, but the employees' and/or supervisors' involvement increases the chances that the BARS will be a valid measure of performance and that employees will accept its use.

Performance	Points	Behaviour
Extremely good	7	Can expect trainee to have valuable suggestions for increased sales and to have positive relationships with customers all over the country.
Good	6	Can expect to initiate creative ideas for improved sales.
Above average	5	Can expect to keep in touch with the customers throughout the year.
Average	4	Can manage, with difficulty, to deliver the goods in time.
Below average	3	Can expect to unload the trucks when asked by the supervisor.
Poor	2	Can expect to inform only a part of the customers.
Extremely poor	1	Can expect to take extended coffee breaks and roam around purposelessly.

Source: Compensation Management, 1st Edition, Mousumi S. Bhattacharya and

Nilanjan Sen gupta, Excel Books

Figure 11.7: Rating Scales

BARS consider the job-related from various groups of people's perspectives. Each job category requires its own BARS, which may make it impractical in many organisations because of the limited number of employees or the cost of development. Figure 11.7 explains the scale.

8. 360-degree method: The 360-degree appraisal takes information from more than one source, that is, superiors, subordinates, peers, customers, and oneself in order to get a 360-degree view of an individual’s performance. Evaluation includes both the ratings of individual employee by superiors on elements in an employee’s performance plan and the evaluation of programmes and teams by senior managers. Generally, 360degree method is used for developmental appraisal purpose and not for evaluative purpose.

Example: HCL Info systems, Tata InfoTech, Ashok Leyland, Wipro and Asian Paints are some of the companies that use 360-degree feedback for performance appraisal.

9. Balanced Scorecard Method: It is a management system that enables organisations to enhance the clarity of their vision and strategy to translate them into action. It uses a range of performance measures to define business goals and monitor performance drivers to achieve strategic objectives. Balanced scorecard reflects the balance between four perspectives viz. financial, customer, business processes, learning and growth and long and short-term objectives as well as between qualitative and quantitative performance measures.

Example: Tata Motors is one of the India’s biggest automobile manufacturing firms that uses balance score card method for appraisals of performance.

Activity II

Suppose you are the HR Manager of your organisation and you are asked to revise and construct a new performance management system in your organisation to gain strategic advantage. Define what points you will keep in mind while its construction and what

objectives would you like your performance management program to satisfy.

4. PAY FOR PERFORMANCE PLANS

Pay for performance plans are methods of remuneration that link pay progression to an assessment of performance, usually measured against pre-agreed objectives. Performance pay plans link pay to a measure of individual, group or organisational performance.

Example: India’s biggest consumer good company Hindustan Unilever which has sharply increased its variable pay component making external employee orientation as its key performance parameter.

Performance based also referred to as variable pay plans can be categorised into three broad types as reflected in table 11.1 below:

Table 11.1: Types of Variable Pay Plans

Individual

Group/Team

Organisation-Wide

• Piece Rate

• Sales Commission

• Bonuses

• Special Resolution

• Safety Awards

• Attendance bonuses

• Gain sharing

• Quality improvement

• cost reduction

• Profit sharing

• Employee Stock Option

• Executive Stock Option

• Deferred Compensation

1. Individual pay plans: Individuals are provided with incentives for rewarding their performance and efforts. Piece-rate systems, bonuses and sales commission are one of the most commonly used variable pay plans. In addition, trips and merchandise are also provided as rewards for special recognition.

2. Team or group pay plans: Organisation also rewards its entire work group or team for their performance resulting in enhancement of cooperation among members. Gain sharing is one of the most commonly used incentive plan provided to teams. This program focuses on reduction of cost, improvement in quality and other results that are measurable.

3. Organisation wide pay plans: These plans reward people on the basis of performance results of the entire organisation. This approach assumes that all employee when work together result in a better financial performance. Employees may receive these organisational incentives as a lump sum amount or different amount may be received

by different levels of employee throughout the organisation. Profit sharing and employee stock options are the widely used organisational incentives.

4.1 Individual Pay Plans

The various types of individual pay plans used by an organisation to reward and retain employees are:

1. Merit pay: Merit incentive pay is employed for recognising and rewarding differential performance that is most suitable for office staff. This system includes the belowmentioned steps:

a) Determining the outcome-oriented procedures of merit rating procedures

b) Identifying job factors and their comparative importance

c) Formulating reward scale

d) Communicating the basis of monetary reward

Merit incentive pay results in a number of benefits like it helps in establishing a prompt relationship between reward and effort. The firm can establish an adequate quantum of reward without incurring any additional cost. It even helps employees to visualise the relationship between their performance and the rewards that they have received.

2. Skill-based pay: Skill-based pay links pay to skills utilised in performing a job. It even sometimes includes linking pay to acquisition and utilisation of additional skills by individuals performing the job. The two types of skill-based pay used in an organisation are:

❖ Conventional job slotting

❖ Progression related to skills

In conventional job slotting, the employees are located in a pay and grade structure depending on their qualifications, training and experience like skilled, semi-skilled and unskilled, etc. Skill-based pay progression on other hand is less conventional method and links a progression to the acquisition of skills.

3. Shop floor incentive and bonus schemes: Such incentives and bonus schemes include pay or part of pay received by an employee to the number of items that they process or produce. It includes the time taken in completion of a particular work and other aspects of their performance. They are frequently referred to as payment by result schemes. Such schemes are of the following types:

❖ The main types of incentive schemes – individual piece work, work measure individual schemes, measure day work and group incentive schemes.

❖ Alternative approaches – high day rates, performance related pay, productivity bonus and the use of other criteria in the bonus schemes.

❖ Bonus schemes in different environment

4.2 Team/Organisation Based Pay Plans

The various team/organisation based pay plans are explained as follows:

1. Annual bonus: Bonuses are extra payments made to the employees in lieu of their good performance. Annual bonuses are frequently used as incentives to reward strategies to provide a number of benefits to the organisation such as:

❖ Improvement of performance in terms of profits, sales or productivity

❖ Helps employees to focus their efforts on key organisation objectives like achievement of desired quality, customer satisfaction and on time delivery, etc

❖ Helps in mounting employee motivation

❖ Supports the ideals formed by shareholders in terms of sharing organisational success with employee in form of sharing of bonuses.

❖ Motivates an atmosphere of change within the organisation and creates a desired work culture.

Example: Companies like Hyundai Motor India, LG Electronics, Samsung and Dabur have well-designed annual bonus plans to reward their team and organisation performance.

2. Gain sharing: It is a formula based factory or organisation wide bonus plan which enables employees to share the financial gains made by a firm as a result of performance improvement. The formula used in gain sharing determines the share that an employee gets with reference to some performance indicator. This indicator can relate to any measure like customer services, delivery, quality or cost deduction, etc. Three types of formulas are traditionally used in gain sharing which are:

a) Scanlon plan: It measures employment cost as a proportion of total sales. In other words, this plan calculates gains based on standard cost reduction.

b) Rucker plan: This plan though based on employment costs are calculated as a proportion of sales minus the material costs and cost of stores.

c) Improshare: It is a proprietary plan, which is based on an established standard that defines the expected hours needed to produce an acceptable output level.

Gain sharing has helped organisations in linking pay with performance, creation of team spirit, increasing flow of creative ideas from employees, enhancement of employee commitment and employee education in business economics, etc.

Example: There are a number of companies using gain sharing throughout the world like Carter-Day, Rexnord, Webster Electrics and Dresser Rand, etc.

3. Goal sharing: Goal sharing plans pay bonuses when performance is above standard covering most or all employees in a particular company or business unit. Goal sharing plans establish goals in areas such as customer satisfaction, quality, cost, delivery time and profitability, etc. It then links a specific bonus amount with achievement of any one or more performance levels on each of these measures.

Goal sharing plans can quickly change focus as an organisation’s business strategy changes, and they are usually easy to explain. So they can be used effectively by an organisation that is undergoing change and by organisations that have not had a history of employee involvement.

Example: Corning Glass employees conducts a gain sharing program where a payout of 75% is given on the basis of 3 unit objectives namely quality, customer satisfaction and production target and the rest is based on its return and equity.

4. Profit sharing: Profit sharing includes paying employees a share in the net profit in addition to their salary or wages. It can be either a payment of dividend or a sum which is based on their basic wage or salary and grade or seniority. It acts as a stimulus for higher performance. Under this plan, an employee may receive an amount additional to normal salary either in form of cash or company shares related to profits of the business. Profit sharing schemes are generally provided to all employees of the firm. The objectives of profit sharing are:

a) To encourage employees to identify themselves more closely with the company by developing a common concern for its progress.

b) To stimulate a greater interest among employees in the affairs of the company as a whole.

c) To encourage better co-operation between the management and the employees.

d) To recognise that the employees have a moral right to share in the profit they have helped to produce.

The main types of profit sharing schemes are:

❖ Cash: A fraction of profits are paid to employees in form of direct cash.

❖ Stock: Employees also receive a proportion of profits in form of shares.

❖ Approved Profit Sharing Schemes (APSS): Sometimes the firm allocates a fraction of their profit to a trust fund which then acquires shares in the firm on employees’ behalf.

❖ Mixed schemes: Sometimes a APSS scheme is provided to employees in addition to a cash scheme, or cash schemes are offered to staff before they are eligible for APSS shares, or as an alternative to PSSS shares.

Example: At DuPont Fibers if the department meets the annual profits than employees are given an opportunity to collect 6 percent of the same as incentive.

5. Employee Stock Options (ESOP): Stock options are opportunities to buy stock at a set price immediately or sometime in future for a stated period. Stock options plan is one of the two forms of variable pay compensation package, other being profit sharing bonus. Employer offers stock options to their employees for several reasons such as:

❖ Employee attraction, retention and motivation

❖ Financial participation by the employees in the wealth created through joint efforts

❖ Garnering commitment of employees

❖ Development of common purpose between employers and employees

❖ Promotion of corporate performance

❖ Proving performance based reward

❖ Supplement retirement/social security benefits

❖ Hedging future hostile takeover

Example: Many FMCG organisations have also begun to offer stock options to their employees. The prominent companies, which have gone for stock option plans, are Castrol, CRISIL, Global Trust Bank, Godrej-GE, HCL, Infosys Technologies, Mastek, NIIT, Proctor and Gamble, WIPRO, Zee Network, etc. Several others are planning to introduce employee stock options.

Now the advantages and disadvantages of ESOP is given in the following table 11.2.

Table 11.2: Advantages and Disadvantages of ESOP

	Advantages		Disadvantages
•	Funded by the market not by the organisation	•	The pay-out is unpredictable
•	Amounts can be sufficiently high to ensure adequate motivation	•	Amounts may be insignificantly low
•	Implies “ownership” in the organisation’	•	Not always available as an alternative, e.g., when dilution of equity is not acceptable to the employer
•	Creates a sense of employee ownership in the business	•	Lock-in periods and other conditions may dilute perceived value
•	Flexible in design	•	Employees are subject to the vagaries of the market
•	Rewards are tied to value creation	•	Administrative hassles exist
•	Self-funding based on economic value creation	•	Lock-in periods may have a negative impact on employee returns
•	Inculcates a performance-driven culture	•	Performance may sometimes not lead to good pay-outs, i.e., high dependency on market conditions
•	Promotes teamwork	•	Pay-out matrix and rules and regulations are at times difficult to understand
•	Provides spectacular gains to employees, i.e., wealth creation

Source: Compensation and Reward Management, 1^st Edition, B.D.Singh, Excel Books

5. BALANCING OF INTERNAL AND EXTERNAL EQUITY

Performance linked compensation can balance both internal and external equity. We will study this in the following sections:

5.1 Internal equity

As analysed in the earlier units, internal equity exists in the compensation structure when employee of the firm perceives their reward system as fair and according to the relative value of their job within an organisation.

In other words, you can say that when an employee perceives his responsibilities, rewards and work conditions as equitable or fair when compared to other employees in same position in the same organisation, internal equity is said to exist. An internal equity determines whether or not a pay equity exists between similar positions and if all roles in the firm are governed by same compensation guidelines.

5.2 External Equity

External equity exists when employees perceive that they are being fairly rewarded in comparison to people who perform similar jobs but in other firms. Usually external equity exists when a firms rate of pay are at least equal to average rates in the firms sector or market. Employees in order to judge external equity compare their roles, the pay in these roles and the pay organisations.

The figure 11.8 shows you that in an industry the pay levels are determined using the combined efforts of both external and internal equity. Therefore, an employee will receive maximum satisfaction from his job and will attain maximum motivation when these two concepts of external and internal equity will equal each other. Therefore, companies while designing its compensation strategy must take into consideration these two equity concepts. This settlement can be done in two ways:

a) A strategic wage-level policy which is organisation wide should be designed to achieve external equity, and

b) Proper internal job evaluation must be done for each job to achieve internal equity.

Source: http://www.slideshare.net/tantia90/compensation-benefit-presentation- final

Figure 11.8: Internal and External Equity

However, in designing the above two critical factors for pay equity equilibrium, pay for performance plays a critical role as it helps a firm in creating compensation and benefits to employees. This results in employee satisfaction and high morale. Performance linked compensation can be stated to help an organisation in designing both a strategic organisation wide wage level policy and job evaluation.

A balance between Internal and External equity can be created by reviewing and making adjustments in the structure of salary. Performance linked pay, thus, provides organisations an opportunity to make these adjustments very appropriately thereby matching pay scales within and among different organisations for the same roles. In such cases, valuation of jobs and their pay is determined on the basis of employees’ contribution in organisational success.

Pay for performance makes market pricing and pay grades within and among different organisation similar. This can be understood by analysing figure 11.9 given below. Total compensation is divided into financial and non-financial rewards. Financial rewards further include direct payment whose component is variable pay.

The last component of total compensation is non-financial rewards which when linked to performance will ultimately bring equilibrium between external and internal equities.

Source: http://www.slideshare.net/tantia90/compensation-benefit-presentation-final

Figure 11.9: Total Compensation Structure

6. SUMMARY

Let us recapitulate the important concepts discussed in this unit:

• Performance linked compensation is a form of compensation received by an employee from its employer directly related to their performance output as may be specified in the contract of employment.

• Performance management is concerned with the way in which the performance of an organisation or organisational units is managed.

• Performance pay plans link pay to individual, group or organisational performance.

• Piece-rate systems, bonuses and sales commission are one of the most commonly used variable pay plans.

• Gain sharing is one of the best plan used incentive plan provided to teams.

• Profit sharing and employee stock options are the widely used organisational incentives.

7. GLOSSARY

• Merit Pay: It links increment in base pay to how highly employee is rated on a subjective performance evaluation.

• Pay for Performance: It is a remuneration method linking pay progression to assessment of an individual performance.

• Performance Appraisal: It is a periodic and systematic process of assessing an employee’s performance in relation to pre-determined criteria.

• Performance Management: It is a systematic process involving management of employees to improve organisational effectiveness in achievement of its goals.

8. TERMINAL QUESTIONS

1. Define the concept of performance management. Also explain why a firm resorts to performance management.

2. What are the different methods used in measurement of performance appraisal?

3. Explain 360-degree method of performance appraisal using a suitable example from Indian industry.

4. What is pay for performance plans? Describe the types of variable pay plans.

5. Differentiate between goal sharing and gain sharing.

6. Performance linked compensation can balance both internal and external equity.

Comment.

9. ANSWERS

Self Assessment Questions

1. Performance

2. True

3. (a) Performance management

4. Individual and team

5. Performance linked rewards

6. (d) Both (a) and (b)

7. True

8. Straight ranking

9. (a) Graphic rating scale

10. 360 Degree method

11. S = skills, K = knowledge & M = motivation

12. True

13. Merit pay

14. (c) Annual bonus

15. Scanlon plan

16. False

17. (d) ESOP

18. Financial

Indirect

Satisfaction

Variable Pay Voluntary

19. Internal equity

20. (b) Equal

21. True

Terminal Questions

1. Performance management is a systematic approach to improving individual and team performance in order to achieve organisational goals. For more details, refer to section

2. Straight ranking, paired comparison ranking, graphic rating scale, 360-degree and balance scorecard methods are the most commonly used techniques for measuring performance appraisal. For more details, refer to section 3.

3. The 360-degree appraisal takes information from more than one source, that is, superiors, subordinates, peers, customers, and oneself in order to get a 360-degree view of an individual’s performance. For more details, refer to section 3.

4. Pay for performance plans are methods of remuneration that links pay progression to an assessment of performance, usually measured against pre-agreed objectives. For more details, refer to section 4.

5. Gain sharing is a formula based factory or organisation wide bonus plan. Goal sharing plans pay bonuses when performance is above standard. For more details, refer to section 4.

6. A balance between Internal and External equity can be created by reviewing and making adjustments in the structure of salary. For more details, refer to section 5.

10. CASE STUDY

TCS Shifts to Performance-linked Salary Structure

Tata Consultancy Services is changing its salary structure and going in for variable compensation based on business performance. The largest software consultancy has been, for a while, under pressure to compete with the ESOP-based compensation structures of its listed rivals in the talent-scarce industry. This is the first time in its history that TCS has decided to give differential pay at the same hierarchical levels and linked it directly to the performance of the business units.

There’s no ceiling on the bonus. It can be equal to the fixed portion of the salary, providing the cell has shown that kind of EVA growth. A Tata Sons division and the country’s largest software services company, has till now based its salaries and compensation on individual appraisals, as well as total performance of the company.

According to industry observers, TCS has been unable to retain talent as its pay scales are not the highest in the industry, and it is also unable to offer stock options. However according to their official reports its attrition level of 11 per cent spread over 14,000 employees is not alarming, and that TCS will continue to hire people at the entry level and train them.

TCS is adopting the Economic Value Added to link incentives and performance for its employees at individual levels. This will imply a significant variance in bonuses or the variable component of people’s salaries, based on the practice and the area of operation. They have been using EVA to track the company’s performance vis-à-vis our competition for a year now. They now intend to take the EVA to individual "cell level" and use it to give incentives for our employees also."

TCS is defining its cells based on the practice, the market it is operating in, and the business it is in. The EVA will vary from cell to cell therefore employees will get different bonus and incentives for the year. The objective of taking the EVA measure to the cell level is not limited to giving incentives only. They want each employee to feel as if they are running their business.

Though TCS is linking the incentives to be paid to the EVA it will not pay the complete EVA in the same year that the growth is made. They will pay their employees a portion of the EVA and bank the remaining, so that in case they are not able to record the same EVA growth in the lean years their compensation will not go down. "The absence of any stock options also limits TCS' ability to attract the best talent industry," industry observers say.

Questions

1. Critically analyse the performance linked compensation strategy at TCS?

2. Do you think TCS EVA strategy for different cells will help it retain its best talent force in Indian industry?

3. What suggestions would you like to give TCS for enhancing the effectiveness of its performance linked compensation strategies?

Source: http://www.tata.com/company/Media/inside.aspx?artid=XcU05YL7RPw= References:

• Singh, Er. Soni Shyam (2008). Compensation Management. Excel Books Pvt. Ltd.

• Bhattacharya, Mousumi S. and Gupta, Nilanjan Sen (2009). Compensation Management.

Excel Books Pvt. Ltd.

• Singh, B. D. (2007). Compensation and Reward Management. Excel Books Pvt. Ltd.

• Milkovich, G. T. & Newman, J.M. (2005). Compensation Management. Tata McGraw Hill. E-References:

• http://208.254.39.65/haygroupusmkting/e_article001004268.cfm?x=b11, Retrieved on 27^thJuly 2012, Time: 5:12 PM

• http://www.hrinfodesk.com/preview.asp?article=29166, Retrieved on 30^th July 2012, Time: 10:54 AM

• http://www.scribd.com/doc/23809590/Performance-Appraisal-at-Wipro, Retrieved on 30^th July 2012, Time: 1:39 PM

MBA Semester IV compensation and benefits -- performance linked compensation-- notes