Productivity linked wage systems

1. Productivity Linked Wage System
The theory in PLWS

2. Outline
1. Incentive Problem
2. Compensation Contracts
3. Output-Based Pay
4. Input-Based Pay
5. Incentive Pay
Source: www.msn.de
PLWS Theory 2

3. 1. Incentive Problem
Coordination and Motivation Problem
Task
Coordination Motivation
Who does what, Individual How do I get somebody
when,... to perfom a task,
improve the quality,...
Allocation of Input Distribution of
=> Incentive Problem
Resources Output
Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51
PLWS Theory 3

4. 1. Incentive Problem
Why do Incentive Problems Exist?
Why do Incentive problems exist?
• Employee and employer have different interests
– Employer would want the employee to take actions that maximize
the profit of the firms, but the employee might rather like spending
his time with his/her family or play golf
– All actions of the employee cannot be monitored and/or controlled
by contracts (risk for the employer)
– Employers have to compensate employees for doing undesirable
tasks
PLWS Theory 4

5. 1. Incentive Problem
How can Incentive Problems be Solved?
• Incentive Problems can be solved through effective compensation
contracts
• Compensation contracts have two functions
– Motivate employees
– Share risk more efficiently
Source: www.euro.fi
PLWS Theory 5

6. 2. Compensation Contracts
Compensation Contracts
Variable Pay Fixed Salary
Payment by Output Payment by Input
Objective Subjective Objective Subjective
Performance Performance Performance Performance
Measures Measures Measures Measures
PLWS Theory 6

7. 2. Compensation Contracts
Payment by Input versus Payment by Output
Variable Pay Straight Salary
(payment by output) (payment by input)
• Compensation depends on measure • Compensation depends on the amount
of what comes out of time or effort spent on an activity
• Amount of time spent on work does • Independent of output consideration
not affect workers‘ compensation
Problem:
Problem: ⇒ Input also not always easy to measure
⇒ Output not always easy to measure • Time at work as a proxy in order to
assess worker‘s effort
Examples: Examples:
• Agricultural workers: piece rates p. tray • Wage per work hour
• A salesperson on straight commission • Monthly salaries
• Compensation of top executives by • Annual salaries
stocks or stock options
PLWS Theory 7

8. 2. Compensation Contracts
How can the Performance of an Employee be
Measured?
•Objective Performance Measure:
– Measure that is easily observable and quantifiable, e.g. parts
produced, hours worked etc.
•Subjective Performance Measures:
– An evaluation which is based on personal opinion of a supervisor,
customer, peers, etc.
Type of evaluat.
objective subjective
Database
Output revenue, dividend customer satisfaction
Input time qualification
PLWS Theory 8

9. 2. Compensation Contracts
Examples of Different Variables as a
Basis of Output-Related Pay
Basis Variables for output-based pay
Quantity of production pieces, weight, size/height
Rejects, grade, customer‘s satisfaction,
Quality of production
individual targets
Reduction of input factors: raw material,
Input reduction
energy, work time
Capacity utilization slack-, repair- and waiting periods
Timeliness vis à vis internal and external
Be on schedule
customers
Value of the firm stock price, economic value added
PLWS Theory 9

10. 3. Output-Based Pay
Advantages of output-based pay
Selection effect Motivation effect
• efficient workers with a high
• output-based pay motivates workers
productivity will join the firm/stay to put forth more effort
• inefficient workers with a low
productivity will not join/leave the firm
Source: www.kone.fi
PLWS Theory 10

11. 3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople
World Book Britannica
Offered compensation scheme variable pay: W = $ 100 . fixed salary: W = $ 500
Labor costs of 10 sets; Cost per x
$ 1,000 ⇒ $ 100 per set $ 500 ⇒ $ 50 per set
set type of salesperson
What high productive sp. low productive sp.
will stay with the firm? x ≥ 5 x ≤ 5
Labor costs of 3 sets; Cost per set $ 300 ⇒ $ 100 per set $ 500 ⇒ $ 166,67 per
set
PLWS Theory 11

12. 3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople (cont.)
W ...Weekly A (World Book)
Pay
500 B (Britannica)
300
3 5 x ... Number of
encyclopedia
⇒ Higher-productivity workers will leave Britannica,
because they will earn more at World Book. Only lower-productivity workers will
stay at Britannica
PLWS Theory 12

13. 3. Output-Based Pay
Disadvantages of Output-Based Pay
• Disadvantage of piecework: Variations of output can be beyond the worker‘s control
Variable pay Straight salary
• Variable pay depends on invested effort • Fixed salary doesn‘t depend on exoge-
and exogenous risks – risky form of nous factors – low-risk form of
compensation compensation
⇒ Firm should smooth out exogenous risks ⇒ Workers are insured against volatilities
from workers‘ compensation ⇒ Firm provides the insurance for risks
⇒ Firm should bear exogenous risks but
endogenous risks should remain with
workers
• Trade-off: More risk⇔higher compensation • Lower compensation level
• Opportunity: participate in good economic • Can not participate in good economic
development development
• Stronger incentives • Weaker incentives
PLWS Theory 13

14. 3. Output-Based Pay
Risk in Output-Based Pay
• The firm should bear the largest portion of risk because of risk pooling
abilities
• Workers with a high average compensation should bear more risks than
workers with a low average compensation.
Source: www.kone.fi
PLWS Theory 14

15. 4. Input-Based Pay
• In spite of all the advantages of output-based schemes: A large
proportion of workforce is paid by input
• Compensation depends on the amount of time or effort spent on an
activity
• Independent of output consideration
⇒ Time at work as a proxy to assess worker‘s effort
Source: www.euro.fi
Examples: wage per work hour, monthly salaries, annual salaries
PLWS Theory 15

16. 4. Input-Based Pay
Benefits of Input-Based Pay
Problems of output-based pay solved by time-based (input-based) pay
• Finding the right output measure
• Costs of measurement
• Overemphasizing quantity, reduction of quality
• Risk aversion of workers
• Promoting long-run performance
However, in many cases output-based schemes could be used if only they
were designed correctly!
PLWS Theory 16

17. Compensation Schemes
Balancing Quantity and Quality
• Piece rates could induce workers to focus on high numbers of low quality
products meeting only the sufficient quality level to ‚count‘
⇒ Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page Price p. page Minutes p. page Revenue per hour
0 $8 20 $ 24
1 $7 15 $ 28
2 $5 12 $ 25
3 $3 10 $ 18
4 $0 9 $0
5 $0 8 $0
PLWS Theory 17

18. 4. Input-Based Pay
Using the Appropriate Time Unit
Input-based pay
Hourly wages Monthly salary Annual salary
• Production workers • Managerial workers • Top Management
• Clerical workers
Tasks: experienced and Tasks: less experienced and Tasks: not experienced and
easy to prescribe not easy to prescribe difficult to prescribe; often
to be defined by top manager
• High correlation between • Low correlation between • Undefined set of tasks (goal),
effort and time invested effort and work time discretion over work
• Time input as a pretty • Time input = bad measure for • Importance of other incen-
good indicator for effort effort ⇒ overinvestment in tives to motivate for effort
easy (pleasant) tasks (long-term, e.g. stock options)
PLWS Theory 18

19. 5. Incentive Pay
Optimal Level of Variable Pay
• Since employees do not diversify their risk
– Large exogenous risks should be born by owners
Fixed salary
• However, employees are motivated by pay for performance
Variable Pay
Part of the pay should be fixed and part variable
PLWS Theory 19

20. 5. Incentive Pay
Forms of Incentive Pay
• Rewards do not need to be monetary, they can consist of anything that
employees value
• E.g
 Piece rates and commissions  Housing
 Bonuses  Education for kids
 Parking spots  Retirement Plan
 Days off  Party
 Promotion
 Training
 Stock ownership
 Health care plan
PLWS Theory 20

21. 5. Incentive Pay
Criticism to Incentive Compensation
• Often heard critics to incentive compensation:
– Money does not motivate
– It is difficult to design effective incentive schemes
• Incentives certainly entail costs
• The major problem is to design incentive schemes where the benefits
exceed the costs
PLWS Theory 21