Performance Based Pay Plans

Performance Based Pay Plans

As organizational structures have become more complex to keep pace with the ever increasing complexity of the business environment, it has become crucial to institute an effective and efficient compensation system that provides not just offers fair rewards to employees but also motivational incentives.

The two basic types of compensation plans in practice today are the pay for performance and pay for skill based systems. The mechanics of both these compensation plans stem from prior motivational research conducted.

Before proceeding to a discussion about the mechanics of the different kinds of compensation plans, it is imperative to study the basics of motivational theory, since all compensation plans, whether skills based or performance based, find their roots in Motivational Theory.

The basis of motivational theory is that all actions of an individual are stimulated by unsatisfied needs that prompt action that would lead to their fulfillment. In other words, according to motivational theory, human behavior can be understood simply as goal directed behavior, where all actions are undertaken with the sole purpose of need satisfaction.

Of the multitude of motivation theories that abound, expectancy and equity theories of motivation have been considered the most important in designing different types of compensation plans.

Proponents of expectancy theory contend that an individual has conscious control over the majority of his/her actions and hence that course of action will always be selected from among the available options that lead to the best possible rewards desired by that individual. The two main tools on which the Expectancy Theory of motivation hinges are valences and expectancies.

Expectancies are the beliefs of an individual about the possible outcomes, while valence is the importance that an individual assigns to a particular outcome. However, despite the fact that at first look the expectancy theory of motivation answers all questions that top management might have about the ideal compensation plans, yet there are some crucial faults with the basic assumptions of the theory itself.

The most crucial of all deficiencies in the theory is the implicit belief that motivation is a completely conscious process and thus all of it can be perfectly understood and controlled by an individual. In many cases motivation may occur completely as a subconscious process with actual realization coming quite late.

Secondly, the theory does not specify what kind of outcomes or benefits would be most desired by a particular individual. It is close to impossible to make generalized assumptions about what truly drives an employee to work, and the motivation is not always dependent upon extrinsic rewards such as bonuses or pay increases.

In the case of non-profit organizations specifically, like my organization, it would not be wrong to conclude that for majority of the people working there (mostly on a volunteer basis), the nature of motivation is extrinsic.

Equity Theory on the other hand simply views the organization and its relationship with the employee in terms of inputs and outputs. If any inequity or discrepancy exists between the inputs and outputs, the employee is forced to take some action to correct the balance.

Inputs are simply what the employee brings to the organization in terms of his skill set, performance levels and effort of performance. While outputs can simply be understood as pay increases or enhanced job status.

Considering the case of non-profit organizations as opposed to public sector organizations, equity theory has more of a role in designing of the compensation plan. The only modification that would have to be made to the theory would be the description of outputs. In the case of a non-profit organization it would be simply be a successful fund raising activity, press conference, or some other form of publicity or success in creating more awareness about a particular issue.

The volunteers involved would make a conscious evaluation of the extent of effort they put into a particular task, and the extent of success achieved as a result of it. In most cases however, it usually takes a long time for a particular issue to gain the awareness it deserves, and hence non-profit organizations tend to have a very long-term view on gauging the relative success of their efforts.

The basic condition of Pay for performance plans is that they establish a direct connection between an employee or a workforce team’s performance and goals achieved to financial benefits. A further differentiation that has been established in pay for performance compensation systems is that of bonus systems and value based systems.

These further classifications of the plan assist an organization in dealing with two different tiers of its management. The middle and top management of most organizations have major differences in their job descriptions and responsibilities and hence the motivating factors for both cannot be clumped together and dealt with by the same type of compensation plan.

Bonus Plans tend to have a short term focus since the payment of the bonus is contingent upon the accomplishment of specified quantitative and qualitative goals. This plan can thus be successfully administered to the middle management of most organizations.

Value based plans on the other hand, are based on the creation of the maximum value for the organization’s stockholders in terms of judging performance of the top management by evaluating the value created in terms of dividend payments and market capitalization.

While the main goal of non-profit organizations is not the generation of the maximum amount of profits to be distributed to its stockholders, but the provision of some basic social service or work toward the accomplishment of a pre decided social objective.

The proponents of pay for performance plans state that the very nature of the plan is such that it has motivational effects on those to whom it is administered. From a psychological viewpoint, pay for performance plans encourage the performance of those actions that lead to organizational goal accomplishment, thereby increasing both efficiency and effectiveness of the entire operation.

This type of pay plan also receives support from micro economists who explain the plan effectiveness by using the relative price paradigm. Pay for performance plans set out clear and precise goals that are the target for the employees and the achievement of which will lead to increased monetary rewards. By default, this implies that any actions or performance that does not conform to the specified goals would go unrewarded.

Again going to the psychological viewpoint of human behavior, motivational theorists insist that all human want to achieve the maximum rewards possible for their actions. Thus, they are most likely to perform those actions that will reap the maximum rewards for them.

Successful administration of a pay for performance pay plans requires the presence of certain factors. First and most important of all the goals, (qualitative or quantitative) must be clearly specified and understood by all concerned personnel.

Secondly, the goals specified at the individual or departmental level must be congruent i.e. the achievement of each goal should contribute towards the overall organizational goals. And last but most important, the employees should be judged only for those goals over which they have control.

In non-profit organizations it has become more and more important to raise the highest possible income from fund raising events and minimize the cost of operations in the process. But the downside of the application of pay for performance plans is that there may be incompatibility and/or incongruity between different goals and hence the overall efficiency of the organization may be harmed severely.

Yet another important consideration highlighted is that pay for performance plans can be successful only when an individual has extrinsic and not intrinsic motivation linked to the goal set. Intrinsic motivation allows an individual to be motivated to perform any activity and that activity only is the desired reward for that person.

Pay for performance plans therefore rely on the pre-existence of extrinsic motivation and also the fact that the stated reward has high valence for the concerned individual. A skill based pay plan on the other hand, focuses not on the actual performance outcomes of an individual, but on the variety and extent of the individual employee’s skill set. A skills based pay plan can be perceived to be the compensation plan of choice in a recessionary period, where almost all organizations are downsizing.

Numerous benefits are there to be gained when such a pay plan is employed by any organization. Primarily the focus of the employees shift from doing one core job perfectly to managing a multitude of tasks with some degree of competence.

From the standpoint of a non-profit organization, a skill based seems to be the more relevant plan since the organization would benefit from having employees who are able to perform a variety of jobs as the needs arise, and the organization would not be forced to hire more employees as its human resource needs diversify.

It has also been pointed out that since the nature of operations and requirements of non-profit organizations, like other business organizations change rapidly, it would be a more feasible option if the existing set of employees are encouraged to adopt a variety of skills, so the operations run smoothly and the employees get intrinsic satisfaction of knowing that their contributions make a strong impact on the organizational outcomes.


Pomeroy, A. (2004) Performance-based pay plans, HR Magazine. Retrieved on July 16th, 2010 from

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