Performance related pay is a system where employers pay employees depending on the quality of their work. In it simplest form, performance related pay is payment by ‘piece meal’. For example, a worker gets paid £1.00 per Kg of potatoes that they pick.
This piece meal payment is an effective way to give workers an incentive to work harder and pick as many potatoes as they can. From the employers point of view it is relatively easy to measure the marginal product of each worker and pay accordingly. The employer can also ensure that employing workers is relatively profitable because they only pay for the product they can sell.
Performance related pay in service sector
In many jobs outside manufacturing and farming, marginal product of workers is harder to measure. If you work in retail, the output of a worker is less clearly defined and dependent on how many customers come into the shop. However, a firm may try and give performance related pay linked to the overall profitability of the individual shop.
This gives workers a sense that if they do a good job, they will share in the proceeds.
However, this performance related pay is likely to be only a small percentage of their total pay. The firm will need to pay an hourly wage, (at least minimum wage). Then the bonus for a good year will be only a small percentage of final take home pay. This may be insufficient to affect incentives to work hard.
There is also a problem of free riding. If a firm employs many people, individual workers may feel that if they slack and don’t work hard, it doesn’t matter because their effort has only a small percentage impact on the overall profitability of the firm.
Also, many workers may be part time or temporary and not feel any connection to the long-term profitability of the firm.
Often performance related pay is only given to managers and executives, who have the biggest responsibility for determining the working conditions and atmosphere of the firm. If managers are highly motivated to gain a performance bonus, this can affect the other workers. However, the work of an executive is hard to measure because there are so many variables which are not always clearly defined.
Advantages of performance related pay
- Gives managers and workers an incentive to improve efficiency and productivity. This can lead to lower costs and help the firm remain profitable and dynamic.
- It gives workers a feeling of being tied to the fortunes of the company making it easier to emphasise with cost cutting measures.
- It can improve workers morale and loyalty if they feel their hard work is rewarded.
Disadvantages of performance related pay
- Often the profitability of a firm may be out of the control of a manager. For example, general market conditions may lead to fall in demand or it may be determined by the overall strength of the product.
- In many service sector jobs, it is very difficult to adequately measure productivity / success of a worker. For example the output of teachers, nurses and doctors is difficult to measure in numeric terms.
- Profit related bonus payments may encourage risk-taking which leads to a chance of high profit and high rewards. This is an issue in banking where generous bonus schemes encouraged many managers to take risks (e.g. take on sub-prime mortgage) because if profitable, they gained a large bonus, but losses would be absorbed by someone else (often taxpayer).
- Profit related pay may distort effort into areas which increase profit in the short-term. If a manager has a profit target, they may choose options which delay investment and take on the easiest way to make profit. However, this can damage the company in the long-term because investment is delayed and their may be a high turnover of staff.
- The success of a job may not be necessarily related to profit or revenue, but whether the manager is successful in treating workers fairly and maintaining awareness of social objectives (e.g. decisions which impact on environment may conflict with profit motive). See objectives of firms
- Some have argued that high bonuses for executives is linked to the strong bargaining power of executives. Top executives use bonus payments as a way to gain higher pay from firms, rather than being linked to increased productivity. (understanding high pay for executives)
- Some workers, classed as self-employed, such as delivery drivers are paid per delivery. However, if roads are congested they may end up with less than the minimum wage. It may also encourage bad driving, such as speeding. Paying per delivery and classing workers as self-employed is a way for firms to cut costs and pay workers less overall.
- It depends how the scheme is set up. For example, in theory, some of the problems can be mitigated by assessing performance on more metrics than profit and revenue – for example, satisfaction of stakeholders.
- The best performance related pay schemes use a variety of measures. For example, part of pay based on skills, duration in company, with performance related pay only linked to part of wage.
- Workers are motivated by many factors and bonuses are often not the biggest factor. Performance related pay may create a competitive environment and dissatisfaction. The firm may be better off trying to improve worker morale in other ways, such as listening to feedback and improving work place environments.
Personal experiences of performance related pay
- Paperboy – £4 for a Sunday delivery. No hourly pay, the quicker you did job, the better the hourly rate.
- Little Chef waiter / dishwasher – £3.00 an hour, no performance related pay. But, I don’t think a performance bonus would have made any difference. I was interested in doing good job and financial bonus wouldn’t have made any difference.
- Marking exam papers. Marking exam papers you get paid per script. In theory, there is an incentive to work quickly and get job done, but there is also responsibility of trying to give correct exam results for students. It’s hard to give performance related pay for marking. Though some examiners got invited to do remarks which were paid at a higher rate.
- Teaching. I’m glad I wasn’t paid related to student exam results. Hard to measure productivity, but head teachers definitely get to know reputation of a teacher, and perhaps the best are paid higher wage to keep at a school.