TEC
AN INTERNATIONAL ORGANIZATION OF CEOs
RESOURCE PRESENTATION SUMMARY
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THE SIN OF WAGES:
THE GKOWING CRISIS CAUSED By
CONVENTIONAL PAY SYSTEMS
AMANDA PHILLIPS WELLFORD, PH.D.
There are two ways to get people to do things they don‘t want to do: positrve or negative
reinforcement. Positive reinforcement is a reward. Negative reinforcement is the avoidance of
an unpleasant outcome. Negative reinforcement is not punishment.
Positive reinforcement provides a specific reward for doing a specific activity or behavior.
Incentive pay works on positive reinforcement, whereas the traditional salary system works on
negative reinforcement. It pays a person the same amount every time unless he or she does
something bad enough to be fired. So the employee focuses more on avoiding certain behaviors
rather than on the ones that provide the needed results. This seems like a small difference, but
it has a major effect on how people behave.
Negative reinforcement comes naturally; it’s the way the world works. Positive reinforcement
is unnatural. It takes a lot of thought and planning. That’s one reason it is difficult to switch
to incentive pay.
Managing by perception, which comes with traditional pay systems, violates one of the most
basic principles of behavior. To get people to do a certain task, they have to know what is
expected, they have to have feedback, and they have to have reasons to want to do it. Most
companies fail to do all three.
People have to know what is expected. For most incentive plans, two to five measures of
performance are the norm. There is no such thing as a good one-measure incentive plan.
INDEXING PAY To PROFITABILITY
In the past few years, annual increases in base pay have dropped froman average of 5.5 to
3.5 . Despite the decline, annual increases still represent a compound growth expense. Even
if your revenues are stable or declining, it creates a potentially explosive program.
With “entitlement” pay systems, people expect increases in base pay regardless of how the
company does. This makes no sense at all. There is no way to justify this system unless you
believe in giving money away.
Many CEOs, especially in private companies, are loath to share financial information. But in
order to have an effective incentive program, you must share it. There is no way to get around
it. If you are going to tie compensation to profitability, people need to know what the numbers
are. If they don’t know the numbers, they can’t fix them. They don’t have to understand your
total profit picture, but they have to understand those aspects they have something to do with.
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Changing the compensation plan is not enough by itself. You also have to train and educate
people on how a business really works. Let people know the direction you’re going in and let
them know what you are going to inspect, not expect.
Ideally, you should create the new plan and test it for 90 days. If it works, then you can want
to ask employees what criteria to use to split up the money if you want to get them involved.
But employees should not be involved in deciding what percentage of profits you want to pay.
One of the real benefits of this process is that it gets you thinking about your business in ways
you haven‘t done before. It forces you to put an economic value on each and every job. If
something has no value, it will become apparent.
CREATING A BRIDGING PROGRAM
Unless you are in serious financial trouble, it‘s not a good idea to move immediately to a full
profit-based compensation program. Doing so creates a major culture shock, and it takes time
for people to adjust and become comfortable with the new way of doing things. Instead, create
a “bridging program,” whereby the company gradually moves toward a partners–in–profit
compensation plan.
A bridging program allows employees to get more comfortable with profitability compensation
because it’s not such a shock. More important, it allows you to make course corrections along
the way. Test your new program for 90 days and then do a course correction. Always reserve
the right to change the plan so that it benefits the customer, the company and employees.
If your company is already successful, one option is to run a parallel program. Run both
programs, fixed salary and profit compensation, and tell employees that at the end of each month
you will pay them the higher of the two. In most cases, this isn’t the most desirable approach
because it sends mixed messages, but it is an option. The upside is that it provides a safety net
and takes away some of the anxiety while people get used to the new model. The downside is
that people may not take the new model seriously.
Before you do anything, check with your attorney to make sure that what you want to do is
legal. For example, if you have hourly people you can’t pay them only on profits. You can,
however, take them down to minimum wage and pay the difference in profit sharing.
It‘s essential to get your employees to buy into the program. But there is a difference between
getting buy-in and abdicating leadership. As CEO, you should define the playing field–what
is appropriate and what is out of bounds–and let your people define how they do things within
the boundaries you set.
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For example, if company profits enable you to pay everybody $100 for the month, but a team
or individual hits only 80 of their goals, they get paid $80.
Controllable net income is revenues and expenses from your P&L that employees influence.
The first step in setting up the incentive system is to identify the line items from the P&L that
employees can influence. Leave out the things they can’t influence, such as overhead
allocations, the cost of the building, and similar items. Fixed operating expenses are covered
in the threshold, not in the distribution above threshold.
Putting in an incentive plan can easily anger employees and create chaos. How you implement
the plan will determine whether or not these occur.
One approach is to start with a capped incentive plan where the opportunity to earn incentives
does not exceed 15 of base pay. Keep your current system in place and run the two programs
parallel. After six months to a year, look at raising the incentive instead of giving the usual 5
annual base pay increase. Raise the incentive so that it at least doubles what the guaranteed
increase would have been.
After a few years, take a look at increasing base pay. For example, if you give 5 annual
increases, after three years your people will be 15 below market. Unless your employees
enthusiastically embrace the plan, you may want to consider increasing base pay.
With this plan, employees don’t have to give up something they already have. Poor performers
will be below market; top performers will be way above market. In essence, this provides for
a redistribution of the market to individuals and teams who deserve it.
A second strategy is to try voluntary reductions. Allow employees to give up part of their base
pay in exchange for doubling the incentive opportunities. Be selective about whom you allow
on this plan. It should be a reward for your top performers.
When you put a modest incentive on top of current pay, there is no risk to the employee. The
only risk to you is the effort to put the plan in because you only payout when the profits are
earned. So other than the equity involved, it is a fairly risk-free system. As time goes by, you
begin to introduce risk to the employees as well. Don’t do it all at once; move at a pace your
people are comfortable with.
3/95
dgm
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