The biggest responsibility managers have is to ensure that employees are performing at the highest level. But in today’s tight labor market, you may be wondering how to attract, retain, and motivate employees. Incentive compensation research, including performance measurement and decision rights, tells us that performance-based pay works. It’s said that what gets measured and rewarded gets attention.


Recent research by James Hesford of the University of Missouri–St. Louis, Nicolas Mangin of the University of Groningen, and Mina Pizzini of Texas State University turns some of that on its head. Their research (henceforth called HMP), published in the Journal of Management Accounting Research, found that higher fixed salaries attract better employees and motivate them to work harder without explicitly linking their pay to performance. In fact, the extra compensation paid was more than covered by extra profits resulting from the high-performing employees. So, if you want better performance, you don’t have to have a bonus or targets; in certain situations, you can just increase your employees’ salaries.


In this article, we discuss the problems with performance-based pay for managers, discuss this new research, and show how the results can help you to get the most performance for your compensation investment.


Performance-Based Pay: Panacea or Problem?

Performance-based pay programs are effective when performance can be unambiguously and accurately measured by metrics that directly reflect employee effort, such as sales commissions. The implicit assumption in this type of pay plan is that sales associates’ knowledge, ability, and effort directly determine sales.


Performance-based pay attracts job candidates who are confident in their ability to excel and provides strong incentives to work hard; however, it also imposes a great deal of risk on a worker. The risk is that the worker may not reach performance goals, and hence receive very low compensation, due to some circumstance beyond their control. Due to the compensation risk imposed by performance-based pay contracts, employers must pay a higher overall level of compensation under a performance-based employment contract compared to compensation that’s entirely based on salary.


When Performance Pay Does and Doesn’t Work


Employee turnover can be costly. The Society for Human Resource Management estimates that replacement of a salaried employee can cost up to six to nine months of their salary. There are hiring, onboarding, and training costs. For managerial staff, the cost of lost productivity looms large, as do the costs of lapses in customer service and employee satisfaction. Minimizing turnover and maximizing performance are the twin goals of managers. With the Great Resignation and recent employee shortage, we’re all aware of the cost of not having good, reliable employees.


Performance incentives are widely touted as a way to increase commitment, drive, and outcomes of employees. And they work. If you pay for something, employees will focus on that. However, performance-based pay isn’t always easy to implement, especially for employees performing managerial tasks. First, there must be something to measure. Without a quantitative performance metric, it’s difficult to implement performance-based pay. Moreover, that metric needs to accurately reflect the manager’s effort. The more that measure is affected by factors outside of the manager’s control, such as new market entrants or supply disruptions, the worse it is at incentivizing the desired actions from the manager. Second, extrinsic motivation through incentives tends to reduce intrinsic motivation.


Take, for example, this review of a book on Amazon: “I read this book for class. It was fantastic. I wish he hadn’t required it.” The person felt that if they had just read the book for pleasure, they would have gotten more out of it. Being forced to read it took some of the joy out of it. Similarly, one could argue that being forced, through explicit incentives, to care about a particular measure makes it difficult to sincerely find joy in serving customers in that way.


Finally, focusing on a particular metric can lead to tunnel vision or attempts by managers to “game” the measure. For employees with a simple, measurable job, performance-based pay can help them excel. However, managers don’t have a simple, measurable job that can be captured in a few easily obtained, quantifiable metrics. Managers need to be able to consider all aspects under their purview, not just the tasks with outcomes that are quantitative and incentivized. Given the potential problems associated with performance-based pay, especially for managers, what other methods can we use to increase productivity?


High Relative Salary Scenarios

1. No objective performance measures accurately reflect workers’ ability and effort.


2. Employees can “game” the measure. For example, customer-facing employees who are evaluated based on Yelp or Google reviews may manipulate the reviews by asking friends and relatives to rate them.


3. Performance-based pay imposes too much risk on the employee, for example, if an employee is implementing a new service or delivery format and there’s a high degree of uncertainty as to success.


Think of an example where the manager of a finance team is responsible for supervising clerks, performing strategic analysis, advising senior management, overseeing operations, financial planning, reconciling balance sheets, monitoring control systems, and so forth. What performance measures would you set to capture their performance? It would be difficult to find a reasonable set of measures. This person may be a candidate for a higher fixed wage. Next, we explore some compensation-related ways to help motivate, attract, and retain employees.


Relative pay. Employees evaluate their compensation by comparing their wages to those of others who work in similar jobs nearby; that is, employees focus on how much they make relative to their peers. A recent survey from Bankrate found that Generation Z workers and Millennials are much more likely to openly discuss their salaries with coworkers and other industry professionals than Gen Xers and Baby Boomers. Thus, younger workers are especially cognizant of where they stand in the wage “pecking order.”


Organizations that pay higher relative salaries tend to attract top talent. Excellent employees typically only leave a position for a salary that’s commensurate or higher. Above-market wages also encourage employees to work hard at their current position to avoid losing that premium and being forced to look for new employment at the lower market wage. Finally, employees earning above-market wages reciprocate for this wage premium by working harder.


Task complexity. As previously discussed, performance-based pay becomes more difficult to implement for complex tasks, like those routinely performed by managers. A task can be complex because of the amount of information an employee must process or because of the lack of structure afforded the employee. To address this complexity, employees need to either be more capable or work harder. As complexity increases, research tells us that high ability is more important than high effort.


Monitoring. If a manager can be easily monitored by a superior, the manager must work hard enough to keep from being reprimanded or terminated. In situations in which monitoring is easy, the company won’t need to pay managers a relatively higher wage to induce them to work hard; the managers will work hard because of the supervision to keep their jobs. If monitoring isn’t easy, the manager can be paid more to ensure that they value their job and don’t want to be terminated.


The research that we discuss looks at differential relative pay, complexity, and monitoring.


Criteria for Relative Pay Success

Paying a relatively higher salary or hourly wage can improve profits only if certain criteria are met:


1. Employee actions and decisions must materially affect organizational performance. Financial managers provide critical decision-making information to senior management. They can have a great impact on company performance.


2. Employees must have broad discretion and autonomy in performing their jobs. If an employee is closely monitored and has little autonomy, there’s no need to offer an above-market wage to induce the employee to work hard. Financial managers often operate autonomously with little oversight. High pay may be ideal in these situations.


New Research Setting


HMP conducted their research on general managers at 436 hotels owned by the same economy lodging chain of a large U.S. hospitality company. The company provided customer satisfaction scores, financial statements, and property characteristics for each hotel. HMP gathered local market data on wages, unemployment, and housing. The hotels were very homogeneous in terms of size, appearance, and operating procedures.


The general manager (GM) runs the day-to-day operations of a hotel with little oversight from the regional manager. The GM hires, trains, schedules, and supervises employees. They market the property and have significant discretion over room rates. The GM is ultimately responsible for the hotel’s appearance and cleanliness, and for responding to customer complaints and concerns. Thus, the GM is critical to hotel performance. According to the chain’s senior management, “Having the right GM makes all the difference.”


GM compensation is composed of a salary and the value of the rent-free, on-site apartment in which they live. (A unique company policy required GMs to live on the property.) Thus, GM compensation isn’t contingent on hotel profitability. Regional differences in the value of the rent-free apartment led to wide variations in GM compensation across locations. For example, the value of a rent-free apartment at a hotel in Santa Barbara, Calif., was nearly twice that of a hotel in Fort Worth, Texas. As a result, some GMs made much more than the median wage for a hotel manager in their area, while others made much less.


The broad responsibilities and discretion afforded GMs, the fixed compensation scheme, the wide variation in relative compensation, and the homogeneity of the individual hotels combined to make this an ideal setting in which to learn more about fixed compensation. The study also controlled for variation in individual hotel characteristics (size, age, and years since renovation) and market factors (competition, unemployment, and housing values) to help ensure the findings are robust.


How to Use Results to Improve your Employees’ Performance


First, HMP found that higher relative compensation was associated with better hotel performance. Specifically, a 1% increase in compensation led to a 0.24% increase in profit. With their sample, that would be a $493 increase in compensation and a $720 increase in profit. The higher wages paid for themselves with more profit. Often, people think that paying more will lead to lower profitability. The extra effort for recognition suggests otherwise.


HMP used competition to measure the complexity of the job—complexity being quite complex to measure. Maintaining or increasing hotel profitability is more difficult in more competitive markets. HMP found that, in more competitive markets (i.e., when the GM’s job is more difficult), above-market wages have a greater positive effect on profits than in less competitive markets. This implies that above-market wages provide a “bigger bang for your compensation buck” when the job is more difficult. Excellent employees provide more value when they’re doing a complex job. Increasing their salary can lead to increased profit.


Finally, HMP found that, in locations that can be easily monitored by the chain’s regional managers, above-market wages have a smaller impact on profits. This suggests that monitoring and wage premiums are substitutes. Therefore, in situations where managers can be monitored more easily, they can be paid less. A finance department manager who is autonomous and lightly monitored needs to be paid more than one who has a regular discussion and reporting environment.


In the right settings, higher wages can pay for themselves: Revenue, profit, and quality are higher. When tasks are more complex, the compensation/profit link is enhanced. In contrast, when monitoring is easier, the compensation/profit link is reduced. If you supervise employees, be sure to consider whether you can find improved performance with higher pay. It may seem counterintuitive to accountants that increasing cost drives greater profit, but the research bears out the result. Finally, if you’re a manager with a complex job and little ability to be monitored, be sure to examine your wage relative to your peers and suggest to your boss that company performance could be increased by increasing your wage.


For more on talent retention, see the IMA report, Talent Retention in the U.S. Accounting and Finance Profession.


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