The theory in PLWS

Productivity Linked Wage System

2PLWS Theory

Outline

1. Incentive Problem

2. Compensation Contracts

3. Output-Based Pay

4. Input-Based Pay

5. Incentive PaySource: www.msn.de

3PLWS Theory

1. Incentive Problem

Coordination and Motivation Problem

          

 

Distribution of Output

Task

Individual

Allocation of Input Resources

Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51

Coordination

Who does what, when,...

Motivation

How do I get somebody to perfom a task,

improve the quality,...

=> Incentive Problem

4PLWS Theory

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

5PLWS Theory

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

6PLWS Theory

2. Compensation Contracts

Variable Pay Fixed Salary

Compensation Contracts

Payment by Output Payment by Input

Subjective Performance

Measures

Objective Performance

Measures

Subjective Performance

Measures

Objective Performance

Measures

7PLWS Theory

Variable Pay(payment by output)

Straight Salary(payment by input)

• Compensation depends on measure of what comes out• Amount of time spent on work does not affect workers‘ compensation

Problem: Output not always easy to measure

Examples:

• Agricultural workers: piece rates p. tray• A salesperson on straight commission• Compensation of top executives by stocks or stock options

• Compensation depends on the amount of time or effort spent on an activity• Independent of output consideration

Problem: Input also not always easy to measure• Time at work as a proxy in order to assess worker‘s effort

Examples:

• Wage per work hour• Monthly salaries• Annual salaries

2. Compensation Contracts

Payment by Input versus Payment by Output

8PLWS Theory

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.

Databaseobjective subjective

Output revenue, dividend customer satisfaction

Input time qualification

9PLWS Theory

Basis Variables for output-based pay

Quantity of production pieces, weight, size/height

Quality of productionRejects, grade, customer‘s satisfaction, individual targets

Input reductionReduction of input factors: raw material, energy, work time

Capacity utilization slack-, repair- and waiting periods

Be on scheduleTimeliness vis à vis internal and external customers

Value of the firm stock price, economic value added

2. Compensation Contracts

Examples of Different Variables as a Basis of Output-Related Pay

10PLWS Theory

Advantages of output-based pay

Selection effect Motivation effect

• efficient workers with a high productivity will join the firm/stay

• inefficient workers with a low productivity will not join/leave the firm

• output-based pay motivates workers to put forth more effort

3. Output-Based Pay

Source: www.kone.fi

11PLWS Theory

World Book Britannica

Offered compensation scheme variable pay: W = $ 100 . x

fixed salary: W = $ 500

Labor costs of 10 sets; Cost per set

$ 1,000 $ 100 per set $ 500 $ 50 per set

What type of salesperson will stay with the firm?

high productive sp.x 5

low productive sp.x 5

Labor costs of 3 sets; Cost per set $ 300 $ 100 per set $ 500 $ 166,67 per set

3. Output-Based Pay

Selection Effect: An Example of Compensating Salespeople

12PLWS Theory

500

A (World Book)

B (Britannica)

W ...Weekly Pay

x ... Number of encyclopedia

53

300

Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will

stay at Britannica

3. Output-Based Pay

Selection Effect: An Example of Compensating Salespeople (cont.)

13PLWS Theory

• Disadvantage of piecework: Variations of output can be beyond the worker‘s control

Variable pay Straight salary

• Fixed salary doesn‘t depend on exoge- nous factors – low-risk form of compensation Workers are insured against volatilities Firm provides the insurance for risks

• Lower compensation level• Can not participate in good economic development• Weaker incentives

• Variable pay depends on invested effort and exogenous risks – risky form of compensation Firm should smooth out exogenous risks from workers‘ compensation Firm should bear exogenous risks but endogenous risks should remain with workers

• Trade-off: More riskhigher compensation • Opportunity: participate in good economic development• Stronger incentives

3. Output-Based Pay

Disadvantages of Output-Based Pay

14PLWS Theory

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

15PLWS Theory

• 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

Examples: wage per work hour, monthly salaries, annual salaries

4. Input-Based Pay

Source: www.euro.fi

16PLWS Theory

4. Input-Based Pay

Benefits of 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!

Problems of output-based pay solved by time-based (input-based) pay

17PLWS Theory

• 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

Compensation Schemes Balancing Quantity and Quality

18PLWS Theory

Hourly wages Monthly salary Annual salary

Input-based pay

• Production workers• Clerical workers

• Top Management• Managerial workers

Tasks: experienced and easy to prescribe

• High correlation between effort and time invested• Time input as a pretty good indicator for effort

• Low correlation between effort and work time• Time input = bad measure for effort overinvestment in easy (pleasant) tasks

Tasks: less experienced and not easy to prescribe

• Undefined set of tasks (goal), discretion over work• Importance of other incen- tives to motivate for effort (long-term, e.g. stock options)

Tasks: not experienced and difficult to prescribe; often

to be defined by top manager

4. Input-Based Pay

Using the Appropriate Time Unit

19PLWS Theory

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

20PLWS Theory

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 Bonuses Parking spots Days off Promotion Training Stock ownership Health care plan

Housing Education for kids Retirement Plan Party

21PLWS Theory

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