Académique Documents
Professionnel Documents
Culture Documents
1, 2006
Mary Jo Ducharme*
Human Resources Management,
School of Administrative Studies, York University,
Toronto, Ontario, Canada
E-mail: ducharme@yorku.ca
*Corresponding author
Mark Podolsky
DeGroote School of Business,
McMaster University, Hamilton, Ontario, Canada
E-mail: podolsmg@mcmaster.ca
1 Introduction
Much of the foundation of variable pay is based on aspects of what has come to be
known in the compensation literature as reinforcement theory (Heneman, 1992), which
has been thoroughly described by authors such as Skinner (1948). Briefly, the operant
conditioning aspect of this theory purports that a behaviour will increase in frequency if it
is followed by a pleasant outcome (positive and negative reinforcement). Conversely,
a behaviour will decrease in frequency if it is followed by an unpleasant outcome
(positive and negative punishment). There are two tenants of operant conditioning and
they are both of particular relevance to this discussion:
• the outcome must be contingent on the behaviour, meaning that the reward
presentation clearly depends on the execution of the proper behaviour. If the reward
is presented occasionally without the proper behaviour the contingency is weakened
• the reward must be contiguous or presented immediately following the proper
behaviour (Skinner, 1948). Motivation decreases when there is a lengthy delay
between the target behaviour and the reward.
These principles gave rise to the use of variable pay as a motivational tool, and
compensation professionals refer to them collectively as line of sight. However, it would
appear, based on the research and published case study evidence that variable pay plans
in general are failing to provide individual performance results (Brown, 2002; Beer and
Katz, 2003; Budman, 1997). Furthermore, many variable pay designs are moving away
from the principles of reinforcement theory, thereby blocking this line of sight. Many
compensation plans are:
• designed so that the pay-off is long-term (three to five years), which violates the
principle of contiguity
• complex in design and involving so many variables that the employee is not able
to easily see the connection or contingency between their behaviour and the reward
• often based to some degree on organisational performance, which has little to do
with the individual behaviours of most employees.
While reinforcement theory has been shown to be very effective in shaping behaviour
and motivating behaviour change in other settings, based on these violations of its
principles, it would not be effective in motivating individual performance. Indeed, while
many site the value of variable pay in terms of its motivating capacity, there is very little
empirical evidence that demonstrates that this is the case. Hiltrop (1996) points out that
while the HR practices that are theoretically or empirically associated with firm
performance vary within the literature, variable pay emerges as one of the most
frequently mentioned successful practices. Empirical studies have linked variable pay
plans with firm-level measures of success, including productivity measures such as
sales or units per worker, accounting-based measures such as ROA and gross rate
of return on capital, and market-based measures such as stock price and Tobin’s Q
(Banker et al., 1996; Delaney and Huselid, 1996; Huselid, 1995; Lazear, 2000). However,
few studies have attempted to determine whether variable pay has a motivating effect on
the individual. Based on reinforcement theory, one can predict that those variable pay
plans that make clear the line of sight between one’s individual performance and one’s
Variable pay: its impact on motivation and organisation performance 71
Taking a pragmatic view of variable pay from the perspective of the organisation,
there are benefits brought by the use of performance-based variable pay plans that are
totally independent of HR considerations. For example, even when holding total
compensation costs constant, a firm’s operating leverage is lowered by the introduction
of a variable pay plan (Burke and Terry, 2004; Gerhart and Trevor, 1996). Operating
leverage is measured as the percentage of fixed costs to total (fixed plus variable)
costs (Horngren et al., 1999). It is an indication of a firm’s risk in that the income of
organisations with lower levels of operating leverage (those with more variable costs)
is less responsive to changes in revenues than the income of organisations with higher
levels of operating leverage (as shown in Figure 1).
Lower volatility in income leads to lower firm-level risk (β), which in turn is a key
determinant of a firm’s required rate of return. A lower β is associated with a lower
required rate of return, which affects a firm’s total cost of acquiring capital. All else
equal, a lower cost of capital can lead to a higher firm valuation for investors and analysts
who use common firm valuation tools such as the discounted dividends model,
discounted abnormal earnings, and discounted cash flow analysis (Palepu et al., 2000).
Thus, a higher level of variable costs has the effect of decreasing the variability of
income. This has a meaningful impact on the firm and on the common methods by which
firm values and stock price expectations are set. By simply converting a portion of the
same overall level of compensation costs from all fixed to a blend of fixed and variable
costs, an organisation lowers its own measure of operational leverage and potentially
lowers its measure of beta. Both measures are of interest to investors and analysts
in that for two otherwise identical firms, the one with lower operating leverage and lower
β should be worth more.
Another benefit of higher levels of organisational performance-based variable
compensation is that a larger portion of the total payroll will increase or decrease with
organisation performance. This leaves the organisation better able to meet its payroll in
any competitive environment, and can function as a more stable employer by not having
to terminate or lay-off employees in response to short-term economic conditions. This
can have positive reputation and cost-saving implications for the firm (Gerhart and
Trevor, 1996).
A recent Hewitt survey showed that base salary costs have risen at a remarkably slow
pace since 2003, and may continue to do so over the foreseeable future (Hansen, 2005).
The survey further reveals that organisations are spending more on variable pay
programs. One possible explanation is that firms are maintaining market-competitive
pay rates by changing the total compensation mix to carry a stronger weighting of
variable pay. This implies that firms may be increasingly converting fixed costs
to variable costs not by reducing base salaries outright, but by reducing the proportion of
base salary in total compensation through the application of market increases to the
variable component of total compensation.
When payout levels and operating leverage are reduced through variable pay tied to
organisational level measures of performance, the firm benefits from improvements in
many of the most important measures of success. For example, where compensation costs
comprise a relatively small proportion of expenses, the cash savings from reducing
incentive payouts can have a noticeable impact on measures of business risk, efficiency,
and profitability ratios such as net profit margin, ROE, and earnings per share, and
growth ratios such as price/earnings. The effect of decreasing variable pay costs in
low-performing years increases as compensation costs comprise a larger proportion of
total expenses.
Variable pay: its impact on motivation and organisation performance 73
In short, many of the indicators of firm performance, measures that are used to compare
competitor firms within and across industries, are noticeably improved by implementing
performance-based variable pay plans that reduce payouts in periods of poor firm
performance. These improvements can have the appearance of a strategic advantage.
However, this advantage is achieved through the transfer of risk from the firm to the
employee. The question of how much risk the employee is willing to take has not yet
been addressed in the research on variable pay, and could be another variable that
impacts the motivational ability of variable pay. Bloom and Milkovich (1998) found
support for their hypothesis that higher levels of business risk are associated negatively
with the use of variable pay. As their measure of business risk included variability in
income stream, it is possible that their results were demonstrating the above-mentioned
phenomenon; that the use of variable pay decreases organisational business risk.
In a study that measures business risk differently, Stroh et al. (1996) found that managers
in higher risk organisations receive a higher proportion of their income in the form of
variable pay than managers in lower risk organisations. Their findings also show that
employees in higher risk firms do not receive higher overall compensation than
employees in lower risk firms, which indicates that organisations receive a no-cost
benefit by off-laying a portion of business risk on employees.
The discussion about variable pay improving measures of firm performance, and of
decreasing business risk raises the question that if the mere presence of variable pay can
increase measures of firm performance, how are the intended benefits of variable pay,
such as motivation and increased individual performance being measured, and what role
do these attributes play in the relationship between variable pay and firm performance?
6 Conclusions
gain true strategic advantage. This missed opportunity will be due to organisational
human resource practices.
Second, we hope that it has been demonstrated how the financial benefits of the
implementation of a variable pay plan transfers risk to the employee resulting in lower
organisation-led turnover, and the appearance of better organisational performance. It is
possible that there is confusion regarding the role that variable pay plays in successful
organisational performance. In years when financial performance is weak, organisations
that utilise variable pay transfer a portion of the financial decrement on to their
employees (i.e., in a bad year, they pay out less to employees), thereby buffering the
impact of a bad performance year. Also, the decreased volatility of income due to lower
operating leverage can lead to higher stock price expectations from analysts and
investors. Several studies have been reported in the literature indicating that following the
implementation of a new variable pay plan, organisational performance increased and
turnover decreased (Gerhart and Trevor, 1996; Milkovich and Milkovich, 1992).
We believe that these findings have added to the assumption that variable pay motivates
individual performance which in turn increases organisational performance, when it is
entirely possible that individual motivation has little to do with the improved
organisational performance noted in organisations that implement variable pay plans.
HR managers need to be aware that there are other financial factors involved.
Improvements in certain measures of organisational performance do not necessarily
indicate that they have designed an effective variable plan which motivates performance.
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