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Performance-based salaries don't always pay off

Paying your employees more for hitting specific targets may sound like a great idea. But new research from Harvard suggests that the practice of connecting pay to performance is far trickier than it at first appears.

What better way to drive people to work harder and more efficiently, you may ask, than to offer them a special carrot: more money for hitting specific company targets? The idea seems perfect.

Managers want their employees to pull out all the stops on Project X, for example. Employees, confident in their ability to reach if not surpass the goals, start banking on the extra money.

In practice, however, the process of connecting pay to performance may be far trickier than it at first appears, according to Harvard Business School professor Michael Beer.

As he discovered when he examined programs in pay-for-performance programs that were discontinued at Hewlett-Packard, these programs may indeed have an upside--but there is a potential downside lurking, too. The HP experience was eye-opening as well as sobering. Thirteen separate units of the company--at different types of sites, in different states--launched pay-for-performance plans in the early 1990s. Within three years, all had dropped them.

In a recent talk to HBS faculty and in two working papers, which he co-authored with Nancy Katz and Mark D. Cannon, respectively, Beer explained why implementing these pay schemes can be so complicated. Clearly, there has been an increase in pay-for-performance programs all over the United States and increasingly all over the world, he said. But his conclusions on the rocky process of conception, design, and implementation may benefit managers who like the idea but who want to avoid the same miscalculations that HP experienced.

An ideal laboratory
In the early 1990s, Hewlett-Packard seemed to be a perfect setting for innovations in pay. A so-called "built-to-last" company, it was highly decentralized and enjoyed a sense of mutual trust, high commitment, and wide usage of objective-based management. The work force was salaried and the merit system was based on peer comparisons at the salaried level. There were no executive bonuses. Stock options were awarded as recognition. But there was also a lot of pressure in the company, said Beer. Managers of thirteen units took the initiative of appealing to headquarters to try something new to spur on their employees.

According to Beer, managers in many companies look to a pay-for-performance program for good reasons. They expect it to attract and motivate people. They expect performance standards to outweigh the costs of whatever incentives they put in place. They also want protection against business exigencies: Should the market go south, they don't want to be permanently stuck with new costs.

The vast majority of employees, in general, also want a pay-for-performance program, Beer said. While they may not think that their current pay system is unfair, they do think pay-for-performance is an opportunity to make it more fair. They think they can outperform whatever pay they get; they usually assume they will benefit in terms of higher pay.

In his working paper co-authored with Mark D. Cannon of Vanderbilt University, "Promise and Peril in Implementing Pay-for-Performance: A

Thirteen separate Hewlett-Packard units launched pay-for-performance plans in the early 1990s. Within three years, all had dropped them.
Report on Thirteen Natural Experiments," Beer also outlined the controversies surrounding traditional pay versus performance-based pay. Some scholars assert that pay becomes an entitlement, and an employee's pay is based on her level and not her actual performance. Others, including HBS professor Teresa M. Amabile, agree with Beer and Cannon's contentions that pay-for-performance programs can cast a pall over self-esteem, teamwork, and creativity.

"Other scholars have argued that the real problem is that incentives work too well. Specifically, they motivate employees to focus excessively on doing what they need to do to gain rewards, sometimes at the expense of doing other things that would help the organization," Beer and Cannon continued.

"I think that there is an implicit negotiation going on between what management wants and expects, and what employees want and expect," observed Beer in his talk to HBS faculty. This implicit negotiation is "embedded" in the context of pay-for-performance, but often goes undiscussed and unacknowledged, he suggested. Misunderstandings about goals are the result. Pay-for-performance programs may also have a natural life cycle of which managers are unaware, he said.

Problems in San Diego
One HP unit that threw the matter into relief was HP's San Diego site. The pay-for-performance experiment began naturally enough, driven by a transition to self-managed teams in production. Managers launched a program of team goals coupled with team-based pay with three possible levels of reward. Managers reckoned that 90 percent of teams could reach Level 1, 50 percent could reach Level 2, and 10 to 15 percent Level 3.

For the first six months, everyone loved the new system. The majority of teams hit Levels 2 and 3. And, said Beer, because the payout was greater than expected, management adjusted the goals upward. Then the complaints began.

The teams were frustrated that factors out of their control, such as the delivery of parts, affected their work. The high-performance teams often refused to admit people whom they thought to be below their level of expertise, leading to disparities among the teams. There was reduced mobility between teams, preventing the transfer of learning across teams. Employees built their lifestyles around the higher level of pay, and were angry when they could not achieve it consistently.

Managers for their part felt they were spending too much time reengineering the pay system. They concluded that it did not motivate employees to work harder or, perhaps more importantly, to learn. It was also hard to maintain consistency of pay across the larger site. Managers also grappled with the question of sustaining pay-for-performance over time.

There were clear short-term benefits that were coupled with clear longer-run costs, Beer suggested, including the cost of constant redesign and negotiation of the system. Other HP units ran into similar difficulties.

The high-performance teams often refused to admit people whom they thought to be below their level of expertise, leading to disparities among the teams.
As he and Cannon wrote in their paper, "The most striking finding from these pay-for-performance experiments is the size of the gap between managers' expectations of benefits and the reality that they experienced in terms of costs."

Were the results due to unique circumstances at HP? The answer is yes and no, Beer and Cannon wrote. "HP's culture is one that historically placed more emphasis on management that builds commitment rather than on monetary incentives. Clearly, (HP) would be more prone to abandon programs that threatened trust and commitment." Similar programs at low-commitment companies might have succeeded where HP failed.

Financial rewards in a fast-changing business environment could undermine a company's ability to build trust and commitment unless management and employees have an honest discussion about their mutual expectations, they added. This is "very difficult to do."

Going forward, Beer suggested that managers recognize pay-for-performance programs not just in instrumental terms--as a carrot, perhaps--but as a larger exercise in fairness and justice within the organization. "Do not proceed until both sides understand what they are getting into."

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© Copyright 2003 President and Fellows of Harvard College