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Value is the Goal

February 1, 2000
Many would shudder at the thought of changing a company’s pay systems. Butas the nature of work changes and as businesses go global, compensation mustevolve to keep up.

In "Pay People Right! Breakthrough Reward Strategies to Create GreatCompanies" (Jossey-Bass, 2000), Patricia K. Zingheim and Jay R. Schusterexplain how flexible options like variable pay link pay and performance tocompany goals. The concept of variable pay has been around a long time in theform of bonuses, commissions and profit sharing. What has changed has been itsmigration from the salesforce and executive suite to the entire workforce. Nowevery unit in the company can share in productivity or profitability rewards. Inthis passage from Chapter 7 of "Pay People Right," Zingheim andSchuster discuss ways to use short-term variable pay to your best advantage.

At a time when speed and adaptability count, the major attractiveness ofvariable pay is its agility and flexibility. It’s fairly easy to showthat variable pay awards are granted only if the business wins economically andif people meaningfully add value to the business.

Variable pay is also helping to manage total pay costs by keeping base pay inflationin check. Because it’s not a "gift that keeps on giving" afterresults are achieved, it requires re-earning and attention to the goals for thenext performance cycle. An enterprise can correct or improve variable pay in thenext year because it gets its money back, so to speak, to start afresh; errorsaren’t plowed into fixed base pay or permanent benefit costs.

However, the potential positive value from variable pay is only partiallybeing realized. Many companies use variable pay to communicate business-alignedgoals, extend people’s line of sight, reward results, and share success. Butsome are struggling.

This is why it’s critical to remain positive on variable pay. Let theworkforce know the enterprise is committed to variable pay as a tool to rewardresults, but remain flexible and experimental until a way becomes evidentto design variable pay for your enterprise most effectively. New productdevelopment doesn’t stop at the first barrier; neither shoulddevelopment of variable pay, or for that matter any total pay solution wepropose.

Problems or Opportunities?

Sometimes there’s trouble in variable pay paradise. Here are some common[complaints] that challenge variable pay:

  • "Variable pay’s an entitlement. Everyone receives the same award and gets it every year. People aren’t paying attention to it."
  • "What do we get from variable pay? What were the goals we used, and where did they come from? Who’s been receiving awards, and why?"
  • "Why doesn’t variable pay ‘pay off’? Is this just a management trick to reduce our pay? The goals for variable pay are beyond our reach."

Why is variable pay in some cases becoming a source of negative messagesrather than positive ones? Clearly, it’s sometimes not accomplishing theobjectives for which it was implemented in the first place.

Variable pay must be a win-win if the company is to maintain it and if peopleare to commit to it. The enterprise must get added value from variable pay cost,and people must believe they have a reasonable win for the performance and theeffort expended.

Also, goals need to be reasonable and achievable. If goals are really high,it’s critical that variable pay begin to grant awards at some reasonable levelalong the way. It makes no sense to have a company miss goals by a bit when theyare extremely tough to achieve, only to find that there’s no funding orawards under variable pay.

On the other hand, variable pay goals shouldn’t be so easily attained thatpeople don’t have to do anything differently to earn awards, or else they’llstart viewing variable pay as an entitlement. With continuous improvement,increasing customer expectations, and global competition, goals can go on havingreasonable stretch. Variable pay can not only reward achieving goals but alsoprovide larger awards for exceeding them, so that people stay in the game toattain the higher level of performance.

The possible combinations of variable pay are nearly unlimited. Thissometimes makes it difficult to categorize a variable pay plan.

Goalsharing or Business Goal Plan

Many companies are willing to award short-term variable pay for meeting goalsthat are aligned with the operating plan. In this instance, short-term variablepay may not self-fund in the same sense that profit sharing and winsharingdo. Goalsharing rewards achieving or exceeding goals.

Typically, the funding either is a pay expense or is determined by the valueof goal achievement. If the funding is a pay expense, the goals prove theirvalue to the business by being key drivers of success. For example, improvementsin quality can reduce rework and scrap and thus reduce cost. Goalsharing isuseful when an enterprise wants to highlight goals in addition to cost and otherfinancial measures and when gainsharing has driven out most of the coststhat can possibly be reduced.

Weyerhaeuser, a Fortune 500 forest and paper products company, hasgoalsharing in its containerboard packaging and recycling plants to optimizeperformance. The objective is to enlist the workforce in a major performanceimprovement initiative to achieve world-class performance. The approach focuseson incremental performance improvement in core measures such as safety, quality,waste, and controllable costs.

The emphasis is on key goals within the control of the workforce. The hourlyworkforce does not have a measure of operating earnings because the fluctuatingcost of the commodity raw material and the cyclic nature of the industry greatlyinfluence operating earnings. This is also because the company wants tooptimize business across the plants, so that they don’t necessarily controlthe price of the product they produce.

Winsharing

The need for self-funding short-term variable pay is one reason for theexistence of winsharing. Winsharing is closely associated with the enterprise’sability to pay and is often the choice in situations where labor cost is a largepercentage of the organization’s total cost and profit margins aresmall.

Extending people’s focus to the measures that ultimately influenceoverall financial results is the objective of winsharing, which buildsfunding in proportion to profit or income performance and pays outproportionally to achievement of other important goals. Financial results can bemeasured at the division, group, business-unit, or company level or somecombination of these levels -- wherever profit or income can becalculated.

The key characteristic of winsharing is the relationship between financialperformance of the organizational unit in which winsharing exists and awardpayments. Unless financial goals are met, it’s little solace that otherresults are generated.

Covey Leadership Center (now Franklin Covey Co.) has been one of the mostsuccessful training and development enterprises in the world. Starting withStephen R. Covey’s "The 7 Habits of Highly Effective People"(Fireside Press, 1990), the center grew quickly and successfully from dozens ofconsultants and advisors to hundreds.

Covey’s son, Stephen M. R. Covey, became chief executive and focused hisefforts on improving alignment of the growing and youthful workforce with theseven habits. The pay solution had been a conglomeration of base pay, pay basedon new product development and execution, sales commissions, and a wide range ofindividualized pay plans that gave mixed messages about roles and goals foreveryone.

A new pay strategy extended Covey Leadership Center’s goals in terms offinancial performance and growth. The strategy defined not only whatto do but also how to do it in terms of values and behaviors. The objectiveswere to live the seven habits and to achieve goals. It implemented -- for allassociates -- variable pay with funding dependent on financialperformance, but it required that they achieve measures of customer value andquality service before distributing the funding. Variable pay permittedalignment of the workforce on key measures of success as well as the route toresults.

Gainsharing

Gainsharing works well in stable organizations with predictable goals andmeasures, but is less flexible and useful in dynamic industries thatrequire rapid business adjustment. It got its start in manufacturing in the1930s and has a shorter history in service organizations. Its objective is toshare a percentage of cost savings. If a company needs to communicate to theworkforce about the importance of cost reduction, gainsharing can do iteffectively and in short order.

Gainsharing plans tend to generate most of their cost savings in the earlyyears; effectiveness depends on whether people find ways to reduce costafter picking the low-hanging fruit. Because the dollars for sharing come fromcost savings, gainsharing is challenged when the company needs other types ofperformance improvement from the workforce.

Gainsharing has been successful in unionized work environments because thecost measure is verifiable. Agile businesses (especially in manufacturing)often use it as their initial form of variable pay and then transition tosolutions with other measures and goals in successive generations of design.However, some argue that it may not add value to the longer-term goals of thebusiness when it only rewards cost reduction because of the limited number ofmeasures used.

Owens Corning is implementing gainsharing in many of its union and nonunionplants. The objective is to improve cost performance and productivity to haveacceptable margins and remain competitive in fiberglass production. Oneplant’s business case for changing rewards involves more than just againsharing plan. It also includes role restructuring and market-basedutilization pay, which is Owens Corning’s form of paying for the skills used.

Owens Corning’s gainsharing approaches share a percentage of manufacturingcost reduction in terms of cents per pound. The majority of the fundingaccumulates automatically; the remainder pays out according to safety and othermeasures of importance to a plant.

Mixing and Matching Variable Pay: Combination Plan

This is where we believe variable pay is going. Pay solutions areincreasingly becoming less easy to pigeonhole. The reality is that a companyshould do what works, and a mix-and-match approach fits the situation.

For example, all of the group and team short-term variable pay solutions --goalsharing, winsharing, gainsharing, profit sharing -- can be combinedwith individual variable pay based on the specific situation on which payis to be focused. Where a combination of shared and individual goals isimportant, one portion of variable pay can be based on shared goals and anotheron individual goals.

An example of a combination plan is from an IT company that offers a varietyof enterprise applications to client businesses. Its objective is to attract andretain the scarce IT talent required to achieve its primary goal of profitablegrowth. Short-term variable pay is one element of a total pay strategy that alsoincludes competency pay that quickly responds to the labor market, enhancedrecognition and celebration, and long-term variable pay.

All IT professionals participate in short-term variable pay that emphasizesfinancial success and customer satisfaction. It has three separatecomponents: company results, to create synergies among lines of business;line-of-business results; and either project team or customer team results,depending on the type of service the team provides.

The weight of the three components varies depending on the individual’sability to affect results. This is a winsharing design for the company andline-of-business components and a team variable pay design for the project andcustomer teams component. Individual performance distributes the funding fromthe three components. The approach constitutes the umbrella framework throughwhich measures can be specified for the particular business situation.

Cash Profit Sharing

We focus here on profit sharing that provides annual, semiannual, orquarterly cash and shares a percentage of profits, generally afterachieving a profitability level that represents a specified level ofreturn on investment. Cash profit sharing is a way to communicate topeople that a company’s bottom-line performance counts. Like winsharing, itcan work wherever bottom-line performance can be calculated. Profitsharing is clearly self-funded because it shares a portion of overall profitperformance -- no profit, no profit-sharing award. From the company’sstandpoint, profit sharing is a win because if profits are there, itpays off.

The challenges faced by profit sharing are that it has a long line ofsight and is often only an annual event. In a large company with little ongoingcommunication about profit results or how the workforce can influenceprofits, annual profit sharing based on overall company profitperformance becomes an entitlement. People often make little connection betweentheir performance and what they get in terms of profit sharing; there’sa belief that they can’t see how they have any chance of influencing thecompany’s overall profitability.

Profit sharing is frequently viewed as a Christmas bonus: appreciatedbut not aligned with any message the company has to communicate about the rolethe workforce plays in organizational performance. Profit sharing caneasily become an entitlement that’s difficult to change.

In our experience, the dollars spent on companywide profit sharingcould be better used for variable pay approaches of alternative design. Exceptin small companies, profit sharing based on overall performance istypically not a teacher of the workforce; some believe that although it doesoffer feedback on company performance, it communicates little about how peopleadd value.

Team Variable Pay

A team can be broadly defined as a group of people who workcollaboratively toward a common goal and have mutual accountability. Whether aloosely woven collaborative team or a tightly knit process team, teams are aboutshared goals.

Team variable pay communicates the role the team plays in adding value to thecompany results. The challenge is to focus on collaboration among teams suchthat they don’t compete with one another or suboptimize performance at ahigher organizational level when they optimize their own performance.

Short-term variable pay at the team level may encompass goalsharing,winsharing, or gainsharing. For example, team variable pay is funded at thecompany, business-unit, group, or site level from financial or othermeasures of performance and distributes awards, depending on how effectivelyeach entire team achieves those of its measures that are important to attainingthe longer line-of-sight measures and goals. When funding for team variable payoccurs at the team level rather than a broad organizational unit level, it’stypically goalsharing.

UCLA Medical Center is a teaching and research tertiary-care medical center.With 4,800 full-time equivalent workers, organizationwide measures had too longa line of sight to drive understanding and performance on two criticalobjectives: quality and customer satisfaction.

The center implemented team variable pay that rewards goal achievement at theteam level on each of the two objectives and increases the funding according tothe financial success of the center. The team is defined as adepartment, a subteam within a major department, or a line of service thatincludes both inpatient and outpatient. Teams develop goals with input fromtheir internal customers on the appropriateness of the goals to ensure that teamgoals are aligned with broader organizational needs.

Individual Variable Pay

The roots of individual variable pay are in the textile industry of the1800s. You may ask why we’d consider a variable pay alternative for greatcompanies that was developed so long ago. The reason is that businesses arefinding that base pay alone can’t fill the bill for rewardingresults and are turning to individual variable pay, combination plans, andlump-sum payments when they want to reward individual performance outcomes.

Individual variable pay is most often developed around measures and goalsthat can be directly influenced by the individual participant. The mostcommon plan of this type is the sales incentive. Another individual variable payapproach is piece rate, which rewards individual productivity. Check processing,fruit picking, sewing garments, and medical transcribing are examples ofproductivity-based approaches to paying individuals with variable pay. These areuseful when working collaboratively would not measurably improve businessresults.

Physicians in one medical group changed their pay by introducing individualincentives based on a combination of such measures as patient access andsatisfaction, quality of care, and patient load. In addition, pay respondsclosely to competitive practice for medical specialties. This requires adjustingthe total cash opportunity consistent with the labor market changes in eachmedical specialty. The objective of this solution is to increase variable pay inthe total cash mix, differentiate pay according to individual performance, and,overall, pay more consistently with the competitive labor market.

Return to Emerald City

In the future, pay for everyone will begin to look more like salescompensation. It’s been easier to measure sales performance than theperformance of many other functions in the past. In the future, it’ll becomeeasier to measure the economic value of a process or a body of work that’scompleted by a group of people or organizational unit. This is becausemeasurement is becoming more sophisticated and we’re learning to determine thevalue of a body of work as we outsource it. This drives thinking about the valueof a body of work done by the workforce, not just contractors, and in turn helpsdetermine variable pay opportunities.

Workforce, February2000, Vol. 79, No. 2, pp. 56-61 -- Subscribenow!