Pay-for-performance systems emerged in the industrial age and remained in many companies, but there is evidence that in the age of knowledge, objective independent compensation systems can have superior results.
By Jonas Solbach, Klaus Müller and Franz Wernsberger, MIT Sloan Management Review
Pay-for-performance (PFP) systems were invented in the industrial age to enhance individual performance, and although research shows that this approach is inappropriate for much of the cognitive work currently being done in organizations, the practice has continued as a standard.
These systems remain stuck in the past for several reasons. The first is essentially inertia: companies have been using PFPs for decades, and the best practices that have been revealed are often derived from compensation advisors. Furthermore, most leaders are not familiar with PFP research or dismiss it as unreliable. Finally, leaving the PFP behind and taking the leap to design and implement a new compensation system can seem daunting, given the potential impact on performance and the consequences of doing it wrong.
However, organizations may lose more than others if they do not exceed the PFP. We conducted a large-scale trial with an objectively independent compensation system. The findings make a strong case for making PFP a thing of the past.
Dysfunctional Elements of PFP Over the past 50 years, scholars such as Edward L. Deci and Jeffrey Pfeiffer, and experts such as Alfie Kuhn and Daniel H. Pink, have argued that pay-for-performance (PFP) is inherently ineffective. This is based on two main sources:
First, the PFP focuses on precisely defined outcomes, such as the number of closed sales, but ignores the ways in which these outcomes are achieved. This presents the possibility of rewarding serendipity—or worse, reprehensible behavior—and that trying to achieve the promised reward undermines other desirable behaviors, such as teamwork and cooperation.
Second, PFP provides extrinsic motivation for financial reward, but ignores strong and beneficial intrinsic motivations such as the joy of the task itself, a sense of contribution and team belonging, and personal development. Financial rewards drive workers to focus on specific goals and to avoid activities that do not directly lead to the achievement of those goals. PFPs suppress intrinsic motivation, which leads, at best, to compliance—and does not fuel an employee’s enduring commitment or identification with the company. In the long run, this reduces overall performance.
No matter what imbalances it can generate, PFP has its uses. It can lead to superior performance when jobs offer little or no opportunity for self-motivation. When jobs are monotonously simple or volume oriented, extrinsic motivation provides focus to workers’ effort and behaviour.
But PFP undermines work performance that requires people to explore complex problems, develop creative solutions, and achieve qualitative results that cannot be fully predetermined. Moreover, when performance goals become outdated, such as when production lines close and sales drop in the initial phase of shutdowns due to COVID-19, the PFP loses its motivational power because it cannot deliver the rewards it has promised.
Find Alternatives to Paying: A Case Study
Leaders of the Hilti Group, a Liechtenstein-based company that provides products and services to the construction industry, have their own doubts about the effectiveness of PFP and whether its focus on individual performance conflicts with the company’s collaborative culture.
The family business employs more than 30,000 people, 70% of whom sell their products and services directly to construction site contractors in 120 countries. Hilti has a decentralized structure, and organizations within the country maintain their own sales teams. As the scope and complexity of the company’s portfolio of products and services has grown, so have the challenges facing sales staff. At first, they were limited to offering the company’s products to as many contractors as possible within their assigned lands. However, with Hilti fully penetrating its sales territories, continued growth required the company to acquire a larger share of contractors. To this end, the company increased personalization and added new digital solutions, but these changes also led to more complex sales, longer sales cycles, and a solution-based selling approach.
Today, Hilti salespeople are more like consultants. They often specialize in the needs of specific industries and collaborate with colleagues, engineers, customer service personnel, and team leaders to meet customer needs.
Hilti’s sales compensation is based on a pay-for-performance system that has been adapted, through centralized guidelines, to local needs. But PFP’s focus on individual sales volume and performance is increasingly not aligned with the company’s strategy and culture. So in 2018, Hilti management asked us to propose and test a new sales compensation system that is more in line with their needs.
We reviewed the company’s market organizations around the world and identified a national organization in Eastern Europe that was well suited for careful consideration of an intervention involving a new compensation regime. In that time, the country’s 190 salespeople received 65% of their salary as fixed compensation and 35% as variable compensation, on average. But there were problems with this system.
Management has invested a significant amount of time and energy in setting fair and motivating compensation goals. Longer sales cycles and the team effort required to close deals made it difficult to allocate sales to individual salespeople. In addition, the questions of when and how goals are to be modified have often been debated and disputed. Despite management efforts to solve these issues in various formats, targeting awards has been a chronic challenge, often resulting in dissatisfaction within the business force.
The compensation system has also become highly complex due to management efforts to use it to drive an increasing number of organizational priorities. Many vendors did not understand their payout or the actions they were meant to encourage, rendering the entire system ineffective as an incentive tool.
Another problem was that salespeople resorted to tactical behaviors to close necessary sales and earn their monthly premiums. These behaviors weakened the organization’s sales strategy, which was to invest the time needed to create and nurture long-term value-based relationships with customers.
Finally, sellers were unhappy with the variance of their compensation. Long sales cycles have caused a high degree of fluctuation in monthly sales compensation, sometimes leaving sellers unable to pay their living expenses.
Read the full article in the August (#140) issue of Human Resources.
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