What’s it: Performance-based pay is a compensation scheme beyond salary adjusted for employee performance. If they reach or exceed the targets set by management, employees get bonuses. The company gives it after evaluating the employee’s achievement through performance appraisal.
Performance-based pay is a way for companies to reward those who perform well. But, in addition, it is also important to encourage those who have not performed well to be eager to improve themselves, hoping to get a bonus.
Why is performance-based pay important?
Performance-based pay is a company’s way of motivating employees. This scheme is important because companies link employee performance and productivity with their compensation. So when they show best, above-average performance, they get paid extra in addition to the monthly salary.
On the one hand, the company appreciates employees for contributing more, hoping to maintain their best performance in the future. On the other hand, companies encourage underperformers to improve. They should work harder to chase bonuses or avoid negative consequences like not getting raises.
By linking compensation to employee performance, the company gains two advantages. First, companies can achieve superior performance supported by motivated employees. Second, companies can reduce turnover and keep their core employees loyal.
How does performance-based pay work?
This bonus scheme is common for managerial, administrative, and professional jobs. Before assigning bonuses, management conducts employee appraisals to evaluate employee performance. It is usually done once a year. Then, management compares their performance with agreed targets or performance standards.
Then, management groups employees based on their performance category. Each category will determine the rewards to be given. For example, when employee performance exceeds the required target, they get high rewards. Meanwhile, those who perform moderately only get adequate compensation. Meanwhile, those who perform poorly may not get any bonuses at all.
Rewards can vary between businesses. But, in general, it involves cash bonuses. Those who excel will receive extra pay. The company may also simultaneously promote them to a higher position or simply increase their salary.
What are the advantages of performance-based pay?
Motivating factor. This scheme provides incentives for employees to perform better. Companies attribute extra pay to their performance. So they understand they can make more money if they perform well. Therefore, they are motivated to strive hard to achieve the targeted performance.
Such a scheme is not like a salary, which is paid at a fixed nominal every month. Whether employees perform well or not, they get paid the same. So, the salary may not make them feel the urgency to improve themselves.
Evaluation standards. Before giving bonuses, the company sets performance standards and targets for each employee. Then, it will be compared with what employees realized for one year. With clearly defined performance standards, it helps companies to objectively assess employee performance.
Clear direction. By setting targets for each job, the company gives direction to employees on what to achieve. As a result, they can determine what activities they must do with clear goals. In addition, when motivated by goals, they are often more enthusiastic about work.
Then, employees can also assess their progress in achieving targets. They should try to find out what is not on track and fix it before the year-end performance appraisal.
Reduce turnover. Performance-based incentives may not only motivate employees. But, it also allows the company to retain key employees. They feel the company appreciates their hard work by paying extra.
Employees are reluctant to leave because it may be difficult to find another company with extra generous pay as it is now. And eventually, it leads to higher loyalty. And when employees are loyal, it is difficult for competitors to hijack them.
What are the disadvantages of performance-based pay?
Complexity and subjectivity. Company operations involve many jobs and tasks. Often they are difficult to measure, especially when employees do not produce physical outputs. Thus, it may be easier to clearly define targeted performance for a physical task. But, it will be very difficult for cognitive tasks.
Such complexity not only makes it difficult to set performance standards. But, it also leads to more subjectivity when assessing employee performance.
Unfair. Subjectivity can lead to unfair compensation. For example, employees who work hard may get fewer bonuses because they engage more in cognitive tasks than physical tasks. Their performance is more difficult to measure objectively. And, often, performance appraisals cannot accommodate their efforts because they are difficult to prove.
Less effective in motivating. Some employees may not be motivated to earn extra financial rewards. They may be satisfied, but it doesn’t lead to higher motivation. In Herzberg’s theory of motivation, performance-based pay represents a hygiene factor, which must be present to avoid dissatisfaction even if it does not lead to higher motivation.
On the other hand, for example, employees want the company to give them the opportunity to self-actualize. So they can develop themselves and advance in their careers. As a result, they need autonomy and flexibility at work to be motivated rather than simply wanting extra pay.
Less collaboration. This scheme focuses on rewarding individuals rather than teams. Thus, it may not contribute much to encourage teamwork and synergize employees.
Instead, employees compete with each other for more rewards. They concern more on individual performance than team performance. As a result, it can damage interpersonal relationships and make it difficult to collaborate.
Disharmony. For example, managers may give favorable appraisals to their confidants during a performance evaluation. But, instead, they give employees they don’t like poor appraisals. Long story short, they tend to give a more subjective assessment.
Such favoritism can damage the manager-employee relationship. So, employees are more likely to be disappointed because they don’t get the appropriate bonus, even though they have worked hard.
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