Pitfalls of Performance-Based Compensation

by Krishna on December 8, 2007

Performance-based compensation has a simple premise: Show better results, obtain greater rewards. Commission-based professions (like sales) are performance-based. It seems like a good idea to have the same principle applied to all jobs within a company. Unfortunately, there are many disadvantages and risks in such an approach.

First, measuring performance is not an easy task. How do you measure and compare the performance of different individuals? You have to measure and weight many different attributes like quality and productivity. Such weights are subjective and are not constant in time or across jobs. Performance also depends on external factors like environment, vendors, customers, etc. The opportunities afforded to an employee can result in a higher or lower compensation for no fault of the employee.

Second, employees depend on one another. The output of an employee depends on the other members of the team. For example, if a manager does not provide timely information, an engineer may be slow to deliver on his work. In knowledge-based work, one employee’s work cannot be separated and measured individually from the output produced by the entire team.

Third, no one thinks that they perform below average. Every employee thinks that they are doing their best. Rating them as “below average” will only result in disappointment and resentment. Many good employees derive great satisfaction from and take pride in their work. Money is only one motivator for them. Throwing money at them for showing better performance demeans them, while it does nothing to increase the capability of weaker employees.

Fourth, market value cannot be ignored. You cannot use the compensation model to pay your employees less what they could get in another company. That would only fuel attrition among the more talented employees who can easily get jobs elsewhere. Also, even less capable employees can get other jobs (think of the employees you fired — are they still unemployed?)

Fifth, a meaningful difference in compensation is difficult. Sometimes an employee performs 5 times better than another employee. Does that mean that the first person should be paid 5 times more? I am guessing probably not. No company can pay more than it earns. So compensation differences between employees are not properly related to the results they produce. This may have the unexpected effect of the high performers reducing their efforts to be more in line with other employees.

Finally, employee comradeship can be affected. Salary disparities can cause friction and jealousy between employees and resentment against the organization. This is particularly true in cultures (like Indian) where people share salary information as part of regular conversation. If salary figures are hidden, heavy consumerism by some employees can create the same effect if your compensation model is performance-based.

Forgoing performance-based compensation does not mean accepting lower performance from your team or setting lower growth targets for your company. You should demand high quality and professionalism from all your employees and pay them all well. Remove anyone who does not perform to the necessary standards. Special sacrifices from team members should be avoided and, if not, compensated through non-monetary means.

However, ditching the performance-based model is not that easy. Some employees want to contribute more and expect more in return — they demand salary differentiation. Your company or project may benefit from such enthusiasm, if properly rewarded. So it depends on what you are trying to do. If your company has some kind of performance-based compensation, it will take effort and time to take a different path. Convincing your organization (even if you are the Man) to accept the change may be harder than you think.

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