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pay plan options

You are the Director of Compensation and Benefits for Lansing-Smith Corporation, a 6-month old sales and service organization that currently has a workforce of 150 employees. You recently joined the organization when the Vice President of Operations decided to move the Compensation and Benefits function out of the Accounting Department, into a separate function. From your own observations you have identified several areas in need of review, redesign or development, including projects such as an audit of current pay plans to ensure they are aligned with federal regulations, an analysis of various pay plans to assess which plans will provide maximum benefit for Lansing-Smith, extensive job analyses to ensure a solid understanding of each position, job evaluations to determine the worth of the positions, consideration of various incentive plan designs to identify a plan that effectively drives individual and group performance to achieve production goals and research, development, communication and management training for a company-wide performance appraisal process.
You are dedicated to developing compensation and benefit practices that are motivating and empowering for employees. You are confident that with well-developed programs and practices, employees will be motivated to perform at higher levels, thereby driving overall company performance.

Details: The VP of operations asks for you to prepare a report for her and upper level management as they consider shifting pay structure.

In your report, discuss various pay plan options- merit-based pay, pay-for-performance, merit plus incentive, and pay-for-knowledge plans.

Within your report you should discuss the advantages and disadvantages of each plan, the type of company or environment is each plan best suited for, and how each type of plan fits in with current philosophy on compensation design. Give your opinion, with solid reasons, as to which choice would be best for Lansing-Smith.

Here is an example organization's review of pay plans and their shift to variable pay:
ATcon: 7X7 ASM Pay Plan (

Solution Preview

Let us discuss each plan one by one:

Merit-based pay:

Heneman (1992) defines merit awards as incentive pay that is based upon past performance and is designed to motivate future performance. Where individual employees are responsible for complete tasks with measurable effects on the total output of the firm, the links between rewards for past performance and future effort are strengthened; conversely, where teamwork is an important component of the production process, it is not only more difficult to evaluate individual performance, but financial rewards may not elicit the appropriate cooperative behaviour among employees. Moreover, financial rewards may diminish the intrinsic value individuals place upon their work; they may decrease the employees' self-esteem if they deem merit awards to be too infrequent or if they hold an inflated self-evaluation of their performance; or may generate the "Matthew effect" where the motivation of underperformers declines and overperformers experience a sense of guilt (Heneman 1992: 49-56).

Economists applying agency theory reach much the same conclusion. Lazear and Rosen (1981) characterize merit pay as a "rank-order tournament," where individuals compete for salary "prizes" on the basis of relative, rather than absolute, performance. Where it is difficult for firms to obtain an absolute measure of worker productivity, or where it is cheaper to obtain an relative measure, firms establish a competitive game among employees and reward the winners with a prize. They offer the example of a handful of junior executives vying for a senior executive position within a firm. Differences in performance may be marginal and the best that can be achieved is a ranking of individuals. By offering promotion and a raise to the most productive, an incentive is created for all competitors to increase their output. Although the winner's new salary may exceed his/her value to the firm, it is an efficient arrangement if the total increase in productivity of all contestants is sufficiently large to justify the winner's higher salary (Lazear and Rosen 1981). Similarly, merit pay schemes involve a zero-sum game relying upon a relative measure of output among contestants vying for a salary prize. A fixed pool of funds is distributed among employees exhibiting the greatest production over an interval of time with the "more exceptional" rewarded by transferring funds away from "less exceptional" performers.

If the salary prize induces enough greater effort, the value of the resulting increase in productivity exceeds the higher salary costs. Alternatively, if production relies upon a high degree of cooperation among employees - in the form of common tasks, or the transfer of knowledge through on-the-job training - merit pay may be inefficient. Rank-order tournaments based upon relative performance create an incentive to withhold cooperative effort. According to Lazear (1989: 578-9): ...

Solution Summary

In your report, discuss various pay plan options- merit-based pay, pay-for-performance, merit plus incentive, and pay-for-knowledge plans.