Unpacking the evolving process of pay-for-performance system implementation

Highlights

• Pay-for-Performance (PFP) system implementation requires a focus on the managerial allocation process.

• Employees' responses are critical factors in influencing managerial allocation beliefs and consensus in PFP systems.

• Managerial discretion plays a very critical role in the issue of organizational control in PFP systems.

Abstract

Compensation researchers and practitioners often wrestle with issues of how organizations manage pay-for-performance (PFP) systems. Research has mostly addressed employee work outcomes of pay practices and has largely considered the PFP system as a static mechanism. We build a cyclical process model of how PFP systems are enacted, transformed, and managed in firms, ultimately providing a theoretical basis for enhancing the understanding of PFP system design and effectiveness. Drawing upon agency theory, cybernetic theory, and Bowen and Ostroff (2004)’s HRM system strength approach, our model identifies critical factors—PFP system formalization, PFP distinctiveness, PFP consistency, and PFP consensus —that influence control over PFP system implementation in organizations. In particular, our model addresses the critical role of managers in implementing and synthesizing PFP systems, which ultimately influences the design of PFP systems over time. Our model explains how the misalignment of espoused and enacted PFP practices is created and resolved in organizations.

Introduction

Pay-for-performance (PFP; i.e., performance-based pay), the most common and well-established compensation system (Gerhart, 2017; Worldatwork, 2016, Worldatwork, 2018, Worldatwork, 2018b), has been considered to be an important control mechanism for maximizing organizational effectiveness (Cardinal, Sitkin, & Long, 2010; Long, Sitkin, & Cardinal, 2014; Ouchi, 1977, Ouchi, 1979). Example types of PFP include merit pay, individual and/or team bonuses, or commission-based pay (e.g., some portions of pay are based on sales) (Conroy & Gupta, 2016; Gerhart & Newman, 2020; Park, 2018). A PFP system includes these various forms of PFP that entail different functionalities (e.g., merit pay permanently increases base pay, bonuses are one-time payments) (Park & Sturman, 2016) and objective (e.g., performance metrics for sales compensation) and/or subjective performance measurements (Eisenhardt, 1985; Gerhart & Newman, 2020). Decisions about PFP system design are often made at the executive level while implementation of these designs occurs through managers throughout the organization with the support of Human Resource professionals.

Research on PFP has repeatedly found that well-designed and implemented PFP systems positively influence employees' attitudes and behaviors at work, attract and retain talent, and achieve maximum productivity (Cadsby, Song, & Tapon, 2007; Gerhart, Rynes, & Fulmer, 2009; Jenkins, Mitra, Gupta, & Shaw, 1998; Nyberg, 2010; Park & Sturman, 2016). Yet, compensation researchers and practitioners often wrestle with issues of how organizations better manage PFP systems. How a PFP system is implemented, evolves over time, and is maintained effectively in an organization has not been sufficiently investigated (e.g., Conroy et al., 2015; Gerhart et al., 2009; Gupta & Shaw, 2014). Given the substantial costs and benefits of the implementation of PFP systems, it is critical to understand the control processes involved in pay practice formation and emergence in organizations by which PFP systems succeed or fail.

Agency theory (Eisenhardt, 1989) posits that organizations have various ways of exerting control, one being the use of PFP systems, and another being the importance of regulating of the effects of such systems in maintaining control within an organization. The theory has been useful in showing how organizations determine pay and design compensation systems to align employees' interests and goals with an organization's interests and objectives through types of behavioral monitoring or outcome-based rewards (i.e., PFP) (Rynes & Bono, 2000). The theory and previous research suggest that the key precept of PFP systems is to link pay with employee performance, merit and effort based on the concept of meritocracy—“merit or talent is the basis for sorting people into position and distributing rewards” (Scully, 1997, p. 413), not with other non-performance factors (e.g., gender, age, politics, or favoritism, Kepes, Delery, & Gupta, 2009; Shaw, 2014).

Despite commonly espoused policies of PFP (i.e., tying the link between pay plans and associated performance), many organizations have pay based at least partially on other factors, such as organizational politics (e.g., favoritism, Kepes et al., 2009; Shi, Johnson, Liu, & Wang, 2013). In fact, Kepes et al. (2009) reported that performance-based pay and politics-based pay were positively correlated, suggesting that for many organizations reporting performance-based pay, the desired PFP system was at least somewhat misaligned with actual practices by political influence. In addition, empirical findings associated with the implementation and change of PFP systems show disparate effects of the PFP system. Some organizations fail to produce a positive effect when they claim that their systems are based on employee performance. For example, Beer and Cannon (2004) explained that of 13 PFP programs, 12 were discontinued at Hewlett-Packard in the mid-nineties. The company attempted to implement different types of PFP at the individual level (e.g., merit pay, cash bonus incentives, sales incentives), at the team level (e.g., sales incentives), and at the organizational level (e.g., profit-sharing program, stock options). The findings, however, showed that the system caused various unexpected outcomes, such as distrust, lower commitment, and lower performance, and ultimately, the costs outweighed the benefits of having the PFP system. The case also found that the roles of managers are significant in determining and maintaining a clear link between pay and performance. As such, in this study, we consider that one important role of managers is whether they align with espoused PFP policies (i.e., the desired goals of an organization keeping the strong link between pay and performance to control employees) when enacting PFP practices (i.e., the actual implementation of those policies) in the process of PFP system implementation.

While traditional PFP practices using numerical performance ratings are continuously used in organizations, some organizations are lowering their control over pay allocations by decoupling pay from performance ratings and delegating more control to managers (Adler et al., 2016; Kuvaas, Buch, & Dysvick, 2017; Ledford, Lawler, & Benson, 2016; Soenarie, 2016), reflecting the problems associated with performance evaluations (e.g., less effective, less valid, less accurate) as well as the drastically changing work environment (Bryant et al., 2020; Gaertner, Shannon, Barge, & Demianenko, 2016; McMullen, Lemaire, & Ferry, 2016). For example, a manager may have to assess his/her employees' performance without numerical ratings and determine the size of raises or bonuses allocated and promotions based on the assessment, increasing subjectivity in pay decisions (Adler et al., 2016; Elvira & Graham, 2002; Ledford et al., 2016). Whether firms use traditional performance ratings or ratingless performance evaluations, the assessment of employee performance and PFP allocation often continue to be the responsibility of managers. This is unlikely to change as organizations deal with the agency problem by exerting control through PFP.

To develop a theoretical understanding for the reasons behind PFP system effectiveness, we extend compensation research by developing a theoretical process model to explain how a PFP system is implemented and evolves over time and that shows the implementation concerns of PFP systems (i.e., the misalignments between espoused and enacted PFP practices are created and resolved in the implementation process) in organizations, ultimately influencing organizational control in the compensation system. In particular, we consider the critical roles of the managerial pay decision-making processes, which are the keys to aligning espoused and enacted pay practices (Cardinal et al., 2010; Kehoe & Han, 2020) and contingent factors in the cyclical process. For this, based on the rational perspective given by agency theory, we integrate cybernetics theory which provides a powerful conceptual framework for understanding how an organization maintains or loses control over the implementation of a PFP system with the three components that create a strong HR system (i.e., distinctiveness, consistency, and consensus, Bowen & Ostroff, 2004) in the context of compensation implementation.

The development of this model leads to a threefold contribution to compensation literature. First, we apply cybernetics, which refers to “the science of control and communications systems,” (Carver, 1979, p. 1253) to build on prior research that has considered the use of PFP systems as a critical means of control to achieve organizational goals (e.g., Castilla & Benard, 2010; Eisenhardt, 1989; Ouchi, 1977, Ouchi, 1979). While it is relatively novel in compensation, our approach to adopting cybernetics theory to organizational processes is not entirely new, as the theory has been used in a variety of fields of research (e.g., management, mechanical engineering, neuroscience, and psychology) (Carver & Scheier, 1982; Green & Welsh, 1988; Snell, 1992; Wright & McMahan, 1992) to explain how control can be maintained, enhanced, or lost through iterative and self-regulating feedback loops. This approach to the compensation literature enables us to propose a systematic model of how PFP systems inherently involve a cyclical, not static, self-regulatory process through which pay allocations can either become more or less aligned with actual performance, which determines the effectiveness of the PFP system. Given that compensation is a basis for organizational control and organizations are susceptible to “control loss” problems (i.e., a growing disconnect between the intentions of the organization and the actual practices in the organization) (Nishii & Wright, 2008; Ouchi, 1979), it is important to explore how organizations maintain, enhance, or lose control over the implementation of their PFP system and in turn, to identify conditions for organizational control. Our cybernetic model illuminates how a PFP system acts as an organizational control mechanism and how the feedback loops in an organization work in the system. This allows us to identify factors that will influence organizational control over the PFP practices enacted in organizations as well as to predict that the evolving process of PFP system implementation can resolve control loss problems or continue to develop toward disorder.

Second, research on compensation has largely considered the effectiveness of PFP systems to be static, by measuring resultant outcomes at one point in time (Conroy et al., 2015; Shaw & Gupta, 2015). Yet, for an organization to succeed in affecting employee behavior through pay practices to achieve desired work outcomes, it is important for the organization to successfully align the desired goals of the organization with the actual implementation and maintain the alignment over time. We propose that PFP system implementation involves a cyclical, self-regulatory process through which managers implement a PFP system, evaluate employees and allocate pay to individuals and teams, then make sense of these allocations, ultimately influencing future iterations of the system.

Third, we build on research identifying distinctiveness, consistency, and consensus as key components of an effective HR system (Bowen & Ostroff, 2004) to identify the role of these components in PFP systems. We extend these ideas by integrating the three factors into a process model; thus, elaborating on the way these components operate in context over time rather than as static indicators of system strength. Specifically, we place the key components of HR system strength in the context of compensation and time to demonstrate how the factors reinforce each other. Our theoretical model shifts efforts of understanding PFP systems from a static view to an evolving process, an area for which compensation scholars have called for more work (Conroy, 2017; Conroy et al., 2015; Gerhart, 2000).