The Pay-for-Performance Conundrum

Published on November 11, 2010

Employers should think carefully before instituting “pay-for-performance” (PFP) schemes to raise productivity, according to Canice Prendergast, W. Allen Wallis Professor of Economics.

Research shows firms embracing PFP saw productivity jump by 25 to 30 percent, yet only a quarter of U.S. workers were part of a scheme, he said. That’s because PFP schemes are not right for all companies, in part because performance pay raises the wage bill.

“Pay for performance costs you something,” he told students, alumni, and executives at Chicago Booth’s London campus November 11 during a Global Leadership Series event. “It does not come for free.”

Rewards for those on PFP schemes vary wildly: traveling sales agents are paid 40 percent more than in-house colleagues, but McDonald’s franchisees who run their own stores earn three times more than company-employed managers.

Prendergast said the easiest way to understand when to use PFP is to look at cases where it didn’t achieve the desired results.

Five Rules for Using PFP

He set out five rules. The first is that the scheme must reward the contribution an employee makes to the firm’s success. For instance, he offered a “ludicrous” example of a machinist’s bonus payout being dependent on Chelsea, an English soccer team, winning the Premier league. Yet this is little different from a firm employing 46,000 people offering a broad brush PFP to each employee who is just a “cog in the machine,” he said.

Secondly, employers need to know PFP is better than standard incentive schemes. He listed three examples: paying people for their input (i.e. for simply turning up); a clear promotion ladder; and workers’ desire to do well so that it looks good on their resumes. While these were suitable for certain categories of workers, PFP worked best in volatile or uncertain environments, where firms wanted to delegate more responsibility to managers in exchange for higher potential rewards, he said.

The third rule is that employers need to choose the right people to provide feedback for measuring performance. Looking to restaurant diners makes sense because customers’ interests are aligned with the companies — both want high-quality service, Prendergast said.

In contrast, he pointed to the Los Angeles Police Department, which decided to forward any complaint against an officer to an external review board that had the power to dismiss them. “It was a disaster,” Prendergast said. Over three years, 1,500 of the 10,000-member force were fired; arrests fell 40 percent, and the murder rate tripled. “The interests of suspects were diametrically opposed to those of the officers,” he said.Fourth, there is a danger in offering PFP to workers who carry out many tasks, since it focuses their efforts on the lone function that is rewarded. “You need to be able to evaluate a good chunk of performance,” Prendergast said.

His final warning was against imposing financial incentives on people who already had an “intrinsic” motivation to perform well. For these people, he said, a financial incentive can “crowd out” personal incentives.

Those factors, Prendergast said, account for about 80 to 90 percent of the difference in salaries between McDonald’s franchisees and company-employed managers.

— Phil Thornton