Four Ways to Improve Your Pay-for-Performance Plan

For all the talk about creating better incentive plans for employees, many proposed ideas are still off the mark. One reason is that managers tend to ignore insights from academic research, while academics do not always focus on practical applications. In two new research papers, Chicago Booth clinical professor Michael J. Gibbs offers insights that bridge academic and practical perspectives.

1. Decide how a company should measure employee performance. Performance evaluation is the most complex issue in designing a good pay-for-performance plan, Gibbs says, and should be determined first before deciding how to tie performance to rewards.
2. Pick the best numeric performance measure for the job. The advantage of a numeric measure is that employees know exactly how they will be evaluated. However, even the best numeric measure has flaws. For example, distortions can arise if a numeric measure motivates employees to focus on activities that the metric recognizes, but ignores hard-to-quantify activities that aren't part of the evaluation but are nevertheless valuable to the firm.
3. Always include a subjective evaluation of performance, as that can address the limitations of numeric performance measures. One way to combine numeric and subjective assessments is to design an incentive plan that gives employees a formal bonus based on a numeric measure, such as profits generated, and a second bonus based on supervisor discretion. The profit-based bonus might distort incentives, but the promise of a supplementary reward at the supervisor's discretion can mitigate that distortion and motivate the employee to look out for the company's overall interests.
4. The overall evaluation—including numeric metrics and subjective evaluation—should be chosen to protect employees from risks they cannot control. No incentive in the world will give a plant manager the power to prevent a heavy snowstorm that makes a factory roof collapse, but incentives can make sure the manager keeps the roof maintained and acts swiftly to make repairs. Performance measures can push employees to use their own knowledge and creativity to find the best ways to perform a job.