Performance pay effectiveness

If you’re trying to figure out the best way to motivate your employees and give your business a competitive edge, the possibility of performance bonuses has likely crossed your mind. But before you implement a pay-for-performance compensation scheme, you might want to look out the window and check out the competition. Pooyan Khashabi of ESSEC Business School and a group of colleagues explored the effectiveness of performance pay in their recent research, finding that market competition plays an important role and that performance pay is most effective when there is moderate competition.

Pay-for-performance (PfP) is probably the most common managerial practice, but research on its effectiveness has largely focused on organizational factors and the structure of the compensation itself, not so much on the influence of the external environment. Dr. Khashabi and colleagues Matthias Heinz (University of Cologne), Nick Zubanov (University of Konstanz), Tobias Kretschmer (LMU Munich) and Guido Friebel (Goethe University Frankfurt) were interested in how the presence (or lack thereof) of competitors impacted the effectiveness of performance pay, studying the case of a German bakery chain.

There are two main, counteracting mechanisms through which competitors can impact PfP effectiveness. The first, which is related to the business stealing by competitors, is called the residual market effect. As this mechanism describes, when a firm shares the market with more competitors, there is a bigger residual market and thus, higher business stealing opportunity, compared to when a firm is a monopolist. Thereby and through this mechanism, competition has a positive effect on PfP effectiveness. The second mechanism is the competitor response effect: the likelihood that the competitors’ react to any competitive initiative and restore the status quo increases with competition. For example, if a nearby bakery notices a decline in sales and realizes the link to the focal bakery’s actions (namely introduction of a bonus scheme), they might try to improve their competitiveness. With more competitors, it’s more likely that at least one of them will react, reducing the payoff of PfP and also employees’ inclination to participate. As a result, the effect of PfP looks a bit like an inverted U: when competition is low, PfP isn’t all that effective because there’s no one to lure business from and so employees aren’t as interested in participating. PfP schemes are also ineffective when there’s a high amount of competition, because employees forecast competitors' response and expect less to be gained from participating. PfP is thus most useful when there is a moderate amount of competition.

Examining the effect of performance pay in the field

To understand when (if) performance pay pays off, the researchers conducted a field experiment involving 193 shops in a bakery chain in a large German metropolis, assigning half to a PfP scheme at random. They also gathered detailed data on competing bakeries in the neighborhood, looking at competitors within a 1km radius. These included both conventional bakeries (about 75% of the competitors) and large retailers selling fresh bread, like Aldi and Lidl. The latter began offering bakery products in late 2011, and offered them in all their locations by 2013 when the study started. Their products were much cheaper than the competitors, so the bakery chain in question had to rethink its strategy, leading it to implement a PfP scheme. This scheme paid a bonus to teams at shops that met their monthly sales target.

They found that initially the effect of PfP on sales increases by about 3% per competitor until there are three nearby competitors (other bakeries). When there are more than three competitors in the neighbourhood, the sales payoff from PfP starts to decrease. Thus, the scheme was most effective in moderate competition.

As predicted, the amount of competitors also had an impact on employees’ interest in participating in a PfP system. As with sales payoff, employee participation was highest when there was a moderate amount (3 or 4) of competitors: when that was the case, teams were about 70% more likely to participate.

Taken together, this shows that pay-for-performance does pay off: but only under certain external conditions, i.e. when there were a moderate amount of competitors nearby. When there were too few or too many competitors - less than 3 or more than 4 - employees were less keen in taking part, and the sales payoff was lower. When there is too little competition, there’s less motivation since there’s less potential for stealing customers away from the competition, and when there is too much, motivation is low since employees are more leery about how their competitors could react and make their efforts in vain. In other words, not all markets are suited to offering PfP contracts, and external competition should be a factor when establishing compensation structure.

Tips for managers

Consider external factors when determining compensation structures: it’s not only internal and the organizational factors that will have an impact on their benefits.
More specifically, before deciding to offer performance bonuses, look out the window, and take stock of the local competition. Performance bonuses are most effective when there is moderate competition nearby.

Reference

Khashabi, P., Heinz, M., Zubanov, N., Kretschmer, T., & Friebel, G. (2021). Market competition and the effectiveness of performance pay. Organization Science, 32(2), 334-351.