Podcast: When does paying for performance pay off?

Podcast: When does paying for performance pay off?

Julia Smith, Editor-in-Chief of ESSEC Knowledge: Hello everyone, welcome to a new episode of Be in the Know, an ESSEC Knowledge podcast bringing you the research and knowledge of ESSEC professors. Today I'm talking to Pooyan Khashabi, a Professor of Management, about his recent research studying if and when performance bonuses actually work. So, thank you for coming today, Pooyan! Can you tell us a little bit of background about the project?

Pooyan Khashabi: Yes, thank you for having me. So, this is a project that he had about the effectiveness of the pay for performance and we wanted to have field data, real data from the field, and wanted to run an experiment. Our sample is about the firm and bakery chain that had financial trouble because of new entrants in the industry. And they had their sales obviously come down, and they wanted to find a strategy to incentivize their employees to work harder and faster.

And that was the time that we decided to offer to run an experiment within their chain. So this is a German bakery. The firm operates in around 193 shops and we actually assigned half to a pay for performance scheme and half to a control group. And then we measured the effectiveness and performance and sales of these shops, which is interesting because then you look at the competitive environment and then you look in which type of competitive environments pay for performance was much more effective and which one wasn't. And again, I think this is interesting because although pay for performance is one of the most common of the US management practices, most of the vast literature which studies effectiveness looks at internal factors, factors that are to do with the internal organization. And most of the time, there's not much work done on the external factors. So we thought it was interesting to look at how an external factor, here which is the market competition, shapes the effectiveness of this very common managerial tool. 

JS: Yeah, it's a really interesting way to look at it because it is thinking outside the box, maybe something that doesn't necessarily come to mind when people are implementing these schemes. And so can you tell us how exactly the presence of external competitors impacts pay for performance effectiveness? 

PK: Sure, sure. So we thought about two mechanisms. One is what we call the residual market effect. It's also been called the business stealing effect, and that is when people are motivated to exert extra effort in hope of getting a bonus or something, They will consider how much extra market share they can gain from that: if there is a lot of competition, a lot of people. Alternatively there is the extreme opposite: if you are the monopoly, so you don't have any other competitors, you are already serving the entire market. They might think that even if I work harder and faster, it is not going to have much impact because I already have the entire market. 

There is also another mechanism that works in the opposite direction. And that is what we call the competitor response effect: the likelihood that the competitors’ react to any competitive initiative and restore the status quo increases with competition. 

Once your company wants your employees to take a competitive action, say here work harder, you are more likely to do so. It is very important that you already know that under some situations in which some initial practice performance pay schemes work. But they work, to increase the operational performance, but what most companies care about is the market performance, and these may not translate that into each other so in some situations, or whatever, but this might just not be translated.but this might just not be translated to your results for your mission. What was the introduction of performance. And also, how the sales are that same month. So we looked at the sales.

And what is found was that the performance pay has the highest impact in moderate competition environments, three or four other bakeries. So we collected information of the number of rivals in one kilometer distance and we counted the number and we also visited them. And we collected information about them, and we showed that in the paper, there is a curvilinear inverted U shaped relationship between the number of competitors and the effectiveness of performance  space so the effect of this initially rises but then it declines.

JS: Interesting. So, can you sum up the conditions in which pay for performance so these performance bonus compensation schemes, when they're most beneficial?

PK:  A lot of researchers and scholars have summarized a lot of factors which are internal to organization, but what I can tell you about the conditions coming out of this research is the external factors, namely competition. First of all, I think this paper shows that the one size fits all kind of compensation strategy does not work. If you want to design your performance, especially in a context like retail, there is the marketing space if you care about performance not operational performance. It's important to consider and factor in your competition.

Take the way you can do it, it is to look at the local competition level of your market, probably, if the market is has a lot of competition, if the competition is fierce, probably performance pay is not sufficient to motivate your employees to exert a lot of high effort because they are going to be discouraged by competition and potential reaction by the competitors.

On the other hand, if you are a monopolist or the competition is less and you are serving the big part of the market, performance pay is not going to be able to motivate your employees to exert extra effort, because simply they think that they will not be able to win much extra market so their effort will not be translated into a bonus.

So this is going to be the sweet spot somewhere in between: moderate competition is going to be the right condition to introduce performance pay schemes that motivate employees.

The last thing I wanted to mention is this: most of the time when you introduce performance pay schemes, you need to have milestones or objectives and the way you define them is important. So sometimes companies may have operational milestones. So if you have a typist, you can ask them to type in a certain number of pages per hour or if you have a worker, you can ask them to make whatever number of pieces for tools per hour. But if you want to put market-level performance schemes, then you should really consider the competitive environment.

You might have cases where the employees are putting in extra effort but their extra effort is being offset or is not effective in increasing sales, so it is not effective in increasing market performance.  

JS: Okay, thank you, and to get a bit deeper into that, what advice would you give a manager who is considering implementing a pay for performance scheme?

PK:  I will tell you, and I think it probably needs future research. So when we say one size does not fit all, we need different compensation schemes for different, say, competitive environments. If you have shops that are operating in the city center, in the airport, or in less competitive environments, probably you should adjust your compensation strategy and bonus strategy with respect to all of these locations. So that is a simple way to think about our results but then, of course, once you introduce different compensation strategies, there might be other problems arising. So a social comparison problem might arise. So, if you offer performance pay and bonus to a group of your employees in one geographical location and do not offer it to others in another competitive environment, people might not like this, because they compare themselves to each other. And that is something that should be taken into account. If you do not have a potential problem with social comparisons, then I think that you can offer performance pay in moderate competition, and in fierce or low competition, it is not going to be effective. Of course, if you are in an environment where people are always in touch and they interact and they communicate the contract to each other, then you should think more deeply about this.

JS: Okay, thank you so much. It's really interesting and it just shows that there's a lot to consider when you're implementing performance bonus and compensation schemes and that it just shows the importance of, as I believe you say in the paper, looking outside the window, and taking into account the competition. Is there anything else that you would like to add before we sign off?

PK:  Thank you very much for the kind words. I think that one thing I want to add, not only about this research but about this line of work, is that I think that human capital is the most valuable part of organizations, and in the past, in situations that machines were introduced, more and more machines were doing the job and now that you're in the knowledge economy, you're back into the situation that more and more human capital are becoming more important for companies and their performance. But, this tells us something: that people are more complicated than machines. And that is why we need more rigorous, and more precise research to understand how to motivate them. And this is one step in a successful human capital strategy of a company: good hiring, good motivation, good retention, and we need much more rigorous research and field experiments about this topic.

JS: People are more complicated than machines than machines, I like that. Thank you for coming on today and sharing your research, I look forward to reading more of your work. 

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