Performance-based pay systems originated in the industrial age and remain in many companies, but there is evidence that in the knowledge age, objectively independent compensation systems can produce better results.

Pohr Jonas Solbach, Klaus Möller, and Franz Wiernsperger, MIT Sloan Management Review

Pay-for-Performance (PFP) systems were invented in the Industrial Age to improve individual performance, and while research shows that this approach is unsuitable for much of the intellectual work currently done in organizations, the practice remains standard.

These systems are stuck in the past for several reasons. First, it is essentially inertia: companies have been using PFP for decades, and the best practices disclosed by compensation consultants are often based on it. In addition, most executives are unaware of PFP studies or dismiss them as unreliable. Finally, abandoning PFP and moving on to designing and implementing a new reward system can seem intimidating given the potential impact on performance and outcomes from poor performance.

However, organizations have the most to lose if they do not go beyond the PFP. We conducted a large-scale experiment with an objectively independent compensation system. The results point to a strong case for leaving PFP behind.

Dysfunctional Elements of PFP Over the past 50 years, scholars such as Edward L. Deci and Jeffrey Pfeffer, and experts such as Alfie Cohn and Daniel H. Pink, have argued that performance-based pay (PPP) is inherently dysfunctional. This is based on two main sources:

1. First, PFP focuses on narrowly defined outcomes, such as the number of sales closed, but ignores how those outcomes are achieved. This introduces the possibility that chance – or worse, reprehensible behavior – is rewarded and that trying to achieve the promised reward undermines other desirable behaviors such as teamwork and collaboration.

Second, PFP provides extrinsic motivation for financial rewards but ignores powerful and rewarding intrinsic motivators such as joy in the task itself, a sense of contribution and belonging to a team, and personal development. Financial rewards force employees to focus on specific goals and avoid activities that do not directly lead to the achievement of those goals. PFP suppresses intrinsic motivation, leading to compliance at best, and does not fuel the employee’s long-term commitment or identification with the company. In the long run, this reduces overall performance.

Regardless of the dysfunctions it may cause, PFP has its uses. This can lead to superior performance when the job offers few or no opportunities for intrinsic motivation. When work is monotonously simple or volume oriented, extrinsic motivation ensures the concentration of efforts and behavior of workers.

But PFP undermines the performance of work that requires people to explore complex problems, develop creative solutions, and achieve quality outcomes that cannot be fully determined in advance. Also, when performance targets become obsolete, such as when production lines were shut down and sales dropped during the initial phase of the COVID-19 lockdown, PFP loses its motivating power because you cannot realize the promised rewards.

Finding alternatives to pay-per-performance: a case study
Executives at the Hilti Group, a Liechtenstein-based company that offers products and services to the construction industry, have their own doubts about the effectiveness of PFP and that its emphasis on individual results is not in line with the company’s collaborative culture.

The family business employs over 30,000 people, 70% of whom sell their products and services directly to building contractors in 120 countries. Hilti has a decentralized structure and in-country organizations have their own sales departments. As the range and complexity of a company’s product and service portfolio grows, so do the challenges its salespeople face. Initially, they were limited to offering the company’s products to as many contractors as possible in their assigned territories. However, as Hilti fully developed its sales territory, further growth required an increase in the share of contractors. To that end, the company has stepped up personalization and added new digital solutions, but these changes have also led to more complex sales, longer sales cycles, and a solution-driven approach to sales.

Today, Hilti salespeople are more like consultants. They often specialize in the needs of specific industries and collaborate with peers, engineers, customer service personnel, and team leaders to meet customer needs.

Sales remuneration at Hilti is based on a pay-for-performance system, adapted to local needs through centrally established rules. But PFP’s focus on individual sales volume and productivity is increasingly at odds with the company’s strategy and culture. Therefore, in 2018, Hilti management asked us to propose and test a new sales compensation system that would better suit their needs.

We looked at the company’s market organizations around the world and found a national organization in Eastern Europe that was well placed to scrutinize the intervention associated with the new compensation system. At that time, the country organization’s 190 salespeople received an average of 65% of their salary as a fixed salary and 35% as a variable salary. But there were problems with this system.

Management has spent a lot of time and effort in setting fair and motivating remuneration targets. Longer sales cycles and the team effort required to close deals made it difficult to allocate sales to individual salespeople. In addition, questions about when and how to adjust goals have often been discussed and contested. Despite attempts by management to address these issues through various formulas, winning awards was a chronic problem, often resulting in dissatisfaction among the commercial forces.

The reward system also became overly complex as management sought to use it to manage a growing number of organizational priorities. Many salespeople didn’t understand their payoff or what actions it was supposed to incentivize, making the whole system ineffective as a motivational tool.

Another problem was that the salespeople resorted to tactics to complete the required sales and earn their monthly bonuses. This behavior diluted the organization’s sales strategy, which was designed to take the time it takes to establish and develop long-term, value-based relationships with customers.

And finally, sellers were unhappy with the volatility of their remuneration. Long sales cycles caused large fluctuations in monthly sales compensation, which sometimes prevented sellers from paying their living expenses.

Read the full article in the August issue (No. 140) of Human Resources.