“On both sides of the Atlantic, there's a great distance between what science has been discovering and what companies have been doing”.
I've chosen this quote by Daniel Pink to begin this article by telling you that your variable compensation strategy might bring more headache than benefits if you won't listen to what science says about the subject. As I am quite certain that you're looking for the best results for your company, I invite you join me onboard and get to understand what the risks of variable compensation are, in what situations it might yield favorable results, what the most important factor in all of it is, and understand the best way of achieving results through this strategy.
Companies that make use of variable compensation models as a form of encouragement do so as a means of motivating their employees, so that they show certain behavior and achieve better results. Sometimes, however, it can consequently undermine their intrinsic motivation. In his book, Motivation 3.0., Daniel Pink explains that compensation has the power of producing "a strange kind of behavioural alchemy", which transforms interesting activities into a burden. This makes people stop doing these activities motivated by innate psychological needs, such as competence, autonomy and connection, and begin to perform the activity for the purpose of getting the promised prize.
Another side effect of variable compensation linked to target-based bonus is that they usually restrict the employee's focus, besides making them worry much more about the "where" (they want to get) rather than "how" (they can get there). The Candle Problem is a great example to get us thinking about the narrowing of focus and its consequences on current organizations. Psychologist Sam Glucksberg performed this test with two groups, having promised the second one a reward for those who finished the task faster. The result was surprising: the average finishing time for the second group was over three minutes longer than the first one. That's because the promise of a reward narrowed down the participant's focus, which reduced their creativity, making them unable to notice other possibilities of use for the objects. In current times, in which innovation is a need connected to the survival of companies, I invite you to think about the impact that this may have upon your organization.
The second side effect is that, by worrying excessively about where they must get, employees may feel the need to overlook values that are important to the company, which may even lead to unethical behavior, which is shown by this study from Harvard Business School.
By reading this text so far, it may seem like variable compensation must not be used at all, but that's not the idea. Let's go back to the Candle Problem. When applying a variation to the test, Glucksberg removed the thumbtacks from the box and left it empty on the table. He then rearranged the groups and promised one of them a reward for those who finished the test first. This time, the result was different: the participants that aimed at the reward had the better timing. This happened because, by leaving the box empty, the solution became more obvious, which turned the previously challenging task into a logical one.
In his studies with different groups, Dan Adriely and other researchers ratified this conclusion: “We have found that, provided that the task involved only mechanical ability, the bonuses worked as expected: the higher the pay, the better the performance. But when we included a task that demanded rudimentary cognitive ability, the result was the same as the study from India: the offer of a higher bonus brought worse performance. We are then able to notice that mechanical, repetitive tasks can be aided by the variable compensation format, while the creative ones can't.
According to Daniel Pink, the most important thing when we think about rewards is, above all, that the base compensation be adequate and fair. This is such an important factor that, without it, it's almost impossible to promote any form of motivation. He also highlights that fairness shouldn't be only external, in other words, related to the rates offered to correlated positions at different companies, but there must also be internal fairness. In an excerpt from his book, he explains:
“Let's say you and Fred work at adjacent bays and that both of you have nearly equivalent experience and responsibilities. If Fred makes much more money, you'll be outraged. And this violation of fairness will make your motivation drop greatly. [...] If Fred has a more difficult position or contributes more to the organization than you, he deserves better compensation. And many studies show that most people won't complain about that. Why? Because it's fair.”
The perception of fairness in compensation is not a direct motivation factor, but its absence certainly is a strong point of demotivation.
Slicing the compensation “pie” in a fair way
Once the impact caused by a perception of injustice in compensation is considerable, it's up to companies to find the best way of promoting internal fairness, not only in compensation as a whole, but also in their variable compensation formats.
The great question surrounding variable compensation, and also where companies usually go wrong, is that there's more gain when the strategy is based on cooperation rather than competition. Each employee's contribution to the result as a whole is what should be considered, instead of isolated effort. And this contribution is certainly better appraised by peers, and not just by HR or managers.
As to compensation, generally speaking, companies ask the wrong question and this compromises all the rest of the process. Instead of asking "Who should get a raise?", the question that must be asked is: "How big a 'slice of the pie' does each person deserve?". Once the question has been posed, we can understand how the compensation budget must be split (how the 'pie should be sliced'), thus accepting its finite nature.
The best way to promote fairness, specifically in variable compensation, as well as in general compensation, is through the Team-Set Salaries (TSS) method. TSS is the only method that allows for an appraisal considering peer opinion and their level of certainty about each colleague's work, without promoting inflated results. It's a method that respects the total compensation budget for the teams and generates reliable, clear, actionable results. You can get to know more about it in this article or by booking a chat with us.