LECTURE 6: INCENTIVES PLANS

Introduction
Incentives schemes are employee motivational program designed to encourage commitment to
increasing productivity or in achieving some worthwhile objective such as reducing the number
of man-hours lost due to accidents. Well-designed staff incentive schemes can have positive
and powerful effects on the productivity, efficiency and quality of organizational productivity.
Conversely, poorly developed schemes can have serious detrimental effects. Incentive schemes
must be transparent so that staff members affected can easily understand the mechanics of the
calculation. Thus the system should not be overly complex and should contain as many
objective factors and as few subjective variables as possible. Furthermore, the “rules of the
game” should be made known to everyone and should not be changed arbitrarily. In addition,
it is essential that the incentive scheme be perceived as being fair, and thus the goals set out by
the scheme must be attainable, and better performing staff members must indeed be rewarded
with higher salaries. Finally, everyone must be able to achieve a higher compensation by
working better and harder. This lecture addresses all these issues of incentive plans

Meaning of incentive plans

Incentives schemes are employee motivational program designed to encourage commitment to
increasing productivity or in achieving some worthwhile objective such as reducing the number
of man hours lost due to accidents. The philosophy of incentives is to:
• Align goals of organization and individual,
• Reward behaviors that should occur most frequently
• Change bad behaviors/attitudes
• Use incentives to increase productivity and growth

Classification of incentive plans

Incentives can be classified based on how they are given. They are given either to individuals,
to groups or to the organisation as a whole

Individual incentive plans

Individual incentives are used by companies as a means to motivate employees by providing
them the opportunity to earn additional income. Individual incentive plans provide income
over and above base salary to individual employees who meet specific individual performance
standards. They are used when it is possible to measure output on an individual basis.
Incentives often take the form of cash, but they can also be paid in the form of a product or a
family vacation. In some cases, incentives can make up the bulk of an employee's income, such
as a salesperson who is compensated on a commission basis.

Individual incentive plans can be further sub- divided into merit pay plans, piece rate system
and standard hourly rate systems. In merit pay system, performance is typically measured
by rating done by supervisors. Piece rate and standard hourly rate system rely on some
countable results to be used as a basis for setting the Pay for performance.(PFP

Merit pay plans is an incentive plan implemented on an institutional wide basis to give all
employees an equal opportunity for consideration. The merit increase program is implemented
when funds are designated for that purpose by the institution's administration, dependent upon
the availability of funds and other constraint. These call for a distribution of pay based on an
appraisal of the worker performance . The merit pay is usually folded into the base pay of the
recipient and is usually granted as a percentage of a workers base pay.

Survey indicates that workers prefer merit pay plans that link individual performance with the
desired outcomes. At least compared to straight pay with no tie-in to performance, workers in
general prefer merit pay plans even after they have been granted what they regard as less than
satisfactory raises based on the plan. Merit pay system is only successful on condition that there
is a clear linkage between employee performance and pay

Piece rate system

In this system the employer pays the worker a sum (called piece rate ) for each unit he or she
produces. A firm using piece-rate will determine an appropriate amount of work to be
accomplished in a set period of time (e.g. an hour) then define this as the standard. Then using
either internal or external measure, a fair rate is set for this period of time. The piece rate is
then calculated by divided the base wage by the standard.

The earliest approach to piece rate was called straight piece work. In this approach, a worker
was paid per unit of production. However today some piece work allows the worker to receive
an extra income for some above normal production – differentiate piece rate system

Standard hourly rate

Instead of getting a rate per piece, the worker gets a premium equal to the percentage by which
his or her performance exceeds the standard. Production standard is expressed in times units.
Using a job analysis, the standards time for a given task is established and the organisation sets
a fair hourly wage rate. The standard rate for any task is the wage rate times the standard.
When managers are considering an incentive system, they must take into account the firms
organizational strategy, culture and position in the market place. For example, if the standard
time for a task is four hours and the fair hourly wage is $10, then the standard rate is $40. The
worker receives the $40 standard rate of pay regardless of the length of time it takes to complete
the task

So if Toms standard is 160 units per day 9 (equal to $64 per day), and he brings in 200 units,
he’d get an extra 25% or $80 for the day

Advantages of individual incentive plans

 • It has equity – because employees are compensated based on the performance.
Therefore it promotes equitable distribution of compensation
• It motivates individual employees to put more effort individually because they know
that they do not have to depend on other employees to be recognized.
• No need for close supervision of employees because the incentives is in itself a
motivator to work
• Allows the employer to differentiate pay given to high performers.
• Helps relate pay to performance by allowing the employer to differentiate pay given to
high performers.
• Allows a differentiation between individual and company performance
• Helps the employer retain best performers

Limitations of individual incentive plan

• Individual pay plans can increase competition and reduce cooperation and teamwork.
Workers are less likely to assist their co workers if such an effort will adversely affect
their own production rate or potential for reward.
• Often it is difficulty in distinguishing between group and individual behavior
• Requires a work system with a lot of autonomy but this is not always possible
• Individual incentive favors individual achievement and not team or organizational
achievement
• To use this system, you must be able to measure individual employee performance and
sometimes this is not possible – especially in service industries
• In case of merit based incentives, there could be lack of skills of the appraisers or
leniency, and bias in rating resulting
• Employees concentrate on output and are less willing to concern themselves with
meeting quality standards or switching from jobs to job ( since doing do could reduce
their productivity)

Group/team incentive plans

Where it is impossible to relate output to an individual employee's efforts it may be possible

to relate it to the efforts of the work group. If, in addition, cooperation is required to produce
the desired output, then a group incentive plan may be the best alternative. Interdependence of
work, then, is a major reason for choosing a group plan over an individual one. A group
incentive plan can reward things that are very different from what an individual plan rewards,
in particular: cooperation, teamwork, and coordination of activities. Where these are highly
valued, a group plan is most appropriate. As organizations become more complex and the
production process more continuous, group incentive pay plans can be expected to become
more popular.
Group plans are also useful where performance standards and measures cannot be defined
objectively. In a group setting, variations tend to average out, so no one gets as hurt by random
variation or lack of continuity. Almost any individual plan can be adapted to a group setting.
Thus the focus in group plans is still higher level of effort.

Group based incentive plans include incentive plans for sales people, for managers and
executives and for professionals

INCENTIVES FOR SALES PEOPLE

Sales compensation plans typically rely heavily on incentive (sales commissions). However
some sales people get straight salaries, and most receive a combination of salary and
commissions.

Salary plan
This involves paying fixed salaries to salespeople (perhaps with some form of bonuses, sales
contest prizes and the like)

Straight salaries make particular sense when the main job involves prospecting (finding new
clients) or when it mostly involves account servicing, such as developing and executing product
training programmes for a customer’s sales force participating in national and local trade
shows.
You will often find jobs like these in industries that sell technical products.

The straight salary plans have pros and cons

Pros
• Straight salary plans make it simple to switch territories or to reassign sales people
• It can foster royalty among sales staff since emphasis is not so much in making the sale
but rather to prospecting and cultivating long-term customers

Cons
• The main disadvantage is that the pay is not proportionate to results which can constrict
some and demotivate potentially high-performing sales people

Commission plans
Commission plans pay salespeople for results, and only for results.

Advantages
• Under these plans sale people have the greatest incentives, and there’s a tendency to
attract high performing salespeople who see that effort Cleary leads to rewards.
• Sales costs are proportionate to sales rather than fixed costs, and the company fixed
sales costs are low.
• It is a plan that is easily to understand and compute

Disadvantages
• Sales people tend to focus on making the sale and on high volume items and may
neglect nonselling duties like servicing small accounts, cultivating dedicated
customers, and pushing hard-so-sell items
• Wide variation in income may occur; this can lead to a feeling that the plan is
inequitable
• In addition pay is often excessive in boom time sand low in recessions.
• Working without safety nets induces sales people to leave – because pay is 100% at
risk. A study shows that where salespeople were on 100% commission pay the turnover
was highest. Turnover was much lower when sale people were paid a combination of
base pay plus commission.

Combination plan

Most companies pay sales people a combination of salary and commission, usually with a
sizable salary component.
Early studies suggest that the most popular salary/commission split was 80% base pay and 20%
incentives, with 70/30 and 60/40 splits being the second and third most frequently reported
arrangement

Advantages
• They give salespeople a floor to their earnings
• It lets the company specify what services the salary component is for (such as serving
a current account) and still provide incentives for superior performance.

Disadvantages

• The salary component isn’t tied to performance, so the employer is obviously trading
away some incentive value.
 • Combination plans tend to become more complicated, and misunderstanding can result.
Most combination plans are not simple. For example, in “commission plus drawing
account” plan, a sales person is paid on commissions but can draw on future earnings
to bet through low sales period. Similarly, in the “commission plus bonus” plan, the
firm pays its sales people mostly based on commissions. However, they also get a small
bonus for directed activities like selecting slow moving items.

Advantages of team based plans:

i. Much work today is organized around teams- project teams, assembly lines etc.
Performance here reflects not just individual team but team effort, so team incentives
make sense.

ii. Team based plans reinforce team planning and problem solving ad help ensure
collaboration
iii. Reduces jealously, and makes group members’ indebted to one another and encourage
a sense of corroboration

iv. Team incentives also facilitate training, since each member has an interest in getting
new members trained as fast as possible.

Disadvantage of team based incentives

i. The primary disadvantage of the group plan is that it weakens the relationship between
the individual's effort and performance.
ii. Where there is likely to be wide variation in the efforts of group members, a group
incentive may lead to more intragroup conflict than cooperation.
iii. In group plans it is also more difficult to monitor performance standards and measures.
iv. Finally, group norms play an expanded role, both positive and negative, in group plans.
They are stronger and more controlling on the individual. Where the group norms are
congruent with management's goals, this is a plus; but where the two differ, it can harm
the chances of success of the incentive plan

Organization-Wide Incentive Pay Plans.

Organization-wide plans differ significantly from individual plans by rewarding different

things. As indicated, most individual and group plans attempt to increase effort. Most
organization-wide plans, however, reward an increase in organization-wide outcomes that
directly affect the cost and/or profit picture of the organization. Usually these plans reward
increases in productivity of the plant or organization as measured by reduction of
organizational costs, in comparison with some measured normal cost. Or they may reward
increased output with the same or fewer inputs.

A major feature of organization-wide incentive pay plans is a change in the relationship

between management on the one hand and employees on the other. Rather than the traditional
adversarial relationship between the two, most organization-wide plans require a high degree
of cooperation. This is because both groups must focus on the desired cost savings and listen
to the other party. All this requires a degree of trust that is hard to achieve in American labor
relations. Failures of the Scanlon Plan have been attributed most often to the inability of
management to take employee input seriously.14

Organisational wide incentive plans include profit sharing, gain sharing, Employee Stock
ownership Plans ( ESOP) and stock options

Profit Sharing plans

Profit Sharing plans are incentive based compensation program to award employees a
percentage of the company's profits. The company contributes a portion of its pre-tax profits
to a pool that will be distributed among eligible employees. The amount distributed to each
employee may be weighted by the employee's base salary so that employees with higher base
salaries receive a slightly higher amount of the shared pool of profits. Generally, this is done
on an annual basis.

Profit sharing is designed to motivate cost saving by allowing workers to share in benefits of
increased profits. Rewards can be periodic cash disbursements or deposits to employee account
(to be paid out at retirement or a predetermined time.). Either a predetermined percentage of
profits or a percentage above a certain threshold is allocated to a pool (e.g. 10 to 25%). This
pool is disbursed to employees on the basis of some ratio, usually related to their wage. Many
companies have options from which employees may select particular profit sharing plan
compatible to his or her long-range plans.

Profit sharing plans have got advantages and limitations

Advantages

• They brings groups of employees to work together toward a common goal (the
success/benefit of the company).
• They helps employees focus on profitability.
• The costs of implementing the plan rise and fall with the company's revenues.
• They enhances commitment to organizational goals.
 • Typically profit sharing plans use profits to fund retirement and is thus advantageous
for tax purposes

Limitations of profit sharing plans

• The pay for each employee moves up or down together (no individual differences for
merit or performance).
• A firm can use this profit sharing as a tool to control employee turnover where the profit
is only distributed on retirement and any employee who leaves before retirement age
automatically looses the incentive.
• Focuses only on the goal of profitability (which may be at the expense of quality).
• For smaller companies, these plans may result in drastic swings in earnings for
employees which the employees may find difficult to manage their personal finances.
• While employees generally approve of profit sharing, they get demotivated and
dissatisfied when their base pay is affected in a negative way by profit sharing
provisions. The major reason for this dissatisfaction is lack of a perceived connection
between workers performance and company profits

GAIN SHARING PLANS

A gain sharing incentive is technique that compensates workers based on improvements in the
company's productivity. Gain sharing plans either try to reduce the amount of labour required
for a given level of output (cost saving) or increase the output for a given amount of labour
(productivity increase). The gains that are measured include increases in production with
equal or less effort or equal levels of production with less effort. Gain sharing is calculated
using a labour/sales ratio or cost- of- quality/sale ratio as a financial measure

A Company shares productivity gains with the workforce. Workers voluntarily participate in
management to accept responsibility for major reforms. This type of pay is based on factors
directly under a worker’s control (i.e., productivity or costs). Gains are measured and
distributions are made frequently through a predetermined formula. Because this pay is only
implemented when gains are achieved, gainsharing plans do not adversely affect company
costs.

For gain sharing to be successful, it must have the following characteristics:

 1. The method for determining the standard production rate and incentive rate must be
clearly defined. Gain sharing plan are generally based on the assumption that better
cooperation among workers and between workers and management will result to greater
effectiveness.

2. Successful gain sharing plans require an organizational climate characterised by trust

across organizational level, workers participation, and cooperative onions.
3. An organized employee suggestion system is also characteristic of almost all gain
sharing plans. To maximize cost saving and productivity increases, there must be
employee involvement in the plan development and execution.

4. A successful gain sharing plan requires workers and management to work towards a
common goal. Gain sharing encounters difficulty when management downgrades
employees input or unions adopt a strong adversarial position

Two major differences between gain sharing and profit sharing:

1. Gain sharing is based on a measure of productivity and not profitability

2. Gain sharing rewards are given out frequently, whereas profit sharing is annual and
often tied to retirement plan s deferred payment.

Four approaches to gain sharing

The are four basic approaches to gain sharing. These are Scanlon plans, Rucker Plan,
Improshare plans and Winsharing. Below is a discussion of each of these

Scanlon plan

Scanlon plan is the oldest form of gain sharing. It was developed by Joseph Scanlon, a steel
worker, a union official, and later a professor Massachusetts Institute of Technology. The
Scanlon plan is a gainsharing plan that uses a bonus formula based on improvements in
historical production. The ratio used is the cost of labor to some measure of productivity
(revenue, sales value of production, or net sales). Assuming a stable historical ratio, a bonus is
realized when the ratio improves. The amount of savings creates a bonus pool that is shared
between the employer and employees (often a 50 : 50 split). The employee share is then
distributed among all employees in the work group (usually as a percentage of basic pay). Like
all other gain sharing plans, employee participant is important component of this. Screening
committees are used to evaluate cost saving suggestions from employees with labour costs
serving as the incentive. Savings are measured by a monthly calculation of the ratio of payroll
to sales value of production compared to baseline data

Features of the Scanlon Plan include:

a) Cooperation

The philosophy in the Scanlon plan is philosophy of cooperation. This philosophy assumes that
managers and workers must rid themselves of us” and “them” attitude than normally inhibits
employees from developing a sense of ownership in the company.

It substitutes a climate in which everyone cooperates because he or she understand tat economic
rewards are contingent on cooperation.

b) Identity

A second feature of the plan is what its practitioners call identity. This means to focus
employees’ involvement, the company must clearly articulate its mission or purpose, and
employees must understand how the business operates in terms of customer, price and costs

c) Competence

Scanlon plan demands high level of competence from employees at all level. The plan assumes
that hourly employees can perform their jobs competently as well as identify and implement
improvements and that supervisors have a leadership skill for the participative management
crucial to a Scanlon Plan

d) Sharing of benefits formula

The Scanlon plan assumes the employees should share directly any extra profits resulting form
the cost cutting suggestion. If suggestion is implemented and successful, all employees share
in the agreed percentage of savings e.g. 75% of the savings. For example, assume that the
normal monthly ratio of payroll cost 50% of sales. (Thus if sales are Ksh6,000,000, resulting
payroll costs should be ksh.3,000,000). Assume the firm implements suggestion that result in
payroll costs of ksh. 2 500,000 in a month. When sales were Ksh. 5,500,000 and pay roll cost
should have been Ksh.2,750,000 (50% of sales). The savings attributed to these suggestions is
Ksh250,000 (Ksh. 2,750, 000 minus Ksh. 250,000). Workers would typically share in 75% of
this ($187500) while Ksh62500 would go to the firm. In practice, the firm sets aside a portion,
usually a quarter of the Ksh. 187500 for the months in which labour costs exceed standard

For Scanlon Plans to be successful, there are key requirements and thses are:
 i. Scanlon plans require a considerable commitment by workers and management to
cooperate in the development and maintenance of a program.
ii. Also Scanlon plans are more effective when the number of participants is fewer than 1,000.
iii. They are more successful when there are stable product lines and costs, since it is important
that the labour cost/sale ratio remains fairly stable.
iv. Good supervision and healthy labour relations is essential
v. And of course, it is crucial that there be strong commitment to the plan on the part of both
the worker and management
vi. The key to success of Scanlon plan is employees trust, understanding, and contributions to
improvement.

Rucker plan

While similar to Scanlon, the Rucker formula includes the value of all supplies, material and
devices. The result is a bonus formula based on the value added to the product per labour dollar.
Thus an incentive is created to save on all inputs including materials and supplies. The
advantage of Rucker plan over Scanlon is the linkage of reward to savings other than labour
savings, plus greater flexibility. The disadvantage is that the concepts such as value added and
the adjustment for inflation make the Rucker plan more difficult to understand and explain
compared to Scanlon plan.

IMPROSHARE

This means “improved productivity through sharing” IMPROSHARE is similar to Scanlon

except that the IMPROSHARE ratio uses standard hours rather than labour costs. Engineering
studies or past performance data are used to specify the standard number of hours required to
produce a base production level. Savings in hours result in reward allocation to workers.
IMPROSHARE “rewards all covered employees equally whenever the actual number of labour
hours used to produce output in the current week or month is less than the estimated number it
would have taken to produce the current level of output in the base period.

IMPROSHARE is easy to administer and employees have not difficulty understanding the
formula.

WINSHARING

These combines gain sharing with profit sharing. Winsharing is based on the rational
proposition that if your PFP system results in more products being produced than can be sold,
your PFP system needs some alterations. Winsharing takes the market demand into
considerations. They work best when company performance levels can be easily quantified.
Employee involvement significantly enhances the effectiveness of incentive pay. When used
simultaneously, productivity gains from combining these techniques can exceed gains achieved
separately.

Winsharing payouts are based on whether group performance is achieved relative to business
goals. Financial performance in excess of the goals is split evenly between workers and the
company.

Winsharing differs from profit sharing because group performance measures are used that are
independent of profit measures.

Advantages of win sharing plans Disadvantages

• Helps companies achieve sustained • The formulas and program may be
increases in productivity. difficult to understand.
• Employees become more involved • Requires a shift to a more team
the productivity gains made by the oriented management style.
employer.
• Employees can share in the benefits
of employee sponsored
improvements.
• Enhances commitment to
organizational goals.

Leads to improvements in other measures of

company performance, including:
teamwork, product quality, lower rates of
absenteeism, defects, and "downtime."

Stock Options

A stock option is a ‘right’ to purchase stock at a given price at some time in the future: the
employee thus hopes to profit by exercising his or her option to buy the shares in the future but
at today’s price. The assumption is that the price of the stock will go up – unfortunately this
depends partly on considerations outside the control of the employee e.g. general economic
conditions.
Companies sell stocks to employees in order to give them financial stakes in the company.

An option is created that specifies that the owner of the option may 'exercise' the 'right'
to purchase a company’s stock at a certain price (the 'grant' price) by a certain
(expiration) date in the future. Usually the price of the option (the 'grant' price) is set to
the market price of the stock at the time the option was sold. If the underlying stock
increases in value, the option becomes more valuable. If the underlying stock decreases
below the 'grant' price or stays the same in value as the 'grant' price, then the option
becomes worthless.

They provide employees the right, but not the obligation, to purchase shares of their
employer's stock at a certain price for a certain period of time. Options are usually
granted at the current market price of the stock and last for up to 10 years. To encourage
employees to stick around and help the company grow, options typically carry a four to
five year vesting period, but each company sets its own parameters.

Stock options are most appropriate for small companies where future growth is
expected and for publicly owned companies who want to offer some degree of company
ownership to employees.

Stock options are not always given to all employees. They are mainly for executive
employees. Before implementing a stock option important considerations must be
made. These include:

• How much stock a company be willing to sell.

• Who will receive the options?
• How many options are available to be sold in the future?
• Is this a permanent part of the benefit plan or just an incentive

Advantages of stock option plans Disadvantages

• Allows a company to share • In a down market, because they
ownership with the employees. quickly become valueless
• Used to align the interests of the • Dilution of ownership
employees with those of the • overstatement of operating income
company
 TYPES OF STOCK OPTIONS PLANS:

Stock Options plan can be:

i. Non qualified,
ii. Restricted
iii. Performance based share units.
iv. Appreciation rights
v. Phantom rights

Non qualified stock option plans grants the employee the option to buy stock at a fixed price
( usually market price) for a fixed exercise period. The advantage is that it will align the
employee interest and the shareholders interest and the company may receive tax educations.
On the other hand it has the disadvantage is that this plan may reduce Earnings Per share an
the investment required by employee may not be affordable.

Restricted stock option plans out rightly grants shares to employees but with restrictions to
sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares
as restrictions lapse taxed as ordinary income. The firm usually awards shares without cost.
The employee can sell the stock (for which he or she paid nothing) but is restricted from doing
so for say 5 years. The advantage of this is that the plan aligns employee interest with the
shareholders interest and no investment is required by employee.

Performance share/units grants contingent shares of stock or a fixed cash value at beginning
of performance period; the employee earns a portion of grant as performance goals are hit.
Therefore shares are awarded for the achievement of predetermined financial targets, such as
profits growth or earnings per share

Advantages Disadvantages
• Aligns executives and shareholders if • Charge to earnings, marked to
stock is used. market.
• Performance oriented. • Difficulty in setting performance
• No executive investment required. targets
• Company receives tax deduction at
payout

Appreciation rights permits the recipient to exercise the stock option (by buying the
stock) or to take any appreciation in the stock price in cash, stock, or some combination
of these.
 Under Phantom stock plan, employees receive not shares but units that are similar to
shares of company stock. Then at some future time, they receive value (usually in cash)
equal to the appreciation of the “phantom” stock they own

Employee Stock Ownership Plan (ESOP)

An ESOP is a defined contribution employee benefit plan that allows employees to become
owners of stock in the company they work for. It is equity based deferred compensation plan.
Stock allocations are made to the employees account based on their relative pay. Employee
Stock Ownership Plans (ESOP) tend to work better when combined with extensive employee
involvement and problem solving. ESOPs give the organisation greater flexibility in response
to a competitive environment

How does ESOP work?

1. The ESOP operates through a trust, setup by the company that accepts tax deductible
contributions from the company to purchase company stock.
2. The contributions made by the company are distributed to individual employee
accounts within the trust.
3. The amount of stock each individual receives may vary according to pre-established
formulas based on salary, service, or position.
4. The employees may ‘cash out’ after vesting in the program or when they leave the
company. The amount they may cash out may depend on the vesting requirements.
5. When an ESOP employee who has at least ten years of participation in the ESOP he or
she may be given the option of diversifying his/her ESOP account.. This option
continues until retirement age at which time the employee has a one-time option to
diversify up to 50% of his/her account.
6. Employees receive the vested portion of their accounts at termination, disability, death,
or retirement. These distributions may be made in a lump sum or in installments over a
period of years. If employees become disabled or die, they or their beneficiaries receive
the vested portion of their ESOP accounts right away.

Advantages Disadvantages
• Capital Appreciation. Companies • Dilution. If the ESOP is used to
sell some or all of their equity to finance the company’s growth, the
employees and by doing so convert cash flow benefits must be weighed
corporate and personal taxes into against the rate of dilution.
tax-free capital appreciation. This
 allows the owner to sell 100% of his • Fiduciary Liability. The plan
or her company, get money out tax- committee members who administer
free and still maintain control of the the plan are deemed to be
company. fiduciaries, and can be held liable if
• Incentive Based Retirement. they knowingly participate in
Provides a cost-effective plan to improper transactions.
motivate employees. After all, who • Liquidity. If the value of the stock
works harder, owners or employees? appreciates substantially, the ESOP
• Tax Advantages. Enables tax and/or the company may not have
advantaged purchasing of stock of a sufficient funds to repurchase stock,
retiring company owner. With this upon employees’ retirement.
purpose, a company owner may sell • Stock Performance. If the value of
their shares to the ESOP and incur the company does not increase, the
no taxable gain on the sale. A employees may feel that the ESOP is
company owner can sell all or some less attractive than a profit sharing
of the company to the employees plan. In an extreme case, if the
cost free. Owners who sell 30% or company fails, the employees will
more of their company to an ESOP lose their benefits to the extent that
are allowed to "roll-over" the the ESOP is not diversified in other
proceeds into other securities and investments
defer taxation on the gain.
• Company reduces its tax liability.
A company can reduce its corporate
income taxes and increase its cash
flow and net worth by simply issuing
treasury stock or newly issued stock
to its ESOP

ANNUAL BONUSES

Bonus are one time payment based on performance. They have the advantage of not adding
permanently to the base wage and can be given based on their rated or not rated output
measures. Bonuses can also be based on individual or group measures.
Some workers prefer them to merit pay plans because they get the money all at once and it
looks like a large sum. Bonus are more effective because they allow for larger one time award
without the amortized effects of tying pay for performance to base pay.
Most firms have annual bonus plans aimed at motivating short term performance of manages
and executives. Short term bonuses can easily result in plus or minus adjustments of 25%or
more in total pay
There are three basic issues to consider when awarding short-term incentives: eligibility, fund
size and individual awards

i. Eligibility
Most firms opt for broad eligibility – they include both top and lower level managers – and
mainly decide who is eligible in one of three ways:
• Based on job level
• Based on job title
• Based on a combination of factors, including job level/title, base salary, and
discretionary considerations (such as identifying key jobs that have a
measurable impact on profitability) of job level and job title

The size of the bonus is usually greater for top level executives. Thus an executive can earn
80% of his or her salary as bonus, while a manager in the same firm earns 30% and a supervisor
only 15%

ii. Fund size

The firm must also decide the total amount of bonus money to make available.

Some use a nondeductible formula - they use straight percentage (usually of the company’s net
income) to create the short-tem incentive fund

Other uses a deductible formula – on the assumption that the fund should start to accumulate
only after the firm get a specified level of earning.

Some firms do not us a formula at all, but make the decision on a totally discretionary basis

iii. Individual awards

The third task is to decide on the actually individual awards. Typically, a target bonus (as well
as maximum amount, perhaps double the target bonus) is set for each eligible position, and the
actual award reflects the person’s performance

The firm:
• Computes performance rating for each manager
• Computes preliminary total bonus estimates
 • And compares the total amount of money required with the bonus funds.
• If necessary, it then adjust the individual bonus estimates

One question is whether managers will receive bonuses based on individual performance,
corporate performance or both. Here again, there is no hard- and- fast rule. Firms usually tie
top level executive bonuses to overall corporate results, but as one moves further down to the
chain of command, the corporate profits become a less accurate gauge of a manager’s
contribution and therefore makes more sense to tie the bonus to individual performance

Many firms tie short term bonuses to both organizational and individual performance. This is
done through a split-award method, which breaks the bonus into two parts. The manage gets
two separate bonuses, one based on his or her individual effort and one based on the
organizational overall performance. One drawback to this approach is that it may give marginal
performers too much – for instance, someone could get company based bonus, even if his or
her own performance is mediocre.

One way to get around this is to use the multiplier method. This method make the bonus a
product of individual and corporate performance where by if your individual performance is
excellent you get a higher percentage bonus for the excellent company performance ( more
percentage of individual bonus and more percentage of corporate bonus). The mediocre
performer may not bet anything from the company performance bonus.

Whichever approach you use, the rule is: don’t pay outstanding performers less than their target
reward, regardless of organizational performance, and pay them substantially higher reward
than you do other managers. The company cannot afford to loose these people.Conversely,
marginal or below average performers should get nothing
LECTURE 7: EMPLOYEE BENEFITS AND SERVICES

While competitive basic salaries strategically make companies attractive to talents in the
employment market, superior benefits should have the strategic purpose of making employees
loyal to the company. Why give benefits? In many companies, management’s primary reason
for granting certain benefits is that it is required by law. In these firms, the minimum legal
requirements are complied with.
Other companies give a little more than the minimum benefits required by law in order to be
competitive or at least be at par with community or industry practices. There are also employers
who give more benefits than required out of compassion for employees who are loyal to the
company. Benefits are a major expense to the companies of today and translate to about 41%
of the payroll . This lecture topic is to help you weigh the pros and cons of various employee
benefits plans. We shall discuss four main types of benefit plans; Supplemental pay
benefits(pay for time not worked) Insurance benefits, Retirement benefits, and employee
services.

Meaning of benefits

These are the indirect financial and non-financial payments employees receive for continuing
their employment in the company. They are elements of remuneration given in addition to
various forms of cash pay. Benefits are in form of differed or contingent pay in that they are
given subject to an event occurring. Benefits include things like health and life insurance,
pension, time off with pay, meals etc. Payment for time not worked represents the biggest
chuck of benefits payment, followed by legally requirement payments like retirement,
insurance and severance pay

In developing benefits plans, employers must address a number of policy issues. These
include:
• Why are we giving the benefits – what are the objectives?
• What benefits to offer?
• Who receives coverage?
• Whether to include retirees in the plan
• Whether to deny benefits to employees during probationary period
• How to finance benefits
• The degree of employee’s choice in determining benefits
• Cost-containment procedures
• How to communicate benefit options to employees

7.1.Objectives of a benefit scheme

The objectives of employee benefits policies and practices in an organisation might be:
i. To increase the commitment of employees to the organisation
 ii. To provided for actual or perceived personal needs of employees including those
concerning security, financial assistance and the provision of assets in addition to pay
such as company cars.

iii. To demonstrate that the company cares for the needs of its employees; to ensure that
an attractive and competitive total remuneration package is provided which both
attracts and retains high quality staff

iv. To provide a tax efficient method of remuneration which reduces tax liabilities
compared to those related to equivalent cash payment

Note that these objectives do not include ‘to motivate employees’ because unlike incentives,
benefits seldom have a direct and immediate effect on performance unless they are awarded
as an incentive. Benefits can however, create more favourable attitudes leading to increase
long term commitment and better performance

Types of benefit plans

We shall discuss four main types of benefit plans
• Supplemental pay benefits(pay for time not worked) such as sick leave and vacation
pay
• Insurance benefits (such as workers compensation
• Retirement benefits (such as pension
• Employee services (such as child care facilities)

PAY FOR TIME NOT WORKED (SUPPLEMENTAL PAY)

This is generally the employer’s most costly benefit because of the large amount of time off
that many employees receive. Common time off with pay include holidays and vacations,
compassionate leave, sick leave, sabbatical leave, maternity leave, retirement leave and
compensation for laid off or terminated employees

7.1.1.1.Leave/Vacations and holidays

The number of paid employee’s vacation days varies considerably from employer to
employer. But on average in Kenya it is between 24 – 30 days per year.
In addition to the time off, some organisations give leave allowances, transport allowance for
the leave etc.

In either the paid vacation or paid for time off (PTO) situations, employees would have to
request the time off in advance, except for emergencies. The time can typically be taken in
half-day increments. The time is accrued on a monthly or quarterly basis and banked until the
employee uses it. If the employee leaves the job, the employee is usually paid for the banked
time. Whether to allow unused vacation days or PTO to carry over to the following year is up
to the employer. Some companies allow a certain number of days to carry over, but any days
over that number are lost. Others allow employees to get special permission from their
managers to carry over days with the stipulation that they be used by a certain date the
following year
Most companies provide paid holidays for all of their employees. These are typically New
Years day, Independence Day, Labor Day, Easter, Christmas Eve, and Christmas day.

7.1.1.2.Sick leave
Sick leave provides pay to employees when they are out of work due to illness. Sick leave
policies grant full pay for a specified number of sick days and for some organisations sick
leave can be extended on half pay beyond the allowed number of days.
In general, no employee should be given leave until its clear what the leave is for. If one
leave is for medical or family reason, the employer should obtain medical certification form
the attending physician or medical practitioner.

7.1.1.3.Severance pay
Most employers provide severance pay – a one time payment when terminating an employee.
Severance pay makes sense on several grounds;
• It is a humanitarian gesture and good public relations
• In addition, most managers expect employees to give at least one or two months
notice if they plan to quit. It is therefore seems appropriate to provide one or two
months severance pay if an employee is being dismissed.

Severance pay can be given in lump some or it can be given in form of salary continuation
(either full or a fraction) over a period of time

INSURANCE BENEFITS
Most employers also provide a number of required or voluntary insurance benefits such as
workers compensation and health insurance.

Worker compensation
The compensation for injuries is determined under the Worker Injuries and Benefits Act 2007
which aims to provide sure, prompt income and medical benefits to work related accidents
victim or their dependants, regardless of fault. Employers are advised to insure their
employees for this with insurance companies.

Workers compensation benefits can be monetary or medical. In the event of a workers death
or disablement, the person’s dependants are paid a cash benefit based on prior earning. If the
injury causes a specific loss (such as an arm), the employee may receive additional befits
based on the statutory list of losses even though he or she may return to work. In addition to
these can benefits; the employer must furnish medical, surgical, and hospital devices as
required by the employee

For workers’ compensation to cover an injury work related illness, one must only prove that
it arose while the employee was on the job. It does not matter that the employee is at fault; if
the person was on the job when injury occurred, he or she is entitle to workers compensation.
Health, hospitalization insurance.

Health and hospitalization insurance looms large in many peoples choice of employer,
because such insurance is so expensive. Most employers, especially large and medium size
ones therefore offer the employees some type of hospitalization, medical and disability
insurance along with life insurance, these benefits form the cornerstone of most benefits
programs. Hospitalization, health and disability insurance helps protect against
hospitalizations costs and loss of income arising from off-the-job accidents or illness.

Many employers purchase the insurance from the insurance companies, Health Maintenance
Organisation (HMOs) or preferred provider Organisation (PPOs).

Most employers offer membership in a Health Maintenance organisation ( HMO) as a

hospital/medical option. The HMO itself is a medical organisation or hospital consisting of
specialist (surgeons, psychiatrist, and so on) operating in a health care centre. It provides
routine round the clock medical services as well as preventive medicine in a clinic type
arrangements to employees who pay a nominal fee. The HMO also receives a fixed annual
fee per employee form the employer (or employer and employee) regardless of whether it
provides that person service

Preferred provides organisations (PPOs) are cross between HMOs and the traditional
doctor patient arrangement. They are “groups of health care providers that contract with
employers, insurance companies, or third party payers to provide medical services at reduced
fee. Unlike HMOs (whose relatively limited list of health providers are often located in one
health care centre) PPOs let employee select provides, (like doctors) form a relatively wide
list, and see them in their offices. The providers agree to provide discounts and submit to
certain utilization controls, such as on the number of diagnostic test then can order.

Most health insurance plans provide at least basic hospitalization and surgical and medical
insurance for all eligible employees at group rate. Medical insurance is generally available to
all employees regardless of health or physical condition. Most basic medical insurance plans
pay for hospital room and board, surgery and doctor’s fee, medial expenses and drugs. Some
also provide major medical coverage to meet the high medical expenses resulting from long-
term or serious illness. The law does not allow for discrimination of medical benefits by the
employer

Most employers also sponsor insurance plans that cover health related expenses like eye care
and dental. In most employer sponsored dental and optical plans, there is a limit as to how
much the employee can spend. Other plans include, life insurance plans, benefits in case of
accidental loss of limbs or sight

Caught between rising health benefits costs, many mangers find controlling and reducing
health care cost high on their agenda. As a result, many employers have been changing their
medical plans to do the following:

• Move away from the 100% medical cost payment and include a deductible

• Increase annual deductible

 • Require medial contribution. Most employers require employees’ contribution to their
medical premium

• Use a gatekeeper. Using general practitioners as gatekeepers to channel patients to

their appropriate specialist and/or hospitals is very effective in reducing cost

• Encourage preventive healthcare e.g. sponsor drug and alcohol abuse programme,
fitness classes, first aid, mammograms, prostrate exams,

• Form health care coalitions

• Manage the cost of AIDS

Life insurance

In addition to hospitalization and medical benefits, most employers provide group life
insurance plans. As with health insurance, employees can obtain lower rates in a group plan.
And group plans usually accept all employees regardless of health or physical conditional.
The life benefit is usually based on one salary and can be something like two 2 years of one
salary

RETIREMENT BENEFITS

The retirement’s benefits include social security funds, and employer pension plans. In
Kenya the social security fund is managed by National Social Security Fund ( NSSF)

7.1.1.4.Social security

Social Security provides benefits on retirement under the social security act. The employer
makes a statutory contributions and the employee makes another contribution. The money is
only accessible after retirement or at age 60 and above. Or after death, the dependants can
access the benefits

The mission of the National Social Security Fund is to provide basic social security services,
and welfare support, to all workers in Kenya. This includes providing workers with financial
security in retirement, as well as providing them with basic security against contingencies
such as employment injury, illness and/or disability and death.

In order to become an NSSF member, you will have to register with NSSF. Once your
employer is registered with NSSF, he/she is also required to ensure that his/her regular
workers register with NSSF.

Members are eligible for this benefit when they reach the age of 55 or whichever is the
retirement ages, or when they ultimately retire from regular paid employment subject to a
minimum age of 50 years.
In case of death of an employee, the s benefit is payable to the
survivor(s)/dependant(s) relative(s) of a deceased member. The dependant relatives qualify
for this benefit in the following order:

i. The husband/wife of the deceased member

ii. All children irrespective of age or gender (if the husband/wife of the deceased member
is also deceased, or if the deceased member was a single parent). Children who are
minors will be paid through bank accounts or confirmed guardians.

iii. The parents of the deceased (if the deceased member was not married and had
no children).

iv. Sisters/brothers of the deceased (if the deceased was single, had no children, and both
parents are deceased).

v. The guardian to the children of the deceased member (where both the parents
are deceased and all the deceased members’ children are minors).

vi. An applicant who has letters of administration (where all dependants are exhausted).
In case of invalidity the benefits are paid to:
a) members who are certified to be permanently incapable of working because of physical or
mental disability

b) members who are at least 50 years of age and suffer from a partial incapacity of a
permanent nature that prevents them from undertaking employment

PENSION PLANS

Pension plans provide income to individuals in their retirement. The employer provides
pension for several reasons:

Some of these reasons are:

i. There is a perceived moral obligation to provide a reasonable standard of post-

retirement living for employees, especially those with long service. A similar logic
extents to pensions for dependants on a current or retired employees death
ii. A good pension scheme demonstrates that the employer has the long term interest of
employees at heart
iii. A good scheme may help to retain and straight high quality staff
iv. Pensions can be tax efficient form of remuneration. This was is especially a
significant issue when personal rate of income tax are higher than the rate on pension
pay
Pension plans can be classified in three basic ways:

i. Contributory versus non contributory

In a contribution plans each of the parties, the employee and the employer contributes
various portions to the pension fund. Under the non contributory plan only the employer
contributes to the pension fund

ii. Qualifies versus unqualified plans

Qualified plans are designed to offer individuals added tax benefits on top of their regular retirement
plans, Employers deduct an allowable portion of pretax wages from the employees, and the
contributions and the earnings then grow tax-deferred until withdrawal. Non-qualified plans are those
that are not eligible for tax-deferral benefits. Consequently, deducted contributions for non-qualified
plans are taxed when income is recognized. This generally refers to when employees must pay
income taxes on benefits associated with their employment.The main difference between the two
plans is the tax treatment of deductions by employers, but there are other differences.

iii. Defined contribution versus defined benefits plans.

With defined benefit plans, the employee know ahead of time the pension benefit he or she
will receive. The defined benefits itself is usually set by a formula that ties the persons
retirement pension to an amount equal to a percentage of the persons pre retirement pay ( for
instance, to an average of his or her last five year employment), multiplied by the number of
years he or she worked for the company

Defined contribution plans on the other hand specify what contributions the employee and
the employer will make to the employees retirement or savings fund. Here, in other words,
the contribution is defined, not the pension. The employer’s pension promises to the
employee is expressed as a contribution formula, typically expressed as a percentage of salary
the contributions are invested and the money used at retirements

With a defined benefit plan, the employee knows that his or her retirement benefit will be
upon retirement. With defined contribution plans, the person’s pension will depend on the
amount contributed to the fund and or the retirement funds investment earning.

Defined contribution plans are increasingly popular among employers today because of their
relative ease of administration, favorable tax treatment and other factors

EMPLOYEES SERVICES

While time off, insurance, and retirement benefits account for the lions share of the benefits
cost, most employers also provide services, including educational subsidies, meals, company
car, loans etc.
Employers also offer personal services such as SACCO facilities and management,
negotiated loans and loan grantees, counseling, social and recreational opportunities, bulk
purchases, educational loans and subsidies such as tuition refunds, employee assistance
programmes such as counseling and or treatment of problems such as substance abuse and
stress, employee transportation and food services – let employees purchase meals at relatively
low prices

7.2.TRENDS IN BENEFIT PLANS

In the last few decades, changes have occurred in the way companies are providing some
benefits. Some noteworthy trends are in the way pensions are being management and the
flexibility of pension plans. Below are some trends

Early retirement windows

Many firms today, faced with the need to reduce workforces, are offering early retirement
window and voluntary separation arrangement. Under. the Early-retirement windows,
specific employees, often 50+ are eligible to participate. The window means that for a limited
time, the company opens up the opportunity for employees to retire earlier than usual. The
financial incentives is generally a combination of improved or liberalized pension benefits
plus cash payment

Portability of pensions

Today’s needs for flexible staffing and the realities of ongoing corporate restructuring are
also prompting employers to make their pension plans more portable. That is making it easier
for employees to take their retirements income when they leave and roll it over into a new
employer’s savings plan. Employers do this by switching form a defined benefit to defined
contribution plans, since the former are more appropriate for employees who plan to stay
with the firm until retirement.

FLEXIBLE BENEFITS PLANS

“Flexible benefits” is a blanket term for employers giving employees more control over their
reward package without the employer incurring extra costs. The approaches different
employers have taken to flexible benefits are varied:

• Introducing new ‘voluntary’ or discounted benefit funded by the employee out of

post tax income or by salary sacrifice;
• Varying up or down the level of existing benefits ( e.g. holiday or cars) with a
compensating adjustment to cash pay
• Redefining the benefits package in terms of a ‘flex fund’ to be spent as the employees
determines

There is a trend towards building flexibility into benefits programmes by letting employees
choose the benefits options they prefer. According to one study, employees’ age, marital
status and sex influence his or her choice of benefits. For example, younger employees
significantly favoured a shorter working week. Married workers showed more preference for
the pension increase. Secondly, each benefit plan must include certain required items – for
example social security, workers compensation etc. The implication of the cafeteria approach
is that employees can make midyear changes to their plans if, for instance, their dependent
case cost rise and they want to divert more contributions for this expense

The main business drivers for flexible benefits are to:

• Meet the increasingly varied needs of today’s diverse workforce

• Increase the perceived value of the package by targeting expenditure into areas
selected by employees
• Aid recruitment and retention (flexible benefits will normally be preferred by
employees to fix benefits of equivalent value)
• Reinforce cultural change – for example. Flexible benefits can reduce status divisions
between grades or be used to encourage greater personal responsibility among
employees
• Position the employer as flexible and forward looking in its approach to manage
people
• Tie in with a range of other people initiatives designed to make HR processes more
flexible, for example: performance-related salary increments; Broad banding, job
families, flexible working hours
• Provide leverage to the employer’s purchasing power to benefit employees and thus
secure loyally
• Highlight the aggregate value of the package
• Respond to employee’s demands
• Take advantage of tax advantages for certain benefits
• Employees can choose the package that suits them best and the firm can adapt to
workers changing needs

• Flexible programmes also make it cheaper to introduce new benefits, since the
employer doe not have to lock them in for all employees

• In the case of a merger, flexible benefits can be relatively inexpensive way of

harmonizing terms and conditions

Disadvantages of flexible benefits

Flexible benefits could be disadvantageous in several ways:

• Employees may make bad choice and find themselves not covered for emergencies
• The administrative costs for such plan can be burdensome
• Employers have to price and periodically update each employee’s package, so even a
medium sized firm should computerize the administration of its plans