A comparative view of unions, involvement and productivity

There is room for performance pay, but it does not necessarily succeed in a vast majority of cases

 

By John S. Heywood

 

Introduction

Recent years have witnessed the individualisation of employment relations in many countries, and an integral part of this process has been the increased use of performance pay. Unions in many countries have historically objected to performance pay for theoretical, moral and practical reasons. Yet the transformation to high performance workplaces and increased market competition have ‘demanded’ performance pay as a response. While substantial variation exists across countries, it is clear that unions are increasingly accepting performance pay as a reality, and participate in its creation, design and enforcement. The employment relations systems that allow for this participation will reap the benefits.

The thesis of this paper is not that performance pay is a panacea or even that it necessarily succeeds in the vast majority of cases. Instead, it proposes: that room exists for more performance pay in most industrial democracies; that on average there are net benefits to such schemes; and that those benefits tend to be larger and more likely when workers are involved in the process.  As a consequence, unions in several countries have begun to work towards performance pay that makes sense for workers and provides value to firms.

There is room for more performance pay

The suggestion that additional performance pay might be welcomed by workers is based on two sets of empirical findings.  First, in the abstract, workers would like to have their pay based on performance to a greater extent than prevails currently.  Second, the job satisfaction of those workers actually receiving performance pay is typically greater than those who do not receive performance pay.  Let me turn to each of these findings.

In an international survey, workers from a wide variety of countries are asked to describe the setting of their earnings in two ways:  one, the determinant of their earnings that they think should be the most important; and two, the determinant of their earnings that they think is actually the most important in practice. The extent to which performance is identified as the most important desired determinant varies substantially across countries (with the US at the highest) but a general pattern emerges. Within most countries, more workers identify that performance should be the most important determinant than they identify that it is the most important determinant. This is one indicator of the room for greater emphasis on performance.

This international survey evidence is matched by detailed within-firm studies and by matched employer-employee surveys. Korea presents a particularly dramatic example.  Korean workers were asked to identify the variation in earnings they thought would be appropriate for the best and worst performing worker doing the same type of work within their firm. The resulting figure of more than 25 per cent was then compared with the actual differences within the workers' firms as reported by the relevant human resource managers. That figure was only about 7 per cent for non-managerial workers.

In a slightly different approach, a representative sample of Korean workers were asked to allocate 100 points across a series of potential earnings determinants as a method of expressing their preferences on how pay should be set. They allocated around 30 points to performance with others to education, tenure and so on. The human resource managers were asked to allocate 100 point across the same series of earnings determinants to describe how pay is actually set in the workers firms.  Only a handful of points (less than 10) were allocated to performance.

The Korean case is interesting because the use of performance pay has typically been fairly low, but has been increasing as employment relations are becoming more individualised.  Also important is that more than two-thirds of Korean workers want more say in how earnings are set, even if the overall level of compensation remained the same.

The second body of research suggests that those who work under performance pay tend to have increased job satisfaction. A series of studies in Australia, the UK, Korea, Germany and the US broadly indicate that in cross-sectional studies, holding other determinants constant, those workers with performance pay have higher job satisfaction. In the US data, people who were paid tips, commissions, stock options or bonuses reported higher job satisfaction, even controlling for total pay. Women paid piece rates report no difference after controlling for pay. For men, piece rates are associated with lower satisfaction, after controlling for pay but not before. Controlling for pay is important, as it suggests that the higher earnings associated with performance pay is not the only source of increased satisfaction.

Longitudinal studies of job satisfaction have been done in the US and UK. These studies control for the characteristics unique to each worker in the sample. In essence, they examine the change in job satisfaction as specific workers move between jobs with and without performance pay. In these studies, performance pay continues to be associated with greater job satisfaction.

The point of reviewing these studies is not to suggest that workers will always be pleased with performance pay. Surely, bad performance pay schemes are worse than none at all.  The point is to suggest that, on average, workers tend to accept the idea that pay and performance should be linked. Moreover, the extent to which they would like to see this linkage often exceeds the extent to which it actually happens. Even after encountering performance pay with all of its potential pitfalls, the typical worker is not dispirited and, if anything, is motivated and reports greater job satisfaction. Thus, I take as a starting point that there will often be scope for more well-structured performance pay.

The promises and pitfalls of performance pay

Performance pay is associated with higher earnings. This is apparent in both cross-sectional and longitudinal data. Moreover, other elements of compensation such as fringe benefits are not substantially reduced. Thus, overall compensation increases in response to performance pay. Behind this increased compensation is the increase in productivity that is usually associated with performance pay. The nature and cause of increased productivity varies by type of performance pay, but I will suggest some of the variations that exist.

In a well-known study of a windscreen installation company, the increased productivity from a new piece-rate scheme came from two sources. First, the scheme attracted more productive workers. Second, retained workers responded to the incentives and increased their productivity. It is important to note that just because productivity may increase, profit need not always increase and it is not suggested that piece rates work everywhere.  In some cases, more sophisticated performance pay – emphasising teams or multiple objectives – may be needed. 

Indeed, these alternative pay schemes have been associated with internal flexibility.  Researchers have found an association between performance pay (especially team-oriented pay) and flatter hierarchies, shorter decision times, fewer rules, greater worker responsibility and greater ease in reallocating resources within the firm.

Even more generally, performance pay is recognised as part of an overall appraisal system. The purpose of such appraisal, reinforced by performance pay, is to better allocate workers to jobs, to make promotion and retention decisions, to guide worker development and engage workers in organisational goals.

Finally, performance pay (especially profit sharing) is associated with labour costs that vary over the business cycle. This reduces both redundancy and unemployment.  Moreover, the reduced probability of separation has been shown to imply longer employment relations and greater investment in worker training.

As even such a cursory review indicates, the use of performance pay has great potential to benefit both workers through greater earnings and firms through greater productivity and potentially profits. Yet, performance pay comes with the risk of substantial pitfalls as well. Again, the pitfalls vary by the type of scheme but it is worth presenting a short itemisation.

Individual performance pay runs the risk of rewarding only one or a few of the many productive activities that firms want workers to engage in. The resulting ‘adverse specialisation’ means that workers allocate too much effort to those productive activities that are highly rewarded and require the least effort. Thus, workers paid by the piece may ignore product quality, safety, maintenance or customer relations. Any worker paid performance pay or given promotions based on individual performance may also have little or no incentive to help co-workers, such as providing informal training.

A merit pay system that attempts to recognise these problems has advantages but brings its own problems. Managers may concentrate on only recent performance. They may also be strategic in their rewards and use of the system. For example, rewarding only those who support the manager, or attempting to signal to the manager's superiors that all workers are above average or that none deserve promotion, and so on. Finally, there is US evidence that racial and ethnic characteristics may play an independent role in performance appraisal. 

Group schemes have uncertain consequences but it is well known that workers may free-ride on the efforts of others, causing the direct incentive to be greatly diminished. Even when peer pressure reduces such free-riding, the peer pressure itself can be so substantial that worker utility is reduced by the scheme.

Again, even such a brief review suggests the ways in which performance pay can malfunction. Indeed, several commentators suggest that performance pay is an expensive undertaking that only succeeds in making everyone unhappy. Yet the real issue is how to maximise the evident potential from performance pay and minimise the equally evident pitfalls.

Worker involvement as an element of success

In thinking about the use of performance pay, Germany provides an interesting illustration. German manufacturing has an extremely high incidence of piece rates and performance pay. It does so in the production of high value products which compete in a world market based largely on their quality. On the face of it, this might seem unlikely.  The reason it prospers is, at least in part, due to the institutions of worker involvement.  The German works councils are given statutory codetermination over the creation and management of piece rates. The consequence is that German workplaces that have works councils are both more likely to have such performance pay and the schemes last longer than in workplaces without councils. The performance pay systems can be made transparent to workers and can be independently verified. As such, there is reduced fear of ratchet effects in which the rate is arbitrarily decreased as workers put forth greater effort.

The German experience is not unique. Even within the more decentralised environment of labour relations in North America, there is evidence that performance pay (gain sharing, in particular) is more likely, generates more productivity and is longer lived when a union is present and involved in the creation and administration of the plan. In addition, more information is shared when compared to either a non-union establishment or one in which the union is not involved. In general, workers have valuable information that may help in the creation of effective performance pay. In addition, worker organisations can create confidence in the process of their establishment and the fairness of their administration.

As a consequence of these types of interactions, it is not suggested that every union (or workers' organisation) will object to performance pay. Certainly, in examining the empirical evidence on the determinants of using piece rates or individual performance pay, there is simply not a uniform negative relationship with unionisation. Across the US, the UK, Korea, Germany and Australia, the typical estimated coefficient on unionisation as a determinant is insignificantly different from zero. This does not mean that some unions are not greatly opposed. It simply means that others are more receptive.

Indeed, it may be fair to suggest that in Europe there has been a growing acceptance among unions of the need for performance pay and the need for unions to be involved in them. The Italian Confederation of Workers' Unions stresses the importance of second-level agreements below the sectoral level that deal with performance pay as an important issue related to competitiveness. Danish, Swedish and Norwegian unions are credited with ‘essentially accepting variable pay’ as a norm, on the condition that it is transparent and regulated. Irish unions are ‘strongly in favour of variable pay’ provided that similar conditions are met. They see performance pay as a way of securing a fairer share of gains and an effective way of making ‘workers as stakeholders.’   

Even in Korea, there have been calls for reinvigoration of the labor-management committees to deal with issues of performance pay. The point is that worker institutions need to be sufficiently strong to become meaningfully involved. A routine and secure way for workers to be involved in the creation of how they are paid is needed. This involvement has the best chance of increasing the potential and decreasing the pitfalls associated with performance pay.

Conclusions

There exists room for additional use of performance pay from the perspective of workers.  Performance pay has the potential to increase the earnings of workers and the surplus for firms. Yet, poorly designed or implemented performance pay can have severe and negative unanticipated consequences. The earnest involvement of workers can help reduce the chance of these consequences. For such involvement to take place, labour market institutions must be allowed meaningful involvement in the creation, administration and alteration of performance pay schemes.

It seems apparent that the use of performance pay around the industrialised world will increase, and the issue is the extent to which such pay will be top-down or, instead, be collaborative. It is the latter that has a greater chance of long-term success in a wider variety of workplaces. 

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A condensed version of the Miegunyah Public Lecture delivered at the University on 1 August 2007.

Professor John Heywood is Professor of Economics and Director of the Graduate Program in Human Resources and Labor Relations at the University of Wisconsin-Milwaukee.  The author thanks Michelle Brown and Uwe Jirjahn for their friendship and recognises the debt owed to his joint work with each in developing this paper.


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