As a business grows, one of its many challenges is identifying a competitive yet manageable compensation structure. After all, offer too little and you likely will not have much success in hiring. Offer too much and you may compromise cash flow and profitability.

But the challenge does not end there. Once you have a feasible compensation structure in place, your organization must then set its course for determining the best way for employees to progress through it. And this is when you must contemplate the nature and efficacy of linking pay to performance.

Issues in play

Some observers believe that companies should not use compensation to motivate employees because workers might stop focusing on quality of work and start focusing on money. In addition, employees may feel that the merit, or “pay-for-performance,” model pits staff members against each other for the highest raises.

Thus, some businesses give uniform pay adjustments to everyone. In doing so, these companies hope to eliminate competition and ensure that all employees are working toward the same goal. But, if everyone gets the same raise, is there any motivation for employees to continually improve?

Two critical factors

Many businesses do not think so and do use additional money to motivate employees, whether by bonuses, commissions or bigger raises. In its most basic form, a merit increase is the amount of additional compensation added to current base pay following an employee’s performance review. Two critical factors typically determine the increase:

1. The amount of money a company sets aside in its ‘merit’ budget for performance-based increases — usually based on competitive market practice
2. Employee performance as determined through a performance review process conducted by management

Although pay-for-performance can achieve its original intent — recognizing employee performance and outstanding contributions to the company’s success — beware that your employees may perceive merit increases as an entitlement or even nothing more than an inflation adjustment. If they do, pay-for-performance may not be effective as a motivational tool.

Communication is the key

The ideal solution to both compensation structure and pay raises will vary based on factors such as the size of the business and typical compensation levels of its industry. Nonetheless, to avoid unintended ill effects of the pay-for-performance model, be sure to communicate clearly with employees. Be as specific as possible about what contributes to merit increases and ensure that your performance review process is transparent, interactive, and understandable. Contact us to discuss this or other compensation-related issues further.