Definition of Incentive
Incentive in simple terms is something that encourages a person or organization to do or achieve something. It is something that incites or has a tendency to incite a determination. This is usually given in cash or in kind.
In business, the objective of incentive is to increase employee productivity, improve industrial and interpersonal relations, and as result increase the overall profit of the organization.
Types of Incentives
Incentives can be generally classified as financial (monetary) incentives and non-financial (non-monetary) incentives.
1. Financial (Monetary) Incentives
Financial incentive pertains to those incentives which are in the form of money or can be measured in monetary terms. This is sometimes referred to as monetary benefit offered to consumers, employees, and organizations to encourage behavior or actions which otherwise would not take place.
These incentives can be given on an individual or group basis and satisfy the monetary and future security needs of individuals. It lifts the eagerness and self-confidence of the employees thus, resulting in better productivity and performance.
The most commonly used financial incentives are:
Pay and allowance salary is the basic incentive given to every employee to work efficiently and effectively in an organization. This includes the basic pay, dearness allowance, clothing allowances, house rent allowances, and other similar allowances. It is paid most commonly monthly.
Typically, employees are given annual increments in their basic pay and allowances depending on the employee’s performance during the year.
- Bonus
It is a sum of money added to the basic salary or wages on a seasonal basis, as a reward for a good performance. Many companies offer bonuses during the festivals of Diwali, Christmas, New Year, etc.
- Productivity linked Wage Incentives
This refers to performance-linked compensation given to increase productivity. Wage incentives are offered to employees to make them perform beyond the accepted standards.
For example, a manufacturing worker is paid 50 dollars per item if he produces 50 items a day but if he produces more than 50 items a day, he is paid 5 dollars extra per item. Thus, on the 51st item, he will receive 55 dollars.
- Profit-Sharing
It is an incentivized compensation program in which an employee receives a direct share of the company’s profits. The amount granted is normally based on the company’s positive earnings over a set period. This motivates them to perform efficiently and give their best to increase the company’s profits.
- Retirement benefits
Retirement benefits like gratuity, pension, provident fund, leave encashment, etc. provide financial security to the employees upon retiring from the company Hence, they work properly during their term of service.
- Commission
Some companies offer a commission on top of the employee’s salary for successfully hitting targets over a set period. This incentive motivates the employees to increase the client base of the organization.
- Perquisites
Several organizations offer perquisites and fringe benefits such as free accommodation, medical, educational, and recreational facilities, car allowances, etc. in addition to the salary and allowances to their employees. Sometimes, this incidental payment, benefit, or privilege is enjoyed as a result of one’s position.
- Co-partnership/Stock Option
Under this incentive system, employees are offered shares at a price that is lower than the market price. This practice helps in creating a feeling of ownership among employees and motivates them to give their all-out contribution towards organizational growth and success.
2. Non-Financial (Non-Monetary) Incentives
These are types of rewards that do not form part of an employee’s pay or cannot be measured in terms of money.
While the monetary and future security needs are important, the fulfillment of an individual’s social, psychological, and emotional needs also plays an important role.
- Status
It is one’s social or professional position. In an organization, this refers to the position in the hierarchy of the organizational chart. Management-level employees have more authority, responsibility, recognition, salary, etc., than those of the rank-and-file employees.
The level of authority and responsibility determine the status of an employee in an organization. Status increases the self-esteem, confidence, and psychological needs of an individual resulting in a motivated attitude at work.
- Organizational Climate
Organizational climate refers to the environmental characteristics of an organization as perceived by its employees. It conveys the impression that people have towards the internal environment of the company within which they work and have a key influence on their performance.
This differs from one organization to another. Several factors may influence the organizational climate of a company, such as organizational structure, individual responsibility, risk and risk-taking, warmth, and support within the company, its tolerance and conflict, and more. A positive organizational climate tends to increase the efficiency of employees at work.
- Career Advancement Opportunity
Organizations have to establish the appropriate skill and career development programs, and even a sound promotion policy for their employees, that serves as a booster for them to perform well and get promoted. Upward progress in one’s career, such as promotion, shows recognition and appreciation of an employee’s work, motivating him to do better.
- Job Enrichment
It refers to the designing of jobs in such a way that it involves challenging and variety of tasks, requiring a higher level of knowledge and skill, more autonomy and responsibility, and more growth opportunities and thus, could also increase employees’ pay. Sometimes, when the job itself is interesting, it already serves as a good source of motivation.
- Job Security
Job security offers future stability and a sense of security among the employees in an organization. Not having to worry about the future gives a sense of enthusiasm at work. While there is an undesirable aspect of this incentive, like employees taking their jobs for granted, the increasing rate of unemployment in our country makes this a great work incentive.
- Employee Recognition Programs
The organization adopts this to raise employee morale, attract and retain key employees, elevate productivity within an organization, and increase competitiveness. This pertains to employers’ initiatives to reward their employees for achievements, new behaviors, anniversaries, and milestones unlocked during their stay in the company.
For example, rewarding the best performer of the month, and announcing and displaying their names on the notice boards, are programs for employee recognition.
- Employee Participation and Empowerment
This refers to the employee’s involvement in decision making on the matters related to them (participation) inducing a sense of belongingness and giving them more autonomy and powers to subordinates (empowerment) to make them feel the importance of their presence and service to the organization.
In a 2009 survey conducted by McKinsey & Company, non-financial incentives were valued as more influential motivators than financial incentives.
The top three financial rewards were performance-based cash bonuses, an increase in base pay, and stock or stock options. The top three non-financial incentives were praise and commendation from an immediate manager, attention from leaders, and opportunities to lead projects or task forces.
- The most popular incentive – praise from the boss
- The second most popular – attention from leaders
- The least popular – stock or stock options
- All three of the non-financial incentives were more popular than the leading financial incentive
According to the survey, the top two incentives are based on getting praise and validation from their immediate supervisors or management. These two elements are considered vital to all dealings, including employee-employer. Commendation and validation should be the focus of non-financial incentives for employees.
Effective Non-financial Incentives
An effective non-monetary incentive for employees directly touches emotions to make the employee feel good, appreciated, and valued.
Investing in the workforce by showing appreciation and recognition in imaginative ways is one of the best ways for companies to retain talented employees and create a sustainable culture of success.
Characteristics of a Good Incentive Plan
The basics of a good incentive plan are:
a. Simple and easy to understand
b. Lessor is not costly to operate
c. Must be discussed with employees before implementation
d. Assist in supervision
e. Able to evaluate employee’s performance
f. Induce cooperation among the employees
g. Encourage workers to perform better
h. Acceptable to employee and employer
i. Ensure sufficient monetary compensation and recognition to employees
j. Ensure reduction in unit production cost
k. Standardized methods of implementation
l. Eliminate distrust between the employee and employer
What is an Accounting-Based Incentive?
An accounting-based incentive is a type of compensation that is offered to corporate executives of business firms based on certain long-term performance indicators such as earnings per share (EPS), capital gains, cash flow, return on assets, return on equity, and gross profits. Accounting-based incentives are part of a performance incentive plan that offers rewards to executives in the form of cash bonuses or company equity or both.
Primary Objective of Accounting-based Incentives
The primary objective of such incentives is to establish the financial accountability of executives over the long term and ensure their involvement in achieving the main goal of company management which is to increase the shareholder value of the company to the highest level possible.
Evaluation of Accounting-based Incentives
This type of incentive gauges the direct contributions of corporate executives in reaching the company’s predetermined earnings targets as well as return on equity (ROE). Typical rewards given to performing executives are cash and company stocks, even employee stock options.
These incentives usually constitute a substantial proportion of an executive’s compensation.
There are three common criteria considered in evaluating the accounting-based incentive:
- Individual salary level of executives
- Assessment of firm-wide performance
- Assessment of performance of particular business units
Advantages and Disadvantages of Accounting-based Incentives
There are many benefits to this practice including the following:
- Tax-deductible bonuses. This incentive is tax-deductible to the company paying them out, thus, offering tax savings.
- No effect on shareholder’s equity. This event does not dilute shareholder equity.
- Align shareholder interests with executive compensation.
On the other hand, there are certain drawbacks to note in the practice of accounting-based incentives as well, such as:
- Complex bonus calculation.
The overall process of bonus calculation becomes highly complex since compensation arrangements often rely heavily on a multitude of performance measurements.
- Selection of types of executive compensation plans.
There exist several types of compensation plans such as long and short-term incentives and stock options. The company management has to identify and choose the plan that best serves shareholder interests.
- Reliability of financial metrics.
Opponents of this practice argue that financial metrics used may not necessarily reflect the changes in the company’s value. In other words, it is likely for a company to indicate an impressive growth in its earnings per share (EPS), while at the same time, using real relative losses or negative real returns to lower the value of the company for its shareholders.
- High-risk decisions.
It is often a risky decision to base executive compensation on the firm’s performance. In the event the executives fail to meet performance targets, the executive may not win a bonus, but still, his or her base salary is spared. Meanwhile, the share price of the company is liable to fail, thus hurting shareholders.
In the past years, businesses have offered accounting-based incentives to their high-performing executives as rewards. While a fair amount of research has gone into evaluating the steady development of performance parameters as well as the definition of commercial success in general, all such studies have concluded that incentive compensation is majorly determined by the success in streamlining employees and executive performance with shareholder objectives and adopting accounting measures as the preferred basis for comparison.
Still, accounting-based incentives are often an arguable subject. Firstly, CEO compensation has shown exponential growth in the past few decades, compared to the pay of typical workers. This has significantly widened the wealth gap between executives and workers, leading to common resentment amongst the latter. Income inequality has been so fiercely discussed by the media in the US and UK that many CEOs from these two countries have declined to accept accounting-based incentives and other similar privileges.
There are some disadvantages of paying performing executives with stocks, such as, these executives are wrongly motivated to focus on short-term events that increase the share price, rather than concentrating on long-term planning and general stability of the business operation.
FAQs
1. What does incentive mean?
Incentive refers to something that motivates someone to do something. In the context of executive compensation, it is usually a financial reward given to executives to encourage them to work harder and achieve specific goals. In business, the objective of incentive is to increase employee productivity, which in turn, should lead to better performance and profitability.
2. What are incentive fees in private equity?
Incentive fees are payments made to private equity firms as a percentage of the profits generated by the companies they have invested in. The incentive fee usually ranges from 20% to 30% and is paid on an annual basis.
3. What are the types of incentives?
There are two types of incentives: financial and non-financial incentives.
Financial (monetary) incentives are payments or rewards that are given in exchange for achieving certain goals or targets. Non-financial incentives are non-monetary rewards, such as awards, privileges, or recognition.
4. What is an example of an incentive?
An example of a financial incentive is a bonus, which is a payment or reward that is given in addition to the regular salary. An example of a non-financial incentive is an award, which is an acknowledgment or plaque given to someone in recognition of their achievements
5. Why are incentives important?
Incentives are important because they motivate employees to work harder and achieve specific goals. This, in turn, should lead to better performance and profitability.
Moreover, incentives help to bridge the gap between employees and executives, by giving employees a sense of what is expected of them and what they can gain by working harder.
