Motivating Employees through Extrinsic Rewards - Principles of Management

Extrinsic rewards come in many forms, but pay and benefits are clearly at the top of the list. In fact, pay and benefits are ranked as two of the most important features in the employment relationship. The reason for this importance is that a paycheck is more than a form of exchange in the employment relationship. It also conveys status, accomplishment, self- esteem, and power. Financial rewards serve four specific objectives: membership and seniority, job status, competencies, and task performance.


Membership- and seniority-based rewards (sometimes called “pay for pulse”) represent the largest part of most paychecks. Some employee benefits, such as free or discounted meals in the company cafeteria, remain the same for everyone, whereas others increase with seniority.

Many Asian companies distribute a “13th month” bonus that every employee expects to receive each year. These membership- and seniority-based rewards potentially attract job applicants (particularly those who desire predictable income) and reduce turnover. However, they do not directly motivate job performance; on the contrary, they discourage poor performers from seeking work better suited to their abilities. Instead the good performers are lured to better-paying jobs. Some of these rewards are also “golden handcuffs” that can undermine job performance because employees resent being held captive by high pay in a job they dislike.


Almost every organization rewards employees to some extent based on the status of the jobs they occupy. Job evaluation is commonly used to rate the worth or status of each job, with higher pay rates going to jobs that require more skill and effort, have more responsibility, and have more difficult working conditions.

Organizations that don’t rely on job evaluation indirectly reward job status based on surveys estimating what other companies pay specific jobs. A senior engineer typically earns more than, say, a purchasing clerk because the work performed by the engineer is worth more to the organization. It has more value (calculated by a job evaluation system or pay survey), so employees in that job receive more statusbased rewards in the organization. People in some higher-status jobs are also rewarded with larger offices, company-paid vehicles, and exclusive dining rooms.

Job status–based rewards create a reward system that employees believe is fair. They also motivate employees to compete for promotions. However, when companies are trying to be more cost-efficient and responsive to the external environment, job status–based rewards potentially do the opposite by encouraging bureaucratic hierarchy. These rewards also reinforce a status mentality, whereas Generation-X and Generation-Y employees expect a more egalitarian workplace. Furthermore, statusbased pay potentially motivates employees to compete with each other and to raise the value of their own jobs by exaggerating job duties and hoarding resources.


Many firms have shifted from job status–based rewards to competency reward systems. The National Health Service (NHS) in the United Kingdom is a recent example. Every job in the NHS is now described in terms of its required skills and knowledge. Employees receive annual pay increases through a wide pay band (range from lowest to highest pay for that job) based on how well they meet the job’s skill and knowledge requirements. Skill-based pay is a variation of competency-based rewards in which employees are rewarded for the number of skill modules mastered and, consequently, on the number of jobs they can perform.

For instance, Marley Cooling Tower Co. in Olathe, Kansas, has about 30 skill modules (skills required for specific jobs) in its production operations. Employees earn the base pay rate for being able to work in one job, but they earn more as they learn other skill modules. Two employees performing the same job would receive different pay rates based on how many skill modules they have mastered. Those who master all 30 modules earn almost three times the base rate because they can perform any job in the production area.

Competency-based rewards improve workforce flexibility by motivating employees to learn a variety of skills and thereby perform a variety of jobs. Product or service quality tends to improve because employees with multiple skills are more likely to understand the work process and know how to improve it.

Competency-based rewards also reward employees who continuously learn skills that will keep them employed. One potential problem is that measuring competencies can be subjective, particularly when described as personality traits or personal values. Skill-based pay systems measure specific skills, so they are usually more objective. However, they are expensive because employees spend more time learning new tasks.


Performance-based rewards have existed since Babylonian days in the 20th century BC, but their popularity has increased dramatically over the past couple of decades. Real estate agents and other salespeople typically earn commissions, in which their pay increases with sales volume. Piece rate systems reward employees based on the number of units produced. For example, Eurofresh crop workers in Arizona get paid by the volume of tomatoes picked; lawn care employees at The Lawn Mowgul in Dallas, Texas, earn a form of piece rate (called “piecemeal”) based on the number of lawns cut.

Many employees receive pay increases or bonuses based on a performance appraisal . Performance appraisal, which we describe in more detail later, is a systematic process of evaluating an employee’s performance. Increasingly, employees are finding larger parts of their total paychecks determined by team more than individual results.

Forward Media, an enterprise software consulting firm in Sydney, Australia, is an example. “We have seen individual incentive programs fail,” says James Ward, who cofounded the company with his wife and employs a few dozen people. “We set a group revenue target for each team, then give people a bonus according to the profit their team achieves.”

Rather than calculating bonuses from team sales or profit, gainsharing plans award bonuses based on cost savings and productivity improvement. John Deere switched to gainsharing a few years ago because its previous individual incentive plan discouraged cooperation and coordination even though jobs were highly interdependent. Under the gainsharing plan, each team at the farm machinery manufacturer has a benchmark work-hour standard to assemble a part, such as an engine or combine attachment.

If the team assembles the part in less time, it receives some of the cost savings as a bonus on top of regular wages. As John Deere has learned, gainsharing plans tend to improve team dynamics, knowledge sharing, and pay satisfaction. They also create a reasonably strong link between effort and performance because much of the cost reduction and labor efficiency is within the team’s control.

Organizational Rewards Along with individual and team-based rewards, many firms rely on organizational-level rewards to motivate employees. Profit-sharing plans calculate bonuses from the previous year’s level of corporate profits. ISG employees in Indiana receive checks for each quarter that the steelmaker (part of Mittel Group) earns a profit.

The profitsharing plan is restricted to union members; but ISG’s managers receive stock options that give them the right to purchase stock from the company at a future date at a predetermined price up to a fixed expiration date. If the stock rises above the predetermined price, employees can buy the stock and reap the windfall. One senior ISG manager had an option to buy stock at $2.76 per share. The manager exercised some of that option when the stock rose to $30, resulting in a hefty bonus that year.

Employee stock ownership plans (ESOPs) encourage employees to buy company stock, usually at a discounted price or with a no-interest loan. Employees are subsequently rewarded through dividends and market appreciation of those investments. Approximately 10 percent of the private sector U.S. workforce participates in an ESOP. Sears Roebuck and UPS are two of the earliest companies to distribute shares to their employees.

A fourth organizational-level reward strategy is the balanced scorecard (BSC) . BSC is a goal-oriented performance measurement system that rewards people (typically executives) for improving performance on a composite of financial, customer, and internal processes, as well as employee factors. The better the measurement improvements across these dimensions, the larger the bonus awarded.

For instance, KT ( formerly Korea Telecom) relied on BSC to transform the former government owned telephone company into a more competitive business after privatization. “It guided our employees with clear direction and balanced perspectives,” says Song Young-han, KT’s executive senior vice president. “By gathering all the employees around BSC, we were able to concentrate our foundation for the performance-oriented organization culture.”

How effective are organizational-level rewards? ESOPs, stock options, and balanced scorecards tend to create an “ownership culture” in which employees feel aligned with the organization’s success. Balanced scorecards have the added benefit of aligning rewards to several specific measures of organizational performance, but they are potentially more subjective and require a particular corporate culture to be implemented effectively.

Profit sharing tends to create less ownership culture, but it has the advantage of automatically adjusting employee compensation with the firm’s prosperity, thereby reducing the need for layoffs or negotiated pay reductions during recessions. The main problem with ESOPs, stock options, and profit sharing (less so with balanced scorecards) is that employees often perceive a weak connection between individual effort and corporate profits or the value of company shares. Even in small firms, the company’s stock price or profitability is influenced by economic conditions, competition, and other factors beyond the employee’s immediate control. This low individual performance- tooutcome expectancy weakens employee motivation.


Not all extrinsic rewards involve giving employees money. In fact, many firms are discovering that some of the most valued and effective extrinsic rewards don’t cost much money at all. “Five to 10 percent of employees leave a company because of money,” explains Christopher Owen, CEO of Meriwest Credit Union in San Jose, California.

“Most of the time it’s because they don’t feel they are being recognized.” Ed Ariniello, vice president of operations at G.I. Joe’s, a sports retailer in Oregon and Washington, goes out of his way to find opportunities to praise employees for a job well done. “I do a lot of walking around patting people on the back,” says Ariniello. “When [other managers and I] do that, the employees feel great.”

The challenge of recognition is to “catch” employees doing extraordinary things. Keyspan Corporation chairman Bob Catell resolves this by regularly asking managers for lists of “unsung heroes” at the New England gas utility. He calls an employee every week, often spending the first few minutes convincing the listener that it is really him.

Approximately one-third of large American firms rely on peer recognition to motivate employees. Among them is Yum! Brands, Inc., the parent company of KFC, Taco Bell, and Pizza Hut. Yum! managers created a system in which employees reward colleagues with “Champs” cards—an acronym for KFC’s values (cleanliness, hospitality, and so on).


Many extrinsic rewards—particularly individual-level performance-based rewards—have come under attack over the years for discouraging creativity, distancing managers from employees, distracting employees from the meaningfulness of the work itself, and being quick fixes that ignore the true causes of poor performance. Although these issues have kernels of truth under specific circumstances, they do not necessarily mean we should abandon performance-based rewards. On the contrary, the top-performing companies around the world are more likely to pay for performance.

Reward systems do motivate most employees, but only when these systems assign higher rewards to those with higher performance. Unfortunately this simple principle seems to be unusually difficult to apply. In one recent large-scale survey, fewer than half of Malaysian employees said they believe their company rewards high performance or deals appropriately with poor performers.

A Gallup survey at an American telecommunications company revealed that management’s evaluation of 5,000 customer service employees was unrelated to the performance ratings that customers gave those employees. “Whatever behaviors the managers were evaluating were irrelevant to the customers,” concluded Gallup executives. “The managers might as well have been rating the employees’ shoe sizes, for all the customers cared.”

How can managers more accurately evaluate employee performance? Although appraisals will always have a degree of subjectivity, there are ways to minimize this problem or get around it altogether:

  1. Use more objective measures of performance . One of the best pieces of advice is simply to rely on more objective indicators of employee performance than performance appraisals. Some companies have switched from traditional appraisals to output measures such as units delivered or number of people served per hour. Objective measures often occur at the team and organizational level, so companies pay individuals a fixed rate and award bonuses for measures of team performance or organizational profits. This approach gets rid of the performance appraisal altogether, at least for determining financial rewards.
  2. Use anchored performance appraisal instruments . Where performance appraisals are necessary (that is, if no objective measures are adequate or available), then managers should use anchored appraisal methods. One form of anchor is goal setting, where employees are expected to complete a specific set of objectives before the next appraisal. ACUITY switched from its subjective system of rating employees to a more objective one in which employee performance is evaluated against mutually agreed goals. Compensation that was previously disconnected from supervisor ratings is now tied more closely to goal achievement. The other form of anchoring is to label performance appraisal rating forms with specific examples so raters have a better understanding of what good or average performance means for each dimension of performance.
  3. Use multiple sources of performance information . An increasingly popular way to improve the accuracy of performance appraisals is through 360-degree feedback.
    This process involves receiving information from a full circle of people around the employee, including subordinates, bosses, coworkers, people in other departments (internal clients), and sometimes external clients. Research suggests that 360-degree feedback tends to provide more complete and accurate information than feedback from a supervisor alone. It is particularly useful when the supervisor is unable to observe the employee’s behavior or performance throughout the year. Lower-level employees also feel a greater sense of fairness and open communication when they are able to provide upward feedback about their boss’s performance. On the downside, 360-degree feedback systems can be time-consuming, produce conflicting and ambiguous information, and encourage politics as employees curry favor from people who will rate them.
  4. Use performance appraisal training . To some degree, performance appraisal accuracy can improve when managers receive various forms of training. Rater error training attempts to reduce perceptual biases by raising awareness of these problems and encouraging raters to avoid them. Performance dimension training attempts to familiarize raters with the meaning of the performance dimensions on the rating instrument. Performance standards training is sometimes called “frame-of-reference” training because it tries to establish a common frame of reference among the raters. This is achieved by presenting samples of job performance along with some indication of the level at which that performance should be rated on the performance evaluation instrument.

The more objective the method of evaluating employee performance, the stronger will be the performance-to-outcome expectancy, which in turn increases employee motivation.

More objective rewards also address another important issue: the extent to which employees believe they are being fairly rewarded. Thus our final topic under extrinsic rewards is equity theory.


Patti Anderson came from a family of Boeing engineers, so she was proud to also work as a manufacturing engineer at the aerospace company’s commercial airplane division in Renton, Washington. But that pride evaporated when Anderson discovered that the men in her family earned more than she did at Boeing for performing the same work. “My husband, brother, and dad also performed the same job as me, and each was paid more than me and consistently received higher raises than I,” said Anderson in a legal statement. “I know this because I saw their pay stubs.”

Patti Anderson’s feelings are explained through equity theory , which says that feelings of equity or inequity occur when employees compare their own outcome/input ratios to the outcome/input ratios of other people. The outcome/ input ratio is the value of the outcomes you receive divided by the value of inputs you provide in the exchange relationship. Anderson probably included her skills and level of responsibility as inputs.

Other inputs might include experience, status, performance, personal reputation, and amount of time worked. Outcomes are the things employees receive from the organization in exchange for the inputs. For Anderson, the main outcomes are the paycheck and pay raises. Some other outcomes might be promotions, recognition, or an office with a window.

Equity theory states that we compare our outcome/input ratio with a comparison other. In our example, Anderson compared herself with her male family members and likely other men who worked in the same jobs at Boeing.

However, the comparison other may be another person or group of people in the same job, another job, or another organization. Some research suggests that employees frequently collect information on several referents to form a “generalized” comparison other. For the most part, however, the comparison other varies from one person to the next and is not easily identifiable.

Feelings of equity or inequity arise from a comparison of our own outcome/ input ratio with the comparison other’s ratio. Patti Anderson felt underreward inequity because her male counterparts received higher outcomes (pay) for inputs that were comparable to what she contributed at Boeing.

Anderson probably would have had feelings of equity if she received the same pay and other outcomes for performing the same work. The third condition, overreward inequity, occurs when people realize they are paid more than others with the same inputs (skills, effort, and the like) or when they receive similar outcomes even though they provide lower inputs (such as getting paid the same as someone who is far more skilled and talented than you are).

Watching Executive–Employee Pay Ratios Over the past few decades many employees have been experiencing feelings of inequity due to the widening pay gap between staff and top management. What is a fair level of pay for corporate executives? Plato (the Greek philosopher) felt that no one in a community should earn more than five times the lowest-paid worker. In the 1970s management guru Peter Drucker suggested that 20 times the lowest worker’s earnings was more reasonable.

John Pierpont Morgan, who in the 1800s founded the financial giant now called J.P. Morgan Chase, also warned that no CEO should earn more than 20 times an average worker’s pay. That advice didn’t stop William B. Harrison Jr., the current CEO of J.P. Morgan Chase, from receiving $15 million to $20 million in pay, bonuses, and stock options for each of the past few years. That’s more than 700 times the pay of the average employee in the United States!

Costco Wholesale chief executive Jim Sinegal thinks such a large wage gap is blatantly unfair and can lead to long-term employee motivation problems. “Having an individual who is making 100 or 200 or 300 times more than the average person working on the floor is wrong,” says Sinegal, who cofounded the Issaquah, Washington, company. With annual salary and bonus of $550,000, Sinegal ranks as one of the lowest-paid executives even though Costco is one of the country’s largest retailers and its employees among the highest paid in the industry.

How Employees Correct Inequity Feelings What happens when employees feel inequitably rewarded? They experience an emotional tension that motivates them to reduce those inequities. Here are the most common ways in which people try to reduce feelings of inequity:

  • Change inputs: Employees either perform at a lower level or subtly ask the better-off coworker to do a larger share of the work to justify his or her higher pay or other outcomes.
  • Change outcomes: Employees might increase their own outcomes by asking for a pay increase or making unauthorized use of company resources. They might reduce the coworker’s outcomes by asking the boss to stop giving favorable treatment to the coworker.
  • Change perceptions: Sometimes employees whisk away feelings of inequity by eventually believing the coworker really is doing more (such as working longer hours) or that the higher outcomes (perhaps a better office) he or she receives really aren’t so much better after all.
  • Leave the situation: Employees have a few ways to remove themselves from the inequitable situation. They might quit or transfer to another job where rewards are more equitably distributed. Those who can’t leave might keep away from the office where the coworker is located, take more time off work, or psychologically withdraw from the job (make it less important in their life).

Managing the Reward Process Fairly Equity theory is good at predicting the perceived fairness of pay and other rewards in a variety of situations, particularly if managers get to know their employees’ needs and keep communication channels open so employees can complain when they feel decisions are unfair.

However, managers also need to pay attention to fairness in the process of reward distribution. This process includes the mechanics of deciding how to allocate valued resources (such as paychecks and preferred office space) and in how employees are treated throughout this process.

How do managers improve fairness in the process of distributing rewards and resources?

A good place to start is by giving employees “voice” in the process—encouraging them to present their facts and opinions to whoever is allocating the resource. Managers also need to remain unbiased, rely on complete and accurate information, apply existing policies consistently, and listen to the different views held by those affected by the resource allocation decision. Employees are also more likely to feel that decisions are fair if they have the right to appeal the decision to a higher authority.

Finally, people usually feel better when managers treat them with respect and give them a full explanation of decisions. If employees believe a decision is unfair, refusing to explain how the decision was made could further inflame those feelings of inequity.

Extrinsic rewards are important, but they aren’t the only thing that motivates employees. “High performers don’t go for the money,” warns William Monahan, CEO of Oakdale, Minnesota –based Imation Corp. “Good people want to be in challenging jobs and see a future where they can get even more responsibilities and challenges.” Rafik O. Loutfy, a Xerox research center director, agrees with this assessment.

“Our top stars say they want to make an impact—that’s the most important thing,” he says. “Feeling they are contributing and making a difference is highly motivational for them.” In other words, Imation, Xerox, and other companies motivate employees mainly by designing interesting and challenging

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