Ranking-Based Versus Outcome-Linked Incentive Systems: Designing an Effective Compensation System
Posted: 11 Feb 2019 Last revised: 21 Aug 2019
Date Written: August 20, 2019
Many firms use ranking systems for the employee performance evaluation process, where they reward with higher wages to top performers and lower wages to low performers. However, in some firms, payoffs of an employee depend on the final outcomes of the assigned tasks and not on the relative performance rankings of the employees. Motivated by examples in business practice where some firms implement a ranking-based mechanism, whereas other firms incentivises their employees based on the outcome of the project. We study both incentive mechanisms and find the conditions for practicing/implementing for each of these evaluation systems. Our analysis reveals some important implications for the design and implementation of the above incentive schemes. We find jobs in which the team member's task precision is low, that is, with high probability the effective effort of the employees which contributes to the final task output is low, it is optimal for the firm to implement a project outcome-based incentive mechanism. Further, if the job structure is such that the team member's task precision is very high, it makes sense for the firm to practice a ranking-based incentive structure. In addition, we also find that, if the firm's profitability from serving the projects that require high degree of teamwork is substantial as compared to the projects which just require individual work, it is optimal for the firm to implement a project outcome-based incentive mechanism. However, in case the firm's profitability by serving the projects which are more individual task oriented is very high as compared to projects that require teamwork, it is optimal for the firm to use ranking-based incentive system. Further, we empirically test the insights developed from our analytical model. We find that our empirical results support the developed insights.
Keywords: Ranking-Based Incentive; Outcome-Based Incentive; Task Individualism; Task Precision; Employee Collaboration
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