Stop using differentiated salaries

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Most companies today uses differentiated salaries for their employees. This is something that is in general considered to be the way it must be; the companies needs the system in order to attract and keep talent employees to secure future profits for the business. This was also my belief until a few years ago; I thought that companies should pay more to the ones that produce more value to the business. Even if I saw cases where I thought people got too big salary increases and others too low at the annual salary review, I believed that in the long run the salaries would reflect the true values of each employee.

But during the last few years I have started to think differently. I do not believe in differentiated salaries any more, at least not for knowledge work like product development. There is too much evidence that the system you need to have in order to enable salary reviews each year, is impeding the progress of the business and lowers its result and profit. Knowledge work is based around motivated employees that have the support and environment they need to be creative during their daily work. Appraisals system, which is needed to implement differentiated salaries, is demotivating for the employees instead, and is therefore working against the high performance of the organization. Also, differentiated salaries is created under the belief that it is external motivations that drive people to be high performers, but as Pink describes in his book, Drive, it is autonomy, mastery and purpose that motivates people, i.e. intrinsic aspects instead.

This is also like Dr. Deming says in his book Out of the Crisis:

Evaluation of performance, merit rating, or annual review… The idea of a merit rating is alluring. the sound of the words captivates the imagination: pay for what you get; get what you pay for; motivate people to do their best, for their own good. The effect is exactly the opposite of what the words promise

My own experiencealign to this as well, both as an employee and as a manager, where I personally have witnessed the negative effect the system has had on its people and the company.

Implicit or explicit appraisals systems

All companies that I have worked at have used differentiated salaries, but the systems that decides the salary increases have varied quite a lot. Since all differentiated salaries are built on some kind of appraisals, all companies have them, but they may either be an implicit or explicit part of the performance review.

  • Implicit appraisals system: At one company the manager tried to observe the employees by himself and used one-to-one meetings with each employee once a year in order to decide on the salary increase. This meeting was a negotiation between the employee and the manager where both sides presented their point of view and argued for a specific salary increase. This system was very efficient and had a low direct cost impact on the company. But it was highly subjective and based on each individual’s capability to argue for his or her sake.
  • Explicit appraisals system: In another company we had a very thorough process during the year with several feedback gatherings and performance reviews. The managers used the system to grade each employee and used that as a basis for calculating the different salary increases. This system was less subjective but had a high cost impact on the company. The managers spent quite a lot of their time on the performance reviews throughout the year, and all employees had to spend time at least twice a year to write feedback to their peers and managers.

My own experience as an employee

I have always been considered to be a high performer. In companies with appraisals I got high grades in general. I appreciated it, but I didn’t put too much attention on the grade since I loved my work and always did whatever I could do to make the projects successful anyway. Then when I was promoted to manager and principal developer, I entered another grading level where it was much tougher to get high grades at the reviews. This may be ok, if you have more responsibilities but also higher expectations on you, then it should be tougher to get the top-level grades. But what bothered me a lot was that the performance review was used for motivating a specific grade rather than to give me honest and concrete feedback about my performance. At one occasion, the only feedback I got, beside a lot of very positive feedback, was that I needed to improve my presentation skills. The problem was that I hadn’t done any presentation during the evaluation period! Due to this my motivation was always a bit lower before and after the performance review; I knew that I wouldn’t learn anything new from them.

My own experience as a manager

As a manager I put quite a lot of effort into making the reviews as valuable as possible for my employees, and I really tried to make the grades as fair as possible. I spent a lot of time during the year in order to understand the employee’s daily work. I also did my best to write down feedback to the employees, both to help them grow as professionals, and as a use to motivate the different grades. But two things were very clear for me during this process.

  • No matter which motivation I put forward in the synchronization meeting with the other managers, I could not give the grade I wanted to give. The organization normalized the grade distribution, and even if I thought that most employees in my group had done a great job during the year, I had to push down several grades due to the normalization.
  • No matter how much energy and time I spent trying to understand my employees daily work and performance, I always missed a lot of important aspects. In some cases I really missed central parts, which made me pick an unfair grade at the end. You could argue that I was incompetent as a manager, but my belief is that this was due to the serious errors in the underlying assumptions of the performance appraisals.

Main errors

There are a lot of research describing the negative impact appraisals have on both individuals and organizations. Below I list a few of them. At the end of this post I list a few books that I highly recommend reading if you are interested in the subject.

  • The system controls performance. According to Deming, 94% of performance outcomes are attributable to the system. Everything from training, work environment, support provided to the employees and organizational culture has a huge effect on the employee’s performance.
  • Performance is an emergent property from all people included in a system and the interactions between them. It is impossible to pinpoint the performance of one person in a team since it depends on the interaction between all team members, and you cannot see for sure who is the source of someone’s high performance.
  • All categorization and rating is biased from ones own background, values, experience and preferences. A programmer that has worked a lot in waterfall methodologies as a specialist, will rate people differently from a coach with a long experience in Agile. And, none of them would have a valid and correct rating of the target.
  • Most people think they are high performers but only a small part of them will be rated as being that. One study found that 98% of people saw themselves in the top half of all performers. Another study showed that 80% of people saw themselves in the top quarter of all performers. Performance reviews systemize demotivation for the employees.
  • As is noted in Robert Austins book about measuring performance in organisations; measuring systems introduce costs that must be taken into account. This cost is often neglected without any real ROI calculation of what the appraisals system give the organisation in the end.

I had one-and-one meetings with my group throughout the year as a way of coaching and helping my employees, but also as a preparation for the reviews. I wanted to understand their daily work so that I could motivate the grades at the end of the year. At that point of time I liked the one-and-one meetings, but now I believe that they are just a way of implementing the control and appraisals system. Without the appraisals, the manager could spend more time on the floor helping the teams communicate and collaborate with each other. The managers could do Gemba walks to understand what’s happening instead. The doors should of course be open if any employee has something they need to discuss, but it should be up to the employees to take the initiative instead of the managers mandating the meeting every second week or every month.

Conflicts with Agile values

The performance review also conflicts with the agile values and will therefore work against a successful implementation of Agile thinking in the organizations.

For example, the appraisals system’s focus on individual accountability compared to the agile perspective on collaborative teams. Also, the organizations tries to use the appraisals system to motivate people by extrinsic incentives through controlling structures, but Agile is based on self-organization, emerging structures and intrinsic motivation.

Finally, there is a clear distinction between how you optimize your organization. The appraisals system is based on the belief that you optimize it by focusing on the individuals, which is like optimizing the parts of the system. Agile focus on optimizing the whole instead, where the employees work on team structures, interaction between teams and systematic issues in the organization that are stopping a high performance in the projects and teams.

What to do instead?

The root problem is the differentiated salaries. If you do not have it, then you do not need the appraisal system. I therefore think companies should employ job-based salaries. Everybody with the same kind of job or title should get salary increases according to a mathematical formula. For example, it could increase a lot in the beginning when you are new at the position, but after that, the slope decreases year after year, according to a predefined transparent formula.

Another use of the appraisals is to use it in order to promote employees to new positions. This is a highly subjective and biased way to reward people in the organization, and we would benefit a lot by eliminating it, even if it hadn’t anything to do with appraisals. Instead, the companies could let all employees apply for new positions, positions that are published by the managers because they are needed, not because they want to reward someone they like. This would remove some of the subjectively selection criteria where the managers selects the employees that they think deserves a promotion.

When you have removed the appraisal system, the managers can change focus to work on the system instead, and to look for systematic issues that impede the organization from increasing its performance. And, they can spend more time coaching the employees in their professional career, and to make sure they have the environment they need to be creative and productive. There may grow an honest and healthy relationship between the employees and the managers where the employees could be transparent about their work without the risk of being negatively assessed at the annual review.

I will in future blogs write more in detail about why performance reviews and individual based salaries are damaging. Stay tuned!

Litterature

For those who are interrested, I recommend you to read the following list of books, and blogs, to get more information regarding the systematic problems with differentiated salaries and the appraisals system.

15 Comments

  • 1
    2012-01-12 - 16:25 | Permalink

    I understand this from a consultant standpoint. Differentiated salaries definitely cause systemic problems within organizations and I’ve yet to experience a ‘review’ process that’s actually useful.

    I’m not sure I agree with job-based salaries. That seems to imply people are robots and perform equally. The Agile Warrior has a great post about “rice pickers and samurai’s” http://agilewarrior.wordpress.com/2010/08/20/are-you-a-samurai-or-a-rice-picker/

    From my experience there are always team members who go above and beyond their ‘job’ responsibilities and there are those who use their job title as a defence mechanism to avoid blame or responsibility. I’ve actually heard some of these people say things like “I’m a senior developer, I don’t do that” regardless if “that” is something the customer desires.

    Given the rice-picker vs samurai analogy, I think exceptional people should be rewarded and I can see damage to the system being created when a samurai is making the same money as a rice-picker.

    I have read about peer-driven salaries and transparency of everyone’s salaries. I can’t remember where I read about it but it did sound interesting. A manager can’t possibly do effective reviews because they are not seeing first hand what the team members are doing.

    • 2
      2012-01-15 - 14:55 | Permalink

      Thanks for the comment 🙂

      I have to admit that the thought of job-based salaries is a tough one and i’m willing to think differently if I just get evident of a better alternative to todays differentiated salaries and the system it brings on the organisations. So far I haven’t seen any other alternative that eliminates the root problem the system brings on you. I think that peer-driven salaries is an interesting alternative, but I do believe that you will get a lot of the same problems in that system as well.

      Most large organizaton will have a few exceptional employees, and those people should be rewarded. But, by definition, it can not be that many that are exceptional, right? So therefore I think it is sub-optimzing to organize the salary system around the exception; we should organize it around the normal case, where we in reality have very small chances of setting fair and right salaries. You should reward the exceptional people and if they are exceptional, all other employees recognize them as so, and will therefore also agree on their recognition they get from the organization.

      I do not agree with you that a job-based salary system would imply that people is robots or perform equally. I believe that a combination of job-based salaries with a focus on respecting people and given them an environment to growth and perform the best they can, is just he opposite; it is a system where we can see the individual an let everybody find their way tot bring value to the organization and their customers.

      I read the post about samurai and rice pickers, and I must say that I do not really like the description. I belive it is systematic reasons in most cases that creates “rice-pickers”, not due to individual laziness or ignorance on their professional duties. So far I have only met a really small number of individuals in our field that didn’t do their best to give value and to perform the best they could. I the cases people haven’t performed well I have seen organizational problems and command and control systems that have pushed down peoples lust to perform well. So, if we have a few samurais an a lot of rice pickers in the organization, then I believe it is the managers highest priority to ask themselves what in their system and the way they manage it, creates the low performers, and then change it accordingly.

  • 3
    Johannes
    2012-01-14 - 03:09 | Permalink

    Amen! I agree on all points. I’ve put some thought in the question why we are so good at rewarding individual effort and equally lousy at rewarding collective dito. I lean towards a “least resistance” theory: management do it because it’s easy, not necessary because it’s the best thing to do. Changing a system is hard. Promoting one individual’s behavior is easy. Not least important, we live in a culture where we see individuals, and not the system. Systems thinking is counter intuitive to many of us for that reason. I would appreciate seeing more examples of companies that really create an environment taking in account for example the findings of intrinsic motivation, described by Daniel Pink. I imagine that such a company might have models with little variation in salary, or that the level for each individual is set to get the question if money “out of the way” (a level that can of course vary from person to person ), rather than connected to an individual goal or KPI.

    • 4
      2012-01-15 - 16:40 | Permalink

      Hi Johannes, and thanks for your comment 🙂

      I agree with what you write, that we live in a culture where we see individuals instead of the systems. Differential salaries is buried so deep down in our culture that it is very hard to see how we can manage to have another kind of system. I wish more managers studied system thinking since it opens your eyes and makes you see things from another angel than before.

  • 5
    Simonas Razminas
    2012-01-19 - 22:42 | Permalink

    Actually, I prefer to agree on salary with employee individually. At the end you are paying salary to the individual, right? But let’s start from the beginning. Performance review – I also try to make them as much valuable as possible for my employees. But why do people want to use grades? And another question: what should this meeting serve for? Personally I find it useful for feedback. No grades are required. I can provide my feedback w/o grades. Actually it is necessary to give feedback quite often (in best case scenario it could be instant). A special review once a year (or once a quarter, or event based; I would prefer the last one when I will find a way to apply it) could be held in order to raise our heads up and have a higher level overview. So I see this meeting as an environment for feedback.
    I like to treat compensation as a totally separate meeting and topic. Just because this is a different topic and because I use it for totally another purpose. What is your purpose for those meetings? Employment is a win-win cooperation, right? Employee creates value to company and company returns it back in another format. So I see compensation serving to satisfy employee while he satisfies the company (manager). So how could compensation be the same for all? People have different needs and behave differently. They do different work. This is where transparency and intensive communication and interaction becomes so important. Otherwise manager cannot see and understand if employee is doing a good job. And manager must follow his employees as much as possible.
    I see no reason why (contribution to) team success could not be a part of compensation meeting. Just take anything what you as manager find as a value to consider.
    Of course, in this case scenario honest managers are required. But who said that you can create a perfect system which could not be damaged by bad manager?
    Just to make sure: we are talking about GenY people here, right?

    • 6
      2012-01-24 - 17:59 | Permalink

      Hi Simonas, and thanks for your comment 🙂

      I see and understand your reasoning about this, but this is what I do not think will work without causing problems in the organization, problems that may be difficult to see and link to the performance reviews and differentiated salaries, but that are there anyway. You talk about having the performance review meeting and the compensation meeting seperated from each other. I cannot see that this changes the situation in any way. You still need to decide on the differentiation, right? And, even if you do not use explicit grades that you communicate to the employees, you still need to have implicit grades since you otherwise will not be able to decide on the compensation for the different employees, or how do you decide on which of the employees to give more compensation on and which to give less or none?

      My point in the post is that no matter how transparent your organization is, you will get problems that are linked to the salary system. No matter how many talent employees you have you will always have some that are under the average and some above, and just a few percent that are exceptional. This is pure statistics. So, by applying this system, on an organization with only high performers, more than 80% of them will be unsatisfied by the compensation; so why continuing with such a bad system with such a low return of investment?

      Regards
      Anderss

  • 7
    Simonas Razminas
    2012-01-31 - 21:29 | Permalink

    Hi Anders,

    I am looking forward to hear more about the problems are caused based on your experience. I haven’t faced or linked one myself.

    I don’t use grades neither explicit neither implicit. I provide and ask for explicit feedback. Some things are measured some not. Different areas and topics are touched for different people. That is how I run performance reviews. Regarding compensation: I do ask people what are their expectations and background for it and then I check if it makes sense or not. This is because I do care to fulfill expectations of employees (in terms when it is possible and meaningful). The situations I had (comparing salaries between people and their outcome) may look not fair. But the point is: fair from statistical point of view is not my goal. My goal is to make people happy and motivated and rewarded according their expectations when it makes sense. What is yours?
    To notice: I don’t use appraisal system. Unless one: ad-hoc.

    I do really agree on you about the talents and high performers, but why 80% of high performers will be unsatisfied?

    I would also like to ask you about transparent formula you propose: how do you add attitude, team spirit and other similar attributes there? How do you get values for such attributes? How complicated formula is? How does it make most of people to be happy? Does it calculate salaries usually above people expectations? I have seen more than one formulas for this, but never saw one working well.

    I might missed something, but I am eager to understand your position and experience. Thanks!

    • 8
      2012-02-02 - 12:24 | Permalink

      Hi Simonas

      I suppose we have worked in quite different kinds of companies with both different cultures as well as HR systems. In the companies that I have worked in we have had a defined pot to divide between the employees. And the goal has been to normalize the distribution in some way so that most of the people got a similar raise and that the high performers and the low performers got a larger and and a smaller raise respectively. In this system it is very difficult to reach the goal that you describe; that you reward your employees according to their expectations. It’s very nice if you have that option, and it will remove some of the problems described in the post.

      And, its nothing wrong for managers to have performance reviews. My point is that it is often more effective if you push the feedback down to peer-to-peer feedback instead of going through the manager. But, you could of course have both peer-to-peer feedbacks and discussions between the manager and their employees to work on the longer perspective.

      Regarding the 80%; as I wrote in the post I have read research which shows that most people think about themselves as high performers. If you have a salary system and/or a grading system which pushes the majority of the people to the average level, you systemize negative feelings and effect on the employees since most people will not get the grade or salary they expect from their performance. But again, if you may meet your employees true expectations this may not be a problem for you.

      Since I believe we are motivated by internal drivers instead of by external ones, like monetary rewards, I would like to have a transparent formula based solely on the number of years in a specific position. You as a manager should then focus on the system to create an environment that is motivating and encourage a team focus and on other values that you strive for in the organization. The salary system needs to be simple and transparent to remove the focus on it and instead get everybody focusing on working together to create value for their customers.

      Regards,
      Anders

  • 9
    Simonas Razminas
    2012-02-03 - 14:19 | Permalink

    Hi Anders,

    Finally I see a consensus! 🙂 Now it all makes sense. Thanks for your explanations.
    It seems the pot made our targets different. At least different priorities for same of the goals. It is neither bad neither good. It is different. Actually Looking forward to hear more on that in next articles!

  • 10
    2012-03-21 - 16:00 | Permalink

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