Incentive Plans: Definition

Incentive plans are used by companies to keep employees motivated. These plans rely on the power of incentives to affect employee behavior.

When incentives are aligned through the use of incentive plans, this encourages employees to perform their tasks with more effort and efficiency.

Advantages of Incentive Plans

In the context of factories, the following advantages typically arise after the introduction of incentive plans:

  • Increase in the rate of production per unit of time; if fixed overheads are high, this may result in considerable savings per unit of production
  • Both employers and employees benefit from the incentive plans
  • Appropriate incentive schemes reduce absenteeism and labor turnover
  • Incentive plans keep the management team alert

Setting Up Incentive Plans

When setting up an incentive plan, the following steps should be carefully considered:

First, the basis of payment should be decided.

Second, the plan must be considered in light of its impact on productivity, cost reduction per unit of product, provision of real inducement, and the practicable incentive bonus earnings.

Third, the plan should be discussed with the shop foremen and workers union.

Fourth, the plan should be introduced with maximum clarification to the workers.

Finally, for a period of three or four months after the introduction of the incentive plan, results achieved must be evaluated to ensure the following:

  • That productivity has actually increased
  • That labor cost and overhead of production per unit have decreased
  • That overall wages have increased and that employees are satisfied.

Basic Principles of Incentive Plans

The following principles must apply to all incentive plans:

First, incentive plans must increase both wages and productivity, despite the fact that employees work the same number of hours as before. As a result, incentive plans create a win-win situation for workers and employers.

Second, bonus payments must be tied as closely as possible to the efforts of workers.

Third, standard production must be within easy reach of an average worker.

Fourth, payments should be made immediately on completion of work.

Finally, incentive plans should be simple, which enables workers to calculate their own projected earnings easily. The plan should also be finished with the approval of the unions if necessary.

Types of Incentive Plans

There are four types of incentive plans:

  1. Premium bonus plan
  2. Profit-sharing and co-ownership
  3. Group incentives
  4. Indirect incentive plans

These plans are discussed below:

1. Premium Bonus Plan

Under premium bonus plans, the time taken to complete a job is fixed based on a careful time analysis.

If a worker performs a job in less time than the average time taken, they receive a bonus for the time saved in production.

Thus, in a premium bonus method of incentives, a time allowance (TA) is given, the time taken is recorded, and a bonus is paid on the basis of time saved (TS).

It is important to remember that this method relates to bonuses (extra payment), while basic pay and allowances remain undisturbed. The formula, therefore, for an employee’s total remuneration (TR) is:

TR = Normal wages + Bonus based on time saved

If no time is saved, then the worker does not earn a bonus. In this case, they are entitled only to normal wages.

Methods to Calculate Premium Bonus

Different methods are available to calculate the payment of bonuses to workers for time saved in production. The relevant formulas are given below.

(a) Halsey Premium Plan
Under this plan, between 50% and 100% of the time saved in production is paid to the worker. If half the time saved is allowed as a bonus, the premium bonus will be:

Bonus = 1/2 time saved x Hourly rate of wages

(b) Halsey Weir Plan
In this plan, the bonus is restricted to one-third of the time saved. That is to say,

Bonus = 1/3 time saved x Hourly rate of wages

(c) Rowan Plan
Under this plan, the bonus amount payable to the worker is determined by the following formula:

Bonus = (Time taken / Time allowed) x Time saved x Hourly rate of wages

2. Profit-Sharing and Co-ownership

Profit-sharing involves making payments to employees of a prescribed proportion of the company’s trading profits.

Co-ownership relates to the plan under which employees may own shares in the company.

Both profit-sharing plans and co-ownership aim to make employees the partner in the enterprise. Workers must decide whether they want to be well-paid risk-free labor or treated as risk-sharing partners.

3. Group Incentives

Some production works can’t be completed by a single worker, hence requiring a group. In these cases, group incentive plans are created and members of the group decide between themselves how to share the bonus.

In group incentive plans, teamwork is essential. Generally, group piece-rate is offered with guaranteed monthly or weekly wages in plans of this kind.

 4. Indirect Incentive Plans

In a direct incentive plan, workers are induced to apply more effort to produce a larger number of units during the same time through direct incentives.

However, there are also indirect incentives that make service in a company attractive. These indirect plans include:

  • Supervisory incentive plans based on departmental or shop output and cost-savings, etc.
  • Pension, gratuity, and provident fund schemes
  • Annual bonus paid after the end of the company’s financial year
  • Group insurance schemes
  • Assisted travel, housing facilities, promotion prospects, and training, etc.
  • Participation in profits

Frequently Asked Questions

What is incentive plan?

Incentive plan may be defined as an arrangement between the employer and employees, under which employees are given share in the profits or receive some other economic benefits.

What are the advantages of an incentive plan?

Advantages of incentive plans for employers include increased productivity, reduced turnover, less supervision, and a better work environment. The advantages for employees include participation in profits, participation in management of the business, possible ownership of a portion of the company, and a higher salary than that paid to workers who do not receive incentives.

What are disadvantages of an incentive plan?

Incentive plans create extra responsibilities for employees and may lead to tension between workers who receive incentives and those who do not.

How is an incentive plan different from a bonus?

An incentive is a payment made to an employee for achieving a specific goal, whereas a bonus is paid without regard to whether or not the goal has been achieved.

Why are incentive plans popular?

Incentive plans are popular because they offer a number of advantages to both employers and employees.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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