Be it in the trades or the office environment, pay for performance (P4P) programs come in many forms. The three most common — merit, year's end bonuses and long-term incentives — all have positive effects on how people perform. But, those positive effects vary greatly. How you pay workers for performance matters a lot more than you might think.

The Merit Pay Quandary

PayScale did a compensation survey in 2013 and reported that 56 percent of respondents used P4P as their main reason for giving raises. Half of the respondents also said they were dropping their across-the-board increases, with 71 percent using variable pay incentives.

The most common type of P4P is merit pay which increases the base pay for workers who meet or exceed performance goals. Many companies see these as expensive because each round of pay increases leads to higher overhead. This makes it tough to compete with other small businesses that don't offer merit pay or that skirt labor laws. Cost has driven companies across all industries to significantly reduce their merit pay budgets since the 1980s, according to a Cornell University study.

Let's See, How Can We Save Money?

Nowadays, many companies use lump-sum, end-of-year bonuses or long-term incentive plans. The problem is that workers don't view them as valuable as merit raises. A 3-percent bonus at the end of a year doesn't put near as much money in the worker's pocket as a 3-percent pay raise calculated over the long term. And most workers would choose $1,000 now rather than waiting a long time for a bigger bonus. That's even more true given the conditions that employers often attach to long-term incentives.

You set up P4P to improve worker motivation, but that only works to the degree that what you're offering is valued by the workers. Successful P4P programs hinge on a strong link between the financial rewards and the program, according to the study.

But, Is It Money Saved, or Money Spent?

Merit pay is the most powerful. A 1-percent merit pay raise had a 27-percent greater effect than a 1-percent bonus. And, a 1-percent merit raise was 8.5 times stronger than a 1-percent long-term incentive. But, even for merit pay, if the money awarded isn't strongly linked to the idea that you're paying the person for performance, then a merit pay system becomes just another annual raise.

Pay for Performance Has Its Benefits

There is plenty of monetary logic behind P4P. If someone performs better than someone else, then they should get more pay. There's also a motivational factor because the opportunity for reward stimulates people to be more interested in their jobs and in the organization's goals.

For trade contractors who provide services to consumers and businesses, your technicians operate independently as they handle service calls. They make decisions all day long that affect not only their own performance but that of the entire department or company. If the P4P program motivates them, then they will make better decisions about efficiency and timeliness.

There is another side benefit of P4P. When workers are more aware of how their performance affects the whole company, they are more likely to spot inefficiencies. They are also more likely to come up with innovative ideas that improve customer support.

P4P is a cost-effective way to distribute labor dollars because you are spending those dollars where you get the best return. But, it's not all a bed of roses.

You Knew This Was Coming, Too

It's not easy to pay for performance. And once set up and running, there's a minefield of potential problems. Issues begin at the top level of companies. Owners of small businesses in the trades might buy in when presented with case studies and numbers backing P4P, but unless the program's importance is constantly reinforced by those in charge, it's too easy for the program to drift into nothing more than an annual raise program.

Business owners, supervisors, and those in the position of rating worker performance must thoroughly understand the program and their roles in it. They must remain objective and not let personal relationships interfere. They also must become super communicators. They will have to tell people they're not getting raises, and they'll have to tell them why. There's a whole lot more damage than just resentment if this part of P4P breaks down. Resentment builds among workers, manager credibility takes a hit, and people stop supporting the concept.

While P4P helps to distribute labor dollars effectively, that only counts when the company's performance is good. It's harder to justify P4P awards when the company isn't performing well. That's even more onerous if poor management is to blame.

People assess your company's performance based on how your workers perform. It's logical to pay for performance. But, you must know what you're doing, keep the intent directly linked to the awards you give and hold everyone accountable to standards.