Staying competitive by transferring pay risks through performance-based compensation

Businesses are shifting the risk of uncontrollable external economic factors such as inflation and downturn away from their fixed nature onto performance metrics that employees directly influence. This has led to a shift toward compensation packages that include a competitive base salary for stability, complemented by performance-linked variable rewards. By emphasising meritocracy and productivity gains, firms can enable employee demands for higher disposable incomes without committing to permanent, company-wide cost escalations that would compel unsustainable price increases and a subsequent loss of market share

My interest in performance-based compensation in Sri Lanka heightened when combating the trickle-down effects of the Global Financial Crisis of 2008 and the end of the civil war in 2009.

The conclusion of Sri Lanka’s civil war in May 2009 ushered in an era of optimism, excitement, and perceived stability. There was great anticipation of a boom in several key sectors, particularly the Tourism Industry. Businesses that had taken risks and weathered the conflict, operating in a sheltered market with limited competition, had enjoyed super profits. This prosperity, coupled with the Government’s push for post-war development, signalled a ripe opportunity for new entrants, both local entrepreneurs and powerful players of global repute.

The rapid influx of these new entrants fundamentally reshaped the competitive landscape. What followed was a classic case of supply outpacing demand growth, especially in industries directly benefiting from the peace dividend. The increased market presence meant that firms were no longer able to command premium prices unless they had significant, non-replicable barriers to entry such as legal protection where patents or copyrights secured temporary monopoly rights, extreme economies of scale that made it cost-prohibitive for a second firm to enter (e.g., utility infrastructure), network effects where the value of the product increased exponentially with each new user (e.g., social platforms), brand dominance that promised consistently reliable services/products or control of key resources through exclusive access to rare raw materials or proprietary technologies. In the absence of such an unassailable competitive advantage, the competitive focus quickly shifted, and firms found themselves competing on price.

This fierce price competition triggered a rapid decline in market prices, making it exceedingly difficult to maintain previous profit margins. For existing firms, the cushion of “super profits” vanished, replaced by the relentless pressure of a rapidly maturing, hyper-competitive market. Just a year earlier, Sri Lanka had suffered the negative impacts of the Global Financial Crisis, with tea and garment exports declining and tourist arrivals dropping due to the global economic slowdown. Survival was contingent upon absolute efficiency. 

With margins squeezed, businesses had to pivot sharply from focusing on sales growth to meticulous cost scrutiny. Every operational expenditure came under the microscope, as even minor savings could make the difference between a viable margin and a loss. The effective cost of production and/or service delivery became the new battleground. This high-pressure environment inevitably brought focus to one of the most significant and often least flexible components of operating costs, i.e., labour. The economic situation demanded strategic solutions for sustained profitability, setting the stage for a broader discussion on how to optimise labour resources and reduce their effective impact on the final price.

The core challenge for businesses lies in navigating the delicate balance between the labour cost-driven pricing and market resistance. It was recognised that inflation-matching pay rises are permanent and add to the cost of goods sold and that in competitive markets, where consumers have many alternatives, it was not possible to increase product prices indefinitely to cover escalating fixed labour costs. A tendency to resort to price stickiness, this being the reluctance to adjust prices upward in the fear of losing market share gradually took root. Faced with consumers who are either unwilling or unable to pay higher prices, firms had to find a way to maintain profitability without eroding their competitive position. The entrenchment of a concept of performance-based compensation, also known as “Pay for Performance” (PFP) was identified as a sustainable way forward. 

I was a part of the Group Executive Committee (GEC) of John Keells Holdings PLC (JKH), Sri Lanka’s largest corporation, in 2008. It was during that time that JKH, led by Susantha Ratnayake, embraced and institutionalised a Pay-for-Performance (PFP) philosophy. It was the ‘mother’ of all transformations and was a classic example of change management. This strategic initiative fundamentally rescripted JKH’s reward structure. Guaranteed compensation was deliberately suppressed to allow a disproportionate increase in the results-driven variable component tied to measurable achievement. The framework differentiated rewards for performers, injected velocity, and accountability, and firmly entrenched a culture of meritocracy. To be a part of a team architecting this groundbreaking benchmark for corporate compensation in the nation was, to me, a source of significant professional pride.

Driven by powerful macroeconomic constraints, particularly high inflation and the consequent loss of corporate pricing power, Pay for Performance (PFP) compensation structures have been a defining feature of the modern labour market. Historically, salary increases were tied, in the main, to inflation rates, providing employees with Cost-of-Living Adjustments (COLAs) to maintain purchasing power. However, as sustained inflation led to increased operational costs, businesses found themselves in a quandary. They were finding it difficult to pass on the traditional wage hikes to consumers. PFP, which links a portion (such portion increasing progressively based on decision-making power) of an employee’s income directly to measurable results, offered a strategic solution to this dilemma by transforming labour costs from a fixed liability into a variable investment tied to productivity and revenue generation.

PFP modes, such as bonuses, commissions, profit-sharing, merit-based pay, and employee share options decouple labour expenses from the inflation index and instead tie them to organisational outcomes. This shift delivers two critical strategic advantages. Firstly, it manages overall labour costs by making variable portions of compensation entirely dependent on the company’s value generation. If the business performs well, costs increase, but they are covered by the increased revenue or efficiency. If the company struggles, the variable cost component contracts, insulating the bottom line. Secondly, PFP acts as a powerful incentive mechanism, directly aligning employee effort with corporate objectives. By rewarding only performance that contributes to measurable success, PFP ensures that every additional dollar spent on wages is a dollar invested in tangible, value-adding output.

This strategic transformation of compensation philosophy is fundamentally about risk transference and efficiency. Businesses are shifting the risk of uncontrollable external economic factors such as inflation and downturn away from their fixed nature onto performance metrics that employees directly influence. This has led to a shift toward compensation packages that include a competitive base salary for stability, complemented by performance-linked variable rewards. By emphasising meritocracy and productivity gains, firms can enable employee demands for higher disposable incomes without committing to permanent, company-wide cost escalations that would compel unsustainable price increases and a subsequent loss of market share. For businesses, PFP represents an essential shift from cost maintenance i.e., trying to minimise fixed salary inflation to value creation i.e., paying for results. It allows companies to reward high-performing employees competitively while maintaining financial flexibility and protecting market viability in an economically volatile environment.

A robust pay-for-performance (PFP) structure is more than just a bonus scheme. It is a fundamental shift in how an organisation defines, measures, and rewards success. To be truly lively, illuminating and motivating, it must incorporate several essential, interconnected features.

Crystal clear goal alignment and line-of-sight

The cornerstone of any effective PFP system is the direct linkage between employee actions and organisational success.

Organisational goals: They must be explicitly, and unambiguously, tied to the company’s strategic objectives (e.g., increased revenue, market share growth, enhanced customer satisfaction, productivity gains).

Individual line-of-sight: Every employee, from the CEO to the front lines, must understand precisely how their daily work contributes to the measured metrics. If a metric feels disconnected or beyond their control, the system will be perceived as arbitrary rather than performance driven. This clarity ensures that there is a visible correlation between effort and outcome, enabling the effort to be channelled towards a specified goal/objective.

Metrics-must be measurable, objective, and balanced

The metrics used to assess performance must be beyond reproach. Fair, transparent, and difficult to manipulate.

Specific, Measurable, Achievable, Relevant, Time-bound (SMART): Metrics should follow the SMART principle. They should not be based on vague concepts like “good attitude” but on quantifiable outcomes (e.g., “close rate,” “project completion on time”, “customer retention score”, “turnaround time”).

Balance of quantity and quality: A strong PFP system avoids rewarding volume at the expense of integrity or quality. It often incorporates a “balanced scorecard” approach, combining financial, operational, and behavioural/qualitative measures to prevent detrimental short-term behaviour (e.g., rewarding sales volume without penalising high customer returns and bad debts).

Differentiated and meaningful reward payouts

The core principle of PFP is that high performance warrants significantly higher rewards than average performance.

Meaningful financial payout: The payout must be large enough to influence behaviour and justify the extra effort required. A bonus that is too small becomes a “thank you” gift and not a powerful incentive.

Performance differentiation: There should be a distinct spread in payouts. Top performers must earn significantly more than average performers, and low performers should earn little to nothing. This differentiation validates and reinforces exceptional effort.

Transparency, credibility, and trust

A PFP system can only be effective if it is trusted. Trust is built through uncompromised transparency.

Open calculation methodology: Employees must know exactly how their reward is calculated. They must be well informed of the formulae, the information source, and the weighting of metrics, and must be familiar with the underlying financial/operational data.

Continuous feedback and coaching: PFP must not be an annual event. It requires ongoing dialogue if it is to be effective. Managers must provide regular, constructive feedback linked to the PFP metrics so employees can adjust their efforts before the measurement period ends. Coaching, mentoring, training, and development must be made available as required. This turns the PFP system into a performance management and development tool, not just a compensation tool.

PFPs designed to align managers’ interests with organisational goals, often lead to a classic agency problem, which being managers “gaming” the system. This behaviour, sometimes unethical or even illegal, focuses on meeting the letter of the metric rather than the spirit of the overall objective, leading to perverse outcomes that can harm the company in the long run. The core motivation is simple. Maximising personal reward, typically a commission, bonus or equity, tied directly to a specific, measurable metric

Organisational readiness and cultural fit

The PFP structure must be supported by a culture that values meritocracy and accountability.

Robust data infrastructure: The organisation must have reliable, transparent, accessible, and accurate data systems to capture and track the performance metrics. Faulty data instantly cripples credibility.

Managerial capability: Managers must be trained not only in the mechanics of the plan but also in how to coach, differentiate performance, and deliver potentially difficult feedback on the lines of ‘the bitter truth is sweeter than the sour lie’. Managers are the crucial link that makes the PFP system work.

The tone from the top

Performance Management Schemes (PMS) which anchor a PFP philosophy must not be mere bureaucratic exercises owned by the Human Resources (HR) department. To be truly effective and transformative, they must be unequivocally championed and driven from the very top of the organisation. When the CEO and the executive leadership team actively set the tone, articulate the strategic necessity, and participate visibly, the entire scheme shifts from a compliance chore to a core business imperative.

Without this executive mandate, PMS inevitably devolves into a tick-box exercise and is perceived as an HR administrative function lacking real impact or consequence. Leadership commitment ensures that performance metrics are directly aligned with strategic organisational goals, not just generic competencies. Leaders must consistently model the desired behaviours, actively use the framework to manage their own teams, and hold senior managers accountable for its effective implementation. There must be strict enforcement and both reward and punishment.

When the scheme is embraced by the C-suite, it signals its gravitas. That high performance is non-negotiable and essential for organisational survival and growth. This top-down enforcement provides the necessary resources, authority, and credibility to embed a true performance culture. It transforms PMS into a powerful tool for strategic execution, talent development, and succession planning, rather than a marginalised annual review ritual. Leadership buy-in is the catalyst that ensures every employee understands that performance management is the lifeblood of the business, not just an HR policy.

A foundation built on these features moves pay for performance schemes from complex administrative exercise to a dynamic engine that clearly communicates what matters, objectively measures its achievement, and powerfully rewards those who deliver the best results.

PFPs designed to align managers’ interests with organisational goals, often lead to a classic agency problem, which being managers “gaming” the system. This behaviour, sometimes unethical or even illegal, focuses on meeting the letter of the metric rather than the spirit of the overall objective, leading to perverse outcomes that can harm the company in the long run. The core motivation is simple. Maximising personal reward, typically a commission, bonus or equity, tied directly to a specific, measurable metric. When a metric is imperfectly aligned with true value, a savvy manager will exploit the gap.

Common gaming tactics include:

Cherry-picking and timing: Managers may accelerate or delay transactions to push results into the current or next reporting period, often referred to as “earnings management.” For example, a sales manager might heavily discount products at the end of a quarter to meet a sales volume target, even if the lower profit margin is detrimental overall. Alternatively, they may defer necessary ‘future seeking’ expenditures, like advertising, promotions, preventive maintenance, or training, to artificially inflate short-term profit metrics.

Resource hoarding: Incentive systems can foster an unhealthy, competitive environment where managers hoard resources, talent, or crucial information. If a bonus is tied to a unit’s specific success, a manager might refuse to lend a top performer to a struggling sister unit, even if the latter’s success would benefit the entire organisation more.

Squeezing quality for quantity: When metrics prioritise quantity (e.g., number of customers, units produced, loans processed), managers can sacrifice quality. A customer service manager, rewarded for handling a high volume of calls, might rush through interactions, leading to unresolved issues and long-term customer dissatisfaction and churn, which is a metric not included in their immediate bonus calculation.

Data manipulation and re-definition: In some cases, managers engage in direct data manipulation. This can be subtle, like adjusting reserves or subjective accounting estimates, or egregious, such as the famous case of the Wells Fargo retail managers who incentivised staff to open millions of unauthorised accounts to hit sales quotas. They were optimising the “number of accounts opened” metric, regardless of whether the accounts were real or valuable to the customer.

The results of gaming are corrosive. While the manager enjoys a short-term payout, the organisation suffers from goal displacement, where local goals (the incentivised metric) supersede global goals (sustainable growth, customer loyalty, ethical conduct).

Incentive gaming erodes trust within the organisation and can lead to a toxic, short-term-focused culture. Alarmingly, it encourages excessive risk-taking, as seen in the financial sector where bonus schemes tied to short-term profits encouraged managers to take on high-risk, high-reward ventures that destabilised their firms and the global economy.

To counteract this, organisations must move beyond single, easily gamed metrics. Effective schemes require a balance which recognises long-term, qualitative, and team-based objectives, making it significantly harder to game without delivering genuine, sustainable value.

In closing, performance-based compensation is vital. It tangibly rewards strategic success, drives accountability, and attracts top talent. It powerfully reinforces the symbiotic link between individual effort and organisational goals. Pay must reflect contribution. Without this critical, results-focused linkage, motivation stagnates and excellence remains unrewarded. Reward what truly matters.

(The writer is currently, a Leadership Coach, Mentor and Consultant and boasts over 50+ years of experience in very senior positions in the Corporate World – local and overseas.)