1. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 1 II. Human Resource Management Variable or Fixed Salary OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURG BEIJING NORMAL UNIVERSITY Prof. Dr. Birgitta Wolff, Marjaana Rehu, M.A. Otto-von-Guericke-University, Germany

2. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 2 „... three critical aspects of organization: The assignment of decision rights within the company The methods of rewarding individuals The structure of systems to evaluate the performance of both individuals and business units“ (BSZ 5) Recap Session I

3. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 3 Outline 1. Incentive Problem 2. Compensation Contracts 3. Output-Based Pay 4. Input-Based Pay 5. Incentive Pay Source: www.msn.de

4. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 4 1. Incentive Problem Coordination and Motivation Problem Distribution of Output Task Individual Allocation of Input Resources Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51 Coordination Who does what, when,... Motivation How do I get somebody to perfom a task, improve the quality,... => Incentive Problem

5. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 5 1. Incentive Problem Why do Incentive Problems Exist? Why do Incentive problems exist? Employee and employer have different interests –Employer would want the employee to take actions that maximize the profit of the firms, but the employee might rather like spending his time with his/her family or play golf –All actions of the employee cannot be monitored and/or controlled by contracts (risk for the employer) –Employers have to compensate employees for doing undesirable tasks

6. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 6 1. Incentive Problem How can Incentive Problems be Solved? Incentive Problems can be solved through effective compensation contracts Compensation contracts have two functions –Motivate employees –Share risk more efficiently Source: www.euro.fi

7. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 7 2. Compensation Contracts Variable Pay Fixed Salary Compensation Contracts Payment by Output Payment by Input Subjective Performance Measures Objective Performance Measures Subjective Performance Measures Objective Performance Measures

8. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 8 Variable Pay (payment by output) Straight Salary (payment by input) Compensation depends on measure of what comes out Amount of time spent on work does not affect workers‘ compensation Problem:  Output not always easy to measure Examples: Agricultural workers: piece rates p. tray A salesperson on straight commission Compensation of top executives by stocks or stock options Compensation depends on the amount of time or effort spent on an activity Independent of output consideration Problem:  Input also not always easy to measure Time at work as a proxy in order to assess worker‘s effort Examples: Wage per work hour Monthly salaries Annual salaries 2. Compensation Contracts Payment by Input versus Payment by Output

9. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 9 2. Compensation Contracts How can the Performance of an Employee be Measured? Objective Performance Measure: –Measure that is easily observable and quantifiable, e.g. parts produced, hours worked etc. Subjective Performance Measures: –An evaluation which is based on personal opinion of a supervisor, customer, peers, etc. Type of evaluat. Database objectivesubjective Outputrevenue, dividendcustomer satisfaction Inputtimequalification

10. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 10 BasisVariables for output-based pay Quantity of production pieces, weight, size/height Quality of production Rejects, grade, customer‘s satisfaction, individual targets Input reduction Reduction of input factors: raw material, energy, work time Capacity utilization slack-, repair- and waiting periods Be on schedule Timeliness vis à vis internal and external customers Value of the firm stock price, economic value added 2. Compensation Contracts Examples of Different Variables as a Basis of Output-Related Pay

11. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 11 Advantages of output-based pay Selection effectMotivation effect efficient workers with a high productivity will join the firm/stay inefficient workers with a low productivity will not join/leave the firm output-based pay motivates workers to put forth more effort 3. Output-Based Pay Source: www.kone.fi

12. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 12 World BookBritannica Offered compensation schemevariable pay: W = $ 100. xfixed salary: W = $ 500 Labor costs of 10 sets; Cost per set $ 1,000  $ 100 per set$ 500  $ 50 per set What type of salesperson will stay with the firm? high productive sp. x  5 low productive sp. x  5 Labor costs of 3 sets; Cost per set $ 300  $ 100 per set$ 500  $ 166,67 per set 3. Output-Based Pay Selection Effect: An Example of Compensating Salespeople

13. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 13 500 A (World Book) B (Britannica) W... Weekly Pay x... Number of encyclopedia 5 3 300  Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will stay at Britannica 3. Output-Based Pay Selection Effect: An Example of Compensating Salespeople (cont.)

14. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 14 Disadvantage of piecework: Variations of output can be beyond the worker‘s control Variable pay Straight salary Fixed salary doesn‘t depend on exoge- nous factors – low-risk form of compensation  Workers are insured against volatilities  Firm provides the insurance for risks Lower compensation level Can not participate in good economic development Weaker incentives Variable pay depends on invested effort and exogenous risks – risky form of compensation  Firm should smooth out exogenous risks from workers‘ compensation  Firm should bear exogenous risks but endogenous risks should remain with workers Trade-off: More risk  higher compensation Opportunity: participate in good economic development Stronger incentives 3. Output-Based Pay Disadvantages of Output-Based Pay

15. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 15 3. Output-Based Pay Risk in Output-Based Pay The firm should bear the largest portion of risk because of risk pooling abilities Workers with a high average compensation should bear more risks than workers with a low average compensation. Source: www.kone.fi

16. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 16 In spite of all the advantages of output-based schemes: A large proportion of workforce is paid by input Compensation depends on the amount of time or effort spent on an activity Independent of output consideration  Time at work as a proxy to assess worker‘s effort Examples: wage per work hour, monthly salaries, annual salaries 4. Input-Based Pay Source: www.euro.fi

17. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 17 4. Input-Based Pay Benefits of Input-Based Pay Finding the right output measure Costs of measurement Overemphasizing quantity, reduction of quality Risk aversion of workers Promoting long-run performance However, in many cases output-based schemes could be used if only they were designed correctly! Problems of output-based pay solved by time-based (input-based) pay

18. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 18 Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to ‚count‘  Appropriate compensation schemes could solve this problem Example: Typist‘s compensation Errors p. pagePrice p. pageMinutes p. pageRevenue per hour 0$ 820$ 24 1$ 715$ 28 2$ 512$ 25 3$ 310$ 18 4$ 09 5 8 Compensation Schemes Balancing Quantity and Quality

19. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 19 Hourly wages Monthly salaryAnnual salary Input-based pay Production workers Clerical workers Top Management Managerial workers Tasks: experienced and easy to prescribe High correlation between effort and time invested Time input as a pretty good indicator for effort Low correlation between effort and work time Time input = bad measure for effort  overinvestment in easy (pleasant) tasks Tasks: less experienced and not easy to prescribe Undefined set of tasks (goal), discretion over work Importance of other incen- tives to motivate for effort (long-term, e.g. stock options) Tasks: not experienced and difficult to prescribe; often to be defined by top manager 4. Input-Based Pay Using the Appropriate Time Unit

20. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 20 5. Incentive Pay Optimal Level of Variable Pay Since employees do not diversify their risk –Large exogenous risks should be born by owners Fixed salary However, employees are motivated by pay for performance Variable Pay Part of the pay should be fixed and part variable

21. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 21 5. Incentive Pay Forms of Incentive Pay Rewards do not need to be monetary, they can consist of anything that employees value E.g Piece rates and commissions Bonuses Parking spots Days off Promotion Training Stock ownership Health care plan Housing Education for kids Retirement Plan Party

22. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 22 5. Incentive Pay Criticism to Incentive Compensation Often heard critics to incentive compensation: –Money does not motivate –It is difficult to design effective incentive schemes Incentives certainly entail costs The major problem is to design incentive schemes where the benefits exceed the costs

23. Prof. Dr. Birgitta Wolff Marjaana Rehu, M.A. Beijing, Sept. 2002 23 Furter Readings Brickley, J. A./Smith, C. W. Jr./Zimmerman, J. L. (2001): Organizational Architecture, 2 nd ed., Irwin Book Team. Lazear, E. P. (1998): Personnel Economics for Managers, New York (John Wiley & Sons)