Chapter 12 Recognizing Employee Contributions with Pay Human Resource Management: Gaining a Competitive Advantage Chapter 12 Recognizing Employee Contributions with Pay Chapter 12 focuses on using pay to recognize and reward employees’ contributions to the organization’s success. Employees’ pay does not depend solely on the jobs they hold. Instead, differences in performance (individual, group, or organization), seniority, skills, and so forth are used as a basis for differentiating pay among employees. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Discuss how pay influences individual employees. Describe three theories that explain compensation’s effect on individuals. Describe pay programs for recognizing employees’ contributions to the organization’s success. List pay programs’ advantages and disadvantages. Learning Objectives: Discuss how pay influences individual employees. Describe three theories that explain compensation’s effect on individuals. Describe pay programs for recognizing employees’ contributions to the organization’s success. List pay programs’ advantages and disadvantages. 12-2

Learning Objectives Describe how organizations combine incentive plans in a balanced scorecard. Discuss issues related to executives’ performance-based pay. Explain importance of process issues such as communication in compensation management. List major factors in matching pay strategy to organization’s strategy. Learning Objectives: Describe how organizations combine incentive plans in a balanced scorecard. Discuss issues related to executives’ performance-based pay. Explain the importance of process issues such as communication in compensation management. List major factors in matching pay strategy to the organization’s strategy. 12-3

Introduction Organizations have discretion in deciding how to pay. Each employee’s pay is based upon individual performance, profits, seniority, or other factors. Regardless of cost differences, different pay programs can have different consequences for productivity and return on investment. This chapter focuses on the design and administration of programs to reward individuals for their contribution to organizational success. Organizations have a relatively large degree of discretion in deciding how to pay. Differences in performance (by an individual, group, or the organization), seniority, or skills are used as a basis for differentiating pay among employees. Regardless of cost differences, different pay programs can have very different consequences for productivity and return on investment. 12-4

Pay Influences Individual Employees 3 Theories Explain Compensation’s Effects: Reinforcement Theory Expectancy Theory Agency Theory There are three theories that help to explain compensation’s effects. These are the reinforcement theory, expectancy theory and the agency theory. The reinforcement, expectancy, and agency theories all focus on the fact that behavior–reward contingencies can shape behaviors. However, agency theory is of particular value in compensation management because of its emphasis on the risk–reward trade-off, an issue that needs close attention when companies consider variable pay plans, which can carry significant risk. The Reinforcement Theory—In Thorndike's Law of Effect, a response followed by a reward is more likely to recur in the future. The importance of a person's actual experience in receiving the reward is critical. If high performance is followed by a reward, high performance is likely to be repeated. The Expectancy Theory—This theory says that motivation is a function of valence, instrumentality, and expectancy. The Agency Theory—This theory focuses on divergent interests and goals of the organization's stakeholders and the ways that compensation can be used to align these interests and goals. 12-5

How Pay Influences Individual Employees Reinforcement Theory – a response followed by a reward is more likely to recur in the future. Expectancy Theory - motivation is a function of valence (utility, personal value of reward), instrumentality (perceived link between performance and pay) and expectancy (link between effort and performance). It has been argued that monetary rewards may increase extrinsic motivation while decreasing intrinsic motivation. Agency Theory- interests of principals (owners) and their agents (managers) may no longer converge. E. L. Thorndike’s Law of Effect states that a response followed by a reward is more likely to recur in the future. The implication for compensation management is that high employee performance followed by a monetary reward will make future high performance more likely. By the same token, high performance not followed by a reward will make it less likely in the future. The theory emphasizes the importance of a person’s actual experience of a reward. Expectancy Theory: Although expectancy theory also focuses on the link between rewards and behaviors, it emphasizes expected (rather than experienced) rewards. In other words, it focuses on the effects of incentives. Behaviors (job performance) can be described as a function of ability and motivation. In turn, motivation is hypothesized to be a function of expectancy, instrumentality, and valence perceptions. Compensation systems differ according to their impact on these motivational components. Generally speaking, the main factor is instrumentality: the perceived link between behaviors and pay. Valence of pay outcomes should remain the same under different pay systems. Expectancy perceptions (the perceived link between effort and performance) often have more to do with job design and training than pay systems. A possible exception would be skill-based pay, which directly influences employee training and thus expectancy perceptions. Agency Theory focuses on the divergent interests and goals of the organization’s stakeholders and the ways that employee compensation can be used to align these interests and goals. Principal: In agency theory, a person (e.g., an owner) who seeks to direct another person’s behavior. Agent: In agency theory, a person (e.g., a manager) who is expected to act on behalf of a principal (e.g., an owner). An important characteristic of the modern corporation is the separation of ownership from management (or control). Unlike the early stages of capitalism, where owner and manager were often the same, today, with some exceptions (mostly smaller companies), most stockholders are far removed from the day-to-day operation of companies. Although this separation has important advantages (like mobility of financial capital and diversification of investment risk), it also creates agency costs—the interests of the principals (owners) and their agents (managers) may no longer converge. What is best for the agent, or manager, may not be best for the owner. 12-6

Agency Costs Agency Costs can arise from goal incongruence between agents and principles and from information asymmetry with regard to what goals the agent is pursuing Agency costs may be minimized by principal choosing a contracting scheme that aligns agent’s interests with principal's interests. Issues: Managers (agents) may not be focused on maximizing shareholder (principal) wealth. Managers may be more risk adverse that principals to protedt their income Decision making horizons may differ (long term vs. short term) Outcome oriented contracts focus on results, behavior based contracts focus on actions Agency costs can arise from two factors. First, principals and agents may have different goals (goal incongruence). Second, principals may have less than perfect information on the degree to which the agent is pursuing and achieving the principal’s goals (information asymmetry). Agency costs may be minimized by the principal choosing a contracting scheme that helps align the interests of the agent with the interests of the principals. These approaches can be behavior oriented (e.g., merit pay) or outcome oriented (e.g., stock options, profit sharing, commissions). Outcome­oriented approaches link the rewards of the organization and individual. However, agents are often risk‑aversive and may demand a compensating wage differential. Behavior­oriented contracts do not transfer risk and therefore do not require a compensating wage differential. The type of contract an organization should use depends partly on the following six factors: • Risk aversion. Risk aversion among agents makes outcome-oriented contracts less likely. • Outcome uncertainty. Profit is an example of an outcome. Agents are less willing to have their pay linked to profits to the extent that there is a risk of low profits. They would therefore prefer a behavior-oriented contract. • Job programmability. As jobs become less programmable (less routine), outcome-- oriented contracts become more likely because monitoring becomes more difficult. • Measurable job outcomes. When outcomes are more measurable, outcome-oriented contracts are more likely. • Ability to pay. Outcome-oriented contracts contribute to higher compensation costs because of the risk premium. • Tradition. A tradition or custom of using (or not using) outcome-oriented contracts will make such contracts more (or less) likely. 12-7

Agency Costs 6 Factors that Influence Type of Contract: risk aversion – preference towards behavior based compensation outcome uncertainty – variables in compensation beyond agent’s control job programmability – portion of job that is based upon routine, predictable portion of job measurable job outcomes – may be difficult to specify ability to pay – easier to fulfill with outcome oriented contracts Tradition – what has been used in the past Agency costs can arise from two factors. First, principals and agents may have different goals (goal incongruence). Second, principals may have less than perfect information on the degree to which the agent is pursuing and achieving the principal’s goals (information asymmetry). Agency costs may be minimized by the principal choosing a contracting scheme that helps align the interests of the agent with the interests of the principals. These approaches can be behavior oriented (e.g., merit pay) or outcome oriented (e.g., stock options, profit sharing, commissions). Outcome­oriented approaches link the rewards of the organization and individual. However, agents are often risk‑aversive and may demand a compensating wage differential. Behavior­oriented contracts do not transfer risk and therefore do not require a compensating wage differential. The type of contract an organization should use depends partly on the following six factors: • Risk aversion. Risk aversion among agents makes outcome-oriented contracts less likely. • Outcome uncertainty. Profit is an example of an outcome. Agents are less willing to have their pay linked to profits to the extent that there is a risk of low profits. They would therefore prefer a behavior-oriented contract. • Job programmability. As jobs become less programmable (less routine), outcome-- oriented contracts become more likely because monitoring becomes more difficult. • Measurable job outcomes. When outcomes are more measurable, outcome-oriented contracts are more likely. • Ability to pay. Outcome-oriented contracts contribute to higher compensation costs because of the risk premium. • Tradition. A tradition or custom of using (or not using) outcome-oriented contracts will make such contracts more (or less) likely. 12-8

Programs Recognizing Contributions Programs differ by payment method, payout frequency and ways of measuring performance. Potential consequences include employees’ performance motivation and attraction, culture and costs. Management style and type of work influence whether a pay program fits the situation. Merit Pay Incentive Pay The programs differ by payment method, frequency of payout, and ways of measuring performance. Table 12.1 provides an overview of the programs for recognizing employee contributions. Each program shares a focus on paying for performance. The programs differ according to three design features: (1) payment method, (2) frequency of payout, and (3) ways of measuring performance. In a perhaps more speculative vein, the table also suggests the potential consequences of such programs for (1) performance motivation of employees, (2) attraction of employees, (3) organization culture, and (4) costs.Potential consequences of such programs are performance motivation of employees, attraction of employees, organization culture, and costs. Contingencies that may influ­ence whether a pay program fits the situation are management style, and type of work. There are two contingencies that may influence whether each pay program fits the situation: (1) management style and (2) type of work. Skill-based Profit Sharing Gain Sharing Ownership 12-9

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Merit Pay Merit pay programs link performance- appraisal ratings to annual pay increases. A merit increase grid combines an employee’s performance rating with employee’s position in a pay range to determine size and frequency of his or her pay increases. Merit pay programs, annual pay increases are usually linked to performance appraisal ratings. The size and frequency of pay increases are most often determined by performance rating (since better‑performing employees should be rewarded more than low performers) and position in range (compa‑ratio). As Table 12.2 indicates, the size and frequency of pay increases are determined by two factors. The first factor is the individual’s performance rating (because better performers should receive higher pay). The second factor is position in range (that is, an individual’s compa-ratio). 12-11

Merit Pay Some organizations provide guidelines regarding percentage of employees who should fall into each performance category. McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved

Merit Pay Edward W. Deming, a critic of merit pay, argued that it is unfair to rate individual performance because "apparent differences between people arise almost entirely from the system that they work in, not the people themselves.” Criticisms of merit pay include: Focus on merit pay discourages teamwork. Measurement of performance is done unfairly and inaccurately. Merit pay may not really exist. Deming, who is a critic of merit pay, argues that it is unfair to rate individual performance because "apparent differences between people arise almost entirely from the system that they work in, not the people themselves." Examples of system factors are co‑workers, the job, materials, equipment, customers, management, supervision, and environmental conditions. These factors are the responsibility of management. 12-13

Individual Incentives Individual incentives reward individual performance but payments are not rolled into base pay and performance is usually measured as physical output rather than by subjective ratings (ex. – piecework). Individual incentives are rare because: Most jobs have no physical output measure. Many potential administrative problems. Employees may do what they get paid for and nothing else. Typically do not fit in with team approach. May be inconsistent with organizational goals. Some incentive plans reward output at the expense of quality or customer service. Individual incentives reward individual performance, but payments are not rolled into base pay, and performance is usually measured as physical output rather than by subjective ratings. Monetary incentives increased production by 30 percent in a study by Locke. Individual incentives are relatively rare. Although individual incentives carry potential advantages, they are not likely to contribute to a flexible, proactive, problem-solving workforce. 12-14

Profit Sharing Under profit sharing, payments are based on a measure of organization performance (profits), and payments do not become a part of base pay. Advantage-profit sharing may encourage employees to think more like owners. Disadvantage-workers may perceive their performance has less to do with profit than top management decisions over which they have little control. Under profit sharing, payments are based on a measure of organization performance (profits) and do not become part of the employees’ base salary. An advantage is that profit sharing may encourage employees to think more like owners and take a broad view of what needs to be done, labor costs are reduced in difficult economic times, and organizations may not have to rely on layoffs. A second advantage is that because payments do not become part of base pay, labor costs are automatically reduced during difficult economic times, and wealth is shared during good times. The drawback is that workers may perceive their performance has little to do with profit but is more related to top management decisions over which they have little control. Another motivational problem is that most plans are deferred. 12-15

Ownership Ownership encourages employees to focus on organization’s success, but may be less motivational the larger the organization. One method to achieve employee ownership is through stock options, which give employees the opportunity to buy company stock at a previously fixed price. Employee stock ownership plans (ESOPs) give employers certain tax and financial advantages when stock is granted to employees. ESOPs can carry significant risk for employees. Employee ownership is similar to profit sharing in some key respects, such as encouraging employees to focus on the success of the organization as a whole. In fact, with ownership, this focus may be even stronger. Like profit sharing, ownership may be less motivational the larger the organization. And because employees may not realize any financial gain until they actually sell their stock (typically upon leaving the organization), the link between pay and performance may be even less obvious than under profit sharing. One way of achieving employee ownership is through stock options, which give employees the opportunity to buy stock at a fixed price. Employee stock ownership plans (ESOPs), under which employers give employees stock in the company, are the most common form of employee ownership. 12-16

Gainsharing Gainsharing programs offer a means of sharing productivity gains with employees and are based on group or plant performance that does not become part of the employee’s base salary. Gainsharing programs offer a means of sharing productivity gains with employees and are based on group or plant performance that does not become part of the employee’s base salary. Although sometimes confused with profit sharing plans, gainsharing differs in two key respects. First, instead of using an organization-level performance measure (profits), the programs measure group or plant performance, which is likely to be seen as more controllable by employees. Second, payouts are distributed more frequently and not deferred. In a sense, gainsharing programs represent an effort to pull out the best features of organization-oriented plans like profit sharing and individual-oriented plans like merit pay and individual incentives. 12-17

Sample Modified Scanlon Gainsharing Plan McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved

Employee Involvement Plans McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved

9 Conditions for Effective Gainsharing management commitment need to change or commitment to continuous improvement management's acceptance and encouragement of employee input high cooperation and interaction employment security information sharing on productivity and costs goal setting Commitment of all involved to the process agreement on a performance standard and calculation that is understandable, seen as fair, and closely related to managerial objectives Gainsharing programs are based on group or plant performance (rather than organization wide profits) that does not become part of the employee’s base salary. One type of gainsharing, the Scanlon plan, provides a monetary bonus to employees (and the organization) if the ratio of labor costs to the sales value of production is kept below a certain standard. Table 12.8 indicates that there is often a strong emphasis on taking advantage of employee know-how to improve the production process through teams and suggestion systems. 12-20

Group Incentives and Team Awards Group incentives measure performace in terms of physical output. Team award plans may use a broader range of performance measures. Individual competition may be replaced by competition between groups or teams. Group incentives and team awards typically pertain to a smaller work group. Group incentives tend to measure performance in terms of physical output, whereas team award plans may use a broader range of performance measures. Drawbacks are that individual competition may be replaced by competition between teams. In addition, dimensions must be perceived as fair by employees, and these standards must not exclude important dimensions such as quality. 12-21

Balanced Scorecard Some companies design a mix of pay programs. 4 Categories of a Balanced Scorecard: financial customer internal learning and growth Some companies find it useful to design a mix of pay programs. Relying exclusively on merit pay or individual incentives may result in high levels of work motivation but unacceptable levels of individualistic and competitive behavior and too little concern for broader plant or organization goals. Table 12.9 in your text shows how a mix of measures might be used by a manufacturing firm to motivate improvements in a balanced set of key business drivers. 12-22

Sample Balanced Scorecard McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved

Managerial and Executive Pay Top managers and executives are a strategically important group whose compensation warrants special attention. Some companies' rewards for executives are high regardless of profitability or stock market performance. Executive pay can be linked to organizational performance (agency theory). Increased pressure from regulators and shareholders to better link pay and performance. Securities and Exchange Commission (SEC) Because of their significant ability to influence organization performance, top managers and executives are a strategically important group whose compensation warrants special attention. One concern appears to be that in some companies rewards for executives are high regardless of organizational performance. Organizations vary a great deal in the extent to which they use both short‑term and long‑term incentive programs. There has been increased pressure from regulators and shareholders to better link pay and performance. The Securities and Exchange Commission (SEC) requires companies to report compensation level for the five highest paid executives and the company’s performance relative to that of competitors over a five-year period. 12-24

Process and Context Issues 3 issues represent areas of significant company discretion and pose opportunities to compete effectively: Employee Participation in Decision Making Pay&Process: Intertwined Effects Communication Process and context issues consider employee participation in decision making and its potential consequences. Involvement in the design and implementation of pay policies has been linked to higher pay satisfaction and job satisfaction. Communication is critical since change in any part of the compensation system is likely to give rise to employee concerns. It is suggested that changing the way workers are treated may boost productivity more than the way they are paid. 12-25

Matching Pay & Organization Strategy Pay Strategy Dimensions Risk sharing (variable pay) Time orientation Pay level (short-run) Pay level (long-run potential) Benefits level Centralization of pay decisions Pay unit of analysis Concentration Low Short-term Above market Below market Centralized Job Growth High Long-term Below market Above market Decentralized Skills Organization Strategy and Compensation Strategy: A Question of Fit— In choosing a pay strategy, one must consider how effectively it will further the organization’s overall business strategy. Table 12.13 shown on this slide and found in your text suggests some matches of strategies. Basically, a growth strategies emphasis on innovation, risk taking, and new markets is linked to a pay strategy that shares risk with employees but also gives them the opportunity for high future earnings by having them share in whatever success the organization has. This means relatively low levels of fixed compensation in the short run but the use of bonuses and stock options, for example, that can pay off handsomely in the long run. 12-26

Summary There are potential advantages and disadvantages of different types of incentive or pay for performance plans. Pay plans can have both intended and unintended consequences. Designing a pay for performance strategy typically seeks to balance the pros and cons of different plans and reduce the chance of unintended consequences. Pay strategy will depend on the particular goals and strategy of the organization and its units. Many organizations are working to link pay to performance and reduce fixed labor costs, although sometimes executives appear slow to reduce what are supposed to be performance-based bonuses when firm performance declines. There are potential advantages and disadvantages of different types of incentive or pay for performance plans. Pay plans can have both intended and unintended consequences. Designing a pay for performance strategy typically seeks to balance the pros and cons of different plans and reduce the chance of unintended consequences. Pay strategy will depend on the particular goals and strategy of the organization and its units. Many organizations are working to link pay to performance and reduce fixed labor costs, although sometimes executives appear slow to reduce what are supposed to be performance-based bonuses when firm performance declines. 12-27