2 Learning ObjectivesDiscuss how pay influences individual employees and 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 and 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
3 Learning ObjectivesDescribe 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:4. Describe how organizations combine incentive plans in a balanced scorecard.5. Discuss issues related to executives’ performance-based pay.6. Explain the importance of process issues such as communication in compensation management.7. List major factors in matching pay strategy to the organization’s strategy.12-3
4 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.Organizations have 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. Key questions arise in evaluating different pay programs for recognizing contributions.First, what are the costs of the program?Second, what is the expected return (in terms of influences on attitudes and behaviors) from such investments?Third, does the program fit with the organization’s human resource strategy and its overall business strategy?Fourth, what might go wrong with the plan in terms of unintended consequences? For example, will the plan encourage managers and employees to pay more attention to some objectives (e.g., short-term sales) than to some others (e.g., customer service, long-term customer satisfaction, and long-term sales)?12-4
5 Pay Influences Individual Employees 3 Theories Explain Compensation’s Effects:ReinforcementTheoryExpectancyTheoryAgencyTheoryPay plans are typically used to energize, direct, or control employee behavior. Three theories that help to explain compensation’s effects are the reinforcement theory, expectancy theory and the agency theory. They all focus on the fact that behavior–reward contingencies can shape behaviors.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.Expectancy Theory—says that motivation is a function of valence, instrumentality, and expectancy. Expectancy Theory focuses on the link between rewards and behaviors and emphasizes expected (rather than experienced) rewards and on the effects of incentives. Behaviors (job performance) can be described as a function of ability and motivation. Motivation is a function of expectancy, instrumentality, and valence perceptions.Agency 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.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.12-5
6 6 Factors To Determine What Type Of Contract An Organization Should Use: 1. Risk Aversion2. Outcome uncertainty.3. Job programmability4. Measurable job outcomes5. Ability to pay6. TraditionThe type of contract that an organization should use depends on 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 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.
7 Agency CostsAgency costs may be minimized by principal choosing a contracting scheme that aligns agent’s interests with principal's interests.Agency costs can arise from two factors:Principals and agents may have different goals(goal incongruence).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 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.12-7
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.MeritPayIncentivePayIn compensating employees, an organization does not have to choose one program over another. A combination of programs is often the best solution. Programs differ by payment method, frequency of payout, and ways of measuring performance. Programs for recognizing employee contributions. share a focus on paying for performance. Potential consequences of such programs include 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.Skill-basedGainSharingProfitSharingOwnership12-8
9 Merit PayMerit 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 Bonus - Merit pay paid in the form of a bonus, instead of a salary increase.Some organizations provide guidelines regarding percentage of employees who should fall into each performance category.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).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).12-9
10 Characteristics of Merit Pay Programs Identify individual differences in performanceMajority of information on individual performance is collected from the immediate supervisorPolicy links pay increases to performance appraisal results.Feedback under such systems tends to occur infrequentlyFlow of feedback tends to be largely unidirectional, from supervisor to subordinate.Merit pay programs have the following characteristics:First, they identify individual differences in performance, which are assumed to reflect differences in ability or motivation. By implication, system constraints on performance are not seen as significant.Second, the majority of information on individual performance is collected from the immediate supervisor. Peer and subordinate ratings are rare, and where they exist, they tend to receive less weight than supervisory ratings.Third, there is a policy of linking pay increases to performance appraisal results.Fourth, the feedback under such systems tends to occur infrequently, often once per year at the formal performance review session.Fifth, the flow of feedback tends to be largely unidirectional, from supervisor to subordinate.
11 Merit PayEdward W. Deming, a critic of merit pay, argued that it is unfair to rate individual performance. Deming’s solution was to eliminate the link between individual performance and pay.Criticisms of merit pay include:Focus on merit pay discourages teamwork.Measurement of performance is unfair and inaccurate.Too much emphasis on individual performanceMerit pay does not really exist - high performers paid more than marginal and poor performersDeming, 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." System factors include co‑workers, the job, materials, equipment, customers, management, supervision, and environmental conditions. They are the responsibility of management.Although Deming’s concerns about too much emphasis on individual performance are well taken, one must be careful not to replace one set of problems with another. Instead, there needs to be an appropriate balance between individual and group objectives. Too little emphasis on individual performance may leave the organization with average and poor performers.Process issues, including communication, expectation setting, and credibility/fairness are important in administering merit pay and pay for- performance. The payoff to high performance that comes from merit bonuses adds to the payoff from merit increases. High performing employees are also more likely to be promoted (into higher paying jobs) and are also more likely to have higher paying opportunities at alternative employers. All these factors can be communicated to employees to help them see the payoff to high performance.12-11
12 Individual Incentives Individual incentives reward individual performance but payments are not rolled into base pay. Performance is measured as physical output rather than by subjective ratings.Individual incentives are rare because:Most jobs have no physical output measure.Many potential administrative problems.Employees may only do what they get paid for.Do not fit in with team approach.May be inconsistent with organizational goals.Some incentive plans reward output over quality or 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.12-12
13 Profit SharingUnder profit sharing, payments are based on a measure of organization performance (profits), and payments do not become a part of base pay.Advantages-profit sharing may encourage employees to think more like owners.labor costs are automatically reduced during difficult economic times, and wealth is shared during good times.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 organizational performance(profits) and do not become part of the employees’ base salary. 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. 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. Employees may react very negatively when they learn that such plans do not pay out during business downturns. Profit sharing may need to be complemented with other pay programs that more closely link pay to outcomes that individuals or teams can control (or “own”), particularly in larger companies. Profit sharing runs the risk of contributing to employee dissatisfaction or higher labor costs, depending on how it is designed.12-13
14 OwnershipOwnership encourages employees to focus on organization’s success, but may be less motivational the larger the organization.Stock options - plan that 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.12-14
15 GainsharingGainsharing – form of compensation based on group or plant performance rather than organizationwide profits that does not become part of the employee’s base salary.offers a means of sharing productivity gains with employees.Improves performanceGainsharing 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. 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.12-15
16 9 Conditions for Effective Gainsharing management commitmentneed to change or commitment to continuous improvementmanagement's acceptance and encouragement of employee inputhigh cooperation and interactionemployment securityinformation sharing on productivity and costsgoal settingcommitment of all involved to the processagreement on a performance standard and calculation that is understandable, fair, and related to managerial objectivesGainsharing 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. There is a strong emphasis on taking advantage of employee know-how to improve the production process through teams and suggestion systems.
17 Group Incentives and Team Awards Group incentives measure performace in physical output.Team award plans may use a broader range of performance measures.Individual competition may be replaced by competition between groups or teams.Risks not recognizing differences in individual performanceGroup 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. competition between groups or teams. Any plan that does not adequately recognize differences in individual performance risks demotivating top performers or losing them. A standard-setting process must be developed that is seen as fair by employees, and these standards must not exclude important dimensions such as quality.12-17
18 4 Categories of a Balanced Scorecard financialcustomerinternallearning and growthSome 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. A mix of measures might be used to motivate improvements in a balanced set of key business drivers.12-18
19 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. 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. 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.12-19
20 Process and Context Issues 3 issues represent areas of company discretion and pose opportunities to compete effectively:Employee Participationin Decision MakingPay & Process:Intertwined EffectsCommunicationProcess 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.Changing the way workers are treated may boost productivity more than the way they are paid.12-20
21 Matching Pay & Organization Strategy Table provides some suggested matches. Basically, a growth strategy’s 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.12-21
22 SummaryPrograms vary as to whether they link pay to individual, group, or organization performance. Often, it is a choice between different combinations of programs that seek to balance individual, group, and organization objectives.Wages, bonuses, and other types of pay influence an employee’s standard of living. Pay can be a powerful motivator.An effective pay strategy can substantially promote an organization’s success; conversely, a poorly conceived pay strategy can have detrimental effects.Employees care about the pay process fairness.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 programs must be explained and administered so that employees understand their rationale and believe it is fair.What succeeds in some organizations may not be a good idea for others.Balanced scorecard suggests the need for organizations to decide what their key objectives are and use pay to support them.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.12-22