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Please click here to access the new HRM Failures case associated with this chapter. HRM
Failures features real-life situations in which an HR conflict ended up in court. Each case
includes a discussion questions and possible answers for easy use in the classroom. HRM
Failures are not included in the text so that you can provide your students with additional
real-life content that helps engrain chapter concepts.
Chapter Summary
This chapter focuses on the design and administration of programs to reward individuals for their
contribution to organizational success. The design often amounts to combinations of individual,
group, and organizational incentives. Rewards must also be designed for the particular
organization and the needs and motives of its employees. Since pay is a powerful motivator
(although certainly not the only one), pay systems' design is critical to organization success.
Learning Objectives
After studying this chapter, the student should be able to:
1. Discuss how pay influences individual employees and describe three theories that explain
the effect of compensation on individuals.
2. Describe the fundamental pay programs for recognizing employees’ contributions to the
organization’s success.
3. List the advantages and disadvantages of the pay programs.
4. Describe how organizations combine incentive plans in a balanced scorecard.
5. Discuss issues related to performance-based pay for executives.
6. Explain the importance of process issues such as communication in compensation
management.
7. List the major factors to consider in matching the pay strategy to the organization’s
strategy.
Extended Chapter Outline
Note: Key words appear in boldface and are listed in the "Chapter Vocabulary" section.
Opening Vignette:
High Performance is Important (and So is How You Get There)
This vignette describes the changing view of performance being taken by some companies. This
new view is not focused solely on financial performance, but also on how that financial
performance is being achieved. The case touches on the new CEO of Citigroup and his
intentions of linking executive performance measures with more balanced scorecard measures of
performance. These measures provide an indication of how financial success is being achieved
so as to avoid extremely risky choices that have caused havoc on the US economy and business
in recent years. The case also overviews a change in WalMart’s philosophies on how to direct
and focus the behaviors of executives. WalMart has recently faced a number of legal compliance
issues that can and will cause long-term harm to the firm.
Discussion Question
1. Why are companies beginning to pay more attention to non-financial measures of
performance today?
Society today requires organizations to not only make money, but to pay attention to how
I. Introduction—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.
II. How Does Pay Influence Individual Employees? Besides the equity theory, described in
the previous chapter, there are other theories that influence compensation's effects.
A. 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.
B. Expectancy Theory— This theory says that motivation is a function of valence,
instrumentality, and expectancy.
C. 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. Today, most stockholders are removed from the
day-to-day operation of companies. This separation has many advantages, but it
also creates costs—the interests of the principals (owners) and their agents
(managers) may no longer converge. Agency costs are as follows:
1. Although shareholders seek to maximize their wealth, management may
spend money on things such as prequisites or “empire building”.
2. Managers and shareholders may differ in their attitudes toward risk.
3. Decision-making horizons may differ, since managers will likely
emphasize short-term gains to ensure promotion and visibility, perhaps at
the cost of long-term success.
D. 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).
Outcome-oriented approaches link the rewards of the organization and
individual. However, agents are often risk-averse and may demand a
compensating wage differential. Behavior-oriented contracts do not
transfer risk and therefore do not require a compensating wage differential.
Deciding what to use is based on the following:
1. Risk aversion among agents makes outcome-oriented contracts less likely.
2. 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.
3. Job Programmability—As jobs become less programmable (less routine)
outcome-oriented contracts are more likely.
4. Measurable Job Outcomes—When outcomes are more measurable,
outcome-oriented contracts are more likely.
5. Ability to Pay—Outcome-oriented contracts contribute to higher
compensation costs because of the risk premium.
6. Tradition—A tradition of using (or not using) outcome-oriented contracts
will make such contracts more (or less) likely.
III. How does pay influence Labor Force Composition?—There is increasing recognition that
individual pay programs may also affect the nature and composition of an organization’s
workforce. Different pay systems appear to attract people with different personality traits
and values. Organizations that link pay to individual performance may be more likely to
attract individualistic employees, whereas organizations relying more heavily on team
rewards are more likely to attract team-oriented employees.
IV. Pay for Performance Programs—Table 12.1 in the text provides an overview of some
programs and potential contributions. The programs differ by payment method,
frequency of payout, and ways of measuring performance. 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.
A. Merit pay programs, annual pay increases are usually linked to performance
appraisal ratings. A merit bonus is merit pay paid in the form of a bonus instead
of a salary increase.
1. 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 – see Table 12.2 for an example) and position in
range (compa-ratio – see Table 12.4). Compa-ratio is used to control
compensation costs and maintain the integrity of the pay structure. Table 12.3
demonstrates an example of a merit increase grid, which combines an
employee’s performance rating with the employee’s position in a pay range to
determine the size and frequency of his or her pay increases. Table 12.3
indicates how compa-ratio targets and performance ratings might be
combined.
Competing Through Technology
Paying for ‘Hot Skills’: The Case of Information Technology
This case describes the current salary increase situation in the market. Jobs that involve so called
“hot skills” are offering much higher than average salary increases – for example, with a market
average increase of about 3%, individuals with mobile application development skills are
commanding upwards of 9%. The case also describes the competition among tech companies
like Google, Facebook and Twitter to retain employees by offering lucrative increases and
performance based compensation packages.
Discussion Question
1. What is the reason for larger salary increases for information technology
employees?
Student responses here will vary, but should recognize the relationship between
2. Why do companies like Google choose to lead the market in paying these (and
other) occupations?
Again each student will likely have an opinion for this question. It is important
2. In general, merit pay programs have the following characteristics:
a. They identify individual differences in performance, which are
assumed to reflect differences in ability or motivation.
3. 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.
b. Deming suggests that the link between individual performance and
c. Another criticism is the way they measure performance. If this is
not done fairly and accurately, employees will perceive the whole
d. A last criticism is that merit pay may not really exist. High
performers are not paid significantly more than mediocre or even
B. 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, however, relatively rare because:
1. Most jobs have no physical output measure.
Competing Through Sustainability:
Increasing Labor Cost Flexibility Using Profit Sharing
This case describes how US automakers were able to simultaneously reduce their labor costs
(especially during downturns in profitability) while concurrently offering performance-based
incentives to their workers. Through the use of a profit-sharing plan, the automakers were able
to negotiate base-pay reductions with the UAW union. This plan provides workers with
additional incentive pay when the companies are profitable, but does away with that added
expense when profits take a downturn making the company and its profitability more sustainable
in the long run.
Discussion Questions
1. What are the advantages and disadvantages of profit sharing from worker and
company perspectives?
Workers – advantage is opportunity to share in the success of the company.. A
disadvantage is having to accept a loss of the incentive during downturns. For the
2. How are theories of motivation relevant?
There are a number of ways this discussion could go. One potential direction is that
Profit Sharing and Ownership
1. Under profit sharing, payments are based on a measure of organization
performance (profits) and do not become part of the employees’ base
salary.
a. An advantage is that profit sharing may encourage employees to
think more like owners and take a broad view of what needs to be
b. A second advantage is that because payments do not become part
c. The drawback is that workers may perceive their performance has
little to do with profit but is more related to top management
d. Another motivational problem is that most plans are deferred.
Dupont eliminated a profit-sharing plan when employees in some
divisions received less than those in comparable divisions and
e. In summary, although profit sharing may be useful as one
component of a compensation system, it may need to be
