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CHAPTER ONE
THE PAY MODEL
Overview
Part One, Introducing the Pay Model and Pay Strategy, contains chapters one and two. This part
of the text talks about what “pay” means and how paying them in different ways can influence
them and influence organization success. The two chapters describe the compensation policies
and techniques that organizations use and the multiple objectives they hope to achieve by
effectively managing these compensation decisions. The aim of Part One is to understand how
compensation strategy decisions interact with the specific context of an organization (its business
and human resource strategies) to influence organization success.
Chapter one starts with a discussion on the role of poorly designed compensation plans in the
current economic situation. It provides an overview of the key components of a compensation
system. The definition of compensation is initially explored from the perspectives of the society,
stockholders, the organization, and the external environment. Next, the various forms of pay are
identified and defined. The major focus is presenting a pay model that provides a structure for
understanding compensation systems. The three main components of the model are (1)
compensation objectives, including the importance given to ethics; (2) policy decisions that
guide the way objectives will be achieved; and (3) techniques that make up the pay system. The
book plan is outlined at the end of chapter one. The remaining chapters examine each of the four
policy decisions—internal alignment, external competitiveness, employee performance, and
management—as well as the techniques, new directions, and related research.
Learning Objectives
Discuss the importance of compensation, including the benefits of a well-designed
compensation system and the detriments of poorly designed compensation systems.
Define compensation from the perspectives of society, stockholders, managers, and
employees; including the incentive and sorting effects of pay on employee behavior.
Examine the various forms of pay including cash compensation, benefits, total earnings
opportunities, and relational returns from work.
Identify a pay model’s three components: compensation objectives; four policy choices of
internal alignment, external competitiveness, employee contributions, and management
of the pay system; and pay techniques.
Lecture Outline: Overview of Major Topics
I. Compensation: Does it Matter (or, “So What?”)
II. Compensation: Definition, Please
III. Forms of Pay
IV. A Pay Model
V. Book Plan
VI. Caveat Emptor—Be an Informed Consumer
VII. Your Turn—The Role of Labor Costs in Retail Electronics
Lecture Outline: Summary of Key Chapter Points
I. Compensation: Does It Matter (Or, “So What?”)
The role of poorly designed compensation plans in the recent economic downturn is
analyzed from different perspectives.
Companies that failed in recent times had labor costs higher than competition without
the corresponding advantages in efficiency, quality, and customer service. Example:
Chrysler Motors.
Successful companies had relatively high pay as well as higher productivity compared
to competitors. Example: Nucor Steel.
Wall Street financial services firms and banks used incentive plans that rewarded
people for developing “innovative” new financial investment vehicles and for taking
risks to earn themselves and their firms a lot of money.
When the markets discovered that many such risks had gone bad, the firms either had to
file for bankruptcy or wait for other companies to take them over.
Congress and the President thought greater expertise in the design and execution of
compensation plans would have controlled excessive risk-taking and prevented other
problematic behaviors while promoting a positive culture.
The resulting legislation was the Troubled Asset Relief Program (TARP), which
included restrictions on executive pay and discouraged executives from taking
“unnecessary and excessive risks.”
Well-designed compensation systems can help an organization achieve and sustain
competitive advantage. Poorly designed compensation systems can play a major role in
undermining organization success.
II. Compensation: Definition, Please
People’s view of compensation differs depending on whether they look at compensation
from the perspective of a member of society, a stockholder, a manager, or an employee.
Thus the definition and importance of compensation is analyzed from several different
perspectives.
A. Society
Some people see pay as a measure of justice.
oFor example: comparing earnings of women with those of men highlights
potential pay inequities.
oIn 2013, among full-time workers in the United States, women earned 82
percent of what men earned, up from 62 percent in 1979.
oIf women had the same education, experience, and union coverage as men
and worked in the same industries and occupations, the ratio could increase
as high as 90 percent, still leaving a sizable gap.
Society has taken interest in such earning differentials by introducing laws and
regulation aimed at eliminating the role of discrimination in causing them.
Benefits given as a part of total compensation may also be seen as a reflection
of societal equity or justice.
Employers spend about 44 cents for benefits on top of every dollar paid for
wages and salaries.
Job losses or gains in a country over time are partly a function of relative labor
costs (and productivity) across countries.
Some consumers know that pay increases often lead to price increases. They do
not believe that higher labor costs benefit them. Other consumers lobby for
higher wages.
B. Stockholders
Stockholders differ on their views of whether employees should be given stock
options or not.
oSupporters of this thought believe that it creates a sense of ownership that
will improve performance and eventually increase stockholder wealth.
oOpponents argue that granting employees too much ownership dilutes
stockholder wealth.
Stockholders have a particular interest in executive pay. To the degree that the
interests of executives are aligned with those of shareholders (e.g., by paying
executives on the basis of company performance measures such as shareholder
return), the hope is that company performance will be higher.
In the absence of a linkage between executive pay and company performance,
concerns arise that the executives can somehow use their influence to obtain
high pay without necessarily performing well.
C. Managers
Managers view compensation as influencing their success in two ways.
oFirst, it is a major expense.
Competitive pressures force managers to consider affordability of
compensation decisions since labor costs can account for more than 50%
of total costs.
oSecond, it is a major determinant of employee attitudes and behaviors (and
thus, organization performance).
The way people are paid affects quality of their work, attitude toward
customers, and willingness to be flexible, learn new skills, or suggest
innovations.
D. Employees
For most employees, pay is a major source of financial security.
Employees may view compensation as:
oa return in an exchange between their employer and themselves,
oas an entitlement for being an employee of the company,
oas an incentive to take/stay in a job and invest in performing well, or
oas a reward for having done so.
Compensation can be all of these things.
E. Incentive and Sorting Effects of Pay on Employee Behaviors
oPay influences employee motivation and behavior in two ways:
Pay can affect the motivational intensity, direction, and persistence of
current employees. Motivation, together with employee ability and
work/organizational design, determines employee behaviors such as
performance. This effect of pay is known as incentive effect, the degree
to which pay influences individual and aggregate motivation among the
employees we have at any point in time.
Pay can also have an indirect, but important, influence via a sorting
effect on the composition of the workforce. That is, different types of
pay strategies may cause different types of people to apply to and stay
with an organization. It is not only how much, but how an organization
pays that can result in a sorting effect.
oFocusing only on the incentive effects of pay can miss the other major
mechanism (sorting) by which pay decisions influence employee behaviors
oCompensation policies work through employee incentive and sorting effects
to either achieve or not achieve the company’s objectives.
F. Global Views—Vive la différence
In English, compensation means something that counterbalances, offsets, or
makes up for something else.
In China, the traditional characters for the word “compensation” are based on
the symbols for logs and water; meaning that compensation provides the
necessities in life.
oIn the recent past, compensation was viewed as an entitlement.
oToday, a new word, dai yu, is used; it refers to how one is treated with
respect to wages, benefits, training opportunities, and so on. The
contemporary meaning of compensation includes returns as well as
entitlement.
“Compensation” in Japanese is kyuyo which means “giving something.”
oTraditionally, compensation was viewed as something given by one’s
superior.
oToday the word hou-syu, which means “reward”, is used; it has no
association with notions of superiors.
oTeate, which means “taking caring of something,” is regarded as
compensation that takes care of employees’ financial needs. It includes the
many allowances (family, housing, and commuting allowances) still used in
many Japanese companies.
Contrasting ideas about compensation—multiple views and multiple meanings
—add richness to the topic. To minimize confusion, the following definition of
“compensation” or “pay” is provided:
Definition: Compensation refers to all forms of financial returns and tangible
services and benefits employees receive as part of an employment relationship.
III. Forms of Pay
Exhibit 1.5 shows the variety of returns people receive from work. They are categorized
as:
oTotal compensation—these returns are transactional in nature and include pay
received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments)
and indirectly as benefits (e.g., pensions, medical insurance, programs to help
balance work and life demands).
oRelational returns—these are psychological and include recognition and status,
employment security, learning opportunities, challenging work and so on.
A. Cash Compensation: Base
Base wage is the cash compensation an employer pays for work performed; it
reflects value of work or skills and generally ignores differences attributable to
individual employees.
In the U.S., salary refers to pay given to employees who are exempt from
regulations of the Fair Labor Standards Act. Nonexempts have their pay calculated
on an hourly wage. Salary is calculated at an annual or monthly rate.
Rather than dividing employees into separate categories of salaried and wage
earners, some organizations (IBM and Walmart) believe an “all-salaried” workforce
reinforces an organizational culture where all employees are part of the same team.
B. Cash Compensation: Merit Increases/Merit Bonuses/COLAs
A cost of living adjustment (COLA) to base wages may be based on changes in what
other employers are paying for the same work, changes in living costs, or changes
in experience or skill.
Merit increases are given as increments to the base pay and are based on
performance.
Companies increasingly use merit bonuses. These are based on performance rating
but are paid in the form of a lump sum rather than becoming (a permanent) part of
the base salary.
C. Cash Compensation: Incentives
Incentives also tie pay increases to performance. However, incentives differ from
merit adjustments:
oThey do not increase base wage and must be re-earned each pay period.
oThe potential size of incentive payment will be known beforehand.
Whereas merit pay programs evaluate past performance of an individual and
then decide on the size of the increase, what must happen in order to receive
the incentive payment is called out very specifically ahead of time. For
example, a Toyota salesperson knows the commission on a Land Cruiser
versus a Prius prior to making the sale.
oAn incentive program relies on an objective measure of performance (e.g. sales)
whereas a merit increase program typically relies on a subjective rating of
performance.
Incentives can be tied to the performance of an individual employee, a team of
employees, a total business unit, or some combination of individual, team, and unit.
The performance objective may be expense reduction, volume increases, customer
satisfaction, revenue growth, return on investments, and increase in stock value—
the possibilities are endless.
Because incentives are one-time payment, they do not permanently increase labor
costs. When performance declines, incentive pay automatically declines, too.
Consequently, incentives (and sometimes merit bonuses also) are frequently
referred to as variable pay.
D. Long-Term Incentives
Incentives may be short- or long-term.
Long-term incentives are intended to focus employee efforts on multiyear results
and are in the form of stock ownership or options to buy stock at a fixed price.
E. Benefits: Income Protection
Exhibit 1.5 showed that benefits, including income protection, work/life services,
and allowances, are also part of total compensation.
Some income protection programs are legally required in the United States;
employers must pay into a fund that provides income replacement for workers who
become disabled or unemployed.
Medical insurance, retirement programs, life insurance, and savings plans are
common benefits. They help protect employees from financial risks inherent in
daily life.
F. Benefits: Work/Life Balance
Programs that help employees better integrate their work and life responsibilities
include time away from work (vacations, jury duty); access to services to meet
specific needs (drug counseling, financial planning); and flexible work
arrangements (telecommuting, nontraditional schedules, nonpaid time off).
G. Benefits: Allowances
Allowances often grow out of whatever is in short supply; for example, housing and
transportation allowances are frequently part of the pay package in China.
H. Total Earnings Opportunities: Present Value of a Stream of Earnings
Up to this point compensation has been treated as something paid or received at a
moment in time. But a firm’s compensation decisions have a temporal effect.
A present-value perspective shifts the comparison of today’s initial offers to
consideration of future bonuses, merit increases, and promotions.
I. Relational Returns from Work
Non-financial returns from work have a substantial effect on employees’ behavior.
Relational returns from work include recognition and status, employment security,
challenging work, opportunities to learn, personal satisfaction from successfully
facing new challenges, and teaming with great co-workers.
The Organization as a Network of Returns
oIt is useful to view an organization as a network of returns created by all the
different forms of pay, including total compensation and relational returns.
oThe challenge is to design this network so that it helps the organization to
succeed.
IV. A Pay Model
Exhibit 1.6 shows a pay model. This pay model serves as both a framework for
examining current pay systems and a guide for most of the text. It contains three basic
building blocks:
1. the compensation objectives,
2. the policies that form the foundation of the compensation system, and
3. the techniques that make up the compensation system.
A. Compensation Objectives
Pay systems are designed to achieve certain objectives. The basic objectives
include:
oEfficiency—can be stated more specifically: (1) improving performance,
increasing quality, delighting customers and stockholders and (2) controlling
labor costs.
oFairness— is a fundamental objective of pay systems. It attempts to ensure
fair treatment for all the employees, by recognizing both employee
contributions, and employee needs. Procedural fairness refers to the process
used to make pay decisions.
oEthics
oCompliance with laws and regulations—compliance means conforming to
various federal and state compensation laws and regulations.
Ethics
oEthics means the organization cares about how its results are achieved.
oBecause it is so important, it is inevitable that managing pay sometimes
creates ethical dilemmas.
oSome compensation professionals and consultants remain silent during ethical
misconduct and outright malfeasance.
oPay objectives guide the design of the pay system and serve as the standards
for judging the success of the pay system.
B. Four Policy Choices
Internal Alignment
oInternal alignment refers to comparisons among jobs or skill levels inside a
single organization.
oJobs and people’s skills are compared in terms of their relative contributions
to the organization’s business objectives.
oInternal alignment pertains to the pay rates both for employees doing equal
work and for those doing dissimilar work.
oPay relationships within the organization affect all three compensation
objectives:
By motivating employees to choose increased training and greater
responsibility in dealing with customers, internal pay relationships
indirectly affect the capabilities of the workforce and hence the efficiency
of the entire organization.
Fairness is affected through employees’ comparisons of their pay to the
pay of others in the organization.
Compliance is affected by the basis used to make internal comparisons.
External Competitiveness
oExternal competitiveness refers to pay comparisons with competitors.
oMany organizations claim their pay systems are market-driven, that is, based
almost exclusively on what competitors pay. “Market driven” gets translated
into practice in different ways.
oExternal competitiveness decisions—both how much and what forms—have a
twofold effect on objectives:
1. To ensure that the pay is sufficient to attract and retain employees—if
employees do not perceive their pay as competitive in comparison to what
other organizations are offering for similar work, they may be more likely
to leave.
2. To control labor costs so that the organization’s prices of products or
services can remain competitive in a global economy.
Employee Contributions
oHow much emphasis should there be on paying for performance? Should one
programmer be paid differently from another if one has better performance
and/or greater seniority? Or should there be a flat rate for programmers?
Should the company share any profits with employees? Share with all
employees, part-time as well as full-time?
oEmphasis placed on employee contributions (or nature of pay mix) is a key
policy decision since it directly affects employees’ attitudes and work
behaviors.
oPerformance-based pay affects fairness in that employees need to understand
the basis for judging performance in order to believe that their pay is fair.
oSome companies combines pay and team incentives to offer higher pay if
team performance warrants.
oThe external competiveness and employee contribution decisions should be
made jointly. Clearly, an above-market compensation level is most effective
and sustainable when it exists together with above-market employee
contributions to productivity, quality, customer service, or other important
strategic objectives.
Management
oManagement means ensuring that the right people get the right pay for
achieving the right objectives in the right way.
oThe ground under compensation management has shifted. The traditional
focus on how to administer various techniques is long gone, replaced by more
strategic thinking—managing pay as part of the business.
C. Pay Techniques
Techniques tie the four basic policies to the pay objectives.
Uncounted variations in pay techniques exist.
V. Book Plan
Part One, Chapters 1 – 2, introduces the pay model and pay strategy. Chapter 2
discusses how to formulate and execute a compensation strategy.
Part Two, Chapters 3 – 6, focuses on internal alignment and examines pay
relationships within a single organization.
Part Three, Chapters 7 – 8, examines external competitiveness – the pay relationships
among competing organizations – and analyzes the influence of market-driven forces.
Part Four, Chapters 9 – 11, focuses on employee contributions, the third building
block in the model, examining issues related to how much to pay each employee, how
much and how often should an employee’s pay be increased and on what basis, etc.
Part Five, Chapters 12 – 13, covers employee services and benefits.
Part Six, Chapters 14 – 16, covers systems tailored for special groups (sales
representatives, executives, contract workers, and unions) and provides more detail on
global compensation systems.
Part Seven, Chapters 17 – 18, discusses critical issues related to managing the
compensation system, including the government’s role in compensation as well as
understanding, communicating, budgeting, and evaluating the results of managing a
compensation system.
Even through the book is divided into sections that reflect the pay model, pay decisions
are not discrete. All of them are interrelated.
VI. Caveat Emptor – Be an Informed Consumer
Students and future managers need to be informed consumers of compensation
research. They must be able to understand the state of knowledge—what is and isn’t
known. It pays to read research. Some studies are irrelevant and poorly performed, but
not reading research literature might turn one into a prey for the latest business
self-help fad.
A consumer’s guide, that includes three questions, is provided to evaluate research
studies.
oIs the Research Useful?
oDoes the Study Separate Correlation From Causation?
Once we are confident that the variables are useful and accurately measured, we
must be sure that they are actually related.
Most often this is addressed through the use of statistical analysis.
The correlation coefficient is a common measure of association and indicates
how changes in one variable are related to changes in another.
Many research studies use a statistical analysis known as regression analysis.
One output from a regression analysis is the R2. The R2 is much like a
correlation in that it tells us what percentage of the variation is accounted for by
the variables we are using to predict or explain.
But even if there is a relationship, correlation does not ensure causation. New
technology, reengineering, improved marketing, or the general expansion of the
local economy may also contribute to the results.
oAre There Alternative Explanations?
