978-1259532726 Chapter 1 Lecture Note

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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?