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CHAPTER EIGHTEEN
MANAGEMENT: MAKING IT WORK
Overview
The financial conditions of an organization, the competitive pressures it faces, and budgeting
are integral to managing compensation. The cost implications such as updating the pay
structure, increasing merit pay, or instituting gain sharing are critical to making sound
decisions. Consequently, budgets are an important part of managing compensation. Creating a
compensation budget requires tradeoffs among the basic pay policies—how much of an
increase in market rates should be budgeted according to employee contributions to an
organization’s success compared to automatic across-the-board increases. Budgeting also
requires understanding the potential returns gained from each compensation program. The
returns might be productivity increases expected from a new profit-sharing plan or the value
gained from attracting and retaining the best people. In the past, budgeting was all about costs.
However, more objective analysis of the gains as well as the costs of compensation decisions is
taking hold. Thus, a total compensation program is a device to allocate financial resources that
is consistent with organizational objectives.
Management includes control of the way managers decide the pay of individual employees’
pay as well as the control of overall labor costs. Some controls are designed into the design of
the pay system (inherent controls, range maximums and minimums, etc.). The salary budgeting
and forecasting processes impose additional controls. The formal budgeting process focuses on
controlling labor costs and generating the financial plan for the pay system. The budget sets the
limits within which the system operates. Other aspects of management include the fair
treatment of employees in communications and participation, approaches to structuring the
compensation function, and the role of pay as a change agent. With the continuous change in
organizations, compensation managers must understand how to manage change to be
knowledgeable business partners.
This chapter focuses on several critical components of managing compensation:
Costs
Communication
Change
Six administrative issues necessary to manage the pay system are discussed in the chapter.
They include:
Managing labor costs
Inherent controls
Forecasting and budgeting
Communication and appeals
Structuring the compensation function
Auditing and evaluating the pay system
The basic point is that pay systems are tools, and like any tools they need to be evaluated in
terms of usefulness in achieving an organization’s objectives.
Learning Objectives
Identify the aspects of managing labor costs including staffing levels, hours, benefits,
average cash compensation, budget controls, and embedded design controls.
Understand the relationship between compensation and future revenues and how to use
compensation to retain top employees while managing pay to support strategy and
change.
Discuss the importance of communication, managing the message and transparency.
Synthesize structuring the compensation function and its roles, including centralization
and decentralization and the importance of ethics in managing, not manipulating.
Lecture Outline: Overview of Major Topics
I. Managing Labor Costs and Revenues
II. Managing Labor Costs
III. Managing Revenues
IV. Managing Pay to Support Strategy and Change
V. Communication: Managing the Message
VI. Structuring the Compensation Function and Its Roles
VII. Your Turn: Communication by Copier
VIII. Still Your Turn: Managing Compensation Costs, Headcount, and
Participation/Communication Issues
Lecture Outline: Summary of Key Chapter Points
Why bother with a formal system at all? If management is that important, why not simply let
every manager pay whatever works best? Such total decentralization of decision making could
create a chaotic array of rates. Managers could use pay to motivate behaviors that achieved
their own immediate objectives, not necessarily those of the organization. Employees could be
treated inconsistently and unfairly.
This was the situation in the United States in the early 1900s. The “contract system” made
highly skilled workers managers as well as workers. The employer agreed to provide the
“contractor” with floor space, light, power, and the necessary raw or semifinished materials.
The contractor hired and paid labor. Pay inconsistencies for the same work were common.
Dissatisfaction and grievances were widespread, which resulted in legislation that outlawed
such practices.
Any discussion of managing pay must again raise the basic questions: So what is the impact of
the decision or technique? Does it help the organization achieve its objectives? How?
Although many pay management issues have been discussed throughout the book, a few
remain to be called out explicitly. These include:
Managing labor costs
Managing revenues
Communication
Designing the compensation department
I. Managing Labor Costs and Revenues
The cost implications of actions such as updating the pay structure, increasing
merit pay, or instituting gain sharing are critical for making sound decisions.
oCreating a compensation budget requires tradeoffs, such as how much of an
increase should be allocated according to employee contributions versus
across-the-board increases.
oTradeoffs also occur over short- versus long-term incentives, over pay increases
contingent on performance versus seniority, and over cash compensation
compared to benefits.
oFinancial planning also requires understanding the potential returns gained from
the allocation.
oTotal compensation makes up at least 50 percent of operating expenses in many
organizations.
Yet, most companies have not tried to analyze the returns from their
compensation decisions.
Returns might be the productivity increases expected from a new
gain-sharing or profit-sharing plan, or the expected value added by boosting
merit increases to the top performers.
Analysis of the expected returns compared to costs is becoming more
common.
II. Managing Labor Costs
Exhibit 18.1 shows a simple labor cost model. Using this model, there are three
main factors to control in order to manage labor costs:
oEmployment (e.g., number of workers and the hours they work)
oAverage cash compensation (e.g., wages, bonuses)
oAverage benefit costs
Labor costs = Number of workers and hours worked × (average cash
compensation + average benefit cost)
A. Number of Employees (a.k.a.: Staffing Levels or Headcount)
Using information about competitors’ average pay helps improve
understanding of labor costs. Exhibit 18.2A shows how one organization pays
its engineers relative to its competitors at each of five job levels, E5–E1.
Exhibit 18.2B provides more insight into the organization’s labor costs.
This part of the exhibit compares the organization’s distribution of engineers
among the five job levels to its competitors’ distributions.
Reducing Headcount
oOrganizations often reduce headcount to cut labor costs.
Such cuts may take the form of layoffs (often with severance
benefits that depend on length of service) or exit incentives that are
designed to encourage employees to leave “by choice.”
oA major advantage of a reduction in force is that it also reduces benefits
costs, something that a pay cut, furlough, or reduction in hours ordinarily
does not achieve.
oTo the degree that headcount reductions can be targeted based on
performance, it can also be an opportunity for an organization to re-shape
its workforce in a way that creates positive sorting effects.
Under such a scenario, stronger performers are unaffected (e.g.,
their pay is not cut) and the organization has an opportunity to
maintain good employee relations with this important group.
oThere are, however, several potential problems with headcount reductions.
Regulatory requirements make it difficult to make targeted cuts.
The Age Discrimination in Employment Act (ADEA) often comes
into play if organizations target reductions among higher paid
employees (to maximize labor cost savings) because higher paid
employees also tend to be older employees.
The Older Worker Benefits Protection Act, part of the ADEA,
requires that exit incentive programs be structured in very specific
ways.
These and other provisions tend to make it difficult to single out
high-wage and/or poor- performing workers.
Workforce reductions, especially if not handled well, can harm
employee relations.
Organizations that make greater (involuntary) workforce
reductions also experience greater voluntary turnover.
RIFs, while reducing costs over time, are very costly in tangible
terms up front due to increases in unemployment insurance tax rates,
disruption of work processes and serving customers, and
administrative costs of handling exits.
Exit incentives, if provided, further drive up costs.
Some companies have learned to run so “lean” (i.e., very few
employees on manufacturing lines), and have controlled hiring so
successfully, that there may be little room to cut headcount.
Where cuts can be made, if the cuts are too deep, an organization
will be poorly positioned to generate revenue if business picks up
again.
An organization may spend a lot of money reducing headcount and
then spend a lot more a short time later to hire new employees to
handle increased product demand.
If other firms increase hiring at the same time, costs will be even
greater.
Announcements of layoffs and plant closings often have favorable
short-run effects on stock prices as investors anticipate improved
cash flow and lower costs.
However, in the longer term, adverse effects such as loss of trained
employees, unrealized productivity, and lowered morale often
translate into lower financial gains than anticipated.
Some evidence indicates that close attention to process and
employee relations during workforce reductions can help financial
results.
oThe regulatory environment differs from country to country.
Many European countries have legislation as part of their social
contracts that makes it very difficult to reduce headcount or wages.
Managing labor costs is a greater struggle in such circumstances.
oMany employers seek to buffer themselves from getting into a position
where layoffs are necessary. Use of overtime is part of this strategy.
In addition, organizations establish different relationships with
different groups of workers.
As Exhibit 18.3 depicts, the two groups are commonly referred
to as:
Core employees—with whom a long-term relationship is desired.
Contingent workers—whose employment agreements may cover
only short and specific time periods. They can be employees, but
can also be independent contractors/vendors or may be employed
by staffing services firms/vendors.
oRather than expand or contract the core workforce, many employers
achieve flexibility and control labor costs by expanding or contracting the
contingent workforce.
B. Hours
Another way to manage labor costs is to examine overtime hours versus
hiring more employees.
The four factors in the labor cost model—number of employees, hours
worked, cash compensation, and benefit costs—are not independent.
oOvertime hours require higher wages but the incremental benefits cost is
substantially lower than that incurred in hiring an additional regular
employee.
oThe higher the fixed benefits costs, the more viable is the option to add
overtime rather than hiring another employee.
oBy not hiring, the organization avoids recruitment/selection costs. It also
gains flexibility to reduce labor costs if the demand declines in the future.
In that case, rather than cutting headcount, it can reduce hours
worked, which helps avoid employee relations problems as well as the
monetary costs of reducing headcount.
During the most recent recession, a number of firms reduced hours and
costs through the use of mandatory unpaid leave or furloughs to cut hours and
thus labor costs.
Reducing hours and pay does mean that fewer headcount reductions are
necessary and by avoiding these, there will be less disruption and private
sector organizations should be better positioned to respond when business
picks up again.
C. Benefits
One of the most common approaches to reducing benefits costs recently
has been for employers to suspend matching contributions (made when
employees contribute) to 401(k) retirement plans.
oSurvey data show about one in four companies either have already
suspended their matching contributions or are considering doing so.
oThe average company match is 50 cents on the dollar up to 6 percent of
pay.
oMore companies may move to a model that makes matching contributions
dependent on profits.
Another action seen is organizations eliminating benefits such as defined
benefit (pension) plans as part of seeking bankruptcy protection from
creditors.
oExamples include several airlines (e.g., United, Delta, USAir, Northwest),
automobile companies (General Motors, Chrysler), and automobile parts
companies (e.g., Delphi).
oThe Pension Benefit Guaranty Corporation (PBGC) provides benefits to
employees who were covered under such plans. However, the maximum
monthly retirement benefit from the PBGC is $5,011, meaning that more
highly paid employees can experience a significant loss in pension
benefits after bankruptcy.
Other, more typical, ways of controlling or reducing benefits costs have
to do with efforts by companies in the area of health care.
D. Average Cash Compensation (Fixed and Variable Components)
Average cost compensation includes average salary level plus variable
compensation payments such as bonuses, gain sharing, stock plans, and/or
profit sharing.
During the most recent recession (in 2009), almost one-half of firms
froze salaries, giving no annual increase, resulting in an average salary
increase budget across companies of just 1.9 percent. As Exhibits 18.5
indicates, salary increase budgets have increased since 2009.
Another major tool used by organizations to control salary costs, in both
good and bad times, is variable pay. As Exhibit 18.6 shows, while the size of
the merit increase budget has come down over time, the size of the variable
pay (e.g., lump sum merit increases, profit sharing) budget has gone up
significantly.
Adjustments to average cash compensation level can be made:
oTop down—top management determines the amount of money to be spent
on pay and allocates it “down” to each subunit for the plan year.
oBottom up—individual employees’ pay for the plan year is forecasted and
summed to create an organization-wide salary budget.
