978-1259532726 Chapter 18 Lecture Note Part 2

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E. Budget Controls: Top Down

Top-down budgeting begins with an estimate from top management of

the pay increase budget for the entire organization. Once the total budget is

determined, it is then allocated to each manager, who plans how to distribute it

among subordinates.

There are many approaches to top-down budgeting. A typical one,

planned pay-level rise, is simply the percentage increase in average pay for

the unit that is planned to occur.

oSeveral factors influence the decision on how much to increase the

average pay level for the next period.

How much the average level was increased this period

Ability to pay

Competitive market pressures

Turnover effects

Cost of living

Current Year’s Rise

This is the percentage change in the average wage in the past year.

average pay at year end average pay at year beginning

Percent pay-level rise = 100 × average pay at year beginning

–

Ability to Pay

Any decision to increase the average pay level is in part a function of the

organization’s financial circumstances.

Financially healthy employers may wish to maintain their competitive

positions in the labor market or share financial success through bonuses and

profit sharing.

Conversely, financially troubled employers may not be able to maintain

competitive market positions.

oThe conventional response has been to reduce employment. By analyzing

pay and staffing at each level, potential cost savings can be discovered.

oOther options are to reduce the rate of increase in average pay by

controlling adjustments in base pay and/or variable pay. Raising

employees’ copays and deductibles for benefits is another.

oOften as a last resort, firms decrease base wages (as well as variable pay).

oOther alternatives also exist. For example, the employers can reduce costs

by reducing the different sources of contract employees.

Competitive Market Pressures

Managers determine an organization’s competitive position in relation to

its competitors. A distribution of market rates for benchmark jobs is collected

and analyzed into a single average wage for each benchmark.

oThis “average market wage” becomes the “going market rate,” and this

market rate changes each year in response to a variety of factors in the

external market.

Turnover Effects

Sometimes referred to as “churn” or “slippage,” the turnover effect

recognizes the fact that when people leave (through layoffs, quitting, retiring),

they typically are replaced by employees who earn a lower wage.

Turnover effect can be calculated as annual turnover multiplied by the

planned average increase.

The turnover effect will reduce benefit costs linked to base pay, such as

pensions.

Cost of Living

Although there is little research to support cost of living increases,

employees undoubtedly compare their pay increases to changes in their living

costs. Unions consistently argue that increasing living costs justify increasing

pay.



It is important to distinguish among three related concepts:

oCost of living—expenditure patterns of individuals for goods and services.

It is more difficult to measure because employees’ expenditures depend on

many things: marital status, number of dependents and ages, personal

preferences, location, and so on.

oChanges in prices in the product and service markets—measured by

several government indexes, one of which is the consumer price index.

oChanges in wages in labor markets—as Exhibit 18.7 shows, changes in

wages in labor markets are measured through pay surveys. These changes

are incorporated into the system through market adjustments in the budget

and updates of the policy line and range structure.

oThe three concepts are interrelated.

Wages in the labor market are part of the cost of producing goods

and services, and changes in wages create pressures on prices.

Changes in the prices of goods and services create the need for

increased wages in order to maintain the same lifestyle.

oMany people refer to the CPI as a “cost-of-living” index, and many

employers choose, as a matter of pay policy or in response to union

pressures, to tie wages to it. However, the CPI does not necessarily reflect

an individual employee’s cost of living.

Instead, it measures changes in prices over time.

oChanges in the CPI indicate only whether prices have increased more or

less rapidly in an area since the base period.

oIf employers decide to use the CPI rather than labor market salary surveys

to determine the merit budget, they basically are paying for inflation rather

than performance or market changes.

oThe CPI is of public interest because changes in it trigger changes in labor

contracts, social security payments, federal and military pensions, and

food stamp eligibility.

oTying budgets or payments to the CPI is called indexing.

Rolling It All Together

Let us assume that the managers take into account all these factors—

current year’s rise, ability to pay, market adjustments, turnover effects,

changes in the cost of living, and geographic differentials—and decide that

the planned rise in average salary for the next period is 6.3 percent.

oThis means that the organization has set a target of 6.3 percent as the

increase in average salary that will occur in the next budget period.

oIt does not mean that everyone’s increase will be 6.3 percent.

oIt means that at the end of the budget year, the average salary calculated to

include all employees will be 6.3 percent higher than it is now.

Distributing the Budget to Subunits

oA variety of methods exist for determining what percentage of the salary

budget each manager should receive.

Some use a uniform percentage, in which each manager gets an

equal percentage of the budget based on the salaries of each subunit’s

employees.

Others vary the percentage allocated to each manager based on

pay-related issues—such as turnover or performance—that have been

identified in that subunit.

oOnce salary budgets are allocated to each subunit manager, they become a

constraint: a limited fund of money that each manager has to allocate to

subordinates.

Typically, merit increase guidelines are used to help managers

make these allocation decisions.

Merit increase grids help ensure that different managers grant

consistent increases to employees with similar performance ratings and

in the same position in their ranges. Additionally, grids help control

costs.

To limit the number of employees placed in high performance

categories (and thus the number of employees receiving the largest

merit increases), some companies used forced distribution approaches.

F. Budget Controls: Bottom Up

In contrast to top-down budgeting, where managers are told what their

salary budget will be, bottom-up budgeting begins with managers’ pay

increase recommendations for the upcoming plan year. Exhibit 18.8 shows the

process involved.

1. Instruct managers in compensation policies and techniques—train

managers in the concepts of a sound pay-for-performance policy, and in

standard company compensation techniques such as the use of

pay-increase guidelines and budgeting techniques. Communicate market

data and the salary ranges.

2. Distribute forecasting instructions and worksheets—furnish managers

with the forms and instructions necessary to preplan increases. Most firms

offer managers computer software to support these analyses and to enter

information and perform what-if analyses.

Adjustments for each individual are fed into the summary merit budget,

promotion budget, equity adjustment budget, and so on, on a summary screen.

The type of information available to each supervisor to guide him or her

in making recommendations might include performance rating history, past

raises, training background, and stock allocations are all included.

Guidelines for increases based on merit, promotion, and equity

adjustments are provided, and all the worksheets are linked so that the

manager can model pay adjustments for employees and see the budgetary

effects of those adjustments immediately.

Some argue that providing such detailed data and recommendations to

operating managers makes the process biased.

3. Provide consultation to managers—offer advice and salary information

services to managers upon request.

4. Check data and compile reports—audit the increases forecasted to ensure

that they do not exceed the pay guidelines and are consistent with

appropriate ranges. Then use the data to feed back the outcomes of pay

forecasts and budgets.

5. Analyze forecasts—examine each manager’s forecast, and recommend

changes based on noted inequities among different managers.

6. Review and revise forecasts and budgets with management—consult with

managers regarding the analysis and any recommended changes. Obtain

top-management approval of forecasts.

7. Conduct feedback with management—present statistical summaries of the

forecasting data by department, and establish unit goals.

8. Monitor budgeted versus actual increases—control the forecasted

increases versus the actual increases by tracking and reporting periodic

status to management.

The result of the forecasting cycle is a budget for the upcoming plan

year for each organization’s unit as well as estimated pay treatment for each

employee.

oThe budget does not lock in the manager to the exact pay change

recommended for each employee. Rather, it represents a plan, and

deviations due to unforeseen changes such as performance improvements

and unanticipated promotions are common.

oThe approach places responsibility for pay management on the managers

by requiring them to plan the pay treatment for each of their employees.

The compensation manager takes on the role of advisor to operating

management’s use of the system.

G. Embedded (Design) Controls

Controls on managers’ pay decisions come from two different aspects of

the compensation process:

oControls that are inherent in the design of the techniques

oThe formal budgeting process

Many other techniques include:

oJob analysis and evaluation

oSkill- and competency-based plans

oPolicy lines

oRange minimums and maximums

oBroad bands

oPerformance evaluation

oGain sharing

oSalary-increase guidelines

Controls are built into these techniques to direct them toward the pay

system objectives.

Range Maximums and Minimums

Ranges set the maximum and minimum dollars to be paid for specific

work.

The maximum is an important cost control.

oIdeally, it represents the highest value the organization places on the

output of the work.

oWith job-based structures, skills and knowledge possessed by employees

may be more valuable in another job, but the range maximum represents

all that the work produced in a particular job is worth to the organization.

oSpecific jobs may have a maximum rate (a cap) but individuals may not.

They can earn beyond the job’s maximum through promotions,

profit sharing, and so on.

oIf employees are paid above the range maximum, these rates are called red

circle rates.

Most employers “freeze” red circle rates until the ranges are

shifted upward by market update adjustments so that the rate is back

within the range again.

An organization also has the option to combine a salary freeze

with the use of merit bonuses, which unlike merit increases, do not

become part of base salary.

If red circle rates become common throughout an organization,

then the design of the ranges and the evaluation of the jobs should be

reexamined.

Green circle rates refer to instances where employees are paid

below the minimum.

Range minimums are the minimum value placed on work.

oOften rates below the minimum are often used for trainees.

oPay below minimum may also occur if outstanding employees receive a

number of rapid promotions and pay increases have not kept up.

Broad Bands

oBroad bands are intended to offer managers greater flexibility compared to

a grade-range design.

Usually broad bands are accompanied by external market

“reference rates” and “shadow ranges” that guide managers’ decisions.

oBands may be more about career management than pay decisions.

Rather, the control is in the salary budgets given to managers.

The manager has flexibility in pay decisions, as long as the total pay

comes in under the budget.

Promotions and External versus Internal Hires

Promotion-based pay increases are often substantial, meaning that cost

control efforts must monitor both rates of promotion and the salary increase

that is given with promotions.

oSome organizations limit the number of promotions permitted within a

time period and some also limit the number of grades/levels that an

employee can advance as well as the size of the promotion salary increase.

Another, more strategic issue concerns the degree to which positions are

filled from the inside via promotion versus the use of outside hires.

oOutside hires often command a pay premium and, to the degree that their

higher pay is known to other employees, internal equity pressures may, in

some cases, result in higher pay for current employees as a means to

preserve current norms regarding relative pay.

Compa-Ratios

Range midpoints reflect the pay policy line of the employer in

relationship to external competition. To assess how managers actually pay

employees in relation to the midpoint, an index called a compa-ratio is often

calculated:

average rate actual paid

Compa-ratio = range midpoint

A compa-ratio of less than 1 means that, on average, employees in a

range are paid below the midpoint. That is, managers are paying less than the

intended policy. There may be several valid reasons for such a situation:

oThe majority of employees may be new or recent hires.

oThe majority of employees may be poor performers.

oPromotion may be so rapid that few employees stay in the job long enough

to get into the high end of the range.

A compa-ratio greater than 1 means that, on average, the rates exceed

the intended policy. The reasons for this are the reverse of those mentioned

above:

oA majority of workers with high seniority

oA majority of workers with high performance

oLow turnover

oFew new hires

oLow promotion rates

Compa-ratios may be calculated for individual employees, for each

range, for organization units, or for functions.

Other examples of controls designed into the pay techniques include the

mutual sign-offs on job descriptions required of supervisors and subordinates.

Another is slotting new jobs into the pay structure via job evaluation,

which helps ensure that jobs are compared on the same factors.

Similarly, an organization-wide performance management system is

intended to ensure that all employees are evaluated on similar factors.

Variable Pay

The essence of variable pay is that it must be re-earned each period, in

contrast to conventional merit pay increases or across-the-board increases that

increase the base on which the following year’s increase is calculated.

Increases added into base pay have compounding effects on costs, and

these costs are significant.

The greater the ratios of contingent to core workers and variable to base

pay, the greater the variable component of labor costs and the greater the

options available to managers to control these costs.

Although variability in pay and employment may be an advantage for

managing labor costs, it may be less appealing from the standpoint of

managing effective treatment of employees. The inherent financial insecurity

built into variable plans may adversely affect employees’ financial well-being,

especially for lower-paid workers.

Analyzing Costs

Costing out wage proposals is commonly done prior to recommending

pay increases, especially for collective bargaining.

Commercial compensation software is available to analyze almost every

aspect of compensation information.

oSoftware can easily compare past estimates to what actually occurred.

oIt can simulate alternate wage proposals and compare their potential

effects.

oIt can also help evaluate salary survey data and simulate the cost impact of

incentive and gain-sharing options.

III. Managing Revenues

Although the cost of compensation is most easily measured, do not forget that

compensation is also central to driving future revenues.

Some companies are beginning to analyze the value added of pay decisions and

how that influences revenues.

oThis analysis requires a shift in how compensation is viewed. Compensation

becomes an investment as well as an expense. Decisions are based on analysis of

the return on this investment.

Exhibit 18.9 illustrated the approach to assessing value gained in different ways,

which directly or indirectly influence revenues.

The practice of analyzing the returns from compensation decisions is in its early

stages. The promise is that it will direct thinking beyond treating compensation as

only an expense to considering the returns gained as well.

A. Using Compensation to Retain (And Recruit) Top Employees

A substantial share of employees, especially high performers, leave their

jobs because of being “pulled” by opportunities elsewhere.

Employers would do well to keep compensation current and competitive

because other organizations will eventually find these “passive job seekers”.