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CHAPTER TWO
STRATEGY: THE TOTALITY OF DECISIONS
Overview
This chapter examines the key aspects of decisions taken during the creation of compensation
strategy. The key premise is that the way employees are compensated can be a source of
sustainable competitive advantage. The three tests to identify if a pay strategy provides
competitive advantage are discussed. The steps involved in developing a total compensation
strategy are described: (1) assessing conditions; (2) deciding on the best strategic choices using
the pay model (objectives, alignment, competitiveness, contributions, and management); (3)
implementing the strategy through the design of the pay system; and (4) reassessing the fit. Two
alternative approaches to developing a compensation strategy are highlighted: (1) “best-fit” and
(2) “best-practices” approach. The best-fit approach presumes that one size does not fit all.
Managing compensation strategically means fitting the compensation system to the business and
environmental conditions. In contrast, the best-practices approach assumes a universal best way
exists. The focus is not on what the best compensation strategy is but on how to best implement
the system and ultimately fit the compensation system to the business and environmental
conditions.
Learning Objectives
Identify and describe similarities and differences in strategies, including different
strategies within the same industry and different strategies within the same company.
Discuss strategic choices that support business strategy and choices that support HR
strategies, included stated versus unstated strategies.
Describe a total compensation strategy in four steps: assess total compensation
implications, map a total compensation strategy, implement strategy, and reassess.
Apply the three tests for sources of competitive advantage: align, differentiate, and add
value.
Compare best practices versus best fit and virtuous and vicious circles.
Lecture Outline: Overview of Major Topics
I. Similarities and Differences in Strategies
II. Strategic Choices
III. Support Business Strategy
IV. Support HR Strategy
V. The Pay Model Guides Strategic Pay Decisions
VI. Developing a Total Compensation Strategy: Four Steps
VII. Source of Competitive Advantage: Three Tests
VIII. “Best Practices” versus “Best Fit”?
IX. Guidance from the Evidence
X. Virtuous and Vicious Circles
XI. Your Turn: Merrill Lynch
XII. Still Your Turn: Mapping Compensation Strategies
Lecture Outline: Summary of Key Chapter Points
I. Similarities and Differences in Strategies
Compensation strategies of three companies (Google, Nucor, and Merrill Lynch) are
compared and contrasted. All three are innovators in their industry. Their decisions on
the five dimensions of compensation strategy (objectives, internal alignment,
externally competitive, employee contribution, and management) are both similar and
different. All three formulate their pay strategy to support their business strategy. All
three emphasize outstanding employee performance and commitment. However, there
are major differences (Exhibit 2.1):
oWhile Google is one of the largest companies in the world, it positions itself as
still being, at heart, the feisty start-up populated by nerds and math whizzes. It
offers all its employees such generous stock options that many of them have
become millionaires.
oNucor Steel is a pioneer in recycling steel scrap and other metals into steel
products, including rebar, angles, rounds, channels, flats, sheet, beams, plate and
other products. The emphasis is on high productivity, high quality, and low cost
products. Nucor provides an opportunity for those who are willing to work hard to
make a lot of money by helping the company be productive and profitable.
oMerrill Lynch, now part of Bank of America, advises companies and clients
worldwide. Merrill Lynch pay objectives are straightforward: to attract, motivate,
and retain the best talent. It relies heavily on the human capital of its employees to
compete.
These three companies operate in different industries and vary in terms of the
conditions they face, the customers they serve, and the talent they employ. So the
differences in their pay strategies may not be surprising. Pay strategies can also differ
among companies competing for the same talent and similar customers.
A. Different Strategies within the Same Industry
Google, Microsoft, and SAS all compete for software engineers and marketing
skills but they focus on different components of an employees’ compensation.
In its earlier years, Microsoft adopted a very similar strategy to Google’s, except
its employees accepted less base pay to join a company whose stock value was
increasing exceptionally. But when its stock quit performing so spectacularly,
Microsoft shifted its strategy to increase base and bonus to the 65th percentile
from the 45th percentile of competitors’ pay. It still retained its strong emphasis
on (still nonperforming) stock-related compensation, but eliminated its
longstanding, broad-based stock option plan in favor of stock grants. Its benefits
continue to lead the market.
SAS Institute, the world’s largest privately owned software company, takes a
different approach. It emphasizes work/life programs over cash compensation
and provides limited bonuses and no stock awards.
B. Different Strategies within the Same Company
Sometimes different business units within the same corporation face very
different competitive conditions, adopt different business strategies, and thus fit
different compensation strategies. For example, the Korean company SK
Holdings has even much variety in its business units. They include a gasoline
retailer, a cellular phone manufacturer, and SK Construction. SK has different
compensation strategies aligned to each of its very different businesses.
A simple “let the market decide our compensation” strategy does not work
internationally. In many nations, markets do not operate as in the United States or
may not even exist. Emerging labor markets in some developing countries and
highly regulated labor markets in some developed countries are responsible for
less movement of people among companies than is common in the U.S., Canada,
or even Korea, and Singapore.
Strategic perspective on compensation is more complex than it first appears.
II. Strategic Choices
Strategy refers to the fundamental directions that an organization chooses. An
organization defines its strategy through the tradeoffs it makes in choosing what (and
what not) to do.
Exhibit 2.2 ties the strategic choices to the quest for competitive advantage.
At the corporate level, the fundamental strategic choice is: What business should we
be in?
At the business unit level, the choice shifts to: How do we gain and sustain
competitive advantage in this business?
At the function level the strategic choice is: How should total compensation help this
business gain and sustain competitive advantage?
The ultimate purpose—the “so what?”—is to gain and sustain competitive advantage.
Definition: A strategic perspective focuses on those compensation choices that help the
organization gain and sustain competitive advantage.
III. Support Business Strategy
A currently popular theory proposes that pay systems align with an organization’s
business strategy. The rationale is based on contingency notions.
oDifferences in a firm’s strategy should be supported by corresponding differences
in its human resource strategy, including compensation.
oThe underlying premise is ‘the greater the alignment, or fit, between an
organization’s strategy and the compensation system, the more effective the
organization.
Exhibit 2.3 gives an example of how compensation systems might be tailored to the
three general business strategies.
oThe innovator strategy stresses new products and short response time to market
trends. A supporting compensation approach places less emphasis on evaluating
skills and jobs and more emphasis on incentives designed to encourage
innovations.
oThe cost cutter strategy focuses on efficiency, doing more with less, and
minimizing costs. It encourages productivity increases, and specifying in greater
detail exactly how jobs should be performed.
oThe customer focused strategy stresses delighting customers and bases employee
pay on how well they do this.
Compensation strategies can also be based on generic strategy frameworks:
oMichael Porter’s business strategy framework includes (1) cost leadership
strategy (focus is on reducing costs) and (2) differentiator strategy (focus is on
providing a unique and/or innovative product or service at premium prices).
oMiles and Snow’s framework includes (1) defenders (companies that operate in
stable markets and compete on cost) and (2) prospectors (companies that focus on
innovation and new markets).
oConventional wisdom would be that competing on cost requires lower
compensation, whereas competing through innovation is likely to be more
successful with high-powered incentives/pay for performance.
oMost firms, however, do not have generic strategies. Instead, they tend to have
aspects of cost and innovation. Likewise, compensation strategies do not
necessarily line up neatly with generic business strategies. For example, Nucor
and Southwest Airlines rely heavily on cost leadership in their strategies, but pay
their employees well above market (e.g., using stock and profit sharing plans)
when firm performance is strong.
oLooking at Exhibit 2.3, one would tend to fit Google as an innovator, Merrill
Lynch as customer focused, and Nucor an innovator as well as a dedicated cost
cutter and productivity-focused. However, managers of these companies say that
they are a unique blend of the three strategies.
When an organization’s business strategy changes, the pay systems should change. A
classic example is IBM’s strategic and cultural transformation is discussed in the text.
IV. Support HR Strategy
A compensation strategy that supports the business strategy implies alignment
between compensation and overall HR strategies.
oIn the literature on high-performance work systems (HPWS) and HR strategy,
researchers Boxall and Purcell have found a commonly used performance theory.
They refer to this as the “AMO theory,” given by P = f (A, M, O).
oThe theory states that performance (P) is a function (f) of three factors: ability
(A), motivation (M), and opportunity (O).
oCompensation is the key to attracting, retaining, and motivating employees with
the abilities necessary to execute the business strategy and handle greater
decision-making responsibilities. Compensation is also the key to motivating
them to fully utilize those abilities.
Compensation strategy and HR strategy are central to successful business strategy
execution. Exhibit 2.5 seeks to capture that idea, the importance of AMO and fit. This
in turn influences the revenues and costs of the company.
All of these factors are critical to increasing the effectiveness of the company through
increased customer satisfaction, competitive advantage, and stakeholder satisfaction.
V. The Pay Model Guides Strategic Pay Decisions
Using the Pay model, the five strategic compensation choices facing Whole Foods
managers will be:
oObjectives: How should compensation support the business strategy and be
adaptive to the cultural and regulatory pressures in a global environment?
oWhole Foods objectives:
oIncrease shareholder value through profits and growth;
oGo to extraordinary lengths to satisfy and delight customers;
oSeek and engage employees who are going to help the company make
money.
oInternal Alignment: How differently should the different types and levels of skills
and work be paid within the organization?
oWhole Foods:
oStore operations are organized around self-managed teams;
oExecutive salaries do not exceed 19 times the average pay of full-time
employees;
oAll full-time employees qualify for stock options and 94 percent of
options go to nonexecutive employees.
oExternal Competitiveness: How should total compensation be positioned against
competitors? What forms of compensation should be used?
oWhole Foods:
oOffers a unique total compensation package compared to competitors.
They provide health insurance to full-time employees and 20 hours of paid
time a year to do volunteer work.
oEmployee Contributions: Should pay increases be based on individual and/or team
performance, on experience and/or continuous learning, on improved skills, on
changes in cost of living, on personal needs, and/or on each business unit’s
performance?
oWhole Foods:
oUses a shared fate technique where monthly team performance, in terms of
revenue per hour worked, directly affects what the team is paid.
oManagement: How open and transparent should the pay decisions be to all
employees? Who should be involved in designing and managing the system?
oWhole Foods:
oUses a “No-secrets” management technique where every store provides
salary amounts for every employee, including executives.
oUsing “You Decide”, employees chose to pick their health insurance rather
than have one imposed by leadership.
These decisions, taken together, form a pattern that becomes an organization’s
compensation strategy.
A. Stated versus Unstated Strategies
All organizations that pay people have a compensation strategy. Some have a
written compensation strategy shared with all employees.
The compensation strategy of other organizations emerges from the pay decisions
they make.
Managers in all organizations make the five strategic decisions (objectives,
internal alignment, externally competitive, employee contribution, and
management). Some do it in a rational, deliberate way, while others do it more
chaotically—as ad hoc responses to pressures from the economic, sociopolitical,
and regulatory context in which the organization operates.
VI. Developing a Total Compensation Strategy: Four Steps
Exhibit 2.6 shows the four simple steps involved in developing a compensation
strategy. While the steps are simple, executing them is complex. Trial and error,
experience, and insight play major roles. Research evidence can also help.
A. Step 1: Assess Total Compensation Implications
Business Strategy and Competitive Dynamics—Understand the Business
oThis first step includes an understanding of the specific industry in which the
organization operates and how the organization plans to compete in that
industry. This corresponds with the first two decisions in Exhibit 2.2: What
business should we be in, and how do we win in that business?
oLearn to gauge the underlying dynamics in the business (or build relationships
with those who can). Different compensation strategies must align with
different business strategies.
oCompetitive dynamics can be assessed globally. However, comparing pay
among countries is complex. Nevertheless, managers must be knowledgeable
about competitive conditions even locally.
B. HR Strategy: Pay as a Supporting Player or Catalyst for Change?
Whatever the overall HR strategy, a decision about the prominence of pay in that
HR strategy is required. Pay can be a supporting player, as in the
high-performance approach, or it can take the lead and be a catalyst for change.
Whatever the role, compensation is embedded in the total HR approach.
Culture/Values
oA pay system reflects the values that guide an employer’s behaviors and
underlie its treatment of its employees; a pay system thus mirrors a company’s
image and reputation.
Social and Political Context
oContext refers to a wide range of factors—legal and regulatory requirements,
cultural differences, changing workforce demographics, and employee
expectations. These also affect compensation choices.
oBecause governments are major stakeholders in determining compensation,
lobbying to influence laws and regulations can also be part of a compensation
strategy. So, from a strategic perspective, compensation managers shape the
sociopolitical environment as well as are shaped by it.
Employee Preferences
oEmployees have different needs and wants from a pay system.
oA major challenge in the design of next-generation pay systems is how to
better satisfy individual needs and preferences—offering more choice is one
approach.
Choice is Good. Yes, No, Maybe?
oContemporary pay systems in the United States do offer some choices
including flexible benefits and choices among health care plans.
oSome studies have found that people do not always choose well. They do not
always understand the alternatives, and too many choices simply confuse
them.
oIn addition to possibly confusing employees, unlimited choice would be a
challenge to design and manage. Unlimited choice may also meet with
disapproval from the U.S. Internal Revenue Service (health benefits are not
viewed by the IRS as income).
Union Preferences
oPay strategies need to be adapted to the nature of the union-management
relationship.
oAlthough union membership among private-sector workers in the U.S. is less
than 10%, unions do influence pay decisions.
oUnions’ interests can differ.
oCompensation deals with unions can be costly to change.
C. Step 2: Map a Total Compensation Strategy
A compensation strategy is formulated based on the five elements of the pay
model: objectives, and the four policy choices of alignment, competitiveness,
contributions, and management.
Mapping is often used in marketing to clarify and communicate a product’s
identity.
Strategic maps offer a picture of a company’s compensation strategy and can be
used to clarify the message a company is trying to deliver with its compensation
system.
oStrategic maps provide a visual reference.
oThey are useful in analyzing a compensation strategy that can be more clearly
understood by employees and managers.
oMaps do not tell which strategy is “best.” Rather, they provide a framework
and guidance.
It is important to realize that the decisions in the pay model work in concert. It is
the totality of the decisions that forms the compensation strategy.
D. Steps 3 and 4: Implement and Reassess
Step 3 involves implementing the strategy through the design and execution of the
compensation system.
Step 4 recognizes that the compensation strategy must change to fit changing
conditions. Thus, periodic reassessment is needed to continuously learn, adapt,
and improve.
VII. Source of Competitive Advantage: Three Tests
Three tests determine whether a pay strategy is a source of competitive advantage.
1. Is it aligned?
2. Does it differentiate?
3. Does it add value?
A. Align
Alignment of the pay strategy includes three aspects:
1. Align with the business strategy,
2. Align externally with the economic and sociopolitical conditions, and
3. Align internally with the overall HR system.
Alignment is probably the easiest test to pass.
B. Differentiate
Some believe that the only thing that really matters about a strategy is how it is
different from everyone else’s. If the pay system is relatively simple for any
competitor to copy, then how can it possibly be a source of competitive
advantage?
The answer according to the advocates of the strategic approach, is in how the pay
system is managed.
It is difficult for a company to imitate the compensation strategy of another
company since each strategy is woven into the fabric of a company’s overall HR
strategy.
oCopying one or another dimension of a strategy means ripping apart the
overall approach and patching in a new one.
oSo, in a sense, the alignment test (weaving the fabric) helps ensure passing the
differentiation test.
C. Add Value
Compensation is often a company’s largest controllable expense
Since consultants and a few researchers treat different forms of pay as
investments, the task is to come up with ways to calculate the return on those
investments (ROI).
Trying to measure an ROI for any compensation strategy implies that people are
“human capital,” a view that some people find dehumanizing. They argue that
viewing pay as an investment with measurable returns diminishes the importance
of treating employees fairly. Of the three tests of strategy—align, differentiate,
add value—the last is the most difficult to “pass.”
Are there advantages to an innovative compensation strategy?
oIn products and services, first movers (innovators) have well-recognized
advantages that can offset the risks involved—high margins, market share,
and mindshare (brand recognition).
oBut, it is not yet proved whether such advantages accrue to innovators in total
compensation.
VIII. “Best Practices” versus “Best Fit”?
The premise of any strategic perspective is that if managers align pay decisions with
the organization’s strategy and values, are responsive to employees and union
relations, and are globally competitive, then the organization is more likely to achieve
competitive advantage.
In contrast to the notion of strategic fit, some believe that (1) a set of best-pay
practices exists and (2) these practices can be applied universally across situations.
Rather than having a better fit between business strategy and compensation plans that
yields better performance, they say that best practices result in better performance
with almost any business strategy.
oThese writers believe that adopting best-pay practices allows the employer to gain
preferential access to superior employees. These superior employees will in turn
be the organization’s source of competitive advantage.
IX. Guidance from the Evidence
There is consistent research evidence that the following practices do matter to the
organization’s objectives.
oInternal alignment: smaller internal pay differences and larger internal pay
differences can both be a “best” practice.
oExternal competitiveness: paying higher than the average paid by competitors can
affect results.
oEmployee contributions: performance-based pay can affect results. An associated
question such as “are performance incentives a “best” practice?” is contextual in
nature.
oManaging compensation: rather than focusing on only one dimension of the pay
strategy, all dimensions need to be considered together.
oCompensation strategy: embedding compensation strategy within the broader HR
strategy affects results. Compensation does not operate alone; it is part of the
overall HR perspective.
Specific pay practices appear to be more beneficial in some contexts than in others.
X. Virtuous and Vicious Circles
Studies have reported that while pay levels (external competitiveness) differed among
companies, they were not related to a company’s subsequent financial performance.
Exhibit 2.9 suggests that performance-based pay works best when there is success to
share.
oPerformance-based pay that shares success with employees does improve
employee attitudes, behaviors, and performance (when coupled with the other
“high-performance” practices).
oWhen organization performance declines, performance-based pay plans do not
pay off; there are no bonuses, and the value of stock declines—with potentially
negative effects on organization performance.
oUnless the increased risks are offset by larger returns, the risk-return imbalance
will reinforce declining employee attitudes and speed the downward spiral.
oThese studies do seem to indicate that performance-based pay may be a best
practice, under the right circumstances.
