978-1259532726 Chapter 2 Lecture Note

Unlock access to all the studying documents.

View Full Document

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.