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VI. Product Market Factors and Ability to Pay
The supply and demand for labor are major determinants of an employer’s pay
level.
However, any organization must, over time, generate enough revenue to cover
expenses, including compensation.
It follows that an employer’s pay level is constrained by its ability to compete in
the product/service market. So product market conditions to a large extent determine
what the organization can afford to pay.
The two key product market factors that affect the ability of an organization to
change what it charges for its products and services are:
oProduct demand
oDegree of competition
A. Product Demand
Although labor market conditions (and legal requirements) put a floor on
the pay level required to attract sufficient employees, the product market puts a
lid on the maximum pay level that an employer can set.
B. Degree of Competition
Employers in highly competitive markets, such as manufacturers of
automobiles or generic drugs, are less able to raise prices without loss of
revenues.
Other factors besides product market conditions affect pay level:
oThe productivity of labor
oThe technology employed
oThe level of production relative to plant capacity available.
These factors vary more across than within industries.
C. A Different View: What Managers Say
Discussions with managers provide insight into how all of the economic
factors translate into actual pay decisions.
In one study, a number of scenarios were presented in which
unemployment, profitability, and labor market conditions varied. Managers
were asked to make wage adjustment recommendations for several positions.
oLevel of unemployment made almost no difference.
oThe company’s profitability was considered a factor for higher management
in setting the overall pay budget but not something managers consider for
individual pay adjustments.
oIn direct contradiction to efficiency-wage theory, managers believed that
problems attracting and keeping people were the result of poor management
rather than inadequate compensation.
In recent times, the unemployment rate is higher than it has been in two
decades and companies are indeed making pay cuts, either outright or by
requiring employees to take days off (often called furloughs) without pay.
oAnother common cut is reducing contributions to 401k retirement plans.
oOther companies are imposing pay freezes.
D. Segmented Supplies of Labor and (Different) Going Rates
One option to reduce labor costs is segmenting the source of labor.
People Flow to the Work
oEmployers may use a segmented labor supply. This means they use multiple
sources of employees, from multiple locations, with multiple employment
relationships. EXHIBIT 7.10
Work Flows to the People—On-site, Off-site, Offshore
oSometimes, when an organization competes for a project, it may structure its
bid in part on the compensation paid to people in different locations. The
organization can staff the project with employees who are on-site, off-site,
or off-shore. It can “mix and match” its people from different sources.
oWhich source the organization includes in its bid depends on many factors:
customer preferences,
time schedules, and
the nature of the project.
There are three points (“so whats?”) to remember from this discussion:
oReality is complex and theories abstract. The theories discussed simply
abstract away the detail, clarifying the underlying factors that help us
understand how reality works.
oThe segmented sources of labor means that determining pay levels and pay
mix increasingly requires understanding market conditions in different, even
worldwide, locations.
oManagers also need to know the jobs required to do the work, the tasks to be
performed, and the knowledge and behaviors required to perform them so
that they can bundle the various tasks to send to different locations.
VII. Organization Factors
A. Industry and Technology
The industry in which an organization competes influences the technologies used.
Labor-intensive industries (education and health care) tend to pay lower than
technology-intensive industries (petroleum or pharmaceuticals), whereas
professional services (consulting firms) pay high.
The introduction of new technology within an industry also influences pay levels.
Qualifications and experience tailored to particular technologies is important in the
analysis of labor markets.
B. Employer Size
There is consistent evidence that large organizations tend to pay more than small
ones.
The relationship between organization size, ability to pay, and pay level is
consistent with economic theory that says that talented individuals have a higher
marginal value in a larger organization because they can influence more people and
decisions, thereby leading to more profits.
C. People’s Preferences
Better understanding of employee preferences of pay forms is increasingly
important in determining external competitiveness.
Markets involve both employers’ and employees’ choices. However, there are
substantial difficulties in reliably measuring preferences.
Researchers find that people place more importance on pay than they are willing to
admit.
D. Organization Strategy
A variety of pay-level and mix strategies exist.
oSome employers adopt a low-wage, no-service strategy; they compete by
producing goods and services with the lowest total compensation possible.
oOthers select a low-wage, high-services strategy.
oStill other employers use a high-wage, high-services approach.
One study found that a variety of pay-level strategies exist within some
organizations.
oPay levels that lead competition are used in jobs that most directly impact
the organization’s success.
oIn jobs with less impact, pay levels reflect a “meet competition” policy.
Efficiency wage argues that some firms, for a variety of reasons do indeed have
efficiency reasons to pay higher wages.
oHigher pay levels, either for the organization as a whole or for critical
jobs, may be well-suited to particular strategies, such as higher value-added
customer segments.
Evidence suggests that organizations making greater use of so-called
high-performance work practices (teams, quality circles, total quality management,
job rotation) and computer-based technology and having higher-skilled workers
also pay higher wages.
The observable benefits of higher wages may include:
ohigher pay satisfaction,
oimproved attraction and retention of employees, and
ohigher quality, effort, and/or performance.
Ultimately, higher wages must bring something in return (e.g., higher productivity,
quality, and/or innovation).
oOtherwise, a firm’s ability to compete and survive is in question.
Evidence shows that in manufacturing, productivity (defined as sales value of
production divided by employee hours worked) is positively correlated ( r = .45)
with hourly wage level.
oThus, the relationship, while far from perfect, is meaningful in
manufacturing.
VIII. Relevant Markets
Defining the relevant markets is a big part of figuring out how and how much to
pay.
Although the notion of a single homogeneous labor market may be a useful
analytical device, each organization operates in many labor markets, each with unique
demand and supply.
oSome face segmented supplies for the same skills in the same market.
oOthers think more broadly about which markets to use as sources of talent.
Consequently, managers must define the markets that are relevant for pay
purposes and establish the appropriate competitive positions in these markets.
The three factors usually used to determine the relevant labor markets are:
oOccupation (skill/knowledge required)
oGeography (willingness to relocate, commute, or become virtual employees)
oCompetitors (other employers in the same product/service and labor markets)
A. Defining the Relevant Market
Little research has been done on how employers choose their relevant
markets.
Two studies do shed some light on this issue:
oThey conclude that managers look at both competitors—their products,
location, and size, and the jobs—the skills and knowledge required and their
importance to the organization’s success.
oSo depending on its location and size, a company may be deemed a relevant
comparison even if it is not a product market competitor.
The data from product market competitors (as opposed to labor market
competitors) are likely to receive more weight when:
1. employee skills are specific to the product market.
2. labor costs are a large share of total costs.
3. product demand is responsive to price changes.
4. the supply of labor is not responsive to changes in pay.
B. Globalization of Relevant Labor Markets: Offshoring and Outsourcing
Work flowing to lower wage locations is not new. Nor is work flowing
across national borders new.
First, it was low-skill and low-wage jobs from the U.S. to China and
Central America; then higher-paid blue collar jobs; now it is service and
professional jobs.
Vastly improved communication and software connectivity have
accelerated these trends.
The following are some of the characteristics of jobs that are thought to
increase susceptibility to offshoring:
oEasily routinized
oInputs/outputs easily transmitted electronically
oLittle need for interaction with other workers
oLittle need for local knowledge such as unique social and cultural factors
When competing firms are either based in lower labor cost countries or are
offshoring or expanding operations there, cost savings is difficult to ignore.
While large differences in labor costs cannot simply be ignored, there are
other factors to consider in deciding where jobs will be.
oCountries with lower average labor costs also tend to have lower average
productivity. So, a company must assure itself that labor costs savings will
not be neutralized by lower productivity.
oAgency theory tells that companies must devote resources to systems that
monitor worker effort or output. This, as well as coordination of efforts, can
be more difficult and more costly when geographic or cultural distance is
great (and time zones different), even with advances in technology.
oCustomers’ reactions must be considered.
oIf labor costs are the driving force behind placing jobs, one must ask for
how long the labor cost advantage at a significantly lower wage even will
hold and whether sufficiently qualified employees will continue to be
available as other companies also tap into this pool of labor. However,
nothing is forever, and labor cost savings from offshoring and/or
outsourcing can, of course, have a substantial effect on profits for many
years before the cost advantage becomes small enough to be offset by other
factors.
IX. Competitive Pay Policy Alternatives
Compensation theories offer some help in understanding the variations in pay
levels observed among employers. They are less helpful in understanding differences in
the mix of pay forms.
There are three conventional pay-level policies:
oto lead,
oto meet, or
oto follow competition.
Newer policies emphasize flexibility: among policies for different employee
groups, among pay forms for individual employees, and among elements of the
employee relationship that the company wishes to emphasize in its external
competitiveness policy.
A. What Difference Does the Pay-Level Policy Make?
The basic premise is that the competitiveness of pay will affect the
organization’s ability to achieve its compensation objectives, and this in turn
will affect its performance.
The probable effects of alternative policies are shown in Exhibit 7.12.
The problem with much pay-level research is that it focuses on base pay
and ignores bonuses, incentives, options, employment security, benefits, or
other forms of pay. Comparisons on base alone can mislead.
B. Pay with Competition (Match)
Given the choice to match, lead, or lag, the most common policy is to
match rates paid by competitors.
A pay-with-competition policy tries to ensure that an organization’s
wage costs are approximately equal to those of its product competitors and
increases its chances of attracting applicants equal to its product competitors
and that its ability to attract applicants will be approximately equal to its labor
market competitors.
Classical economic models predict that employers meet competitive
wages. While this avoids placing an employer at a disadvantage in pricing
products, it may not provide an employer with a competitive advantage in its
labor markets.
C. Lead Pay-Level Policy
A lead pay-level policy maximizes the ability to attract and retain quality
employees and minimizes employee dissatisfaction with pay. It may also offset
less attractive features of the work, à la Adam Smith’s “net advantage.”
Sometimes an entire industry can pass high pay rates on to consumers if
pay is a relatively low proportion of total operating expenses or if the industry is
highly regulated.
A number of researchers have linked high wages to ease of attraction,
reduced vacancy rates and training time, and better-quality employees.
oResearch also suggests that high pay levels reduce turnover and
absenteeism.
oStudies suggest that pay level can have a substantial influence on quit rates.
oSeveral studies found that the use of variable pay (bonuses and long-term
incentives) is related to an organization’s improved financial performance
but that pay level is not.
A lead policy can also have negative effects:
oIt may force the employer to increase wages of current employees too, to
avoid internal misalignment and murmuring.
oIt may mask negative job attributes that contribute to high turnover later on.
D. Lag Pay-Level Policy
A policy of paying below-market rates may hinder a firm’s ability to
attract potential employees. But if a lag pay-level policy is coupled with the
promise of higher future returns (e.g., stock ownership in a high-tech start-up
firm), this combination may increase employee commitment and foster
teamwork, which may increase productivity.
How long this promise works, in the face of flat or declining stock
markets, is unknown. Unmet expectations probably have negative effects.
Additionally, it is possible to lag competition on pay level but to lead on
other returns from work (e.g., hot assignments, desirable location, outstanding
colleagues, cool tools, work/life balance).
E. Different Policies for Different Employee Groups
In practice, many employers go beyond a single choice among the three
policy options. They may:
ovary the policy for different occupational families,
ovary the policy for different forms of pay, and/or
oadopt different policies for different business units that face very different
competitive conditions.
F. Not by Pay Level Alone: Pay-Mix Strategies
Some obvious alternatives to pay-mix policies include performance
driven, market match, work/life balance, and security. Exhibit 7.16 illustrates
these four alternatives.
oCompared to the other three, incentives and stock ownership make up a
greater percent of total compensation in performance driven policies.
oThe market match simply mimics the pay mix competitors are paying.
How managers position their organization’s pay against competitors is
changing. Some alternatives that are emerging focus on total returns from work
(beyond financial returns) and offering people choices among these returns.
Employer of Choice/Shared Choice
oSome companies compete based on their overall reputation as a place to
work, beyond pay level and mix.
oIn a sense, “employer of choice” corresponds to the brand or image a
company projects as an employer.
oShared choice begins with the traditional alternatives of lead, meet, or lag.
But it then adds a second part, which is to offer employees choices
(within limits) in the pay mix, employees have more say in the forms of
pay they receive. This “employee-as-customer” perspective is not all that
revolutionary, at least in the United States.
More advanced software is making the employee-as-customer
approach more feasible.
One risk is that employees will make “wrong” choices that will
jeopardize their financial well-being.
Another is the “24 jars of jam” dilemma—perhaps offering
employees too many choices of different kinds of pay will lead to
confusion, mistakes, and dissatisfaction.
Pitfalls of Pies
oThe pie charts in Exhibit 7.16 contrast various pay mix policies. However,
thinking about the mix of pay forms as pieces in a pie chart has limitations.
These are particularly clear when the value of stock is volatile. So
the possible volatility in the value of different pay forms needs to be
anticipated.
oSome companies prefer to report the mix of pay forms using a “dashboard,”
as depicted in Exhibit 7.18. The dashboard changes the focus from
emphasizing the relative importance of each form within a single company
to comparing each form by itself to the market (many companies).
oThe mix employees receive differs at different levels in the internal job
structure. While the percentages vary among organizations, greater emphasis
on performance (through incentives and stock) at higher levels is common
practice.
This is based on the belief that jobs at higher levels in the
organization have greater opportunity to influence organization
performance.
X. Consequences of Pay-Level and -Mix Decisions: Guidance from the Research
The external competitiveness has two major consequences. It affects:
1. Operating expenses
2. Employee attitudes and work behaviors
Exhibit 7.20 summarizes the above consequences.
A. Efficiency
A variety of theories make assumptions about the effects of relative pay
levels on an organization’s efficiency.
oSome recommend lead policies to diminish shirking and permit hiring
better-qualified applicants.
oOthers—such as marginal productivity theory—recommend matching.
No research suggests under what circumstances managers should choose
which pay-mix alternative.
Which Policy Achieves Competitive Advantage?
oResearch on the effect of pay-level policies is difficult because companies’
stated policies often do not correspond to reality.
oBeyond opinions, there is minimal evidence of the consequences of different
policy alternatives.
While it is known that pay level affects costs, it is not known
whether any effects it might have on productivity or attracting and
retaining employees are sufficient to offset costs.
Nor is it known how much of a pay-level variation makes a
difference to employees.
oIt may be that an employer’s pay level will not gain any competitive
advantage; however, the wrong pay level may put the organization at a
serious disadvantage.
oThe effects of the different pay-mix alternatives or the financial results of
shifting the responsibility for choosing the mix to employees are also not
known.
oIn the absence of satisfactory evidence, the least-risk approach may be to set
both pay level and pay mix to match competition.
oAn obvious concern with flexible policies is to achieve some degree of
business alignment and fair treatment for employees among the choices.
B. Fairness
Satisfaction with pay is directly related to the pay level—more is better.
But employees’ sense of fairness is also related to how others are paid.
Employers have many choices about how and where to invest their
resources.
oEven if the decision is made to invest in improving people’s feelings about
fairness of their pay, there is little research to tell us this will improve
employees’ overall feeling about fair treatment in the workplace.
C. Compliance
Provisions of prevailing wage laws and equal rights legislation must also
be met.
In addition to pay level, various pay forms are also regulated. Pensions
and health care are considered part of every citizen’s economic security and are
regulated to some degree in most countries.
No matter the competitive pay policy, it needs to be translated into
practice. The starting point is measuring the market through use of a salary
survey.
