1 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
CHAPTER ONE
THE PAY MODEL
Overview
Part One, Introducing the Pay Model and Pay Strategy, contains chapters one and two and begins
by talking about what “pay” means and how paying people in different ways can influence them
and, in turn, organization success. The two chapters describe the compensation policies and
techniques that organizations use and the multiple objectives they hope to achieve by effectively
managing these compensation decisions. The aim of Part One is to understand how
compensation strategy decisions interact with the specific context of an organization (its business
and human resource strategies) to influence organization success. The authors emphasize that
good theory and research are fundamental to not only understanding compensation’s likely
effects, but also to developing that healthy skepticism needed toward simplistic claims about
what works and what does not.
Chapter one starts with a discussion on the role of poorly designed compensation plans in the
current economic situation. It provides an overview of the key components of a compensation
system. The definition of compensation is initially explored from the perspectives of the society,
stockholders, the organization, and the external environment. Next, the various forms of pay are
identified and defined. The major focus is presenting a pay model that provides a structure for
understanding compensation systems. The three main components of the model are (1)
compensation objectives, including the importance given to ethics; (2) policy decisions that
guide the way objectives will be achieved; and (3) techniques that make up the pay system. The
book plan is outlined at the end of chapter one. The remaining chapters examine each of the four
policy decisions—internal alignment, external competitiveness, employee performance, and
management—as well as the techniques, new directions, and related research.
Learning Objectives
• Compare the benefits of well-designed compensation systems to the detriments of poorly
designed compensation systems.
• Define compensation from the perspectives of society, stockholders, the organization,
and the external environment.
• Examine the various forms of pay including cash compensation, benefits, total earnings
opportunities, and relational returns from work.
• Understand the three components of the pay model: compensation objectives, policy
choices, and pay techniques.
Chapter One: The Pay Model 1 – 2
Lecture Outline: Overview of Major Topics
I. Compensation: Does it Matter (or, “So What?”)
II. Compensation: Definition, Please
A. Society
B. Stockholders
C. Managers
D. Employees
E. Incentive and Sorting Effects of Pay on Employee Behaviors
F. Global Views – Vive la différence
III. Forms of Pay
A. Cash Compensation: Base
B. Cash Compensation: Merit Increases/Merit Bonuses/COLAs
C. Cash Compensation: Incentives
D. Long-Term Incentives
E. Benefits: Income Protection
F. Benefits: Work/Life Balance
G. Benefits: Allowances
H. Total Earnings Opportunities: Present Value of a Stream of Earnings
I. Relational Returns from Work
IV. A Pay Model
A. Compensation Objectives
B. Four Policy Choices
C. Pay Techniques
V. Book Plan
VI. Caveat Emptor—Be an Informed Consumer
A. Is the Research Useful?
B. Does the Study Separate Correlation from Causation?
C. Are There Alternative Explanations?
VII. Your Turn—The Role of Labor Costs in Retail Electronics
1 – 3 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
Lecture Outline: Summary of Key Chapter Points
I. Compensation: Does It Matter (Or, “So What?”)
• The role of poorly designed compensation plans in the recent economic downturn is
• Successful companies had relatively high pay as well as higher productivity compared
to competitors. The example is the text is of Nucor Steel.
• Wall Street financial services firms and banks used incentive plans that rewarded
people for developing “innovative” new financial investment vehicles and for taking
risks to earn themselves and their firms a lot of money.
• The resulting legislation was the Troubled Asset Relief Program (TARP), which
included restrictions on executive pay and discouraged executives from taking
“unnecessary and excessive risks.”
• How people are paid affects their behavior at work, which affects an organization’s
success.
o For most employers, compensation is a major part of total cost, and often it is the
II. Compensation: Definition, Please
• People’s view of compensation differs depending on whether they look at
compensation from the perspective of a member of society, a stockholder, a manager,
or an employee.
A. Society
• Some people see pay as a measure of justice.
Chapter One: The Pay Model 1 – 4
o For example: comparing earnings of women with those of men highlights
potential pay inequities.
• Society has taken interest in such earning differentials by introducing laws and
regulation aimed at eliminating the role of discrimination in causing them.
• Benefits given as a part of total compensation may also be seen as a reflection
of societal equity or justice.
• Exhibit 1.1 reveals that the hourly compensation (wages plus benefits) for
Mexican manufacturing work ($3.91) are about 10% of those paid in the U.S.
($36.34).
o However, the value of what is produced also needs to be considered.
Mexican worker productivity is 34% of the U.S. level.
• Some consumers know that pay increases often lead to price increases.
B. Stockholders
• Stockholders differ on their views of whether employees should be given stock
options or not.
o Supporters of this thought believe that it creates a sense of ownership that
• Stockholders have a particular interest in executive pay.
o To the degree that the interests of executives are aligned with those of
• In the absence of a linkage between executive pay and company performance,
concerns arise that the executives can somehow use their influence to obtain
high pay without necessarily performing well.
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• Exhibit 1.2 provides data on CEO compensation.
o Note the large total annual compensation of $11.5 million and that the bulk
• Shareholders can influence executive compensation decisions through
shareholder proposals and election of directors in proxy votes.
C. Managers
• Managers view compensation as influencing their success in two ways.
o First, compensation is a major expense that needs managing.
▪ Competitive pressures force managers to consider the affordability of
compensation decisions since labor costs can account for more than 50%
of total costs. Some industries are even higher.
▪ Labor costs as a percent of total costs vary among individual firms.
• The neighborhood grocery, with labor costs between 15-18%, have
▪ Exhibit 1.3 compares the hourly pay rate for retail workers at Costco to
that at Walmart and Sam’s Club.
• Costco chose to pay higher wages to attract and retain a higher
quality workforce.
• As Exhibit 1.3 shows, Costco is quite successful in terms of
employee retention, customer satisfaction, and the efficiency with
which it generates sales.
o Second, it is a major determinant of employee attitudes and behaviors (and
thus, organization performance).
Chapter One: The Pay Model 1 – 6
▪ Pay also may drive employees to unions or even legal action.
D. Employees
• For most employees, pay is a major source of financial security.
• Employees may view compensation as:
o a return in an exchange between their employer and themselves,
E. Incentive and Sorting Effects of Pay on Employee Behaviors
• Pay influences employee motivation and behavior in two ways:
o Pay can affect the motivational intensity, direction, and persistence of
current employees.
o Pay can also have an indirect, but important, influence via a sorting effect
on the composition of the workforce.
• People differ regarding which type of pay arrangement they prefer.
o The question for organizations is simply this: Are you using the pay policy
that will attract and retain the types of employees you want?
▪ Focusing only on the incentive effects of pay can miss the other major
mechanism (sorting) by which pay decisions influence employee
behaviors.
F. Global Views—Vive la différence
• In English, compensation means something that counterbalances, offsets, or
makes up for something else.
1 – 7 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
• In China, the traditional characters for the word “compensation” are based on
the symbols for logs and water; meaning that compensation provides the
necessities in life.
o In the recent past, compensation was viewed as an entitlement.
• “Compensation” in Japanese is kyuyo which means “giving something.”
o Traditionally, compensation was viewed as something given by one’s
superior.
o Today the word hou-syu, which means “reward,” is used; it has no
• Contrasting ideas about compensation—multiple views and multiple
meanings—add richness to the topic.
Definition: Compensation refers to all forms of financial returns and tangible
services and benefits employees receive as part of an employment relationship.
III. Forms of Pay
• Exhibit 1.4 shows the variety of returns people receive from work. They are categorized
as:
o Total compensation—these returns are transactional in nature and include pay
A. Cash Compensation: Base
• Base wage is the cash compensation an employer pays for work performed; it
reflects value of work or skills and generally ignores differences attributable to
individual employees.
• In the U.S., salary refers to pay given to employees who are exempt from
Chapter One: The Pay Model 1 – 8
regulations of the Fair Labor Standards Act and are exempt from overtime pay.
o Nonexempts have their pay calculated on an hourly wage. Salary is calculated
at an annual or monthly rate.
• Rather than dividing employees into separate categories of salaried and wage
B. Cash Compensation: Merit Increases/Merit Bonuses/COLAs
• A cost of living adjustment (COLA) to base wages may be based on changes in what
other employers are paying for the same work, changes in living costs, or changes
in experience or skill.
• Merit increases are given as increments to the base pay and are based on
performance.
• Companies increasingly use merit bonuses.
C. Cash Compensation: Incentives
• Incentives also tie pay increases to performance. However, incentives differ from
merit adjustments:
o An incentive program relies on an objective measure of performance (e.g. sales)
▪ Whereas merit pay programs evaluate past performance of an individual and
then decide on the size of the increase, what must happen in order to receive
o While both merit pay and incentives try to influence performance, incentives
explicitly try to influence future behavior whereas merit recognizes (rewards)
past behavior, which is hoped to influence future behavior.
▪ The incentive-reward distinction is a matter of timing.
• Incentives can be tied to the performance of an individual employee, a team of
employees, a total business unit, or some combination of individual, team, and unit.
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Education.
o When performance declines, incentive pay automatically declines, too.
o Consequently, incentives (and sometimes merit bonuses also) are frequently
referred to as variable pay.
D. Long-Term Incentives
• Incentives may be short- or long-term.
• Long-term incentives are intended to focus employee efforts on multiyear results
and are in the form of stock ownership or options to buy stock at a fixed price.
E. Benefits: Income Protection
• Exhibit 1.4 showed that benefits, including income protection, work/life services,
and allowances, are also part of total compensation.
• Some income protection programs are legally required in the United States;
employers must pay into a fund that provides income replacement for workers who
F. Benefits: Work/Life Balance
• Programs that help employees integrate their work and life responsibilities include:
o time away from work (vacations, jury duty);
G. Benefits: Allowances
• Allowances often grow out of whatever is in short supply; for example, housing and
transportation allowances are frequently part of the pay package in China.
H. Total Earnings Opportunities: Present Value of a Stream of Earnings
• Up to this point compensation has been treated as something paid or received at a
moment in time.
o But a firm’s compensation decisions have a temporal effect.
• A present-value perspective shifts the comparison of today’s initial offers to
consideration of future bonuses, merit increases, and promotions.
Chapter One: The Pay Model 1 – 10
I. Relational Returns from Work
• Non-financial returns from work have a substantial effect on employees’ behavior.
• Exhibit 1.3 includes such relational returns from work as recognition and status,
employment security, challenging work, and opportunities to learn.
The Organization as a Network of Returns
o It is useful to view an organization as a network of returns created by all the
different forms of pay, including total compensation and relational returns.
o The challenge is to design this network so that it helps the organization to
succeed.
IV. A Pay Model
• Exhibit 1.5 shows a pay model.
o This pay model serves as both a framework for examining current pay systems and a
guide for most of this textbook.
o It contains three basic building blocks:
2. the policies that form the foundation of the compensation system, and
3. the techniques that make up the compensation system.
A. Compensation Objectives
• Pay systems are designed to achieve certain objectives.
o The basic objectives, shown at the right side of the model, include efficiency,
fairness, ethics, and compliance with laws and regulations.
▪ Efficiency—can be stated more specifically: (1) improving performance,
increasing quality, delighting customers and stockholders and (2)
controlling labor costs.
• Compensation objectives at Medtronic and Whole Foods are
contrasted in Exhibit 1.6.
▪ Fairness— is a fundamental objective of pay systems.
1 – 11 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
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Education.
• It attempts to ensure fair treatment for all the employees, by
recognizing both employee contributions, and employee needs.
• Procedural fairness refers to the process used to make pay decisions.
▪ Compliance with laws and regulations—compliance as a pay objective
means conforming to various federal and state compensation laws and
regulations.
▪ Ethics – means the organization cares about how its results are achieved.
• Exhibit 1.7 shows one company’s code of conduct.
• Because it is so important, it is inevitable that managing pay
B. Four Policy Choices
• Every employer must address the policy decisions shown on the left side of the
• These are the foundations on which pay systems are built and they serve as
guidelines for managing pay in ways that accomplish the system’s objectives.
Internal Alignment
o Jobs and people’s skills are compared in terms of their relative contributions
to the organization’s business objectives.
o Internal alignment pertains to the pay rates both for employees doing equal
work and for those doing dissimilar work.
▪ Whole Foods tries to manage differences with a salary cap that limits the
o Pay relationships within the organization affect all three compensation
objectives:
▪ By motivating employees to choose increased training and greater
responsibility in dealing with customers, internal pay relationships