9 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
CHAPTER NINE
PAY-FOR-PERFORMANCE: THE EVIDENCE
Overview
This chapter is the first of three chapters comprising Part Four – Employee Contributions:
Determining Individual Pay. The primary focus of Part Three was on determining the worth of
jobs, independent of who performed those jobs. Job analysis, job evaluation, and job pricing all
have a common theme. They are techniques to identify the value a firm places on its jobs. This
fourth part of the book finally brings people into the pay equation. The premise is that different
people performing the same job may add different value to an organization. How much should
one employee be paid relative to another when they both hold the same jobs in an organization?
Entering people into the compensation equation greatly complicates the compensation process.
People do not behave like robots. In this section, the authors argue that organizational success
Chapter Nine: Pay-For-Performance: The Evidence 9 – 2
Lecture Outline: Overview of Major Topics
I. What Behaviors Do Employers Care About? Linking Organization Strategy to Compensation
and Performance Management
II. What Does It Take to Get These Behaviors? What Theory Says
III. What Does It Take to Get These Behaviors? What Practitioners Say
IV. Does Compensation Motivate Behavior?
A. Do People Join a Firm Because of Pay?
B. Do People Stay in a Firm (or Leave) Because of Pay?
C. Do Employees More Readily Agree to Develop Job Skills Because of Pay?
D. Do Employees Perform Better on Their Jobs Because of Pay?
V. Designing a Pay-for-Performance Plan
A. Efficiency
B. Equity/Fairness
C. Compiance
VI. Your Turn: Burger Boy
Learning Objectives
• Define what behaviors employers’ desire and connect organization strategy to employee
behavior.
• Recognize that behavior is a function of motivation, ability, and environment;
9 – 3 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
Lecture Outline: Summary of Key Chapter Points
I. What Behaviors Do Employers Care About? Linking Organization Strategy to
Compensation and Performance Management
• Employers want employees to perform in ways that lead to better organizational
performance.
• Nordstrom’s department stores are known for extremely good quality merchandise and
high levels of customer satisfaction – this is the organization strategy they use to
differentiate themselves from competitors.
• Wanting to succeed isn’t enough.
• Success depends on finding people with ability—that’s the primary job of recruitment,
selection, and training.
o Once good people are hired, they need to be motivated to behave in ways that help
the organization.
o Pay and other rewards should reinforce desired behaviors.
Chapter Nine: Pay-For-Performance: The Evidence 9 – 4
• If employers don’t recognize changing skills requirements (human resource planning),
it’s hard to set up revised training programs or develop compensation packages to
reward these new skills instantly.
• The key lesson from Exhibit 9.2 in an important one: Compensation can’t do it all
alone.
• So, what behaviors does compensation need to reinforce?
o Compensation should be sufficiently attractive to make recruiting and hiring good
• The impact on performance measures a sound compensation package.
o Employers can’t reward performance if they can’t measure it.
• The cells in Exhibit 9.3 help explain why incentives work in some situations and not in
others. The columns divide companies into those with widely variable performance
from year to year and those with much more stable performance across time.
o Situations B and D both suggest a low-incentive component is appropriate in
• What is the conclusion? There are four questions that organizations should address.
o How do we attract good employment prospects to join our company?
▪ The long-run success of any company depends on getting good people to
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Copyright © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
to lose them a short time later.
▪ Once the compensation practices get a good employee in the door, company
needs to figure out ways to ensure it’s not a revolving door.
o How do we get employees to develop skills for current and future jobs?
o How do we get employees to perform well while they are here?
II. What Does It Take to Get These Behaviors? What Theory Says
• In the simplest sense, motivation involves three elements:
o what’s important to a person, and,
• As to the first element, what’s important to employees, data suggest employees prefer
pay systems that are influenced by:
o Individual performance
• To narrow down specific employee preferences, there has been some work on what’s
called flexible compensation – based on the idea that only the individual employee
knows what package of rewards would best suit personal needs.
o The key ingredient is careful cost analysis to make sure the dollar cost of the
• Exhibit 9.4 briefly summarizes some of the important motivation theories.
o The theories try to answer the three questions: what’s important, how do we offer it,
and how does it help deliver desired behaviors.
• Several of the theories in Exhibit 9.4 focus on content—identifying what is important to
people.
o Maslow’s and Herzberg’s theories both fall in this category.
▪ People have certain needs, such as physiological, security, and self-esteem, that
influence behavior.
Chapter Nine: Pay-For-Performance: The Evidence 9 – 6
▪ Although neither theory is clear on how these needs are offered and how they
help deliver behavior, presumably if employees are offered rewards that satisfy
• A second set of theories, best exemplified by expectancy theory, equity theory, and
agency theory, focus less on need states and more on the second element of
motivation—the nature of the exchange– company rewards in exchange for desired
employee behaviors.
o Many compensation practices recognize the importance of a fair exchange.
o Jobs are evaluated using a common set of compensable factors (Chapter 5) in part to
• Expectancy theory argues that people behave as if they cognitively evaluate what
behaviors are possible in relation to the value of rewards offered in exchange.
o According to this theory, employers choose behaviors that yield the most
satisfactory exchange.
▪ Employees look at the exchange as a ratio between what is expected and what is
received.
• Agency theory depicts employees as agents who enter an exchange with principals—the
owners or their designated managers.
o It is assumed that both sides to the exchange seek the most favorable exchange
possible and will act opportunistically if given a chance.
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giving proportionately lower rewards.
• Goal setting theory focuses on the third element of motivation—desired behavior.
o Identifying desired behaviors—and goals expected to flow from these behaviors—is
• Self Determination Theory (SDT) purports to integrate motivation theories under a
broad umbrella.
o This approach believes that employees are motivated not only by reward systems
III. What Does It Take to Get These Behaviors? What Practitioners Say
• In the past, compensation people didn’t ask this question very often.
o Employees learned what behaviors were important as part of the socialization
process or as part of the performance management process.
• Now, progressive companies ask, “What do we want our compensation package to do?”
o For example, “How do we get our product engineers to take more risks?”
o Compensation is then designed to support this risk-taking behavior.
• Compensation is but one of many rewards that influence employee behavior.
o Surveys of workers in general indicate that workers highly value other job rewards
such as empowerment, recognition, and opportunities for advancement.
o Employers may be overpaying in cash and missing the opportunity to let employees
construct both a more satisfying and less-expensive reward package.
▪ Known as flexible compensation, this idea is based on the notion of different
rewards having different dollar costs associated with them.
• If employers don’t think about the presence or absence of rewards other than money in
their organizations, they many find the compensation process producing unintended
Chapter Nine: Pay-For-Performance: The Evidence 9 – 8
consequences. The text explains this concept with the help of the following three
examples:
o Example 1: McDonald’s recently completed a worldwide “employment branding”
exercise.
▪ Their goal was to find out what people liked about jobs at McDonald’s and
feature these rewards in the recruitment strategy for new employees.
▪ Three things emerged as strengths at McDonald’s:
o Example 2: Southwest Airlines promotes a business culture of fun and encourages
employees to find ways to make their jobs more interesting and relevant to them
personally.
▪ All this is accomplished without using incentives as a major source of
competitive advantage.
▪ Indeed, pay at Southwest isn’t any higher than for competitor airlines, yet it’s
much easier to recruit top people there.
▪ Fun, a good social environment, is a reward!
▪ It may be that incentives are too.
• Southwest “pays by the trip,” meaning employees earn more the more flights
they work.
• Employees also have significant ownership in the company through a
discount stock purchase program and receive profit-sharing checks when the
▪ Earning more money and profit-sharing happens only when Southwest does
well.
• This is an example of alignment between the interests of Southwest and its
o Example 3: Consider the relationship between the different forms of compensation
and another of the general rewards listed in Exhibit 9.5: security.
▪ Drastic reductions in middle-management layers during the downsizing decade
of the 1980s increased employee concerns about job security and probably
elevated the importance of this reward to employees today.
▪ Maybe that’s why new millenial workers are concerned not only about
9 – 9 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
employment risk but also about compensation at risk.
▪ There is evidence that compensation at risk (pay based on incentives rather than
• Exhibit 9.6 outlines the different types of wage components.
o It generally orders compensation components from least risky to more risky for
employees.
▪ Risk is defined in terms of stability of income, or the ability to accurately predict
income level from year to year.
• Over the last several decades, companies have been moving more toward compensation
programs higher on the risk continuum.
o New forms of pay are less entitlement-oriented and more linked to the uncertainties
of individual, group, and corporate performance.
o Employees increasingly are expected to bear a share of the risks that businesses
have solely born in the past.
▪ Security-driven employees actually might accept lower wages if they come in a
package that is more stable.
▪ Some employees may be willing to accept higher risk in return for a greater
chance to earn large payouts when performance is high.
Chapter Nine: Pay-For-Performance: The Evidence 9 – 10
IV. Does Compensation Motivate Behavior?
Now let’s look at the role of compensation in motivating the four types of behavior outlined
earlier: the decision to join, to stay, to develop skills, and to perform well.
A. Do People Join a Firm Because of Pay?
• Level of pay and pay system characteristics influence a job candidate’s decision to
join a firm.
o Being perceived as more objective, it’s more easily communicated in the
employment offer.
• Research suggests job candidates look for organizations with reward systems that fit
their personalities.
• Some of the ways that “fit” is important is outlined below:
o Materialistic (relatively more concerned about pay level)
o Low self-esteem (want large, decentralized organization with little pay for
• Evidence suggests talented employees are attracted to companies that have strong
links between pay and performance.
o One way to get this linkage is to give employees some control over the rewards
they receive.
B. Do People Stay in a Firm (or Leave) Because of Pay?
• Much of the equity theory research documented that workers who feel unfairly
treated in pay react by leaving the firm.
o Turnover is much higher for poor performers when pay is based on individual
performance.
• Data suggest dissatisfaction with pay can be a key factor in turnovers.
o Too little pay triggers feelings of unfair treatment, resulting in turnover.
o Supporting this, pay that employees find reasonable can help reduce turnover.
o Even the way an organization pays can impact turnover.
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Copyright © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
personal effort and more to group effort.
▪ Another recent study found superior performing employees were less likely
to leave if they received bonuses.
▪ No such positive result was found with pay increases (thus changing base
pay).
• Recent efforts to use different types of compensation as a tool for retaining workers
have focused on what is called scarce talent.
o If skilled workers are scarce, one way to retain these workers is to develop
• Besides money, other rewards also influence the decision to stay (retention) in a
firm.
o Job Satisfaction – work enjoyment.
C. Do Employees More Readily Agree to Develop Job Skills Because of Pay?
• The answer to this question is not known.
• Skill-based pay is intended, at least partially, to pay employees for learning new
D. Do Employees Perform Better on Their Jobs Because of Pay?
• One particularly good study looked at the HR practices of over 3,000 companies and
asked:
o Did the company have a formal appraisal process?
o Was the appraisal tied to the size of the pay increases?
o Did performance influence who would be promoted?