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Introduction

• Organizations have a relatively large degree of discretion in deciding how to pay.

• Each employee’s pay is based upon individual performance, profits, seniority, or other factors.

• Regardless of cost differences, different pay programs can have very different consequences for productivity and return on investment.

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How Does Pay Influence Individual Employees?

Three different theories help explain compensation’s effects:

Reinforcement Theory

Agency TheoryExpectancy Theory

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How Does Pay Influence Individual Employees?

• Reinforcement Theory - A response followed by a reward is more likely to recur in the future.

• Expectancy Theory - Motivation is a function of valence, instrumentality, and expectancy.

• Agency Theory -The interests of the principals (owners) and their agents (managers) may no longer converge. – Types of agency costs include:

• perquisites• attitudes towards risk• decision-making horizons

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Agency Costs

• Agency costs may be minimized by the principal choosing a contracting scheme that helps align the interests of the agent with the principal's own interests.

• The type of contract depends partly on the following factors:– risk aversion– outcome uncertainty– job programmability– measurable job outcomes– ability to pay– tradition

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Programs for Recognizing Employee Contributions

• Programs differ by payment method, frequency of payout, and ways of measuring performance.

• Potential consequences of such programs are performance motivation of employees, attraction of employees, organization culture, and costs.

• Contingencies that may influence whether a pay program fits the situation are management style, and type of work.

Merit Pay Incentive Pay

Gain Sharing Ownership

Profit SharingSkill-based

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Merit Pay

• Merit pay programs link performance-appraisal ratings to annual pay increases.

• A merit increase grid combines an employee’s performance rating with the employee’s position in a pay range to determine the size and frequency of his or her pay increases.

• Some organizations provide guidelines regarding the percentage of employees who should fall into each performance category.

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Merit Pay

• Edward W. Deming, who is a critic of merit pay, argues that it is unfair to rate individual performance because "apparent differences between people arise almost entirely from the system that they work in, not the people themselves.”

• Criticisms of merit pay include:– The focus on merit pay discourages teamwork.

– The measurement of performance is done unfairly and inaccurately.

– Merit pay may not really exist.

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Individual Incentives

• Individual incentives reward individual performance, but payments are not rolled into base pay, and performance is usually measured as physical output rather than by subjective ratings.

• They are relatively rare because:– Most jobs have no physical output measure.– There are many potential administrative problems.– Employees may do what they get paid for and nothing

else.– They typically do not fit in with the team approach.– They may be inconsistent with organizational goals.– Some incentive plans reward output at the expense of

quality or customer service.

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Profit Sharing

• Under profit sharing, payments are based on a measure of organization performance (profits), and payments do not become a part of base pay.– The advantage is that profit sharing

may encourage employees to think more like owners.

– The drawback is that workers may perceive their performance has little to do with profit but is more related to top management decisions over which they have little control.

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Ownership

• Ownership encourages employees to focus on the success of the organization as a whole, but, like profit sharing, ownership may be less motivational the larger the organization.

• One method to achieve employee ownership is through stock options, which give employees the opportunity to buy company stock at a previously fixed price.

• Employee stock ownership plans (ESOPs) are employee ownership plans that give employers certain tax and financial advantages when stock is granted to employees.– ESOPs can carry significant risk for employees.

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Gainsharing

• Gainsharing programs offer a means of sharing productivity gains with employees, and are based on group or plant performance that does not become part of the employee’s base salary.

• Conditions that should be in place for gainsharing to be effective include: – management commitment– a need to change or a strong commitment to

continuous improvement – management's acceptance and

encouragement of employee input

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Gainsharing

• Conditions that should be in place for gainsharing to be effective include: – high levels of cooperation and interaction– employment security– information sharing on productivity and costs– goal setting– commitment of all involved parties to the

process of change and improvement– agreement on a performance standard and

calculation that is undesirable, seen as fair, and closely related to managerial objectives

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Group Incentives and Team Awards

• Group incentives tend to measure performace in terms of physical output

• Team award plans may use a broader range of performance measures.

• Drawbacks are that individual competition may be replaced by competition between groups or teams.

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Balanced Scorecard

• Some companies find it useful to design a mix of pay programs.

• The four categories of a balanced scorecard include:– financial– customer– internal– learning and growth

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Managerial and Executive Pay

• Top managers and executives are a strategically important group whose compensation warrants special attention.

• In some companies rewards for executives are high regardless of profitability or stock market performance.

• Executive pay can be linked to organizational performance (from agency theory).

• There has been increased pressure from regulators and shareholders to better link pay and performance. – The Securities and Exchange Commission (SEC)

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CEO Pay

• Great Britain 3-1

• Japan 7-1

• USA 450 -1

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Process and Context Issues

Three issues represent areas of significant company discretion and pose opportunities to compete effectively:

Employee Participationin Decision Making

CommunicationPay and Process:

Intertwined Effects

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Matching Pay Strategy and Organization Strategy

Pay Strategy DimensionsRisk sharing (variable pay)Time orientationPay level (short-run)Pay level (long-run potential)Benefits levelCentralization of pay decisionsPay unit of analysis

ConcentrationLowShort-termAbove marketBelow marketAbove marketCentralizedJob

GrowthHighLong-termBelow marketAbove marketBelow marketDecentralizedSkills

Organization Strategy