prof. dr. birgitta wolff marjaana rehu, m.a. beijing, sept. 2002 1 ii. human resource management...
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 1
II. Human Resource Management
Variable or Fixed Salary
OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURGBEIJING NORMAL UNIVERSITY
Prof. Dr. Birgitta Wolff, Marjaana Rehu, M.A.Otto-von-Guericke-University, Germany
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 2
„... three critical aspects of organization:
• The assignment of decision rights within the company
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals and business units“
(BSZ 5)
Recap Session I
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 3
Outline
1. Incentive Problem
2. Compensation Contracts
3. Output-Based Pay
4. Input-Based Pay
5. Incentive PaySource: www.msn.de
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 4
1. Incentive Problem
Coordination and Motivation Problem
Distribution of Output
Task
Individual
Allocation of Input Resources
Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51
Coordination
Who does what, when,...
Motivation
How do I get somebody to perfom a task,
improve the quality,...
=> Incentive Problem
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 5
1. Incentive Problem
Why do Incentive Problems Exist?
Why do Incentive problems exist?
• Employee and employer have different interests
– Employer would want the employee to take actions that maximize the profit of the firms, but the employee might rather like spending his time with his/her family or play golf
– All actions of the employee cannot be monitored and/or controlled by contracts (risk for the employer)
– Employers have to compensate employees for doing undesirable tasks
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 6
1. Incentive Problem How can Incentive Problems be Solved?
• Incentive Problems can be solved through effective compensation contracts
• Compensation contracts have two functions
– Motivate employees
– Share risk more efficiently
Source: www.euro.fi
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 7
2. Compensation Contracts
Variable Pay Fixed Salary
Compensation Contracts
Payment by Output Payment by Input
Subjective Performance
Measures
Objective Performance
Measures
Subjective Performance
Measures
Objective Performance
Measures
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 8
Variable Pay(payment by output)
Straight Salary(payment by input)
• Compensation depends on measure of what comes out• Amount of time spent on work does not affect workers‘ compensation
Problem: Output not always easy to measure
Examples:
• Agricultural workers: piece rates p. tray• A salesperson on straight commission• Compensation of top executives by stocks or stock options
• Compensation depends on the amount of time or effort spent on an activity• Independent of output consideration
Problem: Input also not always easy to measure• Time at work as a proxy in order to assess worker‘s effort
Examples:
• Wage per work hour• Monthly salaries• Annual salaries
2. Compensation Contracts
Payment by Input versus Payment by Output
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 9
2. Compensation Contracts
How can the Performance of an Employee be Measured?
•Objective Performance Measure:
– Measure that is easily observable and quantifiable, e.g. parts produced, hours worked etc.
•Subjective Performance Measures:
– An evaluation which is based on personal opinion of a supervisor, customer, peers, etc.
Type of evaluat.
Databaseobjective subjective
Output revenue, dividend customer satisfaction
Input time qualification
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 10
Basis Variables for output-based pay
Quantity of production pieces, weight, size/height
Quality of productionRejects, grade, customer‘s satisfaction, individual targets
Input reductionReduction of input factors: raw material, energy, work time
Capacity utilization slack-, repair- and waiting periods
Be on scheduleTimeliness vis à vis internal and external customers
Value of the firm stock price, economic value added
2. Compensation Contracts
Examples of Different Variables as a Basis of Output-Related Pay
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 11
Advantages of output-based pay
Selection effect Motivation effect
• efficient workers with a high productivity will join the firm/stay
• inefficient workers with a low productivity will not join/leave the firm
• output-based pay motivates workers to put forth more effort
3. Output-Based Pay
Source: www.kone.fi
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 12
World Book Britannica
Offered compensation scheme variable pay: W = $ 100 . x
fixed salary: W = $ 500
Labor costs of 10 sets; Cost per set
$ 1,000 $ 100 per set $ 500 $ 50 per set
What type of salesperson will stay with the firm?
high productive sp.x 5
low productive sp.x 5
Labor costs of 3 sets; Cost per set $ 300 $ 100 per set $ 500 $ 166,67 per set
3. Output-Based Pay
Selection Effect: An Example of Compensating Salespeople
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 13
500
A (World Book)
B (Britannica)
W ...Weekly Pay
x ... Number of encyclopedia
53
300
Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will
stay at Britannica
3. Output-Based Pay
Selection Effect: An Example of Compensating Salespeople (cont.)
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 14
• Disadvantage of piecework: Variations of output can be beyond the worker‘s control
Variable pay Straight salary
• Fixed salary doesn‘t depend on exoge- nous factors – low-risk form of compensation Workers are insured against volatilities Firm provides the insurance for risks
• Lower compensation level• Can not participate in good economic development• Weaker incentives
• Variable pay depends on invested effort and exogenous risks – risky form of compensation Firm should smooth out exogenous risks from workers‘ compensation Firm should bear exogenous risks but endogenous risks should remain with workers
• Trade-off: More riskhigher compensation • Opportunity: participate in good economic development• Stronger incentives
3. Output-Based Pay
Disadvantages of Output-Based Pay
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 15
3. Output-Based Pay
Risk in Output-Based Pay
• The firm should bear the largest portion of risk because of risk pooling abilities
• Workers with a high average compensation should bear more risks than workers with a low average compensation.
Source: www.kone.fi
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 16
• In spite of all the advantages of output-based schemes: A large proportion of workforce is paid by input
• Compensation depends on the amount of time or effort spent on an activity
• Independent of output consideration
Time at work as a proxy to assess worker‘s effort
Examples: wage per work hour, monthly salaries, annual salaries
4. Input-Based Pay
Source: www.euro.fi
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 17
4. Input-Based Pay
Benefits of Input-Based Pay
• Finding the right output measure
• Costs of measurement
• Overemphasizing quantity, reduction of quality
• Risk aversion of workers
• Promoting long-run performance
However, in many cases output-based schemes could be used if only they were designed correctly!
Problems of output-based pay solved by time-based (input-based) pay
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 18
• Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to ‚count‘
Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page Price p. page Minutes p. page Revenue per hour
0 $ 8 20 $ 24
1 $ 7 15 $ 28
2 $ 5 12 $ 25
3 $ 3 10 $ 18
4 $ 0 9 $ 0
5 $ 0 8 $ 0
Compensation Schemes Balancing Quantity and Quality
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 19
Hourly wages Monthly salary Annual salary
Input-based pay
• Production workers• Clerical workers
• Top Management• Managerial workers
Tasks: experienced and easy to prescribe
• High correlation between effort and time invested• Time input as a pretty good indicator for effort
• Low correlation between effort and work time• Time input = bad measure for effort overinvestment in easy (pleasant) tasks
Tasks: less experienced and not easy to prescribe
• Undefined set of tasks (goal), discretion over work• Importance of other incen- tives to motivate for effort (long-term, e.g. stock options)
Tasks: not experienced and difficult to prescribe; often
to be defined by top manager
4. Input-Based Pay
Using the Appropriate Time Unit
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 20
5. Incentive Pay
Optimal Level of Variable Pay
• Since employees do not diversify their risk
– Large exogenous risks should be born by owners
Fixed salary
• However, employees are motivated by pay for performance
Variable Pay
Part of the pay should be fixed and part variable
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 21
5. Incentive Pay
Forms of Incentive Pay
• Rewards do not need to be monetary, they can consist of anything that employees value
• E.g Piece rates and commissions Bonuses Parking spots Days off Promotion Training Stock ownership Health care plan
Housing Education for kids Retirement Plan Party
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 22
5. Incentive Pay
Criticism to Incentive Compensation
• Often heard critics to incentive compensation:
– Money does not motivate
– It is difficult to design effective incentive schemes
• Incentives certainly entail costs
• The major problem is to design incentive schemes where the benefits exceed the costs
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 23
Furter Readings
Brickley, J. A./Smith, C. W. Jr./Zimmerman, J. L. (2001): Organizational Architecture, 2nd ed., Irwin Book Team.
Lazear, E. P. (1998): Personnel Economics for Managers, New York (John Wiley & Sons)