Comp 1

Milkovich−Newman: Compensation, Eighth Edition

Front Matter 1. The Pay Model © The McGraw−Hill Companies, 2004

1

The Pay Model Chapter Outline

Chapter One

The Employment Relationship Combines Transactional and Relational Returns

Variations in Transactional and Relational Expectations

A Pay Model Compensation Objectives Four Policies Pay Techniques

Book Plan

Caveat Emptor—Be an Informed Consumer

1. Does the Research Measure Anything Useful?

2. Does the Study Separate Correlation from Causation?

3. Are There Alternative Explanations?

Your Turn: Glamorous Internships? or House Elves?

Compensation: Definition, Please? Society Stockholders Managers Employees Global Views—Vive la différence

Forms of Pay Cash Compensation: Base Cash Compensation: Merit Pay/ Cost-of-Living Adjustments Cash Compensation: Incentives Long-Term Incentives Benefits: Income Protection Benefits: Work/Life Focus Benefits: Allowances Total Earnings Opportunities: Present Value of a Stream of Earnings Relational Returns from Work

A friend of ours writes that she is in one of the touring companies of the musical Cats. In the company are two performers called “swings” who sit backstage during each perfor- mance. Each swing must learn five different lead roles in the show. During the perfor- mance, the swing sits next to a rack with five different costumes and makeup for each of the five roles. Our friend, who has a lead in the show, once hurt her shoulder during a dance number. She signaled to someone offstage, and by the time she finished her num- ber, the swing was dressed, in makeup, and out on stage for the next scene.

Our friend is paid $2,000 per week for playing one of the cats in the show. She is ex- pected to do a certain number of performances and a certain number of rehearsals per week. She gets paid for the job she does. The swing gets paid $2,500 per week, whether she performs 20 shows that week or none. She is paid for knowing the five roles, whether she plays them or not.

 

 

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Think of all the other employees, in addition to the performers, required for putting on a performance of Cats. Electricians, trombonists, choreographers, dressers, janitors, nurses, vocal coaches, accountants, stagehands, payroll supervisors, ushers, lighting tech- nicians, ticket sellers—the list goes on. Consider the array of wages paid to these employ- ees. Why does the swing get paid more than other performers? Why does the performer get paid more (or less) than the trombonist? How are these decisions made, and who is involved in making them? Whether the pay is our own or someone else’s, compensation questions engage our attention.

Does the compensation received by all the people connected with Cats matter? Most employers believe that how people are paid affects people’s behaviors at work, which af- fect an organization’s chances of success. Compensation systems can help an organiza- tion achieve and sustain competitive advantage.1

COMPENSATION: DEFINITION, PLEASE?

What image does the word “compensation” bring to mind? It does not mean the same thing to everyone. Yet how people view compensation affects how they behave at work. Thus, we begin by recognizing different perspectives.

Society Some people see pay as a measure of justice. For example, a comparison of earnings of women with those of men highlights what many consider inequities in pay decisions. The gender pay gap in the United States, after adjustment for differences in education, experi- ence, and occupation, narrowed from 36 percent in 1980 to 12 percent in 2003. But this measure masks tremendous variations. When educational choices are taken into account, women’s earnings are 94 percent of those of men. For people age 21 to 35 who live alone and have no children, the gap is close to zero. (Of course, this constitutes a very small segment of the labor force.)2 The gap even varies by cities. Most people were surprised when 2000 census data showed that women in Wichita, Kansas, earn about half of what men earn but that women in Oakland, California, earn more than men.3

Sometimes differences in compensation among countries are listed as a cause of loss of jobs from more developed, higher-wage economies to less developed ones. As Exhibit 1.1 reveals, labor costs in Mexico are about 12 percent of those in the United States. However,

1E. Lawler III, Rewarding Excellence (San Francisco: Jossey-Bass, 2000); Patricia Zingheim and J. R. Schuster, Pay People Right! (San Francisco: Jossey-Bass, 2000); B. Gerhart, “Pay Strategy and Firm Performance,” in Compensation in Organizations: Current Research and Practice, eds. S. L. Rynes and B. E. Gerhart (San Francisco: Jossey-Bass, 2000); B. E. and Mark Huselid, “High Performance Work Systems and Firm Performance: A Synthesis of Research and Management Implications,” in Research in Personnel and Human Resources, ed. G. Ferris (Greenwich, CT: JAI Press, 1998); Barry Gerhart and Sara Rynes Compensation: Theory, Evidence, and Strategic Implications (Thousand Oaks, CA: Sage, 2003). 2H. J. Cummins, “Mommy Wage Gap: It’s Real, but Is It Fair?” Minneapolis Star & Tribune, May 11, 2003; Genaro C. Armas, “White Men Still Outearn Other Groups,” Associated Press, March 21, 2003; F. Blau, and L. Kahn, “Analyzing the Gender Pay Gap,” Quarterly Review of Economics and Finance 39 (1999), pp. 625–646; Francine D. Blau and Lawrence M. Kahn, “Understanding International Differences in the Gender Pay Gap,” NBER Working Paper W8200, Cambridge, MA, April 2001. 3Laurent Belsie, “Gender Pay Gap Varies by City,” Christian Science Monitor, December 12, 2001.

 

 

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Chapter 1 The Pay Model 3

when differences in productivity (the relative output for each dollar of pay) are factored in, the wage advantage of Mexico, Korea, and Taiwan disappears. Therefore, understanding productivity differences among international locations is crucial.

Voters may see compensation, pensions, and health care for public employees as the cause of increased taxes. Public policymakers and legislators may view changes in aver- age pay as guides for adjusting eligibility for social services (medical assistance, food stamps, and the like).

Some consumers may view increases in compensation as the cause of price increases. They may not believe that higher labor costs are to their benefit. Other consumers have lobbied universities to insist on higher wages for laborers in Guatemala who sew shirts and caps bearing the university logo.4 All these differing perspectives are represented within a society and among individuals. After all, public employees, faculty, and students are also taxpayers and consumers. And they vote.

Austria 19.40

0 5 10 15 20 25

U.S. 20.32

Australia 13.15

Mexico 2.44

Japan 19.59

Korea 8.09

Singapore 7.77

Taiwan 5.70

Denmark 21.98

France 15.88

Germany 22.86

Ireland 13.28

Italy 13.76

Netherlands 19.29

Norway 23.13

Portugal 4.75

Spain 10.88

Sweden 18.35

U.K. 16.14

Canada 15.23

EXHIBIT 1.1 Hourly Compensation Costs for Production Workers in Manufacturing in U.S. Dollars

Source: Bureau of Labor Statistics, April 2003

4U.S. Department of Labor, Bureau of Labor Statistics, “International Comparisons of Hourly Compensation Costs for Production Workers in Manufacturing, 2001,” www.bls.gov/fls/flsichcc.pdf; Timothy Aeppel, “Manufacturers Spent Much Less Abroad Last Year,” Wall Street Journal, May 9, 2003, p. A8; S. Greenhouse, “Anti-Sweatshop Movement Is Achieving Gains Overseas,” New York Times, January 26, 2000, p. A10. Websites of interest on the movement include www.maquilasolidarity.org/ and www.geocities.com/whydoyoukeepdeletingme/ASSLLeague.html.

 

 

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Stockholders To stockholders, executive pay is of special interest. Linking executive pay to company performance is supposed to increase stockholders’ wealth. Unfortunately, this does not always happen. In the midst of a recent economic downturn in the United States, total shareholder returns were down by 22 percent, while the median CEO pay rose by 14 per- cent to $13.2 million.5 Robert Nugent led Jack-in-the-Box to a 19 percent decline in shareholder value for which he received a 53 percent increase in his pay. And Walt Dis- ney shareholders experienced an 18 percent reduction in their returns in 2002, while the total pay of the company’s CEO, Michael Eisner, increased by 498 percent.

All is not goofy in the magic kingdom of executive compensation. Contrast the higher pay–lower performance at Jack-in-the-Box and Disney with the low performance–low pay at Eli Lilly, maker of Prozac and other drugs. Sidney Taurel’s pay fell 49 percent to $11.2 million as Eli Lilly’s performance declined.6 There are even a few instances of higher pay for higher performance. At Silicon Graphics, the pay of CEO Robert Bishop increased 46.3 percent, reflecting a 111.5 percent improvement in total shareholder value.7

Managers For managers, compensation influences their success in two ways. First, it is a major ex- pense. Competitive pressures, both internationally and domestically, force managers to consider the affordability of their compensation decisions. Labor costs can account for more than 50 percent of total costs. In some industries, such as financial or professional services or public employment such as education and government, this figure is even higher. However, even within an industry, labor costs as a percent of total costs vary among individual firms. Exhibit 1.2 shows the range of labor costs as a percent of rev- enue within the airline industry. The big airlines have much higher labor costs than many of the smaller, low-fare operators.

In addition to treating pay as an expense, a manager also uses it to influence employee behaviors and improve organization performance. The way people are paid affects the quality of their work; their attitude toward customers; their willingness to be flexible,

5 Graef Crystal, “Bloomberg Report,” April 14, 2003, www.bloomberg.com/news/commentary/gcrystal.html; B. Hall, “What You Need to Know about Stock Options,” Harvard Business Review, March–April 2000, pp. 121–129. 6Jerry Useem, “Have They No Shame?” Fortune, April 28, 2003, pp. 57–64; Janice Revell, “CEO Pensions: The Latest Way to Hide Millions,” Fortune, April 28, 2003, pp. 68–70. Fortune publishes articles on executive pay every April. However, be cautious about using these isolated anecdotes to decide if executive compensation is related to firm performance. There is a wealth of research informing us on this issue. You will read about it in the chapter on special groups. 7”The Boss’s Pay: The WSJ/Mercer 2002 CEO Compensation Survey,” Wall Street Journal, April 14, 2003, pp. R6–R10; Joann S. Lublin, “Why the Get-Rich-Quick Days May Be Over,” Wall Street Journal, April 14, 2003, pp. R1–R3; Brent M. Longnecker, Stock Option Alternatives: A Strategic and Technical Guide to Long-Term Incentives (Scottsdale, AZ: WorldatWork, 2003). For more discussion on executive pay, see Bruce Ellig, The Complete Guide to Executive Compensation (New York: McGraw-Hill, 2002); and Peter T. Chingos, Paying for Performance: A Guide to Compensation Management (New York: Wiley, 2002).

 

 

Milkovich−Newman: Compensation, Eighth Edition

Front Matter 1. The Pay Model © The McGraw−Hill Companies, 2004

Chapter 1 The Pay Model 5

learn new skills, or suggest innovations. People may become interested in unions or legal action against their employer based on how they get paid. This potential to influence em- ployees’ behaviors, and subsequently the productivity and effectiveness of the organiza- tion, makes the study of compensation worth your time.8

Employees The pay individuals receive in return for the work they perform is usually the major source of their financial security. Hence, pay plays a vital role in a person’s economic and social well-being. Employees may see compensation as a return in an exchange be- tween their employer and themselves, as an entitlement for being an employee of the company, or as a reward for a job well done. Compensation can be all of these things, al- though how many employees see their pay as a reward remains an open question.

Describing pay as a reward may sound farfetched to anyone who has reluctantly rolled out of bed to go to work. Even though writers and consultants use that term, do people really say, “They just gave me a reward increase,” or “Here is my weekly reward check?” Sounds silly, doesn’t it? Yet if people see their pay as a return for their contri- butions and investments rather than as a reward, and if writers and consultants persist in trying to convince them that pay is a reward, there is a disconnect that misleads both employees and managers. Employees invest in education and training; they contribute their time and energy at the workplace. Compensation is their return on those invest- ments and contributions.9

8K. Bartol and E. Locke, “Incentives and Motivation,” chap. 4 in Compensation in Organizations, eds. S. Rynes & B. Gerhart (San Francisco: Jossey-Bass, 2000), pp. 104–150; Mary Graham et al., “In the Land of Milk and Money: One Dairy Farm’s Strategic Compensation System,” Journal of Agribusiness, 15(2) (1997), pp. 171–188. 9E. E. Lawler, Rewarding Excellence (San Francisco: Jossey-Bass, 2000); Steven E. Gross and Haig R. Nalbantian, “Looking at Rewards Holistically,” WorldatWork Journal 11(2) (Second Quarter 2002).

United

American

US Airways

Delta

Northwest

Southwest

Continental

Alaska

America West

ATA

AirTran

JetBlue

49.7%

48.5

46.7

46.3

40.5

36.1

35.2

31.7

29.1

27.8

27.7

25.5

EXHIBIT 1.2 Labor Costs as a Percentage of Revenues, Airline Industry

Source: The companies.

 

 

Milkovich−Newman: Compensation, Eighth Edition

Front Matter 1. The Pay Model © The McGraw−Hill Companies, 2004

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10G. T. Milkovich and M. Bloom, “Rethinking International Compensation: From National Cultures to Markets and Strategic Flexibility,” Compensation and Benefits Review, January 1998, pp. 1–10; Atul Mitra, Matt Bloom, and George Milkovich, “Crossing a Raging River: Seeking Far-Reaching Solutions to Global Pay Challenges,” WorldatWork Journal 22(2) (Second Quarter 2002); Mark Fenton-O’Creevy, “HR Practice: Vive la Différence,” Financial Times, October 2002, pp. 6–8; M. Mendenhall and Gary Oddou, Readings and Cases in International Human Resource Management (Cincinnati: South-Western College Publishing, 2000); Anne Tsui and Chung-Ming Lau, The Management of Enterprises in the People’s Republic of China (Boston: Kluwer Academic, 2002); Morley Gunderson, “The Evolution and Mechanics of Pay Equity in Ontario,” Canadian Public Policy 28, suppl. 12 (2002); Francine Blau and Lawrence M. Kahn, “Understanding International Differences in the Gender Pay Gap,” NBER Working Paper W8200, National Bureau of Economic Research, Cambridge, MA, April 2001). 11Participants in an international compensation seminar at Cornell University provided the information on various meanings of compensation.

Global Views—Vive la différence In English, “compensation” means something that counterbalances, offsets, or makes up for something else. However, if we look at the origin of the word in different languages, we get a sense of the richness of the meaning, which can combine entitlement, return, and reward.10

In China, the traditional characters for the word “compensation” are based on the sym- bols for logs and water; compensation provides the necessities in life. In the recent past, the state owned all enterprises and compensation was treated as an entitlement. In today’s China, compensation takes on a more subtle meaning. A new word, dai yu, is used. It refers to how you are being treated—your wages, benefits, training opportunities, and so on. When people talk about compensation, they ask each other about the dai yu in their companies. Rather than assuming that everyone is entitled to the same treatment, the meaning of compensation now includes a broader sense of returns, and rewards, as well as entitlement.

“Compensation” in Japanese is kyuyo, which is made up of two separate characters (kyu and yo), both meaning “giving something.” Kyu is an honorific used to indicate that the person doing the giving is someone of high rank, such as a feudal lord, an emperor, or a samurai leader. Traditionally, compensation is thought of as something given by one’s superior. Today, business consultants in Japan try to substitute the word hou-syu, which means “reward” and has no associations with notions of superiors. The many allowances that are part of Japanese compensation systems translate as teate, which means “taking care of something.” Teate is regarded as compensation that takes care of employees’ fi- nancial needs. This concept is consistent with the family, housing, and commuting al- lowances that are still used in many Japanese companies.11

These contrasting ideas about compensation—multiple views (societal, stockholder, man- agerial, employee, and even global) and multiple meanings (returns, rewards, entitlement)— add richness to the topic. But they can also cause confusion unless everyone is talking about the same thing. So let’s define what we mean by “compensation” or “pay” (the words are used interchangeably in this book):

Compensation refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship.

 

 

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Chapter 1 The Pay Model 7

FORMS OF PAY

Exhibit 1.3 shows the variety of returns people receive from work. They are categorized as total compensation and relational returns. The relational returns (learning opportuni- ties, status, challenging work, and so on) are psychological.12

Total compensation returns are more transactional. They include pay received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments) and indirectly as benefits (e.g., pensions, medical insurance, programs to help balance work and life demands, brightly colored uniforms).13 Programs to pay people can be designed in a wide variety of ways, and a single employer typically uses more than one.

Cash Compensation: Base Base wage is the cash compensation that an employer pays for the work performed. Base wage tends to reflect the value of the work or skills and generally ignores differences at- tributable to individual employees. For example, the base wage for machine operators may be $20 an hour. However, some individual operators may receive more because of their experience and/or performance. Some pay systems set base wage as a function of the skill or education an employee possesses; this is common for engineers and school- teachers.14

12D. Rousseau, Psychological Contracts in Organizations (Thousand Oaks, CA: Sage, 1995). 13”Brightly Colored Uniforms Boost Employee Morale,” The Onion 36(43) (November 30, 2000). 14A. Milanowski, “The Varieties of Knowledge and Skill-Based Pay Design: A Comparison of Seven New Pay Systems for K-12 Teachers,” Working Paper TC-01-2, University of Wisconsin–Madison, Wisconsin Center for Education Research, Consortium for Policy Research in Education, (2001).

Total Returns

Relational Returns

Recognition & Status

Learning Opportunities

Employment Security

Challenging Work

Benefits

Cash Compensation

Total Compensation

Base

Allowances

Long-Term Incentives

Merit/Cost of Living

Income Protection

Work/Life Focus

Short-Term Incentives

EXHIBIT 1.3 Total Returns for Work

 

 

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A distinction is often made in the United States between wage and salary, with salary re- ferring to pay for employees who are exempt from regulations of the Fair Labor Standards Act (FLSA) and hence do not receive overtime pay.15 Managers and professionals usually fit this category. Their pay is calculated at an annual or monthly rate rather than hourly, because hours worked do not need to be recorded. In contrast, workers who are covered by overtime and reporting provisions of the Fair Labor Standards Act—nonexempts—have their pay cal- culated as an hourly wage. Some organizations, such as IBM, Eaton, and Wal-Mart, label all base pay as “salary.” Rather than dividing employees into separate categories of salaried and wage earners, they believe that an “all-salaried” workforce reinforces an organization culture in which all employees are part of the same team. However, merely changing the terminol- ogy does not negate the need to comply with the FLSA.

Cash Compensation: Merit Pay/Cost-of-Living Adjustments Periodic adjustments to base wages may be made on the basis of changes in what other employers are paying for the same work, changes in the overall cost of living, or changes in experience or skill.

According to surveys, 90 percent of U.S. firms use merit pay increases.16 Merit in- creases are given as increments to the base pay in recognition of past work behavior. Some assessment of past performance is made, with or without a formal performance evaluation program, and the size of the increase is varied with performance. Thus, out- standing performers could receive an 8 to 10 percent merit increase 8 months after their last increase, whereas an average performer may receive, say, a 3 to 4 percent increase after 12 or 15 months. In contrast to merit pay, cost-of-living adjustments give the same percent increase across the board to everyone, regardless of performance.

Cash Compensation: Incentives Incentives tie pay increases directly to performance. However, incentives differ from merit adjustments. First, incentives do not increase the base wage, and so must be re-earned each pay period. Second, the potential size of the incentive payment will gener- ally be known beforehand. Whereas merit pay programs evaluate past performance of an individual and then decide on the size of the increase, the performance objective for in- centive payments is called out very specifically ahead of time. For example, a Toyota dealer knows the commission on a Land Cruiser versus a Corolla prior to making the sale. Although both merit pay and incentives try to influence performance, incentives try to influence future behavior whereas merit recognizes (rewards) past behavior. The incentive-reward distinction is a matter of timing.

Incentives can be tied to the performance of an individual employee, a team of em- ployees, a total business unit, or some combination of individual, team, and unit. The per- formance objective may be expense reduction, volume increases, customer satisfaction, revenue growth, return on investments, or increases in total shareholder value—the possi-

15U.S. Department of Labor, Employment Standards Administration, Wage and Hour Division. See Chapter 17 for greater detail on the FLSA and pay. 16Robert Heneman, Merit Pay: Linking Pay Increases to Performance Ratings (Reading, MA.: Addison- Wesley, 1992); Robert J. Greene, “Improving Merit Pay Plan Effectiveness,”ACA News 41(4) (April 1998,).

 

 

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Chapter 1 The Pay Model 9

bilities are endless.17 Prax Air, for example, uses return on capital (ROC). For every quarter that a 6 percent ROC target is met or exceeded, Prax Air awards bonus days of pay. An 8.6 percent ROC means two extra days of pay for that quarter for every em- ployee covered by the program. A ROC of 15 percent means eight and a half extra days of pay.

Because incentives are one-time payments, they do not have a permanent effect on labor costs. When performance declines, incentive pay automatically declines, too. Con- sequently, incentives are frequently referred to as variable pay.

Long-Term Incentives Incentives may be short- or long-term. Long-term incentives are intended to focus em- ployee efforts on multiyear results. Typically they are in the form of stock ownership or options to buy stock at specified, advantageous prices. Stock options straddle the cate- gories of cash compensation and benefits. Some argue that they are not compensation at all, that they are more accurately described as an ownership share granted by owners to employees.18

The idea behind stock options is that employees with a financial stake in the organiza- tion will focus on long-term financial objectives: return on investment, market share, re- turn on net assets, and the like. Bristol-Myers Squibb grants shares of stock to selected “Key Contributors” who make outstanding contributions to the firm’s success. Some companies extend stock ownership beyond the ranks of managers and professionals. Sun Microsystems, Yahoo, PepsiCo, Wal-Mart, and Starbucks offer stock options to all their employees.19

Benefits: Income Protection Exhibit 1.3 shows that benefits, including income protection, work/life balance 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 become disabled or unemployed. Employers also make half the contributions to social security. (Employees pay the other half.) Different countries have different lists of mandatory benefits.

Medical insurance, retirement programs, life insurance, and savings plans are common benefits. They help protect employees from the financial risks inherent in daily life. Often

17Steve Kerr, “The Best Laid Incentive Plans,” Harvard Business Review, January 2003; Michael C. Sturman and J. C. Short, “Lump-Sum Bonus Satisfaction: Testing the Construct Validity of a New Pay Satisfaction Dimension,” Personnel Psychology 53(200), pp. 673–700. 18Some believe greater stock ownership motivates performance; others argue that the link between individual job behaviors and the vagaries of the stock market are tenuous at best. S. Rodrick, The Stock Options Book of 1998 (Oakland, CA: National Center for Employee Ownership, 1998) (see also the center’s website at www.nceo.org); D. Kruse and J. Blasi, “Employee Ownership, Employee Attributes and Firm Performance,” Journal of Employee Ownership, Law and Finance, April 2000, pp. 37–48; testimony of Dr. Douglas Kruse before the Committee on Education and the Workforce, February 13, 2002, edworkforce.house.gov/hearings/107th/eer/enronthree21302/kruse.htm. 19C. Rosen and E. Carberry, “Ownership Matters!” Workspan, October 2002, pp. 29–32; Ben Dunford, John Boudreau, and Wendy Boswell, “When Stock Options Fail to Motivate,” CAHRS Working Paper 02-04, Ithaca, NY.

 

 

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companies can provide these protections to employees cheaper than employees can ob- tain them for themselves. Because the cost of providing benefits has been rising (for ex- ample, employers pay nearly half the nation’s health care bills, and health care expendi- tures have recently been increasing at annual rates around 15 to 20 percent), they are an increasingly important form of pay.20 General Motors spends so much for benefits that it has been called a pension and health care provider that also makes cars. In a Gallup poll, people claimed they would require $5,000 more in extra pay to choose a job without pen- sion, health care, and life insurance.

Benefits: Work/Life Focus Programs that help employees better integrate their work and life responsibilities include time away from work (vacations, jury duty), access to services to meet specific needs (drug counseling, financial planning, referrals for child and elder care), and flexible work arrangements (telecommuting, nontraditional schedules, nonpaid time off). Responding to the changing demographics of the workforce (two-income families who demand em- ployer flexibility so that family obligations can be met), many U.S. employers are giving a higher priority to these benefit forms. Medtronic, for example, touts its Total Well- Being program that seeks to provide “resources for growth—mind, body, heart, and spirit” for each employee. Health and wellness, financial rewards and security, individual and family well-being, and a fulfilling work environment are part of this “total well- being.” Medtronic believes that this program permits employees to be “fully present” at work and less distracted by conflicts between their work and nonwork responsibilities.

Benefits: Allowances Allowances often grow out of whatever is in short supply. In Vietnam and China, housing (dormitories and apartments) and transportation allowances are frequently part of the pay package.21 Sixty years after the end of World War II–induced food shortages, some Japanese companies still continue to offer a “rice allowance” based on the number of an employee’s dependents.22 Almost all foreign companies in China discover that housing, transportation, and other allowances are expected. Companies that resist these allowances must come up with other ways to attract and retain talented employees. In many Euro- pean countries, managers assume that a car will be provided—what make and model are negotiable.23

20Employee Benefits Research Institute’s website, www.ebri.org. See also the EBRI’s Fundamentals of Employee Benefits (Washington, DC: EBRI, 1997) and EBRI Health Benefits Databook (1999); Margaret L. Williams, Stanley B. Malos, and David K. Palmer, “Benefit System and Benefit Level Satisfaction: An Expanded Model of Antecedents and Consequences,” Journal of Management 28(2) (2002), pp. 195–212. 21Anne Tsui and Chung-Ming Lau, The Management of Enterprises in the People’s Republic of China (Boston: Kluwer Academic, 2002). 22Yoshio Yanadori and George Milkovich, “Minimizing Wage Competition? Entry-Level Compensation in Japanese Firms,” working paper, Center for Advanced HR Studies, Ithaca, NY, 2003. 23The websites for the International Labour Organization (www.ilo.org) and the European Industrial Relations Observatory On-Line (www.eiro.eurofound.ie) publish news of developments in HR in Europe.

 

 

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Chapter 1 The Pay Model 11

Total Earnings Opportunities: Present Value of a Stream of Earnings Up to this point we have treated compensation as something paid or received at a moment in time. But compensation decisions have a temporal effect. Say you have a job offer of $50,000. If you stay with the firm five years and receive an annual increase of 4 percent, in five years you will be earning $60,833 a year. The expected cost commitment of the decision to hire you turns out to be $331,649 in cash. If you add in an additional 25 per- cent for benefits, the decision to hire you implies a commitment of over $400,000 from your employer. Will you be worth it? You will be after this course.

A present-value perspective shifts the comparison of today’s initial offers to consider- ation of future bonuses, merit increases, and promotions. Sometimes a company will tell students that its relatively low starting offers will be overcome by larger future pay in- creases. In effect, the company is selling the present value of the future stream of earn- ings. But few students apply that same analysis to calculate the future increases required to offset the lower initial offers. Hopefully, all students who get through Chapter 1 will now do so.

Relational Returns from Work Why does Bill Gates still show up for work every morning? Why do Microsoft million- aires continue to write code? Why does Andy Borowitz write the funniest satirical news site on the web (www.borowitzreport.com) for free? There is no doubt that nonfinancial 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, chal- lenging work, and opportunities to learn. Other relational forms might include personal satisfaction from successfully facing new challenges, teaming with great co-workers, re- ceiving new uniforms, and the like.24 Such factors are part of the total return, which is a broader umbrella than total compensation.

The Organization as a Network of Returns Sometimes it is useful to think of an organization as a network of returns created by all these different forms of pay, including total compensation and relational returns. The challenge is to design this network so that it helps the organization to succeed. As in the case of rowers pulling on their oars, success is more likely if all are pulling in uni- son rather than working against one another. In the same way, the network of returns is more likely to be useful if bonuses, development opportunities, and promotions all work together.

So the next time you walk in an employer’s door, look beyond the cash and health care offered to search for all the returns that create the network. Even though this book focuses on total compensation, let’s not forget that compensation is only one of many

24Austin Collins, “Pay in Theoretical Physics,” California Institute of Technology Newspaper, May 23, 1997, p. 3; Richard P. Feynman, The Pleasure of Finding Things Out (Cambridge, MA: Helix Books, 1999); “Brightly Colored Uniforms Boost Employee Morale,” The Onion 36(43) (November 30, 2000).

 

 

Milkovich−Newman: Compensation, Eighth Edition

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12 Chapter 1 The Pay Model

factors affecting people’s decisions about work, as songwriter Roger Miller made clear in this 1960s tune:

Got a letter just this morning, it was postmarked Omaha. It was typed and neatly written offering me a better job, Better job and higher wages, expenses paid, and a car. But I’m on TV here locally, and I can’t quit, I’m a star. I come on TV a grinnin’, wearin’ pistols and a hat, It’s a kiddie show and I’m the hero of the younger set. I’m the number one attraction in every supermarket parking lot. I’m the king of Kansas City. No thanks, Omaha, thanks a lot. Kansas City Star, that’s what I are . . .

THE EMPLOYMENT RELATIONSHIP COMBINES TRANSACTIONAL AND RELATIONAL RETURNS

We have already described compensation as a return received in exchange for people’s efforts and ideas at their workplace. Exchange is a key part of the relationship. For most people, many of the terms and conditions of their employment exchanges are left un- stated, forming an implicit contract.25

An implicit contract is an unwritten understanding between employers and employees over their reciprocal obligations and returns; employees contribute toward achieving the goals of the employer in exchange for returns given by the employer and valued by the employee.

Compensation is an important part of this employment relationship. Unanticipated changes in compensation often breach this implicit understanding. Replacing annual pay increases with incentives, raising the deductibles on health care insurance, or tinkering with pension plans may have a negative effect on employee behavior that is out of pro- portion to the financial impact of the change if employees feel the implicit contract has been breached.

Variations in Transactional and Relational Expectations These reciprocal obligations and expectations vary among employers and employees. The implicit contract offered—the deal—at one organization is not the same as the one of- fered at another. It is possible to categorize employment relationships in terms of their emphasis on transactional returns (total cash and benefits), relational returns (sociopsy- chological returns), or both.

Exhibit 1.4 shows a grid with transactional returns on one axis and relational returns on the other. In the grid, organizations that pay low cash compensation and offer low re- lational returns are in the “workers as commodity” category. These organizations view

25M. Bloom, “The New Deal: Understanding Compensation in the Employment Relationship,” ACA Journal 8(4), (1999), pp. 58–67; A. S. Tsui, J. L. Pearce, L. W. Porter, and J. P. Hite, “Choice of Employee- Organization Relationships,” in Research in Personnel and Human Resource Management, ed. G. R. Ferris (Greenwich, CT: JAI Press, 1995); and Marvin H. Kosters, “New Employment Relationships and the Labor Market,” Journal of Labor Research 18(4) (Fall 1997), pp. 551–559.

 

 

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labor as input into the production process. In the United States, employers of migrant workers may offer this type of deal.

Organizations that offer both high compensation and high relational returns may be characterized as cultlike. Microsoft, Medtronic, and Toyota are examples. The strong commitment to the organization shows in the words and actions of employees: “being at the center of technology, having an impact on the work, working with smart people, the sheer volume of opportunities, shipping winning products, beating competition.”26

Some organizations offer a family relationship: high relational and low transactional returns. Starbucks is an example; one writer calls it the “touchy-feely coffee company.”27

SAS Institute is another. Finally, there are the “hired guns”—all-transactional, “show- me-the-cash” relationships. Brokerage houses, real estate firms, and auto dealerships in the United States fit this category.

While labeling these companies is fun, and even convenient for describing different deals, it may be misleading. For example, the CEO of the Starbucks “family” states that he pays more than his competitors and offers health insurance and “bean stock” to Star- buck partners-employees as part of the total relationship. In spite of this, Starbucks’ turnover rate is about 60 percent. Most “partners” do not stay in the family very long. So whether or not a deal is successful may depend on your criteria. Perhaps employees are joining Starbucks with different expectations of the implicit contract offered. As Ahmad Fawzi, commenting on U.S. support of Afghanistan, noted, “Reassurances are good. Cash is better.” And perhaps both cash and reassurances are best. Compensation is an impor- tant part, albeit not the only part, of the employment relationship.

HIGH PAY–LOW COMMITMENT

Hired Guns (Stockbrokers)

LOW PAY–LOW COMMITMENT

Workers as Commodity (Employers of Migrant

Farm Workers)

HIGH PAY–HIGH COMMITMENT

Cultlike (Microsoft)

LOW PAY–HIGH COMMITMENT

Family (Starbucks)

HIGHLOW

H IG

H L

O WT R

A N

SA C

T IO

N A

L

RELATIONAL

EXHIBIT 1.4 Framework for Analyzing Employment Relationships

26Steve Balmer, speech quoted in Wall Street Journal Interactive Edition, May 11, 1999, www.wsj.com; D. McKenna and J. McHenry, Microsoft’s Maniacal Work Ethic (Redmond, WA: Microsoft, 1996). 27R. Thomkins, “Touchy-Feely Coffee Company,” Financial Times, October 9, 1997, p. 14.

 

 

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A PAY MODEL

The pay model shown in Exhibit 1.5 serves as both a framework for examining current pay systems and a guide for most of this book. It contains three basic building blocks: (1) the compensation objectives, (2) the policies that form the foundation of the compen- sation system, and (3) the techniques that make up the compensation system.

POLICIES

EFFICIENCY •Performance •Quality •Customers and Stockholders

•Costs

FAIRNESS

COMPLIANCE

Work Analysis

Descriptions Evaluation/ Certification

INTERNAL STRUCTURE

Market Definitions

Surveys Policy Lines PAY STRUCTURE

Senority Based

Performance Based

Merit Guidelines

INCENTIVE PROGRAMS

Costs Communication Change EVALUATIONMANAGEMENT

CONTRIBUTIONS

COMPETITIVENESS

ALIGNMENT

TECHNIQUES OBJECTIVES

EXHIBIT 1.5 The Pay Model

 

 

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Compensation Objectives Pay systems translate the strategy into practice in order to achieve certain objectives. The basic objectives, shown at the right side of the model, include efficiency, fairness, and compliance with laws and regulations. Efficiency can be stated more specifically: (1) im- proving performance, increasing quality, delighting customers and stockholders, and (2) controlling labor costs. Compensation objectives at Medtronic and AES are contrasted in Exhibit 1.6. Medtronic is a medical technology company that pioneered cardiac pace- makers. Its compensation objectives emphasize performance, business success, and salaries that are competitive with other companies whose financial performance matches Medtronic’s. AES generates and markets electricity around the world. Its goal is to “pro- vide electricity worldwide in a socially responsible way.” The notion of social responsi- bility pervades the company.

Fairness is a fundamental objective of pay systems. In Medtronic’s objectives, fair- ness means “ensure fair treatment” and “be open and understandable.” AES’s mission statement acknowledges, “Defining what is fair is often difficult, but we believe it is helpful to routinely question the relative fairness of alternative courses of action. It does not mean that everyone gets treated equally, but instead treated fairly or with justice given the appropriate situation.”28

Thus, the fairness objective calls for fair treatment for all employees by recognizing both employee contributions (e.g., higher pay for greater performance, experience, or training) and employee needs (e.g., a fair wage as well as fair procedures). Procedural

EXHIBIT 1.6 Comparisons of Pay System Objectives

Pay Objectives at Medtronic and AES

Medtronic AES

• Support objectives and increased complexity of business

• Minimize increases in fixed costs • Emphasize performance through

variable pay and stock • Competitiveness aligned with financial

performance: 50th percentile performance paid at 50th percentile of market, 75th percentile performance paid at 75th percentile of market

Our guiding principles are to act with integrity, treat people fairly, have fun, and be involved in projects that provide social benefits. This means we will • Help AES attract self-motivated,

dependable people who want to keep learning new things

• Hire people who really like the place and believe in the AES system

• Pay what others are paid both inside and outside AES, but hire people who are willing to take less to join AES

• Use teams of employees and managers to manage the compensation system

• Make all employees stockholders

28Further information on each company’s philosophy and way of doing business can be deduced from their websites: www.medtronic.com and www.aesc.com. Readers of earlier editions of this book will note that “fairness” is substituted for “equity”. The word “equity” has taken on several meanings in compensation, e.g., stock ownership and pay discrimination. We decided that “fairness” better conveyed our meaning in this book.

 

 

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fairness refers to the process used to make pay decisions.29 It suggests that the way a pay decision is made may be as important to employees as the results of the decision.

Compliance as a pay objective means conforming to federal and state compensation laws and regulations. If they change, pay systems may need to be adjusted to ensure con- tinued compliance.

There are probably as many statements of pay objectives as there are employers. In fact, highly diversified firms such as General Electric and Eaton, which operate in multi- ple lines of businesses, may have different pay objectives for different business units. Ob- jectives at Medtronic and AES emphasize the increased complexity of the business and the importance of integrity, competitiveness, ability to attract and retain quality people, and having fun.

Objectives serve several purposes. First, they guide the design of the pay system. If an objective is to increase customer satisfaction, then incentive programs and merit pay (techniques) might be used to pay for performance (policy). Another employer’s objec- tive may be to develop new products, to innovate. Job design, training, and team building may be used to reach this objective. The pay system aligned with this employer’s objec- tive may have a policy of paying salaries that at least equal those of competitors (external competitiveness) and that go up with increased skills or knowledge (internal alignment). This pay system could be very different from our first example, where the focus is on in- creasing customer satisfaction.

So, objectives guide the design of pay systems. They also serve as the standards for judging the success of the pay system. If the objective is to attract and retain the best and the brightest, yet skilled employees are leaving to take higher-paying jobs with other em- ployers, the system may not be performing effectively. Although there may be many non- pay reasons for turnover, objectives provide standards for evaluating the effectiveness of a pay system.

Four Policies Every employer must address the policy decisions shown on the left side of the pay model: (1) internal alignment, (2) external competitiveness, (3) employee contributions, and (4) management of the pay system. These policies are the foundation on which pay systems are built. They also serve as guidelines for managing pay in ways that accom- plish the system’s objectives.

29J. Brockner, Y. Chen, K. Leung, and D. Skarlick, “Culture and Procedural Fairness: When the Effects of What You Do Depend on How You Do It,” Administrative Science Quarterly 45 (2000), pp. 138–159; Marcia P. Miceli and P. Mulvey, “Consequences of Satisfaction with Pay Systems: Two Field Studies,” Industrial Relations 39 (2000), pp. 62–87; S. Masterson, K. Lewis, B. M. Goldman, and M. S. Taylor, “Integrating Justice and Social Exchange: The Differing Effects of Fair Procedures and Treatment on Work Relationships,” Academy of Management Journal, 43, 2000, pp. 738–748; Frederick P. Morgeson, Michael A. Campion, and Carl P. Maertz, “Understanding Pay Satisfaction: The Limits of a Compensation System Implementation,” Journal of Business and Psychology 16(1) (Fall 2001), pp. 133–149; Mary Konovsky, “Understanding Procedural Justice and Its Impact on Business Organizations,” Journal of Management 26(3) (2000), pp. 489–511; Joel Brockner, “Making Sense of Procedural Fairness: How High Procedural Fairness Can Reduce or Heighten the Influence of Outcome Favorability,” Academy of Management Review 27(1) (2002), pp. 58–76; Charlie O. Trevor and David L. Wazeter, “Reactions to Interdependence among Pay Dispersion, Pay Relative to Internal and External Referents, and Procedural Fairness: Toward a General Compensatory Effect,” working paper, University of Wisconsin–Madison, May 2003.

 

 

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Internal Alignment Internal alignment refers to comparisons among jobs or skill levels inside a single organi- zation. Jobs and people’s skills are compared in terms of their relative contributions to the organization’s business objectives. How, for example, does the work of the program- mer compare with the work of the systems analyst, the software engineer, and the soft- ware architect? Does one contribute to providing solutions for customers and satisfying shareholders more than another? Think back to our friend from Cats and the variety of work required in a touring company to put on the show. Does one actor’s role require more knowledge or experience than another’s? Internal alignment pertains to the pay rates both for employees doing equal work and for those doing dissimilar work. In fact, determining what is an appropriate difference in pay for people performing different work is one of the key challenges facing managers.

Pay relationships within the organization affect all three compensation objectives. They affect employee decisions to stay with the organization, to become more flexible by investing in additional training, or to seek greater responsibility. By motivating employ- ees to choose increased training and greater responsibility in dealing with customers, in- ternal pay relationships indirectly affect the capabilities of the workforce and hence the efficiency of the entire organization. Fairness is affected through employees’ compar- isons of their pay to the pay of others in the organization. Compliance is affected by the basis for making internal comparisons. Paying on the basis of race, gender, age, or na- tional origin is forbidden in the United States.

External Competitiveness External competitiveness refers to compensation relationships external to the organiza- tion: comparison with competitors. How should an employer position its pay relative to what competitors are paying? How much do we wish to pay accountants in comparison to what other employers would pay them? What mix of pay forms—base, incentives, stock, benefits—will help achieve the compensation objectives? Recall that Medtronic’s policy is to pay competitively in its market on the basis of its financial performance versus the financial performance of its competitors, while AES’s policy is to expect people to be willing to take less to join the company.

Increasingly, organizations claim their pay systems are market-driven, that is, based almost exclusively on what competitors pay. However, “market driven” gets translated into practice in different ways. Some employers may set their pay levels higher than their competition, hoping to attract the best applicants. Of course, this assumes that someone is able to identify and hire the “best” from the pool of applicants.

What mix of pay forms a company uses is also part of its external competitive policy. Medtronic sets its base pay to match its competitors but ties incentives to performance. Plus it offers stock options to all its employees to promote a culture of ownership. The big assump- tion is that owners will pay closer attention to the business.30 Further, Medtronic believes that its benefits, particularly its emphasis on programs that balance work and life, make it a highly attractive place to work. It believes that how its pay is positioned and what forms it uses create

30Mary Graham et al., “In the Land of Milk and Money: One Dairy Farm’s Strategic Compensation System,” Journal of Agribusiness 15(2) (1997), 171–188.

 

 

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an advantage over competitors. A Medtronic competitor, say, Boston Scientific, may offer lower base pay but greater opportunity to work overtime or fatter bonuses.

External competitiveness decisions—both how much and what forms—have a twofold effect on objectives: (1) to ensure that the pay is sufficient to attract and retain employees— if employees do not perceive their pay as competitive in comparison to what other organi- zations are offering for similar work, they may be more likely to leave—and (2) to con- trol labor costs so that the organization’s prices of products or services can remain competitive. So external competitiveness directly affects both efficiency and fairness. And it must do so in a way that complies with relevant legislation.

Employee Contributions How much emphasis should there be on paying for performance? Should one program- mer be paid differently from another if one has better performance and/or greater senior- ity? Or should there be a flat rate for programmers? Should the company share any prof- its with employees? With all employees?

The emphasis to place on employee contributions is an important policy decision since it directly affects employees’ attitudes and work behaviors. Eaton and Motorola use pay to support other “high-performance” practices in their workplaces.31 Both use team-based pay and corporate profit-sharing plans. Starbucks emphasizes stock options and sharing the success of corporate performance with the employees. General Electric uses different performance-based pay programs at the individual, division, and companywide level. Performance-based pay also affects fairness in that employees need to understand the basis for judging performance in order to believe that their pay is fair.

Management Policy regarding management of the pay system is the last building block in our model. It means ensuring that the right people get the right pay for achieving objectives in the right way. The greatest system design in the world is useless without competent management. While it is possible to design a system that is based on internal alignment, external com- petitiveness, and employee contributions, the system will not achieve its objectives unless it is properly managed.

Management means understanding and communicating how the pay system works and doing so in ethical and fair ways. Questions to answer include, Are we able to attract skilled workers? Can we keep them? Do our employees believe our pay system is fair? Do they understand what is expected of them? Do they understand how their pay is deter- mined? How do the better-performing firms, with better financial returns and a larger share of the market, pay their employees? Are the systems used by these firms different from those used by less successful firms? How do our labor costs compare to those of our

31B. E. Becker and Mark Huselid, “High Performance Work Systems and Firm Performance: A Synthesis of Research and Management Implications,” in Research in Personnel and Human Resources, ed. G. Ferris (Greenwich, CT: JAI Press, 1998); Rosemary Batt, “Managing Customer Services: Human Resource Practices, Quit Rates, and Sales Growth,” Academy of Management Journal 45(3) (2002), pp. 587–597; A. Colvin, R. Batt, and H. Katz, “How High Performance HR Practices and Workforce Unionization Affect Managerial Pay,” Personnel Psychology 4 (2001), pp. 903–934; Benjamin Schneider, Paul J. Hanges, D. Brent Smith, and Amy N. Salvaggio, “Which Comes First: Employee Attitudes or Organizational, Financial, and Market Performance?” Journal of Applied Psychology, October 2003, 88(5), pp. 836–851.

 

 

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32Robert Prentice, “An Ethics Lesson for Business Schools,” New York Times, August 20, 2002, p. A21; Thomas Catan and Joshua Chaffin, “Bribery Has Long Been Used to Land International Contracts. New Laws Will Make That Tougher,” Financial Times, May 8, 2003, p. 11; Charles Elson, “Worry about the Details,” Across the Board, September/October 2002, pp. 37–48. 33Towers Perrin and Economist Intelligence Unit, High Performance in the New Economy (London: Towers Perrin, 2000).

competitors? Answers to these questions are necessary to tune or redesign the system, to adjust to changes, and to highlight potential areas for further investigation. Ethical behav- ior means the organization cares about how the results are achieved.32

Pay Techniques The remaining portion of the pay model in Exhibit 1.5 shows the techniques that make up the pay system. The exhibit provides only an overview since techniques are discussed throughout the rest of the book. Techniques tie the four basic policies to the pay objec- tives. Internal alignment is typically established through a sequence of techniques that starts with analysis of the work done and the people needed to do it. Information about the person and/or the job is collected, organized, and evaluated. Based on these evalua- tions, a structure of the work is designed.

Cybercomp WorldatWork (www.worldatwork.org) provides information on its compensation-related journals and special publications, as well as short courses aimed at practitioners. The Society of Human Resource Managers (www.shrm.org) also offers compensation-related information as well as more general human resource management (HRM) information. The society’s student services section offers guidance on finding jobs in the field of human resources. Both sites are good sources of information for people interested in careers in HRM. Information on pay trends in Europe is available from the European Industrial Relations Observatory (www.eiro.eurofound.ie). The Employee Benefits Research Institute (EBRI) includes links to other benefits sources on its website (www.ebri.org). The appendix to Chapter 18 describes many additional compensation websites. Every chapter also mentions interesting websites. Use them as a starting point to search out others.

This structure depicts relationships among jobs and skills or competencies inside an organization. It is based on the relative importance of the work in achieving the organiza- tion’s objectives. The goal is to establish a structure that is aligned with and supports the organization’s objectives. In turn, fairness of the pay system affects employee attitudes and behaviors as well as the organization’s regulatory compliance.

External competitiveness is established by setting the organization’s pay level in com- parison with how much competitors pay for similar work and what pay forms they use. The sequence of techniques is to define the relevant labor markets in which the employer competes, conduct surveys of other employers’ pay, and use that information in conjunc- tion with the organization’s policy decisions to generate a pay structure. The pay struc- ture influences how efficiently the organization is able to attract and retain a competent workforce and control its labor costs.

The relative emphasis on employee contributions is established through performance and/or seniority-based pay increases, incentive plans, and stock options and other performance-based approaches. Increasingly, organizations in the United States and around the globe are using some form of incentive plan to share their success with employees.33 In

 

 

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addition to managing costs, these practices are all intended to affect employee attitudes and be- haviors, in particular the decisions to join the organization, to stay, and to perform effectively.

Uncounted variations in pay techniques exist; many are examined in this book. Sur- veys report differences in compensation policies and techniques among firms. Indeed, most consultant firms have web pages in which they report their survey results. You can obtain updated information on various practices by simply surfing the web.

BOOK PLAN

Compensation is such a broad and compelling topic that several books could be devoted to it. The focus of this book is on the design and management of compensation systems. To aid in understanding how and why pay systems work, our pay model provides the structure for much of the book.

Chapter 2 discusses how to formulate and execute a compensation strategy. We ana- lyze what it means to be strategic about how people are paid and how compensation can help achieve and sustain an organization’s competitive advantage.

The pay model plays a central role in formulating and implementing an organization’s pay strategy. The model identifies four basic policy decisions that are the core of the pay strategy. After we discuss strategy, the next sections of the book examine each of these decisions in detail. Part 1, on internal alignment (Chapters 3 through 6) examines pay re- lationships within a single organization. Part 2 (Chapters 7 and 8) examines external competitiveness—the pay relationships among competing organizations—and analyzes the influence of market-driven forces.

Once the compensation rates and structures are established, other issues emerge. How much should we pay each individual employee? How much and how often should a per- son’s pay be increased and on what basis—experience, seniority, or performance? Should pay increases be contingent on the organization’s and/or the employee’s performance? How should the organization share its success (or failure) with employees? These are questions of employee contributions, the third building block in the model, covered in Part 3 (Chapters 9 through 11). In Part 4, we cover employee services and benefits (Chapters 12 and 13). Next, in Part 5, we cover systems tailored for special groups—sales representatives, executives, contract workers, unions (Chapters 14 and 15) as well as pro- vide more detail on global compensation systems (Chapter 16). We conclude, in Part 6, with information essential for managing the compensation system. The government’s role in compensation is examined in Chapter 17. Chapter 18 includes understanding, commu- nicating, budgeting, and evaluating the results obtained.

Even though the book is divided into sections that reflect the pay model, pay decisions are not discrete. All of them are interrelated. Together, they influence employee behav- iors and organization performance and can create a pay system that can be a source of competitive advantage.

Throughout the book our intention is to examine alternative approaches. We believe that rarely is there a single correct approach; rather, alternative approaches exist or can be designed. The one most likely to be effective depends on the circumstances. We hope that this book will help you become better informed about these options and how to design new ones. Whether as an employee, a manager, or an interested member of society, you should be able to assess the effectiveness and fairness of pay systems.

 

 

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CAVEAT EMPTOR—BE AN INFORMED CONSUMER

Most managers do not read research. They don’t subscribe to research journals; they find them too full of jargon and esoterica, and they see them as impractical and irrelevant.34

However, a recent study of 5,000 HR managers concluded that “not knowing this re- search can be costly to organizations.” A team of researchers at the University of Iowa asked the managers if they agreed or disagreed with a number of statements. The results for compensation-related items are presented in Exhibit 1.7. The first column shows the statement; the second, whether the statement is true or false based on research, as well as the percentage who agreed with the statement. The researchers have concluded, “Organi- zations seeking the latest motivational technique may not realize that . . . monetary in- centives produce the largest, most reliable increases in job performance, almost twice as large as the effects of goal setting and job enrichment. Money is the crucial incentive . . . no other incentive or motivational technique even comes close.” 35

So it pays to read the research. There is no question that some studies are irrelevant and poorly performed. But if you are not a reader of research literature, you become prey for the latest business self-help fad. Belief, even enthusiasm, is a poor substitute for in- formed judgment. Therefore, we end the chapter with a consumer’s guide that includes three questions to help make you a critical reader.

1. Does the Research Measure Anything Useful? How useful are the variables in the study? How well are they measured? For example, many studies purport to measure organization performance. However, performance may be accounting measures such as return on assets or cash flow, financial measures such as earnings per share or total shareholder return, operational measures such as scrap rates or defect indicators, or qualitative measures such as customer satisfaction. It may even be the opinions of compensation managers, as in, “How effective is your gain-sharing plan?” (Answer choices are “highly effective,” “effective,” “somewhat,” “disappointing,” “not very effective.” “Disastrous” is not usually one of the choices. If I am the designer of the plan, how do you think I will answer?) The informed consumer must ask, Does this re- search measure anything important?

2. Does the Study Separate Correlation from Causation? Once we are confident that our variables are accurately defined and measured, we must be sure that they are actually related. Most often this is addressed through the use of sta- tistical analysis. The correlation coefficient is a common measure of association and indi- cates how changes in one variable are related to changes in another. Many research stud- ies use a statistical analysis known as regression analysis. One output from a regression analysis is the R2. The R2 is much like a correlation in that it tells us what percentage of

34Sara L. Rynes, Amy E. Colbert, and Kenneth G. Brown, “HR Professionals’ Beliefs about Effective Human Resource Practices: Correspondence between Research and Practice,” Human Resource Management 41(2) (Summer 2002), pp. 149–174; and Sara L. Rynes, Amy E. Colbert, and Kenneth G. Brown, “Seven Common Misconceptions about Human Resource Practices; Research Findings versus Practitioner Beliefs,” Academy of Management Executive 16(3) (2002), pp. 92–102. 35Ibid.

 

 

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Answer % Correct

Item (% Uncertain) Research Evidence

When pay must be reduced or frozen, there is little a company can do or say to reduce employee dissatisfaction and dysfunctional behaviors. Most employees prefer to be paid on the basis of individual performance rather than team or organizational performance.

Merit pay systems cause so many problems that companies without them tend to have higher performance than companies with them.

There is a positive relationship between the proportion of managers receiving organizationally based pay incentives and company profitability. New companies have a better chance of surviving if all employees receive incentives based on organizationwide performance.

Talking about salary issues during performance appraisals tends to hurt morale and future performance.

Both laboratory and organizational field research shows that providing procedurally just explanations of pay cuts can dramatically reduce the negative side effects (Greenberg, 1990, 1993).

Multiple studies have demonstrated this result (e.g., BNA, 1988; Cable & Judge (1994) found that of seven organizational characteristics, the one that best predicted simulated organizational choice was pay for individual (versus team-based) productivity. Positive relationships have been shown between merit systems and organization-level performance by Kopelman & Reinharth (1982) and Kopelman, Rovenpor, & Cayer (1991). Heneman (1992) reviewed five studies establishing a positive merit system– performance link. Even the major empirical study to raise “cautions” about merit pay (Pearce et al., 1985) found increases in performance after merit pay implementation; the increases simply failed to reach statistical significance (with a very small sample size). Gerhart & Milkovich (1990) found that companies with 80% managerial eligibility for stock options had 25% higher return on assets than companies where only 20% of managers were eligible. (See also Welbourne & Andrews, 1996.) New companies that placed a high value on their employees (as coded from prospectuses) and that included high levels of organizational-performance- based pay had dramatically higher five-year survival rates (92%) than those that were low on both dimensions (34%: Welbourne & Andrews, 1996). In a field study of nine different sites, Prince & Lawler (1986) found that salary discussions had positive rather than negative effects on employee attitudes and subsequent performance improvement. In addition, the positive effects were strongest for those with lower initial performance and where initial perceptions of performance were most discrepant between supervisors and employees. For similar results based on employee surveys at General Electric, see Welch (2001).

False 72% (13%)

True 81% (8%)

False 66% (7%)

True 62% (23%)

True 59% (17%)

False 51% (10%)

Source: Sara L. Rynes, Amy E. Colbert, and Kenneth G. Brown, “HR Professionals’ Beliefs about Effective Human Resource Practices: Correspondence between Research and Practice,” Human Resource Management 41(2) (Summer 2002), pp. 149–174. Full citations for the articles listed can be found in the appendix to the Rynes et al. article.

EXHIBIT 1.7 Compensation: Managers’ Beliefs versus Research Findings

 

 

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the variation is accounted for by the variables we are using to predict or explain. For ex- ample, one study includes a regression analysis of the change in CEO pay due to change in company performance. The resulting R2 of between 0.8 percent and 4.5 percent indi- cates that only a very small amount of change in CEO pay is related to changes in com- pany performance.

But even if there is a relationship, correlation does not ensure causation. For example, just because a manufacturing plant initiates a new incentive plan and the facility’s performance improves, we cannot conclude that the incentive plan caused the improved performance. Per- haps new technology, reengineering, improved marketing, or the general expansion of the local economy underlies the results. The two changes are associated or related, but causation is a tough link to make.

EXHIBIT 1.7 continued

A national survey showed that 63% of workers surveyed prefer straight salary, followed by individual incentives (22%) and companywide incentives (12%; BNA, 1988). Cable & Judge, (1994) found a similar preference for fixed pay among job- seeking college students. Also, theories of risk and agency theory have as a core assumption that employees require a compensating risk differential in order to make variable pay acceptable to them (e.g., Jensen & Meckling, 1976). Probably due to social desirability and/or lack of self- insight, people tend to say pay is less important to them than the weights they actually place on pay in making choice decisions (Feldman & Arnold, 1978; Rynes et al., 1983). People also think that others who are “just like them” place a higher importance on pay than they themselves do (Jurgensen, 1978)— further evidence of possible lack of self-insight about motivations. These results are also consistent with broader findings from the decision sciences that people tend to underestimate the importance of the most important factors in their decisions (Slovic & Lichtenstein, 1971).

Most employees prefer variable pay systems (e.g., incentive schemes, gain sharing, stock options) to fixed pay systems.

Surveys that directly ask employees how important pay is to them are likely to overestimate pay’s true importance in actual decisions.

False 40% (12%)

False 35% (10%)

Answer % Correct

Item (% Uncertain) Research Evidence

 

 

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24 Chapter 1 The Pay Model

Too often, case studies, benchmarking studies of best practices, or consultant surveys are presented as studies that reveal cause and effect. They are not. Case studies are descriptive accounts whose value and limitations must be recognized. Just because the best-performing companies are using a practice does not mean the practice is causing the performance.

IBM provides an example of the difficulty of deciding whether a change is a cause or an effect. For a long time IBM pursued a no-layoff policy. Clearly, that policy did not cause the value of IBM stock to increase or improve IBM’s profitability. Arguably, it was IBM’s profitability that enabled its full-employment policy. However, compensation re- search often attempts to answer questions of causality. Does the use of performance- based pay lead to greater customer satisfaction, improved quality, and better company performance? Causality is one of the most difficult questions to answer and continues to be an important and sometimes perplexing problem for researchers.

3. Are There Alternative Explanations? Consider a hypothetical study that attempts to assess the impact of a performance-based pay initiative. The researchers measure performance by assessing quality, productivity, customer satisfaction, employee satisfaction, and the facility’s performance. The final step is to see whether future periods’ performance improves over this period’s. If it does, can we safely assume that it was the incentive pay that caused performance? Or is it equally likely that the improved performance has alternative explanations, such as the fluctuation in the value of currency or perhaps a change in executive leadership in the fa- cility? In this case, causality evidence seems weak.

If the researchers had measured the performance indicators several years prior to and after installing the plan, then the evidence of causality is only a bit stronger. Further, if the researchers repeated this process in other facilities and the results are similar, then the preponderance of evidence is stronger. Clearly, the organization is doing something right, and incentive pay may be part of it.

The best way to establish causation is to account for competing explanations, either statistically or through control groups. The point is that alternative explanations often exist. And if they do, they need to be accounted for to establish causality. It is very diffi- cult to disentangle the effects of pay plans to clearly establish causality. However, it is possible to look at the overall pattern of evidence to make judgments about the effects of pay.

So we encourage you to become a critical reader of all management literature, includ- ing this book. As Hogwarts’ famous Professor Alaster Moody cautions, be on “constant vigilance for sloppy analysis masquerading as research.”36

36J. K. Rowling, Harry Potter and the Goblet of Fire (London: Scholastic, 2000).

 

 

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Chapter 1 The Pay Model 25

Your Turn Glamorous Internships? Or House Elves?

Harry Potter readers will recall the house elves who work in the kitchen at Hogwarts. They would never think of asking to be paid. Hermione finds this outrageous. “This is slavery!” she contends. Of course, Harry Potter is fantasy. Or is it?

Greg Petouvis, a junior at Cornell University, worked for the Equal Employment Opportunity Commission in Washington, DC, during a recent summer. The job included performing site com- pliance visits at several companies, interviewing people who filed discrimination complaints, de- termining whether complaints had merit, and settling disputes. The work was very similar to that done by full-time EEOC field analysts. In fact, the agency manager reported that Greg was one of the top field analysts. But Greg received no pay. Not even a housing allowance for living in Washington, DC, during two and one-half summer months.

Trent Mayberry, from the University of Minnesota, worked for the City of Saint Paul on its “Peanuts on Parade” promotion. (Saint Paul is the birthplace of Charles Schulz, the creator of the Peanuts cartoon strip.) Trent was paid $9 per hour. Krista Lehmkuhl from Notre Dame helped design the cover for this textbook while an intern at McGraw-Hill. McGraw pays their in- terns about $12 an hour.

Hope Wagner, from the University of Nebraska, worked in media relations for a professional sports team one summer. She drafted news releases, filed clippings, and worked on a 75-page media guide. She took home plenty of team souvenirs—coffee mugs, key chains, T-shirts—but not one cent.

The giant chip maker Intel pays undergraduate interns between $450 and $750 a week and tosses in a free rental car during the summer.* General Motors doesn’t provide the car, but it does pay $450 to $600 a week and provide paid vacation days, round-trip travel, plus health in- surance. The Late Show with David Letterman pays nothing, yet claims to receive over 800 appli- cations for 30 unpaid summer intern positions.

So are house elves alive and well?

1. What do employers receive from summer interns? What returns do students get from the op- portunities?

2. Should summer interns be paid? If so, how much? How would you recommend that an em- ployer decide the answers to both these questions?

3. What added information would you like to have before you make your recommendations? How would you use this information?

Sources: America’s Top Internships and The Internship Bible, both part of the Princeton Review series published by Random House.

 

 

Milkovich−Newman: Compensation, Eighth Edition

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26 Chapter 1 The Pay Model

Summary The model presented in this chapter provides a structure for understanding compensation systems. The three main components of the model are the compensation objectives, the policy decisions that guide how the objectives are going to be achieved, and the tech- niques that make up the pay system. The following sections of the book examine each of the four policy decisions—internal alignment, external competitiveness, employee perfor- mance, and management—as well as the techniques, new directions, and related research.

Two questions should constantly be in the minds of managers and readers of this text. First, why do it this way? There is rarely one correct way to design a system or pay an in- dividual. Organizations, people, and circumstances are too varied. But a well-trained manager can select or design a suitable approach.

Second, so what? What does this technique do for us? How does it help achieve our goals? If good answers to the “so-what” question are not apparent, there is no point to the technique. Adapting the pay system to meet the needs of the employees and help achieve the goals of the organization is what this book is all about.

The basic premise of this book is that compensation systems do have a profound im- pact. Yet, too often, traditional pay systems seem to have been designed in response to some historical but long-forgotten problem. The practices continue, but the logic underly- ing them is not always clear or even relevant.

Review Questions 1. How do differing perspectives affect our views of compensation?

2. What is your definition of compensation? Which meaning of compensation seems most appropriate from an employee’s view: return, reward, or entitlement? Compare your ideas with someone with more experience, someone from another country, some- one from another field of study.

3. What is the deal between your instructor and the college? Is it similar to the hired-gun, commodity, family, or cultlike relationship? Discuss whether it would make any dif- ference in teaching effectiveness if the deal were changed. What would you recom- mend and why?

4. What are the four policy issues in the pay model? How does the pay model help orga- nize one’s thinking about compensation?

5. List all the forms of pay you receive from work. Compare your list to someone else’s list. Explain any differences.

6. Answer the three questions in caveat emptor for any study or business article that tells you how to pay people.