Chapter 11- Pay and Incentive Systems

CHANGING PHILOSOPHIES REGARDING PAY SYSTEMS

 Continuing effort to tie more workers’ pay to performance
o Current performance counts, and every year standards are changed
 3 major changes in philosophies
o Increased willingness to reduce size of workforce (outsource jobs, restrict pay)
o Less concern with pay position relative to that of competitors (more about affordability)
o Implementing programs to encourage and reward performance—making pay variable
 Cost containment
o Wage and salary payments account for more than 50% of total cost
o Companies contain staff size, payroll, benefit costs
 Pay freezes and raise postponements = temporary
 Firing execs or offering early retirement, asking for overtime, reducing coverage,
trimming expense accounts = permanent
o CEO need to demonstrate that they are serious about closing the trust gap (execs
getting paid more while employees’ pay is cut, etc.)
 Paying what company can afford
o Company needs sufficient revenues
o Employer’s ability to pay is constrained by ability to compete
o Nature of product or service markets affect firm’s competitiveness & level of pay
o Key factors: degree of competition and level of demand
 Affect ability of firm to change prices
 If employer can’t change prices without suffering loss of revenue, ability to raise
level of pay is constrained
 If employer pays more, it tries to pass increased costs on consumers or hold
prices fixed and allocates more revenue for labor costs
 Programs that encourage and reward performance
o Firms continue to relocate to areas where organized labor is weak and pay rates are low
o Developing pay plans to channel more dollars into incentives, rather than salaries
o Entrepreneurs, high risk orgs, et.c all lived with erratic incomes
o In 2013 base pay was 10% of CEO compensation
o Variable pay systems guarantee cost control in lower levels
 In many plans productivity gains are shared 25% by employees, 75% by co
 Profit sharing
 Bonus awards—90% of large and medium companies offer this
o Relative emphasis placed on performance vs relationships varies with cultural factors
 Chinese managers emphasize relationships more and give larger bonuses to
employees with greater personal needs (americans ignore personal needs)

COMPONENTS AND OBJECTIVES OF ORGANIZATIONAL REWARD SYSTEMS

 Organizational Reward System- anything an employee values and desires that an employer is
able and willing to offer in exchange for contributions
o Compensation includes financial and nonfinancial
 Financial- direct payments (salary) + indirect payments (benefits)
 Nonfinancial- work environment enhancing sense of self-respect and esteem by
others & a positive employer brand
 o Don’t underestimate nonfinancial rewards
 Employees love perks like gyms, flexible hours, amenities
o Companies don’t have a choice
 People look for flexibility, and to keep ppl happy (51% voluntary turnover in
2013 compared to 30% in 2012
o Rewards bridge the gap btwn org and individual objectives
o Effective reward system has four things
 Sufficiency
 Equity with labor market
 Equity inside organization
 Treatment of member in terms of individual needs
o Attract, retain, and motivate (ARM concept)
o MOST IMPORTANT: equity
 Internal
 Fair relative to other jobs in the org
 External
 Fair in terms of competitive market rates
 Individual
 Fair relative to that of other individuals doing same/similar jobs?
o Bases for determining equitable payment
 Assumes employees perceive fair return for what they contribute
 Social comparison, comparison of inputs vs outputs
 Employees who perceive themselves to be in inequitable situation will seek to
reduce the inequity (distorting inputs/outputs)
o Balance- relative size of pay differentials among different workforce segments
 Differential typically varies from 5-30%
 Ratios of 350 to 1 between highest and lowest paid are out of balance

STRATEGIC INTEGRATION OF COMPENSATION PLANS AND BUSINESS PLANS

 Compensation plans need to be tied to org’s strategic mission instead of “others do it”
o i.e. supporting differentiation or cost leadership
 inferior performance by firm  lack of fit btwn pay and biz strategy
 “What do you want your pay system to accomplish?”
 dictates that actual levels of compensation should not be what’s paid in market
o compensation levels derive from assessing what needs to be paid to ATTRACT and
RETAIN the right ppl, as well as what org can afford
 firms must recognize compensation+incentive system as pivotal control
o make pay integral part of strategy, integrate pay considerations into decision-making
processes (planning and control)
o view performance as ultimate criterion of success of pay decisions

DETERMINANTS OF PAY STRUCTURE AND LEVEL

 marginal revenue theory—unless an employee can produce value equal to value received in
wages, it’s not worthwile to hire that worker
 Labor Market Conditions
o “tight” (demand for skills is high while supply is low) increases price paid for skills
o “loose” (supply is plentiful relative to demand) wages decrease
 o payment of wage premiums to attract talent causes substantial differences in pay rates
(even among equal age & education)
 efficiency wage hypothesis
 to enhance productivity in order to offset increase in labor costs
 legislation
o fair labor standards act
 sets minimum wage for employers involved in interstate commerce or
production of goods
 overtime: x 1.5, none for weekend
 no child labor under age 14
o equal pay act
 covers men and women doing “substantiall similar” work
 wage differentials are prohibited
o Sarbanes-oxley act
 Covers executives
 Individuals cannot retain bonuses/profits from selling company stock if they
mislead the public about the health of the company
o Title VII of American Recovery and Reinvestment Act
 Top executives in companies receiving gov support
 Individuals are subject to clawbacks (companies seeking repayment for bonuses,
retention awards, incentives paid to top five senior execs)
o Fair labor standards act affects almost every org in the US
 Source of terms exempt employees and nonexempt employees
 Established first minimum wage in 1938
 Loopholes
 Certain workers (babysitters, farm workers) are excluded, as are small
business and firms not in interstate commerce
 Every state has their own minimum wage
 Cities pay workers living wage (tailored to living costs in an area)
 Collective Bargaining
o Unionized and nonunionized firms bargain to compete with each other
o Affects level of wages and behavior of workers in labor markets
o Open, competitive market: workers gravitate toward higher-paying jobs
o If nonunionized firms fail to match wages of unionized firms, they have trouble
attracting and retaining workers
o Benefits negotiated by union >> nonunionized packages
o Bargaining also used to negotiate procedures for pay, resolving grievances, relative
worth of jobs, pay systems
 Managerial attitudes and org’s ability to pay
o Regardless of competitive position on wages, org must be ABLE to pay
o Management’s desire to maintain/improve morale, attract high-quality employees,
reduce turnover, improve worker’s standards of living AFFECTS wages
o Wage structures vary across firms as a position is more/less critical to firms
o Top management renders judgments about competitive pay positions (above-at-below
market rates)

AN OVERVIEW OF PAY-SYSTEM MECHANICS

 To develop a system that assigns monetary value to each job and orderly procedure for
increasing base rate, we need:
o Updated job description
o Job-evaluation method (rank jobs in terms of worth to org)
o Pay surveys
o Pay structure
 Important job characteristics  compensable factors job evaluation  job hierarchy 
pay surveys to attach pay rates to jobs pay structures to classify grade levelsassignment
of individual pay within range for each job
 Job descriptions identify important characteristics of each job to determine realative worth,
and all is used to ID, define, and weight compensable factors
o Common job characteristics an org is willing to pay for
 Next step: rate worth via job evaluation
o Provide work-related/business-related logic to support pay decisions
o Rank jobs in terms of relative worth so equitable rate of pay
o Diff job evaluation methods yield different rank-orders
 Point method
o Common in US and Europe
o Ach job analyzed and defined in terms of compensable factors
o Points assigned to each level/degree of factor, like responsibility
o Total points assigned are summed
o Hierarchy of job worth is defined when jobs are ranked based on point total
 Resolve policy issues first
o “does management perceive meaningful differences between jobs”
o “is it possible to ID criteria for distinguishing jobs?”
o will job eval result in meaningful distinctions in employees’ eyes?
o Are jobs stable
o Is job eval consistent with org’s goals and strategies
 Linking Internal Pay relationships to market data
o Translate point totals into pay structure
 ID and survey pay rates in relevant markets
 Employees must pay attention to labor AND product markets
o Releveant labor markets requires two key decisions:
 Which jobs to survey
 Characterized by stable tasks and job specs
 Benchmark jobs
 Also include jobs not meeting criteria but are difficult to
fill/characterized by high turnover
 Which markets are relevant for each job
o Relevant labor markets consider geographic boundaries, product-market
competitors and the initial market
o once target market is IDed, obtain survey data
 Bureau of Labor Statistics, employers’ associations, trade/pro associations,
users of job-eval system, compensation consulting firms
o Managers must stay aware of assurance of accurate job match (avoid thumbnail
sketches and ask respondents if salary data is direct match or higher/lower) as well
as explosion of at-risk forms of pay (based on profitability of an org)
 o End result: chart that relates current wage rates to total points assigned to job
 Establish trend lines that indicate average relationship between points
assigned to benchmark jobs and hourly wages for the jobs
 Add midpoint, minimum, and maximum trend lines
 Developing a Pay Structure
o Attach dollar values to jobs by establishing pay grades/ranges characterized by point
spread from min to max for each grade
o Start wages at min and explain highest wage that can be earned
o Actual rates of pay may be adjusted above or below market rates based on local
cost of labor/living
o Rules of thumb to follow:
 Jobs of same general value should be clustered into the same pay grade
 Jobs with different values are in different pay grades
 Smooth progression of point groups
 New system fits realistically into existing allocation of pay
 Pay grades conform to patterns in relevant labor markets
o After pay structure is made, determining pay becomes systematic and orderly
 Alternatives to Pay systems based on job eval
o Market based pay
 Use direct market-pricing approach for all of a firm’s jobs
 Feasible if all jobs are benchmark job (direct matches found)
 Level of pay or mix of pay forms is no longer a source of competitive
advantage
 So many firms question use of peer-group surveys to set pay
o Competency-based pay
 Workers paid on basis of skills or depth of knowledge (competencies)
 Skills  blue collar work; competencies  white collared work
 Focus on depth (specialists), breadth (generalists) or self-management
(planning/training/budgeting)
 Companies use as a way to develop critical behaviors and abilities
employees need to achieve business results
 Linking compensation to individual contributions that make a
difference to an organization helps maintain highest caliber of
workers & provide cross-training to ensure people have skills
 Increasingly expensive as majority of employees become certified at highest
pay levels
 Study shows that # of manufacturing plants that use skill-based pay is 50%
lower than traditional plants
 However 37-month study of skill-based pay showed 58% improvement in
productivity, 16% reduction in cost of labor per part, 82% reduction in scrap
 Another study linked ease of communication of skilled-based plans to
employee perception of being treated fairly
o Summary: important that management understands what behaviors it wants to
compensate, recognize that compensation systems are integral to planning and
control, view firm’s perf as ultimate criterion of success of pay decisions

POLICY ISSUES IN PAY PLANNING AND ADMINISTRATION

 Pay Secrecy
 o Workers don’t really know what the person in the next office makes
o Difficult policy to maintain bc of the internet and easy-to-find market data
o Salary discussions among employees are protected under Natl Labor Relations Act
 Protects right to discuss wages, hours, other terms of employment
o In UK, equality act of 2010 bans forbidding employees from discussing pay and bonuses
 But doesn’t prohibit pay secrecy
 Makes them unenforceable against employees who solicit disclosures
o Openness
 Orgs choose to disclose work/biz rationale for pay, pay ranges, pay-increase
schedules, availability of pay data from compensation dept
 Shows trust in employees and demonstrates employer helping them advance
 Disads
 Forces managers to defend pay decisions with no gurantee that answers
will please everyone
 Cost of mistaken pay decision escalates bc all inconsistencies and
weaknesses are exposed
 Managers may try to reduce diffs in pay to avoid conflict
 Works best when individual/team perf can be measured objectively
 The Effect of Inflation
o Allowance for inflation—firm that fails to increase salary ranges will be behind
competitors
o Difficult to retain and recruit employees
o Avg increases were 2.9% in 2013 while prices rose 1.5%
 Reduce variability by tying pay more to performance
 Pay compression
o Related to inflation, occurs with differences in pay between newly hired or less qualified
employees and more experienced ones is small
o Three forms:
 Hourly pay increases for unionized employees exceeding salaried and nonunion
employees
 Recruitment of new college grads for management or pro jobs at salaries above
current jobholders
 Excessive overtime pay to some employees
o May cause long-sserving employees to rethink their commitment
 Reduces productivity, overtime work, and willingness to cooperate
o Solution: set max rates of pay close to max paid by other companies
 Helps raise pay rates of high performers but not to the point where amx rates
are noncompetitive
o Sign on bonuses to new hires to offer competitive package
 Keep structures unaffected
o Deal with overtime compression by rotating overtime among employees or establish a
policy that offers overtime pay after minimum hours
 Pay raises
o Only measure of a raise is how much it exceeds increase in cost of living
o Simplest, most effective method for dealing with inflation: increase salary ranges
 Maintain competitive hiring rates and maintain merit concept of raises
 o Size of merit increase for level of performance should decrease as employee moves up
salary range
o Person at top of range is already making more than the going rate for the job
 So should demonstrate more-than-satisfactory performance to keep moving up

PERFORMANCE INCENTIVES
 Using incentives opens up possibility of obtaining substantial performance gains
 BUT increases possibility of something going wrong like 2008-2009 crisis
o Subprime mortgages were key cause of crisis
o But it was also riddled with perverse inceptives that forced employees to take more risk
o Unintended consequences of unethical behavior, higher employee turnover, and more
envy/discontent
o So Morgan Stanley developed “clawbacks” that could force executives to return
bonuses under conditions like unethical conduct
 today incentives are 12% of payroll
 related fairly strongly to performance quantity (0.34) even though they were not related to
quality
 classify different incentives and relate pay to performance all the time

REQUIREMENTS OF EFFECTIVE INCENTIVE SYSTEMS

 important to distinguish merit from incentive systems
 merit are applied to exempt employees in form of permanent pay increases
 tie pay increases to job performance
 incentives are supplements awarded on basis of performance and applied to broader segments
of labor force (nonexempt and unionized employees)
 increased motivation improves performance AND recognition is a major factor in that
motivation
 RULES
o Be simple (be clear, brief, and understandable)
o Be specific (employees need to know precisely what to do, not just “produce more”)
o Be attainable (every employee has reasonable chance to gain)
o Be measurable (specific accomplishments related to dollars spent, measurable
objectives)

MERIT-PAY SYSTEMS
 90% of US employers use merit pay
 but doesn’t work:
o incentive value of reward is too low
 give someone a $5000 raise and she keeps 250 a month after taxes
o link between perf and rewards are week
 survey of 10,000 workers, 35% believed performance determines pay
 fewer than 40% of top performers believe they receive better pay than average
performers
o supervisors resist performance appraisal
 few supervisors are trained to give feedback comfortably and accurately
 afraid to make distinctions among workers
o union contracts influence decisions
  failure to match union wages invites dissension and turnover in nonunion
o annuity problem
 past merit payments are incorporated into base salary and form an annuity
 allow productive individuals to slack off for several years and still earn high pay
 Barriers can be overcome
o Lincoln Electric boasts 2x productivity rate compared to other manufacturers
 Pays employee for productivity and ONLy for productivity
 Promotes employees for productivity and ONLY for productivity
o Providing variable pay means 68% more likely to report outstanding financial perf
o But this might be because of the Sorting effect
 Those who do not want to have pay tied to perf don’t accept jobs at such
companies, or they leave when pay-per-perf is implemented

GUIDELINES FOR EFFECTIVE MERIT-PAY SYSTEMS

 Those affected by merit-pay support it if it’s to work as designed
 Employees must feel sense of ownership
 Five steps to follow:
o Establish high standards of performance (low expectations are self-fulfilling prophecies)
o Develop and implement sound perfM systems (clear definitions of good perf)
o Train supervisors in mechanics of perf Appraisal
o Tie rewards closely to performance
o Use wide race of increases

INCENTIVES FOR EXECUTIVES

 Companies with history of outperforming rivals have 1) long-term strategic view of execs and 2)
stability in the exec groups
 Makes sense to develop plans for total exe compensation so that rewards are based on
achieving company long-term goals
 Rebalancing base salary, annual/long-term incentives, benefits, perquisites
 Base salaries are focal point of exec compensation—index for benefit values
o Salary 18%, short-term bonus 24%, long-term incentives 58%
 Emphasis on long term incentives bc
o 1) annual incentive plans encourage efficient use of existing assets
 based on indicators of corporate performance
o 2) long term plans encourage development of new processes, plants, and products
 designed to reward strategic gains rather than short-term contributions
 performance shares (stocks for meeting goals), performance-accelerated shares
(stocks vested sooner if exec meets goals ahead of schedule)
 restricted stock (common stock vesting after specified period)
 restricted stock units (shares awarded over time to defer taxes)
 widespread critisim of exec pay practices though
 stock options are becoming less attractive
 firms are trying to link exec pay to company performance

INCENTIVES FOR LOWER-LEVEL EMPLOYEES

 supplement pay with increments related to improvements
 lump-sum bonus
 o end of the year bonus that doesn’t build into base pay
o company is repositioning itself relative to competitors
 spot bonus
o rewarding exceptional perf with one-time bonus of 50-500 immediately
o 45% of companies offer these
 baseline performance standard, and anything above this is rewarded
o should be high enough but not impossible to attain
 setting performance standards
o incentive systems depend on performance standards
o relatively objective definition of job, targets employees should shoot for, help
supervisors assign work equitably
o employees have opportunity to earn more than base salaries after standards set
o ideal job to measure performance: 1) highly repetitive 2) have short job cycle 3) produce
clear, measurable output
o incentive plans really only differ in how premium rates are determined, and how the
extra payments are made
 union attitudes
o unionized employer subject to negotiation
o employees fear management will manipulate system to disadvantage employees
o so joint participation reassures employees that the plan is fair
o union attitudes vary acc to type of incentive offered
 oppose individual piece-rate systems that pit workers against each other
 support org-wide systems like profit sharing

TEAM INCENTIVES
 to increase productivity and improve morale
 appropriate when jobs are highly interrelated
 make it possible to reward workers that provide essential services to line workers (indirect
labor) & encourage cooperation among workers
 Disads
o Competition between teams
o Inability of workers to see individual contributions and link between effort and rewards
o Top performers often feel disenchanted by having to carry free riders

ORGANIZATIONWIDE INCENTIVES
 Profit sharing
o Deferred or discretionary
o Pay out if firm meets profitability target
o Provides group incentive for productivity, retirement income for employees, flexible
reward that reflects company’s economical position, enhance security and ID with
company, attract retain, educates about company’s bottom line
o BUT most employees don’t feel their jobs have direct impact
 Profits depend on so many other factors beside operating efficiency (consumer
demand, global competition, accounting)
o Most plans: bonus based on percentage of profits
o Improves productivity in 9/10 instances in a review of 27 econometric studies
o Productivity generally 3-5% higher in firms with profit-sharing
 o Not clear about causal relationship
 Potential to make labor costs variable in relation to profits only realized if profit
sharing survives years when no payouts are made
 Actual success depends on stability and security of work environment and
macro factors
 Gain sharing
o Results-based program that links pay to performance at facility level
o Focuses on achieving savings in areas over which employees control—reducing scrap or
lower labor or utility costs
o 12% of firms use this, mostly in manufacturing
o 3 elements comprise of
 philosophy of cooperation
 org climate characterized by high levels of trust, two-way comms,
harmony
 involvement system
 structure and process for improving org productivity
 financial bonus
 determined by calculation that measures differences btwn expected
and actual costs during bonus period
o high cooperation  info sharing  increase employee involvement
o differences from profit sharing
 based on emasure of productivity, not profitability
 frequent events, monthly or quarterly, not annual
 current-distribution plans instead of deferred payments
o if work well, improves sales, customer satisfaction, profits in 4-5% range
o BUT ABANDONED
 Does not work in piecework operations (sales)
 Returns dwindle with increasing plan size
 Firms uncomf with unions being in biz planning
 Managers feel they give up prerogatives
o Requires indepth planning
 Employee stock ownership plans
o 12,000 ESOPs in 2014 with 11 million participants (< 3% are public companies)
o established to increase employee involvement in decision making
o shows employment growth, faster wage growth, and higher average wages
o resort to layoffs less frequently
o established because…
 tax-favored, company-financed transfer of ownership from owner to employees
 borrowing money inexpensively
 firm borrows money from bank using stock as collateral, places stock in
employee stock-ownership trust
 as loan is repaid, trust distributes stock at no cost to employees
 companies deduct principal as well as interest on amount borrowed
 lenders pay taxes on only 50% of income from ESOP loans
 belief in employee ownership
 additional employee benefit
 45 case study longitudinal research says that stock ownership alone does not increase
productivity or motivation
 BUT
o ESOP satisfaction is highest in companies that make large contributions to the plan and
has management committed to employee ownership and communication of ESOP,
perfroamcne, and future company plans
o Employees are satisfied if ESOP is made for employee-centered reasons rather than
financial/strategic reasons (anti-takeover device or tax-savings)
 234 pairs of ESOP vs nonESOP—ESOP had increased sales, employement and sales per employee
by 2.3-2.4% per year
o also more likely to offer other retirement plans
o 33% of ESOP offered 401k savings plans, while 6% of non-ESOP companies did
 but ESOP is not risk free
o not all ESOPs are created equally
o sometimes tradeoff for other wages or benefits
 mostly overall net addition though
o ESOPs may not be ensured and if company is bankrupt, stock is worthless
o