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Strategic Reward Systems I

HR Management
MBAO 6030

MBAO 6030 Human Resource Management


Strategic Reward Systems I:
Pay for Performance

Reward Systems consist of the following


elements:
Financial Rewards – Compensation
1. Base Salary
2. Pay Incentives
3. Employee Benefits
Non-financial Rewards
1. Intrinsic Rewards – centers on the work itself
2. Praise, recognition, time off and other rewards
given to the employee by peers or superiors.
MBAO 6030 Human Resource Management
Strategic Reward Systems I:
Pay for Performance

Reward Systems in most cases should be


consistent with other HR systems.
The Reward System is a key driver of:
 HR Strategy

 Business Strategy

 Organization Culture

MBAO 6030 Human Resource Management


Strategic Reward Systems I:
Need for Consistency with Other HR Systems
Skill-based pay

Training Culture
Overtime
pay rules in
Merit pay reinforces
contract
performance culture
Labor Rewards
Relation
s Performance
Management

Sign-on Bonus
Employment
Merit Pay

MBAO 6030 Human Resource Management


Strategic Reward Systems I

Critical Thinking Question:


1. Should pay policies “lead” or “lag” the
development of other HR systems?

MBAO 6030 Human Resource Management


Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)

Assumptions:
 People develop beliefs about what is a fair reward for
one’s job contribution - an exchange
 People compare their exchanges with their employer to
exchanges with others-insiders and outsiders called
referents
 If an employee believes his treatment is inequitable,
compared to others, he or she will be motivated to do
something about it -- that is, seek justice.

MBAO 6030 Human Resource Management


Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)

Is/Os versus Ir/Or


 O = Outcomes: the type and amount of
rewards received
 I = Inputs: employee’s contribution to
employer
 R = Referent: comparison person
 S = Subject: the employee who is judging
the fairness of the exchange

MBAO 6030 Human Resource Management


Equity Theory – Exchange Scenarios

 Case 1: Equity -- pay allocation is perceived to


be to be fair - motivation is sustained
 Case 2: Inequity (Underpayment) -- Employee
is motivated to seek justice. Work motivation is
disrupted.
 Case 3: Inequity (Overpayment) -- Could be
problem. Inefficient. In other cultures
employees lose face.

MBAO 6030 Human Resource Management


Consequences of Inequity

 The employee is motivated to have an equitable exchange


with the employer.
 To reduce inequity, employee may…
 Reduce inputs (reduce effort)
 Try to influence manager to increase outcomes (complain, file
grievance, etc.)
 Try to influence co-workers’ inputs (criticize others outcomes or
inputs)
 Withdraw emotionally - or physically (engage in absenteeism,
tardiness, or quit)

MBAO 6030 Human Resource Management


Equity Theory Implications

 There is tension between internal and external pay


equity: Decide where to place the emphasis. Example:
“In and out” versus “lifelong” employment system
 Let employees know who their pay referents are in the
pay system: identify pay competitors and internal pay
comparators.
 Strive for consistent pay allocations
 Monitor internal pay structure and position in the labor
market for consistency.

MBAO 6030 Human Resource Management


Agency Theory

 Agency theory is a theory of governance in the


workplace.
 It tries to solve the problem of separation of
ownership (atomistic shareholders) and control
(professional executives and non-owners)
 It also tries to solve conflicts of interest between
managers and employees with delegated
responsibilities.

MBAO 6030 Human Resource Management


Agency Theory

1. Principals = owners or managers who delegate


responsibilities
2. Agents = managers or employees who manage
firm assets for owners or other principals.
3. Information asymmetry = managers or other
agents have greater access to strategic
information than principals, who are not willing
to bear the cost of directly monitoring the
agents due to steep agency costs.

MBAO 6030 Human Resource Management


Agency Theory

4. Risk Preferences – principals are risk neutral


and willing to bear greater risks than agents
because their asset wealth is more likely to be
diversified between corporate assets and other
equities/investments. Agents are more risk
averse than principals, because most of their
wealth is concentrated in the firm and received
in the form of pay and opportunities for
promotion.

MBAO 6030 Human Resource Management


Agency Theory

5. Moral Hazard – agent is tempted (and some


cases succeeds) in taking advantage of
information asymmetry with principal and act
opportunistically (defined as making decisions
not aligned with principal’s interests) and use
the firm resources to maximize wealth of the
agent (often at the expense of the principal).

MBAO 6030 Human Resource Management


Agency Theory

6. Agency Contract – provides solution to moral


hazard/agency problem, by establishing “rules
of the game” to control agent opportunism –
agent’s performance will be judged by
outcomes (often financial benchmarks) not
behaviors (which require direct supervision of
agent’s actions). These outcomes will reflect
principal’s goals and risk preferences.

MBAO 6030 Human Resource Management


Agency Theory

7. Incentive alignment – the agency contract will specify a


compensation plan that aligns the interests of the
principal and agent. This agency contract will be a type
of pay for performance plan. Meeting or exceeding pre-
agreed upon financial or non-financial outcomes triggers
various forms of compensation (individual or group-
based) for the agent. Some agency costs are borne by
the principal in the form of financial incentives for the
agent.

MBAO 6030 Human Resource Management


Tournament Theory

1. Tournaments are competitions between peers to


achieve a promotion to a higher rank along with the
pay and perks that go with it.
2. Tournaments are likely to result in a “winner take all”
outcome.
3. Managers who enter the tournament must forego
other alternatives (such as jobs with other firms, start
own business, receive more pay with an alternative
opportunity) to compete in the tournament.

MBAO 6030 Human Resource Management


Tournament Theory

4. A high pay differential (such as the CEO


receiving much greater pay than any
subordinates) attracts more “players” to the
tournament.
5. Players must “invest” (work long hours, accept
less pay, show loyalty to their boss) to enter the
tournament – firm captures value from these
players, more than what it gives up to the
“winner” for the prize.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

1. Single Mindedness – “you get what you pay


for” – no more, no less. The activities that are
rewarded get done, to the exclusion of other
activities that are not rewarded. Example: The
dysfunctional behaviors that are observed when
a sales representative is put on straight
commission.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

2. Control – externalities can control the


outcomes, positive or negative. There can be
windfall affects (the bull market improving the
stock value of all stock options) or negative
externalities (a bear market or recession that
lowers the value of all stocks). Employee
performance results may be magnified or
diluted by these effects.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

3. Measurement error – some measures can be


“gamed” or manipulated and may not reflect
“true” performance. Sales reps can withhold
sales and report it in a different period so they
are not penalized by a cap on sales
commissions. Managers can use “creative
accounting” measures to report greater profits
than were actually experienced by the firm.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

4. Inflexibility – managers or employees may


resist change of the basis of compensation
because they are comfortable with current basis
for pay and want to avoid risk of taking
reduction in earnings in new system.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

5. Misalignment of incentives – if pay emphasis is on


a goal that is no longer relevant, that goal will
continue to be emphasized until the pay system
places emphasis on a different objective.
For example, managers may emphasize short-term
goals, even if long-term goals are more relevant, until
the pay system recognizes long-term goals to a
greater extent than short-term goals. The reward mix
for complex jobs with several goals must reflect the
relative value of attaining the mix of goals.

MBAO 6030 Human Resource Management


Controversies that Surround Pay for
Performance Plans

6. Line of Sight problem - division performance and


corporate performance should be reflected in the
pay system. If division performance and corporate
performance are closely linked than both division
and corporate performance should contribute
incentives to the managers’ pay for performance
plan. If division performance is independent of
corporate performance, then the emphasis should
be on rewards for meeting division goals.

MBAO 6030 Human Resource Management


Some Suggestions for More Effective Pay For
Performance Plans

Pay and Performance should be Loosely


Coupled – this gives managers more flexibility
to make changes when new situations arise.
Example: a formula with a bonus based on a
moving average of a 3-year historical
performance period. A 3-year period smoothes
out performance over a longer cycle.

MBAO 6030 Human Resource Management


Some Suggestions for More Effective Pay For
Performance Plans

It is Necessary to Nurture the Belief that


Performance Makes a Difference – there are
important cultural values that are supported with
pay for performance even if the accuracy of the
performance metrics and the fairness of the pay
allocations fall short of an ideal situation.
Abandoning pay for performance may be more
problematic than having an imperfect pay
system.

MBAO 6030 Human Resource Management


Some Suggestions for More Effective Pay For
Performance Plans

Pay for Performance systems should be


designed to fit each firm’s unique situation –
imitation of other firm’s plans should be avoided

MBAO 6030 Human Resource Management


Six Myths about Pay (Pfeffer, 1998)

1. Labor rates and labor costs are the same thing.


2. Labor costs can be reduced by lowering labor rates.
3. Labor costs are a significant portion of total costs.
4. Low labor costs are a potent source of competitive
advantage.
5. The most effective way to work productively is through
individual incentive compensation.
6. People work primarily for money.

MBAO 6030 Human Resource Management


Critical Thinking Questions

1. Sears Roebuck Auto Center paid its auto mechanics a


commission based on the volume of services sold to
each customer. This basis of pay resulted in law suits
filed against Sears by angry customers who claimed
they were over-charged for services they did not need.
Sears was forced to pay millions of dollars of penalties
to these customers which hurt its reputation. Pfeffer
believes that Sears’ mistake was that it should have
realized that individual pay incentives are dysfunctional.
Do you agree with this conclusion?

MBAO 6030 Human Resource Management


Critical Thinking Questions
2. Charles Schwab, the discount broker, does not use commissions
as pay incentives for its brokers, bucking financial services
industry pay practices. Why do you think Schwab did this?
3. Do you think that the point of view of the author (of the “6 Myths of
Pay”) would work at a Wall Street investment bank such as
Morgan Stanley?
4. The author of the “6 Myths of Pay” article prefers group-based pay
for performance rather than individual pay for performance plans.
What is the reason behind this? Do you agree?

MBAO 6030 Human Resource Management

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