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2006

Choosing W hether to Lead, Lag , or Match the Market Michael C. Sturman Cornell University, mcs5@cornell.edu

David McCabe Punks Backyard Grill

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Recommended Citation Sturman, M. C., & McCabe, D. (2006). Choosing whether to lead, lag , or match the market [Electronic version]. Retrieved [insert date], from Cornell University, School of Hospitality Administration site: http://scholarship.sha.cornell.edu/articles/333

Choosing W hether to Lead, Lag , or Match the Market

Abstract This paper demonstrates how cost-benefit analysis can be used to develop a company 's pay strategy. Using the case of Punk's Backyard Grill, a new venture starting in the Washington, DC area, quantitative aspects of Utility Analysis are combined with the judgments of the company 's owners to provide estimates of the value associated with seven pay strategies. Results showed that leading the market by 5% produced the greatest return. Sensitivity analysis is used to see how drastically estimates changes owing to the nature of the paper's estimates. This methods presented in this paper should help others making pay policy decisions use cost- benefit analysis as part of their decision process.

Keywords pay strategies, cost-benefit analysis, utility analysis, compensation

Disciplines Hospitality Administration and Management | Human Resources Management

Comments Required Publisher Statement © Taylor & Francis. Final version published as: Sturman, M. C., & McCabe, D. (2006). Choosing whether to lead, lag, or match the market. Journal of Human Resources in Hospitality & Tourism, 7(1), 85-97. Reprinted with permission. All rights reserved.

This article or chapter is available at The Scholarly Commons: http://scholarship.sha.cornell.edu/articles/333

Choosing Whether to Lead, Lag, or Match the Market

Michael C. Sturman, Cornell University David McCabe

This paper demonstrates how cost-benefit analysis can be used to develop a company’s

pay strategy. Using the case of Punk’s Backyard Grill, a new venture starting in the

Washington, DC area, quantitative aspects of Utility Analysis are combined with the judgments

of the company’s owners to provide estimates of the value associated with seven pay

strategies. Results showed that leading the market by 5% produced the greatest return.

Sensitivity analysis is used to see how drastically estimates changes owing to the nature of the

paper’s estimates. This methods presented in this paper should help others making pay policy

decisions use cost-benefit analysis as part of their decision process.

Compensation is a recurring issue in the hospitality industry. It has been shown that pay in

hospitality is lower than in other industry, both for the service industry overall (Bureau of Labor

Statistics, 2005) and even when controlling for the level of human capital of its workers (Sturman, 2001).

At the same time, research is repeatedly showing that pay practices can affect organizational

performance, for both a wide variety of industries (Brown, Sturman, & Simmering, 2003) and the

hospitality industry specifically (Maister, 2001; Peterson & Luthans, 2006). And yet, practitioners are still

faced with the ever practical decision of, “What should we do?”

This paper addresses this question for the particularly salient case of setting pay for a new

company. While for many companies, pay and pay systems change incrementally over time, and thus a

clear strategy may be hard to identify and modify, new start-ups must make determinations of pay and

have the opportunity to establish and implement a clear pay policy. Furthermore, start-ups must face

this decision, as they start with no employees and grow to become a new firm. They must choose a pay

policy, whether that is matching the market (i.e., paying the average level for similar jobs in the labor

market), leading the market (i.e., paying above the average), or lagging the market (i.e., paying below

the average). Furthermore, whether leading or lagging, firms must decide the extent to which they

deviate from the average. The purpose of this paper is to employ cost-benefit analysis to demonstrate

how a company can use a structured process to determine the best pay strategy to implement. This

paper uses the case of an entrepreneurial restaurant venture that is in the process of, among other

activities, setting up its pay structure.

The textbook answer to choosing a pay policy is simple. The pay policy must (1) maximize the

company’s ability to attract and retain qualified employees, (2) be within the company’s ability to pay,

and (3) must be competitive in the marketplace (Anthony, Perrewe, & Kacmar, 1993). The process

entails setting the company’s pay strategy, collecting market data, and then determining pay ranges

(Milkovich & Newman, 2005). Yet while the general process is clear, research has provided little

guidance as to what specific pay policy should be chosen, and how to translate this into actual pay

recommendations.

Cost-benefit analysis, and specifically Utility Analysis (Sturman, 2003), provides a tool to help

make a specific recommendation in this regard. Utility analysis has been applied to compensation

decision before (e.g., Klass & McClendon, 1996; Sturman, Trevor, Boudreau, & Gerhart, 2003), with the

results showing that specific recommendations depend on characteristics of the situation being

examined. To a large extent, pay recommendations hinge on the extent to which the company values

employee performance and the direct costs of the pay system. This tool is applied for a specific case

with two purposes in mind: (1) To demonstrate how utility analysis can be used to make a pay policy

determination for a specific start-up restaurant; and (2) To provide a model so that others can use this

tool applied to their own specific circumstance to make their own pay determinations.

The Case of Punk’s Backyard Grill

As noted above, utility analysis has shown that the value of specific human resource

interventions depends on characteristics of the specific context (Sturman, 2000). This paper applies

utility analysis using the case of Punk’s Backyard Grill. But before launching into the analyses, some

background is needed to provide a context for the parameter choices and so that the reader

understands this specific circumstance.

Punk’s Backyard Grill is a fast-casual restaurant concept based on the familiar backyard grill

gathering. With a comfortable interior décor evocative of the backyard cookout–picnic-style tables,

redwood-style decking, an open grill area, and white picket fencing–Punk’s Backyard Grill is designed to

re-create, in a fast-casual restaurant environment, the nostalgic American backyard grill gathering. The

menu will include items such as beef brisket, grilled chicken, spicy hot links, grilled fish and shrimp,

fresh-ground Niman-Ranch hamburgers, unique entrée salads, homemade side orders, and fresh-baked

deserts. The average check is expected to be around $10.00. To be faithful to a true backyard cookout,

there will be beer and wine–but no fryers–at Punk’s Backyard Grill.

The founders have already integrated into their business plan an expansion strategy. They

intend to open a second unit approximately 12 months after the opening of the first, and intend to build

the first five units all within the Washington, DC Metropolitan area. This means that the main focus will

be on building a brand and preparing for growth. To build a brand and open multiple units in one

metropolitan area, the company feels that it needs to build a positive reputation as an employer of

choice, remain profitable to help fund multiple units, and find ways to retain employees. As pay levels

have often been found to be positively related to the size of the labor pool (Holzer, 1990; Krueger, 1988;

Rynes & Barber, 1990; Gerhart & Milkovich, 1992), to be negatively related to turnover (Campbell, 1993;

Heneman & Judge, 2000), to allow organizations to be more selective when hiring (Milkovich &

Newman, 2005; Williams & Dreher, 1992), and to increase overall efficiency (Brown et al., 2003), there

are likely a significant number of benefits associated with providing higher pay levels. On the other

hand, they need to keep costs under control and elicit all potential benefit from the investments in their

employees. Thus, attempting to quantify the benefits and costs associated with various pay strategies

appeared to be a potentially fruitful approach for designing the new pay system.

Implementing the Cost Benefit Analysis

This paper uses the tool of utility analysis to implement the cost-benefit analysis of various pay

strategies. Utility analysis (described in depth in Sturman, 2003), essentially entails estimating the

quantity of people effected, the extent to which performance changes because of a human resource

intervention, the value associated with performance changes, and the costs associated with

implementing the human resource intervention (see also Boudreau & Berger, 1985). Utility analysis is

implemented in steps, each described in detail below.

Determining Costs

When considering compensation, direct costs are relatively obvious– the amount paid to

employees. This entailed determining what wage would be given to employees in each position, how

many employees would be in each position, and how many hours each employee worked. Table 1

describes the positions, the number of anticipated hires, and the number of hours the owners expect

the employees to work. Table 1 also described the spread of each pay range for each job (for more

information on wage spreads and compensation system design, see Milkovich & Newman, 2005).

Pay levels were estimated through a combination of a pay survey for the Washington, DC area

(Wage Watch, 2005) and various pay strategies. Then, using various pay strategies (from lag by 15% to

lead by 15%, in 5% increments), and assuming employees would be hired at the minimum of the new

pay range, total costs of each pay strategy were computed. Table 2 shows the total annual cost

associated with each pay strategy. Lagging the market by 15% would have a direct wage cost of

$395,897; matching the market would cost $465,761; leading the market by 15% would cost $535,625.

Determining Benefits

Although direct costs are fairly straightforward to determine, benefits are harder to quantify.

The largest issue is that utility analysis requires a number of estimates (Boudreau, 1991; Cascio, 2000;

Sturman, 2000), many of which require data unavailable to a new start-up. On the other hand, one

cannot ignore the question of determining wages. Thus, implementing the utility analysis tool would

require the expertise of those opening Punk’s Backyard Grill to provide those estimates. In part, as this

paper is intended to demonstrate how utility analysis can be used to help make a pay strategy decision,

in an academic sense the specific estimates are not important. Practitioners in other contexts can

substitute values appropriate to their own situation. On the other hand, for practice, the estimates are

critical to reach the optimal solution. Given this need, using expert-estimates, as opposed to empirically

validated estimates, is somewhat questionable. On the other hand, empirical estimates cannot

frequently be used, as the start-up does not have the experience to determine the affects associated

with a pay policy, observe turnover levels, etc. Furthermore, although computations will be based on

estimates, the alternative to deriving these estimates is simply to not conduct the utility analysis and

instead approach the pay strategy question intuitively. Arguably, providing at least an attempt at

quantification will help specify issues that must be considered, and can help lead to more profitable

business decisions. The solution obtained through the cost-benefit analysis will be compared with

common intuitive alternatives: Focus purely on cost, and thus lag the market by as much as possible

(here, by 15%), or avoid the decision by simply choosing to match the market.

The benefit portion of the utility analysis formula is computed as follows:

Utility = (Number of Employees Affected * Change in Performance * SDy) – Cost

Where Change in Performance is how many standard deviations performance improves because

of the pay policy, and SDy is the dollar value of a one standard deviation increase in job performance.

The change in performance is a function of the number of applicants per position, the validity of the

selection device, and the net gain in performance beyond selection caused by the pay policy (see Cascio,

2000 or Sturman, 2003).

For the analysis, the owners of the restaurant are planning to use a situational structured

interview for each position. Past meta-analytical research has shown high validity for situational

structured interview: McDaniel, Whetzel, Schmidt, and Maurer (1994) estimated a validity of 0.50;

Taylor and Small (2002) estimated a validity of 0.45. The slightly more conservative estimate of 0.45 is

employed in the utility analysis implementation described here.

SDy is the value of an individual employee who performs one standard deviation above average.

Often, this is expressed in terms of a percentage of salary. Forty percent is an often used conservative

estimate (Boudreau, 1991; Hunter & Schmidt, 1982; Schmidt, Hunter, Outerbridge, & Trattner, 1986),

although research has shown that SDy does increase with job complexity (Boudreau, 1991; Hunter,

Schmidt, & Judiesch, 1988). Thus, this paper employees the following assumptions: SDy equals 40% of

salary for low complexity jobs (Bus Person and Cashier), 60% for medium/low complexity jobs (food

runner, lead cook, line cook, prep cook, and side server), and 80% for medium complexity jobs (assistant

manager, BOH manager, and front of house manager).

The number of applicants per position, or more specifically the ability of the company to be

selective, will depend on the pay policy. The more the company leads the market, the more they can be

selective, both because of potentially more applicants per position and because fewer applicants will

turn down offers of employment. The number of applicants per open position for each pay policy is also

shown in Table 2. These estimates are based on the founders’ knowledge of the Washington, DC labor

market, local market research, and conversations with other restaurateurs. Additionally, higher

compensation is associated with greater motivation, less shirking, and greater retention (Akerlof &

Yellen, 1986; Campbell, 1993). This also translates into gains in performance, the assumed values of

which are also shown in Table 2 (based on the relevant related research reviewed above).

Note that utility analysis provides an estimate of the incremental value associated with a human

resource intervention (Sturman, 2003). Thus, for all subsequent analyses, this paper uses matching the

market as the point of comparison–so for direct costs, lagging the market saves money, and leading the

market costs money.

With the above assumptions, the results of the utility analyses for each of the pay strategies are

shown in Table 3. According to these results, the pay policy with the greatest utility is to lead the market

by 5%. Because of the value associated with performance and the performance gains achieved through

greater compensation, lagging the market by 15%, even with the lowest payroll costs, led to the lowest

utility.

Sensitivity Analysis

The previous analyses suggest that leading the market by 5% is the optimal pay strategy. Yet, as

noted, this answer is predicated on a large number of assumptions. Granted, these assumptions are

based on earnest attempts by the owners of Punk’s Backyard Grill who have real financial interests at

stake with this decision; nonetheless, it is also clear that these assumptions are imperfect at best, and

thus a well-implemented utility analysis should also provide information on how sensitive the results are

to these estimates. Thus, the utility analysis implementation considers a variety of alternative analyses,

with different sets of assumptions, to see how the resultant decision might change. Such sensitivity

analyses give the owners some idea of how stable the utility estimates are but, also, where they need to

collect data to make better business decisions in the future. In other words, the current solution derived

from the utility analysis may lead to the initial pay strategy decision (i.e., to lead by 5%) and resultant

pay levels for new hires; however, through sensitivity analysis, the owners will know what variables are

most likely to affect the validity of this solution, and thus can collect this data and update the pay policy

incrementally over time.

A number of parameters were varied, the utility analysis was rerun for each new scenario, and

the results were examined to reveal the extent to which the estimates changed. Table 4 presents the

sensitivity analysis by presenting the following information: (1) The new “optimal” pay strategy choice

given the new scenarios; (2) The estimated effect of selecting the “lead by 5% strategy” given the

revised parameters; (3) The estimated effect of selecting the “match the market strategy” given the

revised parameters; and (4) The estimated effect of selecting the “lag the market by 15% strategy” given

the revised parameters. As mentioned earlier, were a decision-maker not to use utility analysis, a highly

likely choice would be either to not differentiate the company with regard to pay policy (i.e., match the

market), or to make a decision purely based on costs (i.e., lag the market by as much as possible). For

the purposes of this paper, the lowest price estimate of lagging by 15% was used as the comparison

point.

As expected, Table 4 shows that changing the assumptions does change the resultant optimal

decision. More importantly, the results show where the owners of Punk’s Backyard Grill should focus

their HR information gathering: on the value of SDy, and on the effects of pay on job incumbents.

Varying the assumed SDy percents changed the resultant recommended pay decision from lagging by

10% to leading by 15%. In other words, the more value associated with employees’ higher performance,

the more value there is associated with investments in those human resources. The results also show

that the more the pay has a motivating effect on job incumbents, the better the policy to lead the

market in pay.

The results also show that, even when parameters are estimated, the results of the initial utility

estimate provide more value on average than more intuitive choices. In the eight scenarios, the average

loss of sticking with the initial utility estimate would be roughly $9,340, whereas it would have been

around $9,600 for matching the market, and $57,055 for lagging the market by 15%. These results

clearly show that, unless one truly thinks employee performance is of little value and hence SDy values

should be very low, then it is not advisable for the owners of Punk’s Backyard Grill to lag the market in

pay. However, SDy estimates used in these analyses are much lower than previous research estimates

have shown them to be in studies on SDy (see Boudreau, 1991), and given the particular emphasis the

owners are placing on customer service, it is unlikely that SDy estimates will be small.

Certainly, more analyses could be conducted, and one could do endless combinations of

sensitivity tests, or even run extensive simulations to vary multiple parameters simultaneously (e.g.,

Sturman, 2000). This purpose here, however, is to demonstrate a realistic use of utility analysis for

helping craft a human resource decision. The fact that the owners found this analysis useful for setting

up their pay structure is a critical piece of evidence that utility analysis can aid in decision making.

Conclusion

Building a compensation strategy for a start-up restaurant is a process that is complex and

individualized, dependent on a number of different factors. The industry segment, the overall strategy

of the start-up, and the capitalization of the business are all unique factors that must be taken into

account when building a compensation plan. Leading the market has some significant benefits, but it is

important to fully understand all aspects of the business before making any pay level strategy decisions.

For Punk’s Backyard Grill, based upon the emphasis on customer service in the fast-casual

segment, the strategy of growth and brand building, and the awareness of the need for additional

capital, this start-up should carry out the strategy of leading the market in pay. This strategy will be

profitable for the business, will lead to a positive reputation within the industry, and will help prepare

the company for growth. Yet the benefits of leading the market must be considered in light of the costs

required to achieve them. Factoring together the benefits and costs of leading the market in pay,

leading by 5% seems to be the best recommendation.

It should be noted that the utility analysis required a significant number of assumptions. There

simply was no data available on certain aspects of the formula, and thus personal experience was used

to fill in these gaps. The analyses employed sensitivity analysis to vary some of these key parameters to

test the stability of the initial recommendation, but the results are based on estimates nonetheless.

While from a research perspective this limits the potential accuracy of the estimate, the reader should

recall that the purpose here is to demonstrate how utility analysis can be used to help make a business

decision regarding the company’s pay strategy. Were cost-benefit analysis not employed, the owners of

Punk’s Backyard Grill would simply have to use intuition to determine their pay strategy. Certainly, the

numbers can be adjusted over time if data are available, or other companies can use their own data (or

estimates) when employing the formula, but the primary advantage of this cost-benefit analysis is that it

provides at least some quantification of human resource issues so as to assist in decision making. For

academics and researchers, it would be desirable to collect more data and validate the utility estimates.

For the practitioners like the owners of Punk’s Backyard Grill, a pay strategy needs to be determined and

other business decisions now need to be made.

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