ENGLIAH ASSIGNMENT AND human resources assignment and reading attached

CHAPTER 11 PAY AND INCENTIVE SYSTEMS

Questions This Chapter Will Help Managers Answer

1. How can we tie compensation strategy to general business strategy?

2. What economic and legal factors should we consider in establishing pay levels for different jobs?

3. What is the best way to develop pay systems that are understandable, workable, and acceptable to employees at all levels?

4. How can we tie incentives to individual, team, or organizationwide performance?

5. In implementing a pay-for-performance system, what key traps must we avoid to make the system work as planned?

Human Resource Management in Action THE TRUST GAP*

Over the years, few topics have generated as much controversy as executive compensation. CEOs say, “We're a team; we're all in this together.” But employees look at the difference between their pay and the CEO's. They see top management's perks—oak dining rooms and heated garages—versus cafeterias for lower-level workers and parking spaces a half mile from the plant. And they wonder, “Is this togetherness?” As the disparity in pay widens, the wonder grows. Thus the median value of total direct compensation for CEOs of Standard & Poor's (S&P) 500 companies was $8.4 million in 2010. Their total compensation in 2010 averaged $11.4 million. Hourly workers and supervisors indeed agree that “we're all in this together,” but what we're in turns out to be a frame of mind that mistrusts senior management's intentions, doubts its competence, and resents its self-congratulatory pay. What's at stake, in short, is nothing less than the public trust essential to a thriving free-market economy.

Study after study, involving hundreds of companies and thousands of workers, has found evidence of a trust gap—and it is growing. Indeed, the attitudes of middle managers and professionals toward the workplace are becoming more like those of hourly workers, historically the most disaffected group.

According to the Economic Policy Institute, executive pay rose about 300 percent from 1992 to 2007. This compares with growth in the same period of about 14 percent in the inflation-adjusted real wages of college graduates. The gap persists because bonuses, typically tied to profits, are routinely awarded to top managers but not to other employees.

What about shareholder pressure to limit CEO pay? The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act grants shareholders a “say on pay” vote on executive compensation. In the year after the law was passed, however, shareholders rejected pay plans at only 39 out of 2,502 companies (1.5 percent).

To be sure, much of the trust gap can be traced to inconsistencies between what management says and what it does—between saying “People are our most important asset” and in the next breath ordering layoffs, or between sloganeering about quality while continuing to evaluate workers by how many pieces they push out the door.

There are other causes as well: lack of penalties to executives who caused the global financial crisis and the meltdown in financial services, together with pay systems that rewarded financial engineering and greed rather than prudent risk management and value creation. Moreover, financial-services leaders and board members failed to say, “Here's what went wrong. Here's how faulty incentives contributed to the problem; here's how we are going to fix it.”

The result is a world in which top management thinks it's sending crucial messages but employees never hear a word. Thus, a recent survey found that 82 percent of Fortune 500 executives believe their corporate strategy is understood by everyone who needs to know. Unfortunately, less than a third of employees in the same companies say management provides clear goals and direction.

Confidence in top management's competence is collapsing. The days when top management could say, “Trust us; this is for your own good,” are over. Employees have seen that if the company embarks on a new strategic tack and it doesn't work, employees are the ones who lose their jobs—not management.

While competence may be hard to judge, pay is known, and to the penny. The rate of increase in CEOs’ pay split from workers’ in 1979 and has rocketed upward ever since. CEOs who make 350 times the average hourly worker's pay are no longer rare. What is rare are policies like those of Whole Foods Market that prevent any executive from earning more than 14 times what the average worker makes. Said one observer, “The gap is widening beyond what the guy at the bottom can even understand. There's very little common ground left in terms of the experience of the average worker and the CEO.”

While most U.S. workers are willing to accept substantial differentials in pay between corporate highs and lows and acknowledge that the highs should receive their just rewards, more and more of the lows—and the middles—are asking, “Just how just is just?”

Challenges

1. To many people, a deep-seated sense of unfairness lies at the heart of the trust gap. How might perceptions of unfairness develop?

2. What are some of the predictable consequences of a trust gap?

3. Can you suggest alternative strategies for reducing the trust gap?

* Sources: Davidoff, S. M. (2011, July 13). Efforts to rein in executive pay meet with little success. The New York Times. Retrieved from http://nyti.ms/uwMaNt on July 31, 2011. See also ABC News. (2011, April 22). CEO pay averaged $11.4 million at largest companies in 2010. Retrieved from abcnews.go.com/Business/ceo-pay-increased-23-percent-2010/story?id=13420978 on April 22, 2011. See also George, B. (2010, Sept. 19). executive pay: Rebuilding trust in an era of rage. BusinessWeek, p. 56. See also Heineman, B. (2009, Feb. 16). Executive compensation: The leadership failure that led to pay caps. Retrieved from blogs.hbr.org/hbr/hbreditors/2009/02/reaping_the_exec_comp_whirlwin.html on February 20, 2009. See also Colvin, G. (2008, Jan. 21). AmEx gets CEO pay right. Fortune, pp. 22, 24. See also Kaplan, S. N. (2008). Are U. S. CEOs overpaid? Academy of Management Perspectives 22, pp. 5–20. See also Lublin, J. S. (2007 Apr. 9). Ten ways to restore investor confidence in compensation. The Wall Street Journal, pp. R1, R3. See also Farnham, A. (1989, Dec. 4). The trust gap, Fortune, pp. 56–78.

The chapter-opening vignette illustrates important changes in the current thinking about pay: Levels of pay will always be evaluated by employees in terms of fairness, and unless pay systems are acceptable to those affected by them, they will breed mistrust and lack of commitment. Pay policies and practices are critically important because they affect every single employee, from the janitor to the CEO. This chapter begins by exploring four major questions: (1) What economic and legal factors determine pay levels within a firm? (2) How do firms tie compensation strategy to general business strategy? (3) How do firms develop systematic pay structures that reflect different levels of pay for different jobs? (4) What key policy issues in pay planning and administration must managers address? These challenges are shown graphically in Figure 11–1.

Figure 11–1 Four key challenges in planning and administering a pay system.

We will then consider what is known about incentives at the individual, team, and organizationwide levels. As an educated worker or manager, it is important that you become knowledgeable about these important issues. This chapter will help you develop that knowledge base.

CHANGING PHILOSOPHIES REGARDING PAY SYSTEMS

Today there is a continuing move away from policies of salary entitlement, in which inflation or seniority, not performance, were the driving forces behind pay increases. Pay-for-performance is the new mantra.1 Managers are asking, “What have you done for me lately?” Current performance is what counts, and every year performance standards are raised. In this atmosphere, we are seeing three major changes in company philosophies concerning pay and benefits:

1. Increased willingness to reduce the size of the workforce; to outsource jobs overseas; and to restrict pay to control the costs of wages, salaries, and benefits.

2. Less concern with pay position relative to that of competitors and more concern with what the company can afford.

3. Implementation of programs to encourage and reward performance—thereby making pay more variable. In fact, a recent study revealed that this is one of the most critical compensation issues facing large companies today.2

We will consider each of these changes, as well as other material in this and the following chapter, from the perspective of the line manager, not from that of the technical compensation specialist.

Cost-Containment Actions

Given that wage and salary payments may account for more than 50 percent of total costs, employers have an obvious interest in controlling them.3 To do so, they are attempting to contain staff sizes, payrolls, and benefits costs. Some of the cutbacks are only temporary, such as pay freezes and postponements of raises.4 Other changes are meant to be permanent: firing executives or offering them early retirement; asking employees to work longer hours, to take fewer days off, and to shorten their vacations; reducing the coverage of medical plans or asking employees to pay part of the cost; and trimming expense accounts, with bans on first-class travel and restrictions on phone calls and entertainment. If such a strategy is to work, however, CEOs will first need to demonstrate to employees at all levels, by means of tangible actions, that they are serious about closing the trust gap (see chapter-opening vignette).

Robert Iger, President and CEO of The Walt Disney Company, has been richly rewarded for his stellar leadership of the diversified worldwide entertainment company.

Paying What the Company Can Afford

To cover its labor costs and other expenses, a company must earn sufficient revenues through the sales of its products or services. It follows, then, that an employer's ability to pay is constrained by its ability to compete. The nature of the product or service markets affects a firm's external competitiveness and the pay level it sets.5

Key factors in the product and service markets are the degree of competition among producers (e.g., fast-food outlets) and the level of demand for the products or services (e.g., the number of customers in a given area). Both of these affect the ability of a firm to change the prices of its products or services. If an employer cannot change prices without suffering a loss of revenues due to decreased sales, that employer's ability to raise the level of pay is constrained. If the employer does pay more, it has two options: try to pass the increased costs on to consumers or hold prices fixed and allocate a greater portion of revenues to cover labor costs.6

Programs That Encourage and Reward Performance

Firms are continuing to relocate to areas where organized labor is weak and pay rates are low. They are developing pay plans that channel more dollars into incentive awards and fewer into fixed salaries. Entrepreneurs in startup, high-risk organizations, salespeople, piecework factory workers, and rock stars have long lived with erratic incomes.7 People in other jobs are used to fairly fixed paychecks that grow a bit every year. It is a bedrock of the U.S. compensation system, but it is gradually being nudged aside by programs that put more pay at risk. In 2010, for example, base pay comprised only 10 percent of CEO compensation.8 These programs are being linked to profit and productivity gains—usually a moving, ever-rising target.

At lower levels, such variable-pay systems almost guarantee cost control. In many new plans, any productivity gains are shared 25 percent by the employees and 75 percent by the company. If business takes off, more pay goes to workers. If it doesn't, the company is not locked into high fixed costs of labor. In the United States, 90 percent of large and medium-sized companies now offer some kind of variable pay—such as profit-sharing and bonus awards—up from 47 percent in 1990 (see Figure 11–2). Globally, that figure is about 80 percent.9 Later in this chapter we will discuss pay-for-performance more fully and how it can be put into effect.

Figure 11–2 Percent of companies offering some form of variable pay, 1990–2008.

INTERNATIONAL APPLICATION Tying Pay to Performance in the United States, Europe, and Japana

In an effort to hold down labor costs, thousands of U.S. companies are changing the way they increase workers’ pay. Instead of the traditional annual increase, millions of workers in industries as diverse as supermarkets and aircraft manufacturing are receiving cash bonuses. For most workers, the plans mean less money. The bonuses take many names: “profit sharing” at Abbott Laboratories and Hewlett-Packard, “gain sharing” at Mack Trucks and Panhandle Energy, and “lump-sum payments” at Boeing. All have two elements in common: (1) They can vary with the company's fortunes, and (2) they are not permanent. Because the bonuses are not folded into base pay (as merit increases are), there is no compounding effect over time. They are simply provided on top of a constant base level of pay. This means that both wages and benefits rise more slowly than they would have if the base level of pay was rising each year. The result: a flattening of wages nationally.

Flexible pay—tied mostly to profitability and promising better job security, but not guaranteeing it—is at the heart of the evolving bonus system. Employees are being asked to share the risks of the new global marketplace.

How large must the rewards be? While hard data on this question are scarce, most experts agree that employees don't begin to notice incentive payouts unless they are at least 10 percent, with 15 to 20 percent more likely to evoke the desired response.b In the United States and most European Union countries, bonus payments have been averaging about 11 percent of a worker's base pay annually.c Conversely, the Japanese currently pay many workers a bonus that represents about 25 percent of base pay. For workers in all nations, a significant amount of their pay is at risk.

Have such plans generated greater productivity in the U.S. manufacturing sector in recent years? Maybe, but an equally plausible explanation is that the gains were due to automation; to company efforts to give workers more of a say in how they do their jobs; and to workers’ fear that if they did not improve their productivity, their plants would become uncompetitive and be closed. In short, the jury is still out on the productivity impact of bonus systems, but evidence does indicate that bonus satisfaction is a separate and distinct component of overall pay satisfaction.d

a Mantell, R. (2011, May 17). Companies tie more of workers’ pay to performance. http://online.wsj.com/article/BT-CO-20110517-706252.html on May 18, 2011. See also Nelson, E. (1995, Sept. 29). Gas company's gain-sharing plan turns employees into cost-cutting vigilantes. The Wall Street Journal, pp. B1, B4. See also Uchitelle, L. (1987, June 26). Bonuses replace wage raises and workers are the losers. The New York Times, pp. A1, D3.

b Milkovich, G. T., Newman, J. M., and Gerhart, B. (2011). Compensation (10th ed.). New York: McGraw-Hill.

c Miller, 2010, op. cit. See also Hall, K. (2009). CEO pay: Don't look to Japan for answers. BusinessWeek, p. 60.

d Sturman, M. C., and Short, J. C. (2000). Lump-sum bonus satisfaction: Testing the construct validity of a new pay satisfaction dimension. Personnel Psychology 53, pp. 673–700.

This international example focused on the outcomes of bonus decisions. However, the process is also important. To a large extent, the relative emphasis managers place on performance versus relationships varies with cultural factors. Thus, when making bonus decisions, Chinese managers tend to place less emphasis on employees’ work performance than do American managers. However, when making decisions about nonmonetary recognition of employees, Chinese managers tend to place more emphasis on employees’ relationships with coworkers and managers than do their American counterparts. Finally, Chinese managers tend to give larger bonuses to employees with greater personal needs, while American managers tend not to take personal needs into consideration when making bonus decisions.10

COMPONENTS AND OBJECTIVES OF ORGANIZATIONAL REWARD SYSTEMS

At a broad level, an organizational reward system includes anything an employee values and desires that an employer is able and willing to offer in exchange for employee contributions. More specifically, such compensation includes both financial and nonfinancial rewards. Financial rewards include direct payments (e.g., salary) plus indirect payments in the form of employee benefits (see Chapter 12). Nonfinancial rewards include everything in a work environment that enhances a worker's sense of self-respect and esteem by others (e.g., work environments that are physically, socially, and mentally healthy; opportunities for training and personal development; effective supervision; recognition). These ideas are shown graphically in Figure 11–3.

Figure 11–3 Organizational reward systems include financial as well as nonfinancial components.

While money is obviously a powerful tool used to capture the minds and hearts of workers and to maximize their productivity, don't underestimate the impact of nonfinancial rewards. In an improved economy, one way companies are trying to keep their employees satisfied is by offering perks—gyms, flexible hours, and other amenities. As an example, consider goodmortgage.com, a 56-employee business in Charlotte, North Carolina. Employees gather in the morning to follow exercise videos on a large flat-screen TV in the full gym and to eat breakfast cooked for them by management. After one employee won a $500 gas card in one of the company's ongoing sales contests, she remarked, “I have a lot of friends in the mortgage industry and a lot of people have tried to recruit me, but no one treats their employees like we're treated here.”11

Companies are doing these things because they don't have much choice. Giving their workers more ease and freedom is simply enlightened self-interest. As one executive noted, “In yesteryear you worked 9 to 5 and that was work-life balance. Today, people look for more flexibility.” Flexibility is just one part of a total rewards system. Employers are rethinking each aspect of it, especially in light of findings from a 2011 Manpower Group survey in which 75 percent of employers reported involuntarily losing some of their highest-performing employees, despite a lagging job market.12

Rewards bridge the gap between organizational objectives and individual expectations and aspirations. To be effective, organizational reward systems should provide four things: (1) a sufficient level of rewards to fulfill basic needs, (2) equity with the external labor market, (3) equity within the organization, and (4) treatment of each member of the organization in terms of his or her individual needs.13 More broadly, pay systems are designed to attract, retain, and motivate employees. This is the ARM concept. Indeed, much of the design of compensation systems involves working out tradeoffs among more or less seriously conflicting objectives.14

Perhaps the most important objective of any pay system is fairness, or equity. Equity can be assessed on at least three dimensions:

1. Internal equity. Are pay rates fair in terms of the relative worth of individual jobs to an organization?

2. External equity. Are the wages paid by an organization fair in terms of competitive market rates outside the organization?

3. Individual equity. Is each individual's pay fair relative to that of other individuals doing the same or similar jobs?

Researchers have proposed several bases for determining equitable payment for work.15 They have three points in common:

1. Each assumes that employees perceive a fair return for what they contribute to their jobs.

2. All include the concept of social comparison, whereby employees determine what their equitable return should be after comparing their inputs (e.g., skills, education, effort) and outcomes (e.g., pay, promotion, job status) with those of their peers or coworkers (comparison persons).

3. The theories assume that employees who perceive themselves to be in an inequitable situation will seek to reduce that inequity. They may do so by mentally distorting their inputs or outcomes, by directly altering their inputs or outcomes, or by leaving the organization.

Reviews of both laboratory and field tests of equity theory are quite consistent: Individuals tend to follow the equity norm and to use it as a basis for distributing rewards. They report inequitable conditions as distressing, although there may be individual differences in sensitivity to equity.16

A final objective is balance—the relative size of pay differentials among different segments of the workforce. If pay systems are to accomplish the objectives set for them, ultimately they must be perceived as adequate and equitable. For example, there should be a balance in pay relationships between supervisors and the highest paid subordinates reporting to them. This differential typically varies from 5 to 30 percent.17 As the chapter-opening vignette illustrated, ratios of 350 to 1 (or greater) between the highest- and lowest-paid employees are generally regarded as out of balance.

STRATEGIC INTEGRATION OF COMPENSATION PLANS AND BUSINESS PLANS

Unfortunately, the rationale behind many compensation programs is “Two-thirds of our competitors do it” or “That's corporate policy.” Compensation plans need to be tied to an organization's strategic mission and should take their direction from that mission. They must support the general business strategy, for example, differentiation (setting yourself apart from the competition) or cost leadership.18 Further, evidence now shows that inferior performance by a firm is associated with a lack of fit between its pay policy and its business strategy.19 From a managerial perspective, therefore, the most fundamental question is “What do you want your pay system to accomplish?”

ETHICAL DILEMMA Does Being Ethical Pay?*

Social responsibility has become big business for many corporations. Companies spend billions of dollars doing good works—everything from boosting diversity in their ranks to developing eco-friendly technology—and then trumpeting those efforts to the public. Do those efforts pay off?

In a series of experiments, consumers were shown the same products—coffee and T-shirts. One group was told that the items were made using high ethical standards, another was told that the items were made using low ethical standards, and a third group (the control group) received no information. In the case of coffee, consumers were willing to pay $9.71 for a pound produced using high ethical standards, $5.89 for a pound produced using unethical standards, and $8.31 when given no information about the ethical standards used in coffee production. Results for T-shirts were similar. The researchers concluded that consumers are willing to pay a small premium for goods produced ethically, but they will punish a product made unethically even more harshly, by buying it only at a steep discount.

The implication of this research is that companies should segment their overall markets, and make special efforts to reach out to buyers with high ethical standards. Those are the customers who can deliver the biggest potential profits on ethically produced goods.

In an effort to attract, retain, and motivate top talent, do you believe that companies should also trumpet their ethical standards? Is there a payoff? What specific actions would you recommend with respect to developing a strategy to recruit new employees and to retain and motivate existing ones?

* Source: Trudel, R., and Cotte, J. (2008, May 12). Does being ethical pay? The Wall Street Journal, p. R4.

As an example, consider IBM's strategic and cultural transformation. The company describes its current strategy as having a “focus on the high-growth, high-value segments of the IT industry.” It notes, for example, that it “has exited commoditizing businesses like personal computers and hard disk drives.” IBM describes its current global capabilities as including “services, software, hardware, fundamental research, and financing,” and that this “broad mix of businesses and capabilities are combined to provide business insight and solutions for the company's clients.”20 A new business strategy meant a new compensation strategy. To do that, IBM cut layers of management, redesigned jobs to build in more flexibility, increased incentive pay to differentiate performance more clearly, and aggressively cut costs. The company changed its pay strategy and pay system to support its changed business strategy.

This approach to managing compensation and business strategies dictates that actual levels of compensation should not be strictly a matter of what is being paid in the marketplace. Instead, compensation levels derive from an assessment of what must be paid to attract and retain the right people, what the organization can afford, and what will be required to meet the organization's strategic goals. The idea is to align the interests of managers and employees.

When compensation is viewed from a strategic perspective, therefore, firms do the following:

1. They recognize compensation as a pivotal control and incentive mechanism that can be used flexibly by management to attain business objectives.

2. They make the pay system an integral part of strategy formulation.

3. They integrate pay considerations into strategic decision-making processes, such as those that involve planning and control.

4. They view the firm's performance as the ultimate criterion of the success of strategic pay decisions and operational compensation programs.21

DETERMINANTS OF PAY STRUCTURE AND LEVEL

Marginal revenue theory in labor economics holds that unless an employee can produce a value equal to the value received in wages, it will not be worthwhile to hire that worker.22 In practice, a number of factors interact to determine wage levels. Some of the most influential of these are labor-market conditions, legislation, collective bargaining, management attitudes, and an organization's ability to pay. Let us examine each of these.

Labor Market Conditions

As noted in Chapter 6, whether a labor market is “tight” or “loose” has a major impact on wage structures and levels. Thus, if the demand for certain skills is high while the supply is low (a tight market), there tends to be an increase in the price paid for these skills. Conversely, if the supply of labor is plentiful, relative to the demand for it, wages tend to decrease. As an example, consider Jordan Machine Company.

HR BUZZ JORDAN MACHINE COMPANY

Jordan Machine Company of Birmingham, Alabama, has never worked so hard to find so few employees. “We've turned over barrels and drums and searched just about everywhere we can think,” says Jerry Edwards, chief executive officer. The company needs skilled machinists to help manufacture molds for everything from fishing lures to submarine hatch covers.a

Small Business Contends with Tight Labor Markets

Despite his efforts—including offers of high pay, full health benefits, and a company-sponsored savings program—Edwards estimated that his company lost more than half a million dollars last year, simply because it couldn't find enough workers to meet the demand for new orders.

Jordan Machine Company is not alone. Companies, high-tech and low-tech alike, simply cannot find workers when labor markets are tight. In tight labor markets, labor shortages are the number 1 headache for many employers. In some cases it has curbed growth and expansion possibilities, and in others it has forced operators to shut down early for lack of staff.b Such tight labor markets have predictable effects on wages. Consider auto-repair technicians, long stereotyped as low-paid grease monkeys. With increasing computerization and complex diagnostics in autos, many older mechanics are choosing to change careers rather than go back for more training. The scarcity is forcing some dealers to poach other shops, and it has driven up auto-repair costs as well as the wages of repair technicians. Their average wages exceeded $41,000 in 2010, up 25 percent in the past decade, and demand for them is projected to grow 5 percent from 2008 to 2018.c

a Jaffe, G. (1997, Jan. 15). South's growth rate hits speed bump. The Wall Street Journal, p. A2. See also World Economic Forum, in collaboration with the Boston Consulting Group. (2011). Global Talent Risk—Seven Responses. Geneva, Switzerland: World Economic Forum.

b Morse, D. (2000, Aug. 22). Labor shortage has franchisees hustling for workers. The Wall Street Journal, p. B2.

c Bureau of Labor Statistics. Automotive service technicians and mechanics. Operational Outlook Handbook, 2010–2011 Edition. Retrieved from www.bls.gov/oco/ocos181.htm on August 1, 2011. See also Where the money is. (2010, Sept. 19), BusinessWeek, pp. 76, 77. See also Higgins, M. (2004, Sept. 23). Latest car-repair problem: Finding a mechanic. The Wall Street Journal, p. D6.

Another labor market phenomenon that causes substantial differences in pay rates, even among people who work in the same field and are of similar age and education, is the payment of wage premiums by some employers to attract the best talent available and to enhance productivity in order to offset any increase in labor costs. This is known as the efficiency wage hypothesis in labor economics, and it has received some support among economic researchers.23 The forces discussed thus far affect pay levels to a considerable extent. So also does government legislation.

Legislation

As in other areas, legislation related to pay plays a vital role in determining internal organization practices. Although we cannot analyze all the relevant laws here, Table 11–1 presents a summary of the coverage, major provisions, and federal agencies charged with administering four major federal laws that affect compensation.

Table 11–1 FOUR MAJOR FEDERAL WAGE-HOUR LAWS

Scope of coverage

Major provisions

Administrative agency

Fair Labor Standards Act (FLSA) of 1938 (as amended)

Employers involved in interstate commerce or in the production of goods for interstate commerce. Exemption from overtime provisions for managers, supervisors, executives, outside salespersons, and professional workers.

Minimum wage of $7.25 per hour for covered employees as of July, 2009; time-and-ahalf pay for more than 40 hours per week; restrictions by occupation or industry on the employment of persons under 18; prohibitation of wage differentials based exclusively on sex—equal pay for equal work. No extra pay required for weekends, vacations, holidays, or severance.

Wage and Hour Division of the Employment Standards Administration, U.S. Department of Labor

Equal Pay Act (1963)

Equal Pay required for men and women doing “substantially similar” work in terms of skill, effort, responsibility, and working conditions.

Equal Employment Opportunity Commission

Sarbanes-Oxley Act (SOX, 2002)

Executives (CEOs and CFOs) cannot retain bonuses or profits from selling company stock if they mislead the public about the financial health of the company.

Public Company Accounting Oversight Board, Securities and Exchange Commission

Title VII of the American Recovery and Reinvestment Act (ARRA, 2009)

Top executives in companies receiving government support are subject to “clawbacks.” That is, companies can seek repayment for bonuses, retention awards, or incentives paid to the top five senior executive officers or the next 20 most highly compensated employees based on statements of earnings, revenues, gains, or other criteria later found to be materially inaccurate.

Securities and Exchange Commission

Of the four laws shown in Table 11–1, the Fair Labor Standards Act (FLSA) affects almost every organization in the United States. It is the source of the terms exempt employees (exempt from the overtime provisions of the law) and nonexempt employees. It established the first national minimum wage (25 cents an hour) in 1938; subsequent changes in the minimum wage and in national policy on equal pay for equal work for both sexes (the Equal Pay Act of 1963) were passed as amendments to this law. About 115 million employees—86 percent of the U.S. workforce—are covered by federal overtime rules, and those rules apply to salaried and hourly workers alike.24 At the same time, many of today's employees no longer fit into the law's outdated categories (see Figure 11–4).

Figure 11–4 Who must be paid overtime?

Source: Orey, M. (2007, Oct. 1). Wage wars. BusinessWeek, p. 58.

There are many loopholes in FLSA minimum-wage coverage.25 Certain workers, including casual babysitters and most farm workers, are excluded, as are employees of small businesses and firms not engaged in interstate commerce. State minimum-wage laws are intended to cover these workers. At the same time, if a state's minimum is higher than the federal minimum, the state minimum applies. For example, while the federal minimum wage is $7.25, more than 17 states have higher minimums. For example, the state of Washington's is $8.55, and it is $8 in California and Massachusetts.26 More than 70 cities and counties pay their workers or contractors a living wage, which is tailored to living costs in an area and may be more than double the federal or state minimums. While opponents argue that such laws will force some businesses to close, at least some academic research suggests that living wage laws do more good than harm. They have imposed little—if any—cost to the cities that have passed them, they have led to few job losses, and they have lifted many families out of poverty.27

An important feature of the FLSA is its provision regarding the employment of young workers. On school days, 14- and 15-year-olds are allowed to work no more than 3 hours (no more than 8 hours on nonschool days), or a total of 18 hours a week when school is in session. They may work 40-hour weeks during the summer and during school vacations, but they may not work outside the hours of 7 a.m. to 7 p.m. (or 9 p.m. June 1 to Labor Day). Both federal and state laws allow 16- and 17-year-olds to work any hours but forbid them to work in hazardous occupations, such as driving or working with power-driven meat slicers.

Of the remaining three laws shown in Table 11–1, the Equal Pay Act was passed as an amendment to the FLSA. SOX and ARRA apply only to senior-level executives.

Collective Bargaining

Another major influence on wages in unionized as well as nonunionized firms is collective bargaining. Nonunionized firms are affected by collective bargaining agreements made elsewhere since they must compete with unionized firms for the services and loyalties of workers. Collective bargaining affects two key factors: (1) the level of wages and (2) the behavior of workers in relevant labor markets. In an open, competitive market, workers tend to gravitate toward higher-paying jobs. To the extent that nonunionized firms fail to match the wages of unionized firms, they may have difficulty attracting and keeping workers. Furthermore, benefits negotiated under union agreements have had the effect of increasing the package of benefits in firms that have attempted to avoid unionization. In addition to wages and benefits, collective bargaining is also used to negotiate procedures for administering pay, procedures for resolving grievances regarding compensation decisions, and methods used to determine the relative worth of jobs.28

Managerial Attitudes and an Organization's Ability to Pay

These factors have a major impact on wage structures and levels. Earlier we noted that an organization's ability to pay depends, to a large extent, on the competitive dynamics it faces in its product or service markets. Therefore, regardless of its espoused competitive position on wages, an organization's ability to pay ultimately will be a key factor that limits actual wages.

This is not to downplay the role of management philosophy and attitudes on pay. On the contrary, management's desire to maintain or improve morale, attract high-caliber employees, reduce turnover, and improve employees’ standards of living also affect wages, as does the relative importance of a given position to a firm.29 A safety engineer is more important to a chemical company than to a bank. Wage structures tend to vary across firms to the extent that managers view any given position as more or less critical to their firms. Thus, compensation administration reflects management judgment to a considerable degree. Ultimately, top management renders judgments regarding the overall competitive pay position of the firm (above-market, at-market, or below-market rates), factors to be considered in determining job worth, and the relative weight to be given seniority and performance in pay decisions. Such judgments are key determinants of the structure and level of wages.30

AN OVERVIEW OF PAY-SYSTEM MECHANICS

The procedures described in this section for developing pay systems help those involved in the development process to apply their judgments in a systematic manner. The hallmarks of success in compensation management, as in other areas, are understandability, workability, and acceptability. The broad objective in developing pay systems is to assign a monetary value to each job in the organization (a base rate) and an orderly procedure for increasing the base rate (e.g., based on merit, inflation, experience, or some combination of these). To develop such a system, we need four basic tools:

1. Updated job descriptions.

2. A job-evaluation method (i.e., one that will rank jobs in terms of their overall worth to the organization).

3. Pay surveys.

4. A pay structure.

Figure 11–5 presents an overview of this process.

Figure 11–5 Traditional job-based compensation model.

Job descriptions are key tools in the design of pay systems, and they serve two purposes:

1. They identify important characteristics of each job so that the relative worth of jobs can be determined.

2. From them we can identify, define, and weight compensable factors (common job characteristics that an organization is willing to pay for, such as skill, effort, responsibility, and working conditions).

Once this has been done, the next step is to rate the worth of all jobs using a predetermined system.

A number of job-evaluation methods are available. Their purpose is to provide a work-related and business-related logic to support decisions about pay. All of the methods also have the same final objective: to rank jobs in terms of their relative worth to the organization so that an equitable rate of pay can be determined for each job. However, different job-evaluation methods yield different rank-orders of jobs, and therefore different pay structures.31 In short, method matters.

As an illustration, consider the point method of job evaluation, the approach most commonly used in the United States and Europe.32 Each job is analyzed and defined in terms of the compensable factors an organization has agreed to adopt. Points are assigned to each level (or degree) of a compensable factor, such as responsibility. The total points assigned to each job across each compensable factor are then summed. A hierarchy of job worth is therefore defined when jobs are rank-ordered from highest point total to lowest point total.

While job evaluation provides a business-related order and logic that supports pay differences among jobs, not all firms use it. One reason is that several policy issues must be resolved first, including33

▪ Does management perceive meaningful differences among jobs?

▪ Is it possible to identify and operationalize meaningful criteria for distinguishing among jobs?

▪ Will job evaluation result in meaningful distinctions in the eyes of employees?

▪ Are jobs stable, and will they remain stable in the future?

▪ Is job evaluation consistent with the organization's goals and strategies? For example, if the goal is to ensure maximum flexibility among job assignments, a knowledge- or skill-based pay system may be most appropriate. We will address that topic more fully in a later section.

Linking Internal Pay Relationships to Market Data

In the point-factor method of job evaluation, the next task is to translate the point totals into a pay structure. Two key components of this process are identifying and surveying pay rates in relevant labor markets. This can often be a complex task because employers must pay attention not only to labor markets but also to product markets (e.g., level of demand and degree of competition).34 Pay practices must be designed not only to attract and retain employees but also to ensure that labor costs (as part of the overall costs of production) do not become excessive in relation to those of competing employers.

The definition of relevant labor markets requires two key decisions: which jobs to survey and which markets are relevant for each job. Jobs selected for a survey are generally characterized by stable tasks and stable job specifications (e.g., computer programmers, purchasing managers). Jobs with these characteristics are known as key or benchmark jobs. Jobs that do not meet these criteria but that are characterized by high turnover or are difficult to fill should also be included.

As we noted earlier, the definition of relevant labor markets should consider geographical boundaries (local, regional, national, or international) as well as product-market competitors (e.g., banks compared to banks, auto dealers to auto dealers). Such an approach might begin with product-market competitors as the initial market, followed by adjustments downward (e.g., from national to regional markets) on the basis of geographical considerations.

Once target populations and relevant markets have been identified, the next task is to obtain survey data. Surveys are available from a variety of sources, including the federal government (Bureau of Labor Statistics), employers’ associations, trade and professional associations, users of a given job-evaluation system (e.g., the Hay Group's point-factor system), and compensation consulting firms.35

HR BUZZ SALARY-COMPARISON SOURCES

In a world where information is power, salary negotiations have long been greatly imbalanced. The Internet, however, is leveling the playing field, as a growing number of Web sites offer salary surveys, job listings with specified pay levels, and even customized compensation analyses.a For example, America's Career InfoNet (www.acinet.org) provides access to wage data compiled by the Bureau of Labor Statistics. However, Salary.com is arguably the most popular provider of salary comparisons, for it provides detailed geographic information and matching job descriptions for more than 3,000 benchmark jobs. The primary tool used by Salary.com is the Salary Wizard, which allows users to enter a job title and zip code and receive a median salary number as well as a range from 25 percent through 75 percent of the median.

What Are You Worth?

The Salary Wizard is based on Salary.com's analysis of data supplied predominately by compensation-consulting firms, which the company's team of compensation specialists aggregates into a database and then uses to power the Wizard. If you prefer to see data presented by industry, try cafepharma.com, Vault.com/Salary, dice.com, healthcaresalary.com, or business.com. Go to these sites and compare the kinds of information presented in each one. Do they provide information on which employers are included and which are not? Where do their data come from? Answering questions like these can help to judge the credibility of the data. Credible data, in turn, can help you do a better job of negotiating compensation in a new job—or trying to improve your pay at your current one. How much more should you expect when switching jobs? Before the global financial crisis, the average was about 12 to 14 percent more than you were currently making, but if a company really wanted you, and the hiring manager knew you were in demand elsewhere, you could reasonably expect an offer of 20 percent more than your current salary. Today, to land a candidate with high-demand skills, the best that one can expect is for a firm to offer a starting salary within 10 percent of the ceiling for a position. What's the moral of this story? The better the fit, the more wiggle room you have.b

a Coleman, B. (2004). How HR pros can use online compensation data. Retrieved from www.salary.com/advice/layouthtmls/advl_display_Cat14_Ser65_Par145.html on September 28, 2004. See also Geary, L. H., and Kirwan, R. (2000, Sept.). Get paid more! Money, pp. 111–118.

b Sammer, J. (2009, Sept.). Money matters in the hiring process. HR Magazine 54(9), pp. 93–96.

Managers should be aware of two potential problems with pay-survey data.36 The most serious is the assurance of an accurate job match. If only a “thumbnail sketch” (i.e., a very brief description) is used to characterize a job, there is always the possibility of legitimate misunderstanding among survey respondents. To deal with this, some surveys ask respondents if their salary data for a job are direct matches or somewhat higher or lower than those described (and therefore worthy of more or less pay).

A second problem has resulted from the explosion of at-risk forms of pay, some of which are based on individual performance and some on the profitability of an organization. As we noted earlier, base pay is becoming a smaller part of the total compensation package for a broad range of employees. This makes it difficult to determine the actual pay of job incumbents and can make survey results difficult to interpret. For example, how do we compare salary figures that include only base pay or direct cash payouts with at-risk pay that may take the form of a lump-sum bonus, additional time off with pay, or an employee stock-ownership plan? Despite these potential problems, all indications are that pay surveys will continue to be used widely.

The end result is often a chart, as in Figure 11–6, that relates current wage rates to the total points assigned to each job. For each point total, a trend line is fitted to indicate the average relationship between points assigned to the benchmark jobs and the hourly wages paid for those jobs. Once a midpoint trend line is fitted, two others are also drawn: (1) a trend line that represents the minimum rate of pay for each point total and (2) a trend line that represents the maximum rate of pay for each point total.37

Figure 11–6 Chart relating hourly wage rates to the total points assigned to each job. Three trend lines are shown—minimum, midpoint, and maximum—as well as 11 pay grades. Within each pay grade there is a 30 percent spread from minimum to maximum and a 50 percent overlap from one pay grade to the next.

Developing a Pay Structure

The final step in attaching dollar values to jobs using the point method is to establish pay grades, or ranges, characterized by a point spread from minimum to maximum for each grade. Starting wages are given by the trend line that represents the minimum rate of pay for each pay grade, while the highest wages that can be earned within a grade are given by the trend line that represents the maximum rate of pay. The pay structure is described numerically in Table 11–2.

Table 11–2 ILLUSTRATIVE PAY STRUCTURE SHOWING PAY GRADES, THE SPREAD OF POINTS WITHIN GRADES, THE MIDPOINT OF EACH PAY GRADE, AND THE MINIMUM AND MAXIMUM RATES OF PAY PER GRADE

For example, consider the job of administrative clerk. Let's assume that the job evaluation committee arrived at a total allocation of 142 points across all compensable factors. The job therefore falls into pay grade 6. Starting pay is $13.12 per hour, with a maximum pay rate of $17.06 per hour.

The actual development of a pay structure is a complex process, but there are certain rules of thumb to follow:

▪ Jobs of the same general value should be clustered into the same pay grade.

▪ Jobs that clearly differ in value should be in different pay grades.

▪ There should be a smooth progression of point groupings.

▪ The new system should fit realistically into the existing allocation of pay within a company.

▪ The pay grades should conform reasonably well to pay patterns in the relevant labor markets.38

Once such a pay structure is in place, the determination of each individual's pay (based on experience, seniority, and performance) becomes a more systematic, orderly procedure. A compensation-planning worksheet, such as that shown in Figure 11–7, can be very useful to managers confronted with these weighty decisions.

Figure 11–7 Sample annual compensation-planning worksheet.

Alternatives to Pay Systems Based on Job Evaluation

There are at least two alternatives to pay systems based on job evaluation: market-based pay and skill- or knowledge-based pay, also referred to as competency-based pay.

Market-Based Pay

The market-based pay system uses a direct market-pricing approach for all of a firm's jobs. This type of pay structure is feasible if all jobs are benchmark jobs and direct matches can be found in the market (e.g., senior-executive positions). Pay surveys can then be used to determine the market prices of the jobs in question. If competitors’ pay decisions determine a company's pay structure though, then the level of pay or the mix of pay forms is no longer a source of potential competitive advantage. It is neither unique nor difficult to imitate. As a result, many firms are questioning the use of peer-group surveys to set compensation. Instead they are looking at the relationship of pay to company performance and to aligning pay structures more closely with the business strategy.39

Competency-Based Pay

Under a competency-based pay system, workers are paid not on the basis of the job they currently are doing, but rather on the basis of their skills or on their depth of knowledge, both of which are termed “competencies.” Skill-based plans are usually applied to so-called blue-collar work and competencies to so-called white-collar work. The distinctions are not hard and fast. They can focus on depth (specialists in corporate law, finance, or welding and hydraulic maintenance), breadth (generalists with knowledge in all phases of operations including marketing, manufacturing, finance, and HR), or self-management (gaining skills that might previously have been reserved for higher levels in the organization, such as planning, training, or budgeting).40 In a world of slimmed-down big companies and agile small ones, the last thing any manager wants to hear from an employee is “It's not my job.” To see how such systems might work in practice, let's consider General Mills and 3M.

HR BUZZ GENERAL MILLS AND 3M

Skill-based plans rely on very specific information on every aspect of the production process. For example, food-products manufacturer General Mills uses four skill categories corresponding to the steps in the production process: materials handling, mixing, filling, and packaging. Each skill category has three blocks: entry level, accomplished, and advanced. A new employee could therefore start at entry level in materials handling and, after being certified in all skills included at that level, can begin training for skills either at the accomplished level within materials handling or else at the entry level in mixing.

Skill- and Competency-Based Pay*

3M has developed a set of six leadership competencies for all executives. They are: thinks from outside in; drives innovation and growth; develops, teaches, and engages others; makes courageous decisions; leads with energy, passion, and urgency; and lives 3M values. Behavioral anchors are used to rate an executive on each of these competencies. The ratings are then used to assess and develop executives worldwide. Because 3M relies so heavily on promotion from within, competency ratings help to develop executive talent for succession planning. While the link to development is clear, the link to pay is less clear.

* Sources: Society for Human Resource Management Foundation. (2008). Seeing forward: Succession planning at 3M (DVD). Alexandria, VA: Society for Human Resource Management Foundation. See also Allredge, M. E., and Nilan, K. J. (2000, Summer/Fall). 3M's leadership competency model: An internally developed solution. Human Resource Management 39, pp. 133–145. See also Shaw, J. D., Gupta, N., Mitra, A., and Ledford, G. E., Jr. (2005). Success and survival of skill-based pay plans. Journal of Management 31, pp. 28–49.

In such learning environments, the more workers learn, the more they earn. Companies view skill- and competency-based pay plans as a way to develop the critical behaviors and abilities employees need to achieve specific business results. By linking compensation directly to individual contributions that make a difference to the organization, a company can maintain the highest caliber of workers, regardless of their particular specialties or roles. Such plans also provide a mechanism for cross-training employees to ensure that people in different functional areas have the behavioral or technical skills to take on additional responsibilities as needed.41

On the other hand, both skill- and competency-based plans become increasingly expensive as the majority of employees become certified at the highest pay levels. As a result, the employer may have an average wage higher than competitors who use conventional job evaluation. Unless the increased flexibility permits leaner staffing, the employer may also experience higher labor costs. This is what caused Motorola and TRW to abandon their plans after just a few years.42

Research at nine manufacturing plants concluded that the number of managers in plants using skill-based pay was as much as 50 percent lower, compared to traditional plants. Of course, this is also likely to dampen managers’ enthusiasm for using skill-based pay!43 Is there any impact on productivity, quality, or labor costs? A 37-month study in a component-assembly plant found a 58 percent improvement in productivity, a 16 percent reduction in the cost of labor per part, and an 82 percent reduction in scrap, compared to a similar facility that did not use skill-based pay.44 Another study linked the ease of communication and understanding of skill-based plans to employees’ general perceptions of being treated fairly by the employer.45 A final study analyzed the relationship between competencies and performance among managers. Managers’ competencies were related to their performance ratings, but there was no relationship to unit-level performance.46 The lesson from these studies is that each organization must weigh the advantages and disadvantages of such plans, relative to its own context and strategy. Currently, only 7 percent of U.S. organizations use skill- or competency-based pay plans.47

In summary, if compensation systems are to be used strategically, it is important that management (1) understand clearly what types of behavior it wants the compensation system to reinforce, (2) recognize that compensation systems are integral components of planning and control, and (3) view the firm's performance as the ultimate criterion of the success of strategic pay decisions and operational compensation programs.

Now let us consider some key policy issues.

POLICY ISSUES IN PAY PLANNING AND ADMINISTRATION

Pay Secrecy

Do workers know what the person in the next office makes? The answer: Not really. Pay secrecy is a difficult policy to maintain, particularly as so much pay-related information is now available on the Web. Anyone with access to the Internet can find out fairly easily what a position is worth in the job market. At Glassdoor.com, which relies on anonymous posting of salary information, they can find out what a position pays at a given company. What about discussing salaries within a particular firm, say, your own employer? As a general matter, salary discussions among employees are protected under the National Labor Relations Act, which protects the right of employees to discuss their wages, hours, and other terms and conditions of their employment.48

In the UK, the Equality Act of 2010 bans “gag orders” that forbid employees from discussing their pay and bonuses with colleagues. The Act does not prohibit pay secrecy clauses. Instead, it makes them “unenforceable” against employees who make or solicit a “relevant pay disclosure”—that is, one designed to uncover inequality in the pay scale based on protected characteristics, such as race or gender.49

Openness versus secrecy is not an either/or phenomenon. Rather, it is a matter of degree. For example, organizations may choose to disclose one or more of the following: (1) the work- and business-related rationale on which the system is based, (2) pay ranges, (3) pay-increase schedules, and (4) the availability of pay-related data from the compensation department.50 Posting salary ranges, experts contend, is a public show of trust in employees. It demonstrates that the employer values them and will help them to advance.51 However, there are also disadvantages to pay openness:

1. It forces managers to defend their pay decisions and practices publicly. Because the process is inherently subjective, there is no guarantee that satisfactory answers will ever be found that can please all concerned parties.

2. The cost of a mistaken pay decision escalates because all the system's inconsistencies and weaknesses become visible once the cloak of secrecy is lifted.

3. Open pay might induce some managers to reduce differences in pay among subordinates in order to avoid conflict and the need to explain such differences to disappointed employees.52

In general, open-pay systems tend to work best under the following circumstances: Individual or team performance can be measured objectively, performance measures can be developed for all the important aspects of a job, and effort and performance are related closely over a relatively short timespan.

The Effect of Inflation

All organizations must make some allowance for inflation in their salary programs. Given an inflation rate of 4 percent, for example, the firm that fails to increase its salary ranges at all over a two-year period will be 8 percent behind its competitors. Needless to say, it becomes difficult to recruit new employees under these circumstances, and it becomes difficult to motivate present employees to remain and, if they do remain, to produce.

How do firms cope? Average increases for salaried employees were 1.5 percent in 2009, for example, while consumer prices rose an average of 2.7 percent. The result: a slight decline in real wages for the average employee.53 To offset that loss, many companies are granting more time off to employees, and implementing flexible schedules (51 percent of companies).54 Companies such as Sprint, WD-40, Corning, DuPont, and Merck are tying pay more to performance in an attempt to make the costs of labor more variable and less fixed. More and more companies, large and small, feel the same way.

Pay Compression

Pay compression is related to the general problem of inflation. It is a narrowing of the ratios of pay between jobs or pay grades in a firm's pay structure.55 Pay compression exists in many forms, including (1) higher starting salaries for new hires, which lead long-term employees to see only a slight difference between their current pay and that of new hires; (2) hourly pay increases for unionized employees that exceed those of salaried and nonunion employees; (3) recruitment of new college graduates for management or professional jobs at salaries above those of current jobholders; and (4) excessive overtime payments to some employees or payment of different overtime rates (e.g., time and a half for some, double time for others). Failure of organizations to address compression issues may cause long-serving employees to rethink their commitment to a company they think does not value or reward loyalty. Their frustration also can show up in the form of lower productivity, reluctance to work overtime, and unwillingness to cooperate with higher-paid new recruits.56 However, first-line supervisors, unlike middle managers, may actually benefit from pay inflation among nonmanagement employees since companies generally maintain a differential between the supervisors’ pay and that of their highest paid subordinates.57

One solution to the problem of pay compression is to institute equity adjustments; that is, give increases in pay to employees to maintain differences in job worth between their jobs and those of others. Of course this increases an organization's overall wage bill, especially relative to competitors. Another approach is to grant sign-on bonuses to new hires in order to offer a competitive total compensation package, especially to those with scarce skills. Because bonuses do not increase base salaries, the structure of differences in pay between new hires and experienced employees does not change. A third approach is to provide benefits that increase gradually to more senior employees. Thus, although the difference between the direct pay of this group and that of their shorter-service coworkers may be slim, senior employees have a distinct advantage when the entire compensation package is considered.

Overtime as a cause of compression can be dealt with in two ways. First, it can be rotated among employees so that all share overtime equally. However, in situations where this kind of arrangement is not feasible, firms might consider establishing an overtime pay policy for management employees; for example, a supervisor may be paid an overtime rate after he or she works a minimum number of overtime hours. Such a practice does not violate the Fair Labor Standards Act; under the law, overtime pay is not required for exempt jobs, although organizations may adopt it voluntarily.58

Pay compression is certainly a difficult problem—but not so difficult that it cannot be managed. Indeed, it must be managed if companies are to achieve their goal of providing pay that is perceived as fair.

Pay Raises

Coping with inflation is the biggest hurdle to overcome in a pay-for-performance plan. On the other hand, the only measure of a raise is how much it exceeds the increase in the cost of living. In 2011, wages in Vietnam rose an average of 12 percent. Unfortunately that trailed the annual inflation rate, so real wages actually dropped. Said one worker, “The price of everything—food, gas, electricity—has gone up by more than my pay raise.”59

The simplest, most effective method for dealing with inflation in a merit-pay system is to increase salary ranges. By raising salary ranges (e.g., based on a survey of average increases in starting salaries for the coming year) without giving general increases, a firm can maintain competitive hiring rates and at the same time maintain the merit concept surrounding salary increases.

The size of the merit increase for a given level of performance should decrease as the employee moves farther up the salary range. Merit guide charts provide a means for doing this. Guide charts identify (1) an employee's current performance rating, and (2) his or her location in a pay grade. The intersection of these two dimensions identifies a percentage of pay increase based on the performance level and location of the employee in the pay grade. Figure 11–8 shows an example of such a chart. The rationale for the merit-guide-chart approach is that a person at the top of the range is already making more than the going rate for that job. Hence she or he should have to demonstrate more than satisfactory performance in order to continue moving farther above the going rate. Performance incentives, one-time awards that must be re-earned each year, allow employees to supplement their income. Let's turn now to this topic.

Figure 11–8 Sample merit guide chart.

PERFORMANCE INCENTIVES

“Using strong incentives opens up the possibility of obtaining substantial performance gains, but it also increases the possibility of something going terribly wrong.”60 To illustrate something going terribly wrong, consider the 2008–2009 global financial crisis.

Experts generally agree that the origination and distribution of subprime mortgages was a key cause (but not the only one) of the crisis. The entire process was riddled with perverse incentives that induced key employees of financial firms to take excessive risks during economic upswings. One key ingredient was the packaging of subprime mortgages into marketable securities. This made it possible to rain down fee income throughout the system—to mortgage brokers who sold the loans, investment bankers who packaged the loans into securities, banks and specialist institutions who serviced the securities, ratings agencies who gave them their seal of approval, and insurance companies that guaranteed holders of such securities against loss through the use of credit default swaps. Since the fees did not have to be returned if the securities later suffered large losses, everyone involved had strong incentives to maximize the flow of loans through the system—whether or not they were sound. The rise in systemic risk fed by these incentives throughout the “perfect calm” helped cause the global financial crisis.61

This is not to suggest that companies abandon financial incentives. Indeed, there is a wealth of evidence demonstrating that they can motivate higher levels of performance and productivity.62 It is important, though, to be attentive to possible unintended consequences, for under certain circumstances, financial incentives may lead to unethical behavior, fuel employee turnover, and foster envy and discontent.63

Today, incentives comprise almost 12 percent of payroll, up from only 4 percent in 1990.64 Evidence indicates that they work. A quantitative review of 39 studies containing 47 relationships revealed that financial incentives were not related to performance quality, but were related fairly strongly (correlation of 0.34) to performance quantity.65

When it comes to performance incentives, the possibilities are endless. Because each has different consequences, each needs special treatment. One way to classify them is according to the level of performance targeted—individual, team, or total organization. Within these broad categories, literally hundreds of different approaches for relating pay to performance exist. This chapter considers the three categories described earlier, beginning with merit pay for individuals—both executives and lower-level workers. First, however, let's consider some fundamental requirements of all incentive programs.

REQUIREMENTS OF EFFECTIVE INCENTIVE SYSTEMS

At the outset it is important to distinguish merit systems from incentive systems. Both are designed to motivate employees to improve their job performance. Most commonly, merit systems are applied to exempt employees in the form of permanent increases to their base pay. The goal is to tie pay increases to each employee's level of job performance. Incentives (e.g., sales commissions, bonuses, profit sharing) are one-time supplements to base pay. They are also awarded on the basis of performance (individual, team, organization, or some combination of those), and are applied to broader segments of the labor force, including nonexempt and unionized employees.

Properly designed incentive programs work because they are based on two well-accepted psychological principles: (1) increased motivation improves performance and (2) recognition is a major factor in motivation.66 Unfortunately, however, many incentive programs are improperly designed, and they do not work. They violate one or more of the following rules (shown graphically in Figure 11–9):

Figure 11–9 Requirements of effective incentive systems.

1. Be simple. The rules of the system should be brief, clear, and understandable.

2. Be specific. It is not sufficient to say “Produce more” or “Stop accidents.” Employees need to know precisely what they are expected to do.

3. Be attainable. Every employee should have a reasonable chance to gain something.

4. Be measurable. Measurable objectives are the foundation on which incentive plans are built. Program dollars will be wasted (and program evaluation hampered) if specific accomplishments cannot be related to dollars spent.

MERIT-PAY SYSTEMS

Surveys show that about 90 percent of U.S. employers use merit-pay systems.67 Unfortunately, many of the plans don't work. Here are some reasons:68

1. The incentive value of the reward offered is too low. Give someone a $5,000 raise and she keeps $250 a month after taxes. The stakes, after taxes, are nominal.

2. The link between performance and rewards is weak. In one survey of 10,000 U.S. workers, only 35 percent believed that performance, not seniority, determines pay at their workplaces.69 Another by Towers Watson reported that fewer than 40 percent of top-performing employees believe that they receive “moderately or significantly better pay raises, annual bonuses, or total pay than do employees with average performance.”70

3. Supervisors often resist performance appraisal. Few supervisors are trained in the art of giving feedback accurately, comfortably, and with a minimum likelihood of creating other problems (see Chapter 8). As a result, many are afraid to make distinctions among workers—and they do not.71 When the best performers receive rewards that are no higher than the worst performers, motivation plummets.

4. Union contracts influence pay-for-performance decisions within and between organizations. Failure to match union wages over a three- or four-year period (especially during periods of high inflation) invites dissension and turnover among nonunion employees.

5. The “annuity” problem. As past merit payments are incorporated into an individual's base salary, the payments form an annuity (a sum of money received at regular intervals) and allow formerly productive individuals to slack off for several years and still earn high pay—an effect called the annuity problem. The annuity feature also leads to another problem: topping out. After a long period in a job, individuals often reach the top of the pay range for their jobs. As a result, pay no longer serves as a motivator because it cannot increase as a result of performance.

These reasons are shown graphically in Figure 11–10.

Figure 11–10 Why merit-pay systems fail.

Barriers Can Be Overcome

Lincoln Electric, a Cleveland-based manufacturer of welding machines and motors, boasts a productivity rate more than double that of other manufacturers in its industry. It follows two cardinal rules:

1. Pay employees for productivity, and only for productivity.

2. Promote employees for productivity, and only for productivity.72

Furthermore, research on the effect of merit-pay practices on performance in white-collar jobs indicates that not all such reward systems are equal. Companies providing variable pay to their best workers are 68 percent more likely than other firms to report outstanding financial performance.73 This may be due a sorting effect, that is, those who do not want to have their pay tied to their performance don't accept jobs at such companies, or else they leave when pay for performance is implemented. This leaves a residual workforce that is more productive and more responsive to merit rewards.74

GUIDELINES FOR EFFECTIVE MERIT-PAY SYSTEMS

Those affected by the merit-pay system must support it if it is to work as designed. This is in addition to the requirements for incentive programs shown in Figure 11–9. From the very inception of a merit-pay system, it is important that employees feel a sense of ownership of the system. Involve them in the design process, if possible. Here are five other steps to follow:

1. Establish high standards of performance. Low expectations tend to be self-fulfilling prophecies. In the world of sports, successful coaches such as Lombardi, Wooden, and Shula have demanded excellence. Excellence rarely results from expectations of mediocrity.

2. Develop and implement sound performance management systems. As we noted in Chapter 9, such systems include clear definitions of what good performance looks like, elimination of roadblocks that might impede performance, regular coaching and feedback, and timely rewards that encourage good performance.

3. Train supervisors in the mechanics of performance appraisal and in the art of giving feedback to subordinates. Train them to manage ineffective performance constructively.

4. Tie rewards closely to performance. For example, use quarterly or semiannual performance reviews as bases for merit increases (or no increases). One review found that 40 of 42 studies looking at merit pay reported increases in performance when pay was tied closely to performance.75

5. Use a wide range of increases. Make pay increases meaningful.

Merit-pay systems can work, but they need to follow these guidelines if they are to work effectively. Figure 11–11 depicts these guidelines graphically.

Figure 11–11 Guidelines for effective merit-pay systems.

INCENTIVES FOR EXECUTIVES

“It took me a long while to learn that people do what you pay them to do, not what you ask them to do,” says Hicks Waldron, former chairman and CEO of Avon Products Inc.76

Companies with a history of outperforming their rivals, regardless of industry or economic climate, have two common characteristics: (1) a long-term, strategic view of their executives and (2) stability in their executive groups.77 It makes sense, therefore, to develop integrated plans for total executive compensation so that rewards are based on achieving the company's long-term strategic goals. This may require a rebalancing of the elements of executive reward systems: base salary, annual (short-term) incentives, long-term incentives, employee benefits, and perquisites.78

Regardless of the exact form of rebalancing, base salaries (considerably more than $1 million a year for CEOs of the largest American corporations79) will continue to be a focal point of executive compensation. This is because they generally serve as an index for benefit values. For example, objectives for short-term incentives frequently are defined as a percentage of base salary. A typical allocation of direct compensation is salary, 18 percent; short-term bonus, 24 percent; and long-term incentives, 58 percent. Why place such emphasis on long-term incentives?80

1. Annual, or short-term, incentive plans encourage the efficient use of existing assets. They are usually based on indicators of corporate performance, such as net income, expenses, or customer-loyalty measures. In light of the salary freezes and pay cuts that many companies implemented during the Great Recession, firms such as Home Depot, Cisco, and Xerox started awarding twice-a-year bonuses. Despite their clear focus on achieving short-term objectives, advocates argue that they boost morale, improve retention, and allow boards to raise goals quickly if economic conditions improve.81

2. Long-term plans encourage the development of new processes, plants, and products that open new markets and restore old ones. Hence long-term performance encompasses qualitative progress as well as quantitative accomplishments. Long-term incentive plans are designed to reward strategic gains rather than short-term contributions to profits. A small but growing number of companies, such as PepsiCo and Lincoln National Corp., let top executives choose how their long-term compensation is paid.82 The choices include, in addition to stock options, restricted stock (common stock that vests after a specified period); restricted stock units (shares awarded over time to defer taxes); performance shares (essentially stock grants awarded for meeting goals); and performance-accelerated shares (stock that vests sooner if the executive meets goals ahead of schedule). This is the kind of view we should be encouraging among executives, for it relates consistently to company success.

In the face of widespread criticism of executive pay practices, some firms are rethinking the way they reward top executives.83 Take stock options, for example. Prior to 2004, they did not have to be disclosed as expenses on financial statements. Since that time, however, according to Financial Accounting Standards Board Statement 123R, the value of all employee stock options must be expensed at estimates of fair value on financial statements (thereby reducing earnings). This has made them less attractive, as firms shift to restricted stock or performance shares, for example. Moreover, even enthusiasts can't prove that options motivate executives to perform better. Critics contend that stock options reward executives not just for their own performance but for a booming stock market. To a large extent, they are right; as much as 70 percent of the change in a company's stock price depends only on changes in the overall market.84 In response, some firms link payoffs from options to outperforming the stock of competitors or to a market index.85 Others now grant stock options not at the market price but at some higher price. These are known as premium-price options.86 Thus, executives will profit only after the stock has risen substantially. Take Monsanto, for example.

HR BUZZ MONSANTO

Premium-Price Options

At Monsanto, the CEO and 31 other executives receive options to purchase stock at prices that ascend over time. Before their options are “in the money” they must increase the stock price by 50 percent over a five-year period. Because all of these executives have to pay for their options, they must raise the share price even higher (an average of 10.5 percent per year) before they can start cashing in. The company allowed them to plow as much as half their salaries into options over the first two years of the plan. All elected to participate. Monsanto is now being run as though its managers have a stake in it, because they really do. If the CEO and his top executives are right about the company's future prospects, they will be richly rewarded. If not, and the market drops and stays depressed, their options will be underwater and the company will have to find some other way to motivate them to stay on.a

a Silverman, R. E. (2001, Apr. 12). Breathing underwater: Companies look for ways to help workers stuck with worthless stock options. The Wall Street Journal, p. R8. See also Simon, R., and Dugan, I. J. (2001, June 4). Options overdose. The Wall Street Journal, pp. C1, C17.

INCENTIVES FOR LOWER-LEVEL EMPLOYEES

As noted earlier in this chapter, a common practice is to supplement employees’ pay with increments related to improvements in job performance. One example is a lump-sum bonus, in which employees receive an end-of-year bonus (based on employee or company performance) that does not build into base pay. Their purpose is to create shock waves in an entitlement culture. By giving lump-sum bonuses for several years, a company is essentially freezing base pay and repositioning itself relative to competitors.87 Another is the spot bonus. Thus, if an employee's performance has been exceptional—such as filling in for a sick colleague or working nights and weekends to complete a project—the employer may reward the worker with a one-time bonus of $50, $100, or $500 shortly after the noteworthy actions. Fully 55 percent of companies now offer such programs.88

Individual incentive plans have a baseline, or normal, performance standard; productivity above this standard is rewarded. The baseline should be high enough so that employees are not given extra rewards for what is really just a normal day's work. On the other hand, the baseline should not be so high that it is impossible to earn additional pay.

It is more difficult to specify performance standards in some jobs than in others. At the top-management level, for instance, what constitutes a normal day's output? As one moves down the organizational hierarchy, however, jobs can be defined more clearly, and shorter-run goals and targets can be established.

Setting Performance Standards

All incentive systems depend on performance standards. The standards provide a relatively objective definition of the job, they give employees targets to shoot for, and they make it easier for supervisors to assign work equitably. Make no mistake about it, though, effective performance is often hard to define. For example, when a Corning group set up a trial program to reward workers for improving their efficiency, a team in one business unit struggled to figure out “What's a meaningful thing to measure? What's reasonable?” The measures finally settled on included safety, quality, shipping efficiency, and forecast accuracy.89 Once performance standards are set, employees have an opportunity to earn more than their base salaries, sometimes as much as 20 to 25 percent more. In short, they have an incentive to work both harder and smarter.

In setting performance standards for production work, the ideal job (ideal only in terms of the ability to measure performance, not in terms of improving work motivation or job satisfaction) should (1) be highly repetitive, (2) have a short job cycle, and (3) produce a clear, measurable output. The standards themselves will vary, of course, according to the type of product or service (e.g., a hospital, a factory, a cable television company); the method of service delivery; the degree to which service can be quantified; and organizational needs, including legal and social pressures. In fact, the many different forms of incentive plans for lower-level employees really differ only along two dimensions:

1. How premium rates are determined.

2. How the extra payments are made.

To be sure, incentives oriented toward individuals are becoming less popular as work increasingly becomes interdependent in nature. Nevertheless, individual incentives remain popular in some industries, particularly manufacturing. Lincoln Electric is a prime example.

HR BUZZ LINCOLN ELECTRIC*

Founded in 1895, Lincoln Electric Company of Cleveland, Ohio, has charted a unique path in worker-management relations, featuring high wages, guaranteed employment, few supervisors, a lucrative bonus-incentive system, and piecework compensation. The company is the world's largest maker of arc-welding equipment. With 40 percent of its revenues from outside the U.S., Lincoln has 9,500 employees in 20 countries and a network of distributors and sales offices in 160 countries. Among the innovative management practices that set Lincoln apart are these:

Individual Incentives

▪ Guaranteed employment for all full-time workers with more than two years’ service, and no mandatory retirement. No worker has been laid off since 1948, and turnover is less than 4 percent for those with more than 180 days on the job.

▪ High wages, including a substantial annual bonus (up to 100 percent of base pay) based on the company's profits. Wages at Lincoln are roughly equivalent to wages for similar work elsewhere in the Cleveland area, but the bonuses the company pays make its compensation substantially higher. Lincoln has never had a strike and has not missed a bonus payment since the system was instituted in 1934. Individual bonuses are set by a formula that judges workers on five dimensions: quality, output, dependability, ideas, and cooperation. The ratings determine how much of the total corporate bonus pool each worker will get, on top of his or her hourly wage.

▪ Piecework—more than half of Lincoln's workers are paid according to what they produce, rather than an hourly or weekly wage. If a worker is sick, he or she does not get paid.

▪ Promotion is almost exclusively from within, according to merit, not seniority.

▪ Few supervisors, with a supervisor-to-worker ratio of 1 to 100, far lower than in much of the industry. Each employee is supposed to be a self-managing entrepreneur, and each is accountable for the quality of his or her own work.

▪ No break periods, and mandatory overtime. Workers must work overtime, if ordered to, during peak production periods and must agree to change jobs to meet production schedules or to maintain the company's guaranteed employment program.

While the company insists on individual initiative—and pays according to individual effort—it works diligently to foster the notion of teamwork. And it did so long before the Japanese became known for emphasizing such concepts. If a worker is overly competitive with fellow employees, he or she is rated poorly in terms of cooperation and team play on his or her semiannual rating reports. Thus, that worker's bonus will be smaller. Says one company official: “This is not an easy style to manage; it takes a lot of time and a willingness to work with people.”

* Sources: Lincoln Electric Company, Annual Report, 2010. Retrieved from www.lincolnelectric.com/en-us/company/Documents/annualreport2010.pdf on August 5, 2011. See also Koller, 2010, op. cit. See also Wiley, C. (1993, Aug.). Incentive plan pushes production, Personnel Journal, pp. 86–91. See also Serrin, W. (1984, Jan. 15). The way that works at Lincoln. The New York Times, p. D1.

Union Attitudes

A unionized employer may establish an incentive system, but it will be subject to negotiation through collective bargaining. Unions may also wish to participate in the day-to-day management of the incentive system, and management ought to consider that demand seriously. Employees often fear that management will manipulate the system to the disadvantage of employees. Joint participation helps reassure employees that the plan is fair.

Union attitudes toward incentives vary with the type of incentive offered. Unions tend to oppose individual piece-rate systems because they pit worker against worker and can create unfavorable intergroup conflict. However, unions tend to support organizationwide systems, such as profit sharing, because of the extra earnings they provide to their members.90 In one experiment, for example, an electric utility instituted a division-level incentive plan in one division but not in others. The incentive payout was based on equal percentage shares based on salary. Relative to a control division, the one operating under the incentive plan performed significantly better in reducing unit cost, budget performance, and on 9 of 10 other objective indicators. Nevertheless, union employees helped kill the plan for two reasons: (1) negative reactions from union members in other divisions who did not operate under the incentive plan and (2) a preference for equal dollar shares, rather than equal percentage shares, because the earnings of bargaining-unit employees were lower, on average, than those of managers and staff employees.91

TEAM INCENTIVES

To provide broader motivation than is furnished by incentive plans geared to individual employees, several other approaches have been tried. Their aim is twofold: increase productivity and improve morale by giving employees a feeling of participation in and identification with the company. Team or workgroup incentives are one such plan.

Team incentives provide an opportunity for each team member to receive a bonus based on the output of the team as a whole. Teams may be as small as 4 to 7 employees or as large as 35 to 40 employees. Team incentives are most appropriate when jobs are highly interrelated. In fact, highly interrelated jobs are the wave of the future and, in many cases, the wave of the present. In the past, relatively few firms used team incentives. In the future, they will need to be more creative in using team performance management and team incentives.92 Here's an example of one firm's efforts to do so.

HR BUZZ NUCOR CORPORATION

Nucor, the largest steel producer in the United States, lives and dies by the spirit of teamwork. That is evident in its organizational design, management philosophy, and incentive plans. Every one of its 11,700 employees participates in one of four incentive plans. The purest team-based compensation plan, however, is the one aimed at groups of 12 to 20 production employees, including maintenance workers and supervisors.

Team Incentives that Fit the Organization's Culture*

Perhaps the most striking feature of the plan is its simplicity: quality tons out the door and pay weekly. Nucor's plan is a true incentive because workers can gain from good performance (bonuses average 170 to 180 percent of weekly base salaries), or lose money for poor performance. That happens when the tonnage of sub-par products is subtracted from total output—in increasing multiples the farther bad products travel from the source. If a team catches inferior goods in its work area, the tonnage is simply subtracted. If it reaches the next internal customer or the shipping department, the amount of bad product subtracted is doubled. If it reaches a customer, the bad tonnage is tripled, and then subtracted from total output.

With bonuses included, the typical Nucor steel mill worker makes $72,000 a year, and participates in a profit-sharing plan that paid out an additional $20,000 per employee per year from 2004 to 2008. On any given day, nearly every production worker can tell you within a tenth of a percent what his or her weekly bonus will be. Says the company's manager of HR and organizational development: “It's truly remarkable how much information the employees know. It's a beautiful thing to see.” Since Nucor adopted its incentive plan in 1966, the company has been profitable every quarter and not a single employee has been laid off. Case 11–1 describes Nucor in more detail.

* Sources: Motley Fool Staff. (2011, Jan. 10). Q-and-A with Nucor CEO Dan DiMicco. Retrieved from www.fool.com/investing/general/2011/01/10/q-and-a-with-nucor-ceo-dan-dimicco.aspx on August 5, 2011. See also Bolch, M. (2007, Feb.). Rewarding the team. HR Magazine, pp. 91–93.

Team incentives have the following advantages:

1. They make it possible to reward workers who provide essential services to line workers (so-called indirect labor), yet who are paid only their regular base pay. These employees do things like transport supplies and materials, maintain equipment, or inspect work output.

2. They encourage cooperation, not competition, among workers.

On the other hand, team incentives also have disadvantages:

1. Competition between teams.

2. Inability of workers to see their individual contributions to the output of the team. If they do not see the link between their individual effort and increased rewards, they will not be motivated to produce more.

3. Top performers grow disenchanted with having to carry “free riders” (those who don't carry their share of the load).

Recent large-scale research with work groups has revealed the critical relationship between employees’ understanding of the work-group incentive plan and their perceptions of the fairness of that plan. Managers should ensure that all members of work groups understand how pay-plan goals are established, what the goals and performance standards themselves are, how the plan goals are evaluated, and how the payouts are determined.93 To overcome some of the first two disadvantages of team incentives, many firms have introduced organizationwide incentives.

ORGANIZATIONWIDE INCENTIVES

In this final section, we consider three broad classes of organizationwide incentives: profit sharing, gain sharing, and employee stock-ownership plans. As we shall see, each is different in its objectives and implementation.

Profit Sharing

Profit-sharing plans pay out if a firm meets its profitability target (e.g., return on assets or net income). Profit-sharing can be either deferred (i.e., to fund retirement) or paid in cash, while payouts may be either formula-based (e.g., a fixed percentage of net income) or discretionary. Firms use it for one or more of the following reasons: (1) to provide a group incentive for increased productivity, (2) to provide retirement income for their employees, (3) to institute a flexible reward structure that reflects a company's actual economic position, (4) to enhance employees’ security and identification with the company, (5) to attract and retain workers more easily, and/or (6) to educate individuals about the factors that underlie business success and the capitalistic system.94

On the downside, most employees don't feel that their jobs have a direct impact on profits, or at least they can't see that link. Why? Because profits depend on numerous factors in addition to operating efficiency—such as the strength of consumer demand, global competition, and accounting practices.

In most plans, employees receive a bonus that is normally based on some percentage (e.g., 10 to 30 percent) of the company's profits beyond some minimum level. Does profit sharing improve productivity? One review of 27 econometric studies found that profit-sharing was positively related to productivity in better than 9 of every 10 instances. Productivity was generally 3 to 5 percent higher in firms with profit-sharing plans than in those without plans.95

Offsetting those encouraging results, however, are research findings that profit sharing seems to be associated with higher overall labor costs (because workers require a compensating differential for accepting the risk involved in such a variable-compensation program). Moreover, despite profit sharing's demonstrated relationship with productivity, it is not clear that one of these causes increases in the other. Finally, the potential to make labor costs variable in relation to profitability will be realized only if profit-sharing plans survive years when no payouts are made.96 While profit sharing can stimulate innovation and creativity, the actual success of such plans depends on the stability and security of the overall work environment, the company's overall HR management policy, and the state of labor-management relations.97 This is even more true of gain-sharing plans.

Gain Sharing

Gain sharing is a results-based program that generally links pay to performance at the facility level.98 In contrast to profit sharing, where many employees cannot see the link between what they do and company profits, gain sharing focuses on achieving savings in areas over which employees do have control—for example, reduced scrap or lower labor or utility costs. As the name suggests, employees share in the gains achieved. Gain sharing is a reward system that has existed in a variety of forms for decades. At present, about 12 percent of firms, mostly in manufacturing, have gain-sharing plans. Sometimes known as the Scanlon plan, the Rucker plan, or Improshare (improved productivity through sharing), gain sharing comprises three elements:99

1. A philosophy of cooperation.

2. An involvement system.

3. A financial bonus.

The philosophy of cooperation refers to an organizational climate characterized by high levels of trust, two-way communication, participation, and harmonious industrial relations. The involvement system refers to the structure and process for improving organizational productivity. Typically, it is a broadly based suggestion system implemented by an employee-staffed committee structure that usually reaches all areas of the organization. Sometimes this structure involves work teams, but usually it is simply an employee-based suggestion system. The employees involved develop and implement ideas related to productivity. The third component, the financial bonus, is determined by a calculation that measures the difference between expected and actual costs during a bonus period.

The three components mutually reinforce one another. High levels of cooperation lead to information sharing, which in turn leads to employee involvement, which leads to new behaviors, such as offering suggestions to improve organizational productivity. This increase in productivity then results in a financial bonus (based on the amount of the productivity increase), which rewards and reinforces the philosophy of cooperation.

Gain sharing differs from profit sharing in three important ways:100

1. Gain sharing is based on a measure of productivity. Profit sharing is based on a global profitability measure.

2. Gain sharing, productivity measurement, and bonus payments are frequent events, distributed monthly or quarterly, in contrast to the annual measures and rewards of profit-sharing plans.

3. Gain-sharing plans are current-distribution plans, in contrast to most profit-sharing plans, which have deferred payments. Hence gain-sharing plans are true incentive plans rather than employee benefits. As such, they are more directly related to individual behavior and therefore can motivate worker productivity.

When gain-sharing plans work, they work well, with improvements in sales, customer satisfaction, and profits in the 4 to 5 percent range.101 Nevertheless, in the 50 years since the inception of gain sharing, it has been abandoned by firms about as often as it has been retained. Here are some reasons:

1. Generally, it does not work well in piecework operations.

2. The returns from gain-sharing programs appear to dwindle with increasing plan size.

3. Some firms are uncomfortable with bringing unions into business planning.

4. Some managers may feel they are giving up their prerogatives.102

Some features of gain-sharing plans clearly favor success, though. Employee (and union) participation in the design of the plan, positive managerial attitudes, the number of years a company has had such a plan, favorable and realistic employee attitudes, and involvement by a high-level executive are strongly related to the success of gain-sharing plans.103 To develop an organizationwide incentive plan that has a chance to survive, let alone succeed, careful, in-depth planning must precede implementation. It is true of all incentive plans, though, that none will work well except in a climate of trustworthy labor-management relations and sound human resource management practices.

Employee Stock-Ownership Plans

Employee stock-ownership plans (ESOPs) have become popular in both large and small companies in the United States (e.g., PepsiCo, Lincoln Electric, DuPont, Procter & Gamble) as well as in western Europe, some countries in central Europe, and China.104 The typical ESOP company is a closely held, small-to-midsize firm, with a few hundred employees. In the United States there were 11,400 ESOPs in 2009, with 13 million participants holding more than $600 billion in assets. The goal is to increase employee involvement in decision making, and hopefully this will build the business. Recent evidence indicates that ESOPs do just that. During the 2007–2009 recession, for example, revenue at ESOP firms grew an average of 15.1 percent, compared to a decline of 3.4 percent for all private-industry revenue. ESOP firms also showed employment growth, faster wage growth, and higher average wages during 2008, compared to declines in those same metrics at other firms.105

Generally, ESOPs are established for any of the following reasons:

▪ As a means of tax-favored, company-financed transfer of ownership from a departing owner to a firm's employees. This is often done in small firms with closely held stock.106

▪ As a way of borrowing money relatively inexpensively. A firm borrows money from a bank using its stock as collateral, and places the stock in an employee stock-ownership trust. As the loan is repaid, the trust distributes the stock at no cost to employees. Companies can deduct the principal as well as interest on the amount borrowed, and lenders pay taxes on only 50 percent of their income from ESOP loans.

IMPACT OF PAY AND INCENTIVES ON PRODUCTIVITY, QUALITY OF WORK LIFE, AND THE BOTTOM LINE

High salary levels alone do not ensure a productive, motivated workforce. It is not how much a company pays its workers but, more importantly, how the pay system is designed, communicated, and managed.a Excessively high labor costs can bankrupt a company.b This is especially likely if, to cover its labor costs, the company cannot price its products competitively. If that happens, productivity and profits both suffer directly, and the quality of work life suffers indirectly. Conversely, when the interests of employees and their organizations are aligned, then employees are likely to engage in behavior that goes above and beyond the call of duty (such as helping others accomplish their goals), is not recognized by the formal reward system, and contributes to organizational effectiveness.c This improves both quality of work life and productivity. What's the bottom line? When sensible policies on pay and incentives are established using the principles discussed in this chapter, everybody wins: the company, the employees, and employees’ families.

a Jackson, 2010, op. cit.

b Martocchio, J. J. (2011). Strategic reward and compensation plans. In S. Zedeck (Ed.), APA Handbook of Industrial and Organizational Psychology, Vol. 1. Washington, DC: American Psychological Association, pp. 343–372. See also Stajkovic, A. D., and Luthans, F. (2001). Differential effects of incentive motivators on work performance. Academy of Management Journal 44(3), pp. 580–590.

c Taub, S. (2004, Sept. 30). Airlines wage pay-cut war. Retrieved from www.cfo.com/article.cfm/3242603?f=search on September 30, 2004.

▪ To fulfill a philosophical belief in employee ownership. Says Barbara Gabel, retiring cofounder of Zachary's Chicago Pizza, “Our community has a great affinity for the mom-and-pop small businesses, and they love it that a company they respect is employee owned. It enhances our hard-earned goodwill…. Currently our employees own about 75 percent of the company, and are on the brink of owning 100 percent. It will be with a sweet sense of joy and pride that we sit on the sidelines and watch them create their own destinies.”107

▪ As an additional employee benefit.

Do ESOPs improve employee motivation and satisfaction? Longitudinal research spanning 45 case studies found that stock ownership alone does not make employees work harder or enjoy their day-to-day work more.108 At the same time, however,

1. ESOP satisfaction tends to be highest in companies where (a) the company makes relatively large annual contributions to the plan; (b) management is committed to employee ownership and is willing to share power and decision-making authority with employees; and (c) there are extensive company communications about the ESOP, the company's current performance, and its future plans.109

2. Employees tend to be most satisfied with stock ownership when the company established its ESOP for employee-centered reasons (management was committed to employee ownership) rather than for strategic or financial reasons (e.g., as an anti-takeover device or to gain tax savings).

How does employee stock ownership affect economic performance? In the largest study of its kind to date, researchers matched 234 pairs of ESOP and non-ESOP companies on size, industry, and region and then examined sales and employment data from three years prior to the adoption of the ESOP and three years after its adoption. ESOPs appear to increase sales, employment, and sales per employee by about 2.3 to 2.4 percent per year over what would have been expected absent an ESOP. ESOP companies are also somewhat more likely to still be in business several years later. Surprisingly, ESOP companies are considerably more likely to offer other kinds of retirement plans [e.g., 33 percent of ESOP companies offered 401(k) savings plans, while only 6 percent of non-ESOP companies did]. A general assumption had been that ESOPs must be a trade-off for other wages or benefits. While this may be true in some ESOP companies, this study shows that in the benefits area, they are an overall net addition to, not a substitute for, retirement plans.110 All ESOPs are not created equally, though, for a recent review found a declining pattern of economic returns by firm size.111

While such data do not prove that employee stock ownership causes success (it may be that successful firms are more likely to make employees part owners), they do suggest that if implemented properly, such plans can improve employee attitudes and economic productivity. Nevertheless, ESOPs are not risk-free to employees. ESOPs are not insured, and if a company goes bankrupt, its stock may be worthless.

IMPLICATIONS FOR MANAGEMENT PRACTICE

In thinking about pay and incentives, expect to see three trends continue:

1. The movement to performance-based pay plans, in which workers put more of their pay at risk in return for potentially higher rewards. Recognize, however, that organizations facing higher risks place less emphasis on short-term incentives than do other organizations. To compensate for such uncertainty, they tend to rely more on higher base pay.a

2. The movement toward the use of teamwide or organizationwide incentive plans at all levels.

3. Use of a wide range of pay increases, in an effort to make distinctions in performance as meaningful as possible.

In the wave of restructurings and reengineerings that continue to unfold, research has found that the jobs of employees who remain may well impose greater demands on them in the form of know-how, problem solving, and accountability.b Be prepared to reevaluate those jobs, and, if justified, to adjust compensation accordingly.

a Tuna, C. (2008, July 7). Pay, your own way: Firm lets workers pick salary. The Wall Street Journal, p. B6. See also Bloom, M., and Milkovich, G. T. (1998). Relationships among risk, incentive pay, and organizational performance. Academy of Management Journal 41, pp. 283–297.

b Elmer, V. (2011, Feb. 1). How to deal with an invisible promotion. Fortune. Retrieved from management.fortune.cnn.com/2011/02/01/how-to-deal-with-an-invisiblepromotion on August 5, 2011. See also Tullar, W. L. (1998). Compensation consequences of reengineering. Journal of Applied Psychology 83, pp. 975–980.

Human Resource Management in Action: Conclusion THE TRUST GAP

What steps can companies take to sew corporate top and bottom back together? Here are seven suggestions:

1. Start with the obvious. Forge a closer link between CEO compensation and company performance. At American Express, CEO Ken Chenault received a huge grant of stock options in 2007, but to get any of them, he has to beat several stretch goals by 2013. AmEx's earnings per share must grow by an average of 15 percent a year, revenues must grow by at least 10 percent a year, return on equity must average at least 36 percent per year, and total return to shareholders must beat the S&P 500 average by at least 2.5 percent per year. Chenault can receive a fraction of the grant for lesser performance, but below certain limits, which are still high, he gets nothing.

2. Consider instituting profit sharing, gain sharing, or some other program that lets employees profit from their efforts. At Aflac, the insurer based in Columbus, Georgia, all of the company's 4,500 employees, from those in the call center to top executives, receive a percentage of their annual salaries in the form of profit-sharing bonuses.

3. Rethink perquisites. Now that proxy-disclosure rules require that all perks of the top five officers who exceed $10,000 be revealed, they just don't have the same appeal to executives as they used to. Yet they still have at least the same downside with the rank and file.

4. Make sure the Board's pay consultants don't work for management. Adopt a written policy that outlaws such an obvious conflict of interest.

5. Make sure your door is really open. If that means meeting with employees at unorthodox times, such as when their shifts end, then do it. Not a single one of the CEOs interviewed by Fortune could recall employees ever abusing an open-door policy. The lesson is clear for managers at all levels: Employees don't walk through your door unless they have to.

6. If you don't survey employee attitudes now, start. What you find can help identify problems before they become crises. Share findings, and be sure employees know how subsequent decisions may be related to them. Don't worry about raising expectations too high. As one executive commented, “Employees by and large are reasonable people. They understand you can't do everything they want. As long as they know their views are being considered and they get some feedback from you to that effect, you will be meeting their expectations.”

7. Explain things—personally. While one study found that 97 percent of CEOs believe that communicating with employees has a positive impact on job satisfaction and 79 percent think it benefits the bottom line, only 22 percent do it weekly or more often.

There is no doubt that these seven steps can help close the trust gap that exists in so many U.S. organizations today. On the other hand, virtually all experts cite one important qualification: It is suicidal to start down this road unless you are absolutely sincere.

SUMMARY

Contemporary pay systems (outside the entertainment and professional sports fields) are characterized by cost containment, pay and benefit levels commensurate with what a company can afford, and programs that encourage and reward performance.

Generally speaking, pay systems are designed to attract, retain, and motivate employees; achieve internal, external, and individual equity; and maintain a balance in relationships between direct and indirect forms of compensation and between the pay rates of supervisory and nonsupervisory employees. Pay systems need to be tied to the strategic mission of an organization, and they should take their direction from that strategic mission. However, actual wage levels depend on labor market conditions, legislation, collective bargaining, management attitudes, and an organization's ability to pay. Our broad objective in developing pay systems is to assign a monetary value to each job or skill set in the organization (a base rate) and to establish an orderly procedure for increasing the base rate. To develop a job-based system, we need four basic tools: job analyses and job descriptions, a job-evaluation plan, pay surveys, and a pay structure. In addition, the following pay policy issues are important: pay secrecy versus openness, the effect of inflation on pay systems, pay compression, and pay raises.

In terms of incentive plans, the most effective ones are simple, specific, attainable, and measurable. Consider merit pay, for example. Merit pay works best when these guidelines are followed: (1) Establish high standards of performance; (2) develop sound performance management systems; (3) train supervisors in the mechanics of performance appraisal and in the art of giving constructive feedback; (4) tie rewards closely to performance; and (5) provide a wide range of possible pay increases.

Long-term incentives, in the form of stock options, restricted stock, or performance shares, are becoming a larger proportion of executive pay packages. Finally, there is a wide variety of individual, group, and organizationwide incentive plans (e.g., profit sharing, gain sharing, employee stock-ownership plans) with different impacts on employee motivation and economic outcomes. Blending fixed versus variable pay in a manner that is understandable and acceptable to employees will present a management challenge for years to come.

KEY TERMS

trust gap

organizational reward system

compensation

financial rewards

nonfinancial rewards

internal equity

external equity

individual equity

balance

compensable factors

job evaluation

benchmark jobs

relevant labor markets

market-based pay system

competency-based pay system

pay openness

pay compression

incentives

merit-pay systems

annuity problem

sorting effect

restricted stock

restricted stock units

performance shares

performance-accelerated shares

premium-price options

(Cascio 416-456)

Cascio, Wayne. Managing Human Resources, 9th Edition. McGraw-Hill Learning Solutions, 2012-02-01. <vbk:0077649117#outline(11)>.