Assigment For Researcher_D

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

2. What economic and legal factors should be considered 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 I avoid to make the system work as planned?

Sources: Lublin, J. S. (2004, Apr. 12). Here comes politically correct pay. The Wall Street Journal, pp. R1, R4; Blackman, A. (2004, Apr. 12). Putting a ceiling on pay. The Wall Street Journal, p. R11; Reilly, D., Ball, D., & Ascarelli, S. (2003, Sept. 19); Europe's low pay-rage threshold. The Wall Street Journal, pp. A8, A9; Farnham, A. (1989, Dec. 4). The trust gap, Fortune, pp. 56-78.

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 (some heads of major U.S. companies receive compensation that is more than 500 times higher than the pay of the average American), the wonder grows. 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. Indeed, the widening gulf has ignited a political firestorm and raised the specter of social turmoil.

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.

An analysis of proxy statements from 350 large U.S. corporations by Mercer Human Resource Consulting revealed that CEOs in office at least two years enjoyed a 7.2 percent rise in salary and bonus in 2003, to a median $2,118,000 (on top of a 10 percent rise in 2002). In contrast, the paychecks of nonunion salaried workers grew 3.6 percent (after a 3.8 percent rise in 2002). The gap persists because bonuses, typically tied to profits, are routinely awarded to top managers but not to other employees.

On the other hand, shareholder pressure has led to a firmer link between CEO compensation and investor returns. The same Mercer study found that total direct compensation for those in charge of the 10 best performing concerns jumped 21.6 percent to $2,382,000 in 2003. Heads of the 10 companies with the poorest returns decreased 51.4 percent to a median of $1,150,860.

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.

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 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?

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.

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. 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.1

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.

Steve Jobs, CEO and chairman of Apple Computer, has been richly rewarded for Apple's stunning product innovations, from the Macintosh computer to the iPod music player.

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.4

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.5

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, about 70 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).8 Later in this chapter we will discuss more fully the pay-for-performance theme and how it can be put into effect.

INTERNATIONAL APPLICATION Tying Pay to Performance in the United States, Europe, and Japan9

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 Eastern Corporation, 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.10 In the United States and most European Union countries, bonus payments have been averaging about 10 percent of a worker's base pay annually.11 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.12

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.

“We have virtually no turnover, we have no quality problems, we have very few supervisors,” asserts Wilton Connor, the company's chief executive. “Those are the hard-nosed business reasons for doing these things.”14 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, “The demand for brains is higher than it's ever been.” Satisfying this demand will require radical rethinking of employment practices that have served organizations reasonably well in the past.15

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.16 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 trade-offs among more or less seriously conflicting objectives.17

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. In terms of the relative worth of individual jobs to an organization, are pay rates fair?

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.18 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.19

ETHICAL DILEMMA The Seven Habits of Highly Effective Board Compensation Committees

Given the recent corporate scandals at Enron, WorldCom, Tyco, Adelphia, and others, together with criminal probes that have resulted in more than 300 convictions and guilty pleas as of late 2004, it is no surprise that the actions of boards of directors are coming under scrutiny too. As an example, consider newspaper publisher Hollinger International Inc., owner of the Chicago Tribune and Jerusalem Post. Hollinger directors, handpicked by the CEO, openly approved transactions that allowed the CEO and his colleagues improperly to siphon more than $400 million from the publisher.21 Investors, Congress, and regulatory agencies are asking, “Where was the board in all of this?” To avoid getting caught in the corruption crossfire, companies should consider these seven recommendations:22

1. At least one member of the board's compensation committee should have relevant knowledge and experience in HR management and executive compensation.

2. Ensure that there are no conflicts of interest and nothing that would tempt a director to be nonindependent.

3. Ensure that directors sit on no more than four boards so they have the time to commit to compensation issues.

4. Provide direct and unfettered access to the top HR executive.

5. Hire a truly independent consultant.

6. Be open to constant education on compensation matters.

7. Tackle the hard issues around executive pay, such as severance, change-in-control, and employment agreements.

Following these guidelines will help to establish the high governance standards that today's investors expect.

As an example, consider Dial Corporation, the big consumer-products maker. Over the three-year period of 1997 to 1999, the company eliminated merit raises for its 1,400 nonunion staffers. Instead they became eligible for annual cash bonuses, which primarily reflect three measures of corporate financial performance—net revenue growth, operating margin, and asset turnover. These measures reflect business strategies of cost leadership and differentiation (setting yourself apart from the competition). Potential bonuses (up to 14 percent of base pay) rose as merit raises were phased out.25

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.26

Marginal productivity 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.27 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.

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.

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.28

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, as companies, high-tech and lowtech alike, simply cannot find workers when labor markets are tight. In tight labor markets, labor shortages are the No. 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.29 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 income was $44,819 in 2004, up 8.6 percent from 2001.30

Small Business Contends with Tight Labor Markets

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 considerable support among economic researchers.31 The forces discussed thus far affect pay levels to a considerable extent. So also does government 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 wage-hour laws. Wage-hour laws set limits on minimum wages to be paid and maximum hours to be worked.

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.

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 three hours (no more than eight 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.

The remaining three laws shown in Table 11-1 apply only to organizations that do business with the federal government in the form of construction or by supplying goods and services.

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.35

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.

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, or some combination of the two). 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 11-4 presents an overview of this process.

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 have been developed since the 1920s, and many of them are still used. They all have the same final objective: ranking 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.38 In short, method matters.

While job evaluation provides a business-related order and logic that supports pay differences among jobs, its use is not universal among firms. One reason is that several policy issues must be resolved first, including40

· 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.

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. 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.42

COMPANY EXAMPLE: SALARY-COMPARISON SOURCES

The end result is often a chart, as in Figure 11-5, 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.47

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.

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 $9.75 per hour, with a maximum pay rate of $12.37 per hour.

· 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.48

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 11-6, can be very useful to managers confronted with these weighty decisions.

There are at least two such alternatives. These are market-based pay and skill-or knowledge-based pay, also referred to as 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) or breadth (generalists with knowledge in all phases of operations including marketing, manufacturing, finance, and HR).50 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 Company.

COMPANY EXAMPLE: 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 Pay51

3M has developed a set of leadership competencies for its global executives. They comprise three levels, fundamental (ethics and integrity, intellectual capacity, and maturity and judgment), essential (customer orientation, developing people, inspiring others, and business health and results), and visionary (global perspective, vision and strategy, nurturing innovation, building alliances, and organizational agility). 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.

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 specialty or role. 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.55 The plans work best when the following conditions exist:56

1. A supportive HRM philosophy underpins all employment activities. Such a philosophy is characterized by mutual trust and the conviction that employees have the ability and motivation to perform well.

2. HRM programs such as profit sharing, participative management, empowerment, and job enrichment complement the competency-based pay system.

3. Technology and organization structure change frequently.

4. Employee exchanges (i.e., assignment, rotation) are common.

5. There are opportunities to learn new skills.

6. Employee turnover is relatively high.

7. Workers value teamwork and the opportunity to participate.

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.

In the United States, the pay of senior executives is disclosed in annual reports. However, this is not the case in Europe. Continental Europe still has a ways to go before it matches the United States and the United Kingdom in disclosing executive pay. Spain and Italy, for example, have no reporting requirements. Under current German law, companies lump together the pay of all management board members. However, France, Switzerland, and especially Ireland are beginning the lift the veil of secrecy that shrouds the compensation of executives in those countries.58

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.59 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.60 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.61

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 time span. The Effect of Inflation

All organizations must make some allowance for inflation in their salary programs. Given an inflation rate of 5 percent, for example, the firm that fails to increase its salary ranges at all over a two-year period will be 10 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? Automatic pay raises for nonunion employees have almost disappeared at most major concerns. Average increases for salaried employees dropped from 4.4 percent in 2001 to an estimated 3.5 percent in 2004.62 As we have seen, companies such as Dial, Corning, DuPont, Merck, and America West Airlines are tying pay more to performance in an attempt to make the costs of labor more variable and less fixed. At Dial, for example, “Employees have gotten merit increases irrespective of company performance … We can't afford to go on doing business through [that] kind of pay program.”63 More and more companies, large and small, feel the same way.

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. Some companies provide for equity adjustments through a constantly changing pay scale. Thus, Aluminum Company of America (Alcoa) surveys its competitors' pay every three months and adjusts its pay rates accordingly. Alcoa strives to maintain at least a 20 percent differential between employees and their supervisors.66

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. Alternatively, some firms 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 it may be adopted voluntarily.67

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.

The simplest, most effective method for dealing with inflation in a meritpay 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. Because a raise in minimum pay for each salary range creates an employee group that falls below the new minimum, it is necessary to raise these employees to the new minimum. Such adjustments technically violate the merit philosophy, but the advantages gained by keeping employees in the salary range and at a rate that is sufficient to retain them clearly outweigh the disadvantages.69

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 11-7 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 reearned each year, allow employees to supplement their income. Let's turn now to this topic.

When it comes to performance incentives, the possibilities are endless.74 Because each has different consequences, each needs special treatment.75 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.

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, profit sharing) are one-time supplements to base pay. They are also awarded on the basis of job performance and are applied to broader segments of the labor force, including nonexempt and unionized employees.

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

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

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

· 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.

Surveys show that about 90 percent of U.S. employers use merit-pay systems.77 Unfortunately, many of the plans don't work. Here are some reasons:78

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.79

2. The link between performance and rewards is weak. A recent survey by Watson Wyatt 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.”80

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. 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.81

These reasons are shown graphically in Figure 11-9.

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

2. Promote employees for productivity, and only for productivity.82

Furthermore, research on the effect of merit-pay practices on performance in white-collar jobs indicates that not all merit 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.83 In addition, merit systems that incorporate a wide range of possible increases tend to generate higher levels of job performance after one year. Some typical ranges used in successful merit systems are: Digital Equipment, 0 to 30 percent; Xerox, 0 to 13 percent; and Westinghouse, 0 to 19 percent.84

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 11-8. From the very inception of a merit-pay system, it is important that employees feel a sense of “ownership” of the system. To do this, consider implementing a merit-pay system on a step-by-step basis (e.g., over a two-year period), coupled with continued review and revision. Here are five 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 accurate performance appraisal systems. Focus on job-specific, results-oriented criteria (outcomes) as well as on employees' behavior (processes).

4. Tie rewards closely to performance. For example, use quarterly or semi-annual 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.85

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 11-10 depicts these guidelines graphically.

“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.86

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. 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.87

Regardless of the exact form of rebalancing, base salaries (considerably more than $1 million a year for CEOs of the largest American corporations88) will continue to be a focal point of executive compensation. This is because they generally serve as an index for benefit values. Objectives for short-and long-term incentives frequently are defined as a percentage of base salary. Long-term incentives now account for more than half of total executive compensation, up from 28 percent a decade ago.89 Here's why:

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.91 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.92Take stock options, for example. Executives are granted the right to buy the company's stock sometime in the future at a fixed price, usually the price on the day the options are granted. Options are popular because they allow issuing companies to contend that the executives won't benefit unless the shareholders do. However, 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.93 In response, companies such as Transamerica, Colgate-Palmolive, and Electronic Data Systems now grant stock options not at the market price but at some higher price. These are known as premium-price options.94 Thus, executives will profit only after the stock has risen substantially. Take Monsanto, for example.

COMPANY EXAMPLE: MONSANTO

At Monsanto, chief executive Robert Shapiro 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 Shapiro and the other 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 Shapiro 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.95

Premium-Price Options

Individual incentive plans have a baseline, or normal, work standard; performance 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 work 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.

All incentive systems depend on workload 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.98 Once workload 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 workload 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; andorganizational 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.

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 piece-work compensation. The company is the world's largest maker of arc-welding equipment. With 2003 revenues exceeding $1 billion, it has 7,000 employees in 18 countries and a network of distributors in 160 countries. Among the innovative management practices that set Lincoln apart are these:

· 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.

Individual Incentives

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.”

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.

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 work-group 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 appraisal and team incentives.102 Here's an example of one firm's efforts to do so.

COMPANY EXAMPLE: XEL

XEL, a manufacturer of electronic equipment for the telecommunications industry, uses a three-tier incentive compensation plan to complement its use of self-managed work teams: a lump-sum profit-sharing plan, a pay-for-skills program, and a team-based variable-pay system. For the team-based pay system, XEL sets aside a percentage of its total payroll, and payouts are determined by team rankings. A team's ranking is based on three criteria: ratings by internal and external customers, achievement of quarterly team objectives, and management input recognizing special circumstances.

In this system, members on the same team do not all receive the same payout because the final payout is adjusted to reflect peer evaluations. For example, if the overall merit-pay budget is 5 percent of payroll, the top-ranked team might get 8 percent, a mid-ranked team 5 percent, and a bottom-ranked team nothing. Further, within the top team there may be a spread of 5 to 10 percent among individual members' ratings. The major benefit of such a system: Team deficiencies get quick attention.

Team Incentives in a Small Business103

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, the goals and performance standards themselves, how the plan goals are evaluated, and how the payouts are determined.104 To overcome some of the first two disadvantages of team incentives, many firms have introduced 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.

Firms use profit sharing for one or more of the following reasons: (1) provide a group incentive for increased productivity, (2) provide retirement income for their employees, (3) institute a flexible reward structure that reflects a company's actual economic position, (4) enhance employees' security and identification with the company, (5) attract and retain workers more easily, and/or (6) educate individuals about the factors that underlie business success and the capitalistic system.105

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. For example, Ford Motor Company distributed 2003 profit-sharing checks to employees that averaged $160. At General Motors, the same types of workers received profit-sharing checks that averaged $940.106 While Ford employees no doubt believe that they deserve more than one-sixth the payout of their GM counterparts, even if they are able to improve operating efficiency, there is no guarantee that profits will increase automatically. Why? Because profits depend on numerous factors in addition to operating efficiency—such as the strength of consumer demand, global competition, and accounting practices.

Profit sharing is a double-edged sword. On the one hand, compensation costs become more variable—a company pays only if it makes a profit. On the other hand, from the employee's perspective, benefits and pensions are insecure. 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.108 This is even more true of gain-sharing plans.

In contrast to profit sharing, where many employees cannot see the link between what they do and company profits, gain sharingfocuses 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. Sometimes known as the Scanlon plan, the Rucker plan, or Improshare (improved productivity through sharing), gain sharing comprises three elements:109

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.110 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:111

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.112 For example, consider a 17-year evaluation of a Scanlon plan in a manufacturing operation, DeSoto Inc. of Garland, Texas. The bonus formula, which measures labor productivity, revealed that average bonuses ranged from 2.5 percent to more than 22 percent, with an overall average of 9.6 percent. Moreover, over the 17-year period of the study, output (as measured by gallons of paint) increased by 78 percent.113 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. Some firms are uncomfortable about bringing unions into business planning.

3. Some managers may feel they are giving up their prerogatives.114

Neither the size of a company nor the type of technology it employs seems to be related to Scanlon plan success. However, employee (and union) participation in the design of the plan, positive managerial attitudes, the number of years a company has had a Scanlon plan, favorable and realistic employee attitudes, and involvement by a high-level executive are strongly related to the success of a Scanlon plan.115 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 (ESOPs) have become popular in both large and small companies in the United States (e.g., Pepsico, Lincoln Electric, DuPont, Coca-Cola) as well as in Western Europe, some countries in Central Europe, and China.116About 10,000 U.S. firms now share ownership with 10 million employees. Employees own an average of 13 percent of the stock at 562 public companies. However, they have board seats at fewer than a dozen of them, and most of those are unionized.117Employee ownership can be found in every industry, in every size firm, and in every part of the country. The goal is to increase employee involvement in decision making, and hopefully this will influence performance.118

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

· As a way of borrowing money relatively inexpensively. A firm borrows money from a bank using its stock as collateral, places the stock in an employee stock ownership trust, and, as the loan is repaid, 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.

· To fulfill a philosophical belief in employee ownership. For example, at 22,000-employee Science Applications International Corp., a $2.1 billion high-tech research and engineering concern, founder J. Robert Beyster began giving employees stock in the company every time they landed a new contract. That was 27 years ago, and he has never stopped. Beyster attributes much of the company's growth not to management skills or to an overarching strategy, but to his ownership philosophy. He says, “Employee ownership really did it. Who has a better right to own the company than the people who make it worth something?” So far that has proved to be a winning formula.123

· As an additional employee benefit.

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. This is evident in the auto industry, where wages are among the highest in the country, yet quality problems and high absenteeism persist. A critical factor, then, is not how much a company pays its workers but, more important, how the pay system is designed, communicated, and managed.120 Excessively high labor costs can bankrupt a company.121 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.122 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.

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.124 However, certain features of ESOPs do promote an increase in employee willingness to participate in company decisions. Companies that take advantage of that willingness can harness employees' energy and creativity.125 In particular,

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).

3. Satisfaction breeds satisfaction. That is, the same individual-level and ESOP characteristics that lead to ESOP satisfaction also lead (somewhat less strongly) to organizational commitment.

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.127

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.128

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.129 Be prepared to reevaluate those jobs, and, if justified, to adjust compensation accordingly.

Human Resource Management in Action: Conclusion

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

1. Start with the obvious. Tie the financial interests of high-and low-level workers closer together by making exposure to risksand rewards more equitable. Thus, when NUCOR, a steel company in Charlotte, North Carolina, went through tough times, the company's president took a 60 percent cut in pay. Said a compensation consultant, “How often do you see that? … It makes a real difference if employees see that their CEO is willing to take it in the shorts along with them”130 Electronic Data Systems CEO Michael H. Jordan has stock options that enrich him only when investors score a big payday as well. One-half of the roughly 1 million options bestowed upon Jordan are worthless unless the company's share price rises at least 30 percent.

2. Consider instituting profit sharing, gain sharing, or some other program that lets employees profit from their efforts. Make sure, however, that incentive pay is linked to performance over which the beneficiaries have control.

3. Rethink perquisites. Now that perks come under taxable income, 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. Look at the office layout with an eye toward equity. In Sweden, for example, same-size offices are the norm. When an American visitor asked his Swedish corporate hosts how they could give the same amount of space to a secretary as to an engineer, they said, “How can we hire a secretary and expect her to be committed to our company, when, by the size of the office we give her, we tell her she's a second-class citizen?”131

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.

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.

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 appraisal systems that focus on job-specific, results-oriented criteria; (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.

· organizational reward system

· compensation

· financial rewards

· nonfinancial rewards

· internal equity

· external equity

· individual equity

· balance

· job descriptions

· 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

· restricted stock

· restricted stock units

· performance shares

· performance-accelerated shares

· premium-price options

· lump-sum bonus

· spot bonus

· workload standards

· profit sharing

· gain sharing

· employee stock ownership plans

“I don't understand it. We're a successful company that pays well, and we have a reputation to uphold. Now you tell me that last year most of the raises employees got were not given on the basis of performance. How can that be?” So asked Shaver Inc.’s chief executive officer, Phyllis Johnstone. Mike Mercer, Shaver Inc.’s vice president for human resources, fumbled for an answer. “Well, we've got a darn good compensation system. The problem is simply that managers don't know how to use it effectively.”

Shaver Inc., a manufacturer of all kinds of wood and steel tables for business and industry, was headquartered in Eugene, Oregon. Its roots date back to 1907, when founder Jason Bishop started up a new business near a sawmill on the outskirts of Eugene and developed a uniquely crafted writing table for bookkeepers. The business initially was family owned and remained relatively small until the 1940s. By then, however, outside investors had begun to take an interest in the quality of workmanship that was demonstrated by the Bishop family, and they purchased the business and began to expand its operations both domestically and overseas. The organization was incorporated in 1952 and continued to expand rapidly throughout the 1950s and 1960s. Today, Shaver manufactures and markets more than 40 varieties of tables and is the leader in the western United States in this particular business.

Shaver enjoys a reputation for excellent management practice and has been written up in numerous business magazines over the years. It consistently receives high ratings for product innovation, return on stockholder investment, product quality, and financial acumen. It also receives high marks for its ability to attract, develop, and retain talented employees.

Shaver has also traditionally been a very profitable organization, which is what attracted the initial investor interest in the 1940s. Until 2002, Shaver had always outperformed its competitors in terms of return on investment for its shareholders. For instance, in 2000, Shaver's return on assets averaged 15 percent while that of its largest competitor averaged only 11 percent in the same year. However, in 2002 the situation began to change. Shaver's traditional lead over its competitors deteriorated, possibly due to changes in organizational structure or to a set of disappointments in new-product innovations in the marketplace. CEO Johnstone was not convinced that only factors such as these were to blame for some of Shaver's problems. She was concerned that perhaps employee motivation was deteriorating as well, and her impressions of the salary and compensation system did not provide her with any comfort in this regard.

Shaver Inc. employs about 16,000 people, roughly half of whom are hourly manufacturing or clerical employees. The other half are salaried exempt employees, including salespeople, engineers, technicians, supervisors and managers, and others. Compensation for the 8,000 exempt salaried employees at Shaver has historically ranked among the top 33 percent of midsize U.S. corporations. These progressive HR policies and pay practices have contributed to inordinately high levels of employee commitment and loyalty, as characterized by historically low voluntary turnover rates (averaging less than 4 percent of the workforce per year).

As with other companies, the salary determination process at Shaver was built on the annual performance review. Shaver's existing performance review process had been designed and developed by Mercer's salary review task force in 2000. Under this plan, supervisors rated employees on a scale from 1 to 5, with 5 designating exceptional performance and 1 indicating unacceptable performance. Plus and minus ratings were allowed, with the exception that no one with a 5 could earn a plus and no one with a 1 could earn a minus. Thus, managers could choose from 13 different rating categories in assigning an overall performance evaluation for a particular employee (5, 5-, 4+, 4, 4-, etc.).

With this formula, an employee with 550 Hay points had a 2005 control point of $3,398 per month. At Shaver, the employee's actual salary could range from 80 percent to 125 percent of the control point. Actual salary as a percentage of the control point is called the employee's compa-ratio. For example, an employee with 550 Hay points and a compa-ratio of 110 would have a 2005 monthly salary of $3,737. On the other hand, an employee with 550 Hay points and a compa-ratio of 80 would have a 2005 monthly salary of $2,718. Each employee's compa-ratio goes down whenever the salary line formula is moved upward and goes up each time he or she gets a merit salary increase.

Shaver, Inc. has always prided itself on being an organization that pays above-average salaries. It sets its salary line formula so that employees with compa-ratios of 100 earn approximately 10 percent more than the average compensation in other medium-sized organizations. This means that an employee at Shaver in a position with 550 Hay points would earn roughly 10 percent more than a similarly situated employee with 550 Hay points at another organization, assuming that both had similar comparatios. To guarantee that Shaver is paying about 10 percent above market, it takes part in a variety of salary surveys each year. In these surveys, it sends its salary data in and receives reports back from the surveying organization showing how its salaries compare with those of other organizations.

The salary-line formula is revised annually on July 1, the beginning of Shaver's fiscal year. The salary-line formula is adjusted upward so that control points for particular positions are approximately 10 percent above the market-salary goal that Shaver sets for itself. However, the salaries themselves are not automatically adjusted when the salary line formula changes. Instead, individual compa-ratios decline every July 1, when control points are increased.

Salary revisions themselves are linked both to control-point increases and performance appraisal ratings through guidelines established by Mercer's HR management department. Theoretically, employees with higher performance appraisal ratings should get larger pay increases, and raises for a given performance rating should be smaller for employees with higher compa-ratios. For example, the salary increase for an employee receiving a performance rating of 4 might be in the 5 to 7 percent range if his or her compa-ratio is 90, but only in the 3 to 5 percent range if his or her compa-ratio is 110.

Employees who achieve compa-ratios considerably above 100 over an extended period of time are generally viewed as the star performers at Shaver. This level of sustained performance suggests that the individual is a clear candidate for promotion. In addition, because salaries are rarely decreased, compa-ratios may be above 100 in the short run for employees who are not performing particularly well and, therefore, not actually candidates for promotion.

Back in 2000 when Mike Mercer and his salary review task force had looked into the problems associated with compensation and the performance appraisal system, they had discovered through interviews that there was general agreement that rewards for excellent performance were inadequate. Outstanding performers were getting salary increases that were in many cases only marginally better than those given to average and below-average performers. And in many cases, outstanding performance was not even being identified through the appraisal system.

The salary review task force had redesigned the appraisal system so that it looked like the 5-point scale described earlier, and this revision had been implemented in 2001. It was the hope of the task force that this redesigned system would help overcome some of the problems that were uncovered during the interviews. According to Mercer, “One thing that really hit home for us was the negative feeling of some of our best performers concerning the reward system here at Shaver. The key issue seemed to be the appraisal system itself and it simply had to be dealt with.”

The problem was that everyone seemed to have different ideas about how to restructure the performance appraisal system. The salary review task force got a variety of opinions, mostly negative, about the existing appraisal system. Many pointed out that managers were afraid to give experienced people ratings below 8 (the old system had been based on an 11-point rating scale). They also pointed out that it was very difficult to get a rating of 10. In many cases the supervisor had never received a rating of 10 and was not about to give that rating to a subordinate. Some other comments that were representative of problems uncovered included:

What's the use of working hard? You still get the same rating everyone else does, and you still get the same 4 percent salary increase. It's demoralizing and demotivating.

Sharlene has been in that job for 11 years and hasn't done anything extraordinary for the last 8. But do you think my boss would give her a 7? No way! If he did, he'd spend the next year listening to Sharlene complain about her rating.

How can I evaluate my direct reports fairly and objectively when the other managers are giving all their people 8s? A 7 simply isn't acceptable. The system would be okay if everyone played by the same rules, but they don't.

It's getting to the point where many of the best people are going to leave Shaver unless they get the right kinds of rewards. Now, who do you want to do the walking? Your best people or your worst?

Questions

1. What are the problems with Shaver's present performance appraisal and salary review program?

2. What changes in Shaver's performance appraisal and salary review system would you recommend?

3. Discuss the rationale and relative advantages of each of the changes you recommend.

1Bates, S. (2003a). Top pay for best performance. HRMagazine, 48 (1), 31-38.

2Milkovich, G. T., & Newman, J. M. (2005). Compensation (8th ed.). Burr Ridge, IL: Irwin/McGraw-Hill

3See, for example, Cascio, W. F., & Wynn, P. (2004). Managing a downsizing process. Human Resource Management, 43 (4), 425-436.

4Milkovich & Newman, op. cit.

5Ibid.

6Stroh, L. K., Brett, J. M., Baumann, J. P., & Reilly, A. H. (1996). Agency theory and variable pay compensation strategies. Academy of Management Journal, 39, 751-767.

7Show you the money? It's with variable pay. (2000, Nov. 16). BusinessWeek, p. 8. See also Koretz, G. (1999, Dec. 13). A safety valve for wages? Variable pay's rewards—and risks. BusinessWeek, p. 32.

8Bates, op. cit. See also Fisher, A. (2000, June 26). Boosting your pay and finding your passion. Fortune, p. 340.

9Sources: Buck survey: Pay raises to remain flat in 1999. (1998, Nov. 27). ACA Newsline. 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; Uchitelle, L. (1987, June 26). Bonuses replace wage raises and workers are the losers. The New York Times, pp. A1, D3.

10IOMA. (1996, Nov.). When are bonuses high enough to improve performance? p. 12.