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Effective Compensation Management For Competitive Advantages: Study of Indian IT Sector
Effective Compensation Management For Competitive Advantages: Study of Indian IT Sector
Associate Professor
IBS, Ahmedabad, India
Introduction
With liberalization of government policies in the 1990s, the Indian information technology (IT)
and IT enabled services (ITeS) industry has prospered and now employs more than three million
people across India and contributes to 6 percent of Indian GDP. IT sector includes packaged
software, IT services and IT training while ITeS includes all business processes being outsourced
or off shored by foreign companies facilitated by Internet, telecom and similar means. 30% of
firms worldwide who have reached Level 5 of Capability Maturity Model Integration (CMMI)
are Indian IT/ITES firms (NASSCOM Deloitte, 2008). From being a mere $2 billion industry in
1994-95, the Indian IT and ITeS industry has grown phenomenally over the years and is
expected to touch $72 billion by 2010. As many as 400 of the Fortune 500 companies now either
have their own business process or IT centers in India or outsource their business processes or
IT to Indian technology firms (NASSCOM, 2005).
Performance of IT firms is negatively influenced by increased market competition, rising wage
bills, reduced IT expenditure due to downturn of business cycle in developed economy such as
US and Europe, and protectionist measures taken by the US government with regard to
outsourcing for safeguarding their local jobs impacted by severe recession in US. Indian IT firms
have stiff competition in the value chain from foreign IT consulting firms present in India like
Accenture, Deloitte, IBM, MphasiS, and Sapient. Since, the beginning of the business cycle
downturn or recession in the US in December 2007, more than 6.5 million jobs have been
downsized, with the number expected to grow in the near future (Krugman, 2009). According
to the U.S. Bureau of Labor Statistics, from December 2007 through July 2010, the total number
of mass layoff events (seasonally adjusted) in the US was 63,461. In 2009 alone, 25,695 mass
layoff events were recorded, involving more than 2.5 million job losses. To increase local
availability of jobs during recession period (with unemployment rate of over 9 per cent), US
government has taken many protectionist steps which have harmed the interest of Indian IT
firms. Recently, Ohio state government banned IT outsourcing by government departments to
offshore locations such as India. In August 2010, the US has steeply increased the fees (by
almost doubling the application fee to about $4,300 from $2,300) for H-1B and L1 visas, sought
by Indian professionals and IT firms. According to NASSCOM, the hike in fees is expected to
put an additional burden of $250 million annually on the Indian IT firms.
______________________________________________________________________________
Madhani, P. M. (2011), Effective Compensation Management for Competitive Advantages:
Study of Indian IT Sector, Journal of Science, Technology and Management, Vol. 3, No. 4, pp.
29-42.
Compensation cost accounts for nearly 50 per cent to 60 per cent of total revenue for Indian IT
firms. Increased pressure to enhance performance and profitability have motivated human
resources (HR) managers of IT firms to identify and implement effective compensation plans for
their employees. Restructuring fixed and variable pay in the pay mix helps firms in maintaining
proper leverage ratio for mitigating adverse impact of contraction phase of business cycle such as
recession. The pay mix is defined as the extent of variable pay and base salary in an individuals
compensation package. This article provides a conceptual framework for properly designing pay
structure and explains with the empirical analysis fixed and variable pay relationship for
effective compensation management in the IT firms.
It is also strategic in nature since it will affect motivation of the employees and profitability of
the IT firm. Compensation plans of organizations are strategically designed when rewards are
linked to activities, attributes and work outcomes that support the organizations strategic
direction and strategic goals (Howard & Dougherty, 2004). Properly designed and deployed
compensation plans drive superior performance of employees, thereby achieving and even
surpassing performance targets of firms without crossing compensation budgets.
Consequently, it is not surprising that IT firms spend significant time and effort designing reward
structures to boost performance of employees. The key to motivating employees who help realize
the organizations goals lies in how the organizations incentives and pay structure relate to their
goals. The main goal of an HR manager in an IT firm is to hire high quality and competent
employees, who can help the firm to earn as much revenue and profit as possible. Once
employees have been hired, inducted, and trained, HR managers need to find a way to motivate
them. Most organizations motivates their employees, by rewarding their achievement and performance through an appropriate compensation strategy.
IT / ITeS Revenue
40.00
Exports
30.00
Total $ Billions
20.00
10.00
0.00
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Exports
0.33
0.49
0.73
1.09
1.76
2.60
3.96
6.22
7.65
9.88
12.90
17.70
23.60
31.30
Total
0.56
0.84
1.22
1.76
2.94
4.01
5.54
8.30
9.96
12.46
16.70
22.60
30.30
39.70
Year
(Source: Madhani, 2008)
Recession
Output
Growth
Growth trend
Recovery
Slump
Time
Business cycle has a significant impact on the sales and profitability of the firms and directly
influences overall compensation costs. Business cycle phases are characterized by changes in the
dynamics of the economy. In particular, expansion phases are periods when economic activity
tends to trend up such as recovery and growth period, whereas contraction phases are periods
when economic activity tends to trend down such as period of recession and slump (Madhani,
2010a). Understanding these phases has been the focus of management researchers to mitigate
negative impacts of business cycle on the IT firms. Indian IT firms need to make sure that their
compensation package will be in line with a continuous changing business environment. A
business cycle portrays the kinds of changes that occur to the performance of the organization in
the terms of product demand and sales revenue, it can become a valid framework for integration
of performance management and compensation strategy of the organization. Business cycle is an
integral part of any IT firm, and coping effectively is also a part of the managerial decisionmaking process. An effective compensation plan is not only about making the right decisions
about compensation structure but also about making timely decisions.
According to the competitive theory, firms must use their resources to cope with and exploit their
environment in order to attain competitive advantage (Porter, 1980). One method for moving
towards a competitive advantage is to create strategies that anticipate and respond to
environmental changes. Applying this principle to compensation management, an organizational
strategy for attaining competitive advantage is implementation of variable pay compensation in
pay structure to protect a firm against declining profits (Gomez-Mejia & Balkin, 1992). The
variable compensation strategy follows Porter's framework because it allows the organization to
flexibly respond to anticipated demand variations, rather than be forced into a more radical
response, such as large scale cyclical layoffs by firms during period of recession. The variable
pay compensation strategy may protect employees against cycles of layoffs by providing a buffer
against short-term financial pressure, allowing a firm to cut compensation costs in difficult times
and to pay employees more when it is in a better financial position (Balkin & Gomez-Mejia,
1987).
Operating leverage =
CM
EBIT
Where,
Operating leverage =
If a high percentage of the firms total costs are fixed costs, then the firm is said to have a high
degree of operating leverage (DOL). DOL is defined as the percentage changes in earnings
before interest and taxes (EBIT) that result from a percentage change in units sold (Sales). DOL
is the degree to which a firm or project relies on fixed costs (fixed costs act like a lever in the
sense that a small percentage change in operating revenue can be magnified into a large
percentage change in operating cash flow). Mathematically,
DOL =
% EBIT
% Sales
Other things being equal, the lower the DOL for the firm, the lower the chances for loss with a
decrease in sales. For example, DOL of 4 will mean a 80 per cent reduction in profits due to 20
per cent decrease in sales, and in that order, DOL of 3 will mean a 60 per cent reduction in
profits due to 20 per cent decrease in sales.
The risk associated with an investment increases as operating leverage (i.e., fixed costs)
increases (Lev, 1974) because the cash flow associated with an investment which is equal to its
total costs (i.e. fixed and variable costs) subtracted from its sales revenue, carries more downside
risk (i.e., risk when sales revenue falls) when fixed costs are high. Business risk is the
uncertainty associated with organizations operating environment and reflected in the variations
of operating income and hence, has a negative impact on the profitability of a given organization
(Madhani, 2010b). Business risk is greatly influenced by the amount of fixed costs used in a
firms operation. Generally, the greater the reliance on fixed costs, the lower the variable costs
and vice versa. When this concept is applied to compensation management, fixed cost of the
organization increases only when base salary is used in compensation structure. However, when
a portion of employee salary is tied to firms performance, employee costs will be lower when
the firm has less ability to pay and higher when ability to pay is higher (Gerhart & Milkovich,
1990). Hence, when a group of employees is paid under a variable, rather than fixed
compensation system, strategy of maintaining employment stability in the firm is a less risky
proposition (Gerhart & Trevor, 1996).
The DOL is directly proportional to a firms level of business risk, and therefore it serves as a
proxy for business risk. Hence, as shown in Figure 2, proactive IT firms will employ strategy of
reducing OL when business risk is high especially influenced by external factor such as business
cycle contraction phase or recession.
Fixed pay / Total Pay
High
Low
Low
High
Business risk
Competitive Advantage
Proactive
IT firms
Passive
IT firms
High
Low
High
Low
Operating leverage (OL)
Figure 2. Relationship of business risk and operating leverage (OL) during business cycle
(Contraction phase)
(Source: Matrix developed by author)
However, passive IT firms do not change their OL and pay mix by restructuring fixed and
variable pay hence; they continue to misalign OL with business cycle. Passive IT firms continue
to give higher level of pay and higher proportion of fixed pay in pay mix even after economy
enters in recession and revenue of IT firm declines. Hence, passive IT firms have high OL during
recession period. Economic slowdown such as recession necessitates a rapid response, so
proactive IT firms restructure their cost structure by reducing fixed cost and increasing variable
cost. This way, proactive IT firms reduce OL and business risk and hence, enhance competitive
advantage. Passive IT firms, fail to recognize the changing dynamics of external environment
and hence continue to lose value to more nimble, proactive IT firms.
Low
Low
Hence, when a group of employees is paid under a variable, rather than fixed, compensation
system, it provides better fit between pay mix and business cycle contraction phase (i.e.
recession). As variable pay reduces OL, it also reduces misfit between OL and business cycle
contraction phase (i.e. recession). This is shown in matrix of Figure 3.
Proactive
IT firms
Low fixed pay &
operating
leverage
Passive
IT firms
High fixed pay &
operating
leverage
High
Low
High
Figure 3. Relationship between fit of pay structure and business cycle and misfit of
operating leverage (OL) and business cycle (Contraction phase)
(Source: Matrix developed by author)
budgets during a down cycle. The slowdown in the US financial service dampened the hiring of
employees by top Indian IT firms in 2008-09 but employee cost, which contributes the most to
overall cost of IT firms, rose heftily in the second quarter as shown in Table -II.
Increase
(per cent)
33
34
26
28
30
Net Employee
Addition
Q2
Q2
2008-09
2007-08
1814
3037
1877
6096
5927
4530
5238
9268
14856
22931
Increase /
Decrease
(per cent)
-40
-69
31
-43
-35
Table III: Restructuring Fixed and Variable Pay of an IT Service Firm: An Illustration
Global Recession
No.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
Calculation
Annual IT Contracts
Decline in annual contracts due to global recession (per
cent)
Unit charge of annual IT contract ($)
IT contract sales revenue ($) = (1) x (3)
Unit variable cost ($)
Variable cost = (5) x (1)
Fixed pay ($)
Other fixed overhead ($)
Total fixed cost ($) = (7) + (8)
Sales revenue commission (per cent)
Variable pay cost ($) = (4) x (10)
Total variable cost of IT contract ($) = (6) + (11)
Total variable cost /IT contract ($) = (12) / (1)
Unit contribution margin ($) = (3) (13)
Contribution margin ($) = (14) x (1)
Contribution margin ratio = (14) / (3)
Total cost ($) = (9) + (12)
Before tax profit (EBIT) ($) = (4) (17)
Degree of operating leverage (DOL) = (15) / (18)
Break-even point (BEP) ($) = (9) / (16)
Break-even point (Contracts) = (20) / (3)
Beta (Estimated)
Cost of Capital
Decline in profitability due to 20 per cent decrease in
contract sales (per cent) = 0.2 x (19)
Proactive Passive
Base case IT Firm IT Firm
4000
3600
3600
100
400000
30
120000
80000
110000
190000
0
0
120000
30
70
280000
0.7
310000
90000
3.11
271429
2714
-10
100
360000
30
108000
0
110000
110000
20
72000
180000
50
50
180000
0.5
290000
70000
2.57
220000
2200
Low
Low
-10
100
360000
30
108000
80000
110000
190000
0
0
108000
30
70
252000
0.7
298000
62000
4.06
271429
2714
High
High
51
81
Hence, during a period of recession, a proactive firm with a lower DOL, due to higher emphasis
on variable compensation will produce profitability estimates that are more consistent with actual
results and will in turn benefit from more consistent and predictable financial returns. This
results in decreased information asymmetry between firms and other stakeholders, and, with a
decrease in information risk premium, beta, or the market risk of the firm will also decrease.
Decrease in market risk of the firm, will also decrease cost of capital. As explained above,
proactive firm can improve its financial performance by reducing its OL and BEP, as a result of
shifting more compensation costs from a fixed to a variable form. Detailed calculation of
operating leverage and BEP for proactive IT firm is shown in Table III.
As calculated in the above illustration, the shift from fixed pay to variable pay results in an
increase in variable costs, a decrease in fixed costs, along with a decrease in BEP and DOL.
Hence, a low DOL signals the existence of a low portion of fixed costs. The rationale underlying
this computation is that as variable costs are substituted for fixed costs, the contribution margin
as a percentage of income before taxes decreases. With other conditions remaining same, it will
also decrease the beta or market risk of the firm. Shifting to more variable compensation also
helps to reduce proactive IT firms BEP as shown in Figure 4, which results in the firm being
able to become profitable more quickly. Hence, proactive IT firm has lower decrease in beforetax profits, a lower BEP, a lower DOL, lower market risk or beta, lower cost of capital and its
profits vary less with changes in sales volume as shown in Table III.
On the other hand, passive IT firm do not do anything during the recession period to lower fixed
cost or reduce fixed pay in compensation structure and continue to employ technical support staff
for service contact on a high pay level of erstwhile growth period that is fixed salary of
$80,000. Hence, it results in higher OL of 4.06 and higher decrease in before-tax profits for the
firm, as calculated in Table III. Also, BEP of passive IT firm does not decrease and remain
unchanged (Table 2). BEP chart for passive IT firm is shown in Figure 5.
to some form of variable pay, employees will likely to leave their jobs, creating in turn,
sizeable turnover costs.
5. Variable pay plans are not suitable for technical support / services and customer related
support task for existing customers.
In this situation, it is necessary to identify optimal ratio of fixed and variable pay in
compensation structure for the IT firms. According to Madhani (2009), the optimal ratio of fixed
pay and variable pay in compensation structure is firm specific and should occur where the EVA
(economy value added) of the firm is maximized. EVA is described as the gauge that suitably
accounts for all of the complex trade-offs involved in creating value and determining the right
measure to use for setting goals and evaluating performance. Balkin and Mejia (1990) also
addressed the importance of combination of variable pay and fixed pay in pay structure and
discussed the importance of matching of compensation strategy with organizational strategy. If
compensation strategy works well with organizational strategy then the firm will have a better
overall performance. This will also build competitive advantages for the IT firms as described
below:
1. Compensation strategy will attract best talent to the IT firm, retain existing employees,
control cost, stimulate, and motivate employees.
2. The compensation strategy that matches with corporate strategy and HR strategy will be
difficult for competitors to imitate, hence provide competitive advantages to IT firm.
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