CHAPTER 9

Flexible compensation is based on the idea that only the individual employee knows what package of
rewards would best suit personal needs. Employees who hate risk could opt for more base pay and less
incentive pay. Tradeoffs between pay and benefits could also be selected. The key ingredient in this new
concept is careful cost analysis to make sure the dollar cost of the package an employee selects meets
employer budgetary limits.

Expectancy theory argues that people behave as if they cognitively evaluate what behaviors are possible
(e.g., the probability that they can complete the task) in relation to the value of rewards offered in
exchange. According to this theory, we choose behaviors that yield the most satisfactory exchange.
Equity theory also focuses on what goes on inside an employee’s head. Not surprisingly, equity theory
argues that people are highly concerned about equity, or fairness of the exchange process. Employees
look at the exchange as a ratio between what is expected and what is received.

DESIGNING A PAY-FOR-PERFORMANCE PLAN

A recent survey of HR professionals indicates widespread use of different pay-forperformance plans

Exhibit 9.8. Our pay model suggests effectiveness is dependent on three things: efficiency, equity, and
compliance in designing a pay system

Efficiency

Efficiency involves three general areas of concern. Strategy Does the pay-for-performance plan support
corporate objectives? For example, is the plan cost-effective, or are we making payouts that bear no
relation to improved performance on the bottom line? Similarly, does the plan help us improve quality of
service? Some pay-for-performance plans are so focused on quantity of per formance as a measure that
we forget about quality. Defect rates rise. Customers must search for someone to handle a merchandise
return. A number of things happen that aren’t consistent with the emphasis on quality that top
organizations insist upon.

Structure

Is the structure of the organization sufficiently decentralized to allow different operating units to create
flexible variations on a general pay-for-performance plan? For example, IBM adapted performance
reviews to the different needs of different units, and the managers in them, resulting in a very flexible
system. In this new system, midpoints for pay

grades don’t exist. Managers get a budget, some training on how to conduct reviews, and a philosophical
mandate: Differentiate pay for stars relative to average performers, or risk losing stars. Managers are
given a number of performance dimensions. Determining which dimensions to use for which employees
is totally a personal decision.

Standards

Operationally, the key to designing a pay-for-performance system rests on standards. Specifically, we

need to be concerned about the following: Objectives: Are they specific yet flexible? Can employees see
that their behavior influences their ability to achieve objectives (called the “line-of-sight” issue in
industry)? Measures: Do employees know what measures (individual appraisals, peer reviews of team
performance, corporate financial measures, etc.) will be used to assess whether performance is
sufficiently good to merit a payout? Eligibility: How far down the organization will the plan run?
Companies like PepsiCo and Starbucks believe all employees should be included. Others think only top
management can see how their decisions affect the bottom line. Funding: Will you fund the program out
of extra revenue generated above and beyond some preset standard? If so, what happens in a bad year?
Many employees become disillusioned when they feel they have worked harder but economic conditions
or poor management decisions conspire to cut or eliminate bonuses.

Equity/Fairness

Our second design objective is to ensure that the system is fair to employees. Two types of fairness are
concerns for employees. The first type is fairness in the amount that is distributed to employees. Not
surprisingly, this type of fairness is labeled distributive justice . 86 Does an employee view the amount of
compensation received as fair? As we discussed earlier in the section on equity theory, perceptions of
fairness here depend on the amount of compensation actually received relative to input (e.g.,
productivity) compared against some relevant standard. Notice that several of the components of this
equity equation are frustratingly removed from the control of the typical supervisor or manager working
with employees.

Compliance

Finally, our pay-for-performance system should comply with existing laws. We want a reward system that
maintains and enhances the reputation of our firm. Think about the companies that visit a college
campus. For some of these companies, students naturally gravitate to interview opportunities—the
interview schedule fills very quickly indeed. Why? Because of reputation. 93 We tend to undervalue the
reward value of a good reputation. To guard this reputation, we need to make sure we comply with
compensation laws.