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McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 11

Compensation: Methods and Polices

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Introduction
Secure Compensation should be Balanced Cost-effective Acceptable to employees Whether pay should be secret These aspects of acceptability will be discussed Communication to achieve acceptability Employee participation in pay decision making

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Determination of Individual Pay

Management must answer these questions
How should one employee be paid relative to another when they both hold the same job? Should all employees doing the same work, at the same level, be paid the same?

Most employers pay different rates to employees performing the same job based on
Differences in experience, skills, and performance Belief that seniority, higher performance, or both deserve higher pay

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Determination of Individual Pay

Reasons to pay different rates for the same job

Employees performing the same job make substantially different contributions to goals
Changed emphasis on job roles, skills, knowledge

Emphasizes the norms of enterprise without having employees change jobs

Satisfies the internal equity norms of employees

Recognizes market changes between jobs in the same grade without overhauling the whole system

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Methods of Payment

Time

worked Output produced Skills Knowledge Competencies A combination of these factors

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Flat Rates
Unions prefer single flat rates Corresponding to some midpoint on a market survey for a given job Seniority and experience are ignored Unions dislike performance differentials

Performance measures are inequitable

Could harm jobs that need cooperative effort

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Flat Rates

Paying flat rate versus different rates depends on the objectives of the compensation analyst Managers use pay differentials to recognize these differences, and to encourage an experienced, efficient, and satisfied workforce

Recognizing differences assumes employees are not interchangeable or equally productive

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Payment for Time Worked

Wage pay calculated at an hourly rate Salary pay calculated at an annual or monthly rate Across-the-board Merit Pay is adjusted upward through increases Cost-of-living adjustment Seniority

Most employees are paid for time worked

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Variable Pay: Incentive Compensation

Any compensation plan that emphasizes a shared focus on organizational success, broadens opportunities for incentives to nontraditional groups, and operates outside the base pay increase system.

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Variable Pay: Incentive Compensation

Employees receiving variable pay

Hourly nonunion

Nonexempt

Exempt

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Variable Pay: Incentive Compensation

Clear goals

Successful variable pay systems are based on

Unambiguous measurements
Visible linkage to employees' efforts Support by management

Key design factors

Acceptance by employees Supportive organizational culture

Timing

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Variable Pay: Incentive Compensation

If goals aren't met, the pay rate will not rise above the base salary

Annual raises are not guaranteed

A percent of employees paycheck is at risk The individual earns all or part of the bonus by meeting objectives Pay returns to base level the next year; employees must again compete for the variable reward

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Variable Pay: Incentive Compensation

Total

compensation includes Base, variable, and indirect pay

Variable

pay helps manage labor costs, but does not guarantee equitable treatment of employees Financial insecurity is built into the system As a result, productivity may actually decline employees on the basis of output is usually referred to as an incentive

Paying

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Merit Incentives
The most widely used plan for managing individual performance

A reward based on how well a job was done

Traditionally results in a higher base salary after an annual performance evaluation

Merit increases usually spread evenly throughout the subsequent year

80 to 90% of firms offer merit raises, but little research has examined merit pay or its effects

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Merit Incentives
Advocates claim merit pay is the most valid type of pay increase Awards are directly linked to performance

Rewarding the best performers with the largest pay is claimed to be a powerful motivator
This premise has two flawed assumptions Competence & incompetence are distributed in evenly within a work group Every supervisor is a competent evaluator

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Merit Incentives
Employees dont make the connection between pay and performance

Many merit pay systems fail

Secrecy of the reward is perceived as inequity

The award is too small to affect performance

Performance criteria are well delineated and assessable

There is a compensation and career plan

Merit plans can work where

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Merit Incentives
Depends on a reward to produce an effect
A promise of increased salary in exchange for satisfactory future work

Focus is on the individual

Employees likely to compete with each other, rather than collaborate or share resources

The oldest form of compensation

Employee is paid for units produced Piecework, production bonuses, commissions

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Individual Incentives: Straight Piecework

The most common individual incentive plan
Pay based on units of production per time period Work standards set through work measurement studies, modified by collective bargaining

Easy for employees to understand, but setting work standards is hard

Standard-hour plan bases wages on completion of a job or task in an expected period of time Ideal for long cycle operations and highly skilled, non-repetitive jobs

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Individual Incentives: Differential Piece Rate

One rate for those producing below or up to standard

Differential piece rate

Another rate for those producing above standard

Designed to reward highly efficient workers and penalize the less efficient Also known as the Taylor plan

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Individual Incentives: Production Bonus

Pays an hourly rate plus a bonus when the standard is exceeded

Bonus usually equals 50 percent of labor savings

Not widely used in the United States

Japanese workers get semi-annual production bonuses

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Individual Incentives: Commissions

Based on a percentage of sales in units or dollars Straight commission equals straight piecework Typically a percentage of the price of the item Variation pays salesperson a small salary plus commission or bonus when sales goal exceeded

Only works if performance is specified in terms of output Employees must work independently of each other for individual incentives to be applied equitably

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Individual Incentives

Firms

with piece rate systems often find that problems result from the compensation plans If an employer tries to change work standards or pay rates, workers often oppose the changes
incentives increase output, but other performance criteria may suffer Some jobs paid at piece rate should not be

Individual

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Individual Incentives
Likely to be effective if
The supervisor reinforces and supports the system Quality of work is not especially important The plan is acceptable to employees and managers Work delays are under the employees' control

The task is liked and not boring

The incentive is large enough to increase output

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Team Incentives

Reasons to choose a team incentive plan 1. Its hard to measure individual output 2. Cooperation is needed to complete a task or project 3. Management thinks this is a more appropriate measure on which to base incentives 4. Need/desire to reduce administrative costs

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Team Incentives
The

Japanese use team incentives to foster group cohesiveness and reduce jealousy In the U.S., there may be a clash between societal norms and group incentive systems

For

small-group incentives to be effective, management must Define objectives Analyze the situation Select an appropriate group incentive

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Team Incentives
In individual and group incentive systems, competition can result in
Withholding information or resources Political gamesmanship Not helping others

Sabotaging the work of others

To minimize these problems, some organizations are using organizationwide incentive plans

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Organizationwide Incentives
Sharing profits generated by the efforts of all Sharing money saved as a result of employees' cost-cutting efforts Suggestion systems Approaches Company group incentive plans (gainsharing) Profit sharing

Payments based on two concepts

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Suggestion Systems
A

formal method of obtaining employee advice about organizational effectiveness Includes some reward based on successful application of the idea The key to success is employee involvement Very cost-effective systems can Improve employee relations Foster high-quality products Reduce costs Increase revenue

Suggestion

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Suggestion Systems

Management commitment

Clear goals

A successful suggestion system includes

Immediate response to suggestions

Regular publicity

Designated administrator

Structured award system

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Gainsharing Incentive Plans

Uses a financial formula to

Distribute organizationwide gains Unite diverse organizational elements in the common pursuit of improved organizational effectiveness Improved productivity Reduced costs Improved quality

Through cash bonuses, these systems share the benefits of

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Gainsharing Incentive Plans

Exceptionally

good at enhancing teamwork in Manufacturing organizations Service organizations plans Lincoln Electric Scanlon Rucker ImproShare

Gainsharing

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Lincoln Electric Plan

Employees are paid only for what they individually produce

No paid holidays, sick leaves, or unions Promotions are based on merit

The most successful gainsharing or productivity sharing plan

Job reassignments must be accepted

Overtime is mandatory

Developed by James F. Lincoln in 1907

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Lincoln Electric Plan

Compensation rests on these principles All compensation is based on piecework No perquisites for managers After two years, a worker cannot be laid off

No mandatory retirement
Lincoln Electric hasnt has a layoff in 40 years, nor lost money in 57

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Lincoln Electric Plan

2/3 of employees participate They own 1/3 of the total stock

The firm has a stock purchase plan

The company subcontracts work to the group Bonus does not substitute for good wages and benefits

Employees hire replacements for vacancies in their work group

When established standards are beaten, employees share generously

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Comparison of Gainsharing Plans

Dimension Scanlon Rucker ImproShare

Philosophy; Original single unit; theory share improvements; people capable of and willing to make suggestions
Primary goal Subsidiary goals Productivity improvement Attitudes, communication, work behaviors, quality, cost reduction

Primarily economic incentive; some reliance on employee participation

Improved productivity Attitudes, communication, work behaviors, quality, cost reduction

Economic incentives increase performance

Improved productivity Attitudes, work

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Comparison of Three Gainsharing Plans

Dimension Scanlon Rucker Screen committee and production committee (sometimes) Formal None ImproShare Bonus committee

Worker Screening participation committee (one) and production committees (many) Suggestion making Role of supervisor Role of managers Formal Chair of production committee

None None None

Direct participation Ideas coordinators: in bonus committee evaluate suggesassignments tions, committee assignments

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Comparison of Three Gainsharing Plans

Dimension Scanlon Rucker ImproShare

Bonus formula

Sales Payroll

Bargaining unit payroll Production value

Monthly Negotiated provisions; screening committee membership Slight

Engineering standard X Base productivity

Weekly Negotiated provisions

Payout Role of union

Monthly Negotiated provisions; screening committee membership Substantial

Impact on mgmt style

None

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New Gainsharing Schemes

Business plan gainsharing

Future-oriented goals determine performance standards

All employees in the group "win" or share equally when goals are met Differs from profit sharing in that to grant awards the company must profit from the results of the team's efforts

Winsharing

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Traditional Gainsharing Schemes

Traditional gainsharing plans like the Scanlon plan fall short in three areas They tend to become institutionalized and thus fail to continue to vary pay with performance

They are not flexible enough to reward "star performers"

Service-sector firms are unable to isolate or measure productivity gains

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Spot Gainsharing

Focuses on a specific problem in a specific department

The goal is to produce peak performance during a specified time period Generally focused on a solution to a specific production problem Employees know the plan ends once the problem is solved, so bonuses are seen as rewards for extra effort

The firm must identify a clear business need unrelated to any failure of management or employees in the unit

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Successful Gainsharing

Employee involvement is critical

Workers must be motivated to assume new and expanded roles

Surveys of employees can help predict how the workforce will respond to the gainsharing scheme
The firm must dedicate the cost-accounting support necessary to ensure accurate and challenging productivity targets

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Unsuccessful Gainsharing Plans

Poorly designed bonus formulas Extended periods of low or no bonuses Lack of management support Cost factors undermine the bonus formula

Poor communication

Lack of trust Administration costs exceed the plan benefits Employee apathy

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Profit-Sharing Plans
Distribute

a fixed percentage of total profit to employees in cash or deferred bonuses Profit sharing is not dominant in other industrialized countries found in three combinations Cash or current distribution plans Deferred plans A combination of both

Typically

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Profit-Sharing Plans

Incentive

value of profit-sharing declines as The time between performance and payoff increases The size of the payoff declines plans have distinct advantages They do not need elaborate cost-accounting systems to calculate rewards Companies of any size can implement them

Profit-sharing

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Ownership

Employee Ownership Plan (ESOP)

Similar to profit sharing, goal is to increase worker commitment and performance A qualified, defined contribution benefit plan that invests primarily in company stock Employer makes yearly contributions that accumulate to produce a benefit

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People-Based Pay

Skill based

Variants of people-based pay

Competency based

Knowledge based

Feedback Credential based

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Skill-Based Pay
Skill-based

pay sets pay levels on the basis of How many skills employees have, or How many jobs they can do positive outcomes Increased quality Higher productivity More flexible workforce Improved morale Decreased absenteeism and turnover

Expected

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Skill-Based Pay

Methods

for defining individual

skills: Direct observation Testing Measurable results

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Skill-Based Pay

Instead of job descriptions, "person" and "skill block" descriptions are developed

Skill block descriptions are priced much like job evaluations

Used for manufacturing workers and routine, highvolume jobs

The more a job has performance outcomes, the better the fit of the pay model

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Skill-Based Pay
Drawbacks Difficult to design Time-consuming to construct skill blocks, map pay progressions, assign dollar values to skills Does not fit all situations Works best when built on a broad base of skills in a stable but expanding work environment

Major advantage for employers Can replace annual raises No raise, even if promoted, until proficiency with new skills is demonstrated

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Knowledge-based Pay
Rewards employees for acquiring knowledge
Applies to current and new jobs Stretches the skill-based model to professionals, managers, and some technical personnel

A study of two manufacturing plants

One used job-centered pay; the other a knowledge-based design

After 10 months, the pay-for-knowledge plant had higher quality, lower absenteeism, fewer accidents The traditional plant had higher productivity

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Credential-based Pay

Rests on the fact that an individual must have A diploma or license, or Pass one or more exams from a thirdparty professional or regulatory agency More cut-and-dried than skill- or knowledge-based pay

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Feedback Pay
Aligning pay with strategic business objectives Based on Establishing direct connection between jobholder and his/her part in accomplishing goals Flows directly from strategic business goals Directly links employees' actions to these goals Sufficient opportunity for rewards to hold employees' attention Timely

Must conform to four principles

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Competency Pay

A combination of skill-, knowledge-, and credential-based pay Term often applied to skill-based pay designs used with highly educated "knowledge workers" Difficult to assign dollar value with this model

Includes personal characteristics in addition to skills, knowledge, credentials

Competencies are independent of the job and can be taken from job to job by the individual

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Executive Pay

The

Enron scandal brought attention to CEO compensation and stock option programs Some question whether any CEO is worth pay packages that exceed $100 million/year The new mantra is pay for performance

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Executive Pay
The

popularity of stock options is waning Fewer CEOs are receiving stock options More boards of directors are reviewing the long-term incentives awarded to senior executives

Executive

compensation has grown dramatically compared to non-executive pay From 140 times what the average worker earns to over 400 times

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Executive Pay

Excessive for a number of reasons Passive boards that do not question pay

No arms length bargaining

Pay is less sensitive to performance

Compensation portion is often a less significant amount of the total pay

No incentives to align manager and shareholder interests

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Stock Options
The right to purchase a specific number of shares of a firms stock At a predetermined price During a specified time period Allows employees to share in the growing value of a company without risking money Gain can be greater than annual compensation Not taxed until exercised and/or the stock is sold

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Issues in Compensation Administration

Managers must make policy decisions that involve the extent to which

Compensation will be secret Compensation will be secure Pay is compressed

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Pay Secrecy or Openness

Open system
Pay ranges/individual pay open to public & fellow employees Public sector, universities, union members Pay known only to employee, superior, HRM Employees cant discuss pay matters or own pay What do employees want to know about pay?

Secret system

Deciding

Will the information harm or help the firm? Weigh performance, interdependence, and causal relationships

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Pay Security
Current compensation can motivate performance

So can belief in future compensation security Plans for providing this security A guaranteed annual wage (GAW) Supplementary unemployment benefits (SUB)
Cost of living allowances (COLAs)

Severance pay
Seniority rules Employment contracts

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Pay Compression
Occurs when employees perceive too narrow a difference between their pay and that of colleagues There is a narrowing gap between senior and junior employees & between supervisors and subordinates Differentials of 10 percent or less are not unusual Junior employees are sometimes brought in at salaries greater than those of their superiors

The resulting low morale can lead to decreasing productivity, higher absenteeism, and turnover
To identify pay compression, compare salaries and incumbents' years of experience with the company

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Pay Compression
Solutions for Pay Compression
Reexamine how many entry-level people are needed Emphasize performance instead of salarygrade assignment

Reassess recruitment

Base all salaries on longevity

Let first-line managers recommend equity adjustments

Limit the number of new hires with excessive salaries