1-1 McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Human Resource Management Gaining a Competitive Advantage Chapter 12 Recognizing Employee Contributions with Pay

12-2 Learning Objectives After reading this chapter, you should be able to: Discuss how pay influences individual employees and describe three theories that explain the effect of compensation on individuals. Describe the fundamental pay programs for recognizing employees’ contributions to the organization’s success. List the advantages and disadvantages of the pay programs.

12-3 Learning Objectives After reading this chapter, you should be able to: Describe how organizations combine incentive plans in a balanced scorecard. Discuss issues related to performance-based pay for executives. Explain the importance of process issues such as communication in compensation management. List the major factors to consider in matching the pay strategy to the organization’s strategy.

12-4 Introduction Organizations have a relatively large degree of discretion in deciding how to pay. Each employee’s pay is based upon individual performance, profits, seniority, or other factors. Regardless of cost differences, different pay programs can have very different consequences for productivity and return on investment.

12-5 How Does Pay Influence Individual Employees? Three different theories help explain compensation’s effects: Reinforcement Theory Agency Theory Expectancy Theory

12-6 How Does Pay Influence Individual Employees? Reinforcement Theory - A response followed by a reward is more likely to recur in the future. Expectancy Theory - Motivation is a function of valence, instrumentality, and expectancy. Agency Theory -The interests of the principals (owners) and their agents (managers) may no longer converge. –Types of agency costs include: perquisites attitudes towards risk decision-making horizons

12-7 Agency Costs Agency costs may be minimized by the principal choosing a contracting scheme that helps align the interests of the agent with the principal's own interests. The type of contract depends partly on the following factors: –risk aversion –outcome uncertainty –job programmability –measurable job outcomes –ability to pay –tradition

12-8 Programs for Recognizing Employee Contributions Programs differ by payment method, frequency of payout, and ways of measuring performance. Potential consequences of such programs are performance motivation of employees, attraction of employees, organization culture, and costs. Contingencies that may influence whether a pay program fits the situation are management style, and type of work. Merit Pay Incentive Pay Gain Sharing Ownership Profit Sharing Skill-based

12-9 Merit Pay Merit pay programs link performance- appraisal ratings to annual pay increases. A merit increase grid combines an employee’s performance rating with the employee’s position in a pay range to determine the size and frequency of his or her pay increases. Some organizations provide guidelines regarding the percentage of employees who should fall into each performance category.

12-10 Merit Pay Edward W. Deming, who is a critic of merit pay, argues that it is unfair to rate individual performance because "apparent differences between people arise almost entirely from the system that they work in, not the people themselves.” Criticisms of merit pay include: –The focus on merit pay discourages teamwork. –The measurement of performance is done unfairly and inaccurately. –Merit pay may not really exist.

12-11 Individual Incentives Individual incentives reward individual performance, but payments are not rolled into base pay, and performance is usually measured as physical output rather than by subjective ratings. They are relatively rare because: –Most jobs have no physical output measure. –There are many potential administrative problems. –Employees may do what they get paid for and nothing else. –They typically do not fit in with the team approach. –They may be inconsistent with organizational goals. –Some incentive plans reward output at the expense of quality or customer service.

12-12 Profit Sharing Under profit sharing, payments are based on a measure of organization performance (profits), and payments do not become a part of base pay. –The advantage is that profit sharing may encourage employees to think more like owners. –The drawback is that workers may perceive their performance has little to do with profit but is more related to top management decisions over which they have little control.

12-13 Ownership Ownership encourages employees to focus on the success of the organization as a whole, but, like profit sharing, ownership may be less motivational the larger the organization. One method to achieve employee ownership is through stock options, which give employees the opportunity to buy company stock at a previously fixed price. Employee stock ownership plans (ESOPs) are employee ownership plans that give employers certain tax and financial advantages when stock is granted to employees. –ESOPs can carry significant risk for employees.

12-14 Gainsharing Gainsharing programs offer a means of sharing productivity gains with employees, and are based on group or plant performance that does not become part of the employee’s base salary. Conditions that should be in place for gainsharing to be effective include: –management commitment –a need to change or a strong commitment to continuous improvement –management's acceptance and encouragement of employee input

12-15 Gainsharing Conditions that should be in place for gainsharing to be effective include: –high levels of cooperation and interaction –employment security –information sharing on productivity and costs –goal setting –commitment of all involved parties to the process of change and improvement –agreement on a performance standard and calculation that is undesirable, seen as fair, and closely related to managerial objectives

12-16 Group Incentives and Team Awards Group incentives tend to measure performace in terms of physical output Team award plans may use a broader range of performance measures. Drawbacks are that individual competition may be replaced by competition between groups or teams.

12-17 Balanced Scorecard Some companies find it useful to design a mix of pay programs. The four categories of a balanced scorecard include: –financial –customer –internal –learning and growth

12-18 Managerial and Executive Pay Top managers and executives are a strategically important group whose compensation warrants special attention. In some companies rewards for executives are high regardless of profitability or stock market performance. Executive pay can be linked to organizational performance (from agency theory). There has been increased pressure from regulators and shareholders to better link pay and performance. –The Securities and Exchange Commission (SEC)

12-19 Process and Context Issues Three issues represent areas of significant company discretion and pose opportunities to compete effectively: Employee Participation in Decision Making Communication Pay and Process: Intertwined Effects

12-20 Matching Pay Strategy and Organization Strategy Pay Strategy Dimensions Risk sharing (variable pay) Time orientation Pay level (short-run) Pay level (long-run potential) Benefits level Centralization of pay decisions Pay unit of analysis Concentration Low Short-term Above market Below market Above market Centralized Job Growth High Long-term Below market Above market Below market Decentralized Skills Organization Strategy