McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Compensation: Methods and Policies chapter 11

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved A Compensation system should be: (* focus of this chapter) Adequate Equitable Balanced* Cost-effective* Secure* Incentive- providing Acceptable to the employee*

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved To the individual employee, the most important compensation decision is how much he or she will earn.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Determination of Individual Pay Three questions need to be addressed: 1. How should one employee be paid relative to another when they both hold the same job in the organization? 2. Should we pay all employees doing the same work at the same level the same? 3. If not, on what basis should we make the distinction?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Pay differentials are based on: 1. Individual differences in experience, skills, and performance 2. Expectations that seniority, higher performance (or both) deserve higher pay

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Reasons for choosing to pay employees at different rates for the same job: (1 of 3) Pay differentials allow firms to recognize that different employees performing the same job make substantially different contributions to meeting organizational goals Differentials allow employers to communicate a changed emphasis on important job roles, skills, knowledge, etc.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Reasons for choosing to pay employees at different rates for the same job: (2 of 3) Differentials provide organizations with an important tool for emphasizing norms of enterprise without having employees change jobs (i.e., promotion) Pay differentials allow firms to recognize market changes between jobs in the same grade without requiring a major overhaul of the whole compensation system

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Reasons for choosing to pay employees at different rates for the same job: (3 of 3) Without differentials, the pay system violates the internal equity norms of most employees, reducing satisfaction with pay, and making attraction and retention of employees more difficult

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Methods of Payment Flat Rates Payment for Time Worked Variable Pay: Incentive Compensation

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Payment for Time Worked General, across-the-board increase for all employees Merit increases paid to some employees based on some indicator of job performance Cost-of-living adjustment (COLA) based on the consumer price index (CPI) Seniority

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Variable Pay Percentage of an employees paycheck is put at risk If business goals are not met, the pay rate will not rise above the lower base salary Annual raises are not guaranteed Helps manage labor costs Does not guarantee equitable treatment of employees

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Support by management Acceptance by employees Supportive organizational culture Timing Variable Pay: Key Design Factors

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Types of Variable Pay Individual Incentives Group Incentives Organization Incentives

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Individual Variable Pay Merit incentives Individual incentives piecework production bonuses commissions

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Merit Pay Problems 1. Employees fail to make the connection between pay and performance 2. The secrecy of the reward is perceived by other employees as inequity 3. The size of the merit award has little effect on performance

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Individual Incentives Possible only in situations where performance can be specified in terms of output e.g., sales dollars generated e.g., number of items completed Employees must work independently of each other so that individual incentives can be applied equitably

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Conditions for Effective Individual Incentive Plans 1. The task is liked 2. The task is not boring 3. The supervisor reinforces and supports the system 4. The plan is acceptable to employees and managers 5. The incentive is financially sufficient to induce increased output 6. Quality of work is not especially important 7. Most delays in work are under the employees control

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Reasons to Use Team Incentives When it is difficult to measure individual output When cooperation is needed to complete a task or project When management feels this is a more appropriate measure on which to base incentives

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Organization-wide Incentives Usually based on one of two performance concepts: A sharing of profits generated by all employees altogether A sharing of money saved as a result of employees efforts to reduce costs

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Approaches to Organization-wide Incentives Suggestion Systems Gainsharing Profit Sharing Ownership

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Suggestion Systems: Essential Elements 1. Management commitment 2. Clear goals 3. Designated administrator 4. Structured award system 5. Regular publicity 6. Immediate response to each suggestion

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Gainsharing Plans Employees earn bonuses tied to unit-wide performance as measured by a predetermined, gainsharing formula Commonly used gainsharing plans: Lincoln Electric Plan Scanlon Plan Rucker Plan ImproShare

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Key Elements in Designing a Gainsharing Plan Strength of reinforcement Productivity standards Sharing the gains Scope of the formula Perceived fairness of the formula Production variability

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Newer Approaches to Gainsharing Business Plan Gainsharing Winsharing Spot Gainsharing

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Typical Profit Sharing Plans 1. Cash or current distribution plans provide full payment to participants soon after profits have been determined 2. Deferred plans credit a portion of current profits to employees accounts with cash payments made at the time of retirement, disability, severance, or death 3. A combination of both incorporates aspects of current and deferred options

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Ownership Employee stock ownership plan (ESOP) – employees receive stock in the company ESOPs are tax qualified i.e., in return for meeting certain rules designed to protect the interests of plan participants, ESOP sponsors receive various tax benefits ESOPs are defined contribution plans the employers makes yearly contributions that accumulate to produce a benefit that is not defined in advance

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved People-Based Pay Skill-Based Pay Knowledge- Based Pay Credential- Based Pay Feedback Pay

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Executive Pay More likely to be based on comparative performance: 1. Compensation committees link CEOs pay to returns to shareholders 2. Variable performance-based pay is emphasized over guarantees 3. CEOs are encouraged to invest in company stock 4. Performance yardsticks are linked to actual key productivity indices, to the competition, or to both 5. CEOs are held responsible for the cost of capital

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Issues in Compensation Administration Pay Secrecy or Openness Pay Security Pay Compression

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Guaranteed Annual Wage (GAW) Supplementary Unemployment Benefits (SUB) Cost of Living Adjustments (COLAS) Severance Pay Pay Security Plans

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Solutions to the Problem of Pay Compression (1 of 2) 1. Reexamining how many entry-level people are needed 2. Reassessing recruitment itself 3. Focusing on the job evaluation process, emphasizing performance instead of salary- grade assignment 4. Basing all salaries on longevity

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Solutions to the Problem of Pay Compression (2 of 2) 5. Giving first-line supervisors and other managers the authority to recommend equity adjustments for incumbents who have been unfairly victimized by pay compression 6. Limiting the hiring of new employees seeking excessive salaries

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc. All rights reserved Summary There is a growing realization that traditional pay systems do not effectively link pay to performance The trend is toward a total compensation approach made up of base pay, variable pay, and benefits Flexibility is an essential ingredient in any compensation plan and can be built using a variable pay approach