1. 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.
This chapter focuses on the design and administration of programs to reward individuals for their contribution to organizational success. Organizations have a relatively large degree of discretion in deciding how to pay. Differences in performance (by an individual, group, or the organization), seniority, or skills are used as a basis for differentiating pay among employees. Regardless of cost differences, different pay programs can have very different consequences for productivity and return on investment.

2. How Does Pay Influence Individual Employees?
Three different theories help explain compensation’s effects:
Reinforcement Theory
Besides the equity theory, described in the previous chapter, there are other theories that influence compensation's effects. There are three theories that help to explain compensations effects. These are the reinforcement theory, expectancy theory and the agency theory.
Expectancy Theory
Agency Theory

3. 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
The Reinforcement Theory—In Thorndike's Law of Effect, a response followed by a reward is more likely to recur in the future. The importance of a person's actual experience in receiving the reward is critical. If high performance is followed by a reward, high performance is likely to be repeated.
The Expectancy Theory—This theory says that motivation is a function of valence, instrumentality, and expectancy.
The Agency Theory—This theory focuses on divergent interests and goals of the organization's stakeholders and the ways that compensation can be used to align these interests and goals.

4. 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
Agency costs may be minimized by the principal choosing a contracting scheme that helps align the interests of the agent with the interests of the principals. These approaches can be behavior oriented (e.g., merit pay) or outcome oriented (e.g., stock options, profit sharing, commissions). Outcome­-oriented approaches link the rewards of the organization and individual.
However, agents are often risk‑aversive and may demand a compensating wage differential. Behavior­-oriented contracts do not transfer risk and therefore do not require a compensating wage differential. Deciding what to use is based on the following:

5. 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.
Table 12.1 in the text provides an overview of some programs and potential contributions. The 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
Skill-based
Profit Sharing
Gain Sharing
Ownership

6. 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.
Merit pay programs, annual pay increases are usually linked to performance appraisal ratings. The size and frequency of pay increases are most often deter­mined by performance rating (since better‑performing employees should be rewarded more than low performers) and position in range (compa‑ratio). Table 12.3 in your text indicates how compa‑ratio targets and performance ratings might be combined.

7. 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.
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." Examples of system factors are co‑workers, the job, materials, equipment, customers, management, supervision, and environmental conditions. These factors are the responsibility of management.

8. 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.
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. Monetary incentives increased production by 30 percent in a study by Locke. Individual incentives are relatively rare.

9. 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.
Under profit sharing, payments are based on a measure of organization performance (profits) and do not become part of the employees’ base salary. An advantage is that profit sharing may encourage employees to think more like owners and take a broad view of what needs to be done, labor costs are reduced in difficult economic times, and organizations may not have to rely on layoffs. A second advantage is that because payments do not become part of base pay, labor costs are automatically reduced during difficult economic times, and wealth is shared during good times. 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. Another motivational problem is that most plans are deferred.

10. 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.

11. 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
Gainsharing can be motivational for employees at a local plant. It also can be considered a type of bonus based on performance

12. 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
Gainsharing programs are based on group or plant performance (rather than organization wide profits) that does not become part of the employee’s base salary. One type of gainsharing, the Scanlon plan, provides a monetary bonus to employees (and the organization) if the ratio of labor costs to the sales value of production is kept below a certain standard. Table 12.6 indicates that there is often a strong emphasis on taking advantage of employee know-how to improve the production process through teams and suggestion systems.

13. 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.
Group incentives and team awards typically pertain to a smaller work group. Group incentives tend to measure performance in terms of physical output, whereas team award plans may use a broader range of performance measures. Drawbacks are that individual competition may be replaced by competition between teams. In addition, dimensions must be perceived as fair by employees, and these standards must not exclude important dimensions such as quality.

14. 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
Some companies find it useful to design a mix of pay programs. Relying exclusively on merit pay or individual incentives may result in high levels of work motivation but unacceptable levels of individualistic and competitive behavior and too little concern for broader plant or organization goals. Table 12.7 in your text shows how a mix of measures might be used be a manufacturing form to motivate improvements in a balanced set of key business drivers.

15. 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)
Because of their significant ability to influence organization performance, top managers and executives are a strategically important group whose compensation warrants special attention. One concern appears to be that in some companies rewards for executives are high regardless of organizational performance.
Organizations vary a great deal in the extent to which they use both short‑term and long‑term incentive programs.
There has been increased pressure from regulators and shareholders to better link pay and performance. The Securities and Exchange Commission (SEC) requires companies to report compensation level for the five highest paid executives and the company’s performance relative to that of competitors over a five-year period.

16. Great Britain 3-1 Japan 7-1 USA 450 -1 CEO Pay
A report that came out nearly a decade ago compared the average worker’s pay to that of a CEO’s pay in terms of ratio. For example, in Great Britain if an average worker earned $20K annually, the CEO earned $60K. As you can see, The US was far and beyond any of the other countries involved in the survey.

17. Process and Context Issues
Three issues represent areas of significant company discretion and pose opportunities to compete effectively:
Employee Participation
in Decision Making
Process and context issues consider employee participation in decision making and its potential consequences.
Involvement in the design and implementation of pay policies has been linked to higher pay satisfaction and job satisfaction.
Communication is critical since change in any part of the compensation system is likely to give rise to employee concerns.
It is suggested that changing the way workers are treated may boost productivity more than the way they are paid.
Pay and Process:
Intertwined Effects
Communication

18. 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
Centralized
Job
Growth
High
Long-term
Below market
Above market
Decentralized
Skills
Organization Strategy and Compensation Strategy: A Question of Fit— In choosing a pay strategy, one must consider how effectively it will further the organization’s overall over all business strategy. Table shown on this slide and found in your text suggests some matches of strategies.