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INealChapter 12
Recognizing Employee Contributions with Pay
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Learning Objectives
LO12-1 Discuss how pay influences individual employees, and describe three theories that explain the effect of compensation on individuals.
LO12-2 Describe the fundamental pay programs for recognizing employees’ contributions to the organization’s success.
LO12-3 List the advantages and disadvantages of the pay programs.
LO12-4 Describe how organizations combine incentive plans in a balanced scorecard.
LO12-5 Discuss issues related to performance-based pay for executives.
LO12-6 Explain the importance of process issues such as communication in compensation management.
LO12-7 List the major factors to consider in matching the pay strategy to the organization’s strategy.
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How Does Pay Influence Individual Employees? 1 of 6
Reinforcement Theory
A response followed by a reward is more likely to recur in the future
High employee performance followed by a monetary reward will make future high performance more likely
LO 12-1
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How Does Pay Influence Individual Employees? 2 of 6
Expectancy Theory
Emphasizes expected rewards
Focuses on the effects of incentives
The main influence of compensation is on instrumentality: the perceived link between behaviors and pay.
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How Does Pay Influence Individual Employees? 3 of 6
Expectancy Theory continued
Intrinsic and extrinsic motivation
Extrinsic motivation depends on rewards (such as pay and benefits) controlled by an external source
Intrinsic motivation depends on rewards that flow naturally from work itself
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How Does Pay Influence Individual Employees? 4 of 6
Agency Theory
The divergent interests and goals of the organization’s stakeholders (principles and agents)
The ways that employee compensation can be used to align these interests and goals
Goal congruence and incongruence
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Principle In agency theory, a person (e.g., the owner) who seeks to direct another person’s behavior.
Agent A person (e.g., a manager) who is expected to act on behalf of a principle (e.g., an owner).
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How Does Pay Influence Individual Employees? 5 of 6
Agency Theory continued
The principal must choose a contracting scheme that helps align the interests of the agent with the principal’s own interests
Outcome-oriented contracts
Behavior-based contracts
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How Does Pay Influence Individual Employees? 6 of 6
Agency Theory continued
What type of contract an organization should use depends on
Risk aversion
Outcome uncertainty
Job programmability
Measurable job outcomes
Ability to pay
Tradition
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How Do Pay Sorting Effects Influence Labor Force Composition?
Sorting Effect
Individual pay programs may affect the nature and composition of an organization’s workforce
Linking pay to performance may attract retain more high performers
Personality traits and values
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Sorting effect the effect a pay plan has on the composition of the current workforce (the types of employees attracted and retained).
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Pay-for-Performance Programs 1 of 10
Differentiation in Performance and Pay
Important to pay high performers an amount they feel is equitable
Differentiation Strength/Incentive Intensity: Promise and Peril
Incentive intensity
Strengthens motivation but also unintended consequences
LO 12-2
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Incentive intensity the strength of the relationship between performance and pay (i.e., how strongly we differentiate in performance and pay).
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Pay-for-Performance Programs 2 of 10
Types of Pay for Performance
Pay programs differ
Whether payouts become part of base pay, are a fixed cost, or are variable.
Some programs measure performance using primarily subjective measures, whereas others rely on more objective performance measures.
Performance can be measured at the individual level or at the unit or organization level.
Combination of programs may work best.
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Table 12.1 Programs for Recognizing Employee Contributions
Design Features | MERIT PAY | MERIT BONUS | INCENTIVE PAY | PROFIT SHARING | STOCK OWNERSHIP/STOCK OPTIONS | GAIN-SHARING | SKILL BASED |
Fixed (becomes part of base salary) or variable | Fixed | Variable (bonus) | Variable (bonus) | Variable (bonus) | Variable (equity changes) | Variable (bonus) | Fixed |
Performance measure (subjective or objective) | Subjective (usually supervisor rating) | Subjective (usually supervisor rating), but higher-level jobs may include objective components also | Objective (e.g., productivity) | Objective (profit) | Objective (stock price/returns) | Objective (productivity, safety, rework, customer satisfaction) | Objective and/or subjective (certifying which skills are acquired) |
Performance measure (individual or collective) | Individual | Individual, but higher-level jobs may include unit and/or organization outcomes. | Individual | Collective (organiza-tion) | Collective (organization) | Collective (unit) | Objective and/or subjective (certifying which skills are acquired) |
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Pay-for-Performance Programs 3 of 10
Merit Pay and Merit Bonuses
With merit pay, programs, annual base pay increases are usually linked to performance appraisal ratings.
Merit bonuses may define and reward various performance dimensions.
Merit increase grid based on
Performance rating
Compa-ratio
Distribution of performance ratings
LO 12-3
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Merit pay Traditional form of pay in which base pay is increased permanently.
Merit bonus Merit pay paid in the form of a bonus, instead of a salary increase.
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Table 12.2 Performance Dimensions for Lower to Mid-level Managers, Arrow Electronics
Exercises good business judgment
Inspires enthusiasm, energy, understanding, loyalty for company goals
Attracts, grows, and retains outstanding talent
Shows initiative
Has position-specific knowledge
Delivers results
Builds internal good will
SOURCE: R. Riphahn, “Evidence on Incentive Effects of Subjective Performance Evaluations,” Industrial and Labor Relations Review 64 (2011).
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Table 12.3 Merit Increase Grid
RECOMMENDED SALARY INCREASES BY PERFORMANCE RATING AND COMPA-RATIO
Compa-ratio 80-90% | Compa-ratio 91-110% | Compa-ratio 111-120% | |
Performance rating | Blank | Blank | Blank |
Exceeds expectations | 7% | 5% | 3% |
Meets expectations | 4% | 3% | 2% |
Below expectations | 2% | 0% | 0% |
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Table 12.4 Performance Ratings and Compa-Ratio Targets
PERFORMANCE RATING | COMPA-RATIO TARGET |
Exceeds expectations | 111–120 |
Meets expectations | 91–110 |
Below expectations | Below 91 |
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Pay-for-Performance Programs 4 of 10
Merit Pay and Merit Bonuses continued
Characteristics of Traditional Merit Pay Programs
They identify individual differences in performance, which are assumed to reflect differences in ability or motivation.
The majority of information on individual performance is collected from the immediate supervisor.
There is a policy of linking pay increases to performance appraisal results.
Feedback under such systems tends to occur infrequently, often once per year at the formal performance review session.
The flow of feedback tends to be largely unidirectional, from supervisor to subordinate.
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Pay-for-Performance Programs 5 of 10
Merit Pay and Merit Bonuses continued
Criticisms of Merit Pay Programs
It is unfair to rate individual performance because “apparent differences between people arise almost entirely from the system that they work in, not from the people themselves.”
The individual focus of merit pay discourages teamwork.
If the performance measure is not perceived as being fair and accurate, the entire merit pay program can break down.
Merit pay does not really exist.
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Table 12.5 Examples of Procedural Justice in Merit Pay Decisions
Employees’ Belief That in Evaluating Their Performance, Their Supervisor...
Was honest and ethical and tried to be fair
Considered your input
Used consistent standards
Provided feedback
Took the time to become familiar with your role and performance, including factors beyond your control
After a merit pay decision was made, was receptive to discussion of how the decision was made (and/or an appeal) and working together to develop an action plan going forward
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Pay-for-Performance Programs 6 of 10
Merit Pay and Merit Bonuses continued
Individual Incentives
Payments not rolled into base pay.
Performance is usually measured as physical output rather than by subjective ratings.
Rare because
Most jobs have no physical output measure.
Administrative problems
Employees only do what they are paid for.
Don’t fit with a team approach
May be inconsistent with learning new skills
May reward output volume at the expense of quality or customer service
May undermine motivation
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Pay-for-Performance Programs 7 of 10
Merit Pay and Merit Bonuses continued
Profit sharing and ownership
Advantages of profit sharing
Employees think more like owners, taking a broad view of what needs to be done to make the organization more effective
Labor costs are automatically reduced during difficult economic times, and wealth is shared during good times
Disadvantages
Most employees are unlikely to see a strong connection between what they do and what they earn under profit sharing.
Most plans are deferred.
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Under profit sharing, payments are based on a measure of organization performance (profits), and the payments do not become part of the base salary.
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Pay-for-Performance Programs 8 of 10
Merit Pay and Merit Bonuses continued
Profit sharing and ownership
Employee ownership
Encourages employees to focus on the success of the organization as a whole
May not motivate in large organizations
Employees may not realize any financial gain until they actually sell their stock
Stock options
Employee stock ownership plans (ESOPs)
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One way of achieving employee ownership is through stock options, which give employees the opportunity to buy stock at a fixed price.
Employee stock ownership plans (ESOPs), under which employers give employees stock in the company, are the most common form of employee ownership.
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Pay-for-Performance Programs 9 of 10
Gainsharing, Group Incentives, and Team Awards
Gainsharing
Measures group or plant performance
Payouts are not deferred
More motivating to employees
Group incentives and team awards
Typically pertain to a smaller work group
May use a broader range of performance measures
May demotivate top performers
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Gainsharing programs offer a means of sharing productivity gains with employees.
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Pay-for-Performance Programs 10 of 10
Balanced Scorecard
Use a mix of pay programs
Balanced scorecard
Balances multiple objectives
LO 12-4
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Managerial and Executive Pay
Agency theory perspective
The goal of owners (shareholders) is to encourage the agents (managers and executives) to act in the best interests of the owners.
More emphasis on outcome-oriented “contracts” that make some portion of executive pay contingent on the organization’s profitability or stock performance
Balanced scorecard is necessary
LO 12-5
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Process and Context Issues 1 of 2
Employee Participation in Decision Making
Linked to higher pay satisfaction and job satisfaction
Delegation of decision making can be costly
LO 12-6
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Process and Context Issues 2 of 2
Communication
Deal with employee concerns
Pay and Process: Intertwined Effects
Gainsharing can positively affect productivity
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Organization Strategy and Compensation Strategy: A Question of Fit
Pay Strategy
Important to consider how it will match the organization’s overall strategies
Best practices
Choosing a pay level that balances the ability to compete in the product market and in the labor market
Paying for performance to obtain positive incentive and sorting effects
Paying attention to both distributive (e.g., equity theory) and procedural justice issues
Complying with regulatory requirements
LO 12-7
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