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Chapter 12

Recognizing Employee Contributions with Pay

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

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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