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Human Resource Management
Gaining a Competitive Advantage
Chapter 12
Recognizing Employee Contributions
with Pay
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
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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.
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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.
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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.
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How Does Pay Influence Individual
Employees?
Three different theories help explain
compensation’s effects:
Reinforcement Theory
Expectancy Theory
Agency Theory
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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
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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
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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
Profit Sharing
Skill-based
Gain Sharing
Ownership
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Merit Pay
• Merit pay programs link performanceappraisal 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.
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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.
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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.
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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.
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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.
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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
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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
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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.
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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
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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)
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Process and Context Issues
Three issues represent areas of significant
company discretion and pose opportunities to
compete effectively:
Employee Participation
in Decision Making
Pay and Process:
Intertwined Effects
Communication
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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
Organization Strategy
Concentration
Growth
Low
High
Short-term
Long-term
Above market
Below market
Below market
Above market
Above market
Below market
Centralized
Decentralized
Job
Skills
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