chapter 1
Ethics
Asian philosophy gives us the concept of yin and yang—complementary opposites rather than substitutes or trade-offs. It is not yin or yang; part of yin is in yang, and part of yang is in yin. So it is with objectives in the pay model. It is not efficiency versus fairness versus compliance. Rather, the aim is to achieve all three simultaneously. The tension of working toward all objectives at once creates fertile grounds for ethical dilemmas. Ethics means the organization cares about how its results are achieved. Scan the websites or lobby walls of corporate headquarters and you will inevitably find statements of "Key Behaviors," "Our Values," and "Codes of Conduct." One company's code of conduct is shown in Exhibit 1.7. The challenge is to put these statements into daily practice. The company in the exhibit is the formerly admired, now reviled, Enron, whose employees lost not only their Enron jobs, but also the money they invested in Enron stock (in some cases, their entire retirement nest egg). Because it is so important, it is inevitable that managing pay sometimes creates ethical dilemmas. Manipulating results to ensure executive bonus payouts, misusing (or failing to understand) statistics used to measure competitors' pay rates, repricing or backdating stock options to manipulate (increase) their value, encouraging employees to invest a portion of their wages in company stock while executives are bailing out, offering just enough pay to get a new hire in the door while ignoring the relationship to co-workers' pay, and shaving the hours recorded in employees' time card—these are all-too-common examples of ethical lapses. Some, but not all, compensation professionals and consultants remain silent during ethical misconduct and outright malfeasance. Absent a professional code, compensation managers must look to their own ethics—and the pay model, which calls for combining the objectives of efficiency and fair treatment of employees as well as compliance. There are probably as many statements of pay objectives as there are employers. In fact, highly diversified firms such as General Electric and Eaton, which operate in multiple lines of businesses, may have different pay objectives for different business units. At General Electric, each unit's objectives must meet GE overall objectives. Objectives serve several purposes. First, they guide the design of the pay system. If an objective is to increase customer satisfaction, then incentive programs and merit pay might be used to pay for performance. Another employer's objective may be to develop innovative new products. Job design, training, and team building may be used to reach this objective. The pay system aligned with this objective may include salaries that are at least equal to those of competitors (external competitiveness) and that go up with increased skills or knowledge (internal alignment). This pay system could be very different from our first example, where the focus is on increasing customer satisfaction. Notice that policies and techniques are the means to reach the objectives. In summary, objectives guide the design of pay systems. They also serve as the standards for judging the success of the pay system. If the objective is to attract and retain the best and the brightest skilled employees, but they are leaving for higher-paying jobs elsewhere, the system may not be performing effectively. Although there may be many nonpay reasons for such turnover, objectives provide standards for evaluating the effectiveness of a pay system.
Managers
For managers, compensation influences their success in two ways. First, it is a major expense that must be managed. Second, it is a major determinant of employee attitudes and behaviors (and thus, organization performance). We begin with the cost issue. Competitive pressures, both global and local, force managers to consider the affordability of their compensation decisions. Labor costs can account for more than 50 percent of total costs. In some industries, such as financial or professional services and in education and government, this figure is even higher. However, even within an industry, labor costs as a percentage of total costs vary among individual firms. For example, small neighborhood grocery stores, with labor costs between 15 percent and 18 percent, have been driven out of business by supermarkets that delivered the same products at a lower cost of labor (9 percent to 12 percent). Supermarkets today are losing market share to the warehouse club stores such as Sam's Club and Costco, which enjoy an even lower cost of labor (4 percent to 6 percent), even though Costco pays wages that are above average for the industry. And, now Amazon has entered the grocery business by purchasing Whole Foods, which is expected to cause further cost reductions and disruption. Exhibit 1.3 compares the hourly pay rate for retail workers at Costco to that at Walmart and Sam's Club (which is owned by Walmart). Each store tries to provide a unique shopping experience. Walmart and Sam's Club compete on low prices, with Sam's Club being a "warehouse store" with especially low prices on a narrower range of products, often times sold in bulk. Costco also competes on the basis of low prices, but with a mix that includes more high-end products aimed at a higher customer income segment. To compete in this segment, Costco appears to have chosen to pay higher wages, perhaps as a way to attract and retain a higher quality workforce. A Costco's annual report states, "With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize the wages and benefits that they earn. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce." By comparison, Walmart simply states in its annual report that they "experience significant turnover in associates [i.e., employees] each year." Based on Exhibit 1.3, Costco is quite successful, relative to its competitors, in terms of employee retention, customer satisfaction, and the efficiency with which it generates sales (see revenue per square foot and revenue per employee). So, although Costco's labor costs are higher than those of Sam's Club and Walmart, it appears that this model works for Costco because it helps it gain an advantage over its competitors. Thus, rather than treating pay only as an expense to be minimized, a manager can also use it to influence employee behaviors and to improve the organization's performance. High pay, as long as it can be documented to bring high returns through its influences on employees, can be a successful strategy. As our Costco (versus Sam's Club and Walmart) example seems to suggest, the way people are paid affects the quality of their work and their attitude toward customers. It may also affect their willingness to be flexible, learn new skills, or suggest innovations. On the other hand, people may become interested in unions or legal action against their employer based on how they are paid (e.g., if they perceive their pay to be unfairly low). This potential to influence employees' behaviors, and subsequently the productivity and effectiveness of the organization, means that the study of compensation is well worth your time, don't you think?
CAVEAT EMPTOR—BE AN INFORMED CONSUMER
Most managers do not read research. They do not subscribe to research journals; they find them too full of jargon and esoterica, and they see them as impractical and irrelevant. However, a study of 5,000 HR managers compared their beliefs to the research evidence in several areas and identified seven common and important misconceptions held by managers. The study authors concluded that being unaware of key research findings may prove costly to organizations. For example, when it comes to motivating workers, organization efforts may be somewhat misguided if they do not know that "money is the crucial incentive . . . no other incentive or motivational technique comes even close to money with respect to its instrumental value." So it pays to read the research. There is no question that some studies are irrelevant and poorly performed. But if you are not a reader of research literature, you become prey for the latest business self-help fad. Belief, even enthusiasm, is a poor substitute for informed judgment. Therefore, we end this chapter with a consumer's guide to research that includes three questions to help make you a critical reader—and a better-informed decision maker. 1. Is the Research Useful? - How useful are the variables in the study? How well are they measured? For example, many studies purport to measure organization performance. However, performance may be accounting measures such as return on assets or cash flow, financial measures such as earnings per share, operational measures such as scrap rates or defect indicators, or qualitative measures such as customer satisfaction. It may even be the opinions of compensation managers, as in, "How effective is your gain-sharing plan?" (Answer choices are "highly effective," "effective," "somewhat," "disappointing," "not very effective." "Disastrous" is not usually one of the choices.) The informed consumer must ask, Does this research measure anything useful? 2. Does the Study Separate Correlation from Causation? - Once we are confident that the variables are useful and accurately measured, we must be sure that they are actually related. Most often this is addressed through the use of statistical analysis. The correlation coefficient is a common measure of association and indicates how changes in one variable are related to changes in another. Many research studies use a statistical analysis known as regression analysis. One output from a regression analysis is the R2. The R2 is a squared correlation and tells us what percentage of the variation in the outcome variable is accounted for by the variables we are using to predict or explain. But even if there is a relationship, correlation does not ensure causation. For example, just because a manufacturing plant initiates a new incentive plan and the facility's performance improves, we cannot conclude that the incentive plan caused the improved performance. Perhaps new technology, reengineering, improved marketing, or the general expansion of the local economy underlies the results. The two changes are associated or related, but causation is a tough link to make. Too often, case studies, benchmarking studies of best practices, or consultant surveys are presented as studies that reveal cause and effect. They do not. Case studies are descriptive accounts whose value and limitations must be recognized. Just because the best-performing companies are using a practice does not mean the practice is causing the performance. IBM provides an example of the difficulty of deciding whether a change is a cause or an effect. Years ago, IBM pursued a no-layoff policy. While IBM was doing well, the no-layoff policy was cited as part of the reason. Later, when performance declined, IBM eventually ended the no-layoff policy as a partial response. Did the policy contribute to company success at one time, but not later due to changing circumstances? Did it always act as a drag on company success? Or was it a mistake to get rid of it? Causality is difficult to infer as we do not know what would have happened had IBM never had the policy and/or if they had it and kept it (versus ending it). Perhaps because of such challenges in inference, compensation research often does attempt to answer questions of causality. Yet good policy decisions rest on making good causal inferences.78 Thus, we need to strive to overcome the challenges to answer key questions such as: How does the use of performance-based pay influence employee ability and motivation, customer satisfaction, product quality, and company performance? 3. Are There Alternative Explanations? - Consider a hypothetical study that attempts to assess the impact of a performance-based pay program. The researchers measure performance by assessing quality, productivity, customer satisfaction, employee satisfaction, and the facility's performance. The final step is to see whether future periods' performance improves compared to this period's. If it does, can we safely assume that it was the incentive pay that caused performance? Or is it equally likely that the improved performance has alternative explanations, such as the fluctuation in the value of currency or perhaps a change in leadership in the facility? In this case, causality evidence seems weak. Alternative explanations exist. If the researchers had measured the performance indicators several years prior to and after installing the plan, then the evidence of causality is only a bit stronger. Further, if the researchers repeated this process in other facilities and the results were similar, then the preponderance of evidence is stronger yet. It could then be concluded that clearly the organization is doing something right, and incentive pay is part of it. The best way to establish causation is to account for competing explanations, either statistically or through control groups. The point is that alternative explanations often exist. And if they do, they need to be accounted for to establish causality. It is very difficult to disentangle the effects of pay plans to clearly establish causality. However, it is possible to look at the overall pattern of evidence to make judgments about the effects of pay. So we encourage you to become a critical reader of all management literature, including this book. As Hogwarts' famous Professor Alastor Moody cautions, have "constant vigilance for sloppy analysis masquerading as research."
Incentive and Sorting Effects of Pay on Employee Behaviors
Pay can influence employee motivation and behavior in two ways. First, and perhaps most obviously, pay can affect the motivational intensity, direction, and persistence of current employees. Motivation, together with employee ability and work/organizational design (which can help or hinder employee performance), determines employee behaviors such as performance. We will refer to this effect of pay as an incentive effect, the degree to which pay influences individual and aggregate motivation among the employees we have at any point in time. However, pay can also have an indirect, but important, influence via a sorting effect on the composition of the workforce. That is, different types of pay strategies may cause different types of people to apply to and stay with (i.e., self-select into) an organization. In the case of pay structure/level, it may be that higher pay levels help organizations attract more high-quality applicants, allowing them to be more selective in their hiring. Similarly, higher pay levels may improve employee retention. Less obviously, perhaps, it is not only how much but how an organization pays that can result in sorting effects. Ask yourself: Would people who are highly capable and have a strong work ethic and an interest in earning a lot of money prefer to work in an organization that pays about the same amount to all employees doing the same job, regardless of their performance? Or would they prefer to work in an organization where their pay can be much higher (or lower) depending on how they perform? If you chose the latter answer, then you believe that sorting effects matter. People differ regarding which type of pay arrangement they prefer. The question for organizations is simply this: Are you using the pay policy that will attract and retain the types of employees you want? Keep in mind that high performers have more alternative job opportunities and that more opportunities, all else being equal (e.g., if they are not paid more for their higher performance), translate into higher turnover—which is likely to be a significant problem if it is the high performers who are leaving, especially if high performers in particular roles create a disproportionately high amount of value for organizations. This also raises the issue of dealing with outside offers that employees receive. We know that a substantial share of employee turnover results from receiving unsolicited outside offers. In other words, turnover is not always in response to dissatisfaction. Sometimes it is driven by opportunity. These are likely to be some of the most valuable employees, and thus policies and practices for dealing with outside offers (hopefully informed by research) are important. Let's take a look at one especially informative study conducted by Edward Lazear regarding incentive and sorting effects. Individual worker productivity was measured before and after a glass installation company switched one of its plants from a salary-only (no pay for performance) system to an individual incentive plan under which each employee's pay depended on his/her own performance. An overall increase in plant productivity of 44 percent was observed comparing before and after. Roughly one-half of this increase was due to individual employees becoming more productive. However, the remaining one-half of the productivity gain was not explained by this fact. So, where did the other one-half of the gain come from? The answer: Less-productive workers were less likely to stay in their jobs under the new individual incentive system because it was less favorable to them. When they left, they tended to be replaced by more-productive workers (who were happy to have the chance to make more money under a system that rewards performance than they might make elsewhere). Thus, focusing only on the incentive effects of pay (on current workers) can miss the other major mechanism (sorting) by which pay decisions influence employee behaviors. The pay model that comes later in this chapter includes compensation policies and the objectives (efficiency, fairness, compliance) these are meant to influence. Our point here is that compensation policies work through employee incentive and sorting effects to either achieve or not achieve those objectives.
Society
Some people see pay as a measure of justice. For example, a comparison of earnings between men and women highlights what many consider inequities in pay decisions. In 2016, U.S. Bureau of Labor Statistics data indicated that, among full-time workers in the United States, women earned 82 percent of what men earned, up from 62 percent in 1979. If women had the same education, experience, and union coverage as men and also worked in the same industries and occupations, the ratio would increase, but most evidence suggests that no more than one-half of the gap would disappear. Thus, even under such a best-case scenario the ratio of women's earnings to men's would be about 90 percent, still leaving a sizable gap. Society has taken an interest in such earnings differentials. One indicator of this interest is the introduction of laws and regulations aimed at eliminating the discrimination that causes them. Benefits given as part of a total compensation package may also be seen as a reflection of equity or justice in society. Civilian employers spend about 46 cents for benefits on top of every dollar paid for wages and salaries. (State and local government employers pay even more: 60 cents in benefits on top of every wage dollar.) Individuals and businesses in the United States spend $3.5 trillion per year, or about 18 percent of U.S. economic output (gross domestic product) on health care. Nevertheless, 27.6 million people in the United States (over 8 percent of the population) have no health insurance. (Prior to implementation of The Affordable Care Act of 2010, 44 million were uninsured.) A major reason is that the great majority of people who are under the age of 65 and not below the poverty line obtain health insurance through their employers, but small employers, which account for a substantial share of employment, are much less likely than larger employers to offer health insurance to their employees. As a result, the great majority of uninsured in the United States are from working families. (Of the uninsured, 85 percent have a full-time worker in the family and another 11 percent have a part-time worker in the family.) Given that those who do have insurance typically have it through an employer, it also follows that whenever the unemployment rate increases, health care coverage declines further. (Some users of online dating services provide information on their employer-provided health care insurance. Dating service "shoppers" say they view health insurance coverage as a sign of how well a prospect is doing in a career.) Job losses (or gains) within a country over time are partly a function of relative labor costs (and productivity) across countries. People in the United States worry about losing manufacturing jobs to Mexico, China, and other nations. (Increasingly, white-collar work in areas like finance, computer programming, and legal services is also being sent overseas.) China's estimated $5.45 per hour is about 14 percent of the U.S. rate. However, the value of what is produced also needs to be considered. Productivity in China is 24 percent of that of U.S. workers, whereas Mexican worker productivity is 34 percent of the U.S. level. Finally, if low wages are the goal, there always seems to be somewhere that pays less. Some companies (e.g., Coach) are now moving work out of China because its hourly wage, especially after recent increases, is not as low as in countries like Vietnam, India, and the Philippines. However, for other companies—such as Foxconn, which builds iPhones and iPads for Apple—even with rapid increases in wages in China, labor costs remain very low in China compared to those in the United States and other advanced economies. Foxconn appears to be poised to continue having a larger presence in China. (More recently, Foxconn has also announced it will build a major new presence in southeast Wisconsin. Reasons include proximity to the U.S. market, as well as major incentives provided by the State of Wisconsin. Some consumers know that pay increases often lead to price increases. They do not believe that higher labor costs benefit them. But other consumers lobby for higher wages. While partying revelers were collecting plastic beads at New Orleans' Mardi Gras, filmmakers were showing video clips of the Chinese factory that makes the beads. In the video, the plant manager describes the punishment (5 percent reduction in already low pay) that he metes out to the young workers for workplace infractions. After viewing the video, one reveler complained, "It kinda takes the fun out of it."
Relational Returns from Work
Why do Google millionaires continue to show up for work every morning? Why does Andy Borowitz write the funniest satirical news site on the web (www.borowitzreport.com) for free? There is no doubt that nonfinancial returns from work have a substantial effect on employees' behavior. Exhibit 1.4 includes such relational returns from work as recognition and status, employment security, challenging work, and opportunities to learn. Other forms of relational return might include personal satisfaction from successfully facing new challenges, teaming with great co-workers, receiving new uniforms, and the like. Such factors are part of the total return, which is a broader umbrella than total compensation.
COMPENSATION: DOES IT MATTER? (OR, "SO WHAT?")
Why should you care about compensation? Do you find that life goes more smoothly when there is at least as much money coming in as going out? (Refer, for example, to the lyrics for the Beatles' song "Money." To exaggerate a bit, they say something like: Money doesn't buy everything, but if money can't buy it, I can't use it.) Of course, it is the same for companies. It really does help to have as much money coming in (actually, more is better) as going out. Until recently, production workers at Chrysler received total compensation (i.e., wages plus benefits) of about $76 per hour. U.S. workers doing the same jobs at Toyota received $48 per hour, and the average total compensation per hour in U.S. manufacturing was $25 (and $16 in Korea, $3 in Mexico). It is one thing to pay more than your competitors if you get something more (e.g., higher productivity and/or quality) in return. But Chrysler was not. So its "strategy" was not sustainable. Chrysler ended up going through bankruptcy, being bought out by Fiat, and then reducing worker compensation costs as part of its strategy for a return to competitiveness. Specifically, Chrysler took steps (as part of its bankruptcy plan) to bring its hourly labor costs down to about $49. General Motors (GM), like Chrysler, has for decades paid its workers well—too well, perhaps, for what it received in return. So what? Well, in 1970, GM had 150 U.S. plants and 395,000 hourly workers. In sharp contrast, GM now has 35 U.S. manufacturing plants and 57,000 U.S. hourly workers.3 In June 2009, GM, like Chrysler, had to file for bankruptcy (avoiding it for a while thanks to loans from the U.S. government—i.e., you, the taxpayer). Not all of GM's problems were compensation related. Building too many vehicles that consumers did not want was also a problem. But having labor costs higher than the competition's, without corresponding advantages in efficiency, quality, and customer service, does not seem to have served GM or its stakeholders well. Its stock price peaked at $93.62/share in April 2000. Its market value was about $60 billion in 2000. That shareholder wealth was wiped out in bankruptcy. Think also of the billions of dollars the U.S. taxpayer had to put into GM. Think of all the jobs that have been lost over the years and the effects on communities that have lost those jobs. On the other hand, Nucor Steel pays its workers very well, relative to what other companies inside and outside of the steel industry pay. But Nucor also has much higher productivity than is typical in the steel industry. The result: Both the company and its workers do well. Apple Computer is able to reduce the prices for its iPads and iPhones by outsourcing manufacturing to China in facilities owned by the Hon Hai Precision Industry Co., Ltd. (Foxconn), a Taiwanese company. As we will see later, doing so generates billions (yes, billions with a "b") of dollars in cost savings per year. Google and Facebook are companies that are known for paying very well. So far that seems to have worked, in that their high pay allows them to be very selective in who they hire and who they keep, and they would say that their talent-rich strategy has helped them to foster growth and innovation. Wall Street financial services firms and banks used incentive plans that rewarded people for developing "innovative" new financial investment vehicles and for taking risks to earn a lot of money for themselves and their firms. But several years ago, the markets discovered that many such risks had gone bad. Blue chip firms such as Lehman Brothers slid quickly into bankruptcy, whereas others, like Bear Stearns and Merrill Lynch, survived to varying degrees by finding other firms (J.P. Morgan and Bank of America, respectively) to buy them. The issue has not gone away. U.S. Federal Reserve officials have "made it clear that they believe bad behavior at banks goes deeper than a few bad apples and are advising firms to track warning signs of excessive risk taking and other cultural breakdowns." In the words of one Fed official, "Risk takers are drawn to finance like they are to Formula One racing." An important driver of risk taking among traders and others is the incentive system that encourages them to be "confident and aggressive" and that often results in those who thrive under this incentive rising to top leadership positions at the banks. Does greater expertise in the design and execution of compensation plans help control excessive risk taking and other problematic behaviors and encourage a more positive culture? Congress and the president seemed to think so, because in hopes of avoiding a similar financial crisis in the future they put into place legislation—the Troubled Asset Relief Program (TARP)—that included restrictions on executive pay that were designed to discourage executives from taking "unnecessary and excessive risks." One commentator agreed. In an opinion piece in The Wall Street Journal, entitled "How Business Schools Have Failed Business," the former director of corporate finance policy at the United States Treasury argued that misaligned incentives were a major cause of the global financial crisis (see above) and wondered how many of the business schools that educated top executives and directors included a course on how to design compensation systems. His answer: not many. Our book, we hope, can play a role in helping to better educate you, the reader, about the design of compensation systems, both for managers and for workers. How people are paid affects their behaviors at work, which affect an organization's success. For most employers, compensation is a major part of total cost, and often it is the single largest part of operating cost. These two facts together mean that well-designed compensation systems can help an organization achieve and sustain competitive advantage. On the other hand, as we have recently seen, poorly designed compensation systems can likewise play a major role in undermining organization success.
Cash Compensation: Merit Increases/Merit Bonuses/COLAs
A cost of living adjustment (COLA) to base wages may be made on the basis of changes in what other employers are paying for the same work, changes in living costs, or changes in experience or skill. Such provisions are less common than in the past as employers continually try to control fixed costs and link pay increases to individual and/or company performance. Merit increases are given as increments to base pay and are based on performance. According to a WorldatWork survey, 94 percent of U.S. firms use merit pay increases. Given that 22 percent of respondents to the survey were in the nonprofit, not-for-profit, or public sectors where we know that the use of merit pay is less, it may be that nearly 100 percent of U.S. private sector organizations use merit pay. Merit payments are based on an assessment (or rating) of recent past performance made (with or without a formal performance evaluation). In recent years, merit increase budgets (or average merit increases) have been around 3 percent. Survey data indicate that, on average, an outstanding performer receives a 4.4 percent increase, an average performer a 2.8 percent increase, and a poor performer a 0.4 percent increase. Finally, companies increasingly use merit bonuses. As with merit increases, merit bonuses are based on a performance rating but, unlike merit increases, are paid in the form of a lump sum rather than becoming (a permanent) part of the base salary. Merit bonuses may now be more important than traditional merit Page 15increases. "Indeed, merit bonuses now appear to account for more of the pay-performance relationship than do the traditional and most often discussed form of pay for individual performance, merit pay." In companies that use merit bonuses and among those workers who receive them, the average annual merit bonus in recent years has been about 5 percent for hourly employees, 6 percent for lower level salaried employees, and 13 percent for higher level (but below officers/executives) salaried employees, all much larger than the more often discussed recent merit increase pools of around 3 percent.
Management
A policy regarding management of the pay system is the last building block in our model. Management means ensuring that the right people get the right pay for achieving the right objectives in the right way. The greatest system design in the world is useless without competent management. Managing compensation means answering the "So What?" question. So what is the impact of this policy, this technique, this decision? Although it is possible to design a system that is based on internal alignment, external competitiveness, and employee contributions, what difference does it make? Does the decision help the organization achieve its objectives? The ground under compensation management has shifted. The traditional focus on how to administer various techniques is long gone, replaced by more strategic thinking—managing pay as part of the business. It goes beyond simply managing pay as an expense to better understanding and analyzing the impact of pay decisions on people's behaviors and organizations' success. The impact of pay decisions on expenses is one result that is easily measured and well understood. But other measures—such as pay's impact on attracting and retaining the right people, and engaging these people productively—are not yet widely used in the management of compensation. Efforts to do so are increasing, and the perspective is shifting from "How to" toward trying to answer the "So What?" question. Ease of measurement is not the same as importance; costs are easy to measure (and, of course, important), so there is a tendency to focus there. Yet the consequences of pay, although often less amenable to measurement, are nonetheless just as important.
Four Policy Choices
Every employer must address the policy decisions shown on the left side of the pay model: (1) internal alignment, (2) external competitiveness, (3) employee contributions, and (4) management of the pay system. These policies are the foundation on which pay systems are built. They also serve as guidelines for managing pay in ways that accomplish the system's objectives.
Benefits: Income Protection
Exhibit 1.4 showed that benefits, including income protection, work/life services, and allowances, are also part of total compensation. Some income protection programs are legally required in the United States; employers must pay into a fund that provides income replacement for workers who become disabled or unemployed. Employers are also required to pay one-half the payroll tax for each employee to fund Social Security coverage. (Employees pay the other half.) Different countries have different lists of mandatory benefits. Medical insurance, retirement programs, life insurance, and savings plans are common benefits. They help protect employees from the financial risks inherent in daily life. Often companies can provide these protections to employees more cheaply than employees can obtain them for themselves. In the United States, employers spend roughly $657 billion per year on health care costs, or 20 percent of all U.S. health care expenditures. Among employers that provide health insurance, the cost to provide family coverage is $18,764 per year per employee. The average employer pays $13,050 (70 percent) of that and the average employee pays the remaining $5,714 (30 percent).55 Given the magnitude of such costs, it is no surprise that employers have sought to rein in or reduce benefits costs. One approach has been to shift costs to employees (e.g., having employees pay a larger share of health insurance premiums). Some companies have allowed their benefits costs to get so far out of control that more drastic action has been taken. For example, as noted, companies like Chrysler, GM, and American Airlines have recently gone through bankruptcy, which has been used to reduce benefits costs and labor costs more generally. GM benefits costs had gotten so high that GM was sometimes described as a pension and health care provider that also makes cars.
FORMS OF PAY
Exhibit 1.4 shows the variety of returns people receive from work. Total returns are categorized as total compensation and relational returns. The relational returns (learning opportunities, status, challenging work, and so on) are psychological. Total compensation returns are more transactional. They include pay received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments) and indirectly as benefits (e.g., pensions, medical insurance, programs to help balance work and life demands, brightly colored uniforms). So pay comes in different forms, and programs to pay people can be designed in a wide variety of ways. WorldatWork has a Total Rewards Model that is similar and includes compensation, benefits, work-life, performance/recognition, and development/career opportunities. The importance of monetary rewards as a motivator relative to other rewards (e.g., intrinsic rewards such as how interesting the work is) has long been a topic of interest, as have the conditions under which money is more or less important to people (and even whether money is sometimes too important to people). Although scholars and pundits have sometimes debated which is more important (and have sometimes argued that money does not motivate or even that it demotivates), our reading of the research indicates that both types of rewards are important and that it is usually not terribly productive to debate which is more important. It will no doubt come as little surprise that we will focus on monetary rewards (total compensation) in a book called Compensation. Whatever other rewards employees value, it is our experience that they expect to be paid for their work, that how and how much they are paid affects their attitudes, performance, and job choice, as well as their standard of living. These effects of compensation on employees (as well as the cost of employee compensation) have major implications for how successfully organizations can execute their strategies and achieve their goals, as we will see.
External Competitiveness
External competitiveness refers to pay comparisons with competitors. How much do we wish to pay in comparison to what other employers pay? Many organizations claim their pay systems are market-driven—that is, based almost exclusively on what competitors pay. "Market-driven" gets translated into practice in different ways. Some employers may set their pay levels higher than their competition, hoping to attract the best applicants. Of course, this assumes that someone is able to identify and hire the "best" from the pool of applicants. And what is the appropriate market? When, for example, should international pay rates be considered? Should the pay of software engineers in New Delhi or Minsk influence pay for engineers in Silicon Valley or Boston? External competitiveness decisions—both how much and what forms—have a twofold effect on objectives: (1) to ensure that the pay is sufficient to attract and retain employees—if employees do not perceive their pay as competitive in comparison to what other organizations are offering for similar work, they may be more likely to leave—and (2) to control labor costs so that the organization's prices of products or services can remain competitive in a global economy.
Employee Contributions
How much emphasis should there be on paying for performance? Should one programmer be paid differently from another if one has better performance and/or greater seniority? Or should there be a flat rate for programmers? Should the company share any profits with employees? Should it share with all employees, part-time as well as full-time? The emphasis to place on employee contributions (or nature of pay mix) is an important policy decision because it directly affects employees' attitudes and work behaviors. Eaton and Motorola use pay to support other "high-performance" practices in their workplaces. Both use team-based pay and corporate profit-sharing plans. Starbucks emphasizes stock options and sharing the success of corporate performance with the employees. General Electric uses different performance-based pay programs at the individual, division, and company-wide levels. Performance-based pay affects fairness, in that employees need to understand the basis for judging performance in order to believe that their pay is fair. What mix of pay forms—base, incentives, stock, benefits—do our competitors use in comparison to the pay mix we use? Whole Foods combines base pay and team incentives to offer higher pay if warranted by team performance. Nucor targets base pay below market, but targets total cash compensation (including profit sharing and gain-sharing/plant production bonuses) at well above the market median. Medtronic sets its base pay to match its competitors but ties bonuses to performance. It offers stock to all its employees, based on overall company performance. Further, Medtronic believes that its benefits, particularly its emphasis on programs that balance work and life, make it a highly attractive place to work. It believes that how its pay is positioned and what forms it uses create an advantage over competitors. The external competitiveness and employee contribution decisions should be made jointly. Clearly, an above-market compensation level is most effective and sustainable when it exists together with above-market employee contributions to productivity, quality, customer service, or other important strategic objectives.
Global Views—Vive la Différence
In English, compensation means something that counterbalances, offsets, or makes up for something else. However, if we look at the origin of the word in different languages, we get a sense of the richness of the meaning, which combines entitlement, return, and reward. In China, the traditional characters for the word "compensation" are based on the symbols for logs and water, suggesting that compensation provides the necessities in life. In the recent past the state owned all Chinese enterprises, and compensation was treated as an entitlement. In today's China, compensation takes on a more subtle meaning. A new word, dai yu, is used. It refers to how you are being treated—your wages, benefits, training opportunities, and so on. When people talk about compensation, they ask each other about the dai yu in their companies. Rather than assuming that everyone is entitled to the same treatment, the meaning of compensation now includes a broader sense of returns as well as entitlement. "Compensation" in Japanese is kyuyo, which is made up of two separate characters (kyu and yo), both meaning "giving something." Kyu is an honorific used to indicate that the person doing the giving is someone of high rank, such as a feudal lord, an emperor, or a samurai leader. Traditionally, compensation is thought of as something given by one's superior. Today, business consultants in Japan try to substitute the word hou-syu, which means "reward" and has no associations with notions of superiors. The many allowances that are part of Japanese compensation systems translate as teate, which means "taking care of something." Teate is regarded as compensation that takes care of employees' financial needs. This concept is consistent with the family, housing, and commuting allowances that are still used in many Japanese companies. These contrasting ideas about compensation—multiple views (societal, stockholder, managerial, employee, and even global) and multiple meanings (returns, rewards, entitlement)—add richness to the topic. But they can also cause confusion unless everyone is talking about the same thing. So let's define what we mean by "compensation" or "pay" (the words are used interchangeably in this book): - Compensation refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship.
Cash Compensation: Incentives
Incentives also tie pay increases to performance. However, incentives differ from merit adjustments. First, incentives are tied to objective performance measures (e.g., sales) usually in a formula-based way, whereas a merit increase program typically relies on a subjective performance rating. There is also some subjectivity in the size of the pay increase awarded for a particular rating. Second, incentives do not increase the base wage and so must be re-earned each pay period. Third, the potential size of the incentive payment will generally be known (given the use of a formula) beforehand. Whereas merit pay programs evaluate past performance of an individual and then decide on the size of the increase, what must happen in order to receive the incentive payment is called out very specifically ahead of time. For example, a Toyota salesperson knows the commission on a Land Cruiser versus a Prius prior to making the sale. The larger commission he or she will earn by selling the Land Cruiser is the incentive to sell a customer that car rather than the Prius. Fourth, while both merit pay and incentives try to influence performance, incentives explicitly try to influence future behavior whereas merit recognizes (rewards) past behavior, which is hoped to influence future behavior. The incentive-reward distinction is a matter of timing. Incentives can be tied to the performance of an individual employee, a team of employees, a total business unit, or some combination of individual, team, and unit. The performance objective may be expense reduction, volume increases, customer satisfaction, revenue growth, return on investments, increase in stock value—the possibilities are endless. Prax Air, for example, used return on capital (ROC). For every quarter in which a 6 percent ROC target is met or exceeded, Prax Air awarded bonus days of pay. An 8.6 percent ROC means 2 extra days of pay for that quarter for every employee covered by the program. An ROC of 15 percent means 8.5 extra days of pay. Because incentives are one-time payments, they do not permanently increase labor costs. When performance declines, incentive pay automatically declines, too. Consequently, incentives (and sometimes merit bonuses also) are frequently referred to as variable pay. Incentives can have powerful effects, both good and bad, on performance. On average, these effects are positive and substantial. However, incentives are risky, and they can go wrong in spectacular fashion. One example is the Great Financial Crisis, which apparently stemmed in large part from improper and aggressive incentives paid to encourage loan officers to give home loans (mortgages) to people who were unlikely to be able to pay them back. (Recent events at Wells Fargo provide further examples.) We will talk about more examples in later chapters.
Long-Term Incentives
Incentives may be short- or long-term. Long-term incentives are intended to focus employee efforts on multiyear results. Typically they are in the form of stock ownership or else options to buy stock at a fixed price (thus leading to a monetary gain to the degree the stock price later goes up). The belief underlying stock ownership is that employees with a financial stake in the organization will focus on long-term financial objectives: return on investment, market share, return on net assets, and the like. Bristol-Myers Squibb grants stock to selected "Key Contributors" who make outstanding contributions to the firm's success. Stock options are often the largest component in an executive pay package. Some companies extend stock ownership beyond the ranks of managers and professionals. Intel, Google, and Starbucks, for example, offer stock and/or stock options to all their employees.
Stockholders
Stockholders are also interested in how employees are paid. Some believe that using stock to pay employees creates a sense of ownership that will improve performance, which in turn will increase stockholder wealth. But others argue that granting employees too much ownership dilutes stockholder wealth. Google's stock plan cost the company $600 million in its first year of operation. So people who buy Google stock (stockholders) are betting that this $600 million will motivate employees to generate more than $600 million in extra stockholder wealth. Stockholders (also called shareholders) have a particular interest in executive pay. To the degree that the interests of executives are aligned with those of shareholders (e.g., by paying executives on the basis of company performance measures such as shareholder return), the hope is that company performance will be higher. There is debate, however, about whether executive pay and company performance are strongly linked in the typical U.S. company. In the absence of such a linkage, concerns arise that executives can somehow use their influence to obtain high pay without necessarily performing well. Note the large numbers (total annual compensation of $11.5 million) and also that the bulk of compensation (stock-related) is connected to shareholder return or other (primarily short-term, or one year or less) performance measures (bonus). As such, one would expect changes in CEO wealth and shareholder wealth to generally be aligned. For example, during the meltdown in the financial services industry, top executives at Bear Stearns and Lehman Brothers regularly exercised stock options and sold stock during the period 2000-2008 prior to the meltdown. One estimate is that these stock-related gains plus bonus payments generated $1.4 billion for the top five executives at Bear Stearns and $1 billion for those at Lehman Brothers during the 2000-2008 period. "Thus, while the long-term shareholders in their firms were largely decimated, the executives' performance-based compensation kept them in positive territory." The problem here is that shareholders paid a huge penalty for what appears to have been overly aggressive risk-taking by executives, but the executives, in contrast, did quite well because of "their ability to claim large amounts of compensation based on short-term results." Shareholders can influence executive compensation decisions in a variety of ways (e.g., through shareholder proposals and election of directors in proxy votes). In addition, the Dodd-Frank Wall Street Reform and Consumer Protection Act Among its provisions is "say on pay," which requires public companies to submit their executive compensation plan to a vote by shareholders. The vote is not binding. However, companies seem to be intent on designing compensation plans that do not result in negative votes. In addition, clawback provisions (designed to allow companies to reclaim compensation from executives in some situations) are available under Dodd-Frank and have also been adopted in stronger form by some companies.
Employees
The pay individuals receive in return for the work they perform and the value they create is usually the major source of their financial security. Hence, pay plays a vital role in a person's economic and social well-being. Employees may see compensation as a return in an exchange between their employer and themselves, as an entitlement for being an employee of the company, as an incentive to decide to take/stay in a job and invest in performing well in that job, or as a reward for having done so. Compensation can be all of these things. The importance of pay is apparent in many ways. Wages and benefits are a major focus of labor unions' efforts to serve their members' interests. The extensive legal framework governing pay—including minimum wage, living wage, overtime, and nondiscrimination regulations—also points to the central importance of pay to employees in the employment relationship. Next, we turn to how pay influences employee behaviors.
A PAY MODEL
The pay model shown in Exhibit 1.5 serves as both a framework for examining current pay systems and a guide for most of this book. It contains three basic building blocks: (1) the compensation objectives, (2) the policies that form the foundation of the compensation system, and (3) the techniques that make up the compensation system. Because objectives drive the system, we will discuss them first.
Pay Techniques
The remaining portion of the pay model in Exhibit 1.5 shows the techniques that make up the pay system. The exhibit provides only an overview since techniques are discussed throughout the rest of the book. Techniques tie the four basic policies to the pay objectives. Uncounted variations in pay techniques exist; many are examined in this book. Most consultant firms tout their surveys and techniques on their web pages. You can obtain updated information on various practices by simply surfing the web.
Total Earnings Opportunities: Present Value of a Stream of Earnings
Up to this point we have treated compensation as something received at a moment in time. But a firm's compensation decisions have a temporal effect. Say you have a job offer at $50,000 a year. If you stay with the firm for five years and receive an annual increase of 4 percent, in five years you will be earning $60,833 a year. For your employer, the five-year cost commitment of the decision to hire you turns out to be $331,649 in cash. If you add in an additional 30 percent for benefits, the decision to hire you implies a commitment of over $430,000 from your employer. Will you be worth it? You will be, after this course. A present-value perspective shifts the comparison of today's initial offers to consideration of future bonuses, merit increases, and promotions. Sometimes a company will tell applicants that its relatively low starting offers will be overcome by larger future pay increases. In effect, the company is selling the present value of the future stream of earnings. But few candidates apply that same analysis to calculate the future increases required to offset the lower initial offers. Hopefully, everyone who reads Chapter 1 will now do so.
Benefits: Allowances
Allowances often grow out of whatever is in short supply. In Vietnam and China, housing (dormitories and apartments) and transportation allowances are frequently part of the pay package. Many decades after the end of World War II-induced food shortages, some Japanese companies still continue to offer a "rice allowance" based on the number of an employee's dependents. Almost all foreign companies in China discover that housing, transportation, and other allowances are expected. Companies that resist these allowances must come up with other ways to attract and retain employees. In many European countries, managers assume that a car will be provided—only the make and model are negotiable.
Cash Compensation: Base
Base wage is the cash compensation that an employer pays for the work performed. Base wage tends to reflect the value of the work or skills and generally ignores differences attributable to individual employees. For example, the base wage for machine operators may be $20 an hour. However, some individual operators may receive more because of their experience and/or performance. Some pay systems set base wage as a function of the skill or education an employee possesses; this is common for engineers and schoolteachers. A distinction is often made in the United States between wage and salary, with salary referring to pay for employees who are exempt from regulations of the Fair Labor Standards Act (FLSA) and hence do not receive overtime pay. Managers and professionals usually fit this category. Their pay is calculated at an annual or monthly rate rather than hourly, because hours worked do not need to be recorded. In contrast, workers who are covered by overtime and reporting provisions of the Fair Labor Standards Act—nonexempts—have their pay calculated as an hourly wage. Some organizations, such as IBM, Eaton, and Walmart, label all base pay as "salary." Rather than dividing employees into separate categories of salaried and wage earners, they believe that an "all-salaried" workforce reinforces an organizational culture in which all employees are part of the same team. However, merely changing the terminology does not negate the need to comply with the FLSA.
BOOK PLAN
Compensation is such a broad and compelling topic that there are several books devoted to it. This book focuses on the design and management of compensation systems. To aid in understanding how and why pay systems work, our pay model provides the structure for much of the book. Chapter 2 discusses how to formulate and execute a compensation strategy. We analyze what it means to be strategic about how people are paid and how compensation can help achieve and sustain an organization's competitive advantage. The pay model plays a central role in formulating and implementing an organization's pay strategy. The model identifies four basic policy choices that are the core of the pay strategy. After we discuss strategy, the next sections of the book examine each of these policies in detail. Part 2 on internal alignment (Chapters 3, 4, 5, and 6) examines pay relationships within a single organization. Part 3 (Chapters 7 and 8) examines external competitiveness—the pay relationships among competing organizations—and analyzes the influence of market-driven forces. Once the compensation rates and structures are established, other issues emerge. How much should we pay each individual employee? How much and how often should a person's pay be increased, and on what basis—experience, seniority, or performance? Should pay increases be contingent on the organization's and/or the employee's performance? How should the organization share its success (or failure) with employees? These are questions of employee contributions, the third building block in the model, covered in Part 4 (Chapters 9, 10, and 11).
COMPENSATION: DEFINITION, PLEASE
How people view compensation affects how they behave. It does not mean the same thing to everyone. Your view will probably differ depending on whether you look at compensation from the perspective of a member of society, a stockholder, a manager, or an employee. Thus, we begin by recognizing different perspectives.
Internal Alignment
Internal alignment refers to comparisons among jobs or skill levels inside a single organization. Jobs and people's skills are compared in terms of their relative contributions to the organization's business objectives. How, for example, does the work of the programmer compare with the work of the systems analyst, the software engineer, and the software architect? Does one contribute to solutions for customers and satisfied stockholders more than another? What about two marketing managers working in different business units of the same organization? Internal alignment pertains to the pay rates both for employees doing equal work and for those doing dissimilar work. In fact, determining what is an appropriate difference in pay for people performing different work is one of the key challenges facing managers. Whole Foods tries to manage differences with a salary cap that limits the total cash compensation (wages plus bonuses) of any executive to 19 times the average cash compensation of all full-time employees. The cap originally started at eight times the average. However, attraction and retention problems were cited as a need for raising the cap several times since. (Note that the cap does not include stock options.) Pay relationships within the organization affect all three compensation objectives. They affect employee decisions to stay with the organization, to become more flexible by investing in additional training, or to seek greater responsibility. By motivating employees to choose increased training and greater responsibility in dealing with customers, internal pay relationships indirectly affect the capabilities of the workforce and hence the efficiency of the entire organization. Fairness is affected through employees' comparisons of their pay to the pay of others in the organization. Compliance is affected by the basis used to make internal comparisons. Paying on the basis of race, gender, age, or national origin is illegal in the United States.
Compensation Objectives
Pay systems are designed to achieve certain objectives. The basic objectives, shown at the right side of the model, include efficiency, fairness, ethics, and compliance with laws and regulations. Efficiency can be stated more specifically: (1) improving performance, increasing quality, delighting customers and stockholders, and (2) controlling labor costs. Compensation objectives at Medtronic and Whole Foods are contrasted in Exhibit 1.6. Medtronic is a medical technology company that pioneered cardiac pacemakers. Its compensation objectives emphasize performance, business success, minimizing fixed costs, and attracting and energizing top talent. Whole Foods is the nation's largest organic- and natural-foods grocer. Its markets are a "celebration of food": bright, well stocked, and well staffed. The company describes its commitment to offering the highest quality and least processed foods as a shared responsibility. Its first compensation objective is "Increase long-term shareholder value." Fairness (sometimes called equity) is a fundamental objective of pay systems. In Medtronic's objectives, fairness means to "ensure fair treatment" and "recognize personal and family well-being." Whole Foods's pay objectives discuss a "shared fate." In their egalitarian work culture, pay beyond base wages is linked to team performance, and employees have some say about who is on their team. The fairness objective calls for fair treatment for all employees by recognizing both employee contributions (e.g., higher pay for greater performance, experience, or training) and employee needs (e.g., a fair wage as well as fair procedures). Procedural fairness refers to the process used to make pay decisions.65 It suggests that the way a pay decision is made may be equally as important to employees as the results of the decision (distributive fairness). Compliance as a pay objective means conforming to federal and state compensation laws and regulations. If laws change, pay systems may need to change, too, to ensure continued compliance. As companies go global, they must comply with the laws of all the countries in which they operate.
Benefits: Work/Life Balance
Programs that help employees better integrate their work and life responsibilities include time away from work (vacations, jury duty), access to services to meet specific needs (drug counseling, financial planning, referrals for child and elder care), and flexible work arrangements (telecommuting, nontraditional schedules, nonpaid time off). Responding to the changing demographics of the workforce (two-income families or single parents who need work-schedule flexibility to meet their family obligations), many U.S. employers are giving a higher priority to these benefit forms. Medtronic, for example, touts its Total Well-Being Program that seeks to provide "resources for growth—mind, body, heart, and spirit" for each employee. Health and wellness, financial rewards and security, individual and family well-being, and a fulfilling work environment are part of this "total well-being." Medtronic believes that this program permits employees to be "fully present" at work and less distracted by conflicts between their work and nonwork responsibilities.
The Organization as a Network of Returns
Sometimes it is useful to think of an organization as a network of returns created by all these different forms of pay, including total compensation and relational returns. The challenge is to design this network so that it helps the organization to succeed. As in the case of crew rowers pulling on their oars, success is more likely if all are pulling in unison rather than working against one another. In the same way, the network of returns is more likely to be useful if bonuses, development opportunities, and promotions all work together. So the next time you walk through an employer's door, look beyond the cash and health care offered to search for all the returns that create the network. Even though this book focuses on compensation, let's not forget that compensation is only one of many factors affecting people's decisions about work. (You might enjoy listening to Roger Miller's song "Kansas City Star," or Chely Wright's "It's the Song" for some other reasons people choose their work.)
