Chapter 1 Notes -- Compensation PDF

Chapter 1 Notes -- Compensation **[Society]** Increases in productivity are **necessary** to generate increases in income and wealth for most of the population. Growth in economic output is the basis for growth in overall income (and wealth). **Women in Workforce** - Women earn 82 percent of w...

Chapter 1 Notes -- Compensation **[Society]** Increases in productivity are **necessary** to generate increases in income and wealth for most of the population. Growth in economic output is the basis for growth in overall income (and wealth). **Women in Workforce** - Women earn 82 percent of what men earn (up from 60 percent in 1980). - If women had the same characteristics as men the gap narrows by one-half or more. Women would earn 93 percent of what comparable to men's earnings. - Society has mandated laws to eliminate the discrimination. **Kahneman and Deaton study**, annual income beyond \$75,000 did not increase their happiness any further. Smaller employers are less likely than large employers to offer health insurance. - Most uninsured individuals in the U.S. come from working families, with **85%** having a full-time worker and **11%** a part-time worker in the household. - Job losses (or gains) are a function of relative labor costs (and productivity) - Some companies moving work out of China to Vietnam, India, and the Philippines due to cheaper wages. **[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. 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. Shareholders can influence executive compensation decisions in a variety of ways (e.g., through shareholder proposals and election of directors in proxy votes). Dodd-Frank Wall Street Reform and Consumer Protection Act (see Chapter 14) was signed into law in 2010. Among its provisions is \"say on pay,\" which requires public companies to submit their executive compensation plan to a vote by shareholders. 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. **[Customers]** - Employment costs are **largest single operating cost**. - Keep labor costs low to provide cheaper products for customers. - ESG issues affect compensation. **[Managers]** For managers, compensation influences their success. 1\. It's a major expense that must be managed. 2\. It's a major determinant of employee attitudes and behaviors (and thus, organization performance). Instead of viewing pay solely as a cost to be reduced, a manager can leverage it to influence employee behavior and enhance organizational performance. - High pay, as long as it can be documented to bring high returns through its influences on employees, can be a successful strategy. **[Employees]** The pay employees receive and the value they create is usually the major source of their financial security. Pay plays a vital role in a person\'s economic and social well-being. - Employees view compensation as an **entitlement.** - They are less likely to quit jobs that pay more. - When they quit, it's to increase their pay at another workplace. **HOW PAY INFLUENCES BEHAVIORS: INCENTIVE AND SORTING EFFECTS** 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), deter- mines 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. **Sorting effect** is the 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. It is not only how much but how an organization pays that can result in sorting effects. 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 would be the case, for example, if performance, instead of following a normal distribution, follows a [power law distribution], which allows more extreme values (e.g., in the form of very high and valuable performance). 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. Edward Lazear study regarding incentive and sorting effects. \*\*(RE-READ SECTION)\*\* One study found that newly hired \"stars\" from other firms generally did less well in their new firms, but their performance decline was less when moving with other members of their team, rather than alone. Thus, there are implications. First, star performance may be somewhat firm-specific. Second, a firm cannot necessarily \"buy talent\" and be sure that talent will perform at the same level as at its previous firm. Third, to the degree that is the case, the firm-specificity may stem at least partly from the additional value created by being part of a well-functioning team. Other research on stars, this time in the hedge fund industry, finds that, compared to other members of their team, stars get more credit when things go well and more blame when things go poorly. **Compensation** refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship. **FORMS OF PAY** 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. **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. 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. **Cash Compensation: Merit Increases/Short-Term Incentives (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. Merit increases are given as increments to base pay and are based on performance. 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 (also referred to as short-term incentives) may now be more important than traditional merit increases. \"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.\" **Cash Compensation: Incentives** Incentives also tie pay increases to performance. 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. 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. **Commission Definition** 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. Incentives are one-time payments, they do not permanently increase labor costs. 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. **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. **Benefits: Income Protection** Benefits add an average of \$0.46 in cost for every \$1.00 in wages and salaries. (See Chapter 12.) 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.) Medical insurance, retirement programs, life insurance, and savings plans are common benefits. In the United States, employers spend roughly \$725 billion per year just on health care costs, or 19 percent of all U.S. health care expenditures. **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 (e.g., remote work, nontraditional sched- ules, 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. **Benefits: Allowances** Allowances. Companies in China discover that housing, transportation, and other allowances are expected. In many European countries, man- agers assume that a car will be provided-only the make and model are negotiable. **Total Earnings Opportunities: Present Value of a Stream of 2000 Earnings** 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. **Relational Returns from Work** 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. Interestingly, as you may have noticed, the types of rewards just listed, other than money, are sometimes viewed as being, for lack of a better word, more noble (or higher order as Maslow and Herzberg might say) than money. In fact, at least one study reports that candidates for a job who come across as more motivated by money are sometimes inferred to have lower levels of higher order motivations, resulting in them being evaluated lower. The researchers refer to this as \"motivation purity bias.\" **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. **A PAY MODEL** The pay model 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. **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 Fairness (sometimes called equity) is a fundamental objective of pay systems. Procedural fairness refers to the process used to make pay decisions. 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. **Ethics** Ethics means the organization cares about how its results are achieved. \"Key Behaviors,\" \"Our Values,\" and \"Codes of Conduct.\" 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. 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. 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. 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. **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. **Internal Alignment** Internal alignment refers to comparisons among jobs or skill levels inside a single 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 **External Competitiveness** **External competitiveness** refers to pay comparisons with competitors. How much do we wish to pay in com- parison to what other employers pay? pay systems are market-driven 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** 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. 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. **Management** Management means ensuring that the right people get the right pay for achieving the right objectives in the right way. Managing compensation means answering the \"So What?\" question. 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. **Pay Techniques** Techniques tie the four basic policies to the pay objectives. **pay techniques** **CAVEAT EMPTOR-BE AN INFORMED CONSUMER** Most managers do not read research, they find them too full of jargon and esoterica, and they see them as impractical and irrelevant. 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.\" **1. Is the Research Useful?** 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 R^2^. The R^2^ 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 associ- ated or related, but causation is a tough link to make. **3. Are There Alternative Explanations?** 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. **Summary** Two questions should constantly be in the minds of managers and readers of this text. First, Why do it this way? There is rarely one correct way to design a system or pay an individual. Organizations, people, and circumstances are too varied. But a well-trained manager can select or design a suitable approach. Second, So what? What does this technique do for us? How does it help achieve our goals? If good answers to the \"So What?\" question are not apparent, there is no point to the technique. Adapting the pay system to meet the needs of the employees and helping to achieve the goals of the organization is what this book is all about. The basic premise of this book is that compensation systems do have a profound impact. Yet, too often traditional pay systems seem to have been designed in response to some historical but long-forgotten problem. The practices continue, but the logic underlying them is not always clear or even relevant. 1. **Why do it this way?** -- There is rarely a single correct approach to designing a pay system, as organizations and circumstances vary. A skilled manager can choose or create an appropriate method. 2. **So what?** -- What benefits does this technique provide? How does it help achieve our goals? If the answers aren\'t clear, the technique may not be worthwhile. Adapting pay systems to meet employee needs and support organizational goals is essential.