Compensation
Twelfth Edition
Jerry M. Newman
State University of New York–Buffalo
Barry Gerhart
University of Wisconsin–Madison
George T. Milkovich
Cornell University
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COMPENSATION, TWELFTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGrawHill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014,
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Library of Congress Cataloging-in-Publication Data
Milkovich, George T., | Newman, Jerry M., | Gerhart, Barry A., author.
Compensation / George T. Milkovich, Cornell University, Jerry M. Newman, State University of New
York/Buffalo, Barry Gerhart, University of Wisconsin/Madison.
Twelfth ed. | New York, NY: McGraw-Hill Education, [2017]
LCCN 2015041046 | ISBN 9781259532726 (alk. paper)
LCSH: Compensation management.
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Table of Contents
Preface
xiii
2. Does the Study Separate Correlation from
Causation? 26
3. Are There Alternative Explanations? 27
PART ONE
Your Turn: The Role of Labor Costs in Retail
Electronics 27
INTRODUCING THE PAY MODEL
AND PAY STRATEGY
Chapter One
The Pay Model
Chapter Two
Strategy: The Totality of Decisions
3
Compensation: Does It Matter? (or, “So What?”) 3
Compensation: Definition, Please 5
Society 5
Stockholders 7
Managers 9
Employees 11
Incentive and Sorting Effects of Pay on Employee
Behaviors 11
Global Views—Vive la Différence 12
Forms of Pay
13
Cash Compensation: Base 14
Cash Compensation: Merit Increases/Merit
Bonuses/COLAs 14
Cash Compensation: Incentives 15
Long-Term Incentives 16
Benefits: Income Protection 16
Benefits: Work/Life Balance 16
Benefits: Allowances 17
Total Earnings Opportunities: Present Value of a
Stream of Earnings 17
Relational Returns from Work 17
A Pay Model
18
Compensation Objectives
Four Policy Choices 22
Pay Techniques 24
18
Book Plan 25
Caveat Emptor—Be an Informed Consumer
1. Is the Research Useful?
26
25
Similarities and Differences in Strategies
40
40
Different Strategies within the Same Industry 43
Different Strategies within the Same Company 43
Strategic Choices 44
Support Business Strategy 45
Support HR Strategy 47
The Pay Model Guides Strategic Pay
Decisions 48
Stated versus Unstated Strategies
49
Developing A Total Compensation Strategy:
Four Steps 50
Step 1: Assess Total Compensation
Implications 51
HR Strategy: Pay as a Supporting Player or
Catalyst for Change? 51
Step 2: Map a Total Compensation Strategy 54
Steps 3 and 4: Implement and Reassess 57
Source of Competitive Advantage:
Three Tests 57
Align 57
Differentiate 57
Add Value 58
“Best Practices” versus “Best Fit”? 59
Guidance from the Evidence 59
Virtuous and Vicious Circles 60
Your Turn: Merrill Lynch 61
Still Your Turn: Mapping Compensation
Strategies 63
iii
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iv
Table of Contents
PART TWO
INTERNAL ALIGNMENT:
DETERMINING THE STRUCTURE
Chapter Three
Defining Internal Alignment
73
Jobs and Compensation 74
Compensation Strategy: Internal Alignment
Supports Organization Strategy
Supports Work Flow 75
Motivates Behavior 76
Structures Vary among Organizations
Number of Levels 77
Differentials 77
Criteria: Content and Value
74
75
76
77
What Shapes Internal Structures?
80
Economic Pressures 80
Government Policies, Laws, and Regulations 81
External Stakeholders 81
Cultures and Customs 82
Organization Strategy 82
Organization Human Capital 83
Organization Work Design 83
Overall HR Policies 83
Internal Labor Markets: Combining External and
Organization Factors 84
Employee Acceptance: A Key Factor 84
Pay Structures Change 85
Strategic Choices in Designing Internal
Structures 86
Tailored versus Loosely Coupled 86
Hierarchical versus Egalitarian and Layered versus
Delayered Structures 86
Guidance from the Evidence
88
Equity Theory: Fairness 89
Tournament Theory (and Pay Dispersion):
Motivation and Performance 90
Institutional Theory: Copy Others and
Conform 92
(More) Guidance from the Evidence 92
Consequences of Structures
Efficiency 94
Fairness 94
Compliance 94
mil32720_fm_i-xviii.indd 4
94
Your Turn: So You Want to Lead an
Orchestra! 95
Still Your Turn: (If You Don’t Want to Lead the
Orchestra...) 96
Still (yes, still) Your Turn: (NCAA) 99
Chapter Four
Job Analysis 106
Structures Based on Jobs, People,
or Both 107
Job-Based Approach: Most Common
Why Perform Job Analysis?
109
109
Job Analysis Procedures 110
What Information Should Be Collected?
111
Job Data: Identification 111
Job Data: Content 111
Employee Data 113
“Essential Elements” and the Americans With
Disabilities Act 116
Level of Analysis 117
How Can the Information Be Collected?
118
Conventional Methods 118
Quantitative Methods 118
Who Collects the Information? 120
Who Provides the Information? 120
What about Discrepancies? 121
Job Descriptions Summarize the Data
122
Using Generic Job Descriptions 122
Describing Managerial/Professional Jobs
Verify the Description 123
Job Analysis: Bedrock or Bureaucracy?
Job Analysis and Globalization 126
122
125
Job Analysis and Susceptibility to
Offshoring 126
Job Analysis Information and Comparability
across Borders 128
Judging Job Analysis
128
Reliability 128
Validity 129
Acceptability 129
Currency 129
Usefulness 129
A Judgment Call 130
Your Turn: The Customer-Service Agent
131
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Table of Contents
Chapter Five
Job-Based Structures and Job
Evaluation 140
Competencies and Employee Selection and
Training/Development 192
Guidance (and Caution) from the Research
on Competencies 192
Job-Based Structures: Job Evaluation 141
Defining Job Evaluation: Content, Value,
and External Market Links 142
Content and Value 142
Linking Content with the External Market
Technical and Process Dimensions 143
“How-To”: Major Decisions
One More Time: Internal Alignment Reflected in
Structures (Person-Based or Job-Based) 194
Administering and Evaluating the Plan 194
142
143
Wages Criteria Bias
198
201
147
PART THREE
Who Should Be Involved?
EXTERNAL COMPETITIVENESS:
DETERMINING THE PAY LEVEL
161
The Design Process Matters
161
The Final Result: Structure 163
Balancing Chaos and Control 164
Your Turn: Job Evaluation at Whole Foods
Chapter Six
Person-Based Structures
Chapter Seven
Defining Competitiveness
165
Types of Skill Plans 174
Purpose of the Skill-Based Structure
How Labor Markets Work
Labor Demand 224
Marginal Product 224
Marginal Revenue 224
Labor Supply 226
177
178
Person-Based Structures: Competencies
188
186
221
221
Modifications to the Demand Side
183
Defining Competencies 186
Purpose of the Competency-Based Structure
Objective 188
What Information to Collect? 188
Whom to Involve? 190
Establish Certification Methods 190
Resulting Structure 190
Compensation Strategy: External
Competitiveness 214
What Shapes External Competitiveness?
Labor Market Factors 221
174
What Information to Collect? 179
Whom to Involve? 179
Establish Certification Methods 181
Outcomes of Skill-Based Pay Plans: Guidance
from Research and Experience 181
“How-To”: Competency Analysis
213
Control Costs and Increase Revenues 215
Attract and Retain the Right Employees 219
173
Person-Based Structures: Skill Plans
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195
198
The Perfect Structure 199
Your Turn: Climb the Legal Ladder
146
Ranking 147
Classification 148
Point Method 149
“How To”: Skill Analysis
Reliability of Job Evaluation Techniques
Validity 197
Acceptability 198
Bias in Internal Structures
Establish the Purpose 144
Single versus Multiple Plans 144
Choose among Job Evaluation Methods
Job Evaluation Methods
v
226
Compensating Differentials 226
Efficiency Wage 227
Sorting and Signaling 229
Modifications to the Supply Side (Only
Two More Theories to Go) 230
Reservation Wage 230
Human Capital 230
Product Market Factors and Ability to Pay
Product Demand 231
Degree of Competition 231
A Different View: What Managers Say
231
232
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vi Table of Contents
Segmented Supplies of Labor and (Different)
Going Rates 232
Organization Factors
234
Industry and Technology 234
Employer Size 234
People’s Preferences 234
Organization Strategy 235
Relevant Markets
Interpret Survey Results and Construct a
Market Line 278
236
Defining the Relevant Market 236
Globalization of Relevant Labor Markets:
Offshoring and Outsourcing 237
Competitive Pay Policy Alternatives
240
What Difference Does the Pay-Level Policy Make? 240
Pay with Competition (Match) 240
Lead Pay-Level Policy 242
Lag Pay-Level Policy 242
Different Policies for Different Employee
Groups 243
Not by Pay Level Alone: Pay-Mix Strategies 243
Consequences of Pay-Level and Pay-Mix
Decisions: Guidance from the Research 248
Efficiency 248
Fairness 249
Compliance 249
Your Turn: Two-Tier Wages
250
Verify Data 279
Statistical Analysis 284
Update the Survey Data 286
Construct a Market Pay Line 286
Setting Pay for Benchmark and Non-benchmark
Jobs 288
Combine Internal Structure and External
Market Rates 290
From Policy to Practice: The Pay-Policy
Line 291
Choice of Measure 291
Updating 291
Policy Line as Percent of Market Line
Why Bother with Grades and Ranges? 292
Develop Grades 293
Establish Range Midpoints, Minimums,
and Maximums 293
Overlap 294
Flexibility-Control
7-A: Utility Analysis 252
Reconciling Differences
Chapter Eight
Designing Pay Levels, Mix, and Pay
Structures 262
Major Decisions 263
Specify Competitive Pay Policy
The Purpose of a Survey 264
263
Adjust Pay Level—How Much to Pay? 264
Adjust Pay Mix—What Forms? 264
Adjust Pay Structure? 264
Study Special Situations 265
Estimate Competitors’ Labor Costs 265
Select Relevant Market Competitors
Design the Survey
mil32720_fm_i-xviii.indd 6
269
270
295
298
Balancing Internal and External Pressures:
Adjusting The Pay Structure 298
255
Fuzzy Markets
292
From Policy to Practice: Grades and Ranges 292
From Policy to Practice: Broad Banding
Appendix
Your Turn
Who Should Be Involved? 270
How Many Employers? 270
Which Jobs to Include? 273
What Information to Collect? 275
265
Market Pricing
298
299
Business Strategy (More Than “Follow
the Leader”) 299
Review 300
Your Turn: Google’s Evolving Pay
Strategy 301
Still Your Turn: Word-of-Mouse: Dot-Com
Comparisons 302
PART FOUR
EMPLOYEE CONTRIBUTIONS:
DETERMINING INDIVIDUAL PAY
Chapter Nine
Pay-for-Performance: The Evidence 312
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vii
Table of Contents
What Behaviors Do Employers Care About?
Linking Organization Strategy to Compensation
and Performance Management 314
What Does It Take to Get These Behaviors? What
Theory Says 319
What Does It Take To Get These Behaviors?
What Practitioners Say 323
Does Compensation Motivate Behavior? 328
Do People Join a Firm Because of Pay? 328
Do People Stay in a Firm (or Leave) Because
of Pay? 329
Do Employees More Readily Agree to Develop
Job Skills Because of Pay? 330
Do Employees Perform Better on Their Jobs
Because of Pay? 330
Designing a Pay-for-Performance Plan
334
Efficiency 334
Equity/Fairness 336
Compliance 337
Your Turn: Burger Boy
Employee Stock Ownership Plans (ESOPs) 375
Performance Plans (Performance Share and
Performance Unit) 375
Broad-Based Option Plans (BBOPs) 376
Combination Plans: Mixing Individual and
Group 376
Your Turn
377
Appendix
10-A: Profit-Sharing (401K) at
Walgreens 378
Chapter Eleven
Performance Appraisals
The Role of Performance Appraisals in
Compensation Decisions 386
Performance Metrics
337
348
What is a Pay-for-Performance Plan? 348
Does Variable Pay Improve Performance
Results? The General Evidence 350
Specific Pay-for-Performance Plans: Short Term 350
Merit Pay 350
Merit Bonuses Aka Lump-Sum Bonuses 352
Individual Spot Awards 352
Individual Incentive Plans 353
Individual Incentive Plans: Advantages and
Disadvantages 356
Individual Incentive Plans: Examples 357
Team Incentive Plans: Types
384
387
Strategies for Better Understanding and
Measuring Job Performance 388
Chapter Ten
Pay-for-Performance Plans
358
Comparing Group and Individual Incentive
Plans 364
Large Group Incentive Plans 365
Gain-Sharing Plans 365
Profit-Sharing Plans 370
Earnings-at-Risk Plans 371
Group Incentive Plans: Advantages and
Disadvantages 372
Group Incentive Plans: Examples 373
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Explosive Interest in Long-Term Incentive Plans 373
The Balanced Scorecard Approach 388
Strategy 1: Improve Appraisal Formats 389
Strategy 2: Select the Right Raters 398
Strategy 3: Understand How Raters Process
Information 400
Strategy 4: Training Raters to Rate More
Accurately 404
Putting It All Together: The Performance
Evaluation Process 405
Equal Employment Opportunity and
Performance Evaluation 407
Tying Pay to Subjectively Appraised
Performance 408
Competency: Customer Care 409
Performance- and Position-Based
Guidelines 410
Designing Merit Guidelines 411
Your Turn: Performance Appraisal at American
Energy Development 413
Appendix
11-A: Balanced Scorecard Example:
Department of Energy (Federal
Personal Property Management
Program) 417
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viii Table of Contents
11-B: Sample Appraisal Form for
Leadership Dimension: Pfizer
Pharmaceutical 420
Defined Contribution Plans 481
Individual Retirement Accounts (IRAs) 483
Employee Retirement Income Security Act
(ERISA) 483
How Much Retirement Income to Provide? 485
PART FIVE
Life Insurance 486
Medical and Medically Related Payments
EMPLOYEE BENEFITS
Chapter Twelve
The Benefit Determination
Process 442
Why the Growth in Employee Benefits?
444
Wage and Price Controls 444
Unions 444
Employer Impetus 444
Cost Effectiveness of Benefits 445
Government Impetus 445
The Value of Employee Benefits 445
Key Issues in Benefit Planning, Design, and
Administration 446
Benefits Planning and Design Issues
Benefit Administration Issues 448
Components of a Benefit Plan
446
450
Employee Benefit Communication
Claims Processing 459
Cost Containment 460
Your Turn: World Measurement
457
474
Retirement and Savings Plan Payments
mil32720_fm_i-xviii.indd 8
481
491
Benefits for Contingent Workers 493
Your Turn: Adapting Benefits to a Changing
Strategy 493
EXTENDING THE SYSTEM
501
Who Are Special Groups? 502
Compensation Strategy for Special
Groups 502
461
Workers’ Compensation 474
Social Security 476
Unemployment Insurance 478
Family and Medical Leave Act (FMLA) 480
Consolidated Omnibus Budget Reconciliation
Act (COBRA) 480
Health Insurance Portability and Accountability Act
(HIPAA) 480
Defined Benefit Plans
491
Paid Time Off During Working Hours
Payment for Time Not Worked 491
Child Care 492
Elder Care 492
Domestic Partner Benefits 493
Legal Insurance 493
Chapter Fourteen
Compensation of Special Groups
458
Chapter Thirteen
Benefit Options 470
Legally Required Benefits
Miscellaneous Benefits
PART SIX
Employer Factors 451
Employee Factors 455
Administering The Benefit Program
486
General Health Care 486
Health Care: Cost Control Strategies 489
Short- and Long-Term Disability 490
Dental Insurance 491
Vision Care 491
480
Supervisors 502
Corporate Directors 503
Executives 504
What’s All the Furor over Executive
Compensation? What the Critics and Press
Say 510
What’s All the Furor over Executive Compensation?
What Academics Say 514
Scientists and Engineers in High-Technology
Industries 516
Sales Forces 520
Contingent Workers 524
Your Turn: A Sports Sales Plan
526
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Table of Contents
Chapter Fifteen
Union Role in Wage and Salary
Administration 534
Localizer: “Think Global, Act Local” 582
Exporter: “Headquarters Knows Best” 582
Globalizer: “Think and Act Globally and Locally” 582
Expatriate Pay
The Impact of Unions in Wage
Determination 536
Unions and Alternative Reward Systems
543
Lump-Sum Awards 544
Employee Stock Ownership Plans (ESOPs)
Pay-for-Knowledge Plans 544
Gain-Sharing Plans 545
Profit-Sharing Plans 545
544
546
550
555
MANAGING THE SYSTEM
560
569
571
The Total Pay Model: Strategic Choices
572
National Systems: Comparative Mind-Set
572
Japanese Traditional National System 572
German Traditional National System 576
Strategic Comparisons: Traditional Systems in
Japan, Germany, United States 577
Evolution and Change in the Traditional Japanese
and German Models 580
582
614
Minimum Wage 618
Overtime and Hours of Work
Child Labor 627
Trade Unions and Employee Involvement 564
Ownership and Financial Markets 564
Managerial Autonomy 565
Comparing Costs (and Productivity) 566
Labor Costs and Productivity 566
Cost of Living and Purchasing Power
Overview
Fair Labor Standards Act Of 1938
Is National Culture a Major Constraint on
Compensation? 562
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Borderless World Borderless Pay?
Globalists 591
Your Turn: IBM’s Worldwide Business and
Employment Strategies and Compensation 592
Still Your Turn: Globalization of the Labor
Market: The English Premier League 596
Government as Part of the Employment
Relationship 614
Centralized or Decentralized Pay-Setting
Regulation 557
Strategic Market Mind-Set
Objectives? Quel
Chapter Seventeen
Government and Legal Issues in
Compensation 611
The Global Context 552
The Social Contract 554
Comparing Systems
Expatriate Systems
dommage! 590
584
PART SEVEN
Your Turn: Predicting a Contract’s Clauses
Culture
583
Elements of Expatriate Compensation
The Balance Sheet Approach 586
Union Impact on General Wage Levels 536
The Structure of Wage Packages 538
Union Impact: The Spillover Effect 539
Role of Unions in Wage and Salary Policies and
Practices 539
Chapter Sixteen
International Pay Systems
ix
618
620
Living Wage 627
Employee or Independent Contractor?
Prevailing Wage Laws 631
Antitrust Issues 631
Pay Discrimination: What is it? 632
The Equal Pay Act 634
628
Definition of Equal 634
Definitions of Skill, Effort, Responsibility,
Working Conditions 635
Factors Other Than Sex 635
“Reverse” Discrimination 636
Title VII of the Civil Rights Act of 1964 and
Related Laws 636
Disparate Treatment 638
Disparate Impact 639
Executive Order 11246
639
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x
Table of Contents
Pay Discrimination And Dissimilar Jobs
642
Evidence of Discrimination: Use of Market
Data 642
Evidence of Discrimination: Jobs of
Comparable Worth 643
Earnings Gaps
646
Sources of the Earnings Gaps
Compliance: A Proactive Approach 652
Your Turn: From Barista to Manager 653
Still Your Turn: “I Was Gaga’s Slave” 654
Managing Labor Costs and Revenues
Managing Labor Costs 667
665
666
Number of Employees (a.k.a.: Staffing Levels
or Headcount) 667
Hours 671
Benefits 672
Average Cash Compensation (Fixed and
Variable Components) 672
Budget Controls: Top Down 673
Budget Controls: Bottom Up 677
Embedded (Design) Controls 679
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681
Using Compensation to Retain (and Recruit)
Top Employees 682
Managing Pay to Support Strategy and Change 684
Communication: Managing The Message 684
Say What? (Or, What to Say?)
Opening the Books 689
648
Chapter Eighteen
Management: Making It Work
Managing Revenues
689
Structuring The Compensation Function and
Its Roles 690
Centralization–Decentralization (and/or
Outsourcing) 690
Ethics: Managing or Manipulating? 694
Your Turn: Communication by Copier 695
Still Your Turn: Managing Compensation Costs,
Headcount, and Participation/Communication
Issues 696
Glossary
702
Name Index
Subject Index
721
733
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About the Authors
JERRY M. NEWMAN
Dr. Jerry Newman is a SUNY Distinguished Professor at State University of New
York–Buffalo. His interests are in the area of human resource management, with
particular emphasis on compensation and rewards. He is author of the book My Secret Life on the McJob: Lessons in Leadership Guaranteed to Supersize Any Management Style (McGraw-Hill, 2007). This book was selected as one of the twelve
“Best of 2007” by The Wall Street Journal. Newman is also coauthor with George
Milkovich of earlier editions of Compensation, a best-in-class-book for McGrawHill since 1984. His article, “Compensation Lessons from the Fast Food Trenches”
(WorldatWork, March 2007, pp. 22–27), was chosen as SNAPS National feature
article winner in 2008. He is also author of approximately 100 articles on compensation and rewards, performance management, and other HR issues. In more than
30 years of consulting, Jerry has worked with such companies as Cummins Engine,
AT&T, Graphic Controls, Hewlett-Packard, RJR Nabisco, Sorrento Cheese,
McDonalds, and A & W Root Beer. Dr. Newman is a recipient of nine teaching
awards, including the SUNY Chancellor’s Award for Excellence in teaching. He
loves to work with students, so send him an e-mail sometime!
BARRY GERHART
Barry Gerhart is the Bruce R. Ellig Distinguished Chair in Pay and Organizational Effectiveness, School of Business, University of Wisconsin–Madison. Professor Gerhart
received his B.S. in Psychology from Bowling Green State University and his Ph.D. in
Industrial Relations from the University of Wisconsin–Madison. He serves on the editorial
boards of the Academy of Management Journal, Industrial and Labor Relations Review,
International Journal of Human Resource Management, Journal of Applied Psychology,
Journal of World Business, Management and Organization Review, Management
Revue, and Personnel Psychology. Professor Gerhart is a past recipient of the Scholarly
Achievement Award, the International Human Resource Management Scholarly Achievement Award (twice), and the Heneman Career Achievement Award, all from the Human
Resources Division, Academy of Management. He is also a Fellow of the Academy of
Management. Professor Gerhart has served previously as a department chair and/or area
coordinator at Cornell, Vanderbilt, and Wisconsin. He has held visiting appointments at
Bayreuth University, King’s College London, and Copenhagen Business School.
GEORGE T. MILKOVICH
George T. Milkovich is the M. P. Catherwood Emeritus Professor at the Industrial
Labor Relations School, Cornell University. For more than 40 years he has studied
and written about how people get paid and what difference it makes. Milkovich
served on several editorial boards and received many awards for his research contributions. He received the Keystone Award for Lifetime Achievement from the
WorldatWork Association and the Distinguished Career Contributions Award from
xi
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xii About the Authors
the Academy of Management, and he is a Fellow in both the Academy of Management and the National Academy of Human Resources. He chaired the National
Academy of Sciences Committee on Performance and Pay. Milkovich is one of the
founders of the Center for Advanced HR Studies, a research and development partnership of leading corporations and Cornell’s ILR School. He also advised numerous companies around the world on their compensation strategies, received three
outstanding teacher awards, and was a visiting professor at several international
universities in Europe and Asia. Milkovich conducted executive seminars in many
countries and served on advisory boards of leading academic/research centers in
the United States and China.
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Preface
A few books can change your life. Our book may not be one of them. However, if
you read it, you will better understand that pay matters. After all, you can’t pick up a
newspaper, power up a computer, or read a blog today without someone talking about
compensation. The Great Recession had major ramifications for pay. Some folks had
their hours cut and/or their pay frozen or reduced. Why? Because it’s a way to cut
compensation costs (though not necessarily the benefits portion of compensation
costs) without laying off workers. Others, of course, were laid off and lost their jobs,
income, and benefits. The recession also focused attention on executive compensation.
As the government bailed out the financial industry, newspapers were reporting large bonuses going to the very employees who helped cause the financial disaster. With the end
of the recession, we saw employers put less emphasis on cutting labor costs and more
emphasis on hiring (sometimes even in the United States). However, job growth was initially quite modest. Why? Employers have become increasingly careful about adding
new workers because they want to keep costs under control and they don’t want to have
to reduce the workforce if they guess wrong about increasing product demand (and the
need for more workers). But competition for some types of workers has increased and
wages, salaries, and benefits have likewise increased for such workers, meaning that employers must continually evaluate and benchmark their pay to be competitive.
Pay also matters around the globe. For example, if you are a Russian cosmonaut,
you can earn a bonus of $1,000 for every space walk you take (technically known as
“extravehicular activity,” or EVA), up to three per space trip. A contract listing specific
tasks to be done on a space mission permits you to earn up to $30,000 above the $20,000
you earn while you are on the ground. (In contrast to the Russian cosmonauts, wealthy
Americans are lining up to pay $15 million [plus an additional $20 million airfare] to the
Russian Space Agency for their own personal EVA.) Conclusion: Pay matters.
If you read this book, you will also better understand that what you pay for matters.
Many years ago, when Green Giant discovered too many insect parts in the pea packs
from one of its plants, it designed a bonus plan that paid people for finding insect
parts. Green Giant got what it paid for: insect parts. Innovative Green Giant employees
brought insect parts from home to add to the peas just before they removed them and
collected the bonus.
The Houston public school district also got what it paid for when it promised
teachers bonuses of up to $6,000 if their students’ test scores exceeded targets. Unfortunately, several teachers were later fired when it was discovered that they had
leaked answers to their students and adjusted test scores.
Such problems are global. A British telephone company paid a cash bonus to operators based on how quickly they completed requests for information. Some operators discovered that the fastest way to complete a request was to give out a wrong number or—
even faster—just hang up on the caller. “We’re actually looking at a new bonus scheme,”
says an insightful company spokesperson. Conclusion: What you pay for matters.
If you read this book, you will also learn that how you pay matters. Motorola
trashed its old-fashioned pay system that employees said guaranteed a raise every six
xiii
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xiv
Preface
months if you were still breathing. The new system paid for learning new skills and
working in teams. Sound good? It wasn’t. Employees resented those team members
who went off for six weeks of training at full pay while remaining team members
picked up their work. Motorola was forced to get rid of its new-fashioned system, too.
Microsoft employees were also grumbling. More were leaving; top recruits were
going elsewhere. The lackluster performance of Microsoft stock was depressing the
value of the eye-popping stock options the company routinely doled out. What to do?
Rather than stock options, Microsoft changed its pay system to give employees actual
shares of stock with a value that was immediately known. This move increased the value
of employees’ pay and eliminated the risk they faced from the stock performance. What
did Microsoft get? Happier, more expensive people. No word yet on product innovation,
customer satisfaction, or even quality of new hires. Conclusion: How you pay matters.
We live in interesting times. Anywhere you look on the globe today, economic and
social pressures are forcing managers to rethink how people get paid and what difference it makes. Traditional approaches to compensation are being questioned. But
what is being achieved by all this experimentation and change? We have lots of fads
and fashions, but how much of it is folderol?
In this book, we strive to cull beliefs from facts, wishful thinking from demonstrable
results, and opinions from research. Yet when all is said and done, managing compensation is part science, but also part art.
ABOUT THIS BOOK
This book focuses on the strategic choices in managing compensation. We introduce these
choices, real-world issues that managers confront from New York to New Zealand and
all points between, in the total compensation model in Chapter 1. This model provides an
integrating framework that is used throughout the book. Major compensation issues are
discussed in the context of current theory, research, and practice. The practices illustrate
new developments as well as established approaches to compensation decisions.
Each chapter contains at least one e-Compensation box to point you to some of the vast
compensation information on the Internet. Real-life Your Turn cases ask you to apply the
concepts and techniques discussed in each chapter. For example, the Your Turn in Chapter 9
draws on Professor Newman’s experience when he worked undercover for 14 months in
seven fast-food restaurants. The case takes you into the gritty details of the employees’
behaviors (including Professor Newman’s) during rush hour, as they desperately work to
satisfy the customers’ orders and meet their own performance targets set by their manager.
You get to recommend which rewards will improve employees’ performance (including
Professor Newman’s) and customers’ satisfaction. We tackle major compensation issues
from three sides: theory, research, and practice—no problem can survive that onslaught!
The authors also publish Cases in Compensation, an integrated casebook designed
to provide additional practical skills that apply the material in this book. The casebook is available directly from the authors (e-mail: cases.in.compensation@gmail.com).
Completing the integrated case will help you develop skills readily transferable to
future jobs and assignments. Instructors are invited to e-mail for more information on
how Cases in Compensation can help translate compensation research and theory into
practice and build competencies for on-the-job decisions.
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Preface
xv
But caveat emptor! “Congress raises the executive minimum wage to $565.15
an hour,” reads the headline in the satirical newspaper The Onion (www.onion.
com, “America’s Finest News Source”). The article says that the increase will help
executives meet the federal standard-of-easy-living. “Our lifestyles are expensive
to maintain,” complains one manager. Although the story in The Onion may clearly
be fiction, sometimes it is more difficult to tell. One manager told us that when she
searched for this textbook in her local bookstore, store personnel found the listing in
their information system—under fiction!
WHAT’S NEW
All chapters have been revised, in recognition of ongoing changes at organizations
and in their competitive environments around the world. Many examples are provided
of the current pay strategies or practices used in specific, named companies. Some
of these are well established and successful (Apple, IBM, Microsoft, Merrill Lynch,
Nucor, Toyota), some face real problems (American Airlines, Best Buy, General Motors), and others are using unique practices (Google, Whole Foods). Whenever possible, we observe how the challenges faced by these companies have evolved over time.
This edition continues to emphasize the importance of total compensation and its relevance for achieving sustainable competitive advantage. It reinforces our conviction
that beyond how much people are paid, how they are paid really matters. Managing
pay means ensuring that the right people get the right pay for achieving objectives in
the right way. Greater emphasis is given to theoretical advances and evidence from
research. Throughout the book we translate this evidence into guidance for improving
the management of pay.
ACKNOWLEDGMENTS
In addition to our bookstore shopper, many people have contributed to our understanding of compensation and to the preparation of this textbook. We owe a special, continuing debt of gratitude to our students. In the classroom, they motivate and challenge us,
and as returning seasoned managers, they try mightily to keep our work relevant:
Kenneth Abosch
Hewitt Associates
Stephanie Argentine
Rich Products
Patrick Beall
Lockheed Martin
Joseph Bruno
Kodak
Karee Buerger
Hewitt Associates
Federico Castellanos
IBM EMEA
mil32720_fm_i-xviii.indd 15
Cindy Cohen
Impac
Andrew Doyle
Oppenheimer Fund
Brian Dunn
Maclagan
Bruce Ellig
Author
Thomas Fentner
Health Now
Rich Floersch
McDonald’s USA
04/12/15 3:08 pm
xvi Preface
Beth Florin
Clark Consulting
Richard Frings
Johnson & Johnson
Takashi Fujiwara
Mitsubishi
Yuichi Funada
Toshiba
Ted Grasela
Cognigen
Thomas Gresch
General Motors
Peter Hearl
YUM Brands (emeritus)
Lada Hruba
Bristol Meyers Squibb
Richard Ivey
KFC
Tae-Jin Kim
SK Group
Joe Kreuz
Advantage Professionals
Hiroshi Kurihara
Fuji Xerox
Christian LeBreton
IBM EMEA
Mitch Linnick
IBM
Tony Marchak
IBM EMEA
Masaki Matsuhashi
Toshiba
Randy McDonald
IBM
Nancy McGough
Room & Board
Matt Milkovich
Registry Nursing
Michael Milkovich
Warecorp
mil32720_fm_i-xviii.indd 16
Sarah Milkovich
Jet Propulsion Laboratory
Sonja Milkovich
Sled Dog Software
Pat Murtha
Pizza Hut
David Ness
Medtronic
Erinn Newman
American Express
Kelly Newman
Presbyterian Residence
Terrie Newman
HR Foundations
Stephen O’Byrne
Shareholder Value Advisors
Tony Ragusa
Stereo Advantage
Jaime Richardson
GE Healthcare
Lindsay Scott
Lindsay Scott & Associates
Jason Sekanina
Linear Technology
Rich Severa
Accretive Partners & Strategies LLC
Diana Southall
HR Foundations
Cassandra Steffan
Frito-Lay
Masanori Suzuki
Google Japan
Ichiro Takemura
Toshiba
Richard Their
Xerox
Jan Tichy
Merck
Andrew Thompson
Link Group Consultants
04/12/15 3:08 pm
Preface
Jose Tomas
Burger King
Karen Velkey
Northrop Grumman
xvii
Ian Ziskin
Northrop Grumman
Our universities—Cornell, Buffalo, and Wisconsin—provide forums for the interchange of ideas among students, experienced managers, and academic colleagues. We
value this interchange. Other academic colleagues also provided helpful comments on
this and previous editions of the book. We particularly thank:
Tom Arnold
Westmoreland Community College
Lubica Bajzikova
Comenius University, Bratislava
Stuart Basefsky
Cornell University
Glenda Barrett
University of Maryland
University College
Melissa Barringer
University of Massachusetts
Rebecca Bennett
Louisiana Tech University
Matt Bloom
University of Notre Dame
James T. Brakefield
Western Illinois University
Timothy Brown
San Jose State University
Lisa Burke
University of Tennessee–Chattanooga
Wayne Cascio
University of Colorado–Denver
Dennis Cockrell
Washington State University–Pullman
H. Kristi Davison
University of Mississippi
Lee Dyer
Cornell University
Allen D. Engle Sr.
Eastern Kentucky University
mil32720_fm_i-xviii.indd 17
Ingrid Fulmer
Rutgers University
Luis Gomez-Mejia
Arizona State University
Thomas Hall
Penn State University
Kevin Hallock
Cornell University
Robert Heneman
Ohio State University
Vandra Huber
University of Washington
Greg Hundley
Purdue
Debra D. Kuhl
Pensacola State College
Frank Krzystofiak
SUNY–Buffalo
David I. Levine
University of California–Berkeley
Frank B. Markham
University of Mississippi
Janet Marler
SUNY–Albany
Patrenia McAbee
Delaware County Community
College
Atul Mitra
Northern Iowa University
Michael Moore
Michigan State University
04/12/15 3:08 pm
xviii Preface
Bahaudin Mujtaba
Nova Southeastern University
Teresa S. Nelson
Butler County Community College
Bryan J. Pesta
Cleveland State University
Richard Posthuma
University of Texas at El Paso
Janez Prasnikar
University of Ljubljana
Vlado Pucik
IMD
Hesan Ahmed Quazi
Nanyang Business School
Sara Rynes
University of Iowa
Dow Scott
Loyola University Chicago
Jason Shaw
University of Minnesota
Thomas Stone
Oklahoma State University
mil32720_fm_i-xviii.indd 18
Warren Scott Stone
University of Arkansas at Little Rock
Michael Sturman
Cornell University
Ningyu Tang
Shanghai Jiao Tong
University
Thomas Li-Ping Tang
Middle Tennessee State
University
Tom Timmerman
Tennessee Tech University
Charlie Trevor
University of Wisconsin
Zhong-Ming Wang
Zhejiang University
Yoshio Yanadori
University of British Columbia
Tae Seok Yang
Western Illinois University
Nada Zupan
University of Ljubljana
04/12/15 3:08 pm
Part One
Introducing the Pay
Model and Pay Strategy
Why do we work? If we are fortunate, our work brings meaning to our lives,
challenges us in new and exciting ways, brings us recognition, and gives us
the opportunity to interact with interesting people and create friendships.
Oh yes—we also get a paycheck. Here in Part One of your book, we begin
by talking about what we mean by “pay” and how paying people in different ways can influence them and, in turn, influence organization success.
Wages and salaries, of course, are part of compensation, but so too, for
some employees, are bonuses, health care benefits, stock options, and/or
work/life balance programs.
Compensation is one of the most powerful tools organizations have to influence their employees. Managed well, it can play a major role in organizations
successfully executing their strategies through their employees. We will see how
companies like Whole Foods, Nucor, the SAS Institute, Microsoft, Google, and
others use compensation to attract, motivate, and retain the right employees to
execute their strategies. We will also see how companies like Apple sell premium
products at attractive price points, to an important degree by using suppliers
that have low labor costs. Managed less well, as bankruptcies at General Motors,
Chrysler, Lehman Brothers, and American Airlines (which stated that it needed
to reduce labor costs by $1.25 billion per year to be competitive), for example,
might indicate, compensation decisions can also come back to haunt you. In Part
One, we describe the compensation policies and techniques that organizations
use and the multiple objectives they hope to achieve by effectively managing
these compensation decisions.
Although compensation has its guiding principles, we will see that “the devil
is in the details” and how any compensation program is specifically designed and
implemented will help determine its success. We want you to bring a healthy
skepticism when you encounter simplistic or sweeping claims about whether a
particular way of managing compensation does or does not work. For example,
organizations, in general, benefit from pay for performance, but there are many
types of pay for performance programs and it is not always easy to design and
implement a program that has the intended consequences (and avoids unintended consequences). So, general principles are helpful, but only to a point.
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Part One Introducing the Pay Model and Pay Strategy
Thus, in Part One, our aim is to also help you understand how compensation
strategy decisions interact with the specific context of an organization (e.g., its
business and human resource strategies) to influence organization success. We
emphasize that good theory and research are fundamental to not only understanding compensation’s likely effects, but also to developing that healthy skepticism we want you to have toward simplistic claims about what works and what
does not.
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Chapter One
The Pay Model
Chapter Outline
Compensation: Does It Matter?
(or, “So What?”)
Compensation: Definition, Please
Society
Stockholders
Managers
Employees
Incentive and Sorting Effects of Pay on
Employee Behaviors
Global Views—Vive la différence
Forms of Pay
Cash Compensation: Base
Cash Compensation: Merit
Increases/Merit Bonuses/COLAs
Cash Compensation: Incentives
Long-Term Incentives
Benefits: Income Protection
Benefits: Work/Life Balance
Benefits: Allowances
Total Earnings Opportunities: Present
Value of a Stream of Earnings
Relational Returns from Work
A Pay Model
Compensation Objectives
Four Policy Choices
Pay Techniques
Book Plan
Caveat Emptor—Be an Informed
Consumer
1. Is the Research Useful?
2. Does the Study Separate Correlation
from Causation?
3. Are There Alternative Explanations?
Your Turn: The Role of Labor Costs in
Retail Electronics
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.”)1 They say something like: it’s true money
doesn’t buy everything, but if money can’t buy it, I can’t use it. OK, maybe something
of an exaggeration, but . . . . Yes? Well, 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, workers at Chrysler got total compensation (i.e., wages plus benefits) of
about $76 per hour, whereas U.S. workers 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, the
“strategy” was not sustainable. It ended up going through bankruptcy, being bought
3
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4
Part One Introducing the Pay Model and Pay Strategy
out by Fiat, and then reducing worker compensation costs as part of its strategy for
return to competitiveness. Specifically, Chrysler took steps (as part of its bankruptcy
plan) to bring its hourly labor costs down to about $49 more recently.2
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 40 U.S. manufacturing plants and 51,000 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. Of course, building too many vehicles that consumers did not want was also a
problem. But, having labor costs higher than the competition, 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 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 keep prices for its iPad and iPhone
lower than otherwise by outsourcing manufacturing to China in facilities owned
by the Hon Hai Precision Industry Co., Ltd (Foxconn), a Taiwanese company. (See
Chapter 7.) 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 themselves and their firms a lot of money.4 That is what happened—until
several years ago. Then, 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. Recently, 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.5
Does greater expertise in the design and execution of compensation plans play
a role in controlling excessive risk taking and other problematic behaviors and
encouraging a more positive culture? Congress and the president seemed to think so,
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Chapter 1
The Pay Model
5
because in hopes of avoiding a similar financial crisis in the future they put into place
legislation, the Troubled Asset Relief Program (TARP), which included restrictions
on executive pay designed to discourage executives from taking “unnecessary and
excessive risks.” Another 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 he 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.7 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.
COMPENSATION: DEFINITION, PLEASE
How people view compensation affects how they behave. It does not mean the same
thing to everyone. Your view probably differs, 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.
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 2013, among full-time workers in the United States, U.S. Bureau of Labor Statistics
data indicate that women earned 82 percent of what men earned, up from 62 percent in
1979.8 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, under
even a best case scenario, such adjustments would increase the women/men earnings
ratio to as high as about 90 percent, still leaving a sizable gap.9 Society has taken an
interest in such earnings differentials. One indicator of this interest is the introduction of laws and regulation aimed at eliminating the role of discrimination in causing
them.10 (See Chapter 17.)
Benefits given as part of a total compensation package may also be seen as a reflection of equity or justice in society. Employers spend about 44 cents for benefits on top
of every dollar paid for wages and salaries.11 Individuals and businesses in the United
States spend $2.9 trillion per year, or 17.4 percent of its economic output (gross domestic
product) on health care.12 Nevertheless, roughly 41 million people in the United States
(14 percent of the population) have no health insurance.13 (The Affordable Care Act of
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6
Part One Introducing the Pay Model and Pay Strategy
2010 is aimed at increasing coverage and one projection is the number of uninsured
will decrease to 23 million by 2023.)14 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, 8 in 10 of the uninsured in the United States are from
working families.15 Given that those who do have insurance typically have it through
an employer, it also follows then that as 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) in 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.) Exhibit 1.1 reveals that the hourly compensation (wages plus benefits)
for Mexican manufacturing work ($6.82) are about 19 percent of those paid in the
United States ($36.34). China’s estimated $3.38 per hour is about 9 percent of the U.S.
rate. However, the value of what is produced also needs to be considered. Productivity
in China is about 22 percent of that of U.S. workers, whereas Mexican worker productivity is 30 percent of the U.S. level.16 Finally, if low wages are the goal, there always
seems to be somewhere that is lower. Some companies (e.g., Coach) are now moving
work from 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 and Foxconn appears to be poised
to continue having a larger presence in China.17 (We return to the topic of international
comparisons in Chapter 7 and Chapter 16.)
EXHIBIT 1.1 Hourly Compensation Costs for Production Workers in Manufacturing and Economy-wide
Productivity (Gross Domestic Product, GDP, per Employed Person), in U.S. Dollars
Hourly Compensation Cost
China
Mexico
Czech Republic
United States
Germany
3.38
6.82
12.17
36.34
49.98
Productivity (GDP per employee)
15,250
20,275
26,781
68,374
42,343
Source: Hourly Compensation Cost: The Conference Board. International Comparisons of Hourly Compensation Costs in Manufacturing, 2013. December
2014. Productivity: The World Bank. http://data.worldbank.org/indicator/SL.GDP.PCAP.EM.KD. Extracted February 3, 2015.
Notes: Compensation includes wages and benefits. The most recent Conference Board compensation cost was $3.07 (in 2012) for China. The estimate for
China was obtained by inflating the Conference Board estimates based on data from the National Bureau of Statistics of China. Productivity is gross domestic
product (GDP), in constant 1990 PPP $, divided by total employment in the economy. Purchasing power parity (PPP) GDP is GDP converted to 1990 constant
international dollars using PPP rates. An international dollar has the same purchasing power over GDP that a U.S. dollar has in the United States.
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Chapter 1
The Pay Model
7
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.”18
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 will, in turn, 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
are betting that this $600 million will motivate employees to generate more than $600
million in extra revenue.
Stockholders have a particular interest in executive pay.19 (Executive pay will be
discussed further in Chapter 14.)20 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.21 In the absence
of such a linkage, concerns arise that executives can somehow use their influence to
obtain high pay without necessarily performing well. Exhibit 1.2 provides descriptive
data on chief executive officer (CEO) compensation. Note the large numbers (total
annual compensation of about $10 million to $11 million, depending on whether one
uses the median or mean) and also that the bulk of compensation (stock-related) is
connected to shareholder return or other performance measures (bonus). As such, one
would expect changes in CEO wealth and shareholder wealth to be, generally speaking, aligned. To be sure, there are overpaid executives who earn a lot and produce little
EXHIBIT 1.2
Annual
Compensation of
Chief Executive
Officers, 200
Largest (by
revenues)
U.S. Public
Companies
Median
Mean
Compensation Component
Salary
Bonus
Other
Stock granted + (estimated) value
of stock options granted
$ 1,100,000
$ 2,139,014
$ 184,674
$ 6,198,613
$ 1,161,343
$ 2,866,328
$ 284,929
$ 6,754,191
Total Annual Compensation
$10,130,520
$11,066,790
Source: Original data from S&P Capital IQ; USA TODAY research, as reported in Barbara Hansen and Mark Hannan. Millions
by millions, CEO pay goes up. USA TODAY, April 4, 2014 http://www.usatoday.com/story/money/business/2014/04/03/2013
-ceo-pay/7200481/.
Notes: Based on 200 Standard & Poor’s 500 companies that filed proxies with the Securities and Exchange Commission between
January 1 and March 27, 2014. Mean (but not median) compensation components sum to equal total annual compensation.
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Part One Introducing the Pay Model and Pay Strategy
in return for shareholders (or other stakeholders such as employees). However, the assessment of whether an executive is being paid appropriately for performance is not as
simple as it may seem:
Consider the example of Richard Fairbank, the CEO of Capital One, as reported in the annual
Wall Street Journal/Mercer CEO Compensation Survey (April 13, 2006). In 2005, Capital
One shareholders earned a one-year return of 2.7 percent, and over five years, had earned a
return of 5.8 percent. The survey reported that Fairbank received $249.3 million in total direct
compensation from Capital One in 2005. This large lump sum, compared with a relatively
small shareholder return number, implies a lack of alignment between shareholder return and
CEO compensation that was widely reported in the popular press. However, most of the
$249.3 million received by Fairbank arose from the exercise of stock options granted to him
in 1995 (and that expired in 2005, forcing him to exercise them or lose them). Over that longer time period (1995–2005), shareholder wealth at Capital One increased by $23 billion, for
a cumulative shareholder return of 802 percent.22
As the example indicates, the answer to how strongly CEO pay and shareholder return are related depends to some degree on how carefully the timing and measurement
of performance are addressed. One study, which sought to address this issue found a
strong relationship (ΔR2 = .35, ΔR = .59) over time between total shareholder return
and a new, corresponding concept, CEO return (i.e., change in CEO wealth). Exhibit
1.3 shows how CEO wealth changes in response to changes in shareholder wealth.
Although CEO and shareholder interests appear to be significantly aligned on average, there are important exceptions and it is certainly an ongoing challenge to ensure
that executives act in the best interest of shareholders. 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 2000 to 2008
period 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 risktaking 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.”23
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 was signed into law in 2010.
EXHIBIT 1.3
Chief Executive
Officer (CEO)
Return and
Shareholder
Return
Shareholder Return
25th percentile
Median
75th percentile
Shareholder Return in $
(change in wealth)
−198 milion
+163 million
+553 million
CEO Return in $
(change in wealth)
−0.7 million
+9.5 million
+21.6 million
Source: A. Nyberg, I. S. Fulmer, B. Gerhart, and M. A. Carpenter, “Agency Theory Revisited: CEO Returns and Shareholder Interest
Alignment,” Academy of Management Journal, 53 (2010), pp. 1029–1049.
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9
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.24
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 percent 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, who
enjoy an even lower cost of labor (4 percent to 6 percent), even though Costco pays
above-average wages for the industry.
Exhibit 1.4 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.25 Indeed, in a recent annual report, Costco 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 a recent annual report
that they “experience significant turnover in associates [i.e., employees] each year.”26
Based on Exhibit 1.4, 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 its
labor costs are higher than those of Sam’s Club and Walmart, it appears that this model
works for Costco because it helps 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 that it brings high returns through
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$11.00
$10.00
$ 8.40
$20.89
$15.00a
$12.57
$16.00
$ 9.08
$10.00
84
80
77
20%
50%
50%
Customer
Average Satisfac- Employee
Cashier tion (100 = Annual
Wage
highest)
Turnover
663
632
4,203
10,942
Stores
$110.2 billion
$ 57.2 billion
$279.4 billion
$476.3 billion
Revenues
143,288
132,911
156,793
100,621
Store Size
Average
(square ft.)
195,000
—
—
1,200,000
$1,160
$ 680
$ 424
$ 433
$565,190
—
—
$396,912
Revenue Revenues
Number of
per
per
Employees Square ft. Employee
aEstimated.
Notes: Separate turnover data unavailable for Sam’s Club. Overall Walmart turnover rate is thus used.
Sources: Starting Wage, Employee Annual Turnover, and Wage after 4 Years from Liza Featherstone, “Wage Against the Machine,” Slate, June 27, 2008; “The Costco Craze.” CNBC Television Report, April
26, 2012; Brad Stone. “Costco CEO Craig Jelinek Leads the Cheapest, Happiest Company in the World,” Business Week, June 06, 2013. www.businessweek.com. Customer Satisfaction Data from American
Customer Satisfaction IndexTM. http://www.theacsi.org/. Extracted May 17, 2012. Store Size, Number of Employees from 2014 Costco and 2014 Walmart annual reports. Average Cashier Wage from www
.glassdoor.com, extracted February 4, 2015.
Costco
Sam’s Club
Walmart
Walmart +
Sam’s Club
Wage
Starting after
Wage 4 Years
EXHIBIT 1.4 Pay Rates at Retail Stores, Customer Satisfaction, Employee Turnover, and Sales/Square Ft.
10 Part One
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11
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.27 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. 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?28
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.29
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. (See Chapter 14.) 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. (See Chapter 17.) Next, we turn to
how pay influences employee behaviors.
Incentive and Sorting Effects of Pay on Employee Behaviors
Pay can influence employee motivation and behavior in two ways. First, and perhaps
most obvious, 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.30 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 to attract more high-quality applicants, allowing them to be more selective in their
hiring. Similarly, higher pay levels may improve employee retention. (In Chapter 7, we
will talk about when paying more is most likely to be worth the higher costs.)
Less obvious perhaps, it is not only how much, but how an organization pays that can
result in sorting effects.31 Ask yourself: Would people who are highly capable and have
a strong work ethic and interest in earning a lot of money prefer to work in an organization that pays employees doing the same job more or less the same amount, 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
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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 equal (e.g., if they are not paid more for their higher performance),
translate into higher turnover, a likely significant problem to the degree it is the high performers leaving, especially to the degree that high performers in particular roles create a
disproportionately high amount of value for organizations.32 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 policy and
practice on dealing with outside offers (hopefully informed by research) is important.33
Let’s take a look at one especially informative study conducted by Edward Lazear
regarding incentive and sorting effects.34 Individual worker productivity was measured
before and after a glass installation company switched one of its plants from a salaryonly (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 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 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.
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.35
In China, the traditional characters for the word “compensation” are based on the symbols for logs and water; compensation provides the necessities in life. In the recent past,
the state owned all 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.36
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“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.37
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.
FORMS OF PAY
Exhibit 1.5 shows the variety of returns people receive from work. They are categorized
as total compensation and relational returns. The relational returns (learning opportunities, status, challenging work, and so on) are psychological.38 Total compensation
returns are more transactional. They include pay received directly as cash (e.g., base,
EXHIBIT 1.5 Total Returns for Work
TOTAL RETURNS
Relational Returns
Total
Compensation
Benefits
Cash
Compensation
Base
Merit/Cost
of Living
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Recognition &
Learning
Status
Opportunities
Employment Challenging
Security
Work
Income
Allowances
Protection
Work/Life
Long-Term
Balance
Incentives
Short-Term
Incentives
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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).39 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.40 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).41 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.42 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.
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.43
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.44 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.
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
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15
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.45 According to surveys, 90 percent of U.S. firms use merit pay increases.46 An
assessment (or rating) of recent past performance is made, with or without a formal
performance evaluation. In recent years, merit increase budgets (or average merit increases) have been just under 3 percent, creeping up to 3 percent most recently. 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.47 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.48 Merit bonuses 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.”49 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.50 We return to this issue in Chapter 18.
Cash Compensation: Incentives
Incentives also tie pay increases to performance.51 However, incentives differ from
merit adjustments. First, incentives do not increase the base wage and so must be reearned
each pay period. Second, the potential size of the incentive payment will generally
be known 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. Third, an incentive program
relies on an objective measure of performance (e.g., sales), whereas a merit increase
program typically relies on a subjective rating of performance. Although 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, uses return on capital (ROC). For every
quarter that a 6 percent ROC target is met or exceeded, Prax Air awards 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.
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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.
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 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 options to all their employees.52
Benefits: Income Protection
Exhibit 1.5 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
also make half the contributions to Social Security. (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 $611 billion per year on health care costs, or about 21 percent of all U.S.
health care expenditures. Among employers that provide health insurance, the cost
to provide family coverage is $16,834 per year per employee (the average employer
pays $12,011 of that and the average employee pays the remaining $4,283).53 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).54 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 it was
sometimes described as a pension and health care provider that also makes cars.
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
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17
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 so that family obligations
can be met), 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.”55 Medtronic believes that
this program permits employees to be “fully present” at work and less distracted by
conflicts between their work and nonwork responsibilities.
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. Sixty years 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.56 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.57
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 of
$50,000. If you stay with the firm 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.
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
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effect on employees’ behavior.58 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.59 Such factors are part of the total return, which is a
broader umbrella than total compensation.
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 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 in 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.)
A PAY MODEL
The pay model shown in Exhibit 1.6 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.
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 1.7. 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.60 The company
describes its commitment to offering the highest quality and least processed foods as a
shared responsibility. Its first compensation objective is “. . . committed to increasing
shareholder value.”
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19
EXHIBIT 1.6 The Pay Model
POLICIES
OBJECTIVES
TECHNIQUES
INTERNAL
ALIGNMENT
Work
Descriptions
Analysis
Evaluation/ INTERNAL
Certification STRUCTURE
EFFICIENCY
• Performance
• Quality
• Customer
COMPETITIVENESS
Market
Surveys
Definitions
Policy
Lines
PAY
STRUCTURE
and
Stockholder
• Cost
FAIRNESS
CONTRIBUTIONS
Seniority
Incentives
Based
Merit
Guidelines
PAY FOR
PERFORMANCE
COMPLIANCE
MANAGEMENT
Cost
Communication Change
EVALUATION
ETHICS
Fairness is a fundamental objective of pay systems.61 In Medtronic’s objectives,
fairness means “ensure fair treatment” and “recognize personal and family wellbeing.” 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.
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EXHIBIT 1.7 Pay Objectives at Medtronic and Whole Foods
Medtronic
Whole Foods
Support Medtronic mission and increased
complexity of business
Minimize increases in fixed costs
Attract and engage top talent
Emphasize personal, team, and Medtronic
performance
Recognize personal and family total well-being
Ensure fair treatment
We are committed to increasing long-term shareholder
value.
Profits are earned every day through voluntary exchange
with our customers.
Profits are essential to create capital for growth,
prosperity, opportunity, job satisfaction, and job security.
Support team member happiness and excellence.
We share together in our collective fate.
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.62 It suggests that the way a pay decision is made
may be equally as important to employees as the results of the decision.
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
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, it is all three simultaneously. All three must be
achieved. 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.63 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 1.8. 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 their jobs and pensions in the wake of legal and ethical misdeeds by
those at the top.
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, re-pricing
or backdating stock options to 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.
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Chapter 1
The Pay Model
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EXHIBIT 1.8 Enron’s Ethics Statement
Foreword
“As officers and employees of Enron Corp., its subsidiaries, and its affiliated companies, we are responsible
for conducting the business affairs of the companies in accordance with all applicable laws and in a moral
and honest manner. . . . We want to be proud of Enron and to know that it enjoys a reputation for fairness
and honesty and that it is respected. . . . Enron’s reputation finally depends on its people, on you and me.
Let’s keep that reputation high.”
July 1, 2000
Kenneth L. Lay
Chairman and Chief Executive Officer
Values
Respect
We treat others as we would like to be treated ourselves. We do not
tolerate abusive or disrespectful treatment. Ruthlessness, callousness, and
arrogance don’t belong here.
We work with customers and prospects openly, honestly, and sincerely.
When we say we will do something, we will do it; when we say we cannot
or will not do something, then we won’t do it.
We have an obligation to communicate. Here, we take the time to talk
with one another . . . and to listen.
We are satisfied with nothing less than the very best in everything we do.
. . . The great fun here will be for all of us to discover just how good we
can really be.
Integrity
Communication
Excellence
Source: www.thesmokinggun.com.
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.64
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 ...
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