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Compensation Twelfth Edition Jerry M. Newman State University of New York–Buffalo Barry Gerhart University of Wisconsin–Madison George T. Milkovich Cornell University mil32720_fm_i-xviii.indd 1 04/12/15 3:08 pm 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, 2011, and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOC/DOC 1 0 9 8 7 6 ISBN MHID 978-1-259-53272-6 1-259-53272-0 Senior Vice President, Products & Markets: Kurt L. Strand Managing Director: Susan Gouijnstook Vice President, Content Production & Technology Services: Kimberly Meriwether David Director: Michael Ablassmeir Brand Managers: Anke Weekes/Laura Hurst Spell Product Developer: Laura Hurst Spell Digital Product Analyst: Sankha Basu Executive Program Manager: Faye M. Herrig Content Project Manager: Mary Jane Lampe Content Project Managers (Assessment): Evan Roberts/Keri Johnson Buyer: Jennifer Pickel Content Licensing Specialists: Lori Slattery/Deanna Dausener Cover Designer: Studio Montage Compositor: MPS Limited Typeface: 10/12 Times Lt Std Printer: R. R. Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. 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. LCC HF5549.5.C67 M54 2017 | DDC 658.3/2—dc23 LC record available at http://lccn.loc.gov/2015041046 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. www.mhhe.com mil32720_fm_i-xviii.indd 2 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 3 04/12/15 3:08 pm 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 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 5 195 198 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 04/12/15 3:08 pm 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 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 7 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 04/12/15 3:08 pm 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 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 9 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 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 10 681 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 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 11 04/12/15 3:08 pm 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. mil32720_fm_i-xviii.indd 12 04/12/15 3:08 pm 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 mil32720_fm_i-xviii.indd 13 04/12/15 3:08 pm 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. mil32720_fm_i-xviii.indd 14 04/12/15 3:08 pm 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. mil32720_ch01_001-039.indd 1 02/12/15 11:25 am 2 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. mil32720_ch01_001-039.indd 2 02/12/15 11:25 am 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 mil32720_ch01_001-039.indd 3 02/12/15 11:25 am 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, mil32720_ch01_001-039.indd 4 02/12/15 11:25 am 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 mil32720_ch01_001-039.indd 5 02/12/15 11:25 am 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. mil32720_ch01_001-039.indd 6 02/12/15 11:25 am 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. mil32720_ch01_001-039.indd 7 02/12/15 11:25 am 8 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. mil32720_ch01_001-039.indd 8 02/12/15 11:25 am Chapter 1 The Pay Model 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 mil32720_ch01_001-039.indd 9 02/12/15 11:25 am mil32720_ch01_001-039.indd 10 $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 Introducing the Pay Model and Pay Strategy 02/12/15 11:25 am Chapter 1 The Pay Model 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 mil32720_ch01_001-039.indd 11 02/12/15 11:25 am 12 Part One Introducing the Pay Model and Pay Strategy 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 mil32720_ch01_001-039.indd 12 02/12/15 11:25 am Chapter 1 The Pay Model 13 “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 mil32720_ch01_001-039.indd 13 Recognition & Learning Status Opportunities Employment Challenging Security Work Income Allowances Protection Work/Life Long-Term Balance Incentives Short-Term Incentives 02/12/15 11:25 am 14 Part One Introducing the Pay Model and Pay Strategy 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 mil32720_ch01_001-039.indd 14 02/12/15 11:25 am Chapter 1 The Pay Model 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. mil32720_ch01_001-039.indd 15 02/12/15 11:25 am 16 Part One Introducing the Pay Model and Pay Strategy 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 mil32720_ch01_001-039.indd 16 02/12/15 11:25 am Chapter 1 The Pay Model 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 mil32720_ch01_001-039.indd 17 02/12/15 11:25 am 18 Part One Introducing the Pay Model and Pay Strategy 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.” mil32720_ch01_001-039.indd 18 02/12/15 11:25 am Chapter 1 The Pay Model 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. mil32720_ch01_001-039.indd 19 02/12/15 11:25 am 20 Part One Introducing the Pay Model and Pay Strategy 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. mil32720_ch01_001-039.indd 20 02/12/15 11:25 am Chapter 1 The Pay Model 21 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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