CHAPTER 1 THE PAY MODEL LEARNING OUTCOMES After studying Chapter 1 students should be able to: Describe how compensation is viewed differently by society, stakeholders, managers, and employees in Canada and around the world. Define the term compensation. Discuss major components of total returns for work. Identify and explain the three strategic objectives of compensation. Describe the four strategic policies in the pay model and the techniques associated with them. CHAPTER SUMMARY People may have different perspectives on compensation. From the societal perspective, compensation is viewed as a measure of justice as we as a cause of increased taxes and price increases. Stakeholders believe that paying employees in stock creates a sense of ownership that will improve organizational performance. Managers view compensation as a major expense and a means to influence employee behaviour. Employees view compensation as a return in exchange with their employer, or a reward. In other countries, compensation relates to being taken care of. Compensation refers to all forms of financial returns and tangible services and benefits that employee receive as part of an employment relationship. The two major components of total rewards are total compensation and relational returns. Total compensation is composed of cash compensation (base pay and incentives) and benefits. Relational returns include psychological aspects of work such as recognition and status, challenging work, and learning opportunities. The strategic objectives of compensation are (1) efficiency in performance and quality, satisfying customers and stockholders, and controlling costs, (2) fairness, and (3) compliance with laws and regulations. The four strategic policies in the pay model are internal alignment, external competitiveness, employee contributions, and management. The internal structure techniques associated with alignment are job analysis, descriptions, and evaluations/certification. The pay structure techniques associated with competitiveness are market definitions, surveys, and pay policy lines. The incentive program techniques associated with contributions are seniority-based, performance-based, and merit guidelines. The evaluation techniques associated with management are planning, budgeting, and communication. LECTURE OUTLINE WHY SHOULD WE CARE ABOUT COMPENSATION? Compensation influences the way employees behave. The link between behaviour and organizational effectiveness is important to consider. If employees also perceive compensation is not fair, then there is great potential for changes in their behaviour to undermine organizational performance. Compensation is a significant component of operating expenses and therefore must be controlled and monitored to ensure organizational viability. COMPENSATION: DEFINITION Compensation does not mean the same thing to everyone. Yet, how people view compensation affects how they behave at work. Thus, we must begin by recognizing different perspectives. Compensation refers to all forms of financial returns and tangible services and benefits that employees receive as part of an employment relationship. Society perceives compensation as a measure of justice (distributive). See Exhibit 1.1 on page 3 to observe the compensation gap between men and women. Stockholders view executive pay as a special interest. In Canada, pay for executives is supposed to be tied to the financial performance of the company. Unfortunately, this does not always happen. Managers view compensation as both an expense and an influence on employee work behaviours. Employees view compensation as a return for the work they perform. Global views of compensation differ around the world. For example, in China, the traditional characters are based on the signs for logs and water, provides the necessities in life. The word dai yu refers to how someone is being treated. In Japan, the word kyuyo is used for compensation, which means giving something.. FORMS OF PAY There are numerous forms of pay that collectively create a system of total rewards. See Exhibit 1.2 on page 6. Total rewards are all rewards received by employees, including: Cash compensation Benefits, and Relational returns A) Cash Compensation Base Pay Wage is the pay expressed at an hourly rate Salary is the pay expressed at monthly or annual rate. Merit increases are given as an increment to the base pay in recognition of past work behaviour. Cost-of-living adjustment gives the same percentage increase across the board to everyone, regardless of performance, in order to maintain pay levels relative to increases in the cost of living. Incentives/Variable Pay is one-time payments for meeting preestablished performance objectives in a future time period. Long-Term Incentives are intended to focus employee efforts on multi-year results. Incentives may be short or long term. B) Benefits Benefits are indirect compensation which includes health insurance, dental insurance, pensions, and life insurance. They help protect employees from the financial risks inherent in daily life. Insurance and Pensions include those legislated by law (CPP/QPP, EI and Workers’ Compensation) and those provided by the employer (company pension, health insurance, and life insurance) Work/Life Programs help employees better integrate their work and life responsibilities include time away from work (vacations, jury duty, drug counselling, financial planning, referrals for child and elder care, flexible work arrangements) Allowances are compensation to provide for items that are in short supply. C) Relational Returns Relational returns are the psychological returns employees believe they receive in the workplace, like the following Recognition and Status Employment Security Challenging Work Learning Opportunities What Do Employees Want? In the 2010 Global Workforce Study with 20 000 employees in 22 markets, the following were the primary wants of employees: Job security Job stability Managerial support Freedom and flexibility Personalized work experience Relational returns A PAY MODEL Pay Model in Exhibit 1.3 on page 10, contains three basic building blocks: the strategic compensation objectives, the strategic policies that form the foundation of the compensation system, and the techniques of compensation. 1) Strategic Compensation Objectives shape the pay system and serve as standard for evaluating the pay system. Efficiency improves performance, quality, delighting customers and stockholders and controlling labour costs. Fairness attempts to ensure fair pay treatment for all employees by recognizing employee contributions and employee needs. Procedural fairness is the fairness of the process used to make a decision. Compliance as a pay objective involves conforming to various federal, provincial and territorial compensation laws and regulations. 2) Four Strategic Policies Internal Alignment refers to pay comparisons between jobs or skill levels inside a single organization. Jobs and people’s skills are compared in terms of their relative contributions to the organization’s objectives. External Competitiveness refers to compensation relationships external to the organization; i.e., comparison with competitors. Since employees will make comparisons with others doing similar jobs, or with similar skills or competencies outside the organization, pay must be high enough to attract and retain a motivated work force. On the other hand, pay cannot be too high because the employer must control labour costs in order to remain competitive. Employee Contributions refers to relative emphasis placed on performance. The degree of emphasis to be placed on performance is an important policy decision, since it directly affects employees’ attitudes and work behaviours. Employers with strong pay-for-performance policies are more likely to place greater emphasis on incentives and merit pay. Management refers to the fact that the system will not achieve its objectives unless it is managed properly. Managers need to be competent and choose what forms of pay to include and how to position pay against competitors. They must communicate with employees and judge whether the system is achieving its objectives. 3) Pay Techniques Pay techniques are the procedures used to operationalize policy decisions. They are the mechanisms used to link the policy decisions to the overall compensation objectives. Job analysis and job evaluation are techniques used to establish a pay structure in order to achieve internal consistency in the pay system. Pay surveys are one technique used to establish external competitiveness. Incentive plans or performance based pay increases are techniques to distinguish employee contributions. BOOK PLAN Chapter 2 discusses how to formulate and implement a compensation strategy. Chapters 3, 4, 5, 6 (internal alignment) examines pay relationships within a single organization. Chapters 7, 8 examines external competitiveness- the pay relationships among competing organizations and analyzes the influence of market-driven forces. Chapters 9, 10 examines the amount of pay for each employee, how much and how often should pay be increased and on what basis. Chapter 11 discusses employee services and benefits. Chapter 12 examines the role of the government and unions in compensation. Chapter 13 includes planning, budgeting, evaluating and communication. More detail on global compensation systems is provided in the Appendix. CHAPTER 2 STRATEGIC PERSPECTIVE LEARNING OUTCOMES After studying Chapter 2 students should be able to: Identify the four steps to develop a total compensation strategy. Explain why managers should tailor their pay systems to support the organization’s strategy. Describe the three tests used to determine whether a pay strategy is a source of competitive advantage. Contrast the “best fit” perspective on compensation with the “best practices” perspective. CHAPTER SUMMARY The four steps to develop a total compensation strategy are: (1) assess total compensation implications, including business strategy and competitive dynamics, HR strategy, culture/values, social and political context, employee/union preferences and fit with other HR systems; (2) map out a total compensation strategy;(3) implement the strategy; and finally, (4) assess and realign the strategy to ensure achievement of the objectives. To improve organizational effectiveness, managers should align the compensation strategy to the organization’s strategy. The three tests used to determine whether a pay strategy is a source of competitive advantage are (1) Does it align? (2) Does it differentiate? And (3) Does it add value? The “best fit” perspective on compensation suggests that compensation be aligned, or fit. With the specific business strategy adopted by the organization. given its environment, in order to maximize competitive advantage. The “best practices” perspective suggests there is one set of best pay practices that can be applied universally across situations and strategies, attracting superior employees who then create a winning strategy. LECTURE OUTLINE SIMILARITIES AND DIFFERENCES IN STRATEGIES Sometimes different business units within the same corporation will have very different competitive conditions, adopt different business strategies, and thus fit different compensation strategies. As seen in Exhibit 2.1 on page 17, the compensation strategies for Google, Medtronic, and Merrill Lynch are compared and contrasted to demonstrate inter-company differences along the dimensions of objectives, internal alignment, external competitiveness, employee contributions, and management. In addition to inter-company differences, compensation strategies are also diverse within the same industry as compared with Google, Microsoft, and SAS. who collectively compete from the same pool of candidates and so it is important for each company to differentiate itself from its competitors. Finally, compensation strategies can vary within the same company pending the types of jobs and their linkage to industry compensation norms. Thus, a strategic perspective on compensation is more complex than it first appears. Taking a strategic perspective requires a focus on compensation decisions that help the organization gain and sustain competitive advantage. STRATEGIC CHOICES Compensation strategies require many critical decisions that are ongoing as opposed to static and fixed once struck. It is important to understand the relationship between strategy and competitive advantage. Ultimately an effective strategy will produce competitive strategy for the business. In determining strategy, key questions that need to be asked include: What business should we be in? How do we gain and sustain competitive advantage in this business? How should total compensation help this gain competitive advantage? See Exhibit 2.2 to see how these questions can be aligned with strategic choices. Strategy refers to the fundamental business decisions that an organization has made in order to achieve its strategic objectives, such as what business to be in and how to obtain competitive advantage. Competitive Advantage is a business practice or process that results in better performance than one’s competitors. What should the Compensation System Support? Support business strategy Support HR strategy Support Business Strategy The most common choice is that the compensation system should support the business strategy at the very least because the ultimate purpose of a business strategy is to gain and sustain competitive advantage. As business strategies change, compensation systems need to change (e.g., IBM’s strategic and cultural transformation.) Some typical strategic frameworks include Porter’s model and Miles and Snow. See Exhibit 2.3 on page 21 to review how different strategies lead to business responses that help to develop compensation systems. Support HR strategy It is logical to assume that the business strategy is created first prior to the HR strategy. Once the HR strategy is in place, the compensation system can be generated. The processes of recruiting and selecting, retaining, rewarding, compensating and motivating employees are linked to the HR strategy. For example, SAS keeps turnover low by having generous benefits as opposed to having the highest salaries. THE PAY MODEL GUIDES STRATEGIC PAY DECISIONS The Pay Model from Chapter 1 can be used to assess the strategic compensation decisions along the following dimensions: Objectives: How should compensation support the business strategy and be adaptive to the cultural and regulatory pressures in a global environment? Internal alignment: How differently should the different types of levels of skills and work be paid within the organization? External competitiveness: How should total compensation be positioned against competitors? Employee contributions: Should pay increases be based on individual and/or team performance, on experience and/or continuous learning, on improved skills, on changes in cost of living, etc.? Management: How open and transparent should the pay decisions be to all employees? Stated versus Unstated Strategies All organizations that pay people have a compensation strategy. Some may have written, or stated, compensation strategies for all to see and understand. Others may not even realize they have a compensation strategy (unstated strategy), claiming that “We do whatever it takes.” DEVELOPING A TOTAL COMPENSATION STRATEGY: FOUR STEPS Step 1: Assess Total Compensation Implications Business Strategy and Competitive Dynamics Organizations need to understand the industry in which they operate and plan to compete with. Competitive dynamics can be assessed globally. Pay comparisons between countries are difficult because of different practices and different priorities. HR Strategy: Does Pay Play a Supporting Roles or a Catalyst for Change? Compensation must fit the HR strategy so things like performance systems support the HR strategy. Whereas a flexible compensation system can be used to activate changes to the HR strategy. Culture/Values Pay systems should be congruent with the overall organization’s philosophy about the way they do business and the way they treat employees in the organization. See Exhibit 2.5 on page 25 for an example of the Medtronic Mission and Values statement. Social and Political Context Legal and regulatory requirements, cultural differences, changing work force demographics, expectations take on new meaning when addressed globally. Employee Preferences Employees are different, and have different preferences. Pay systems can be designed to reflect these differing preferences by increasing flexibility in the system. Union Preferences Influence by unions on pay systems remains significant in Canada. Unions are major players in Europe. The organization must consider union desires and work to design a pay system that will accomplish their goals yet still satisfy the union. Step 2: Decide On a Total Compensation Strategy Compensation strategy is formulated on the five decisions outlined in the pay model: set objectives specify four policy choices of: internal alignment external competitiveness employee contributions, and management. Steps 3 and 4: Implement the Strategy and Reassess the Fit Step 3 includes implementing the strategy via the design and execution of the compensation system. This means to essentially take the plan from the strategy and make it come to life in practice. Step 4 reassesses the fit from changing conditions and realigns the strategy to close the loop. Reassessing the fit supports continuous opportunities to learn, adapt and improve SOURCE OF COMPETITIVE ADVANTAGE: THREE TESTS There are three questions that are aligned with three tests of competitive advantage including the following: Is it aligned? Does it differentiate? And Does it add value? Align- with the business strategy, externally with the economic and socio-political conditions and internally within the overall HR system. Differentiate- sustained competitive advantage comes from how the pay system is different from others. One important aspect of competitive advantage is that it will strengthen if the pay system is unique and cannot be copied. Add Value- finding ways to calculate the return on investments from incentives, benefits and base pay. This supports a compensation system that focuses on human capital as the recipient of investments which can be dehumanizing for some. Of all the tests, adding value is the most difficult. “BEST FIT” VERSUS “BEST PRACTICES” The underlying premise of designing any pay system is that if the system reflects the organization’s strategy and values, and is responsive to both external considerations and internal employee needs, it is more likely to be successful in achieving its objectives. “Best Fit” The basic underlying premise of any strategic perspective is that if managers align pay decisions with the organization’s strategy and values, are responsive to employees and union relations, and are globally competitive, then the organization is more likely to achieve competitive advantage. The challenge is to design the “fit” with the environment, business strategy, and pay plan. The better the fit, the greater the competitive advantage. “Best Practices” Some believe that (1) a set of best practices exists, and (2) these practices can be applied universally across situations. Adopting best pay practices gives employer preferential access to superior HR talent. This talent, in turn, influences the strategy the organization adopts and be a source of competitive advantage. But many writers advocate their own view of what are “best practices.” GUIDANCE FROM THE EVIDENCE Research supports that specific pay strategies are only relevant under certain contextual boundaries. The most important question is to ask: “What practices pay off best under what conditions?” VIRTUOUS AND VISCIOUS CIRCLES Two examples of best practices include performance-based pay and stock options grants. In a virtuous circle (see Exhibit 2.6 on page 30), performance-based pay works best with an effective and productive organization. On the contrary, when an organization is not performing well, a vicious circle results in performance-based pay being ineffective. CHAPTER 3 DEFINING INTERNAL ALIGNMENT LEARNING OBJECTIVES After studying Chapter 3, students should be able to: Define what is meant by internal alignment and pay structure. Describe the three factors that determine how internal pay structures are designed. Describe the factors that shape internal structure. Explain the two strategic choices involved in designing internal pay structures. Explain three theoretical approaches to determine which pay structure is best for an organization. Describe three consequences of an internally aligned pay structure. LECTURE NOTES CHAPTER SUMMARY Internal alignment refers to the pay relationships between jobs, skills, and competencies within a single organization. The relationships form a structure that supports organizational strategy, supports the workflow, and motivates employee behaviour toward organization objectives. A pay structure is the array of pay rates for different work or skills. The three types of factors that define how internal pay structures are designed are: (1) the number of levels of work, (2) the pay differentials between the levels, and (3) the criteria used to determine these levels and differentials. The factors that shape internal pay structures are: (1) external factors such as economic pressures, government policies and regulations, and culture and (2) organizational factors such as strategy, human capital, work design, and employee acceptance. The two strategic choice involved in designing internal pay structures are: (1) how closely to link the pay structure to organization design and workflow (tailored or loosely coupled) and (2) how to distribute pay throughout the levels in the structure (egalitarian or hierarchical. Three theoretical approaches to determining which pay structure is best for an organization are equity theory, tournament theory and the institutional model. Equity theory focuses on how employees compare are work, qualifications, and pay to those of others. Tournament theory suggests that the greater the differences between salaries in the pay structure, the harder employees will work. Institutional theory suggests that organizations copy the “best practices” of others. Three consequences of an internally aligned pay structure are efficiency, fairness and legal compliance. COMPENSATION STRATEGY: INTERNAL ALIGNMENT (INTERNAL EQUITY) An internally consistent pay structure is one that supports the organization’s internal structure and is perceived as equitable when pay rates for different jobs within the organization are compared, i.e., the array of wage rates for different jobs in the organization is deemed to be fair or equitable. Internal alignment (Internal equity) Internal alignment, often called internal equity, refers to the relationship inside the organization between the jobs within a single organization. It is the relationship between pay structure and the design of the organization and the work that is relevant. It focuses attention on the importance of designing a pay structure that supports: the organization’s strategy, the workflow, and motivates behaviour toward the organization objectives See Exhibit 3.1 on page 37 to see an example of the Job Structure at an Engineering Firm. Supports Organization Strategy - An organization’s strategy is the plan to achieve its goals and objectives. Internal job structure needs to be aligned with the organizational strategy for these goals and objectives to be realized. Pay Structure - The array of pay rates for different work or skills within a single organization; the number of levels; the differentials in pay between the levels, and the criteria used to determine these differences create the structure Work Flow - Workflow refers to the process by which goods and services are delivered to the customer. The challenge is to design a pay structure that supports the efficient flow of that work. Motivates Behaviour - Internal pay structures influence employees’ behaviour by providing additional pay for promotions, more responsibility and more challenging work. The goal is to design the structures so they direct people’s efforts toward organization objectives. The criteria or rationale on which the structure is based should make clear the relationship between each job and the organization’s objectives. This is an example of “line-of-sight” which enables employees to see their work in relations to others, thereby offering the work greater transparency. STRUCTURES VARY BETWEEN ORGANIZATIONS An internal pay structure is defined by: The number of levels of work The pay differentials between the levels, and The criteria used to determine those levels and differentials Levels Levels reflect the overall hierarchy of the flow of work in the organization. It is important to note the number of levels and reporting relationships. Differentials Pay differences between the levels are called differentials. Differentials should be based on some measure of the differences in the value of the work to the organization. Criteria: Content and Value – work content and value are the most bases for determining internal structures. Content refers to the work performed in a job and how it gets done (like tasks, behaviours and knowledge). Value refers to the worth of the work: its relative based on skills required, complexity of tasks, and/or responsibility. Job-and Person-Based Structures- A job-based structure looks at work content - tasks, behaviours, responsibilities. A person-based structure shifts the focus to the employee: the skills, knowledge, or competencies the employee possesses. See Exhibit 3.2 on page 39 which shows how competencies for GE Healthcare. WHAT SHAPES INTERNAL STRUCTURES? There are many factors which shape internal structures both internal and external to the organization including: External Factors Economic pressures Government policies, laws, regulations Stakeholders Cultures and customs Organizational Fsctors Strategy Technology Human capital HR policy Employee acceptance Cost implications Internal Structure Levels Differentials Criteria EXTERNAL FACTORS Economic Pressures - Early theorists concentrated on the supply of labour to explain pay structures with the most famous being marginal productivity theory. Government Policies, Laws, and Regulations - In Canada, human rights legislation forbids pay systems that discriminate on the basis of gender, race, religion, sexual orientation, national origin and many other grounds. Pay equity acts require “equal pay for work of equal value,” based on skill, effort, responsibility, and working conditions. Much pay-related legislation attempts to regulate economic forces to achieve social welfare objects. The most obvious place to affect an internal structure is at the minimums (minimum wage legislation) and maximums (special reporting requirements for executive pay). External Stakeholders - Unions, stakeholders, and political groups all have a stake in formulating internal pay structures. Unions seek small pay differences among jobs and seniority-based promotions as a way to promote solidarity among members. Cultures and Customs - Culture is the mental programming for processing information that people share in common. Such shared mindsets may form a judgement of what is “fair.” Incorporates views from various disciplines, including sociology and philosophy. Society values of the 13th and 14th centuries were known as the ‘just wage doctrine’. This approach utilized customs and societal norms to determine wage rates. Appropriate wages were set according to the class of society. Market factors were ignored in the wage determination. ORGANIZATION FACTORS Organization Strategy - The basic belief of a strategic perspective is that pay structures that are not aligned with the organization strategy may become obstacles to the organization’s success. Organization’s Human Capital - A major influence on internal structures for human capital include education, experience, knowledge, abilities and skills. The stronger the link between skills, experience and an organization’s strategic objective, the more pay those skills will command. Organization and Work Design - Technology used to produce goods and services influences the organization design, and the skills/knowledge to perform the work. Overall HR Policies - The amount of pay tied to a promotion, the nature of promotions (i.e., lateral, development, and greater responsibilities) pay differences must be consistent with what the organization is trying to accomplish. There is a belief that more frequent promotions are perceived by employees as career progress. Internal Labour Markets: Combining External and Organizational Factors - The notion of internal labour markets, i.e., the policies and procedures that regulate internal hiring and promotions, form career paths, and pay is based on internal policy. This theory combines both economic and organizational factors. Internal labour markets do two things: determine pay for different jobs and allocate employees to those jobs. See Exhibit 3.5 for an Illustration of an Internal Labour Market Employee Acceptance: A Key Factor - Acceptance is based on two measures of fairness, distributive justice and procedural justice, along with ensuring employees that the structure is fair. Procedural justice refers to the fairness of the process by which a decision about compensation is made. (Were compensation policies followed?) Distributive justice refers to the fairness of the decision outcomes. (Were the financial resources divided fairly?) STRATEGIC CHOICES IN DESIGNING INTERNAL STRUCTURES Tailored versus Loosely Coupled – In a tailored structure the pay structure is well-defined for jobs with relatively small differences in pay; Loosely coupled structure occurs when pay structure for jobs are flexible, adaptable, and changing. Egalitarian versus Hierarchical - Egalitarian structures operate on the belief that all employees should be treated equally in their pay. This means that there are few levels, less hierarchy and small pay differentials between levels. A hierarchical pay structure would form the other extreme, with large pay differentials between levels that are linked with the organizational chart. See Exhibit 3.7 on page 48 to review a comparison of hierchical and egalitarian characteristics. GUIDANCE FROM THE EVIDENCE Equity Theory: Fairness Employees judge the equity of their pay by comparing the work, qualifications, and pay for jobs similar to theirs. Internal equity refers to compensation comparisons made within an organization, and external equity focuses on compensation comparisons and their perceived fairness relative to positions outside the organization. However, very little research addresses the question of which specific factors influence employees’ perceptions of the equity or fairness of the pay structure, as opposed to the equity or fairness of the pay. Most employees are not given their position within the pay stricture so that either egalitarian or hierarchical pay structures my be supported. Tournament Theory: Motivation and Performance Structures with greater differentials at the top have a more positive effect on performance than smaller differentials for people at all levels in the structure, according to tournament theory. The main thing affected by individuals’ performance is whether or not they get promoted to the next level. Pay has little motivational effect on people already in a job. Instead, the pay offered for a higher position motivates those at lower levels in the organization to come to work and do their best in order to stay in contention for promotion. Therefore, pay should be determined with its motivational effects on employees at lower levels in mind. It then follows that, within limits, the bigger the prize for getting to the next level, the greater the motivational impact the structure will have. See Exhibit 3.8 on page 50 to see how the pay differentials increase in relative terms to the previous levels with greater percent increases. Institutional Theory: Copy Others Institutional theory is one of the most interesting theories to consider when determining pay structure because rarely do organizations create a new structure from scratch when an organization is born. For purposes of efficiency and potentially legal compliance, a new organization will mimic the pay structures of effective organizations pending it has the resources to fully or partially implement the copied pay structure. Institutional theory says that practices of other firms influence an organization’s pay structure decisions and simply copy what others are doing. (More) Guidance From the Evidence Exhibit 3.9 summarizes the organizational outcomes that are aligned with internally aligned structure on page 51 including the following: Undertake training Increase experience Reduce turnover Facilitate career progression Facilitate performance Reduce pay-related grievances Reduce pay-related work stoppages WHICH STRUCTURE FITS BEST? In practice, the decision about which structures best fits a particular business strategy probably lies in our original definition of internal alignment: An internally aligned structure supports the work flow, is fair to employees, and directs their behaviour toward organization objectives. CONSEQUENCES OF STRUCTURES There are two practical reasons for paying attention to internal structures. The first is that there are unique jobs that reflect organization idiosyncrasies. The second reason for paying attention to internal alignment is that some jobs are valued by a specific organization more or less than the rates for that job in the market. What to consider? Efficiency Fairness Legal Compliance CHAPTER 2 STRATEGIC PERSPECTIVE LEARNING OUTCOMES After studying Chapter 2 students should be able to: Identify the four steps to develop a total compensation strategy. Explain why managers should tailor their pay systems to support the organization’s strategy. Describe the three tests used to determine whether a pay strategy is a source of competitive advantage. Contrast the “best fit” perspective on compensation with the “best practices” perspective. CHAPTER SUMMARY The four steps to develop a total compensation strategy are: (1) assess total compensation implications, including business strategy and competitive dynamics, HR strategy, culture/values, social and political context, employee/union preferences and fit with other HR systems; (2) map out a total compensation strategy;(3) implement the strategy; and finally, (4) assess and realign the strategy to ensure achievement of the objectives. To improve organizational effectiveness, managers should align the compensation strategy to the organization’s strategy. The three tests used to determine whether a pay strategy is a source of competitive advantage are (1) Does it align? (2) Does it differentiate? And (3) Does it add value? The “best fit” perspective on compensation suggests that compensation be aligned, or fit. With the specific business strategy adopted by the organization. given its environment, in order to maximize competitive advantage. The “best practices” perspective suggests there is one set of best pay practices that can be applied universally across situations and strategies, attracting superior employees who then create a winning strategy. LECTURE OUTLINE SIMILARITIES AND DIFFERENCES IN STRATEGIES Sometimes different business units within the same corporation will have very different competitive conditions, adopt different business strategies, and thus fit different compensation strategies. As seen in Exhibit 2.1 on page 17, the compensation strategies for Google, Medtronic, and Merrill Lynch are compared and contrasted to demonstrate inter-company differences along the dimensions of objectives, internal alignment, external competitiveness, employee contributions, and management. In addition to inter-company differences, compensation strategies are also diverse within the same industry as compared with Google, Microsoft, and SAS. who collectively compete from the same pool of candidates and so it is important for each company to differentiate itself from its competitors. Finally, compensation strategies can vary within the same company pending the types of jobs and their linkage to industry compensation norms. Thus, a strategic perspective on compensation is more complex than it first appears. Taking a strategic perspective requires a focus on compensation decisions that help the organization gain and sustain competitive advantage. STRATEGIC CHOICES Compensation strategies require many critical decisions that are ongoing as opposed to static and fixed once struck. It is important to understand the relationship between strategy and competitive advantage. Ultimately an effective strategy will produce competitive strategy for the business. In determining strategy, key questions that need to be asked include: What business should we be in? How do we gain and sustain competitive advantage in this business? How should total compensation help this gain competitive advantage? See Exhibit 2.2 to see how these questions can be aligned with strategic choices. Strategy refers to the fundamental business decisions that an organization has made in order to achieve its strategic objectives, such as what business to be in and how to obtain competitive advantage. Competitive Advantage is a business practice or process that results in better performance than one’s competitors. What should the Compensation System Support? Support business strategy Support HR strategy Support Business Strategy The most common choice is that the compensation system should support the business strategy at the very least because the ultimate purpose of a business strategy is to gain and sustain competitive advantage. As business strategies change, compensation systems need to change (e.g., IBM’s strategic and cultural transformation.) Some typical strategic frameworks include Porter’s model and Miles and Snow. See Exhibit 2.3 on page 21 to review how different strategies lead to business responses that help to develop compensation systems. Support HR strategy It is logical to assume that the business strategy is created first prior to the HR strategy. Once the HR strategy is in place, the compensation system can be generated. The processes of recruiting and selecting, retaining, rewarding, compensating and motivating employees are linked to the HR strategy. For example, SAS keeps turnover low by having generous benefits as opposed to having the highest salaries. THE PAY MODEL GUIDES STRATEGIC PAY DECISIONS The Pay Model from Chapter 1 can be used to assess the strategic compensation decisions along the following dimensions: Objectives: How should compensation support the business strategy and be adaptive to the cultural and regulatory pressures in a global environment? Internal alignment: How differently should the different types of levels of skills and work be paid within the organization? External competitiveness: How should total compensation be positioned against competitors? Employee contributions: Should pay increases be based on individual and/or team performance, on experience and/or continuous learning, on improved skills, on changes in cost of living, etc.? Management: How open and transparent should the pay decisions be to all employees? Stated versus Unstated Strategies All organizations that pay people have a compensation strategy. Some may have written, or stated, compensation strategies for all to see and understand. Others may not even realize they have a compensation strategy (unstated strategy), claiming that “We do whatever it takes.” DEVELOPING A TOTAL COMPENSATION STRATEGY: FOUR STEPS Step 1: Assess Total Compensation Implications Business Strategy and Competitive Dynamics Organizations need to understand the industry in which they operate and plan to compete with. Competitive dynamics can be assessed globally. Pay comparisons between countries are difficult because of different practices and different priorities. HR Strategy: Does Pay Play a Supporting Roles or a Catalyst for Change? Compensation must fit the HR strategy so things like performance systems support the HR strategy. Whereas a flexible compensation system can be used to activate changes to the HR strategy. Culture/Values Pay systems should be congruent with the overall organization’s philosophy about the way they do business and the way they treat employees in the organization. See Exhibit 2.5 on page 25 for an example of the Medtronic Mission and Values statement. Social and Political Context Legal and regulatory requirements, cultural differences, changing work force demographics, expectations take on new meaning when addressed globally. Employee Preferences Employees are different, and have different preferences. Pay systems can be designed to reflect these differing preferences by increasing flexibility in the system. Union Preferences Influence by unions on pay systems remains significant in Canada. Unions are major players in Europe. The organization must consider union desires and work to design a pay system that will accomplish their goals yet still satisfy the union. Step 2: Decide On a Total Compensation Strategy Compensation strategy is formulated on the five decisions outlined in the pay model: set objectives specify four policy choices of: internal alignment external competitiveness employee contributions, and management. Steps 3 and 4: Implement the Strategy and Reassess the Fit Step 3 includes implementing the strategy via the design and execution of the compensation system. This means to essentially take the plan from the strategy and make it come to life in practice. Step 4 reassesses the fit from changing conditions and realigns the strategy to close the loop. Reassessing the fit supports continuous opportunities to learn, adapt and improve SOURCE OF COMPETITIVE ADVANTAGE: THREE TESTS There are three questions that are aligned with three tests of competitive advantage including the following: Is it aligned? Does it differentiate? And Does it add value? Align- with the business strategy, externally with the economic and socio-political conditions and internally within the overall HR system. Differentiate- sustained competitive advantage comes from how the pay system is different from others. One important aspect of competitive advantage is that it will strengthen if the pay system is unique and cannot be copied. Add Value- finding ways to calculate the return on investments from incentives, benefits and base pay. This supports a compensation system that focuses on human capital as the recipient of investments which can be dehumanizing for some. Of all the tests, adding value is the most difficult. “BEST FIT” VERSUS “BEST PRACTICES” The underlying premise of designing any pay system is that if the system reflects the organization’s strategy and values, and is responsive to both external considerations and internal employee needs, it is more likely to be successful in achieving its objectives. “Best Fit” The basic underlying premise of any strategic perspective is that if managers align pay decisions with the organization’s strategy and values, are responsive to employees and union relations, and are globally competitive, then the organization is more likely to achieve competitive advantage. The challenge is to design the “fit” with the environment, business strategy, and pay plan. The better the fit, the greater the competitive advantage. “Best Practices” Some believe that (1) a set of best practices exists, and (2) these practices can be applied universally across situations. Adopting best pay practices gives employer preferential access to superior HR talent. This talent, in turn, influences the strategy the organization adopts and be a source of competitive advantage. But many writers advocate their own view of what are “best practices.” GUIDANCE FROM THE EVIDENCE Research supports that specific pay strategies are only relevant under certain contextual boundaries. The most important question is to ask: “What practices pay off best under what conditions?” VIRTUOUS AND VISCIOUS CIRCLES Two examples of best practices include performance-based pay and stock options grants. In a virtuous circle (see Exhibit 2.6 on page 30), performance-based pay works best with an effective and productive organization. On the contrary, when an organization is not performing well, a vicious circle results in performance-based pay being ineffective. CHAPTER 3 DEFINING INTERNAL ALIGNMENT LEARNING OBJECTIVES After studying Chapter 3, students should be able to: Define what is meant by internal alignment and pay structure. Describe the three factors that determine how internal pay structures are designed. Describe the factors that shape internal structure. Explain the two strategic choices involved in designing internal pay structures. Explain three theoretical approaches to determine which pay structure is best for an organization. Describe three consequences of an internally aligned pay structure. LECTURE NOTES CHAPTER SUMMARY Internal alignment refers to the pay relationships between jobs, skills, and competencies within a single organization. The relationships form a structure that supports organizational strategy, supports the workflow, and motivates employee behaviour toward organization objectives. A pay structure is the array of pay rates for different work or skills. The three types of factors that define how internal pay structures are designed are: (1) the number of levels of work, (2) the pay differentials between the levels, and (3) the criteria used to determine these levels and differentials. The factors that shape internal pay structures are: (1) external factors such as economic pressures, government policies and regulations, and culture and (2) organizational factors such as strategy, human capital, work design, and employee acceptance. The two strategic choice involved in designing internal pay structures are: (1) how closely to link the pay structure to organization design and workflow (tailored or loosely coupled) and (2) how to distribute pay throughout the levels in the structure (egalitarian or hierarchical. Three theoretical approaches to determining which pay structure is best for an organization are equity theory, tournament theory and the institutional model. Equity theory focuses on how employees compare are work, qualifications, and pay to those of others. Tournament theory suggests that the greater the differences between salaries in the pay structure, the harder employees will work. Institutional theory suggests that organizations copy the “best practices” of others. Three consequences of an internally aligned pay structure are efficiency, fairness and legal compliance. COMPENSATION STRATEGY: INTERNAL ALIGNMENT (INTERNAL EQUITY) An internally consistent pay structure is one that supports the organization’s internal structure and is perceived as equitable when pay rates for different jobs within the organization are compared, i.e., the array of wage rates for different jobs in the organization is deemed to be fair or equitable. Internal alignment (Internal equity) Internal alignment, often called internal equity, refers to the relationship inside the organization between the jobs within a single organization. It is the relationship between pay structure and the design of the organization and the work that is relevant. It focuses attention on the importance of designing a pay structure that supports: the organization’s strategy, the workflow, and motivates behaviour toward the organization objectives See Exhibit 3.1 on page 37 to see an example of the Job Structure at an Engineering Firm. Supports Organization Strategy - An organization’s strategy is the plan to achieve its goals and objectives. Internal job structure needs to be aligned with the organizational strategy for these goals and objectives to be realized. Pay Structure - The array of pay rates for different work or skills within a single organization; the number of levels; the differentials in pay between the levels, and the criteria used to determine these differences create the structure Work Flow - Workflow refers to the process by which goods and services are delivered to the customer. The challenge is to design a pay structure that supports the efficient flow of that work. Motivates Behaviour - Internal pay structures influence employees’ behaviour by providing additional pay for promotions, more responsibility and more challenging work. The goal is to design the structures so they direct people’s efforts toward organization objectives. The criteria or rationale on which the structure is based should make clear the relationship between each job and the organization’s objectives. This is an example of “line-of-sight” which enables employees to see their work in relations to others, thereby offering the work greater transparency. STRUCTURES VARY BETWEEN ORGANIZATIONS An internal pay structure is defined by: The number of levels of work The pay differentials between the levels, and The criteria used to determine those levels and differentials Levels Levels reflect the overall hierarchy of the flow of work in the organization. It is important to note the number of levels and reporting relationships. Differentials Pay differences between the levels are called differentials. Differentials should be based on some measure of the differences in the value of the work to the organization. Criteria: Content and Value – work content and value are the most bases for determining internal structures. Content refers to the work performed in a job and how it gets done (like tasks, behaviours and knowledge). Value refers to the worth of the work: its relative based on skills required, complexity of tasks, and/or responsibility. Job-and Person-Based Structures- A job-based structure looks at work content - tasks, behaviours, responsibilities. A person-based structure shifts the focus to the employee: the skills, knowledge, or competencies the employee possesses. See Exhibit 3.2 on page 39 which shows how competencies for GE Healthcare. WHAT SHAPES INTERNAL STRUCTURES? There are many factors which shape internal structures both internal and external to the organization including: External Factors Economic pressures Government policies, laws, regulations Stakeholders Cultures and customs Organizational Factors Strategy Technology Human capital HR policy Employee acceptance Cost implications Internal Structure Levels Differentials Criteria EXTERNAL FACTORS Economic Pressures - Early theorists concentrated on the supply of labour to explain pay structures with the most famous being marginal productivity theory. Government Policies, Laws, and Regulations - In Canada, human rights legislation forbids pay systems that discriminate on the basis of gender, race, religion, sexual orientation, national origin and many other grounds. Pay equity acts require “equal pay for work of equal value,” based on skill, effort, responsibility, and working conditions. Much pay-related legislation attempts to regulate economic forces to achieve social welfare objects. The most obvious place to affect an internal structure is at the minimums (minimum wage legislation) and maximums (special reporting requirements for executive pay). External Stakeholders - Unions, stakeholders, and political groups all have a stake in formulating internal pay structures. Unions seek small pay differences among jobs and seniority-based promotions as a way to promote solidarity among members. Cultures and Customs - Culture is the mental programming for processing information that people share in common. Such shared mindsets may form a judgement of what is “fair.” Incorporates views from various disciplines, including sociology and philosophy. Society values of the 13th and 14th centuries were known as the ‘just wage doctrine’. This approach utilized customs and societal norms to determine wage rates. Appropriate wages were set according to the class of society. Market factors were ignored in the wage determination. ORGANIZATION FACTORS Organization Strategy - The basic belief of a strategic perspective is that pay structures that are not aligned with the organization strategy may become obstacles to the organization’s success. Organization’s Human Capital - A major influence on internal structures for human capital include education, experience, knowledge, abilities and skills. The stronger the link between skills, experience and an organization’s strategic objective, the more pay those skills will command. Organization and Work Design - Technology used to produce goods and services influences the organization design, and the skills/knowledge to perform the work. Overall HR Policies - The amount of pay tied to a promotion, the nature of promotions (i.e., lateral, development, and greater responsibilities) pay differences must be consistent with what the organization is trying to accomplish. There is a belief that more frequent promotions are perceived by employees as career progress. Internal Labour Markets: Combining External and Organizational Factors - The notion of internal labour markets, i.e., the policies and procedures that regulate internal hiring and promotions, form career paths, and pay is based on internal policy. This theory combines both economic and organizational factors. Internal labour markets do two things: determine pay for different jobs and allocate employees to those jobs. See Exhibit 3.5 for an Illustration of an Internal Labour Market Employee Acceptance: A Key Factor - Acceptance is based on two measures of fairness, distributive justice and procedural justice, along with ensuring employees that the structure is fair. Procedural justice refers to the fairness of the process by which a decision about compensation is made. (Were compensation policies followed?) Distributive justice refers to the fairness of the decision outcomes. (Were the financial resources divided fairly?) STRATEGIC CHOICES IN DESIGNING INTERNAL STRUCTURES Tailored versus Loosely Coupled – In a tailored structure the pay structure is well-defined for jobs with relatively small differences in pay; Loosely coupled structure occurs when pay structure for jobs are flexible, adaptable, and changing. Egalitarian versus Hierarchical - Egalitarian structures operate on the belief that all employees should be treated equally in their pay. This means that there are few levels, less hierarchy and small pay differentials between levels. A hierarchical pay structure would form the other extreme, with large pay differentials between levels that are linked with the organizational chart. See Exhibit 3.7 on page 48 to review a comparison of hierchical and egalitarian characteristics. GUIDANCE FROM THE EVIDENCE Equity Theory: Fairness Employees judge the equity of their pay by comparing the work, qualifications, and pay for jobs similar to theirs. Internal equity refers to compensation comparisons made within an organization, and external equity focuses on compensation comparisons and their perceived fairness relative to positions outside the organization. However, very little research addresses the question of which specific factors influence employees’ perceptions of the equity or fairness of the pay structure, as opposed to the equity or fairness of the pay. Most employees are not given their position within the pay stricture so that either egalitarian or hierarchical pay structures my be supported. Tournament Theory: Motivation and Performance Structures with greater differentials at the top have a more positive effect on performance than smaller differentials for people at all levels in the structure, according to tournament theory. The main thing affected by individuals’ performance is whether or not they get promoted to the next level. Pay has little motivational effect on people already in a job. Instead, the pay offered for a higher position motivates those at lower levels in the organization to come to work and do their best in order to stay in contention for promotion. Therefore, pay should be determined with its motivational effects on employees at lower levels in mind. It then follows that, within limits, the bigger the prize for getting to the next level, the greater the motivational impact the structure will have. See Exhibit 3.8 on page 50 to see how the pay differentials increase in relative terms to the previous levels with greater percent increases. Institutional Theory: Copy Others Institutional theory is one of the most interesting theories to consider when determining pay structure because rarely do organizations create a new structure from scratch when an organization is born. For purposes of efficiency and potentially legal compliance, a new organization will mimic the pay structures of effective organizations pending it has the resources to fully or partially implement the copied pay structure. Institutional theory says that practices of other firms influence an organization’s pay structure decisions and simply copy what others are doing. (More) Guidance From the Evidence Exhibit 3.9 summarizes the organizational outcomes that are aligned with internally aligned structure on page 51 including the following: Undertake training Increase experience Reduce turnover Facilitate career progression Facilitate performance Reduce pay-related grievances Reduce pay-related work stoppages WHICH STRUCTURE FITS BEST? In practice, the decision about which structures best fits a particular business strategy probably lies in our original definition of internal alignment: An internally aligned structure supports the work flow, is fair to employees, and directs their behaviour toward organization objectives. CONSEQUENCES OF STRUCTURES There are two practical reasons for paying attention to internal structures. The first is that there are unique jobs that reflect organization idiosyncrasies. The second reason for paying attention to internal alignment is that some jobs are valued by a specific organization more or less than the rates for that job in the market. What to consider? Efficiency Fairness Legal Compliance Instructor Manual for Compensation George T. Milkovich, Jerry M. Newman, Barry Gerhart, Cole, Margaret Yap 9780071051569, 9781259086878, 9780078029493
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