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CHAPTER 11 PAY-FOR-PERFORMANCE PLANS LEARNING OUTCOMES After studying Chapter 11, students should be able to: Describe three short-term individual pay-for-performance plans. Discuss the five causes of problems with group compensation systems. Explain seven key issues in designing a gain-sharing plan. Explain the difference between stock options, broad-based option plans, and employee stock ownership plans. Describe three possible explanations for extremely high levels of CEO compensation. Identify the five basic elements of executive compensation packages. Define dual career ladders and maturity curves, and explain how these are used in compensating scientists and engineers in high-tech industries. CHAPTER SUMMARY Three short-term, individual pay-for-performances plans are: merit pay, lump-sum bonuses, and individual spot awards Five causes of problems with team compensation systems are: the need for different compensation programs for different types of teams, the loss of motivational impact if the team is very large, overly complex team compensation plans, lack of control by teams over what they are measured on, and poor communication of team-based plans. Seven key issues in designing a gain-sharing plan are: strength of reinforcement, productivity standards, sharing the gains between management and workers, scope of the formula, perceived fairness of the formula, ease of administration, and production variability. Employee stock ownership plans offer employees the opportunity to purchase company stock, often partially or fully matched by employer-paid stock for the employee. Stock options provide an employee with the right to purchase company stock at a specified price at a future time. Broad-based option plans are stock grants to employees over a specified time frame. Three possible explanations for extremely high levels of CEO compensation are: social comparisons to salaries of lower-level employees, the desirability of a relationship between pay and company success, and the agency theory suggestion that CEOs act with a self-protecting, political motivation. The five basic elements of executive compensation packages are: base salary, short-term (annual) incentives or bonuses, long-term incentives and capital accumulation plans, executive benefits, and perquisites. Dual career ladders are two different ways of progressing in an organization, one through a managerial ladder, the other through a scientific ladder. This approach helps to deal with the plateauing effect of gradual technological obsolescence, and accommodates the opportunity for mature scientists and engineers to switch to the management ladder. Maturity curves reflect the relationship between scientist/engineer compensation and years of experience in the labour market, as pay increases sharply for the first five to seven years and then rises more gradually due to the effect of technological obsolescence. LECTURE NOTES WHAT IS A PAY-FOR-PERFORMANCE PLAN? There is a shift in thinking about compensation in organizations from a sense of entitlement (paycheque) towards incorporating performance as a component of pay. Essentially, variable pay is linked to performance as a variable cost. As performance increases, there should be a subsequent increase to variable pay. These programs are becoming more popular for several reasons. One reason for initiating an alternative reward system is to try and control costs by linking rewards to performance. Another reason for the use of these plans is to encourage employees to adopt new technology and learn new skills and new ways to perform jobs to help the organization remain competitive. It is part of a movement away from a sense of entitlement. See Exhibit 11.1 on page 248 to review the extent of different variable pay plans in Canada. It is clear that cash bonuses or incentives are used by the majority of organizations that give these types of compensation. See .NETWORTH on page 249 to review the drivers of change in variable pay plans. The greatest drive of change is that variable pay plans are used for better alignment with business strategy. SPECIFIC PAY-FOR-PERFORMANCE PLANS: SHORT TERM Merit Pay Merit pay is an increase in base pay related to past performance. A merit pay system links increases in base pay (called merit increases) to how highly employees are rated on a subjective performance evaluation. At the end of a performance year, the employee is evaluated, usually by the direct supervisor. See Exhibit 11.2 on page 250 to review performance-based guidelines for merit pay See Exhibit 11.3 on page 251 to review an example of performance rating matrix for merit increases. Lump-Sum Bonuses Lump-sum bonuses are used by many Canadian organizations usually as a year-end bonus that does not build into base pay. See Exhibit 11.4 on page 252 to review an example that compares and contrasts the difference between merit pay and lump sum bonuses. Note that typically merit pay is more expensive because it increases the base pay. Individual Spot Awards Technically, spot awards should fall under pay-for-performance plans. About 30 percent of all companies use spot awards. Usually these payouts are awarded for exceptional performance, often on special projects or for performance that so exceeds expectations as to be deserving of an add-on bonus. Individual Incentive Plans: Types The common feature of all incentive plans is an established standard against which worker performance is compared to determine the amount of the incentive. Beyond that however, incentive plans can vary in (1) the method of rate determination (the way the standard is set); and (2) the specified relationship between production level and wages (the way wages are tied to output). See Exhibit 11.5 on page 253 to see an example of individual incentive plans while relating production and pay. Rate determination is done either based on the number of units of production in a certain time period, or on the time period per unit of production. The relationship between production level and wages can either be set so that wages are a constant function of production, or that wages vary as a function of production. Based on these qualifications, four general types of plans can be developed. Cell 1 illustrates the straight piecework system, where rate determination is based on units of production per time period, and wages vary directly as a function of production level. The advantage of this type of system is that it is easily understood by workers. The difficulty comes in setting an appropriate standard. See Exhibit 11.6 on page 254 to review an illustration of a straight piecework plan. Cell 2 illustrates two plans that set standards based on time per unit and tie incentives to the level of output. The first is a standard hour plan, which sets the incentive rate based on completion of a task in some expected time period. Regardless of the time actually taken to complete the task, pay is geared to the standard time. A Bedeaux plan is a variation on the straight piecework and standard hour plans. This plan divides a task into actions and measures the time required to perform each action. Cell 3 includes two plans that vary incentives as a function of the units of production per time period. Both are intended to reward efficient workers and penalize inefficient ones. The Taylor differential piece rate system varies the incentive level as a function of the level of production relative to a standard. A rate is used once production expectations are met. The Merrick multiple piece rate system operates similar to the Taylor plan except that three rates are established. See Exhibit 11.7 on page 255 to compare and contrast the differences between Taylor and Merrick plans. Cell 4 illustrates three plans that vary as a function of the standard set as a function of time period per unit of production. The Halsey 50-50 method splits between workers and the organization any savings in direct costs. The savings result from completion of a task in less time than a time study suggests. Individual Incentive Plans: Advantages and Disadvantages A common problem with incentive plans is that employees and managers end up in conflict because the incentive system often focuses only on one small part of what it takes for the company to be successful. See Exhibit 11.8 on page 256 to review some of the main advantages and disadvantages of individual incentive plans. See Exhibit 11.9 on page 256 to see the example of Lincoln Electric in Cleveland, Ohio as a successful example of individual incentives. Group Incentive Plans There is a shift to group incentives as we focus on people working in teams. A group incentive plan is incentive pay for meeting or exceeding team performance standards. The group might be a work team, a department, a division, or the whole company. See Exhibit 11.10 on page 257 to review the performance measures typically used in a balanced scorecard performance system. Challenges with Group Incentive Plans Individual incentive plans have better potential and probably better track records in delivering higher productivity. Group plans suffer from what is called the “free-rider” problem where at least one person doesn’t carry his or her share of the load. Yet, when it comes time to divide the rewards, they typically are shared equally. Problems like this have caused some companies to phase out many of its team reward packages. Top-performing employees quickly grow disenchanted with having to carry free riders. End result- turnover of the very group that is most costly to lose. Problems with group incentive plans have at least five additional causes including: Teams come in many varieties so it is hard to find one best type of plan. The “level problem” is related to the breadth of teams and so the motivational aspects of incentives can be diluted. Some incentives plans are too complex. There are some issues within the organization that occur beyond the control of the group or team. Many team-based pay plans are not well communicated. Types of Group Incentive Plans Gain-Sharing Plans Employees share in the gains in these types of group incentive plans. The following issues are key elements in designing a gain-sharing plans: strength of reinforcement, productivity standards, sharing the gains-split between management and workers, scope of the formula, perceived fairness of the formula, ease of administration, and production variability Scanlon Plans Scanlon plans are designed to lower labour costs without lowering the level of a firm’s activity. Incentives are designed as a function of the ratio between labour costs and sales value of production. See Exhibit 11.11 on page 260 to review some examples of a Scanlon plan. Rucker Plan While Scanlon plans focus on labour savings, Rucker plans focus on a variety of savings, thus making Rucker plans more flexible, yet more complex. In a Rucker plan ratio is calculated that expresses the value of production required for each dollar of total wages. Improshare Improshare is an acronym for IMproved PROductivity through SHARing. Improshare plans focus on savings achieved from production on an agreed upon output level in fewer than the expected hours, as determined from time and motion studies or historical records. The firm and the worker share the savings. Profit-Sharing Plans Profit-sharing plans are variable pay plans requiring a profit target to be met before any payouts occur. Profit-sharing plans are used in about 16 percent of Canadian organizations and continue to be popular because the focus is on the measure that matters most to people: some index of profitability. When payoffs are linked to these measures, employees spend more time learning about financial measures and the business factors that influence them. Earnings-at-Risk Plans are incentive plans that include reductions in base pay in unsuccessful years. In an earnings-at-risk plan, the base pay is reduced by some amount relative to the level that would be offered in a success-sharing plan. Clearly, earnings-at-risk plans shift some of the risk of doing business from the company to the employee. Group Incentive Plans: Advantages and Disadvantages Individual plans are stable or declining in interest, while group plans are becoming more common. This results from changing the nature of work whereby employees work together and their jobs are interdependent which makes determining individual incentives more difficult. Individual incentives yield higher productivity gains but group incentives are often more effective when team coordination is critical. See Exhibit 11.12 on page 262 to see more advantages and disadvantages of group incentive plans. See Exhibit 11.13 on page 263 to review the characteristics that help choose between individual and group plans. See also Exhibit 11.14 on pages 263-264 to consider the typical variable pay plans and their advantages and disadvantages. EXPLOSIVE INTERST IN LONG-TERM INCENTIVE PLANS All the previous individual and group incentives discussed earlier are short-term in nature which means typically for a year or less. Long-term incentives focus on performance beyond one year. The most common are Employee Stock Ownership Plans and Performance Plans. Stock Options A stock option is the right to purchase stock at a specified (exercise) price for a fixed time period. They are the most common type of long-term incentive used in Canada. Broad-Based Option Plans (BBOPs) Broad-based option plans are stock options provided to employees at all levels. BBOP are stock grants whereby the company gives employees shares of stock over some time frame. The strength of BBOPs is their versatility. Depending on the way they are distributed to employees, they can either reinforce a strong emphasis on performance or inspire greater commitment and retention of employees. Employee Stock Ownership Plans (ESOPs) Employee stock ownership plans are plans that offering employees the opportunity to purchase company stock, often partially or fully matched by employer-paid stock for the employee. One of the best examples of ESOPs is WestJet. PAY- FOR- PERFORMANCE FOR SPECIAL EMPLOYEE GROUPS Special groups share two characteristics. First, special groups tend to be placed in positions that have built-in conflict, conflict that arises because different factions place incompatible demands on members of the group. And second, simply facing conflict is not sufficient; the way that this conflict is resolved has important consequences for the success of the company. When both of these characteristics are present, it tends to find distinctive compensation practices adopted to meet the needs of these special groups. See Exhibit 11.15 on page 266 to review some of the conflicts faced by special groups. Compensation Strategy for Supervisors Organizations have devised several strategies to attract workers to supervisory jobs. The most popular method is to key the base salary of supervisors to some amount exceeding the top paid subordinate in the unit. Another method to maintain equitable differentials is simply to pay supervisors for scheduled overtime. The current trend in supervisory compensation centres on increased use of variable pay. Compensation Strategy for Corporate Directors Approximately two-thirds of boards now include more outside directors than inside directors. Outside members now include unaffiliated business executives and major shareholders. Outside directors usually are paid higher compensation. In addition to cash compensation, there is an increasing emphasis on director rewards that link to corporate performance. Compensation Strategy for Executives Much criticism has been levelled at the “excessive” compensation executives receive. However, it is important ask if the executive compensation seems reasonable. Possible Explanations for CEO Compensation: One explanation for the high pay of CEOs has to do with social comparisons. Here, upper level salaries maintain a consistent relative relationship to lower level salaries and rise when they do. Another explanation focuses on the level of executive wages, and says that the value of the CEO should correspond to some measure of the success of the organization. A third explanation involves political motivations and says that CEOs act in their own best interest to keep their pay high. See Exhibit 11.16 on page 268 to see the top earners in Canada in 2012. Note that the base-pay is very consistent but the total rewards vary significantly. Components of an Executive Compensation Package - there are five basic elements of most executive compensation packages: base salary, bonuses, long-term incentives and capital appreciation plans, executive benefits, and executive perquisites. The base salary and bonuses are important components of executive compensation. Long-term incentives are increasingly popular. See Exhibit 11.17 on page 271 to review an example of compensation components for executives. See also Exhibit 11.18 on page 271 to see examples of long-term incentives for executives. Compensation Strategy for Professional Employees Professional employees are those who have received special training of a scientific or intellectual nature, like scientists and engineers. A dual career track is a career progression on either a managerial path or a professional path. Because of the volatility of these occupations, organizations have developed maturity curves to reflect the external market data in order to price the base pay. Maturity curves reflect the relationship between scientist/engineer compensation and years of experience in the labour market. See Exhibit 11.19 n page 273 to review an example of IBM’s dual ladders. See Exhibit 11.20 on page 274 to review maturity curves. Designing a Sales Compensation Plan The challenge in setting compensation levels for the sale force is to equitably reward employees who are expected to work with much initiative, under little supervision, whose success often depends primarily on external market factors. There are six major factors that influence the design of sales compensation plans: the nature of people who enter the sales profession organizational strategy market maturity competitor practices economic environment the product to be sold. According to studies, pay is the highest ranked reward for sales people; therefore, compensation should focus on financial rewards more than other work attributes. The sales compensation must also be linked to the strategy of the organization. The measure of sales success should correspond to the strategy. Sales people have the often-unique opportunity to gather information from competitors about their compensation, so maintaining external equity in sales compensation is crucial to retention of the sales force. The nature of the product often influences the sales compensation. The level relationship between base salary and incentives depends on the kind of product being sold. If, for instance, the salesperson is expected to sell a new product and must spend a great deal of time in training to learn about the product, base salary might be greater. Compensation Strategy for Contingent Workers Contingent workers (AKA precarious employment) represent about one-third of the Canadian workforce. We define contingent workers as anyone who works through a temporary help agency, on-call, a contract company, or as an independent contractor. The first two of these groups typically earn less than workers in traditional arrangements; the latter two earn more. The fastest growing segment of contingent workers is technical experts. The real reason for contingent workers may be the added flexibility such employment offers the employer. In today’s fast-paced marketplace, lean and flexible are desirable characteristics. A major compensation challenge for contingent workers is identifying ways to deal with equity problems. Contingent workers may work along side permanent workers yet often receive lower wages and benefits for the same work. Employers deal with this potential source of inequity on two fronts. One company response is to view contingent workers as a pool of candidates for more permanent hiring status. A second way to look at contingent workers is to champion the idea of boundary-less careers. At least for high skilled contingent workers, it is increasingly popular to view careers as a series of opportunities to acquire valuable increments in knowledge and skills. CHAPTER 12 THE ROLE OF GOVERNMENT AND UNIONS IN COMPENSATION LEARNING OUTCOMES After studying Chapter 12, students should be able to: Explain the role of government in compensation. Describe the major compensation-related provisions of employment standards legislation. Explain the impact of human rights legislation on compensation. Discuss the causes of the male-female wage gap and explain what pay equity legislation is intended to accomplish Describe four ways in which unions have an impact on wage determination. Explain why union attitudes regarding pay-for-performance have gradually become more favourable. CHAPTER SUMMARY The role of government in compensation is to assess whether procedures for determining pay are fair, whether safety nets for the unemployed and disadvantaged are sufficient, and whether employees are protected from exploitation. Governments affect the supply of and demand for workers. The major compensation-related provisions of employment standards legislation are minimum wage, paid vacations, paid holidays, standard hours of work and overtime pay, pay on termination of employment, minimum age of employment, and equal pay for equal work by men and women. Human rights legislation affects compensation in that compensation decisions based on any of the prohibited grounds for discrimination are illegal. Employers must ensure that their compensation systems treat all groups neutrally, compensating for merit rather than membership in a particular group. The persistent wage gap between men and women can be partially, but not fully, explained by factors such as differences in: Occupation Hours worked Types of industries and firms where they are employed, and Union membership. Pay equity legislation is intended to redress the unexplained portion of the wage gap assumed to be due to gender discrimination. The laws are intended to address the effects of occupational segregation and the historical undervaluing of work done by women by requiring that female-dominated jobs be compensated in the same way as male-dominated jobs of the same value. Unions affect wage determination through their impact on: General wage levels The structure of wages Spillover effect on non-union firms, and Wage and salary policies and practices in unionized firms Union attitudes regarding pay-for-performance have gradually become more favourable because of the threat of overseas competitors with lower labour costs taking so much market share from unionized companies that they go out of business. LECTURE NOTES GOVERNMENT AS PART OF THE EMPLOYMENT RELATIONSHIP There is no exact role for government in the workplace because of differing political ideologies. Essentially, government is an important stakeholder in employment issues. It helps to determine whether procedures for determining pay are fair, ensures safety nets for the unemployed and disadvantaged are sufficient, and that employees are protected from exploitation. Others believe that government should exist to carry out public policy. Government policy decisions also affect compensation by affecting the supply and demand for labour. Supply of Labour Legislation aimed at protecting specific groups also tends to restrict that group’s participation in the labour market. Labour supply can also be influenced through licensing for certain occupations and immigration policy. Demand for Labour Government affects demand for labour most directly as a major employer. A government also indirectly affects labour demand through its purchases as well as its public policy decisions. If the government decides to lower interest rates, then this might stimulate greater demand for labour and put upward pressure on wages. EMPLOYMENT STANDARDS ACTS Each of the 14 jurisdictions regulating employment across Canada has enacted legislation. These jurisdictions include 10 provinces, 3 territories and the federal government. Employment standards acts will set out the minimum terms and conditions of employment. Minimum Wage Minimum wage laws are intended to provide an income floor for workers in society’s least productive job. The minimum hourly wage varies by jurisdiction, and is increased regularly as the cost of living rises. See Exhibit 12.1 on page 284 to show the minimum wages for different jurisdictions in Canada. Paid Vacation Each jurisdiction recognizes that vacations are necessary to ensure continued employee health and productivity. The specific amounts of minimum vacation vary across jurisdictions, but the basic structure and philosophy of the laws regarding vacations are similar across the country. In lieu of vacation time, vacation pay is often given to employees. Paid Holidays Each jurisdiction recognizes that there are days of special significance that citizens celebrate together and provide for paid days off from work to observe these holidays. (e.g., Labour Day) Standard Hours of Work and Overtime Pay Employment standards legislation sets out the standard hours of work for employees, and provides for overtime pay when an employee is required to work more than these standard hours. Standard hours of work vary between 40-48 hours per week. Pay on Termination of Employment In the event that the company terminates the employment of one of its workers, certain payments are required to be made. The employer must provide a minimum notice of termination during which time the employee continues to be paid or else receives the same payment in lieu of notice. Minimum Age of Employment Restrictions on child labour were one of the primary reasons for the creation of employment laws, in recognition of the importance of ensuring that children have access to education, and of protecting their safe and normal development. All jurisdictions have established a minimum age for employment, ranging from 14 to 17. Equal Pay for Equal Work by Men and Women All jurisdictions require that men and women who are doing similar work be paid equally. The legislation also applies to men and women doing substantially the same work, based on an assessment of skill, effort, responsibility, and working conditions required in each case. HUMAN RIGHTS LAWS Human rights legislation has been enacted in every jurisdiction in Canada, and guarantees every person equal treatment in regard to employment and opportunity for employment regardless of race, colour, creed/religion, sex, sexual orientation, marital status, age, mental or physical disability. The human rights legislation is based on the Charter of Rights and Freedoms and so it is complaint-based. It is up to the employee to initiate a complaint to the human rights tribunal and to absorb all the legal expenses until an investigation is made. PAY EQUITY Sadly, gender remains the best predictor of wages. In Canada, women earn approximately $0.70 for every dollar a Canadian man. The 30 percent difference is called the gender wage gap. The gender wage gap is defined as the amount by which the average pay for female workers is less than the average pay for male workers. A variety of factors contribute to the wage gap including: differences in occupations, qualifications and experience differences in industries and firms differences in union membership the presence of discrimination See Exhibit 12.2 on page 287 to review some earnings data to review the significant differences in full-time workers between 2000-2009. Differences in Occupations, Qualifications, and Experience One of the most important factors in the pay gap is differences in jobs held by men and women. Occupational segregation is the historical segregation of women into a small number of occupations such as clerical, sales, nursing and teaching. See Exhibit 12.3 on page 288 to review the differences in earnings between men and women. Differences in Number of Hours Worked On average, male full-time workers put in 6 percent more hours per week than women full-time workers. Much of the narrowing the initial wage gap and of the widening of wage pay as the years progressed was “unexplained,” meaning it was not explained by job characteristics, experience, or individual characteristics. The one factor that did explain some of the wage gap was hours of work; women have been working fewer hours than men, particularly women with children. Differences in Industries and Firms Other factors that affect earnings differences between men and women are the industry and the firms in which they are employed. Differences in the firm’s compensation policies and objectives within a specific industry are another factor that accounts for some of the earnings gap. Differences in Union Membership Finally, we also know that belonging to a union will affect differences in earnings. Belonging to a union increases wages. Presence of Discrimination. Many factors negatively affect pay including discrimination. It should be noted that discrimination is not just a male-female issue. Discrimination can be based on disabilities, race, sex, and sexual orientation, age, creed, and so forth. Pay Equity Legislation Pay Equity is intended to redress the unexplained portion of the wage gap assumed to be due to gender discrimination. Pay equity legislation is legislation intended to redress the unexplained portion of the gender wage gap by requiring employers to proactively pursue equal pay for work of equal value between female-dominated and male-dominated jobs. The Pay equity process is detailed, technical and complex. The following steps are the basic components of a pay equity process: identify the unit for which the pay equity plan will be developed. identify job classes with similar duties and responsibilities. identify male and female job classes. assess the value of jobs using a gender-neutral (free of gender bias) job evaluation system based on skill, effort, responsibility and working conditions compare male and female job classes. identify where compensation adjustments are required due to disparities in compensation between male and female job classes of equal value. develop a pay equity plan that sets out how the differences in compensation that were discovered through the pay equity process will be remedied. make compensation adjustments, up to limits prescribed by legislation. There are three methods to compare male and female job classes including: job-to-job method – this is a method of comparing pay for male- and female-dominated job classes, in which each female job class is compared to a male job class of equal of comparable value. proportional value-wage line method – this is a method of comparing pay for male- and female-dominated job classes when female job classes have no appropriate male comparators under the job-to-job system, in which the wage line for male job classes is applied when setting pay for female job classes proxy comparison method – method of comparing pay for male- and female-dominated job classes when pay equity cannot be achieved through job-to-job or proportional value methods, in which female job classes are compared to similar female job classes that have achieve pay equity with another employer. See Exhibit 12.4 on page 291 to review a graph for a proportional value-wage line method. THE IMPACT OF UNIONS ON WAGE DETERMINATION There are four general factors that affect wages in unionized organizations including: general wage levels the structure of wages non-union firms (also known as spillover) wage and salary policies and practices in unionized firms. Union Impact on General Wage Levels A common belief about unions is that they raise the level of wages and benefits of workers above those of non-union workers. In practice, it is difficult to compare union and non-union wages to determine the impact of the union. The ideal situation would be to examine two organizations that were identical except for the presence of the union. An alternative approach is to examine organizations in the same industry that differ in their level of unionization. Another approach is to examine organizations in different industries with different levels of unionization. This is difficult, however, since there are many other differences in industries besides the presence or absence of a union that could influence wage rates. The general conclusion from research on the issue is that union workers earn approximately 10 percent more than their non-union counterparts and the size of the gap varies from year to year. The Structure of Wage Packages Unions also have a strong influence on the structure of wage packages. Unions have traditionally bargained for good benefits packages. A more recent element of wage structure includes the use of two-tier wage structures that differentiate wages based on an employee’s hiring date. Organizations use these structures to help control costs. Unions see them as an alternative to wage freezes and layoffs. Since two-tier plans go against union principles of equal treatment, unions may favour other cost control strategies as an alternative to two-tier plans. Union Impact: The Spillover Effect The effects of unions on the wages of non-union organizations is known as the spillover effect. The spillover effect is a situation where employers` seeking to avoid unionization offer workers the wages, benefits, and working conditions won in rival unionized firms. Here, organizations will offer wages, benefits, and working conditions similar to those offered in unionized organizations in order to remain union free. Role of Unions in Wage and Salary Policies and Practices The areas of union involvement in the administration of compensation generally include: (1) Basis for pay; (2) Occupational-wage differentials; (3) Experience/Merit differentials; (4) Other differentials; (5) Vacations and Holidays; and (6) Wage adjustment provisions. The areas of involvement are illustrated by examining how they are addressed in union contracts. As a basis for pay, most contracts specify that jobs are to be paid on an hourly basis, with overtime after a fixed number of hours. Contracts may also specify a premium for working non-standard shifts. If incentive pay is included, unions generally want to discuss their establishment and include specifics of the incentive plan in the contract. Unions agree to occupation/wage differentials across occupations but prefer one wage rate within an organization. Single rate contracts for jobs do not have provisions for experience/merit differentials within a job classification. For jobs paid within a range, most contracts specify that the basis for increases in the range will be seniority. Contracts may also specify that movement in the range will be based on merit, or a combination of seniority and merit, but unions specify that disputes in the size of merit awards will be settled through grievance procedures. Other differentials may be possible for the pay of new or probationary employees. Therefore, contracts address pay differentials for geographic area and some address differentials for part-time and temporary employees. Vacations and Holidays are very specifically addressed in contracts. Wage adjustment provisions are made to handle wage adjustments during multi-year contracts. One example of this kind of provision is a cost of living agreement. UNIONS AND ALTERNATIVE REWARD SYSTEMS International competition causes a fundamental problem for unions. If a unionized company settles a contract and the company raises prices to cover the increased wage costs, there is always the threat that an overseas competitor with lower labour costs will capture market share. Eventually, enough lost market share means the unionized company will be out of business. To keep this from happening, unions have become more receptive in recent years to alternative reward systems that link pay to performance. After all, if worker productivity rises, product prices can remain relatively stable, even with wage increases. Alternative reward systems include lump sum, piece rate, gain-sharing, profit sharing, and skill-based pay. Willingness to try such plans is greater when the firm faces extreme competitive pressure. CHAPTER 13 COMPENSATION BUDGETS AND ADMINISTRATION LEARNING OUTCOMES After studying Chapter 13, students should be able to: Explain the three components of labour cost and how they are mathematically combined to create total labour cost. Describe how salary level can be controlled by a top-down approach and a bottom-up approach. Identify four inherent controls in compensation design techniques. Explain the six stages in the compensation communication cycle. Discuss the various issues regarding how organizations structure the compensation function. CHAPTER SUMMARY The three components of labour cost are employment (number of employees and hours they work), average cash compensation, and average benefit cost. Average cash compensation and average benefit cost are added together and then multiplied by employment levels in order to create total labour cost. Salary levels can be controlled by a top-down budgeting approach by requiring top management of each unit to estimate the pay increase budget for the entire unit, and then allocating it to each manager, who plans how to distribute it among subordinates. The bottom-up budgeting approach requires each manager to forecast the pay increases he or she will recommend during the upcoming plan year, which are then reviewed by top management for approval. Four inherent controls on pay decision making in compensation design techniques are range maximums and minimums, compa-ratios, variable pay, and cost of wage proposals. The six stages in the compensation communication cycle are: Defining the objectives and goals of the communication program; Obtaining information on the current compensation program; Developing the strategy for the best overall communication approach – a marketing (sales) approach or a more technical communication approach; Determining the media and tools that are most appropriate; Conducting communication sessions; and Evaluating the success of the program. Various issues regarding how organizations structure their compensation function include: Decisions on centralization versus decentralization of compensation management. Level of flexibility for compensation management decisions within corporate-wide principles for all systems, and Consideration of reengineering or outsourcing the compensation function. LECTURE NOTES Without a formal pay system, there is a good possibility that employees can be treated unfairly in pay decisions. The compensation system must be developed based on goals and the achievement of the pay model objectives of external competitiveness, internal consistency and compliance. Pay techniques should be used to help achieve these objectives. This chapter covers a variety of compensation administration issues including (1) managing labour costs, (2) variable pay as a cost control, (3) inherent controls, (4) communication, and (5) structuring the compensation function. MANAGING LABOUR COSTS Financial planning is integral to managing compensation. It also requires understanding the potential returns gained from its allocation since total compensation is typically at least fifty percent or more of operating costs. In a simple labour cost model, the three main variables that must be considered in order to manage labour costs include: employment (the number of employees and the hours they work), average cash compensation (wages and bonuses), and average benefits (health, life insurance, pensions etc.) See Exhibit 13.1 on page 302 to review a diagram about how to manage labour costs. Controlling Employment: Number of Employees and Hours The most obvious approach to managing labour costs is to control the number of employees and the hours they work. Employers may avoid the negative consequences of layoffs and work reductions by using contingent workers who work for short time periods, in addition to the core employees who are employed for long periods. Contingent workers may be part-time or full-time employees. They are generally cheaper than core employees since contingent workers often do not receive benefits. See Exhibit 13.2 on page 304 to see a diagram of core and contingent employees. Another approach to managing costs is to examine the use of overtime versus adding to the workforce. One other method would be to offer inducements to encourage early retirement for employees who, because they have been at the organization longer, are a higher cost for the organization. There are several problems with workforce reductions including: If all employees are eligible for exit incentives, this might encourage top employees to leave. Workforce reductions can harm employee relations. Large workforce reductions can trigger greater voluntary turnover. Workforce reductions are expensive including administrative costs, productivity disruptions, customer service disruptions, severance pay, and exit incentives. Workforce reductions can be too harsh so that there is nothing more to cut. Workforce reductions can severely influence the organization’s ability to increase revenue and hence profitability. Controlling Average Cash Compensation In order to control the average cash compensation, the organization must manage increases in variable compensation and in the average salary level. The Average Salary Level can be managed through a “top down” or a “bottom up” approach. With the top down approach, top management determines the pay and allocates it down to lower units who then allocate to employees. With a bottom up approach, next year’s pay for each employee is forecasted and summed to create the organization’s salary budget. CONTROL SALARY LEVEL: TOP DOWN The top down approach uses unit level budgeting to distribute pay increases to employees. The type of unit level budgeting illustrated in the chapter is the planned pay-level rise approach. Decisions about how much to increase the average pay level depends on an examination of the last pay level increase, the organization’s ability to pay, competitive pressures, turnover, and cost-of-living considerations. Current Year’s Rise The current year’s rise is the percentage change in the average wage in the past year. (See page 305 for formula). Ability to Pay The financial situation of the organization obviously has an important effect on its ability to increase the average pay level. Competitive Market Rates The organization may change the average pay level in response to changes in the average rates for benchmark jobs in the marketplace in order to remain externally competitive. The market rates adjust every year in response to the external environment. Turnover Effects The turnover effect results in a decreased budget required as lower-paid workers replace employees who leave, calculated as annual turnover rate times planned average increase. One result of turnover is that when employees leave, workers earning lower wages usually replace them. Thus, the turnover effect can influence the average pay and benefit level in the organization. Cost of Living Changes in the cost of living are important since employees compare changes in their pay to changes in the cost of living and use cost of living changes to argue for pay increases. A distinction is made between three interrelated concepts when examining cost changes. Changes in wages in the labour market are measured through wage surveys. Changes in the prices of goods and services are measured through changes in indices such as the consumer price index. Changes in the cost of living depend on many factors and can vary from one employee to another. The concepts are interrelated in the sense that changes in wages may increase the cost of goods and services, which in turn may increase the cost of living. See Exhibit 13.3 on page 306 to review three distinct concepts and their measures related to the above changes. Consumer Price Index In examining “What is the CPI?” it is important to remember that the consumer price index (CPI) does not necessarily reflect an individual’s cost of living. Rather, the CPI measures changes in the prices of a market basket of goods and services. The CPI measures changes in the prices of 265 categories of expenditures, weighted by their percentage of total expenditure. While employers often index wage increase to the CPI, the CPI is criticized because it does not allow for the purchase of substitute items in the event of price increases and does not include discount prices. Geographical differences in the CPI are reflected in separate indices calculated for different regions. Differences in the CPI across cities reflect the relative increase in prices from the base year to the present. If Halifax has a CPI of 110 and Vancouver has a CPI of 140, this means that prices rise faster in Vancouver. Rolling It All Together An example of a planned rise in an average salary of 2.9 percent does not mean that each employee will get a 2.9 percent increase in wages. It means that the average salary for all employees at the end of the next year is targeted to be 2.9 percent greater than the average salary now. Distributing the budget in subunits is the next step. The percentage of the budget that each subunit should receive is calculated with various methods. Some organizations give a uniform percentage to each subunit based on the salaries of the subunit employees. Some vary the percentage to try and correct subunit problems. CONTROL SALARY LEVEL: BOTTOM UP Managers are required to forecast the pay increase they will recommend for each subordinate during the upcoming year. The compensation forecasting cycle steps are: Instruct managers in compensation policies and techniques. Distribute forecasting instructions and worksheets. Provide consultation to mangers. Check data and compile reports. Analyze forecasts. Review and revise forecasts and budgets with management. Conduct feedback with management. Monitor budgeted versus actual increases. See Exhibit 13.4 on page 308 to review a flow diagram for compensation forecasting and budgeting cycle. ETHICS: MANAGING OR MANIPULATING? It is important to have a professional code of ethics and behaviours in order to guide compensation decisions to achieve both efficiency and fairness. Budgeting average compensation costs is increasingly complicated for two reasons: The increased use of variable forms of pay (i.e., gain-sharing, performance bonuses and stock options) The use of generally accepted accounting practices that permit earnings to be “managed.” EMBEDDED CONTROLS The two processes that control pay decisions in the pay system are the budgeting process and pay controls inherent in the design of the techniques of the system. These inherent controls include range maximums and minimums, broad bands, compa-ratios, variable pay, and, cost analysis. Range Maximums and Minimums A range maximum represents the highest value the organization places on the output of the work. Any wage rate paid above the maximum is known as a red circle rates. Any rates below the minimum are known are green circle rates. Broad Bands Broad bands are intended to offer managers greater flexibility than a grade-range design. Usually broad bands are accompanied by external market “reference rates” and “shadow ranges” that guide managers’ decisions. Compa-Ratios The compa-ratio is used to assess employees’ pay relative to the midpoint of the range. A compa-ratio of less than 1.00 means that employees in the range are paid on average, below the midpoint, or that pay is less than intended policy. Conversely, a compa-ratio of greater than 1.00 means that on average, pay is higher than intended policy, perhaps due to high seniority or performance. Compa-ratio = (Average rates actually paid)/(Range Midpoint) Variable Pay Variable pay can be used as a cost control device since it is not added to base pay and must be re-earned each period. The use of variable pay gives the organization more flexibility in managing its labour costs but is less appealing to employees. Analyzing Costs The costs of any wage proposal are routinely calculated before pay increases are recommended. Proposals are also costing out before and negotiations with unions. Every aspect of compensation can be analyzed by computer software which has the potential to ultimately improve compensation administration. Value Added Although many software programs exist to assist in compensation administration, few organizations consider the value-added by such an analysis. If compensation is merely viewed as cost control, then assessing value-added is probably not done. However, if there is a shift in thinking about compensation as an investment, then it is more likely than an organization will consider the value added analysis as given below. See Exhibit 13.5 on pages 312-313 to review an illustration of value-added analysis. COMMUNICATION: MANAGING THE MESSAGE Communication to employees about their pay may foster good will and affect their perceptions about the fairness of the system. Communication may convince employees that there is a work and business related logic behind the pay system. World at Work, an international group of compensation and human resource professionals, recommends a six-stage process of communication. See Exhibit 13.6 on page 315 to revie3w the compensation communication cycle. Step one is defining the objectives of the communication program. Step two is to collect information from executives, managers, and employees concerning their current perceptions, attitudes, and understanding of the compensation programs in effect. Step three is to develop a communication strategy will accomplish the original objectives. Step four and five of the communication process is to determine the most effective media, in light of the message and the audience, and conduct the campaign. Step six of the communication process suggests that the program be evaluated. Did it accomplish its goals? Pay communication can have unintended consequences. Amount of Information to Communicate Some organizations “sell” the pay system like they would a product. The idea is to manage expectations and attitudes about pay. It does not address the specifics of the pay system as does the communications approach. The two main reasons to communicate pay information are that doing so will give employers an accurate view of the system and influence their attitudes about it, and that communication will decrease the likelihood that employees will wrongly overestimate the pay of other employees. “What to Communicate” includes that rationale on which the system is based, range information for an employee’s job, and information on typical increases for a given level of performance? Communication should also encourage employee involvement and feedback in order to develop an equitable pay system. There will always be a situation of information asymmetry between employees and the employer, and so sufficient information should be disclosed on a timely basis only to satisfy the information demands of employees. Some organizations believe that more transparency, or opening the books. will reduce the chance of having compensation problems with employees See Exhibit 13.7 on page 316 to review an example of the necessary components for conducting formal communication sessions for various audiences including executives, managers, and employees. PAY: CHANGE AGENT IN RESTRUCTURING Compensation often plays a singular role when organizations restructure. Strategic changes in the business strategy means the compensation strategy must be realigned as well. Pay is a powerful signal of change; changing people’s pay captures their attention. Pay changes can play two roles in any restructuring. Pay can be a leading catalyst for change or a follower of the change (i.e., support). Shifts from conventional across-the-board annual increases to profit sharing or from narrow job descriptions and ranges to broad roles and bands send signals of major change to employees. STRUCTURING THE COMPENSATION FUNCTION Decisions about the structure of the compensation function have to do with who should have the responsibility for the design and administration of the pay system. Centralization-Decentralization Decentralization refers to the management strategy of giving separate organization units the responsibility to design and administer their own systems. Decentralizing pushes responsibility down to lowest feasible level. The advantage is that the system can be tailored to unique needs. The disadvantage is that policies may not be consistent across the organization. Centralization locates the design and administration responsibility in a single corporate unit. A centralized function makes it easier to ensure accurate and timely delivery of pay. One issue with decentralization is that each unit might design the compensation system that supports the unit better than overall corporate objectives. This means that flexibility might be more conducive. Flexibility within Corporate-wide Principles Problems that occur with decentralization can be handled by developing corporate-wide guidelines that all units must follow. How the compensation function is staffed will depend on its organization. The system must be congruent with other organizational functions, like, finance, information systems. Reengineering and Outsourcing Reengineering the compensation function involves changing the process of paying people. It means reshaping the compensation function to make it more client- or customer-focused. The basic question asked during reengineering is, “Does each specific activity directly contribute to our objectives?” The next question, “Should we be doing the specific activity in-house, or can others do it more effectively? That is, should we outsource it?” Outsourcing is a viable alternative in the compensation field as organizations struggle to cease doing activities that do not directly contribute to objectives. Cost savings is the apparent major short-term advantage of outsourcing. Major disadvantage of outsourcing include less responsiveness to unique and specific employee-manager problems, less control over decisions that are often critical to all employees and information leaks to rivals and competitors. Balancing Flexibility and Control Traditional compensation plans might become highly bureaucratic and so broadbanding and awards and bonuses might eliminate excessive controls and guidelines. In order to balance flexibility and control in the compensation system it is important that efficiency, fairness and compliance with regulations be used to guide the organization in its achievement of organizational objectives. Excessive controls can cause chaos, while too much flexibility can also create problems with fairness. Instructor Manual for Compensation George T. Milkovich, Jerry M. Newman, Barry Gerhart, Cole, Margaret Yap 9780071051569, 9781259086878, 9780078029493
