Cash compensation component Gone are the days when attendants – or “clubbies’ in dugout lingo – did little more than shine shoes and pass out towels in exchange for the occasional dollar

Cash compensation component

Gone are the days when attendants – or “clubbies’ in dugout lingo – did little more than shine shoes and pass out towels in exchange for the occasional dollar. Nowadays, their jobs are more like those of Hollywood personal assistants: When they aren’t sorting socks, they’re arranging dinner reservations and programming player iPods.

In most sports, Junior locker-room attendants are paid roughly$7 – 8 an hour by the team while more senior managers, who sometime double as travel coordinators, can earn salaries of up to $80,000 before bonuses or tips.

Bonuses work as follows:

1. Among players. It’s understood that unusual requests should be rewarded and that wealthier players should be more generous. During the season players often reward clubbies with tips of as much a $300 for (errands).
2. Players and coaches also are expected to add gratuities to the daily “dues” they pay to clubhouse managers at home and on the road. (The dues cover food and drinks, which clubhouse managers pay for out of their own pockets).
3. By custom, team members meet privately at the end of the regular season to vote on how the postseason “shares” will be allocated. When the Boston Red Sox won the title in 2019, Clubhouse Manager Tommy McLaughlin was awarded a full share that came out to $416,838.

Questions:

1. Which part of the compensation for “clubbies” is similar to what happens in any organization?
2. Does the compensation for Tommy McLaughlin seem excessive” is he like a highly paid executive?
3. How is the compensation different in baseball? And how does this effect clubby pay?
4. From the information provided above, what part of the total package is base pay? What kind of incentive rewards are the rest of the forms of compensation? Does there appear to be any merit pay in this package?

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BARRY GERHART | JERRY M. NEWMAN Compensation TH I RTEENTH EDITION Compensation Thirteenth Edition Barry Gerhart University of Wisconsin–Madison Jerry M. Newman State University of New York–Buffalo COMPENSATION, THIRTEENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2020 by ­­ McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2014, and 2011. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 LCR/LCR 21 20 19 ISBN   978-1-260-04372-3 (bound edition) MHID 1-260-04372-X (bound edition) ISBN   978-1-260-48618-6 (loose-leaf edition) MHID 1-260-48618-4 (loose-leaf edition) Portfolio Manager: Laura Hurst Spell Marketing Manager: Lisa Granger Content Project Managers: Jessica Portz, Katie Reuter, Karen Jozefowicz Buyer: Susan K. Culbertson Design: Jessica Cuevas Content Licensing Specialist: Sarah Flynn Cover Image: ©Shutterstock/Style_TTT Compositor: Aptara®, Inc All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Names: Newman, Jerry M., author. | Gerhart, Barry A., author. | Milkovich, George T., author. Title: Compensation / Jerry M. Newman, State University of New York, Buffalo, Barry Gerhart, University of Wisconsin, Madison, George T. Milkovich, Cornell University. Description: Thirteenth Edition. | Dubuque, IA : McGraw-Hill Education, [2019] | Revised edition of the authors’ Compensation, [2017] Identifiers: LCCN 2019000181| ISBN 9781260043723 (hard cover: alk. paper) | ISBN 126004372X (hard cover: alk. paper) Subjects: LCSH: Compensation management. Classification: LCC HF5549.5.C67 M54 2019 | DDC 658.3/2—dc23 LC record available at https://lccn.loc.gov/2019000181 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. mheducation.com/highered Table of Contents Preface xii 2. Does the Study Separate Correlation from Causation? 26 3. Are There Alternative Explanations? 27 PART ONE Your Turn: The Role of Labor Costs in Retail Electronics 28 INTRODUCING THE PAY MODEL AND PAY STRATEGY Chapter One The Pay Model Chapter Two Strategy: The Totality of Decisions 40 3 Compensation: Does It Matter? (Or, “So What?”) 3 Compensation: Definition, Please 5 Similarities and Differences in Strategies Society 5 Stockholders 7 Managers 8 Employees 10 Incentive and Sorting Effects of Pay on Employee Behaviors 11 Global Views—Vive la Différence 12 Forms of Pay 13 Stated versus Unstated Strategies Source of Competitive Advantage: Three Tests 58 Align 58 Differentiate 58 Add Value 59 18 1. Is the Research Useful? 26 50 Step 1: Assess Total Compensation Implications 51 HR Strategy: Pay as a Supporting Player or a Catalyst for Change? 52 Step 2: Map a Total Compensation Strategy 55 Steps 3 and 4: Implement and Reassess 57 Compensation Objectives 18 Four Policy Choices 22 Pay Techniques 24 Book Plan 25 Caveat Emptor—Be an Informed Consumer Strategic Choices 44 Support Business Strategy 45 Support HR Strategy 48 The Pay Model Guides Strategic Pay Decisions 49 Developing a Total Compensation Strategy: Four Steps 51 Cash Compensation: Base 14 Cash Compensation: Merit Increases/Merit Bonuses/COLAs 14 Cash Compensation: Incentives 15 Long-Term Incentives 16 Benefits: Income Protection 16 Benefits: Work/Life Balance 16 Benefits: Allowances 17 Total Earnings Opportunities: Present Value of a Stream of Earnings 17 Relational Returns from Work 17 A Pay Model 40 Different Strategies within the Same Industry 43 Different Strategies within the Same Company 44 26 “Best Practices” versus “Best Fit”? 60 Guidance from the Evidence 60 Virtuous and Vicious Circles 61 Your Turn: Merrill Lynch 62 Still Your Turn: Mapping Compensation Strategies 64 iii iv Table of Contents PART TWO INTERNAL ALIGNMENT: DETERMINING THE STRUCTURE Chapter Three Defining Internal Alignment 73 Jobs and Compensation 74 Compensation Strategy: Internal Alignment 74 Supports Organization Strategy 75 Supports Work Flow 75 Motivates Behavior 76 Structures Vary among Organizations 76 Number of Levels 77 Differentials 77 Criteria: Content and Value 77 What Shapes Internal Structures? 80 Economic Pressures 80 Government Policies, Laws, and Regulations 81 External Stakeholders 81 Cultures and Customs 82 Organization Strategy 82 Organization Human Capital 83 Organization Work Design 83 Overall HR Policies 83 Internal Labor Markets: Combining External and Organization Factors 84 Employee Acceptance and Perceived Fairness 84 Pay Structures Change 85 Strategic Choices in Designing Internal Structures 86 Tailored versus Loosely Coupled 86 Hierarchical versus Egalitarian and Layered versus Delayered Structures 86 Guidance from the Evidence 88 Equity Theory: Fairness 89 Tournament Theory (and Pay Dispersion): Motivation and Performance 90 Institutional Theory: Copy Others and Conform 92 (More) Guidance from the Evidence 92 Consequences of Structures Efficiency 94 94 Fairness 94 Compliance 94 Your Turn: So You Want to Lead an Orchestra! 95 Still Your Turn: (If You Don’t Want to Lead the Orchestra...) 96 Still (yes, still) Your Turn: NCAA 99 Chapter Four Job Analysis 106 Structures Based on Jobs, People, or Both 107 Job-Based Approach: Most Common 109 Why Perform Job Analysis? 109 Job Analysis Procedures 110 What Information Should Be Collected? 112 Job Data: Identification 113 Job Data: Content 113 Employee Data 113 “Essential Elements” and the Americans With Disabilities Act 116 Level of Analysis 117 How Can the Information Be Collected? 118 Conventional Methods 118 Quantitative Methods 118 Who Collects the Information? 120 Who Provides the Information? 120 What about Discrepancies? 121 Job Descriptions Summarize the Data 122 Using Generic Job Descriptions 122 Describing Managerial/Professional Jobs Verify the Description 124 Job Analysis: Bedrock or Bureaucracy? Job Analysis, Globalization, and Automation 127 122 126 Job Analysis and Susceptibility to Offshoring 127 Job Analysis Information and Comparability across Borders 130 Judging Job Analysis Reliability 130 Validity 131 Acceptability 131 Currency 131 130 Table of Contents v Usefulness 132 A Judgment Call 133 Your Turn: The Customer-Service Agent 133 Chapter Five Job-Based Structures and Job Evaluation 138 Job-Based Structures: Job Evaluation 139 Defining Job Evaluation: Content, Value, and External Market Links 139 Content and Value 139 Linking Content with the External Market 140 Technical and Process Dimensions 141 “How-To”: Major Decisions 142 145 199 PART THREE EXTERNAL COMPETITIVENESS: DETERMINING THE PAY LEVEL 159 The Final Result: Structure 161 Balancing Chaos and Control 162 Your Turn: Job Evaluation at Whole Foods Chapter Six Person-Based Structures 163 173 Types of Skill Plans 173 Purpose of the Skill-Based Structure 175 176 What Information to Collect? 176 Whom to Involve? 178 Establish Certification Methods 178 Outcomes of Skill-Based Pay Plans: Guidance from Research and Experience 179 Person-Based Structures: Competencies 180 Defining Competencies 183 Purpose of the Competency-Based Structure 184 “How-To”: Competency Analysis Chapter Seven Defining Competitiveness 209 Compensation Strategy: External Competitiveness 210 Control Costs and Increase Revenues 211 Attract and Retain the Right Employees 215 171 Person-Based Structures: Skill Plans Objective 186 196 196 The Perfect Structure 197 Your Turn: Climb the Legal Ladder The Design Process Matters 159 “How-To”: Skill Analysis Reliability of Job Evaluation Techniques 193 Validity 195 Acceptability 196 Wages Criteria Bias Ranking 146 Classification 147 Point Method 149 Who Should Be Involved? One More Time: Internal Alignment Reflected in Structures (Person-Based or Job-Based) 192 Administering and Evaluating the Plan 192 Bias in Internal Structures Establish the Purpose 142 Single versus Multiple Plans 143 Choose among Job Evaluation Methods 145 Job Evaluation Methods What Information to Collect? 186 Whom to Involve? 188 Establish Certification Methods 188 Resulting Structure 188 Competencies and Employee Selection and Training/Development 190 Guidance (and Caution) from the Research on Competencies 190 186 What Shapes External Competitiveness? Labor Market Factors 217 How Labor Markets Work Labor Demand 220 Marginal Product 220 Marginal Revenue 220 Labor Supply 222 217 217 Modifications to the Demand Side 222 Compensating Differentials 222 Efficiency Wage 223 Sorting and Signaling 225 Modifications to the Supply Side (Only Two More Theories to Go) 226 Reservation Wage 226 Human Capital 226 vi Table of Contents Product Market Factors and Ability to Pay 227 Product Demand 227 Degree of Competition 227 A Different View: What Managers Say 228 Segmented Supplies of Labor and (Different) Going Rates 228 Organization Factors 230 Adjust Pay Mix—What Forms? 259 Adjust Pay Structure? 259 Study Special Situations 260 Estimate Competitors’ Labor Costs 260 Select Relevant Market Competitors Fuzzy Markets Design the Survey 265 Who Should Be Involved? 265 How Many Employers? 265 Which Jobs to Include? 268 What Information to Collect? 270 Industry and Technology 230 Employer Size 230 People’s Preferences 230 Organization Strategy 231 Relevant Markets 232 Defining the Relevant Market 232 Globalization of Relevant Labor Markets: Offshoring and Outsourcing 233 Competitive Pay Policy Alternatives 236 What Difference Does the Pay-Level Policy Make? 236 Pay with Competition (Match) 236 Lead Pay-Level Policy 238 Lag Pay-Level Policy 238 Different Policies for Different Employee Groups 239 Not by Pay Level Alone: Pay-Mix Strategies 239 Consequences of Pay-Level and Pay-Mix Decisions: Guidance from the Research 244 Efficiency 244 Fairness 245 Compliance 245 Your Turn: Two-Tier Wages 246 Your Turn: Combining Pay Survey and Job Evaluation Data 247 Appendix Interpret Survey Results and Construct a Market Line 273 Verify Data 274 Statistical Analysis 279 Update the Survey Data 281 Construct a Market Pay Line 281 Setting Pay for Benchmark and Non-Benchmark Jobs 283 Combine Internal Structure and External Market Rates 285 From Policy to Practice: The Pay-Policy Line 286 Choice of Measure 286 Updating 286 Policy Line as Percent of Market Line 287 From Policy to Practice: Grades and Ranges 287 Why Bother with Grades and Ranges? 287 Develop Grades 288 Establish Range Midpoints, Minimums, and Maximums 288 Overlap 289 From Policy to Practice: Broad Banding Flexibility Control 290 293 Balancing Internal and External Pressures: Adjusting the Pay Structure 293 7-A: Utility Analysis 249 Reconciling Differences Chapter Eight Designing Pay Levels, Mix, and Pay Structures 257 Major Decisions 258 Specify Competitive Pay Policy The Purpose of a Survey 259 260 264 258 Adjust Pay Level—How Much to Pay? 259 Market Pricing 293 294 Business Strategy (More than “Follow the Leader”) 294 Review 295 Your Turn: Google’s (now Alphabet’s) Evolving Pay Strategy 296 Still Your Turn: Word-of-Mouse: Dot-Com Comparisons 297 Table of Contents vii PART FOUR Individual Incentive Plans: Examples EMPLOYEE CONTRIBUTIONS: DETERMINING INDIVIDUAL PAY Chapter Nine Pay-for-Performance: Theory and Evidence 306 What Behaviors Do Employers Care About? Linking Organization Strategy to Compensation and Performance Management 308 What Does It Take to Get These Behaviors? What Theory Says 313 What Does It Take to Get These Behaviors? What Practitioners Say 317 Does Compensation Motivate Behavior? 323 Do People Join a Firm Because of Pay? 323 Do People Stay in a Firm (or Leave) Because of Pay? 324 Do Employees More Readily Agree to Develop Job Skills Because of Pay? 325 Do Employees Perform Better on Their Jobs Because of Pay? 326 Designing a Pay-for-Performance Plan 330 Efficiency 330 Equity/Fairness 331 Compliance 332 Your Turn: Burger Boy 358 Pay-for-Performance: Short-Term Incentive Plans (Team-Based) 359 Comparing Group and Individual Incentive Plans 363 Large Group Incentive Plans 366 Gain-Sharing Plans 366 Profit-Sharing Plans 372 Earnings-at-Risk Plans 373 Group Incentive Plans: Advantages and Disadvantages 373 Group Incentive Plans: Examples 373 Pay-for-Performance: Long-Term Incentive Plans 374 Employee Stock Ownership Plans (ESOPs) 376 Performance Plans (Performance Share and Performance Unit) 377 Broad-Based Option Plans (BBOPs) 377 Combination Plans: Mixing Individual and Group 377 Does Variable Pay (Short-Term and Long-Term Incentives) Improve Performance Results? The General Evidence 378 Your Turn: Pay at Delta and American Airlines 378 Appendix 333 Chapter Ten Pay-for-Performance: Types of Plans 344 What Is a Pay-for-Performance Plan? 344 How Widely Used Is Pay for Performance (PFP)? 345 The Important Role of Promotion in Pay for Performance 348 Pay-for-Performance: Merit Pay Plans 349 Pay-for-Performance: Short-Term Incentive Plans (Individual-Based) 352 Merit Bonuses aka Lump-Sum Bonuses 352 Individual Spot Awards 353 Individual Incentive Plans 354 Individual Incentive Plans: Returns (But Also Risks) 357 1 0-A: Profit-Sharing (401k) at Walgreens 380 Chapter Eleven Performance Appraisals 386 The Role of Performance Appraisals in Compensation Decisions 387 Performance Metrics 388 Strategies for Better Understanding and Measuring Job Performance 389 The Balanced Scorecard Approach 390 Strategy 1: Improve Appraisal Formats 391 Strategy 2: Select the Right Raters 400 Strategy 3: Understand How Raters Process Information 404 Strategy 4: Training Raters to Rate More Accurately 408 viii Table of Contents Strategy 5: Improving Rater Motivation and Opportunity to Rate More Accurately 409 Putting It All Together: The Performance Evaluation Process 410 “New” Performance Appraisal The Value of Employee Benefits 451 Key Issues in Benefit Planning, Design, and Administration 452 Benefits Planning and Design Issues Benefit Administration Issues 454 412 Equal Employment Opportunity and Performance Evaluation 412 Tying Pay to Subjectively Appraised Performance 414 Components of a Benefit Plan 456 Employer Factors 457 Employee Factors 461 Competency: Customer Care 415 Performance- and Position-Based Guidelines 416 Designing Merit Guidelines 416 Administering the Benefit Program Employee Benefit Communication Claims Processing 464 Cost Containment 465 Your Turn: Performance Appraisal at American Energy Development 420 Your Turn: World Measurement Appendix Chapter Thirteen Benefit Options 474 11-A: Balanced Scorecard Example: Department of Energy (Federal Personal Property Management Program) 423 The BSC Perspective 423 Customer Perspective 423 Internal Business Processes Perspective 424 Learning and Growth 424 Financial Perspective 424 Objectives, Measures, and Targets 452 425 General 425 National (Core) Measures 425 Local Measures 425 467 478 Workers’ Compensation 478 Social Security: Old Age, Survivors, Disability & Health (OASDI) + Medicare 480 Unemployment Insurance 483 Family and Medical Leave Act (FMLA) 484 Consolidated Omnibus Budget Reconciliation Act (COBRA) 484 Health Insurance Portability and Accountability Act (HIPAA) 485 Retirement and Savings Plan Payments Appendix 11-B: Sample Appraisal Form for Leadership Dimension: Pfizer Pharmaceutical 426 PART FIVE 485 Defined Benefit Plans 486 Defined Contribution Plans 486 Individual Retirement Accounts (IRAs) 489 Employee Retirement Income Security Act (ERISA) 489 How Much Retirement Income to Provide? 491 Life Insurance 492 Medical and Medically Related Payments EMPLOYEE BENEFITS Chapter Twelve The Benefit Determination Process 446 Why the Growth in Employee Benefits? Legally Required Benefits 463 464 449 Wage and Price Controls 449 Unions 449 Employer Impetus 450 Cost (Including Tax) Effectiveness of Benefits 450 Government Impetus 451 General Health Care 493 Health Care: Cost Control Strategies 496 Short- and Long-Term Disability 497 Dental Insurance 497 Vision Care 498 Miscellaneous Benefits 498 Paid Time Off during Working Hours Payment for Time Not Worked 498 Child Care 499 498 493 Table of Contents ix Elder Care 500 Domestic Partner Benefits 500 Legal Insurance 500 Addressing Financial Precarity 500 Role of Unions in Discipline, Job Security, and Assignments 555 Unions and Alternative Reward Systems (and Variable Pay) 556 Benefits for Contingent Workers 500 Your Turn: Adapting Benefits to a Changing Strategy 501 Lump-Sum Awards/Bonuses 557 Employee Stock Ownership Plans (ESOPs) Pay-for-Knowledge Plans 557 Gain-Sharing Plans 558 Profit-Sharing Plans 558 PART SIX 557 EXTENDING THE SYSTEM Your Turn: Comparing Tier 1 and Tier 2 Contract Outcomes (and Explaining Them) 560 Chapter Fourteen Compensation of Special Groups: Executives and Others 507 Chapter Sixteen International Pay Systems Who Are Special Groups? 508 Compensation Strategy for Special Groups 509 Supervisors 509 Corporate Directors 509 Executives 510 How Aligned are Executive Pay and Performance? 512 Say on Pay (Shareholder Votes) 513 Why Is Everyone So Interested in Executive Compensation? And . . . Some Different Perspectives 525 Scientists and Engineers in High-Tech Industries 530 Sales Forces 533 Contingent Workers and Workers under Alternative Work Arrangements 537 Your Turn: A Sports Sales Plan 539 Chapter Fifteen Union Role in Wage and Salary Administration 546 The Impact of Unions in Wage Determination 548 Union Impact on Compensation 548 The Structure of Wage Packages 550 Union Impact: The Spillover (or Threat) Effect 551 Role of Unions in Wage and Salary Policies and Practices 551 565 The Global Context 567 The Social Contract 569 Centralized or Decentralized Pay-Setting Regulation 572 Culture 570 575 Is National Culture a Major Constraint on Compensation? 576 Trade Unions and Employee Involvement 578 Ownership and Financial Markets 579 Managerial Autonomy 580 Comparing Costs (and Productivity) 580 Labor Costs and Productivity 581 Cost of Living and Purchasing Power Comparing Systems 585 586 The Total Pay Model: Strategic Choices 586 National Systems: Comparative Mind-Set 587 Japanese Traditional National System 587 German Traditional National System 590 Strategic Comparisons: Traditional Systems in Japan, Germany, United States 592 Evolution and Change in the Traditional Japanese and German Models 594 Strategic Market Mind-Set 596 Localizer: “Think Global, Act Local” 596 Exporter: “Headquarters Knows Best” 596 Globalizer: “Think and Act Globally and Locally” 597 Expatriate Pay 597 Elements of Expatriate Compensation The Balance Sheet Approach 601 599 x Table of Contents Expatriate Systems dommage! 605 Earnings Gaps Objectives? Quel Borderless World Borderless Pay? Globalists 606 Your Turn: Globalization of the Labor Market: The English Premier League 606 PART SEVEN MANAGING THE SYSTEM Overview 622 626 630 Living Wage 636 Employee or Independent Contractor? Prevailing Wage Laws 639 Antitrust Issues 640 Pay Discrimination: What Is It? 640 The Equal Pay Act 642 Chapter Eighteen Management: Making It Work 672 673 Number of Employees (a.k.a.: Staffing Levels or Headcount) 674 Hours 677 Benefits 678 Average Cash Compensation (Fixed and Variable Components) 679 Budget Controls: Top Down 680 Budget Controls: Bottom Up 684 Embedded (Design) Controls 685 Government as Part of the Employment Relationship 622 Fair Labor Standards Act of 1938 656 Compliance: A Proactive Approach 661 Your Turn: From Barista to Manager 662 Still Your Turn: “I Was Gaga’s Slave” 662 Managing Labor Costs and Revenues Managing Labor Costs 673 Chapter Seventeen Government and Legal Issues in Compensation 619 Minimum Wage 626 Overtime and Hours of Work Child Labor 635 654 Sources of the Earnings Gaps Managing Revenues 637 691 Structuring the Compensation Function and Its Roles 697 Title VII of the Civil Rights Act of 1964 and Related Laws 645 Disparate Treatment 647 Disparate Impact 647 Evidence of Discrimination: Use of Market Data 650 Evidence of Discrimination: Jobs of Comparable Worth 651 Managing Pay to Support Strategy and Change 690 Communication: Managing the Message Say What? (Or, What to Say?) 696 Opening the Books 696 Definition of Equal 643 Definitions of Skill, Effort, Responsibility, Working Conditions 643 Factors Other than Sex 643 “Reverse” Discrimination 644 Executive Order 11246 647 Pay Discrimination and Dissimilar Jobs 688 Using Compensation to Retain (and Recruit) Top Employees 690 650 Centralization–Decentralization (and/or Outsourcing) 697 Ethics: Managing or Manipulating? 700 Your Turn: Communication by Copier 701 Still Your Turn: Managing Compensation Costs, Headcount, and Participation/Communication Issues 702 Glossary 707 Name Index 720 Subject Index 734 About the Authors BARRY GERHART Barry Gerhart is the Bruce R. Ellig Distinguished Chair in Pay and Organizational Effectiveness, School of Business, University of Wisconsin–Madison. Professor ­G erhart received his B.S. in Psychology from Bowling Green State University and his Ph.D. in Industrial Relations from the University of Wisconsin–Madison. ­Professor Gerhart is a recipient of the Scholarly Achievement Award, the International Human Resource Management Scholarly Achievement Award (twice), the Herbert ­Heneman Jr. Career Achievement Award, and the Mahoney Mentoring Award, all from the Human Resources Division, Academy of Management. He has also received the Michael R. Losey Excellence in Human Resource Research Award, the career achievement award of the Society for Human Resource Management. ­Professor Gerhart is a Fellow of the Academy of Management and of the American Psychological ­Association. He has served as a department chair and/or area coordinator at Cornell, Vanderbilt, and Wisconsin, as well as senior associate dean and interim dean at ­Wisconsin. He has held visiting appointments at Bayreuth University, King’s ­College London, and Copenhagen Business School. JERRY M. NEWMAN Dr. Jerry Newman is an Emeritus SUNY Distinguished Professor at State University of New York–Buffalo. His interests are in the area of human resource management, with particular emphasis on compensation and rewards. He is author of the book My Secret Life on the McJob: Lessons in Leadership Guaranteed to Supersize Any ­Management Style (McGraw-Hill, 2007), which was selected as one of the twelve “Best of 2007” books by The Wall Street Journal. His article “Compensation Lessons from the Fast Food Trenches” (WorldatWork, March 2007, pp. 22–27) was chosen as SNAPS National feature article winner in 2008. He is also author of approximately 100 articles on compensation and rewards, performance management, and other HR issues. In more than 30 years of consulting, Jerry has worked with such companies as Cummins Engine, AT&T, Graphic Controls, Hewlett-Packard, RJR Nabisco, Sorrento Cheese, McDonalds, and A&W Root Beer. Dr. Newman is a recipient of nine teaching awards, including the SUNY Chancellor’s Award for Excellence in teaching. He loves to work with students, so send him an e-mail sometime! xi Preface You can’t read a news article or blog today without someone talking about compensation (wages/salaries, but also benefits like health care and retirement). Compensation is uniquely important in organizations because it typically represents the single largest operating cost, especially where employee skills or human capital are the source of competitive advantage (e.g., Google/Alphabet, Facebook; investment banking, law, accounting, and consulting firms; professional sports teams; universities). ­Compensation is also important because employees regularly report it as the most important factor that goes into their decision of whether to take a job or stay in a job. Compensation also plays a major role in what employees choose to do on the job: their effort level, where they direct their effort/what goals they pursue, how cooperative they are, how flexible they are, how ethical they are, and so forth. These all add up to determine how efficient, innovative, customer-oriented and (in the case of for-profit) how profitable an organization is over time. Profits, in turn, create jobs. In the absence of profits, jobs disappear. An organization that pays too much, pays too little, ties too much compensation up as fixed costs, and/or pays for the wrong things puts the company, its investors, and its employees at risk. On the other hand, designing and executing an effective compensation strategy can play a key role in great shared success. Compensation challenges ebb and flow with changes in the economy. The Financial Crisis of 2008 and the related Great Recession brought job cuts (with the national unemployment rate rising to 10 percent, the highest since 1983), reduced hours, reduced employer contributions to 401(k) retirement plans, reduced bonus/profit-sharing payments, and some wage cuts. With revenue and profits down and with labor costs often the single largest operating cost, employers cut labor costs in these ways. The Great Recession also focused attention on executive compensation. As the government bailed out the financial industry, newspapers were reporting large bonuses going to the very executives who helped cause the financial disaster. Eventually, as company revenues picked up again, we gradually saw employers put less emphasis on cutting labor costs and more emphasis on hiring. However, job growth was initially quite modest. At the beginning of 2013, the unemployment rate was still at 8 percent. Why? Employers have become increasingly careful about adding new workers because they want to keep costs under control and they don’t want to have to reduce the workforce if they guess wrong about increasing revenue growth/product demand (and the need for more workers). But competition for some types of workers has increased and wages, salaries, and benefits have likewise increased for such workers, meaning that employers must continually evaluate and benchmark their pay to be competitive. As economic growth has continued, competition for employees has increased and the U.S. unemployment rate is now under 4 percent, the lowest it has been since 1969. However, as we will see, wage gains remain modest. That is because employers are careful not only about hiring, as we have noted. They are also careful about giving wage/salary increases because once those are added to base pay, “they are there forever.” Increasingly, employers seek to make labor costs variable, which means greater reliance on bonuses and/or profitsharing, where payments to employees go up during good times, but automatically go down during bad times when profits and revenues are down. xii Preface xiii Pay also matters around the globe. To take a (bit light) example, if you were a Russian cosmonaut, you could earn a bonus of $1,000 for every space walk you took (technically known as “extravehicular activity”), up to three per space trip. A contract listing specific tasks to be done on a space mission permits you to earn up to $30,000 above the $20,000 you earn while you are on the ground. Conclusion: Pay matters. (As a small aside, in contrast to the Russian cosmonauts, wealthy Americans had the opportunity to pay many millions to the Russian Space Agency for their own personal extravehicular activity. More recently, Elon Musk’s company, SpaceX, has announced planned trips not only to the moon, but also to Mars. Musk is aiming for a cost of $200,000 per person, but some of his projections in the past have not been completely accurate.) After you have read this book, you will also better understand that what you pay for matters. Many years ago, when Green Giant discovered too many insect parts in the pea packs from one of its plants, it designed a bonus plan that paid people for finding insect parts. Green Giant got what it paid for: insect parts. Innovative Green Giant employees brought insect parts from home to add to the peas just before they removed them and collected the bonus. The Houston public school district also got what it paid for when it promised teachers bonuses of up to $6,000 if their students’ test scores exceeded targets. Unfortunately, several teachers were later fired when it was discovered that they had leaked answers to their students and adjusted test scores. Teachers were motivated to raise test scores, just not to raise them in the way desired (improved student learning). Wells Fargo wanted customers to sign up for more of its products to increase its potential for revenue and profit growth. To achieve this goal, Wells Fargo incentivized its employees so they would be rewarded for achieving this goal (and/or penalized if they did not achieve it). This incentive certainly “worked,” if you think this includes employees setting up fake accounts, which the customers did not sign up for, in order to achieve their targets for performance (new account sign-ups). Again, employees were motivated to achieve the outcome, but not necessarily in the appropriate way.1 Such problems are global. A British telephone company paid a cash bonus to operators based on how quickly they completed requests for information. Some operators discovered that the fastest way to complete a request was to give out a wrong number or— even faster—just hang up on the caller. “We’re actually looking at a new bonus scheme,” says an insightful company spokesperson. Conclusion: What you pay for matters. After you have read this book, you will also have learned that how you pay matters. Motorola ended its old-fashioned pay system that employees said guaranteed a raise every six months if you were still breathing. The new system paid for learning new skills and working in teams. Sound good? It wasn’t. Employees resented those team members who went off for six weeks of training at full pay while remaining team members picked up their work. Motorola was forced to get rid of its new-fashioned system, too. 1 E. Glazer, “Wells Fargo to Roll Out New Compensation Plan to Replace Sales Goals: Bankers Say Previous Lofty Goals Pushed Them to Open Accounts without Customers’ Knowledge,” Wall Street Journal, January 6, 2017. xiv Preface Wells Fargo also, not surprisingly, had to change how it pays and what it pays for.2 Specific changes made include: ?? No product sales goals. ?? Performance evaluation based on customer service, usage and growth, not simply on new accounts opened. ?? Incentives associated with direct customer feedback and product usage. ?? A higher percentage of employee compensation comprised of base salary, rather than variable incentives. ?? More employee performance metrics focused on the goals of a given bank branch, instead of on an individual worker. To summarize, compensation is a powerful tool that has major consequences for the success or failure of an organization. Our aim is to put you in a better position to design and/or execute compensation strategies to make success more likely. That will be helpful whatever the scale and scope of your responsibility, from a unit of a few employees to an entire organization. Our book will also help you better understand how your own compensation is managed and how that can help you achieve your own career goals. ABOUT THIS BOOK This book focuses on the strategic choices in managing compensation. We introduce these choices, real-world issues that managers confront from New York to New Zealand and all points between, in the total compensation model in Chapter 1. This model provides an integrating framework that is used throughout the book. Major compensation issues are discussed in the context of current theory, research, and practice. The practices illustrate new developments as well as established approaches to compensation decisions. We live in interesting times. Anywhere you look on the globe today, economic and social pressures are forcing managers to rethink how people get paid and what difference it makes. Traditional approaches to compensation are being questioned. But what is being achieved by all this experimentation and change? What is merely fad and fashion, and what, instead, is supported by the evidence? In this book, we strive to separate beliefs from facts, wishful thinking from demonstrable results, and opinions from research. Yet when all is said and done, managing compensation is part science, but also part art. Each chapter contains at least one e-Compensation box to point you to some of the vast compensation information on the Internet. Real-life Your Turn cases ask you to apply the concepts and techniques discussed in each chapter. For example, the Your Turn in Chapter 9 draws on Professor Newman’s experience when he worked undercover for 14 months in seven fast-food restaurants. The case takes you into the gritty details of the employees’ behaviors (including Professor Newman’s) during rush hour, as they desperately worked to fill customers’ orders and meet their own performance targets set by their manager. You get to recommend which rewards will improve ­employees’ performance (including Professor Newman’s) and customers’ satisfaction. We tackle major compensation issues from three sides: theory, research, and ­practice—no problem can survive that onslaught! 2 Kevin McCoy, “Wells Fargo Revamps Pay Plan after Fake-Accounts Scandal,” USA Today, January 11, 2017. Preface xv The authors also publish Cases in Compensation, an integrated casebook designed to provide additional practical skills that apply the material in this book. The casebook is available directly from the authors (e-mail: cases.in.compensation@gmail.com). Completing the integrated cases will help you develop skills readily transferable to future jobs and assignments. Instructors are invited to e-mail for more information on how Cases in Compensation can help translate compensation research and theory into practice and build competencies for on-the-job decisions. But caveat emptor! “Congress raises the executive minimum wage to $565.15 an hour,” reads the headline in the satirical newspaper The Onion (www.onion.com, “America’s Finest News Source”). The article says that the increase will help executives meet the federal standard-of-easy-living. “Our lifestyles are expensive to maintain,” complains one manager. Although the story in The Onion may clearly be fiction, sometimes it is more difficult to tell. One manager told us that when she searched for this textbook in her local bookstore, store personnel found the listing in their information system—under fiction! WHAT’S NEW All chapters have been revised, in recognition of ongoing changes at organizations and in their competitive environments around the world. Many examples are provided of the current pay strategies or practices used in specific, named companies. Some of these are well established and successful (Apple, IBM, Microsoft, Merrill Lynch, Nucor, Toyota), some face real problems (American Airlines, Best Buy, General Motors), and others are using unique practices (Google, Whole Foods). Whenever possible, we observe how the challenges faced by these companies have evolved over time. This edition continues to emphasize the importance of total compensation and its relevance for achieving sustainable competitive advantage. It reinforces our conviction that beyond how much people are paid, how they are paid really matters. Managing pay means ensuring that the right people get the right pay for achieving objectives in the right way. Greater emphasis is given to theoretical advances and evidence from research. Throughout the book we translate this evidence into guidance for improving the management of pay. ACKNOWLEDGMENTS A very special thanks goes to George T. Milkovich, who was the lead author on the first 11 editions of Compensation. George has long been our mentor, colleague, and friend. His influence on us and on Compensation continues. Many people have contributed to our understanding of compensation and to the preparation of this textbook over the years and editions. We owe a special, continuing debt of gratitude to our students. In the classroom, they motivate and challenge us, and as returning seasoned managers, they try mightily to keep our work relevant: Kenneth Abosch Aon Stephanie Argentine Rich Products Patrick Beall Lockheed Martin Joseph Bruno Kodak xvi Preface Karee Buerger Greater Chicago Area Federico Castellanos IBM EMEA Cindy Cohen Impac Andrew Doyle Oppenheimer Fund Brian Dunn Maclagan Bruce Ellig Author Thomas Fentner Health Now Rich Floersch McDonald’s USA Beth Florin Pearl Meyer & Partners Richard Frings Johnson & Johnson Takashi Fujiwara Mitsubishi Yuichi Funada Toshiba Ted Grasela Cognigen Thomas Gresch General Motors Peter Hearl YUM Brands (emeritus) Lada Hruba Bristol Meyers Squibb Richard Ivey KFC Tae-Jin Kim SK Group Joe Kreuz Advantage Professionals Hiroshi Kurihara Fuji Xerox Christian LeBreton IBM EMEA Mitch Linnick IBM Tony Marchak IBM EMEA Masaki Matsuhashi Toshiba Randy McDonald IBM Nancy McGough Room & Board Matt Milkovich Registry Nursing Michael Milkovich brightpeak financial Sarah Milkovich Jet Propulsion Laboratory Sonja Milkovich Sled Dog Software Pat Murtha Pizza Hut David Ness Medtronic Erinn Newman American Express Kelly Newman Presbyterian Residence Terrie Newman HR Foundations Stephen O’Byrne Shareholder Value Advisors Tony Ragusa Stereo Advantage Jaime Richardson Align Technology Lindsay Scott Lindsay Scott & Associates Jason Sekanina Linear Technology Rich Severa Accretive Partners & Strategies LLC Diana Southall HR Foundations Preface xvii Cassandra Steffan Frito-Lay Masanori Suzuki Google Japan Ichiro Takemura Toshiba Richard Their Xerox Jan Tichy Merck Andrew Thompson Link Group Consultants Jose Tomas Burger King Karen Velkey Northrop Grumman Ian Ziskin Northrop Grumman Our universities, past and present, Cornell, SUNY–Buffalo and the University of Wisconsin–Madison, and Vanderbilt have provided forums for the interchange of ideas among students, experienced managers, and academic colleagues. We value this interchange. Other academic colleagues have also played a role in our research and thinking and/or provided helpful comments on this and previous editions of the book. We particularly thank: Tom Arnold Westmoreland Community College Lubica Bajzikova Comenius University, Bratislava David Balkin University of Colorado Stuart Basefsky Cornell University Glenda Barrett University of Maryland University College Melissa Barringer University of Massachusetts Rebecca Bennett Louisiana Tech University Matt Bloom University of Notre Dame James T. Brakefield Western Illinois University Timothy Brown San Jose State University Lisa Burke University of Tennessee–Chattanooga Wayne Cascio University of Colorado–Denver Michael Chase Indiana Wesleyan University Dennis Cockrell Washington State University–Pullman H. Kristi Davison University of Mississippi Rebecca Decardenas Barry University Lee Dyer Cornell University Allen D. Engle Sr. Eastern Kentucky University Meiyu Fang National Central University Jie (Jasmine) Feng Rutgers University Dwight D. Frink University of Mississippi Ingrid Fulmer Rutgers University Marilyn Gagné Curtin University Kubilay Gok Winona State University Mary Graham Syracuse University Luis Gomez-Mejia Arizona State University xviii Preface Nina Gupta University of Arkansas Thomas Hall Penn State University Kevin Hallock Cornell University Robert Heneman Ohio State University Vandra Huber University of Washington Greg Hundley Purdue Debra D. Kuhl Pensacola State College Frank Krzystofiak SUNY–Buffalo David I. Levine University of California–Berkeley Frank B. Markham The University of Mississippi Janet Marler SUNY–Albany Patrenia McAbee Delaware County Community College Atul Mitra Northern Iowa University Michael Moore Michigan State University Bahaudin Mujtaba Nova Southeastern University Brian Murray University of Dallas Teresa S. Nelson Butler County Community College Anthony J. Nyberg University of South Carolina Bryan J. Pesta Cleveland State University Richard Posthuma University of Texas at El Paso Janez Prasnikar University of Ljubljana Vlado Pucik IMD Hesan Ahmed Quazi Nanyang Business School Greg Reilly University of Connecticut Sara Rynes University of Iowa Donald P. Schwab University of Wisconsin–Madison Dow Scott Loyola University Chicago James Sesil University of Wisconsin–Madison Jason Shaw Nanyang Technical University Thomas Stone Oklahoma State University Warren Scott Stone University of Arkansas at Little Rock Michael Sturman Rutgers University Ningyu Tang Shanghai Jiao Tong University Thomas Li-Ping Tang Middle Tennessee State University Tom Timmerman Tennessee Tech University Charlie Trevor University of Wisconsin–Madison Lee Tyner University of Central Oklahoma Zhong-Ming Wang Zhejiang University Yoshio Yanadori University of South Australia Tae Seok Yang Western Illinois University Nada Zupan University of Ljubljana Part One Introducing the Pay Model and Pay Strategy Why do we work? If we are fortunate, our work brings meaning to our lives, ­challenges us in new and exciting ways, brings us recognition, and gives us the opportunity to interact with interesting people and create friendships. Oh yes— we also get a paycheck. Here in Part 1 of your book, we begin by talking about what we mean by “pay” and how paying people in different ways can influence them and, in turn, influence organization success. Wages and salaries, of course, are part of compensation, but so too, for some employees, are bonuses, health care benefits, stock options, and/or work/life balance programs. Compensation is one of the most powerful tools organizations have to influence their employees. Managed well, it can play a major role in organizations successfully executing their strategies through their employees. We will see how companies like Whole Foods, Nucor, the SAS Institute, Microsoft, Google, and others use compensation to attract, motivate, and retain the right employees to execute their strategies. We will also see how companies like Apple sell premium products at attractive price points, to an important degree by using suppliers that have low labor costs. When they are managed less well—as bankruptcies at General Motors, Chrysler, Lehman Brothers, and American Airlines (which stated at the time that it needed to reduce labor costs by $1.25 billion per year to be competitive), for example, might indicate—compensation decisions can also come back to haunt you. In Part 1, we describe the compensation policies and techniques that organizations use and the multiple objectives they hope to achieve by effectively managing these compensation decisions. Although compensation has its guiding principles, we will see that “the devil is in the details”—how a compensation program is specifically designed and implemented will help determine its success. We want you to bring a healthy skepticism when you encounter simplistic or sweeping claims about whether a particular way of managing compensation does or does not work. For example, organizations, in general, benefit from pay for performance, but there are many types of pay-for-performance programs, and it is not always easy to design and implement a program that has the intended consequences (and avoids unintended consequences). So, general principles are helpful, but only to a point. 2 Part One Introducing the Pay Model and Pay Strategy Thus, in Part 1, our aim is to also help you understand how compensation ­strategy decisions interact with the specific context of an organization (e.g., its business and human resource strategies) to influence organization success. We emphasize that good theory and research are fundamental, not only to ­understanding compensation’s likely effects, but also to developing that healthy skepticism we want you to have toward simplistic claims about what works and what does not. Chapter One The Pay Model Chapter Outline Compensation: Does It Matter? (or, “So What?”) Compensation: Definition, Please Society Stockholders Managers Employees Incentive and Sorting Effects of Pay on Employee Behaviors Global Views—Vive la Différence Forms of Pay Cash Compensation: Base Cash Compensation: Merit Increases/ Merit Bonuses/COLAs Cash Compensation: Incentives Long-Term Incentives Benefits: Income Protection Benefits: Work/Life Balance Benefits: Allowances Total Earnings Opportunities: Present Value of a Stream of Earnings Relational Returns from Work A Pay Model Compensation Objectives Four Policy Choices Pay Techniques Book Plan Caveat Emptor—Be an Informed Consumer 1. Is the Research Useful? 2. Does the Study Separate Correlation from Causation? 3. Are There Alternative Explanations? Your Turn: The Role of Labor Costs in Retail Electronics COMPENSATION: DOES IT MATTER? (OR, “SO WHAT?”) Why should you care about compensation? Do you find that life goes more smoothly when there is at least as much money coming in as going out? (Refer, for example, to the lyrics for the Beatles’ song “Money.”1 To exaggerate a bit, they say something like: Money doesn’t buy everything, but if money can’t buy it, I can’t use it.) Of course, it is the same for companies. It really does help to have as much money coming in (actually, more is better) as going out. Until recently, production workers at Chrysler received total compensation (i.e., wages plus benefits) of about $76 per hour. U.S. workers doing the same jobs at Toyota received $48 per hour, and the average total compensation per hour in U.S. manufacturing was $25 (and $16 in Korea, $3 in ­Mexico). It is one thing to pay more than your competitors if you get something more (e.g., higher productivity and/or quality) in return. But Chrysler was not. So its “strategy” was not sustainable. Chrysler ended up going through bankruptcy, being bought out by Fiat, and then reducing worker compensation costs as part of its strategy 3 4 Part One Introducing the Pay Model and Pay Strategy for a return to competitiveness. Specifically, Chrysler took steps (as part of its bankruptcy plan) to bring its hourly labor costs down to about $49.2 General Motors (GM), like Chrysler, has for decades paid its workers well—too well, perhaps, for what it received in return. So what? Well, in 1970, GM had 150 U.S. plants and 395,000 hourly workers. In sharp contrast, GM now has 35 U.S. manufacturing plants and 57,000 U.S. hourly workers.3 In June 2009, GM, like Chrysler, had to file for bankruptcy (avoiding it for a while thanks to loans from the U.S. government—i.e., you, the taxpayer). Not all of GM’s problems were compensation related. Building too many vehicles that consumers did not want was also a problem. But having labor costs higher than the competition’s, without corresponding advantages in efficiency, quality, and customer service, does not seem to have served GM or its stakeholders well. Its stock price peaked at $93.62/share in April 2000. Its market value was about $60 billion in 2000. That shareholder wealth was wiped out in bankruptcy. Think also of the billions of dollars the U.S. taxpayer had to put into GM. Think of all the jobs that have been lost over the years and the effects on communities that have lost those jobs. On the other hand, Nucor Steel pays its workers very well, relative to what other companies inside and outside of the steel industry pay. But Nucor also has much higher productivity than is typical in the steel industry. The result: Both the company and its workers do well. Apple Computer is able to reduce the prices for its iPads and iPhones by outsourcing manufacturing to China in facilities owned by the Hon Hai Precision Industry Co., Ltd. (Foxconn), a Taiwanese company. (See Chapter 7.) As we will see later, doing so generates billions (yes, billions with a “b”) of dollars in cost savings per year. Google and Facebook are companies that are known for paying very well. So far that seems to have worked, in that their high pay allows them to be very selective in who they hire and who they keep, and they would say that their talent-rich strategy has helped them to foster growth and innovation. Wall Street financial services firms and banks used incentive plans that rewarded people for developing “innovative” new financial investment vehicles and for taking risks to earn a lot of money for themselves and their firms.4 But several years ago, the markets discovered that many such risks had gone bad. Blue chip firms such as Lehman Brothers slid quickly into bankruptcy, whereas others, like Bear Stearns and Merrill Lynch, survived to varying degrees by finding other firms (J.P. Morgan and Bank of America, respectively) to buy them. The issue has not gone away. U.S. Federal Reserve officials have “made it clear that they believe bad behavior at banks goes deeper than a few bad apples and are advising firms to track warning signs of excessive risk taking and other cultural breakdowns.” In the words of one Fed official, “Risk takers are drawn to finance like they are to Formula One racing.” An important driver of risk taking among traders and others is the incentive system that encourages them to be “confident and aggressive” and that often results in those who thrive under this incentive rising to top leadership positions at the banks.5 Does greater expertise in the design and execution of compensation plans help control excessive risk taking and other problematic behaviors and encourage a more positive culture? Congress and the president seemed to think so, because in hopes of avoiding a similar financial crisis in the future they put into place legislation—the Troubled Asset Relief Program (TARP)—that included restrictions on executive pay Chapter 1 The Pay Model 5 that were designed to discourage executives from taking “unnecessary and excessive risks.” One commentator agreed. In an opinion piece in The Wall Street Journal, entitled “How Business Schools Have Failed Business,” the former director of corporate finance policy at the United States Treasury argued that misaligned incentives were a major cause of the global financial crisis (see above) and wondered how many of the business schools that educated top executives and directors included a course on how to design compensation systems. His answer: not many.6 Our book, we hope, can play a role in helping to better educate you, the reader, about the design of compensation systems, both for managers and for workers. How people are paid affects their behaviors at work, which affect an organization’s success.7 For most employers, compensation is a major part of total cost, and often it is the single largest part of operating cost. These two facts together mean that well-designed compensation systems can help an organization achieve and sustain competitive advantage. On the other hand, as we have recently seen, poorly designed compensation systems can likewise play a major role in undermining organization success. COMPENSATION: DEFINITION, PLEASE How people view compensation affects how they behave. It does not mean the same thing to everyone. Your view will probably differ depending on whether you look at compensation from the perspective of a member of society, a stockholder, a manager, or an employee. Thus, we begin by recognizing different perspectives. Society Some people see pay as a measure of justice. For example, a comparison of earnings between men and women highlights what many consider inequities in pay decisions. In 2016, U.S. Bureau of Labor Statistics data indicated that, among full-time workers in the United States, women earned 82 percent of what men earned, up from 62 percent in 1979.8 If women had the same education, experience, and union coverage as men and also worked in the same industries and occupations, the ratio would increase, but most evidence suggests that no more than one-half of the gap would disappear. Thus, even under such a best-case scenario the ratio of women’s earnings to men’s would be about 90 percent, still leaving a sizable gap.9 Society has taken an interest in such earnings differentials. One indicator of this interest is the introduction of laws and regulations aimed at eliminating the discrimination that causes them.10 (See Chapter 17.) Benefits given as part of a total compensation package may also be seen as a reflection of equity or justice in society. Civilian employers spend about 46 cents for benefits on top of every dollar paid for wages and salaries. (State and local government employers pay even more: 60 cents in benefits on top of every wage dollar.)11 Individuals and businesses in the United States spend $3.5 trillion per year, or about 18 percent of U.S. economic output (gross domestic product) on health care.12 Nevertheless, 27.6 million people in the United States (over 8 percent of the population) have no health insurance.13 (Prior to implementation of The Affordable Care Act of 2010, 44 million were uninsured.)14 A major reason is that the great majority of people who are under the age of 65 and not below the poverty line obtain health insurance through their employers, but small 6 Part One Introducing the Pay Model and Pay Strategy employers, which account for a substantial share of employment, are much less likely than larger employers to offer health insurance to their employees. As a result, the great majority of uninsured in the United States are from working families. (Of the uninsured, 85 percent have a full-time worker in the family and another 11 percent have a part-time worker in the family.)15 Given that those who do have insurance typically have it through an employer, it also follows that whenever the unemployment rate increases, health care coverage declines further. (Some users of online dating services provide information on their employer-provided health care insurance. Dating service “shoppers” say they view health insurance coverage as a sign of how well a prospect is doing in a career.) Job losses (or gains) within a country over time are partly a function of relative labor costs (and productivity) across countries. People in the United States worry about losing manufacturing jobs to Mexico, China, and other nations. (Increasingly, white-collar work in areas like finance, computer programming, and legal services is also being sent overseas.) Exhibit 1.1 reveals that hourly compensation (wages plus benefits) for Mexican manufacturing work ($3.91) is about 10 percent of the compensation paid in the United States ($36.34). China’s estimated $5.45 per hour is about 14 percent of the U.S. rate. However, the value of what is produced also needs to be considered. Productivity in China is 24 percent of that of U.S. workers, whereas Mexican worker productivity is 34 percent of the U.S. level. Finally, if low wages are the goal, there always seems to be somewhere that pays less. Some companies (e.g., Coach) are now moving work out of China because its hourly wage, especially after recent increases, is not as low as in countries like Vietnam, India, and the Philippines. However, for other companies—such as Foxconn, which builds iPhones and iPads for Apple—even with rapid increases in wages in China, labor costs remain very low in China compared to those in the United States and other advanced economies. Foxconn appears to be poised to continue having a larger presence in China.16 (More recently, Foxconn has also announced it will build a major new presence in southeast Wisconsin. Reasons include proximity to the U.S. market, as well as major incentives provided by the State of Wisconsin. We return to the topic of international comparisons in Chapter 7 and Chapter 16.) EXHIBIT 1.1 Hourly Compensation Costs for Production Workers in Manufacturing and Economy-Wide Productivity (Gross Domestic Product [GDP] per Employed Person), in U.S. Dollars China Mexico Czech Republic United States Germany Hourly Compensation Cost 5.45 3.91 10.71 39.03 43.18 Productivity (GDP per employee) 27,196 38,306 65,467 113,922 89,309 Source: “Hourly Compensation Cost: The Conference Board. International Comparisons of Hourly Compensation Costs in Manufacturing, 2016,” February 16, 2018. Productivity (projected for 2017): The World Bank, http://data.worldbank.org/indicator/SL.GDP.PCAP.EM.KD, retrieved March 15, 2018. Notes: Compensation includes wages and benefits. The most recent Conference Board compensation cost was $4.11 (in 2013) for China. The 2016 estimate for China was obtained by inflating the Conference Board estimates based on data on annual average wage growth in urban units from the China Statistical Yearbook, Table 4-12, National Bureau of Statistics of China. Productivity is gross domestic product (GDP), in constant 2011 PPP $, divided by total employment in the economy. Purchasing power parity (PPP) GDP is GDP converted to 2011 constant international dollars using PPP rates. (As such, these GDP per employee numbers are higher than past estimates using 1990 constant international dollars using PPP rates.) An international dollar has the same purchasing power over GDP that a U.S. dollar has in the United States. Chapter 1 The Pay Model 7 Some consumers know that pay increases often lead to price increases. They do not believe that higher labor costs benefit them. But other consumers lobby for higher wages. While partying revelers were collecting plastic beads at New Orleans’ Mardi Gras, filmmakers were showing video clips of the Chinese factory that makes the beads. In the video, the plant manager describes the punishment (5 percent reduction in already low pay) that he metes out to the young workers for workplace infractions. After viewing the video, one reveler complained, “It kinda takes the fun out of it.”17 Stockholders Stockholders are also interested in how employees are paid. Some believe that using stock to pay employees creates a sense of ownership that will improve performance, which in turn will increase stockholder wealth. But others argue that granting employees too much ownership dilutes stockholder wealth. Google’s stock plan cost the company $600 million in its first year of operation. So people who buy Google stock (stockholders) are betting that this $600 million will motivate employees to generate more than $600 million in extra stockholder wealth. Stockholders (also called shareholders) have a particular interest in executive pay.18 (Executive pay will be discussed further in Chapter 14.)19 To the degree that the interests of executives are aligned with those of shareholders (e.g., by paying executives on the basis of company performance measures such as shareholder return), the hope is that company performance will be higher. There is debate, however, about whether executive pay and company performance are strongly linked in the typical U.S. company.20 In the absence of such a linkage, concerns arise that executives can somehow use their influence to obtain high pay without necessarily performing well. Exhibit 1.2 provides descriptive data on chief executive officer (CEO) compensation. Note the large numbers (total annual compensation of $11.5 million) and also that the bulk of compensation (stock-related) is connected to shareholder return or other (primarily short-term, or one year or less) performance ­measures (bonus). As such, one would expect changes in CEO wealth and shareholder wealth to generally be aligned. We will return to this topic in more depth in Chapter 14. EXHIBIT 1.2 Annual Compensation of Chief Executive Officers, U.S. (S&P 500) Public Companies Median Compensation Component Salary Bonus Perquisites Stock Awards Stock Option Awards Total Annual Compensation $ 1,200,000 $ 2,100,000 $ 171,000 $ 5,800,000 $ 666,000 $11,700,000 Source: The Associated Press. How AP and Equilar Calculated CEO Pay. AP News, May 26, 2018. https://apnews.com/a3d216dc4 88347b8b9b23651b5f08e31 Notes: N = 339 chief executive officers in that role for at least two years at an S & P 500 company. Because medians are used, compensation components do not add up to equal total annual compensation. 8 Part One Introducing the Pay Model and Pay Strategy In Chapter 14 we will suggest that, on average, CEO interests and shareholder interests appear to be significantly aligned, but there are important exceptions and it is certainly an ongoing challenge to ensure that executives act in the best interest of shareholders. For example, during the meltdown in the financial services industry, top executives at Bear Stearns and Lehman Brothers regularly exercised stock options and sold stock during the period 2000–2008 prior to the meltdown. One estimate is that these stock-related gains plus bonus payments generated $1.4 billion for the top five executives at Bear Stearns and $1 billion for those at Lehman Brothers during the 2000–2008 period. “Thus, while the long-term shareholders in their firms were largely decimated, the executives’ performance-based compensation kept them in positive territory.” The problem here is that shareholders paid a huge penalty for what appears to have been overly aggressive risk-taking by executives, but the executives, in contrast, did quite well because of “their ability to claim large amounts of compensation based on short-term results.”21 Shareholders can influence executive compensation decisions in a variety of ways (e.g., through shareholder proposals and election of directors in proxy votes). In addition, the Dodd–Frank Wall Street Reform and Consumer Protection Act (see Chapter 14) was signed into law in 2010. Among its provisions is “say on pay,” which requires public companies to submit their executive compensation plan to a vote by shareholders. The vote is not binding. However, companies seem to be intent on designing compensation plans that do not result in negative votes. In addition, clawback provisions (designed to allow companies to reclaim compensation from executives in some situations) are available under Dodd-Frank and have also been adopted in stronger form by some companies.22 Managers For managers, compensation influences their success in two ways. First, it is a major expense that must be managed. Second, it is a major determinant of employee attitudes and behaviors (and thus, organization performance). We begin with the cost issue. Competitive pressures, both global and local, force managers to consider the affordability of their compensation decisions. Labor costs can account for more than 50 percent of total costs. In some industries, such as financial or professional services and in education and government, this figure is even higher. However, even within an industry, labor costs as a percentage of total costs vary among individual firms. For example, small neighborhood grocery stores, with labor costs between 15 percent and 18 percent, have been driven out of business by supermarkets that delivered the same products at a lower cost of labor (9 percent to 12 percent). Supermarkets today are losing market share to the warehouse club stores such as Sam’s Club and Costco, which enjoy an even lower cost of labor (4 percent to 6 percent), even though Costco pays wages that are above average for the industry. And, now Amazon has entered the grocery business by purchasing Whole Foods, which is expected to cause further cost reductions and disruption. Exhibit 1.3 compares the hourly pay rate for retail workers at Costco to that at Walmart and Sam’s Club (which is owned by Walmart). Each store tries to provide a unique shopping experience. Walmart and Sam’s Club compete on low prices, $ 29,352 $ 45,239 $13.00 $11.00a $10.00 $14.00 $10.00 $9.00 83 80 71 higher lower No Yesb 741 660 11,035 11,695 $126 billion $ 57 billion $424 billion $481 billion Revenues 144,804 133,333 97,508 99,530 Store Size Average (Sq. ft.) 239,000 — — 2,300,000 Number of Employees $1,176 $ 652 $ 394 $ 414 $528,033 — — $209,268 Revenues Revenue per per (Sq. ft.) Employee b#1 on Forbes list. aEstimated. Sources: Customer Satisfaction data from American Customer Satisfaction Index TM, http://www.theacsi.org/, retrieved March 27, 2017; Annual Turnover after 4 Years from Liza Featherstone, “Wage against the Machine,” Slate, June 27, 2008; Number of Stores, Revenues, Store Size, Number of Employees from Wal-Mart 2017 10-K (Annual Report) and Costco 2017 10-K (Annual Report); Average Wage from www.glassdoor.com, retrieved March 27, 2017. Costco Sam’s Club Walmart Walmart + Sam’s Club Average Pharmacy Average Average Customer Tech Stocker Cashier Satisfaction Employee On Best Annual Hourly Hourly (100 = Annual Employer Wage Wage Wage highest) Turnover List? Stores EXHIBIT 1.3 Pay Rates at Retail Stores, Customer Satisfaction, Employee Turnover, and Sales/Square Ft. Chapter 1 The Pay Model 9 10 Part One Introducing the Pay Model and Pay Strategy with Sam’s Club being a “warehouse store” with especially low prices on a narrower range of products, often times sold in bulk. Costco also competes on the basis of low prices, but with a mix that includes more high-end products aimed at a higher customer income segment. To compete in this segment, Costco appears to have chosen to pay higher wages, perhaps as a way to attract and retain a higher quality workforce.23 A Costco’s annual report states, “With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize the wages and benefits that they earn. Rather, we believe that achieving our longerterm objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce.” By comparison, Walmart simply states in its annual report that they “experience significant turnover in associates [i.e., employees] each year.”24 Based on Exhibit 1.3, Costco is quite successful, relative to its competitors, in terms of employee retention, customer satisfaction, and the efficiency with which it generates sales (see revenue per square foot and revenue per employee). So, although Costco’s labor costs are higher than those of Sam’s Club and Walmart, it appears that this model works for Costco because it helps it gain an advantage over its competitors. Thus, rather than treating pay only as an expense to be minimized, a manager can also use it to influence employee behaviors and to improve the organization’s performance. High pay, as long as it can be documented to bring high returns through its influences on employees, can be a successful strategy. As our Costco (versus Sam’s Club and Walmart) example seems to suggest, the way people are paid affects the quality of their work and their attitude toward customers.25 It may also affect their willingness to be flexible, learn new skills, or suggest ­innovations. On the other hand, people may become interested in unions or legal action against their employer based on how they are paid (e.g., if they perceive their pay to be unfairly low). This potential to influence employees’ behaviors, and subsequently the productivity and effectiveness of the organization, means that the study of compensation is well worth your time, don’t you think?26 Employees The pay individuals receive in return for the work they perform and the value they create is usually the major source of their financial security. Hence, pay plays a vital role in a person’s economic and social well-being. Employees may see compensation as a return in an exchange between their employer and themselves, as an entitlement for being an employee of the company, as an incentive to decide to take/stay in a job and invest in performing well in that job, or as a reward for having done so. Compensation can be all of these things.27 The importance of pay is apparent in many ways. Wages and benefits are a major focus of labor unions’ efforts to serve their members’ interests. (See Chapter 14.) The extensive legal framework governing pay—including minimum wage, living wage, overtime, and nondiscrimination regulations—also points to the central importance of pay to employees in the employment relationship. (See Chapter 17.) Next, we turn to how pay influences employee behaviors. Chapter 1 The Pay Model 11 Incentive and Sorting Effects of Pay on Employee Behaviors Pay can influence employee motivation and behavior in two ways. First, and perhaps most obviously, pay can affect the motivational intensity, direction, and persistence of current employees. Motivation, together with employee ability and work/organizational design (which can help or hinder employee performance), determines employee behaviors such as performance. We will refer to this effect of pay as an incentive effect, the degree to which pay influences individual and aggregate motivation among the employees we have at any point in time. However, pay can also have an indirect, but important, influence via a sorting effect on the composition of the workforce.28 That is, different types of pay strategies may cause different types of people to apply to and stay with (i.e., self-select into) an organization. In the case of pay structure/level, it may be that higher pay levels help organizations attract more high-quality applicants, allowing them to be more selective in their hiring. Similarly, higher pay levels may improve employee retention. (In Chapter 7, we will talk about when paying more is most likely to be worth the higher costs.) Less obviously, perhaps, it is not only how much but how an organization pays that can result in sorting effects.29 Ask yourself: Would people who are highly capable and have a strong work ethic and an interest in earning a lot of money prefer to work in an organization that pays about the same amount to all employees doing the same job, regardless of their performance? Or would they prefer to work in an organization where their pay can be much higher (or lower) depending on how they perform? If you chose the latter answer, then you believe that sorting effects matter. People differ regarding which type of pay arrangement they prefer. The question for organizations is simply this: Are you using the pay policy that will attract and retain the types of employees you want? Keep in mind that high performers have more alternative job opportunities and that more opportunities, all else being equal (e.g., if they are not paid more for their higher performance), translate into higher turnover—which is likely to be a significant problem if it is the high performers who are leaving, especially if high performers in particular roles create a disproportionately high amount of value for organizations.30 This also raises the issue of dealing with outside offers that employees receive. We know that a substantial share of employee turnover results from receiving unsolicited outside offers. In other words, turnover is not always in response to dissatisfaction. Sometimes it is driven by opportunity. These are likely to be some of the most valuable employees, and thus policies and practices for dealing with outside offers (hopefully informed by research) are important.31 Let’s take a look at one especially informative study conducted by Edward Lazear regarding incentive and sorting effects.32 Individual worker productivity was measured before and after a glass installation company switched one of its plants from a salaryonly (no pay for performance) system to an individual incentive plan under which each employee’s pay depended on his/her own performance. An overall increase in plant productivity of 44 percent was observed comparing before and after. Roughly one-half of this increase was due to individual employees becoming more productive. However, the remaining one-half of the productivity gain was not explained by this fact. So, where did the other one-half of the gain come from? The answer: Less-productive 12 Part One Introducing the Pay Model and Pay Strategy workers were less likely to stay in their jobs under the new individual incentive system because it was less favorable to them. When they left, they tended to be replaced by more-productive workers (who were happy to have the chance to make more money under a system that rewards performance than they might make elsewhere). Thus, focusing only on the incentive effects of pay (on current workers) can miss the other major mechanism (sorting) by which pay decisions influence employee behaviors. The pay model that comes later in this chapter includes compensation policies and the objectives (efficiency, fairness, compliance) these are meant to influence. Our point here is that compensation policies work through employee incentive and sorting effects to either achieve or not achieve those objectives. Global Views—Vive la Différence In English, compensation means something that counterbalances, offsets, or makes up for something else. However, if we look at the origin of the word in different languages, we get a sense of the richness of the meaning, which combines entitlement, return, and reward.33 In China, the traditional characters for the word “compensation” are based on the symbols for logs and water, suggesting that compensation provides the necessities in life. In the recent past the state owned all Chinese enterprises, and compensation was treated as an entitlement. In today’s China, compensation takes on a more subtle meaning. A new word, dai yu, is used. It refers to how you are being treated—your wages, benefits, training opportunities, and so on. When people talk about compensation, they ask each other about the dai yu in their companies. Rather than assuming that everyone is entitled to the same treatment, the meaning of compensation now includes a broader sense of returns as well as entitlement.34 “Compensation” in Japanese is kyuyo, which is made up of two separate characters (kyu and yo), both meaning “giving something.” Kyu is an honorific used to indicate that the person doing the giving is someone of high rank, such as a feudal lord, an emperor, or a samurai leader. Traditionally, compensation is thought of as something given by one’s superior. Today, business consultants in Japan try to substitute the word hou-syu, which means “reward” and has no associations with notions of superiors. The many allowances that are part of Japanese compensation systems translate as teate, which means “taking care of something.” Teate is regarded as compensation that takes care of employees’ financial needs. This ­concept is consistent with the family, housing, and commuting allowances that are still used in many Japanese companies.35 These contrasting ideas about compensation—multiple views (societal, stockholder, managerial, employee, and even global) and multiple meanings (returns, rewards, entitlement)—add richness to the topic. But they can also cause confusion unless everyone is talking about the same thing. So let’s define what we mean by “compensation” or “pay” (the words are used interchangeably in this book): Compensation refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship. Chapter 1 The Pay Model 13 FORMS OF PAY Exhibit 1.4 shows the variety of returns people receive from work. Total returns are ­categorized as total compensation and relational returns. The relational returns (learning opportunities, status, challenging work, and so on) are psychological.36 Total ­compensation returns are more transactional. They include pay received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments) and indirectly as benefits (e.g., pensions, medical insurance, programs to help balance work and life demands, brightly colored uniforms).37 So pay comes in different forms, and programs to pay people can be designed in a wide variety of ways. WorldatWork has a Total Rewards Model that is similar and includes compensation, benefits, work-life, performance/recognition, and development/career opportunities.38 The importance of monetary rewards as a motivator relative to other rewards (e.g., intrinsic rewards such as how interesting the work is) has long been a topic of interest, as have the conditions under which money is more or less important to people (and even whether money is sometimes too important to ­people).39 Although scholars and pundits have sometimes debated which is more important (and have sometimes argued that money does not motivate or even that it demotivates), our reading of the research indicates that both types of rewards are important and that it is usually not terribly productive to debate which is more important.40 It will no doubt come as little surprise that we will focus on monetary rewards (total compensation) in a book called Compensation. Whatever other rewards employees value, it is our experience that they expect to be paid for their work, that how and how EXHIBIT 1.4 Total Returns for Work TOTAL RETURNS Relational Returns Total Compensation Benefits Cash Compensation Base Merit/Cost of Living Recognition & Learning Status Opportunities Employment Challenging Security Work Income Allowances Protection Work/Life Long-Term Balance Incentives Short-Term Incentives 14 Part One Introducing the Pay Model and Pay Strategy much they are paid affects their attitudes, performance, and job choice, as well as their standard of living. These effects of compensation on employees (as well as the cost of employee compensation) have major implications for how successfully organizations can execute their strategies and achieve their goals, as we will see. Cash Compensation: Base Base wage is the cash compensation that an employer pays for the work performed. Base wage tends to reflect the value of the work or skills and generally ignores differences attributable to individual employees. For example, the base wage for machine operators may be $20 an hour. However, some individual operators may receive more because of their experience and/or performance. Some pay systems set base wage as a function of the skill or education an employee possesses; this is common for engineers and schoolteachers.41 A distinction is often made in the United States between wage and salary, with salary referring to pay for employees who are exempt from regulations of the Fair Labor Standards Act (FLSA) and hence do not receive overtime pay.42 Managers and professionals usually fit this category. Their pay is calculated at an annual or monthly rate rather than hourly, because hours worked do not need to be recorded. In contrast, workers who are covered by overtime and reporting provisions of the Fair Labor Standards Act—nonexempts—have their pay calculated as an hourly wage. Some organizations, such as IBM, Eaton, and Walmart, label all base pay as “salary.” Rather than dividing employees into separate categories of salaried and wage earners, they believe that an “all-salaried” workforce reinforces an organizational culture in which all employees are part of the same team. However, merely changing the terminology does not negate the need to comply with the FLSA. Cash Compensation: Merit Increases/Merit Bonuses/COLAs A cost of living adjustment (COLA) to base wages may be made on the basis of changes in what other employers are paying for the same work, changes in living costs, or changes in experience or skill. Such provisions are less common than in the past as employers continually try to control fixed costs and link pay increases to individual and/or company performance. Merit increases are given as increments to base pay and are based on performance.43 According to a WorldatWork survey, 94 percent of U.S. firms use merit pay increases.44 Given that 22 percent of respondents to the survey were in the nonprofit, not-for-profit, or public sectors where we know that the use of merit pay is less,45 it may be that nearly 100 percent of U.S. private sector organizations use merit pay. Merit payments are based on an assessment (or rating) of recent past performance made (with or without a formal performance evaluation). In recent years, merit increase budgets (or average merit increases) have been around 3 percent.46 Survey data indicate that, on average, an outstanding performer receives a 4.4 percent increase, an average performer a 2.8 percent increase, and a poor performer a 0.4 percent increase.47 Finally, companies increasingly use merit bonuses. As with merit increases, merit bonuses are based on a performance rating but, unlike merit increases, are paid in the form of a lump sum rather than becoming (a permanent) part of the base salary.48 Merit bonuses may now be more important than traditional merit Chapter 1 The Pay Model 15 increases. “Indeed, merit bonuses now appear to account for more of the pay-performance relationship than do the traditional and most often discussed form of pay for individual performance, merit pay.”49 In companies that use merit bonuses and among those workers who receive them, the average annual merit bonus in recent years has been about 5 percent for hourly employees, 6 percent for lower level salaried employees, and 13 percent for higher level (but below officers/executives) salaried employees, all much larger than the more often discussed recent merit increase pools of around 3 percent.50 We return to this issue in Chapter 18. Cash Compensation: Incentives Incentives also tie pay increases to performance.51 However, incentives differ from merit adjustments. First, incentives are tied to objective performance measures (e.g., sales) usually in a formula-based way, whereas a merit increase program typically relies on a subjective performance rating. There is also some subjectivity in the size of the pay increase awarded for a particular rating. Second, incentives do not increase the base wage and so must be re-earned each pay period. Third, the potential size of the incentive payment will generally be known (given the use of a formula) beforehand. Whereas merit pay programs evaluate past performance of an individual and then decide on the size of the increase, what must happen in order to receive the incentive payment is called out very specifically ahead of time. For example, a Toyota salesperson knows the commission on a Land Cruiser versus a Prius prior to making the sale. The larger commission he or she will earn by selling the Land Cruiser is the incentive to sell a customer that car rather than the Prius. Fourth, while both merit pay and incentives try to influence performance, incentives explicitly try to influence future behavior whereas merit recognizes (rewards) past behavior, which is hoped to influence future behavior. The incentive-reward distinction is a matter of timing. Incentives can be tied to the performance of an individual employee, a team of employees, a total business unit, or some combination of individual, team, and unit.52 The performance objective may be expense reduction, volume increases, customer satisfaction, revenue growth, return on investments, increase in stock value—the possibilities are endless. Prax Air, for example, used return on capital (ROC). For every quarter in which a 6 percent ROC target is met or exceeded, Prax Air awarded bonus days of pay. An 8.6 percent ROC means 2 extra days of pay for that quarter for every employee covered by the program. An ROC of 15 percent means 8.5 extra days of pay. Because incentives are one-time payments, they do not permanently increase labor costs. When performance declines, incentive pay automatically declines, too. Consequently, incentives (and sometimes merit bonuses also) are frequently referred to as variable pay. Incentives can have powerful effects, both good and bad, on performance. On average, these effects are positive and substantial. However, incentives are risky, and they can go wrong in spectacular fashion.53 One example is the Great Financial Crisis, which apparently stemmed in large part from improper and aggressive incentives paid to encourage loan officers to give home loans (mortgages) to people who were unlikely to be able to pay them back. (Recent events at Wells Fargo provide further examples.) We will talk about more examples in later chapters. 16 Part One Introducing the Pay Model and Pay Strategy Long-Term Incentives Incentives may be short- or long-term. Long-term incentives are intended to focus employee efforts on multiyear results. Typically they are in the form of stock ownership or else options to buy stock at a fixed price (thus leading to a monetary gain to the degree the stock price later goes up). The belief underlying stock ownership is that employees with a financial stake in the organization will focus on long-term financial objectives: return on investment, market share, return on net assets, and the like. Bristol-Myers Squibb grants stock to selected “Key Contributors” who make outstanding contributions to the firm’s success. Stock options are often the largest component in an executive pay package. Some companies extend stock ownership beyond the ranks of managers and professionals. Intel, Google, and Starbucks, for example, offer stock and/or stock options to all their employees.54 Benefits: Income Protection Exhibit 1.4 showed that benefits, including income protection, work/life services, and allowances, are also part of total compensation. Some income protection programs are legally required in the United States; employers must pay into a fund that provides income replacement for workers who become disabled or unemployed. Employers are also required to pay one-half the payroll tax for each employee to fund Social Security coverage. (Employees pay the other half.) Different countries have different lists of mandatory benefits. Medical insurance, retirement programs, life insurance, and savings plans are common benefits. They help protect employees from the financial risks inherent in daily life. Often companies can provide these protections to employees more cheaply than employees can obtain them for themselves. In the United States, employers spend roughly $657 billion per year on health care costs, or 20 percent of all U.S. health care expenditures. Among employers that provide health insurance, the cost to provide family coverage is $18,764 per year per employee. The average employer pays $13,050 (70 percent) of that and the average employee pays the remaining $5,714 (30 percent).55 Given the magnitude of such costs, it is no surprise that employers have sought to rein in or reduce benefits costs. One approach has been to shift costs to employees (e.g., having employees pay a larger share of health insurance premiums).56 Some companies have allowed their benefits costs to get so far out of control that more drastic action has been taken. For example, as noted, companies like Chrysler, GM, and American Airlines have recently gone through bankruptcy, which has been used to reduce benefits costs and labor costs more generally. GM benefits costs had gotten so high that GM was sometimes described as a pension and health care provider that also makes cars. Benefits: Work/Life Balance Programs that help employees better integrate their work and life responsibilities include time away from work (vacations, jury duty), access to services to meet specific needs (drug counseling, financial planning, referrals for child and elder care), and flexible work arrangements (telecommuting, nontraditional schedules, nonpaid time off). Responding to the changing demographics of the workforce (two-income families or Chapter 1 The Pay Model 17 single parents who need work-schedule flexibility to meet their family obligations), many U.S. employers are giving a higher priority to these benefit forms. Medtronic, for example, touts its Total Well-Being Program that seeks to provide “resources for growth—mind, body, heart, and spirit” for each employee. Health and wellness, financial rewards and security, individual and family well-being, and a fulfilling work environment are part of this “total well-being.”57 Medtronic believes that this program permits employees to be “fully present” at work and less distracted by conflicts between their work and nonwork responsibilities. Benefits: Allowances Allowances often grow out of whatever is in short supply. In Vietnam and China, housing (dormitories and apartments) and transportation allowances are frequently part of the pay package. Many decades after the end of World War II–induced food shortages, some Japanese companies still continue to offer a “rice allowance” based on the number of an employee’s dependents. Almost all foreign companies in China discover that housing, transportation, and other allowances are expected.58 Companies that resist these allowances must come up with other ways to attract and retain employees. In many European countries, managers assume that a car will be provided—only the make and model are negotiable.59 Total Earnings Opportunities: Present Value of a Stream of Earnings Up to this point we have treated compensation as something received at a moment in time. But a firm’s compensation decisions have a temporal effect. Say you have a job offer at $50,000 a year. If you stay with the firm for five years and receive an annual increase of 4 percent, in five years you will be earning $60,833 a year. For your employer, the five-year cost commitment of the decision to hire you turns out to be $331,649 in cash. If you add in an additional 30 percent for benefits, the decision to hire you implies a commitment of over $430,000 from your employer. Will you be worth it? You will be, after this course. A present-value perspective shifts the comparison of today’s initial offers to consideration of future bonuses, merit increases, and promotions. Sometimes a company will tell applicants that its relatively low starting offers will be overcome by larger future pay increases. In effect, the company is selling the present value of the future stream of earnings. But few candidates apply that same analysis to calculate the future increases required to offset the lower initial offers. Hopefully, everyone who reads Chapter 1 will now do so. Relational Returns from Work Why do Google millionaires continue to show up for work every morning? Why does Andy Borowitz write the funniest satirical news site on the web (www.borowitzreport. com) for free? There is no doubt that nonfinancial returns from work have a substantial effect on employees’ behavior.60 Exhibit 1.4 includes such relational returns from work as recognition and status, employment security, challenging work, and opportunities 18 Part One Introducing the Pay Model and Pay Strategy to learn. Other forms of relational return might include personal satisfaction from successfully facing new challenges, teaming with great co-workers, receiving new uniforms, and the like.61 Such factors are part of the total return, which is a broader umbrella than total compensation. The Organization as a Network of Returns Sometimes it is useful to think of an organization as a network of returns created by all these different forms of pay, including total compensation and relational returns. The challenge is to design this network so that it helps the organization to succeed.62 As in the case of crew rowers pulling on their oars, success is more likely if all are pulling in unison rather than working against one another. In the same way, the network of returns is more likely to be useful if bonuses, development opportunities, and promotions all work together. So the next time you walk through an employer’s door, look beyond the cash and health care offered to search for all the returns that create the network. Even though this book focuses on compensation, let’s not forget that compensation is only one of many factors affecting people’s decisions about work. (You might enjoy listening to Roger Miller’s song “Kansas City Star,” or Chely Wright’s “It’s the Song” for some other reasons people choose their work.) A PAY MODEL The pay model shown in Exhibit 1.5 serves as both a framework for examining current pay systems and a guide for most of this book. It contains three basic building blocks: (1) the compensation objectives, (2) the policies that form the foundation of the compensation system, and (3) the techniques that make up the compensation system. Because objectives drive the system, we will discuss them first. Compensation Objectives Pay systems are designed to achieve certain objectives. The basic objectives, shown at the right side of the model, include efficiency, fairness, ethics, and compliance with laws and regulations. Efficiency can be stated more specifically: (1) improving performance, increasing quality, delighting customers and stockholders, and (2) controlling labor costs. Compensation objectives at Medtronic and Whole Foods are contrasted in Exhibit 1.6. Medtronic is a medical technology company that pioneered cardiac pacemakers. Its compensation objectives emphasize performance, business success, minimizing fixed costs, and attracting and energizing top talent. Whole Foods is the nation’s largest organic- and natural-foods grocer. Its markets are a “celebration of food”: bright, well stocked, and well staffed.63 The company describes its commitment to offering the highest quality and least processed foods as a shared responsibility. Its first compensation objective is “Increase long-term shareholder value.” Fairness (sometimes called equity) is a fundamental objective of pay systems.64 In Medtronic’s objectives, fairness means to “ensure fair treatment” and “recognize #2378991 Chapter 1 The Pay Model 19 EXHIBIT EXHIBIT 1.61.5 The Pay Model POLICIES OBJECtIvES tECHNIQuES INtERNAL ALIGNMENt Work Descriptions Analysis Evaluation/ INtERNAL Certification StRuCtuRE EFFICIENCY • Performance • Quality • Customer COMPEtItIvENESS Market Surveys Definitions Policy Lines PAY StRuCtuRE and Stockholder • Cost FAIRNESS CONtRIButIONS Seniority Incentives Based Merit Guidelines PAY FOR PERFORMANCE COMPLIANCE MANAGEMENt Cost Communication Change EvALuAtION EtHICS personal and family well-being.” Whole Foods’s pay objectives discuss a “shared fate.” In their egalitarian work culture, pay beyond base wages is linked to team performance, and employees have some say about who is on their team. The fairness objective calls for fair treatment for all employees by recognizing both employee contributions (e.g., higher pay for greater performance, experience, or 20 Part One Introducing the Pay Model and Pay Strategy EXHIBIT 1.6 Pay Objectives at Medtronic and Whole Foods Medtronic Support Medtronic mission and increased complexity of business Minimize increases in fixed costs Attract and engage top talent Emphasize personal, team, and Medtronic performance Recognize personal and family total well-being Ensure fair treatment Whole Foods Increase long-term shareholder value Earn profits daily through voluntary exchange with our customers Through profits, create capital for growth, prosperity, opportunity, job satisfaction, and job security Support team member happiness and excellence Acknowledge that team outcomes are collective training) and employee needs (e.g., a fair wage as well as fair procedures). Procedural fairness refers to the process used to make pay decisions.65 It suggests that the way a pay decision is made may be equally as important to employees as the results of the decision (distributive fairness). Compliance as a pay objective means conforming to federal and state compensation laws and regulations. If laws change, pay systems may need to change, too, to ensure continued compliance. As companies go global, they must comply with the laws of all the countries in which they operate. Ethics Asian philosophy gives us the concept of yin and yang—complementary opposites rather than substitutes or trade-offs. It is not yin or yang; part of yin is in yang, and part of yang is in yin. So it is with objectives in the pay model. It is not efficiency versus fairness versus compliance. Rather, the aim is to achieve all three simultaneously. The tension of working toward all objectives at once creates fertile grounds for ethical dilemmas. Ethics means the organization cares about how its results are achieved.66 Scan the websites or lobby walls of corporate headquarters and you will inevitably find statements of “Key Behaviors,” “Our Values,” and “Codes of Conduct.” One company’s code of conduct is shown in Exhibit 1.7. The challenge is to put these statements into daily practice. The company in the exhibit is the formerly admired, now reviled, Enron, whose employees lost not only their Enron jobs, but also the money they invested in Enron stock (in some cases, their entire retirement nest egg). Because it is so important, it is inevitable that managing pay sometimes creates ethical dilemmas. Manipulating results to ensure executive bonus payouts, misusing (or failing to understand) statistics used to measure competitors’ pay rates, repricing or backdating stock options to manipulate (increase) their value, encouraging employees to invest a portion of their wages in company stock while executives are bailing out, offering just enough pay to get a new hire in the door while ignoring the relationship to co-workers’ pay, and shaving the hours recorded in employees’ time card—these are all-too-­common examples of ethical lapses. Some, but not all, compensation professionals and consultants remain silent during ethical misconduct and outright malfeasance. Absent a professional code, compensation managers must look to their own ethics—and the pay model, which calls Chapter 1 The Pay Model 21 EXHIBIT 1.7 Enron’s Ethics Statement Foreword “As officers and employees of Enron Corp., its subsidiaries, and its affiliated companies, we are responsible for conducting the business affairs of the companies in accordance with all applicable laws and in a moral and honest manner. . . . We want to be proud of Enron and to know that it enjoys a reputation for fairness and honesty and that it is respected. . . . Enron’s reputation finally depends on its people, on you and me. Let’s keep that reputation high.” July 1, 2000 Kenneth L. Lay Chairman and...