CHAPTER 11: COMPENSATION Copyright © 2005 South-Western. All rights reserved. footer.

CHAPTER 11:

COMPENSATION

Copyright © 2005 South-Western. All rights reserved. footer

Copyright © 2005 South-Western. All rights reserved. 1–2

Importance of CompensationImportance of CompensationImportance of CompensationImportance of Compensation

• Impacts employer’s ability to attract, motivate, and Impacts employer’s ability to attract, motivate, and retain employeesretain employees

• Ensure optimal levels of employee performance in Ensure optimal levels of employee performance in meeting organization’s strategic objectivesmeeting organization’s strategic objectives

• Compensation’s componentsCompensation’s components– DirectDirect compensation in wages or salary compensation in wages or salary

• Base pay (hourly, weekly, monthly)Base pay (hourly, weekly, monthly)

• Incentives (sales bonuses and/or commissions)Incentives (sales bonuses and/or commissions)

– IndirectIndirect compensation in form of benefits compensation in form of benefits• Legally required benefits (e.g., Social Security)Legally required benefits (e.g., Social Security)

• Optional (e.g., group health benefits)Optional (e.g., group health benefits)

• Impacts employer’s ability to attract, motivate, and Impacts employer’s ability to attract, motivate, and retain employeesretain employees

• Ensure optimal levels of employee performance in Ensure optimal levels of employee performance in meeting organization’s strategic objectivesmeeting organization’s strategic objectives

• Compensation’s componentsCompensation’s components– DirectDirect compensation in wages or salary compensation in wages or salary

• Base pay (hourly, weekly, monthly)Base pay (hourly, weekly, monthly)

• Incentives (sales bonuses and/or commissions)Incentives (sales bonuses and/or commissions)

– IndirectIndirect compensation in form of benefits compensation in form of benefits• Legally required benefits (e.g., Social Security)Legally required benefits (e.g., Social Security)

• Optional (e.g., group health benefits)Optional (e.g., group health benefits)


Exhibit 11-1Exhibit 11-1

Compensation SystemCompensation SystemExhibit 11-1Exhibit 11-1

Compensation SystemCompensation System


Internal EquityInternal EquityInternal EquityInternal Equity

• Fairness of pay differentials Fairness of pay differentials between different jobs in between different jobs in organization organization

• Established by job ranking, job Established by job ranking, job classification, point systems or classification, point systems or factor comparisons (factor comparisons (job job evaluationevaluation))

• Fairness of pay differentials Fairness of pay differentials between different jobs in between different jobs in organization organization

• Established by job ranking, job Established by job ranking, job classification, point systems or classification, point systems or factor comparisons (factor comparisons (job job evaluationevaluation))


External EquityExternal EquityExternal EquityExternal Equity

• Fairness of organizational Fairness of organizational compensation levels relative to compensation levels relative to external compensation external compensation

• Assessed by collecting Assessed by collecting wage and wage and salary surveysalary survey information to guide in information to guide in setting organization’s pay strategy to setting organization’s pay strategy to lead, meet, or lag labor market wageslead, meet, or lag labor market wages

• Fairness of organizational Fairness of organizational compensation levels relative to compensation levels relative to external compensation external compensation

• Assessed by collecting Assessed by collecting wage and wage and salary surveysalary survey information to guide in information to guide in setting organization’s pay strategy to setting organization’s pay strategy to lead, meet, or lag labor market wageslead, meet, or lag labor market wages


Individual EquityIndividual EquityIndividual EquityIndividual Equity

• Fairness about pay differentials among individuals Fairness about pay differentials among individuals in same job in same job

• Established by usingEstablished by using– Seniority-basedSeniority-based pay systems: Reward longevity pay systems: Reward longevity – Merit-basedMerit-based pay systems: Reward employee performance pay systems: Reward employee performance– Incentive plansIncentive plans: Employees receive part of compensation : Employees receive part of compensation

based on performancebased on performance– Skills-basedSkills-based pay systems: Compensation based on pay systems: Compensation based on

employees possessing skills that firm valuesemployees possessing skills that firm values– Team-basedTeam-based pay plans: Encourage cooperation and flexibility pay plans: Encourage cooperation and flexibility

• Fairness about pay differentials among individuals Fairness about pay differentials among individuals in same job in same job

• Established by usingEstablished by using– Seniority-basedSeniority-based pay systems: Reward longevity pay systems: Reward longevity – Merit-basedMerit-based pay systems: Reward employee performance pay systems: Reward employee performance– Incentive plansIncentive plans: Employees receive part of compensation : Employees receive part of compensation

based on performancebased on performance– Skills-basedSkills-based pay systems: Compensation based on pay systems: Compensation based on

employees possessing skills that firm valuesemployees possessing skills that firm values– Team-basedTeam-based pay plans: Encourage cooperation and flexibility pay plans: Encourage cooperation and flexibility



Equity TheoryEquity TheoryExhibit 11-2Exhibit 11-2

Equity TheoryEquity Theory



Equity & Work-Related OutcomesEquity & Work-Related OutcomesExhibit 11-3Exhibit 11-3

Equity & Work-Related OutcomesEquity & Work-Related Outcomes



Classification System – Federal GovernmentClassification System – Federal GovernmentExhibit 11-4Exhibit 11-4

Classification System – Federal GovernmentClassification System – Federal Government



Point System Point System MethodMethod


Point System Point System MethodMethod



Comparison of Job Evaluation MethodsComparison of Job Evaluation MethodsExhibit 11-7Exhibit 11-7

Comparison of Job Evaluation MethodsComparison of Job Evaluation Methods


External EquityExternal EquityExternal EquityExternal Equity

• LagLag policy policy – Lower wages than Lower wages than

competitors, competitors, compensates employees compensates employees through other meansthrough other means

• Opportunity for Opportunity for advancementadvancement

• Incentive plansIncentive plans

• Good locationGood location

• Good working Good working conditionsconditions

• Employment securityEmployment security

• LagLag policy policy – Lower wages than Lower wages than

competitors, competitors, compensates employees compensates employees through other meansthrough other means

• Opportunity for Opportunity for advancementadvancement

• Incentive plansIncentive plans

• Good locationGood location

• Good working Good working conditionsconditions

• Employment securityEmployment security

• MarketMarket policy policy – Wages equal to Wages equal to

competitorscompetitors– Neutralizes pay as factorNeutralizes pay as factor

• LeadLead policy policy– Higher wages than Higher wages than

competitors to ensure competitors to ensure organization becomes organization becomes employer of choiceemployer of choice

• MarketMarket policy policy – Wages equal to Wages equal to

competitorscompetitors– Neutralizes pay as factorNeutralizes pay as factor

• LeadLead policy policy– Higher wages than Higher wages than

competitors to ensure competitors to ensure organization becomes organization becomes employer of choiceemployer of choice



• Basing pay on seniorityBasing pay on seniority• Merit pay systemsMerit pay systems• Incentive payIncentive pay

– Returns financial rewards to employees responsible for Returns financial rewards to employees responsible for creating themcreating them

– Allows organizations to adjust compensation expenses Allows organizations to adjust compensation expenses based on organizational performancebased on organizational performance

– Variety of formsVariety of forms– Tied to employee’s, work unit’s, or organization’s resultsTied to employee’s, work unit’s, or organization’s results

• Basing pay on seniorityBasing pay on seniority• Merit pay systemsMerit pay systems• Incentive payIncentive pay

– Returns financial rewards to employees responsible for Returns financial rewards to employees responsible for creating themcreating them

– Allows organizations to adjust compensation expenses Allows organizations to adjust compensation expenses based on organizational performancebased on organizational performance

– Variety of formsVariety of forms– Tied to employee’s, work unit’s, or organization’s resultsTied to employee’s, work unit’s, or organization’s results



• Skill-based pay systemsSkill-based pay systems– Base compensation on acquisition and mastery of Base compensation on acquisition and mastery of

skillsskills– Give employees incentives to learnGive employees incentives to learn– Promote flexibilityPromote flexibility– Easily linked with training programs and strategic Easily linked with training programs and strategic

needsneeds

• Skill-based pay systemsSkill-based pay systems– Base compensation on acquisition and mastery of Base compensation on acquisition and mastery of

skillsskills– Give employees incentives to learnGive employees incentives to learn– Promote flexibilityPromote flexibility– Easily linked with training programs and strategic Easily linked with training programs and strategic

needsneeds



• Team-based pay plansTeam-based pay plans– Can be less time-consuming than administering individual Can be less time-consuming than administering individual

reward systemsreward systems– May impact group dynamicsMay impact group dynamics– Can adversely impact and intensify conflictCan adversely impact and intensify conflict– Need decentralized decision-making systemNeed decentralized decision-making system– Need high level of communication with employeesNeed high level of communication with employees– Employees should have voice and provide input into designEmployees should have voice and provide input into design– Team members need to feel the system is fair and equitableTeam members need to feel the system is fair and equitable

• Team-based pay plansTeam-based pay plans– Can be less time-consuming than administering individual Can be less time-consuming than administering individual

reward systemsreward systems– May impact group dynamicsMay impact group dynamics– Can adversely impact and intensify conflictCan adversely impact and intensify conflict– Need decentralized decision-making systemNeed decentralized decision-making system– Need high level of communication with employeesNeed high level of communication with employees– Employees should have voice and provide input into designEmployees should have voice and provide input into design– Team members need to feel the system is fair and equitableTeam members need to feel the system is fair and equitable


Legal Issues in CompensationLegal Issues in CompensationLegal Issues in CompensationLegal Issues in Compensation

• Title VII of Civil Rights Act of 1964Title VII of Civil Rights Act of 1964– Protects workers rights to fair treatmentProtects workers rights to fair treatment

• Equal Pay Act of 1963Equal Pay Act of 1963– Requires equal pay for equal work (male-female)Requires equal pay for equal work (male-female)

• Comparable worthComparable worth– Argues that standards of equal pay for equal work should be replaced Argues that standards of equal pay for equal work should be replaced

with doctrine of equal pay for work of equal valuewith doctrine of equal pay for work of equal value– Objective, measurable data to support assessment of value of different Objective, measurable data to support assessment of value of different

jobs is lackingjobs is lacking– No basis in current law for arguments of comparable worth (cf. “pay No basis in current law for arguments of comparable worth (cf. “pay

equity” in Canada).equity” in Canada).

• Title VII of Civil Rights Act of 1964Title VII of Civil Rights Act of 1964– Protects workers rights to fair treatmentProtects workers rights to fair treatment

• Equal Pay Act of 1963Equal Pay Act of 1963– Requires equal pay for equal work (male-female)Requires equal pay for equal work (male-female)

• Comparable worthComparable worth– Argues that standards of equal pay for equal work should be replaced Argues that standards of equal pay for equal work should be replaced

with doctrine of equal pay for work of equal valuewith doctrine of equal pay for work of equal value– Objective, measurable data to support assessment of value of different Objective, measurable data to support assessment of value of different

jobs is lackingjobs is lacking– No basis in current law for arguments of comparable worth (cf. “pay No basis in current law for arguments of comparable worth (cf. “pay

equity” in Canada).equity” in Canada).


Legal Issues in CompensationLegal Issues in CompensationLegal Issues in CompensationLegal Issues in Compensation

• Fair Labor Standards Act of 1938Fair Labor Standards Act of 1938– Regulates minimum wageRegulates minimum wage– Sets overtime policy Sets overtime policy – Establishes exempt classes for managers and other Establishes exempt classes for managers and other

professional employeesprofessional employees

• Fair Labor Standards Act of 1938Fair Labor Standards Act of 1938– Regulates minimum wageRegulates minimum wage– Sets overtime policy Sets overtime policy – Establishes exempt classes for managers and other Establishes exempt classes for managers and other

professional employeesprofessional employees


Executive CompensationExecutive CompensationExecutive CompensationExecutive Compensation

• No real average or standardNo real average or standard

• Typical annual compensation for senior Typical annual compensation for senior executivesexecutives– 20% salary20% salary– 30% annual incentives30% annual incentives– 50% long-term incentives50% long-term incentives

• No real average or standardNo real average or standard

• Typical annual compensation for senior Typical annual compensation for senior executivesexecutives– 20% salary20% salary– 30% annual incentives30% annual incentives– 50% long-term incentives50% long-term incentives


Executive CompensationExecutive CompensationExecutive CompensationExecutive Compensation

• Stock Grants Stock Grants – Require organization meet specific financial goalsRequire organization meet specific financial goals

• Stock Options Stock Options – Provide opportunity to purchase shares at some future date, Provide opportunity to purchase shares at some future date,

at price determined when options are awardedat price determined when options are awarded– Focus employee attention on creating shareholder valueFocus employee attention on creating shareholder value– Do not have to be reported as expensesDo not have to be reported as expenses– Can create culture obsessed with improving stock Can create culture obsessed with improving stock

performance at expense of other concernsperformance at expense of other concerns– Can prompt executives to engage in creative accounting Can prompt executives to engage in creative accounting

practicespractices

• Stock Grants Stock Grants – Require organization meet specific financial goalsRequire organization meet specific financial goals

• Stock Options Stock Options – Provide opportunity to purchase shares at some future date, Provide opportunity to purchase shares at some future date,

at price determined when options are awardedat price determined when options are awarded– Focus employee attention on creating shareholder valueFocus employee attention on creating shareholder value– Do not have to be reported as expensesDo not have to be reported as expenses– Can create culture obsessed with improving stock Can create culture obsessed with improving stock

performance at expense of other concernsperformance at expense of other concerns– Can prompt executives to engage in creative accounting Can prompt executives to engage in creative accounting

practicespractices


Key Key StrategicStrategic Issues in Issues in CompensationCompensation

Key Key StrategicStrategic Issues in Issues in CompensationCompensation

• Determining compensation relative to marketDetermining compensation relative to market

• Balance between fixed and variable compensationBalance between fixed and variable compensation

• Deciding whether or not to utilize team-based Deciding whether or not to utilize team-based versus individual payversus individual pay

• Creating appropriate mix of financial and non-Creating appropriate mix of financial and non-financial compensationfinancial compensation

• Developing a cost-effective compensation program Developing a cost-effective compensation program resulting in high performanceresulting in high performance

• Determining compensation relative to marketDetermining compensation relative to market

• Balance between fixed and variable compensationBalance between fixed and variable compensation

• Deciding whether or not to utilize team-based Deciding whether or not to utilize team-based versus individual payversus individual pay

• Creating appropriate mix of financial and non-Creating appropriate mix of financial and non-financial compensationfinancial compensation

• Developing a cost-effective compensation program Developing a cost-effective compensation program resulting in high performanceresulting in high performance


Reading 11.1 (Pascarella)Reading 11.1 (Pascarella)

Compensating TeamsCompensating TeamsReading 11.1 (Pascarella)Reading 11.1 (Pascarella)

Compensating TeamsCompensating Teams

• Reasons for tailoring compensation to Reasons for tailoring compensation to individualsindividuals– Motivation comes from within individual, as opposed Motivation comes from within individual, as opposed

to groupto group– Development of skills and behaviors is individual Development of skills and behaviors is individual

undertakingundertaking– Fairness in dealing with teams does not mean equal Fairness in dealing with teams does not mean equal

pay for allpay for all– Team compensation is not payoff, but means of Team compensation is not payoff, but means of

nurturing behavior that benefits the teamnurturing behavior that benefits the team

• Reasons for tailoring compensation to Reasons for tailoring compensation to individualsindividuals– Motivation comes from within individual, as opposed Motivation comes from within individual, as opposed

to groupto group– Development of skills and behaviors is individual Development of skills and behaviors is individual

undertakingundertaking– Fairness in dealing with teams does not mean equal Fairness in dealing with teams does not mean equal

pay for allpay for all– Team compensation is not payoff, but means of Team compensation is not payoff, but means of

nurturing behavior that benefits the teamnurturing behavior that benefits the team


Reading 11.1Reading 11.1

Compensating TeamsCompensating TeamsReading 11.1Reading 11.1


• Look for ways to add on incentives and Look for ways to add on incentives and recognition for team participationrecognition for team participation

• Reward behaviors and activities, rather than Reward behaviors and activities, rather than resultsresults

• Other ways of saying “thank you” constitute best Other ways of saying “thank you” constitute best incentive over long runincentive over long run

– Nonmonetary recognitionNonmonetary recognition– Gifts of appreciation after factGifts of appreciation after fact

• Be careful about anything that may be viewed as Be careful about anything that may be viewed as “buying”“buying”

• Look for ways to add on incentives and Look for ways to add on incentives and recognition for team participationrecognition for team participation

• Reward behaviors and activities, rather than Reward behaviors and activities, rather than resultsresults

• Other ways of saying “thank you” constitute best Other ways of saying “thank you” constitute best incentive over long runincentive over long run

– Nonmonetary recognitionNonmonetary recognition– Gifts of appreciation after factGifts of appreciation after fact

• Be careful about anything that may be viewed as Be careful about anything that may be viewed as “buying”“buying”



Compensating TeamsCompensating TeamsReading 11.1Reading 11.1


• Management often overlooks powerful Management often overlooks powerful intrinsic rewards that come from intrinsic rewards that come from – Team participation Team participation – Being part of corporate decision-making processBeing part of corporate decision-making process

• Let team decide who gets what from Let team decide who gets what from awards basketawards basket

• Management often overlooks powerful Management often overlooks powerful intrinsic rewards that come from intrinsic rewards that come from – Team participation Team participation – Being part of corporate decision-making processBeing part of corporate decision-making process

• Let team decide who gets what from Let team decide who gets what from awards basketawards basket


Reading 11.2 (Singh & Agarwal)Reading 11.2 (Singh & Agarwal)

Executive Compensation: New Executive Compensation: New PerspectivesPerspectives

Reading 11.2 (Singh & Agarwal)Reading 11.2 (Singh & Agarwal)


• CEOs in larger firms generally earn CEOs in larger firms generally earn moremore

• Mixed empirical evidence on Mixed empirical evidence on relationship between executive relationship between executive compensation and firm performancecompensation and firm performance

• CEOs in larger firms generally earn CEOs in larger firms generally earn moremore

• Mixed empirical evidence on Mixed empirical evidence on relationship between executive relationship between executive compensation and firm performancecompensation and firm performance






• Classifications of firm strategy:Classifications of firm strategy:– Prospector firms emphasize long-term incentivesProspector firms emphasize long-term incentives– Defender firms are more likely to emphasize fixed payDefender firms are more likely to emphasize fixed pay– AnalyzerAnalyzer– ReactorReactor

• Significant relationship between organizational Significant relationship between organizational strategy and executive compensationstrategy and executive compensation

• Firm size continues to be major determinant of Firm size continues to be major determinant of executive compensationexecutive compensation

• Classifications of firm strategy:Classifications of firm strategy:– Prospector firms emphasize long-term incentivesProspector firms emphasize long-term incentives– Defender firms are more likely to emphasize fixed payDefender firms are more likely to emphasize fixed pay– AnalyzerAnalyzer– ReactorReactor

• Significant relationship between organizational Significant relationship between organizational strategy and executive compensationstrategy and executive compensation

• Firm size continues to be major determinant of Firm size continues to be major determinant of executive compensationexecutive compensation






• Earnings per share is significant predictor Earnings per share is significant predictor of short-term executive compensation of short-term executive compensation earned as annual bonusesearned as annual bonuses

• Predictors of long-term executive Predictors of long-term executive compensation earned through stock option compensation earned through stock option exercise exercise – Share price growthShare price growth– Return on stocksReturn on stocks– Market measures of firm performanceMarket measures of firm performance

• Earnings per share is significant predictor Earnings per share is significant predictor of short-term executive compensation of short-term executive compensation earned as annual bonusesearned as annual bonuses

• Predictors of long-term executive Predictors of long-term executive compensation earned through stock option compensation earned through stock option exercise exercise – Share price growthShare price growth– Return on stocksReturn on stocks– Market measures of firm performanceMarket measures of firm performance


Reading 11.3 (Lawler)Reading 11.3 (Lawler)New Thinking for New MillenniumNew Thinking for New Millennium

Reading 11.3 (Lawler)Reading 11.3 (Lawler)New Thinking for New MillenniumNew Thinking for New Millennium

• Strategic approaches to make compensation Strategic approaches to make compensation systems more effectivesystems more effective

– Pay the personPay the person for individual worth (knowledge, skills and for individual worth (knowledge, skills and competencies), rather than for value of job they perform competencies), rather than for value of job they perform

– Reward excellenceReward excellence through pay for performance through pay for performance compensation that establishes clear relationship between compensation that establishes clear relationship between significant amount of pay and attainment of organizational significant amount of pay and attainment of organizational objectivesobjectives

– Individualize pay systemIndividualize pay system to give employees choices in how to give employees choices in how they are rewarded and what reward they receivethey are rewarded and what reward they receive

• Strategic approaches to make compensation Strategic approaches to make compensation systems more effectivesystems more effective

– Pay the personPay the person for individual worth (knowledge, skills and for individual worth (knowledge, skills and competencies), rather than for value of job they perform competencies), rather than for value of job they perform

– Reward excellenceReward excellence through pay for performance through pay for performance compensation that establishes clear relationship between compensation that establishes clear relationship between significant amount of pay and attainment of organizational significant amount of pay and attainment of organizational objectivesobjectives

– Individualize pay systemIndividualize pay system to give employees choices in how to give employees choices in how they are rewarded and what reward they receivethey are rewarded and what reward they receive

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