Compensation

Nov 5, 2024
Which type of contract should an organization use?

It depends partly on the following factors:

• Risk aversion. Risk aversion among agents makes outcome-oriented contracts less likely.
• Outcome uncertainty. Profit is an example of an outcome. Agents are less willing to have their pay
linked to profits to the extent that there is a risk of low profits. They would therefore prefer a
behavior-oriented contract.
• Job programmability. As jobs become less programmable (less routine), outcome-oriented
contracts become more likely because monitoring becomes more difficult.
• Measurable job outcomes. When outcomes are more measurable, outcome-oriented contracts
are more likely.
• Ability to pay. Outcome-oriented contracts contribute to higher compensation costs because of
the risk premium.
• Tradition. A tradition or custom of using (or not using) outcome-oriented contracts will make such
contracts more (or less) likely.
 How does pay influence attitude and behavior?
Incentive effect- The effect a pay plan has on the behaviors of current employees
Sorting effect
• The effect a pay plan has on the composition of the current workforce (the types
of employees attracted and retained).
• Organizations that link pay to individual performance may be more likely to
attract individualistic and risk-oriented employees,
• whereas organizations relying more heavily on team rewards are more likely to
attract team-oriented employees.
• The implication is that the design of compensation programs needs to be
carefully coordinated with the organization and human resource strategy
 Pay-for-Performance Programs

Differentiation in Performance and Pay:

• using pay to differentiate between employees (i.e., create pay dispersion) based
on their performance
• paying high performers an amount they feel is equitable to motivate them (i.e.,
achieve positive incentive effects), as well as to attract and retain them (i.e.,
achieve positive sorting effects)
• employees will pay close attention to why different employees get paid
differently and how fair those differences are, and their perceptions of fairness
will drive their behaviors.
Differentiation Strength/Incentive Intensity: Promise and Peril
• A key decision in designing pay-for-performance plans concerns incentive
intensity, the strength of the relationship between performance and pay (i.e.,
how strongly we differentiate in performance and pay).
• For example, if I increase (decrease) my performance by 20%, by what percent
will my pay increase (decrease)? The larger the change in pay, the stronger the
incentive intensity.
• For jobs in which objective, results-based measures of performance are available
(e.g., sales, executives, stock brokers, investment bankers, investment portfolio
managers, loan officers), incentive intensity tends to be higher, compared to jobs
in which more subjective, behavior based (e.g., performance ratings) must be
used (e.g., staff jobs in human resources, accounting).
• High incentive intensity 🡪 high motivation but unintended consequences?
• Low incentive intensity 🡪 low motivation + sorting effects?
Pay programs
Dimension Details
Fixed or variable Whether payouts becomes part of base pay (merit pay, skill-based
pay), are a fixed cost, or are variable

Performance measurement Whether performance is assessed using subjective measures

(merit pay and merit bonuses) or
objective measures (e.g., incentive pay, gainsharing)
Performance assessment level Whether performance is being measured at an individual level
(e.g., merit pay) or at the unit
(gainsharing) or organizational level (profit sharing, ownership)
Merit Pay (and Merit Bonuses)

• Merit pay Traditional form of pay in which base pay is increased permanently.
• Merit bonus Merit pay paid in the form of a bonus, instead of a salary increase.
• In traditional merit pay programs, annual base pay increases are usually linked to performance
appraisal ratings
• The first factor is the individual’s performance rating (better performers receive
higher pay).
• The second factor is position in range (that is, an individual’s compa-ratio).
• An individual's compa ratio, or compensation ratio, is a metric that compares an
employee's salary to the median or midpoint salary for similar roles in the same
industry or location. It's expressed as a percentage, and is calculated using the
formula:
• Individual compa-ratio = employee's salary / midpoint of their pay range
• So, for example, an employee with a performance rating that exceeds expectations and a
compa-ratio of 120 would receive a pay increase of roughly 3%. By comparison, an employee with
a performance rating of exceeds expectations and a comparatio of 85 would receive an increase
of around 7%.
• Merit increase grid A grid that combines an employee’s performance rating with his or her
position in a pay range to determine the size and frequency of his or her pay increases.
 PERFORMANCE RATING COMPA-RATIO TARGET
Exceeds expectations 111–120
Meets expectations 91–110
Below expectations Below 91

• An employee who consistently performs at the highest level is targeted to be paid at 111– 120%
of the market (i.e., a compa-ratio of 111–120).
• To the extent that the employee is far from that pay level, larger and more frequent pay increases
are necessary to move the employee to the correct position.
• However, if the employee is already at that pay level, smaller pay increases will be needed.
• The main objective in the latter case would be to provide pay increases that are sufficient to
maintain the employee at the targeted compa-ratio.
Individual Incentives

• Like merit pay, individual incentives reward individual performance, but with two important differences.
• First, payments are not rolled into base pay. They must be continuously earned and re-earned.
• Second, performance is usually measured as physical output (such as number of water faucets produced)
rather than by subjective ratings. Individual incentives have the potential to significantly increase performance

• https://hbr.org/2016/09/wells-fargo-and-the-slippery-slope-of-sales-i
ncentives
• Although individual incentives carry potential advantages and, in fact, can have
large positive effects, they are not likely to contribute to a flexible, proactive,
quality-conscious, problem-solving workforce unless they can be designed to
avoid the potential pitfalls described here.
• Incorporating a broader range of objectives beyond physical output alone is one
common step toward that end. Importantly, assessing performance not just in
terms of output, but also whether it was achieved in a way that aligns with the
values of the organization is important.
Profit Sharing and Ownership

Profit sharing
• A compensation plan in which payments are based on a measure of organization performance
(profits) and do not become part of the employees’ base salary.
• At the other end of the individual–group continuum are profit sharing and stock ownership plans
Advantages
• It may encourage employees to think more like owners, taking a broad view of what needs to be
done to make the organization more effective. It might reduce narrow self-interest encouraged by
individual incentive plans (and perhaps also by merit pay). Instead, increased cooperation and
citizenship are expected.
Disadvantages
• Weak instrumentality perception (Link between performance and rewards)
• Deferred pay
Ownership (Including Stock Options)

• Employee ownership is similar to profit sharing in some key respects, such as encouraging
employees to focus on the success of the organization as a whole.
• Increased sense of participation, collaboration, social exchange

Disadvantages?
• Ownership may be less motivational the larger the organization. And because employees may not
realize any financial gain until they actually sell their stock (typically upon leaving the
organization)
• Low instrumentality 🡪 the link between pay and performance may be even less obvious than
under profit sharing.
• From a reinforcement theory standpoint (with its emphasis on actually experiencing rewards), the
effect on performance motivation may be limited
Stock options

• An employee ownership plan that gives employees the opportunity to buy the company’s stock at a previously
fixed price
• Some studies suggest that organization performance is higher when a large percentage of top and mid-level
managers are eligible for long-term incentives such as stock options, which is consistent with agency theory’s
focus on the problem of encouraging managers to think like owners
• But would it hold up for lower-level employees, particularly in larger companies, who may see much less
opportunity to influence overall organization performance?
• What happens if price goes up? v/s down?
• Employee stock ownership plans (ESOPs) : An employee ownership plan that provides employers certain
tax and financial advantages when stock is granted to employees.
How Does an Employee Stock Ownership Plan (ESOP) Work in India?
• Employers decide the number of shares to be offered under ESOPs, their price,
and the beneficiary employees. ESOPs are then granted to employees, and a
grant date is provided.
• Once ESOPs are offered, they remain in a trust fund for a specific period, called
the vesting period. Employees should stay with the organization for the vesting
period to avail the ownership of stock by exercising the ESOP.
• Once the vesting period expires, employees get the right to exercise their ESOPs.
• Employees can exercise their ESOPs and buy the company shares at allotted
prices, which are lower than the market value. Employees can also sell the shares
that they have bought through ESOPs and make a gain on their holdings.
Gainsharing, Group Incentives, and Team Awards

• Gainsharing
• A form of group compensation based on group or plant performance (rather than organization
wide profits) that does not become part of the employee’s base salary.
• Gainsharing programs offer a means of sharing productivity gains with employees. Although
sometimes confused with profit sharing plans, gainsharing differs in two key respects
• First, instead of using an organization-level performance measure (profits), the programs measure
group or plant performance, which is likely to be seen as more controllable by employees.
• Second, payouts are distributed more frequently and not deferred.
• Advantages 🡪 an effort to combine the best features of organization-oriented plans like profit
sharing and individual-oriented plans like merit pay and individual incentives and increases
employee concerns for wider goals, cooperation, citizenship etc.
Scanlon Plan

• One type of gainsharing, the Scanlon plan

(developed in the 1930s by Joseph N. Scanlon, president of a local union at Empire
Steel and Tin Plant in Mansfield, Ohio)
provides a monetary bonus to employees (and the organization) if the ratio of labor
costs to the sales value of production is kept below a certain standard.
On achieving this, financial benefit is spilt 50-50
• Gainsharing plans like the Scanlon plan and pay-for-performance plans in general
often encompass more than just a monetary component. There is often a strong
emphasis on taking advantage of employee know-how to improve the production
process through problem-solving teams and suggestion systems.
• Because actual costs ($850,000)
were less than allowable costs
($907,500) in the first and second
periods, there is a gain of
$57,500.
• The organization receives 45% of
the savings, and the employees
receive the other 55%, although
part of the employees’ share is
set aside in the event that actual
costs exceed the standard in
upcoming months
Group Incentives and Team Awards.

• Whereas gainsharing plans are often plant-wide, group incentives and team awards typically
pertain to a smaller work group.
• Group incentives (like individual incentives) tend to measure performance in terms of physical
output,
• Team award plans may use a broader range of performance measures (like cost savings,
successful completion of product design, or meeting deadlines).
• Competition shifts from individual to groups
• Due to the pay effects on workforce composition, any plan that does not adequately recognize
differences in individual performance risks demotivating top performers or losing them
• Need for procedural fairness- Need for standard setting process that is fair.