Developing a Compensation Strategy

8/3/2019 Developing a Compensation Strategy

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Cornell University ILR School

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CAHRS Working Paper SeriesCenter for Advanced Human Resource Studies

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12-1-1989

Developing a Compensation StrategyGeorge T. MilkovichCornell University

Renae F. BroderickCornell University

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Milkovich, George T. and Broderick, Renae F., "Developing a Compensation Strategy" (1989). CAHRS Working Paper Series. Paper417.http://digitalcommons.ilr.cornell.edu/cahrswp/417
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DEVELOPING A COMPENSATION STRATEGY

GEORGE MILKOVICHRENAE BRODERICK

WORK ING PA PER #89-19

CENTER FOR ADVANCED HUMAN RESOURCE STUDIESSCHOOL OF INDUSTRIAL AND LABOR RELATIONS

CORNELL UN IVERSITY

To be published in the Third Edition of the McGraw-Hill Handbook of Wa~e and SalaryAdministration, M . L. Rock and L. A. Berger 008.

This paper has not undergone fonnal review or approval of the faculty of the ILR School.It is intended to m ake the results of Center research, conferences, and projects available toothers interested in hum an resource m anagem ent in prelim inary fonn to encouraged iscuss ion and suggestions .


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Developing a Compensa tion S tr ate gyGeorge Mi lkov ich and Renae Broder ick

The management of change remains the challenge of the 1990s. Theobjectives of this change are to foster better perfonnance, control costs, ande nh an ce flex ib ility --all n ec essary to su cce ssfu lly comp ete in fierce mark ets. A llmanagers are challenged by the pace and magnitude of this change. Humanre so urce man ag ers are n ot ex cep ted . b ein g co nfro nted d aily w ith q ue stio ns ab ou thow to m anage em ployees to support changes in technology, changes ino rg an izatio n stru ctu res, an d c hange s in busin ess strateg y. And emplo yee sth emse lv es a re c hangin g: in th eir v alu es a nd expe ctatio ns, th eir d emog ra ph icd iversity, thei r educa tion , and thei r wi llingnes s to accep t change.

When confronted w ith the need for rapid and large-scale change, hum anre sour ce managers , lik e th eir c ounte rp arts in marke tin g, fin an ce , a nd p roductio n,tend to adopt strategies that enable them to m anage their w ork forces effectivelyin the face of uncertainty. D eveloping a hum an resource strategy requiresdefining th e worl< :fo rc e p erfo rm an ce g oals n ee ded to su pp ort th e o rg an iz atio n'soverall b usin ess strateg y and th e human re so urce imp lic atio ns o f th ese goals;diagnosing th e o rg an iz atio n's in te rn al a nd e xtern al en viro nmen t to p in po in thum an resource strengths and w eaknesses relative to these goals; and designingth e m ix of h uman resou rce po licies and p ro gram s that exp loits streng th s anddownp lays or COIT ectsw eak nesses. T he aim is to sh ap e a work force fo cu sedon stra teg ic p erfo nn an ce goals an d ca pab le o f ach iev in g th em .


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Compen satio n is a critical piece of ov erall human reso urce strateg y.Because compensation is both visible and important to employees, acompen satio n p ro gram d esig ned to commun icate and rew ard strateg ic g oalsincreases the probability that em ployees w ill not only understand w hat thosegoals are but also will achieve them . Because em ployees also understand thatcom pensation dollars are im portant to the organization, the strategic intent ofother hum an resource efforts, such as perform ance m anagem ent, recruiting,career developm ent, and the like, is also clearer if their designs are consistentwith the compensa tion p rogram . In sho rt, re aliz ation o f compensa tion stra tegyreq uires th at th e mon ey match th e messag e.

Developing a com pensation strategy requires the same process ofdefin ition, d iagnos is , and des ign des cribed above fo r human re source s tra tegy .T his ch ap ter pro vides som e g uidelines for b eg inning th is p ro cess.

WHICH COMPENSATION DEC ISIONS ARE STRATEGIC ?

S trate gy re fers to th e fu nd amen ta l d ire ctio ns o f a n o rg an iz atio n. S tra teg ies se rv eto g uide th e d ep loym en t of all reso urces, includ ing com pen satio n exp en ditures.B ut not all com pensation decisions are strategic. O nly those decisions that arecritical to the success of the business are strategic, such as those that affectlabo r co sts and p erfo rm an ce. D ecisio ns ab ou t tech niq ues, su ch as w hich jo bevaluation plan to use or w here to slot the com pensation m anager in the pay


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structure. are probably not strategic. Policy decisions. such as linking a portionof pay increases to corporate and unit performance and detennining thecom petitive position in the m arket, probably are. W e propose five basicd ecisio ns, sh own in F ig ure 1 , as a p lace to b eg in . T he fo llowin g d ecisio ns areconsidered strategic by those w ho m anage com pensation system s.

(Insert Figure 1 here)

Compensation's R ole in H um an R esources C ompensation is only pan of thepolicies and programs organizations use to manage employee relations.D ecisions regarding em ploym ent security. developm ent and training. careero pportu nitie s, emp lo ye e a ssis tan ce p ro grams. an d o rg an iz atio n d es ig n, a lo ng w ithcompen sa tio n, fo rm patte rn s o f human re sourc es polic ie s. The se patte rn s maybe w ell-integrated or so disjointed as to w ork at cross-purposes. C om pensationcan act as an instrum ent of change or sim ply act to support the overall hum anresources strategy. T he im plem enting of profit sharing plans. for exam ple, actsto signal competitive environments, encourage employees to identify withc orp ora te p erfo rman ce . a nd support c orp ora te v alu es . A lte rn ativ ely , o th er h umanre so urc es in itia tiv es, su ch a s tra ns fo nn in g o rg an iz atio n stru ctu re s, fo nn in g workteam s. and other flexible m angem ents. m ay act as the change agent in theo verall h uman reso urces strateg y. In su ch cases. compen satio n's ro le m ay b eto support, rather than be on the cusp of the hum an resources strategy.


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Determ ining com pensation's role in the larger hum an resources p ictureis a fam iliar m essage. All m anagers nod in agreem ent but often neglect it whenmaking decisions. Compensation decisions are part of the pattern of humanresources decisions; they do not operate in a vacuum . The rush to im plem entpay program s, particularly in centive pay, w ithout fU 'S t exam in in g their role inth e to tal h uman reso urc es strate gy , o ften re su lts in fa ilu re a nd emp lo ye e d istru stH en ce, d eterm in in g comp en sa tio n's ro le in th e o verall h uman reso urce s strateg yis a strateg ic d ec isio n.

Competitiveness Wha t leve l o f pay --ba se , b enefits , in centiv e, p erqu is ite s-sh ou ld b e offered relativ e to competito rs? What m ix o f th ese fo rm s sh ould beoffered --base , f lexib le benef it s, s tock op tions, cash bonuses, s tock appreciat ionrights, etc.? W hat should the proportion of guaranteed compensation (base.benefits) relative to riskier returns (incentives) be? C hoices on m arket position,mix . and the p ropo rtion o f gua rante ed compensa tion d ir ec tly a ff ec t manage rs'ab ility to m eet strateg ic perform ance goals. T he com petitiv e position m anagerscho se affects th e q uality of the work fo rce and its o verall co sts.

Choices about compet it ive posi tion also communica te to both prospectiveand incumbent em ployees. S avvy employees, for exam ple, can discern theorg an izatio n's ability and w illing ness to recog nize th eir needs based on theflexibility and tax protectio n offered in benefit p lans or th e opportu nity to sharein th e fum 's su cc ess th ro ugh sto ck - a nd p erfo rman ce -b ase d p lan s.


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In te rnal S tructu re s Decis ions on in te rnal s tructu re sde te rm ine the d is tr ibutionof base pay to different jobs or skills. In som e cases, this distribution isd ete rm in ed by mark et p ric in g, th ro ugh matc hin g competito rs' s tru ctu re s re ponedin the market. In others, the number and uniqueness of jobs and skills and thestreng th o f o rg an izatio ns' valu es d ictates sen sitivity to bo th in tern al an d mark etfactors.

Figure 1 lists several decisions associated w ith the internal structure ofcom pensation system s. T hese range from the num ber of structures (national andlocal, tech nical an d no ntechn ical, an d manag erial, etc.) an d th e n umber of lev elsin each pay structure to the size of differentials among levels. O bjective datashow that these decisions differ am ong organizations in different industries andin vastly different m arkets w ith no reference to business strategies. Fore xamp le , busin esse s th at a re h ighly la bo r-in te nsiv e, s uch a s sp ac e and defe nsecontractors, tend to exhibit more levels, smaller differentials, and greateremphasis on in te rn al norms and tra ditio ns. In c on tra st, b usin ess units w ith le sslabor-intensive technologies, such as chem icals and plastics, tend to have few erle ve ls a nd w ider d iffe re ntia ls. However, e ven busin ess units c ompeting in th esame indu strie s a nd mark ets may exh ib it v ery d iffe re nt in te rn al p ay stru ctu re sco nsisten t w ith th eir p articular b usin ess strategy .

In tern al stru ctu res let emplo yee s k now th e relativ e v alu e o f th eir jo bsa nd sk ills a nd delin ea te c are er p ath s. Consequen tia lly , dua l la dders, te chnic al


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and m anagerial, are believed to signal the technical contributors' value to ano rga nizatio n. .T he e xten t to w hich emplo yees v iew th ese d ecisio ns as eq uita ble-with reference to either m arket values or internal norm s-will influence theirsen se o f fair treatm ent and their motiv ation to perfo rm . S tructural d ecisio nsa lso in flu ence the fle xib ility manage rs have in r ea ss igning employees withou tch ang in g their pay . T o illustrate, G eneral E lectric C o. 's plastics divisionadopted an exem pt pay structure w ith only four levels: executive, director,leadership, and technical and professional. M anagers believe that it providesgreater flexibility to m ove em ployees without requiring pay changes. It alsocommunicates to em ployees a relatively egalitarian philosophy about the value(b ase p ay ) of different skill g rou ps. However, to b e su ccessful, the in creasedflex ib ility must b e m an ag ed effectiv ely . In co nsisten cies w ith in lev els ca n resu ltin a narchy a nd quick ly w ill le ad to emp loyee d iss atisfa ctio n and d istru st.

GE 's competito rs typic ally opt fo r more me rito rious h ie ra rchic al- ba sedstru ctu res, w ith more lev els an d/o r larg er p ay d ifferen tials lin ked to emplo yees'jo bs an d sk ills. T he circ um stan ce s u nd er w hich th ese eg alitarian v s. h ie rarch ica lstructures m ay be m ost effective is currently under study. W itho ut su chevidence, structural decisions seem to be based m ore on follow ing fads, beliefs,a nd c onv en tio ns th an o n stra teg ic co nsid eratio ns.

Employee Contr ibutions Determ ining the whys, hows, and whens ofemployee p ay in creases is perhap s the most im portant strategic pay decision .


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Increases in pay are powerful communicators. For exam ple, bonus plans tiedto exceeding annual operating plans, such as those recently adopted by D uPontCo., Unio n C arbid e Corp ., S co tt P ap er Co., and others, are b elieved to focu semployees ' a tte ntion and e ffo rts on the unit's p erf ormance. Ac ro ss -th e-boardincreases based on a co st-of-living in dex , on th e o ther hand, m ake inflationmore sa lie nt, an d merit in crea ses m ak e p erfo rm an ce a ppra isals an d c ompetito rs'practices impon ant T he n atu re o f pay increases signals what an org anizationvalues. R etaining experienced and talented em ployees, rew arding theirco ntribu tio ns, re co gn izin g u nit p erfo rm an ce, an d ev en o ffse ttin g in flatio n are aU ,Ctto som e degree, objectives of pay increases. The art of strategic m anagem entinvolves choosing the pay increase plans that best serve the unit's businessstrategy and com plem ent its overall hum an resources strategy.

Admin istratio n Decisio ns abou t h ow to adm in ister p ay may als o b e s tra teg ic.T he y can in flu en ce manag ers' s en se o f ownersh ip and employe es' v iews o f th efairness of their pay. Both ownership and fairness are thought to be achievedth rough decen tra liz ation, pan ic ipation, and communic ation. For example , onecurrently popular axiom is that deciding "how best to com pete" rests w ithb usiness un it m an agers; hen ce, en suring that pay system s help them competesh ou ld a lso b e th eir re sp on sib ility .

Decentralization, however, is not a universal good--more is notnecessarily better. D eterm ining w hich decisions should be decentralized and to


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w hich organization level involves experienced judgem ent B enefits seem to bebest m anag ed corporatew ide, incentiv es are b est m an aged at vario us levels,depen din g on th e typ e of plan , an d ch oices ab out structures and competitivepositions seem to depend on the skills and product m arkets in w hich unitscom pete. H ence, decentralization decisions probably m ust be custom ized to fite ac h o rg an iz atio n's u niq ue situ atio ns .

Employees' sense of fairness regarding their pay is thought to beh eig hten ed if its admin istratio n is in te rn ally c on siste nt, if commun icatio n isperceived as open, and if em ployees believe they have the opportunity top articip ate. T hu s, while many d ecisio ns in vo lv ed in th e a dm in is tratio n o f p ayare ope ratio na l, th e b asic policie s u nd erly in g th e n atu re o f th e admin istra tio nseem critical to em ployee perform ance and the success of the business.

These f iv e bas ic dec is ions -- compensat ion's r ole , compet itiv enes s, in te rnals truc tu re s, employee con tr ibu tions, and adminis tr ation-on ly serve as a s ta rtingpoint T ailoring to each organ ization 's u niq ue situation is req uired. Thechoices m ade affect every organization's success.

KEY STEPS IN DEVELOPING A COMPENSATION STRATEGY

Developing compensat ion strategies is a sim ple process. O ne fam iliar to anym anager is the generic decision m odel:


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. Analyze compensa tion imp lications. Establi sh objec tives. Compare actual cond itions w ith ob jectives to identify gaps. D evelop actions to close gaps. Follow th rough.F ig ure 2 sh ow s th is mod el a pp lie d to d ev elo pin g c ompe nsa tio n stra te gie s.

It involves (1) analyzing the com pensation im plications of the organization.sbus in es s s tra te gy . e xte rn al e nv ironment. a nd in te rn al human r esou rc es conditio ns ;(2) establishin g the desired strategic com pen satio n po sition invo lving the fiv estrategic choices discussed above; (3) detennining any gap between theim plications derived from the analysis and the desired strategic position; (4)designing com pensation program s to. close the gap and to translate thecom pensation strategy into p ractice; and (5) fo llow ing th rou gh. T hese step s areexp la ined below in g reate r deta il.


Analyzing Compensation Imp lic ations T he ch ang in g forces o f th e ex ternale nv ironmen t th rough which o rg an iza tio ns must n av ig ate were exam ined in th ep revious chapte r. Here. we only re-emphasize that they are crucial todev elop in g compensatio n strateg ies. P erh ap s a majo r issu e is w heth er th ese


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environmental forces allow any room for managers to adopt differentcompen sation polic ies in support o f th eir busin ess stra teg ie s. L eg isla tion onhealth benefits, pensions, and deferred contributions have reduced the viablechoices for executive and m anager com pensation. Yet, we do know that finnspursue different options in responding to changes accom panying advances inte chno logy , chang ing popula tion demograph ic s, a nd shiftin g regu la to ry conce rn s.Aga in , man ag ers c ha rg ed w ith d ev elo pin g compen sa tio n stra teg ies must in no va tecomp en sation strategies that o ffer competitive advantages w ith in the ch ang in gpressures that op erate in the ex ternal env iro nm en t.

Business strategies' im plication for compensation reside in the workfo rc e's p erfo rman ce a nd th e su stain ab le lab or c osts asso cia ted w ith its su cc essfu limplementation. For example, the decision to enter a new market requires awork force that is willing to take risks, put in long hours, and quickly solveproblems not previously encountered. At the same time, especially for newventures, cash flow is o ften restricted. A compensation strateg y that attracts an dm otivates the necessary w ork force w hile dealing w ith cash lim itations-all elsebeing equa l--w ill in cre ase th e new ven tu re 's ch ance s o f su cce ss.

P ro po ne nts o f c ompensa tio n strateg y d ev elo pmen t main tain th at d iffere ntbusin ess strateg ies v ary in th eir work -fo rce perfo rman ce req uirements an dsustainable labor costs, and, thus, in the compensation strategies that bestsu pp ort th em .


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Develo pin g a S tra teg ic Positio n Two re late d lev els o f b us in ess strateg y n ee dto be considered w hen developing com pensation strategy: the corporate unit andthe business unit. C om pensation strategy is m ost directly related to the businessunit's strategy, but, as depicted in Figure 3, both the corporate and humanre so urc e s tra te gie s a lso in flu en ce c ompen sa tio n stra te gy d ev elo pment.


Business unit strategies are designed to answ er the question, "H owshould w e com pete in this particular product or service m arket?" Manyapproaches exist, but m ost classify business unit strategic types in term s of tW op re domin an t strateg ies . One is la belled "G rowth ," th e o th er, "Ma in ten an ce."T he d iscu ssion of both th ese strategies is ideal in the sen se that actu ally veryfew o rg an izatio ns c ompletely exhib it th e p attern s to b e d esc rib ed . However,these tW o types do serve to guide the developm ent of com pensation strategiesu nd er d iffe re nt b us in ess s tra te gie s.

Man agers p ursuing a G row th strategy mak e high investm ents an d tak es ign if ican t f inancia l r isks to expand thei r market sha res. The ideal o rgan izationdesign allows for m axim um flexibility in dealing w ith new m arkets andte chno logie s. D iv is ion o f labo r is p roduct o r servic e-c en te red with little job o rfu nctio nal sp ecializatio n. D ec isio nmak in g is d ece ntraliz ed ; the re are few fo rm alcontrols such as budget, inventory, or even human resource programs.


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H ierarchies, supervision, and w ork rules are m inim al. Inform ation flow s freelyand inform ally throughout the organization. Perfo rmance criteria fo cu s onmark et o utcomes , s uch as expandin g sales a nd mark et s hare.

A Ma in tenance s tra tegy emphas iz es ma in ta in ing current ma rket sha re swhile m in im izin g c osts and improvin g cu stome r sa tis factio n. Here, th e id ealo rg anization d esign ex plo its th e org an izatio n's past learn ing an d success indealing w ith a particular m arket and technology. The division of labor isfunctional w ith relatively high job specialization. Decisionm aking is m orecentralized, and m ore form al control, hierarchy, supervision, and work rulesexist here than in the Grow th strategy. Inform ation flows through w ell-e stab lish ed commun icatio n ch an nels an d is more re stricte d. P erfo rm anc e c riteriafocus on cost savings, quality, and custom er satisfaction.

T he strategic com pensation decisions thought to best support the G row thand Ma in ten an ce stra teg ies a re shown in F ig ure 4 and a re d eriv ed from s tu dieso f compensa tion s tta te gy in Growth and Ma in tenance o rgan iz ations . The logicunderly ing these re su lts is re ad ily apparent when considering the perfo rmanceand labo r cos t imp lic ations a ssoc ia ted with e ach s tta te gy . The Growth s tta te gy ,f or example , requ ir es heavy inve stments in ma rketing and development w ithou tth e ben efits o f high cash in come--at least over the sho rt term . T his m eans thatdollars are not available for high base salaries and benefits, but significantperform ance and ow nership incentives can be offered. In order to realizein cen tiv e pote ntial, emp loyees mu st b e w illin g to tak e risk s, work lo ng hou rs,


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creatively solve problem s, and focus on the m arket outcom es critical to G row ths trategy success .

(Insert F igure 4 here)

C ompen satio n p lay s a d om in an t, lead ro le in th e o verall h uman reso urcesstrategy. It serves to signal the climate of risk and reward. Incentives tied tothe organization level and m arket outcom es w ith high, annual payout potentialh elp attract and d ire ct th e ty pes o f employe es n ee ded . In tern al stru ctu res andadministrat ive decisions tha t a llow maximum flexibil ity are a lso consis tent wi ththe organizational design and adm inistrative style thought ideal for Growths tra tegy succe ss .

One stud y of th e relation ship betw een human reso urce strategies andbusiness unit strategies show ed that units successfully pursuing G row th w erem ore likely to em phasize the im portance of com pensation program s than thosepursu ing Main tenance s trategies . While the results of one study are notdeterm ining, they suggest that w hen m aking choices about developing acom pensation strategy for several business units, those pursuing G row ths tra tegie s should take p re cedence because pay appea rs to p laya more dominan trole.

R esearch also confIrm s that the internal structures and adm inistration ofpay are related to the cultures and management styles used throughout the


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organization. It follow s that any shift tow ard either a G row th and M aintenancestrategy must be supported by sim ilar changes in the organization itself. Acompensa tion stra tegy a t odds w ith the o rgan izationa l cultu re is fu tile .

D esigning a Compensation Strategy to Close A ny G ap The compen sa tionsystems of most organizations w ill not look exactly like either of theMain tenance o r G rowth p ro file s. The Ma in ten ance and G rowth p ro file s shownin F ig ure 4 really serv e as p olar g uid ep osts fo r manag in g strategic ch an ge an dd evelo pmen t. A simple ex ample illu strates h ow th ese p ro files can b e used toguid e s tra te gy development.

T he cu rrent compensation system pro f11e s hown in F igure 5 comes froma u nit w ho se mark et o rientation , stru cture, and admin istrativ e sty le p lace itclosest to a Maintenance type. T he unit's business strategy is to continue itscu rren t mark et o rientatio n: main ten an ce o f market share. It also an ticip ates,however, that increased levels o f m arket competition m ean that m inim izing co stsand increasing quality and custom er service are no longer enough. Internalstructure, adm in istrativ e sty le, w ork fo rce perfonn an ce, and labor costs all needto be more flexible in order to accommodate changes in market demand.Flexibility of the order recommended to support a G rowth strategy is notdesired. T he Maintenance unit just w ants a little more flexibility and maybesome co rrectio n o f p ast p ro blems: red undant jo bs an d emplo yees, lacklu sterperfonnance s tandards, and overspeciali za tion of jobs.


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In order to develop a compensation strategy that promises morefle xib ility , th e compensa tion p ro file o f th e Growth type o ffe rs a guide. F igure5 show s the unit's current com pensation profile, the ideal G row th profile, andth e re commended compen sa tio n s tra te gy .

The recommended strategy infuses a little m ore risk into the system andpoten tially lowers la bo r co sts. The pay system role in the total humanresources strategy shifts to the role of a change agent. The shift toward aG row th strategy requires a com petitive position m ore sensitive to m arketpressures and less to internal traditions and norms. A higher proportion ofin centiv es in to ta l compensa tion is p roposed; th ere is le ss gua rante e that th esein cen tiv es w ill b e p aid . A p ro fit s harin g p lan ties abou t 1 0 p ercen t o f p oten tialpay increases to unit perform ance, and, if realized, this am ount w ill not beadded to base salary . A lso, more info rm atio n w ill be sh ared w ith emplo yees.In particular, the profit sharing plan calls for em ployee education in basicf inancia l concepts , employe is markets , and the like.


Following Through Implemen ta tio n o f th ese stra teg ic ch anges is trick y.Compensation changes cannot take place overnight, but most can beaccomp lished with in time framework a ssoc ia ted with shifts most bus ines s unitstrateg ies. T he key is to identify which' ch anges sh ould h appen first in order


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to ensure that success. ja !J~b3eq1S ent.For the recommended strategy in Figure5, the profit sharing program m ight have enough visible im pact in year two tocarry internal support for reductions in job levels, changes in the m erit plan,and increased em phasis on external m arket pressures.

THE PAYOFFS FROM DEVELO PING A COMPENSATION STRATEGY

Why spen d the tim e d evelo ping compensatio n strategy ? One recen t estim atea ssessed th e d ev elo pmen t time at ab ou t six mon th s. T he und erly in g p rem ise o fany strategic perspective is: If m anagers m ake pay decisions consistent withthe organization's business strategy, responsive to external and internalconditions, and consistent w ith the overall hum an resources strategy, then theorganization is m ore likely to be com petitive. T his statem ent is based on belief,not system atic evidence. N o studies link the im plem entation of com pensationstrateg y w ith busin ess su ccess. In dee d, th ere a re so many fa cto rs u nrelated tocomp en sation th at c an in flu en ce b usin ess strateg y su cce ss th at d isen tan glin g th eeffects of com pensation strategy is a difficult task.

Recent studies do offer guidelines on the effects of certain decisions,specifically pay-far-perform ance plans, on fum perform ance. It has beendocum ented, for exam ple, that G ainsharing plans are related to betw een 10percent and 17 percent im provem ent in perform ance. Perform ance in thesestu dies in cluded rates of ab senteeism , su ggestions, an d safety as w ell as co st


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and production m easures. The longest period covered by any study w as 18months. It has also been shown that firms distinguish themselves throughdecisions on incentive pay plans m ore than they do through decisions about thecom petitive level of base pay. Thus, the conventional com petitive decisions,su ch as lead in g o r m eetin g competitio n, m ay be o bso lete. R ath er, fmns seemto establish com petitive positions based on the nature of their incentive plans.Furth er, stu dies sh ow th at g reater u se o f b on uses an d lo ng -term in cen tiv es isa sso cia te d w ith b ette r fIrm perfo rmance . S pe cifIc ally , a cc ord ing to one studyof over 250 fm ns, an increase of 10 percentage points in the bonus!base ratiois associated with .21 to .95 greater return on assets. Som e evidence alsosuggests that such plans are m ore successful w hen they are part of a total orstra teg ic a pp ro ac h to c ompensa tio n.

A note of caution: Negative results and failed com pensation plans areseldom reported. Consequently, m uch of the work in this area needs to betreated w ith some cau tio n. H ow ever, a con serv ativ e co nclu sio n is th at empiricalevidence does support the proposition that perform ance-based pay, as part of ano verall strateg ic app ro ach, d oes con trib ute to fIrm p erfo rm ance.

T here are also some po tential side ben efIts of d ev elo pin g a compen satio nstrategy. It p ro vid es a b usin ess-related ratio nale fo r compen satio n sy stemchanges that m ay be useful in explaining decisions to both em ployees andouts ide regu la to rs . The p roce ss o f compensa tion s tra tegy development requ ire sthe m anagers involved to stretch their understanding of all aspects of the


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organization and the environm ent in w hich they are com peting and theirrelationship to pay. T he process m ay spark ideas for m uch needed change ino ften o verly b urea ucratic p ay system s.

18


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F iflu re 1 : S tr ate flic C om ve ns atio n D ec is io ns

1. Role in Total H um an R esources StrategyInitiate, O n the pointFollow-supportive

2. Competitiveness

3.

Market pos itionM ix -b as e, b en efits. in ce ntiv e fo rmsP ercentage of guaranteed payStructure

S en sitiv ity to intern al an d mark et fac to rsN um ber of levels in hierarchyS ize o f d ifferen tials b etw een le vels4. Employee Cont ri bu tions

Pay increase cri te ria: objec tive /subjec tive performance ,experience, inflationLeve l o f measurement : corpora te . d iv is ion , fac ili ty . team,individualS iz e, f re quency o f payou tRen ewal, p ro po rtio n not adde d to b aseNumber. m ix o f in crease p rograms5. Administration

Commun icatio n: d eta il an d ty pe o f p ay in fo rmatio n p rovid edCen tr aliz ation: extent and employee par tic ip ation in des ign andimplementa tion of bus iness un itForma liz ation: extent o f writte n ru le s, manuals . budge tprocedures. etc.

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.20

Fi$!ure 2: A P ro cess: D evelo Din $! a C om D en sa tio n S tra teflV

1. Analyze impl ica tionsBusines s s tr ategyExte rna l envi ronmentIn te rn al h uman re so urc es c onditio ns

2. Dev elo p a comp en satio n strateg ic p ositio nC ompensation's role in total hum an resources strategyCompet it ive posi tionInterna l s truc tu resEmployee cont ribu tionsAdministration

3. De te rm ine any gap between s tr ategic pos ition and ana ly sis o fconditions and deisgn compensa tion s tr ategy to c l~ se it4. Follow th ro ugh


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Fi$?ure 3: S trate$? ic Perspect iv e: An I llus trat ion

STRATEGICBUS INESS IS SUES

COMPENSATIONENVIRONMENT

CORPORATESTRATEGY

BUSINESS UNITSTRATEGY

HRSTRATEGY

STRATEGICCOMPENSATIONDECISIONS

COMPENSATIONSTRATEGY

COMPENSATIONSYSTEM

STRATEGICHR ISSUES


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S trateg ic Compensat ionDecisions

(1 ) R ole in H um anResources Strategy:(2 ) Competitiveness:Market posit ion

Pay m ix

Percen tage ofguaranteed pay(3 ) Internal Structure:M ix in te rn al a ndmaItet p ay v alu es

Number of lev els inpay h ie ra rchyDifferentials

(4 ) N ature of PayIncreases:Criteria

L ev el o f mea su reS ize o f pay outRenewal

(5 ) Administration:CommunicationCentralizationFormalization

22Fi2ure 4: SU22es ted Comoensat i! ll l.. l! .J1d jJes fo rBusiness U nit Strate2ic TW Jes

BUSIN ESS UNIT STRATEG IC TY PESMaintenance Growth

Suppo rt o r S ubordin ate Lead, S ig na ls R is ks a ndRewards

Emphasize base, benefits Emphasi ze inc en ti ve sVarie ty a nd cho ic e inbenefits Variety in incen tives, choicein benefi tSHigher Lower

Internal and m aItet sensitive M aItet sensitive

More Fewer

Larger Smaller

Exper ience , Inflat ion .Performance Appra isal

Objec tive Performance

Individual, group Unit, individualSmaller Larger

N ot added to basedded to base

Restricted OpenHighHigh

LowLow


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23.~Fit!ure5: lllu stra te d C om pa riso n o f C urre nt a nd

Compensation Stra teJ!Y Profi le

COMPENSATIONSYSTEM PROFILESStrategic CompensationDecisions Current/Actual Growth Recommended

(1 ) R ole in H um an Support o r Subord ina te Lead, Signals, R isk and Shift to Higher Profile,Resources Strategy: Rewards P ay Sys tem(2 ) Competitiveness:Marlcetposition L ead in b ase , b en efits Lead wi th Incent ives Meet in Bas e, Ben efits ,and Incent ives

Pay m ix Va ri ety o f benef it s Variety of Incent ives No ch an gePercentage of High--90 percent Low Moderate-8S percentguaranteed pay

(3 ) Internal Structure:M ix in te rn al a nd Both used Market No ch an gemarlcet sensitivityNumber o f le ve ls 2S levels Fewer Reducein p ay h ie ra rc hyDifferentials Large Flat No ch an ge

(4 ) EmployeeContributions:Criteria Perform ance A ppraisals Financials M ix of both& Sen io ri ty

L ev el o f mea su re Individual Unit Individual Un it and Ind iv idua lS ize o f p ay out Small Large Mode ra te -I S p erc en t o ftot al p ayRenewal Added to Base Not Added Not Add edM ix Merit, seniority-based Incentives only Merit (S percent) Profi tplans sha ring (10 per cent )

(5 ) Administration:Communication Restricted Open Mo re open: In fo re le va nto p ro fit s ha ringCentralization High Low No ch ang eFormalization High Low No ch ang e


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SELECTED REFERENCES

Balkin, D . and Gomez-Mejia, L. (1987). Toward a contingent theory ofcompensation strategy. Strategic Management Journal, 8, 169-182.Broderick, R . (1987). Pay policy, organization strategy and structure:A question of "fit". In R. Niehaus (ed.) Strategic Human ResourcePlanning Applications, pp. 43-58, New York, NY: Plenum Press.carroll, S. (1987). Business strategies and compensation systems. InD. Balkin and L. Gomez-Mejia (eds.) New Perspectives in Compensation,pp. 343-355, Englewood Cliffs, NJ: Prentice Hall.Cooke, F. (1986). strategic Compensation. Frederick W . Cooke Associates.Dyer, L. (1985). Strategic human resource management and planning. InK. Rowland and G. Ferris (eds.), Research in Personnel and HumanResources Management, 3, pp. 1-30, Greenwich, CT: JAI Press.Dyer, L and Theriault, R. (1976). The determinants of pay satisfaction.Journal of Applied Psychology, 61, 5, pp. 596-604.Ellig, B. (1981). Compensation elements: market phase determ ines the mix.C om pensation R eview I Third Quarter, pp. 30-38.Gailbraith, J. and Nathanson, D, (1979). The role of organization structureand process in strategy implementation. In D. Schendel and C. Hofer(eds.) Strategic Management: A New View of Business Policy andPlanning, pp. 249-283, Boston, MA: Little, Brown and Company.Gearhart, B. and M ilkovich, G. (1989). Organizational differences inmanagerial compensation and financial performance. Working Paper #89-11, Center for Advanced Human Resource Management. School ofIndustrial and Labor Relations, Cornell University.Kerr, J. (1985). Diversification strategies and managerial rewards: an empiricalstudy. Academy of Management Journal, 28, pp. 155-179.Lawler, E. (1981). Pay and Organizational Development. Reading, MA:Addison-Wesley.M iles, P. and Snow, C. (1978). Organizational Strategy, structure and

Process. New York, NY: McGraw Hill.M ilkovich, G. (1988). A strategic perspective on compensation management.In K. Rowland and G. Ferris (eds.) Research in Human ResourcesManagement, 6, pp. 263-288, Greenwich, CT: JAI Press.M ilkovich, G. (1987). Gainsharing in managing and compensating humanresources. Working Paper #87-03, Center for Advanced Human ResourceStudies. School of Industrial and Labor Relations, Cornell University.


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Milkovich G. and Rabin, B . ( forthcomming ). Firm performance: does executivecompensation really matter? In F. Foulkes (ed.) Executive Compensationin the 1990 's: A strategic Approach. Boston, MA: Harvard BusinessS chool P ress.Ochsner, R . (1988). Customized contingent compensation: the wave of thefuture. In C. Fay and R. Beatty (eds.) The Compensation Sourcebook.pp. 38-40, Amherst, MA: Human Resource Development Press.Schuster, M . (1985). Gainsharing: issues for senior managers. Working paper.School of M anagement, Syracuse University.W allace, M . (1988). A lternative reward strategies: improving productivity andcompetitiveness. Certification Course 12. The American CompensationAssociation.Weiner, N . (1980). Determ inants and behavioral consequences of paysatisfaction: a comparison of two models. Personnel Psychology,33, pp. 741-757.W ils, T . and Dyer, L. (1984). Relating business strategy to human resourcestrategy: some preliminary evidence. Paper presented at the 44th AnnualMeeting of the Academy of Management. Boston, MA.

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Developing a Compensation Strategy