Our initial task in this course is to present the rationale for studying

compensation in the first place. We then consider how organizations

adopt a strategic perspective on compensation decisions to increase their
effectiveness. Each of these issues is addressed in turn.
Why study compensation? Is too much emphasis placed on carefully
designing and administering compensation systems in organizations
today? Some critics assert that managers spend too much time focusing
on how to motivate their employees with compensation (Pfeffer, 1998).
These critics contend that money is not a primary motivator and that
managers often overlook other, more effective managerial techniques.
After all, they claim, employees primarily appreciate work for the meaning
it contributes to their lives, and employers should not demean their
workers by “bribing” them to perform their jobs. So, why should we bother
with studying the theory, research, and practice of compensation?
Compensation is important to study because research indicates that pay
does indeed matter a great deal to employees. The decisions managers
make about compensating employees matter because money is both 1) a
utilitarian commodity allowing employees to provide for their economic
well-being and 2) a symbol conveying achievement and status (Mitchell &
Mickel, 1999). Moreover, the value of monetary reward systems to
employees is evident in the relationship between compensation and a
variety of important outcomes that have relevance for employees and
organizations alike, including attraction and retention, job satisfaction and
job performance, and organizational performance.
Attraction and Retention
First, let us consider  attraction and retention. Research indicates that pay
level, compared to other job attributes, is an important consideration
when job seekers are making the decision whether or not to apply to work
for an organization. Accordingly, pay level “can increase the size of the
applicant pool, the likelihood of acceptance, and the quality of job
applicants” (Gerhart & Milkovich, 1992, p. 491). Prospective applicants
often lack information to evaluate job openings in terms of the quality of
supervision or working conditions, but salary information is an easily
observable characteristic used to compare job offers. Accordingly,
research has indicated that relative to other job attributes, the amount of
pay ranks highly in the decision to apply (Barber & Roehling, 1993). Higher
pay also translates into higher retention (or lower turnover) of workers,
which reduces the cost of searching for, selecting, and training
replacements (Shaw, Delery, Jenkins, & Gupta, 1998). In addition, while
high performing employees may be more attracted to organizations with
higher pay levels, retaining them may hinge on performance-based pay
that rewards them more than their lower-performing counterparts (Lawler
& Jenkins, 1992). Both attraction and retention relate to
the efficiency objective in Milkovich and Newman’s (2004) Pay Model by
virtue of their role in controlling labor costs.
Job Satisfaction and Job Performance
Aside from attracting and retaining good employees, organizations also
need to attend to the job satisfaction and job performance of these
employees. Research has determined that workers are more satisfied with
higher pay, but also that employee attitudes about pay are more strongly
affected by the perceived fairness of how their pay is established than the
actual level of pay itself (Heneman & Judge, 2000). Hence, Milkovich and
Newman (2004) include  fairness as an important objective in their Pay
Model. In addition, a vast body of research has examined how various
managerial techniques relate to employee effort and performance, and a
summary of this work concludes, “Money is the crucial incentive because,
as a medium of exchange, it is the most instrumental  . . . . No other
incentive or motivational technique comes even close to money with
respect to its instrumental value” (Locke, Feren, McCaleb, Shaw, & Denny,
1980, p. 379). In Assignment #4, we examine this issue as it relates to pay-
for-performance programs. For now, insofar as compensation systems are
associated with increased job performance, they help to achieve the
efficiency objective in the Pay Model.
Organizational Performance
Finally, managers want to optimize organizational performance, also a key
consideration in the efficiency objective in Milkovich and Newman’s (2004)
Pay Model. Labor costs represent a significant expense for many
organizations (Blinder, 1990) and need to be carefully controlled.
Organizations have a large stake in how employees are compensated
relative to the value these employees contribute to the organization’s
success. Therefore, research has begun to explore how aspects of
compensation systems may relate to increased firm performance in
measures, such as return on assets (Gerhart & Milkovich, 1990).
In summary, compensation decisions affect a number of variables
significant to organizations and employees alike. Knowing that
compensation decisions relate to organizational performance, we raise
the question of how managers can use their compensation systems to
gain and sustain competitive advantage. 
Strategic Alignment
Having established the connection between compensation system
decisions and various employee- and organizationally-relevant outcome
variables, we now consider how we might leverage those decisions to
produce the most optimal results for our company. Importantly, not all
companies achieve the same degree of success with their compensation
systems, even when they attempt to mimic successful compensation
programs in other organizations (Milkovich & Newman, 2004). A strategic
perspective acknowledges that what works well in one organization may
not work equally well in another organization, even if both operate in the
same industry. The key to compensation system effectiveness, under this
perspective, is the extent to which there is pay strategy alignment. That is,
the compensation strategy should be aligned with the business strategy,
with external economic and sociopolitical conditions, and with other
internal HR functions (Milkovich & Newman, 2004). So while competitors
may attempt to copy certain aspects of a successful organization’s
compensation program (a best practices approach), the strategic
perspective contends that competitive advantage is derived from the way
in which compensation and other HR functions fit together with the
overall business strategy.
Alignment with the organization’s business strategy is also referred to
as vertical fit, and out of the three types of alignment, this one has
received most of the research attention to date. Derived from analyzing
the organization’s strengths, weaknesses, opportunities, threats, vision,
mission, values, and operational plans, top management charts an overall
business strategy. The strategic perspective of compensation indicates
that the organization is most likely to achieve competitive advantage when
the compensation strategy is consistent with and reinforces the
organization’s business strategy. 
Montemayor (1996) collected survey data from a sample of high-
performing firms across multiple industries to test this notion. These firms
provided ratings that placed them into one of three different types of
business strategy. A cost leadership strategy was characterized by process
innovation, improving current products or services, and quality control.
A differentiation strategy was characterized by advertising, brand
identification, and innovative marketing. Finally, an innovation strategy
was characterized by development of new products or services, offering
specialty products or services, and customer retention. (Note that this
typology of business strategies diverges slightly from what is presented by
Milkovich and Newman, 2004.) These firms also reported on aspects of
their pay policies in five areas: 

1. Relative emphasis on cost control, attraction/retention, and

motivation
2. The choice of whether to lead, lag, or match market rates of
pay
3. Incentive pay-to-base pay mix
4. Reliance on individual merit pay increases
5. Degree of transparency and employee participation in making
compensation decisions. 

From these reports, Montemayor made a series of predictions about how

firms with different business strategies would support or fit these
strategies with their pay policies.
Finally, Montemayor collected data on dollar sales per employee, return
on assets, and profits. Results from the study indicated that firms with
different business strategies tend to have different compensation
strategies (e.g., pay policies). For example, cost leaders were found to place
more emphasis on controlling labor costs than differentiators. In addition,
firms that had vertical fit (alignment between business strategy and
compensation strategy/pay policies) outperformed firms that lacked
vertical fit. 
These results indicate it is worthwhile to consider in more detail how
strategic alignment can be improved to increase organizational
effectiveness. Heneman and Dixon (2001) have provided some guidance
in this matter. Going beyond the three types of alignment mentioned by
Milkovich and Newman (2004), Heneman and Dixon argue that optimal
results occur when alignment exists among the business strategy, the
organizational structure, the organizational culture, and the reward
system. They elaborate by specifying typologies for each of these
categories and mapping out reward systems supporting each combination
of business strategy, organizational structure, and organizational culture.