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.