Chapter 1- The Pay Model
Compensation: Does it matter?
Compensation is one of the most powerful tools organizations have to influence their employees. General Motors (GM), like Chrysler, has, for decades, paid its workers well—too well perhaps for what it received in return.
Having labor costs higher than the competition, without corresponding advantages in efficiency, quality, and customer service, does not seem to have served GM or its stakeholders well.
On the other hand, Nucor Steel pays its workers very well relative to what other companies inside and outside of the steel industry pay. But Nucor also has much higher productivity than is typical in the steel industry.
Wall Street financial services firms and banks used incentive plans that rewarded people for developing “innovative” new financial investment vehicles and for taking risks to earn themselves and their firms a lot of money.
Troubled Asset Relief Program (TARP), which included restrictions on executive pay designed to discourage executives from taking “unnecessary and exces-sive risks.” In an opinion piece in The Wall Street Journal, entitled “How Business Schools Have Failed Business,” the former director of corporate finance policy at the United States Treasury wrote that “misaligned incentive programs are at the core of what brought our financial system to its knees.” 7 He says that we “should ask how many of the business schools attended by America’s CEOs and directors educate their students about the best way to design managerial compensation systems.”
How people are paid affects their behaviors at work, which affect an organization’s success. 8 For most employers, compensation is a major part of total cost, and often it is the single largest part of operating cost. These two facts together mean that well- designed compensation systems can help an organization achieve and sustain competitive advan-tage. On the other hand, as we have recently seen, poorly designed compensation systems can likewise play a major role in undermining organization success.
Compensation: Definition, Please
How people view compensation affects how they behave. It does not mean the same thing to everyone. Your view probably differs, depending on whether you look at com-pensation from the perspective of a member of society, a stockholder, a manager, or an employee.
Society
Some people see pay as a measure of justice. In 2007, among full-time workers in the United States, women earned 81 percent of what men earned, up from 62 percent in 1979. If women had the same education, experience, and union coverage as men and also worked in the same industries and occupations, they would be expected to earn about 90 percent of what men earn. Society has taken an interest in such earnings differentials. In 2007, among full-time workers in the United States, women earned 81 percent of what men earned, up from 62 percent in 1979. If women had the same education, experience, and union coverage as men and also worked in the same industries and occupations, they would be expected to earn about 90 percent of what men earn. Society has taken an interest in such earnings differentials.
One indicator of this interest is the introduction of laws and regulation aimed at eliminating the role of discrimination in causing them. Benefits given as part of a total compensation package may also be seen as a re-flection of equity or justice in society. Employers spend about 44 cents for benefits on top of every dollar paid for wages and salary.
16% of the population have no healthcare. A major reason is that the great majority of people (who are under the age of 65 and not below the poverty line) obtain health insurance through their employers, but small employers, which account for a substantial share of employment, are much less likely than larger employers to offer health insurance to their employees. As a result, 8 in 10 of the uninsured in the United States are from working families. Job losses (or gains) in a country over time are partly a function of relative labor costs (and productivity) across countries.
However, the value of what is produced also needs to be considered. Productivity in China is about 15 percent of that of U.S. workers, whereas Mexican worker productiv-ity is 30 percent of the U.S. level. Some consumers know that pay increases often lead to price increases. They do not believe that higher labor costs benefit them. But other consumers lobby for higher wages.
Stockholders
Some believe that using stock to pay employees creates a sense of ownership that will improve performance, which will, in turn, increase stockholder wealth. But others argue that granting em-ployees too much ownership dilutes stockholder wealth. Stockholders have a particular interest in executive pay.
To the degree that the interests of executives are aligned with those of shareholders (e.g., by paying executives on the basis of company performance measures such as shareholder return), the hope is that company perfor-mance will be higher. There is debate, however, about whether executive pay and com-pany performance are strongly linked in the typical U.S. company. 19 In the absence of such a linkage, concerns arise that executives can somehow use their influence to ob-tain high pay without necessarily performing well. Forbes compared the performance of the chief executive officer (CEO) at large U.S. firms to his/her compensation (see Exhibit 1.2 ). The idea, one might say, was to identify the CEOs who gave shareholders the “most (and least) bang for the buck.”
Shareholders can influence executive compensation decisions in a variety of ways (e.g., through shareholder proposals and election of directors in proxy votes). In ad-dition, the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010. Among its provisions is “say on pay,” which requires public compa-nies to submit their executive compensation plan to a vote by shareholders. The vote is not binding. However, companies seem to be intent on designing compensation plans that do not result in negative votes. In addition, clawback provisions (designed to allow companies to reclaim compensation from executives in some situations) are available under Dodd-Frank and have also been adopted in stronger form by some companies.
Managers
For managers, compensation influences their success in two ways. First, it is a major expense. Competitive pressures, both global and local, force managers to consider the affordability of their compensation decisions. Labor costs can account for more than 50 percent of total costs. In some industries, such as financial or professional services and in education and government, this figure is even higher. However, even within an industry, labor costs as a percent of total costs vary among individual firms.
Thus, rather than treating pay only as an expense to be minimized, a manager can also use it to influence employee behaviors and to improve the organization’s performance. The way people are paid affects the quality of their work and their attitude toward customers.
It may also affect their willingness to be flexible, learn new skills, or suggest innovations. On the other hand, people may become interested in unions or legal action against their employer based on how they are paid.
Employees
The pay individuals receive in return for the work they perform is usually the major source of their financial security. Hence, pay plays a vital role in a person’s economic and social well-being. Employees may see compensation as a return in an exchange between their employer and themselves, as an entitlement for being an employee of the company, or as a reward for a job well done.
Employees invest in education and training; they contribute their time and energy at the workplace. Compensation is their return on those investments and contributions.
Incentive and Sorting Effects of Pay on Employers’ Behaviors
Pay can influence employee motivation and behavior in two ways. First, and perhaps most obvious, pay can affect the motivational intensity, direction, and persistence of current employees. Motivation, together with employee ability and work/organiza-tional design (which can help or hinder employee performance), determines employee behaviors such as performance. We will refer to this effect of pay as an incentive effect , the degree to which pay influences individual and aggregate motivation among the em-ployees we have at any point in time.
However, pay can also have an indirect, but important, influence via a sorting effect on the composition of the workforce. 27 That is, different types of pay strategies may cause different types of people to apply to and stay with (i.e., self-select into) an organization. In the case of pay structure/level, it may be that higher pay levels help organizations to attract more high-quality applicants, allowing them to be more selective in their hiring. Similarly, higher pay levels may improve employee reten-tion.
Global Views
In English, compensation means something that counterbalances, offsets, or makes up for something else. However, if we look at the origin of the word in different lan-guages, we get a sense of the richness of the meaning, which combines entitlement, return, and reward.
In China, the traditional characters for the word “compensation” are based on the symbols for logs and water; compensation provides the necessities in life. In the recent past, the state owned all enterprises and compensation was treated as an entitlement. In today’s China, compensation takes on a more subtle meaning. A new word, dai yu, is used. It refers to how you are being treated—your wages, benefits, training opportuni-ties, and so on. When people talk about compensation, they ask each other about the dai yu in their companies. Rather than assuming that everyone is entitled to the same treatment, the meaning of compensation now includes a broader sense of returns as well as entitlement.
“Compensation” in Japanese is kyuyo, which is made up of two separate characters ( kyu and yo ), both meaning “giving something.” Kyu is an honorific used to indicate that the person doing the giving is someone of high rank, such as a feudal lord, an emperor, or a samurai leader. Traditionally, compensation is thought of as something given by one’s superior. Today, business consultants in Japan try to substitute the word. hou-syu, which means “reward” and has no associations with notions of superiors. The many allowances that are part of Japanese compensation systems translate as teate, which means “taking care of something.” Teate is regarded as compensation that takes care of employees’ financial needs. This concept is consistent with the family, hous-ing, and commuting allowances that are still used in many Japanese companies.
Finally, compensation refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship.
Forms of Pay
They are categorized as total compensation and relational returns . The relational returns (learning opportunities, status, challenging work, and so on) are psychological. 34 Total compensation returns are more transactional. They include pay received directly as cash (e.g., base, merit, incentives, cost-of-living adjustments) and indi-rectly as benefits (e.g., pensions, medical insurance, programs to help balance work and life demands, brightly colored uniforms). 35 So pay comes in different forms, and programs to pay people can be designed in a wide variety of ways.
Cash Compensation: Base
Base wage is the cash compensation that an employer pays for the work performed. Base wage tends to reflect the value of the work or skills and generally ignores differ-ences attributable to individual employees. For example, the base wage for machine operators may be $20 an hour. However, some individual operators may receive more because of their experience and/or performance. Some pay systems set base wage as a function of the skill or education an employee possesses; this is common for engineers and schoolteachers.
A distinction is often made in the United States between wage and salary, with salary referring to pay for employees who are exempt from regulations of the Fair Labor Standards Act (FLSA) and hence do not receive overtime pay. Managers and professionals usually fit this category. Their pay is calculated at an annual or monthly rate rather than hourly, because hours worked do not need to be recorded. In contrast, workers who are covered by overtime and reporting provisions of the Fair Labor Standards Act— nonexempt —have their pay calculated as an hourly wage.
Cash Compensation: Merit Pay/ Cost of living adjustments
Periodic adjustments to base wages may be made on the basis of changes in what other employers are paying for the same work, changes in the overall cost of living, or changes in experience or skill. Merit increases are given as increments to base pay and are based on performance. According to surveys, 90 percent of U.S. firms use merit pay increases. An assessment (or rating) of recent past performance is made, with or without a formal performance evaluation. In recent years, merit increase budgets (or average merit increases) have been just under 3%. In contrast to merit pay, cost-of-living adjustments give the same increases to everyone, regardless of performance. Finally, companies may also use merit bonuses. As with merit increases, merit bonuses are based on a performance rating but, unlike merit increases, are paid in the form of a lump sum rather than becoming (a permanent) part of the base salary.
Cash Compensation: Incentives
Incentives also tie pay increases to performance. 45 However, incentives differ from merit adjustments. First, incentives do not increase the base wage and so must be re-earned each pay period. Second, the potential size of the incentive payment will generally be known beforehand. Whereas merit pay programs evaluate past performance of an individual and then decide on the size of the increase, what must happen in order to receive the incentive payment is called out very specifically ahead of time. For example, a Toyota salesperson knows the commission on a Land Cruiser versus a Prius prior to making the sale. The larger commission he or she will earn by selling the Land Cruiser is the incentive to sell a customer that car rather than the Prius. Third, an incentive program relies on an objective measure of performance (e.g., sales), whereas a merit increase program typically relies on a subjective rating of performance. Although both merit pay and incentives try to influence performance, incentives explicitly try to influence future behavior whereas merit recognizes (rewards) past behavior, which is hoped to influence future behavior. The incentive-reward distinction is a matter of timing.
Incentives can be tied to the performance of an individual employee, a team of employees, a total business unit, or some combination of individual, team, and unit. The performance objective may be expense reduction, volume increases, customer satisfaction, revenue growth, return on investments, increase in stock value—the possibilities are endless.
Because incentives are one-time payments, they do not permanently increase labor costs. When performance declines, incentive pay automatically declines, too. Consequently, incentives (and sometimes merit bonuses also) are frequently referred to as variable pay.
Long Term Incentives
Incentives may be short- or long-term. Long-term incentives are intended to focus em-ployee efforts on multiyear results. Typically they are in the form of stock ownership or options to buy stock at a fixed price (thus leading to a monetary gain to the degree the stock price later goes up). The belief underlying stock ownership is that employees with a financial stake in the organization will focus on long-term financial objectives: return on investment, market share, return on net assets, and the like. Stock options are often the largest component in an executive pay package. Some companies extend stock ownership beyond the ranks of managers and professionals.
Benefits: Income Protection
Medical insurance, retirement programs, life insurance, and savings plans are common benefits. They help protect employees from the financial risks inherent in daily life. Often companies can provide these protections to employees more cheaply than employees can obtain them for themselves. In the U.S., employers spend roughly $535 billion per year on health care costs, or about 21% of all U.S. health care expenditures. Among employers that provide health insurance, the employer cost to provide family coverage is $15,073 per year per employee (and the employee pays an additional $4,129 per year). 47 Given the magnitude of such costs, it is no surprise that employers have sought to rein in or reduce benefits costs. One approach has been to shift costs to employees (e.g., having employees pay a larger share of health insurance premiums). 48 Some companies have allowed their benefits costs to get so far out of control that more drastic action has been taken.
Benefits: Work/ Life Balance
Programs that help employees better integrate their work and life responsibilities include time away from work (vacations, jury duty), access to services to meet specific needs (drug counseling, financial planning, referrals for child and elder care), and flexible work arrangements (telecommuting, nontraditional schedules, nonpaid time off). Responding to the changing demographics of the workforce (two-income families or single parents who need work-schedule flexibility so that family obligations can be met), many U.S. employers are giving a higher priority to these benefit forms.

Benefits Allowances
Allowances often grow out of whatever is in short supply. In Vietnam and China, housing (dormitories and apartments) and transportation allowances are frequently part of the pay package. Total Earning Opportunities : Present Value of a stream of Earnings
A present-value perspective shifts the comparison of today’s initial offers to consideration of future bonuses, merit increases, and promotions. Sometimes a company will tell applicants that its relatively low starting offers will be overcome by larger future pay increases. In effect, the company is selling the present value of the future stream of earnings. But few candidates apply that same analysis to calculate the future increases required to offset the lower initial offers.
Relational Returns from Work
There is no doubt that nonfinancial returns from work have a substantial effect on employees’ behavior. There is no doubt that nonfinancial returns from work have a substantial effect on employees’ behavior.
Relational returns from work as recognition and status, employment security, challenging work, and opportunities to learn. Other forms of relational return might include personal satisfaction from successfully facing new challenges, teaming with great co-workers, receiving new uniforms, and the like. 53 Such factors are part of the total return, which is a broader umbrella than total compensation.
The organization as a network of returns
Sometimes it is useful to think of an organization as a network of returns created by all these different forms of pay, including total compensation and relational returns. The challenge is to design this network so that it helps the organization to succeed.
A Pay Model
It contains three basic building blocks: (1) the compensation objectives, (2) the policies that form the foundation of the compensation system, and (3) the techniques that make up the compensation system.
STUDY EXHIBIT 1.5
Compensation Objectives
Pay systems are designed to achieve certain objectives.
The basic objectives, shown at the right side of the model, include efficiency, fairness, ethics, and compliance with laws and regulations. Efficiency can be stated more specifically: (1) improving performance, increasing quality, delighting customers and stockholders, and (2) con-trolling labor costs.
The fairness objective calls for fair treatment for all employees by recognizing both employee contributions (e.g., higher pay for greater performance, experience, or train-ing) and employee needs (e.g., a fair wage as well as fair procedures). Procedural fair-ness refers to the process used to make pay decisions. 56 It suggests that the way a pay decision is made may be equally as important to employees as the results of the decision. Compliance as a pay objective means conforming to federal and state compensa-tion laws and regulations. If laws change, pay systems may need to change, too, to en-sure continued compliance. As companies go global, they must comply with the laws of all the countries in which they operate.
Ethics
It is not efficiency versus fairness versus compliance. Rather, it is all three simultaneously. All three must be achieved. The tension of working toward all objectives at once creates fertile grounds for ethical dilemmas. Ethics means the organization cares about how its results are achieved. The challenge is to put these statements into daily practice. Manipulating results to ensure executive bonus payouts, misusing (or failing to understand) statistics used to measure competitors’ pay rates, re-pricing or backdating stock options to increase their value, encouraging employees to invest a portion of their wages in company stock while executives are bailing out, offering just enough pay to get a new hire in the door while ignoring the relationship to co-workers’ pay, and shaving the hours recorded in employees’ time card—these are all too common examples of ethical lapses. Managers must look to their own ethics—and the pay model, which calls for combining the objectives of efficiency and fair treatment of employees as well as compliance.
Pay objectives
There are probably as many statements of pay objectives as there are employers.
Objectives serve several purposes. First, they guide the design of the pay system. If an objective is to increase customer satisfaction, then incentive programs and merit pay might be used to pay for performance. Another employer’s objective may be to develop innovative new products. Job design, training, and team building may be used to reach this objective. The pay system aligned with this objective may include salaries that are at least equal to those of competitors (external competitiveness) and that go up with increased skills or knowledge (internal alignment). In summary, objectives guide the design of pay systems. They also serve as the standards for judging the success of the pay system. If the objective is to attract and retain the best and the brightest skilled employees, but they are leaving for higher-paying jobs elsewhere, the system may not be performing effectively. Although there may be many non-pay reasons for such turnover, objectives provide standards for evaluating the effectiveness of a pay system.
Four Policy Choices
Every employer must address the policy decisions shown on the left side of the pay model: (1) internal alignment, (2) external competitiveness, (3) employee contributions, and (4) management of the pay system. These policies are the foundation on which pay systems are built. They also serve as guidelines for managing pay in ways that accomplish the system’s objectives.
Internal Alignment
Refers to comparisons among jobs or skill levels inside a single organization. Jobs and people’s skills are compared in terms of their relative contributions to the organization’s business objectives.
Internal alignment pertains to the pay rates both for employees doing equal work and for those doing dissimilar work. In fact, determining what is an appropriate difference in pay for people performing different work is one of the key challenges facing managers.
Pay relationships within the organization affect all three compensation objectives. They affect employee decisions to stay with the organization, to become more flexible by investing in additional training, or to seek greater responsibility. By motivating employees to choose increased training and greater responsibility in dealing with customers, internal pay relationships indirectly affect the capabilities of the workforce and hence the efficiency of the entire organization. Fairness is affected through employees’ comparisons of their pay to the pay of others in the organization. Compliance is affected by the basis used to make internal comparisons. Paying on the basis of race, gender, age, or national origin is illegal in the United States.
External Competiveness
Refers to pay comparisons with competitors. Many organizations claim their pay systems are market-driven, that is, based almost exclusively on what competitors pay. “Market driven” gets translated into practice in different ways. 60 Some employers may set their pay levels higher than their competition, hoping to attract the best applicants. Of course, this assumes that someone is able to identify and hire the “best” from the pool of applicants.
External competitiveness decisions—both how much and what forms—have a two-fold effect on objectives: (1) to ensure that the pay is sufficient to attract and retain employees—if employees do not perceive their pay as competitive in comparison to what other organizations are offering for similar work, they may be more likely to leave—and (2) to control labor costs so that the organization’s prices of products or services can remain competitive in a global economy.

Employee Contributions
The emphasis to place on employee contributions (or nature of pay mix) is an important policy decision since it directly affects employees’ attitudes and work behaviors. Performance-based pay affects fairness in that employees need to understand the basis for judging performance in order to believe that their pay is fair.The external competitiveness and employee contribution decisions should be made jointly. Clearly, an above-market compensation level is most effective and sustainable when it exists together with above-market employee contributions to productivity, quality, customer service, or other important strategic objectives.

Management
Management means ensuring that the right people get the right pay for achieving the right objectives in the right way . The greatest system design in the world is useless without competent management. The ground under compensation management has shifted. The traditional focus on how to administer various techniques is long gone, replaced by more strategic thinking—managing pay as part of the business. It goes beyond simply managing pay as an expense to better understanding and analyzing the impact of pay decisions on people’s behaviors and organizations’ success. The impact of pay decisions on expenses is one result that is easily measured and well understood. But other measures—such as pay’s impact on attracting and retaining the right people, and engaging these people productively—are not yet widely used in the management of compensation. Efforts to do so are increasing and the perspective is shifting from “How To” toward trying to answer the “So What” question. 64 Ease of measurement is not the same as importance; costs are easy to measure (and, of course, important), so there is a tendency to focus there. Yet, the consequences of pay, although often less amenable to measurement, are nonetheless just as important.

Three questions to help make you a critical reader—and a better-informed decision maker. 1. Is the Research Useful? 2. Does the Study Separate Correlation from Causation? Once we are confident that the variables are useful and accurately measured, we must be sure that they are actually related. Most often this is addressed through the use of statistical analysis. The correlation coefficient is a common measure of association and indicates how changes in one variable are related to changes in another. Many re-search studies use a statistical analysis known as regression analysis. But even if there is a relationship, correlation does not ensure causation. For ex-ample, just because a manufacturing plant initiates a new incentive plan and the facility’s performance improves, we cannot conclude that the incentive plan caused the improved performance. Perhaps new technology, reengineering, improved marketing, or the general expansion of the local economy underlies the results. The two changes are associated or related, but causation is a tough link to make. Too often, case studies, benchmarking studies of best practices, or consultant surveys are presented as studies that reveal cause and effect. They do not. Case studies are descriptive accounts whose value and limitations must be recognized. Just because the best-performing companies are using a practice does not mean the practice is causing the performance. 3. Are There Alternative Explanations? The best way to establish causation is to account for competing explanations, either statistically or through control groups. The point is that alternative explanations often exist. And if they do, they need to be accounted for to establish causality. It is very difficult to disentangle the effects of pay plans to clearly establish causality. However, it is possible to look at the overall pattern of evidence to make judgments about the effects of pay.

Chapter 2: Strategy: The Totality of Decisions

Even if they did, deciphering what “the market” has “decided” requires an investment in information search and cognitive processing. Information has a cost, and in processing information, people are only “boundedly rational”
SIMILARITIES AND DIFFERENCES IN STRATEGIES
The decisions of the different companies in book have both similar and different strategies on the five dimensions of compensation strategy. All three formulate their pay strategy to support their business strategy. All three emphasize outstanding employee performance and commitment. However, there are major differences.
Different Strategies within the Same Industry
Pay strategies can also differ among companies competing for the same talent and similar customers.
Different Strategies within the Same Company
Sometimes different business units within the same corporation will have very different competitive conditions, adopt different business strategies, and thus fit different compensation strategies.
A simple, “let the market decide our compensation” approach doesn’t work internationally either. In many nations, markets do not operate as in the United States or may not even exist. People either do not—or in some cases, cannot—easily change employers. In China, central Asia, and some eastern European countries, markets for labor are just emerging.
Even in some countries with highly developed economies, such as Germany and France, the labor market is highly regulated. Consequently, there is less movement of people among companies than is common in the United States, Canada, or even Korea and Singapore.

Strategic Choices
Strategy refers to the fundamental directions that an organization chooses. An organization defines its strategy through the tradeoffs it makes in choosing what (and what not) to do.
A strategic perspective focuses on those compensation choices that help the organization gain and sustain competitive advantage.
At the corporate level, the fundamental strategic choice is: What business should we be in? At the business unit level, the choice shifts to: How do we gain and sustain competitive advantage in this business? At the function level the strategic choice is: How should total compensation help this business gain and sustain competitive ad-vantage? The ultimate purpose—the “so what?”—is to gain and sustain competitive advantage.

Support business strategies
A currently popular theory found in almost every book and consultant’s report tells managers to tailor their pay systems to align with the organization’s business strategy. The rationale is based on contingency notions. That is, differences in a firm’s business strategy should be supported by corresponding differences in its human resource strategy, including compensation. The underlying premise is that the greater the alignment, or fit, between the organization and the compensation system, the more effective the organization.
Three general business strategies. The innovator stresses new products and short response time to market trends. A supporting compensation approach places less emphasis on evaluating skills and jobs and more emphasis on incentives designed to encourage innovations. The cost cutter’s efficiency-focused strategy stresses doing more with less by minimizing costs, encouraging productivity increases, and specifying in greater detail exactly how jobs should be performed. The customer-focused business strategy stresses delighting customers and bases employee pay on how well they do this.
Other business strategy frameworks rely on similar ideas. In Michael Porter’s strategy work, firms that cut costs would be said to follow a cost leadership strategy, while those that seek to provide a unique and/or innovative product or service at a premium price are said to follow a differentiation strategy. Likewise, Miles and Snow refer to defenders as those that operate in stable markets and compete on cost, whereas pros- pectors are more focused on innovation, new markets, and so forth. 15 These are known as generic strategy frameworks. Conventional wisdom would be that competing on cost requires lower compensation, whereas competing through innovation is likely to be more successful with high-powered incentives/pay for performance.
If you think about it, if a particular business strategy automatically meant that a particular pay strategy would work best, there would not be much need for managers. These generic business strategy and pay strategy ideas are a good starting point. 17 But, to do better than its competitors, a firm must consider how to fashion its own unique way of adding value through matching its business strategy and pay strategy. It also follows that when business strategies change, pay systems should change, too.
Support HR strategy
Although a compensation strategy that supports the business strategy implies alignment between compensation and overall HR strategies, this topic is important enough that we want to explicitly deal with it. In the literature on so-called high-performance work systems (HPWS) and HR strategy, Boxall and Purcell find an increasingly common “very basic theory of performance” being used, which they refer to as “AMO theory”: P = f (A,M,O) P is performance, which is specified to be a function ( f ) of three factors: A is ability, M is motivation, and O is opportunity. 20 In other words, the AMO logic is that HR systems will be most effective when roles are designed to allow employees to be involved in decisions and have an opportunity to make an impact, when employee ability is developed through selective hiring and training and development, and when the compensation system motivates employees to act on their abilities and take advantage of the opportunity to make a difference.
Although a compensation strategy that supports the business strategy implies alignment between compensation and overall HR strategies, this topic is important enough that we want to explicitly deal with it. In the literature on so-called high-performance work systems (HPWS) and HR strategy, Boxall and Purcell find an increasingly common “very basic theory of performance” being used, which they refer to as “AMO theory”: P = f (A,M,O) P is performance, which is specified to be a function ( f ) of three factors: A is ability, M is motivation, and O is opportunity. 20 In other words, the AMO logic is that HR systems will be most effective when roles are designed to allow employees to be in-volved in decisions and have an opportunity to make an impact, when employee ability is developed through selective hiring and training and development, and when the com-pensation system motivates employees to act on their abilities and take advantage of the opportunity to make a difference. Compensation (through incentive and sorting effects) is the key to attracting, retaining, and motivating employees with the abilities necessary to execute the business strategy and handle greater decision-making responsibilities. Compensation is also the key to motivating them to fully utilize those abilities. As such, higher pay levels and pay for performance are often part of such a HPWS. Consider alignment between compensation and other aspects of HR at SAS. Rather than being sold in a one-time transaction, SAS’s software is licensed.

STUDY EXHIBIT 2.5

Compensation strategy and HR strategy are central to successful business strategy execution. Exhibit 2.5 seeks to capture that idea, the importance of AMO and fit. It also makes the very simple, but very important, observation that all of this comes down to effects on either revenues or costs. Compensation strategy, HR strategy, and business strategy ultimately seek to decrease costs or increase revenues, relative to competitors. 22 At the same time, key stakeholders (e.g., employees, customers, shareholders) must be happy with their “deal” or relationship with the company. To the extent all of this happens, effectiveness is more likely to follow.
The pay model guides strategic pay decisions
Stated versus Unstated Strategies
All organizations that pay people have a compensation strategy. Some may have writ-ten compensation strategies for all to see and understand. Others may not even realize they have a compensation strategy. Ask a manager at one of these latter organizations about its compensation strategy and you may get a pragmatic response: “We do whatever it takes.” Its compensation strategy is inferred from the pay decisions it has made. Managers in all organizations make the five strategic decisions discussed earlier. Some do it in a rational, deliberate way, while others do it more chaotically—as ad hoc responses to pressures from the economic, sociopolitical, and regulatory con-text in which the organization operates. But in any organization that pays people, there is a compensation strategy at work.

DEVELOPING A TOTAL COMPENSATION STRATEGY: FOUR STEPS

Step 1: Assess Total Compensation Implications
a) Business Strategy and Competitive Dynamics—Understand the Business
This first step includes an understanding of the specific industry in which the organization operates and how the organization plans to compete in that industry. This corresponds with the first two decisions in Exhibit 2.2: What business should we be in, and how do we win in that business? 26 To cope with the turbulent competitive dynamics, focus on what factors in the business environment (i.e., changing customer needs, competitors’ actions, changing labor market conditions, changing laws, globalization) are important today. What will be important in the future? What is your company’s strategy? How do you compete to win? How should the compensation system support that strategy? Learn to gauge the underlying dynamics in your business (or build relationships with those who can). Organizations are innovators and cost cutters and customer centered. All three, and more. The orderly image conveyed in the exhibits does not adequately capture the turbulent competitive dynamics underlying this process. 27 Competitive dynamics can be assessed globally. 28 However, comparing pay among countries is complex. In Chapter 1, we noted differences in hourly labor costs and productivity (output per dollar of wages) among countries. But as we shall see in Chapter 16 on global pay, countries also differ on the average length of the work-week, the average number of paid holidays, the kinds of national health care and retirement programs, and even how pay is determined. Nevertheless, managers must become knowledgeable about competitive conditions both globally and locally.
b) HR Strategy: Pay as a Supporting Player or Catalyst for Change? Whatever the overall HR strategy, a decision about the prominence of pay in that HR strategy is required. Pay can be a supporting player, as in the high-performance approach, or it can take the lead and be a catalyst for change. Whatever the role, compensation is embedded in the total HR approach. 30 So, the compensation implications of all the above factors—the organization’s business strategy, global competitive dynamics, culture and values, the sociopolitical context, employee preferences, and how pay fits with other HR systems—all are necessary to formulate a compensation strategy.

c) Culture/ value
A pay system reflects the values that guide an employer’s behavior and underlie its treatment of employees. The pay system mirrors the company’s image and reputation.

d) Social and political context
Context refers to a wide range of factors, including legal and regulatory requirements, cultural differences, changing workforce demographics, expectations, and the like. These also affect compensation choices. Because governments are major stakeholders in determining compensation, lobbying to influence laws and regulations can also be part of a compensation strategy. In the United States, employers will not sit by while Congress considers taxing employee benefits. Similarly, the European Union’s “social contract” is a matter of interest. 33 And in China, every foreign company has undoubtedly discovered that building relationships with government officials is essential. So, from a strategic perspective, managers of compensation may try to shape the sociopolitical environment as well as be shaped by it.

e) Employee Preferences
The simple fact that employees differ is too easily overlooked in formulating a compensation strategy. Individual employees join the organization, make investment decisions, interact with customers, design new products, assemble components, and so on. Individual employees receive the pay. A major challenge in the design of next-generation pay systems is how to better satisfy individual needs and preferences. Offering more choice is one approach. Older, highly paid workers may wish to defer taxes by putting their pay into retirement funds, while younger employees may have high cash needs to buy a house, support a family, or finance an education.
f) Union preference
Pay strategies need to take into account the nature of the union-management relationship. 39 Even though union membership among private-sector workers in the United States is now less than 10 percent of the workforce, union influence on pay decisions remains significant, especially in key sectors (e.g., manufacturing, health care, education). Union preferences for different forms of pay (e.g., protecting retirement and health care plans) and their concern with job security affect pay strategy.
Compensation deals with unions can be costly to change.
Step 2: Map a Total Compensation Strategy
The compensation strategy is made up of the elements in the pay model: objectives, and the four policy choices of alignment, competitiveness, contributions, and management. Mapping these decisions is Step 2 in developing a compensation strategy. Mapping is often used in marketing to clarify and communicate a product’s identity. A strategic map offers a picture of a company’s compensation strategy. It can also clarify the message that the company is trying to deliver with its compensation system.
Objectives: Prominence is the measure of how important total compensation is in the overall HR strategy. Is it a catalyst, playing a lead role? Or is it less important, playing a more supporting character to other HR programs?
Internal Alignment: This is described as the degree of internal hierarchy. For example, how much does pay differ among job levels and how well does compensation support career growth?
External Competitiveness: This includes comparisons on two issues. How much are our competitors paying, and what forms of pay are they using? The importance of work/life balance achieved via benefits and services is also part of external competitiveness.
Employee Contributions: These two companies take a very different approach to performance-based pay. SAS uses only limited individual-based performance pay. This is consistent with its overall egalitarian approach. Microsoft makes greater use of pay based on individual and company performance. Management: Ownership refers to the role non-HR managers play in making pay decisions. Transparency refers to openness and communication about pay.
Each company’s profile on the strategy map reflects its main message or “pay brand”: Microsoft: Total compensation is prominent, with a strong emphasis on market competitiveness, individual accomplishments, and performance-based returns. SAS: Total compensation supports its work/life balance. Competitive market position, companywide success sharing, and egalitarianism are the hallmarks. In contrast to the verbal description earlier in this chapter, strategic maps provide a visual reference. They are useful in analyzing a compensation strategy that can be more clearly understood by employees and managers. 42 Maps do not tell which strategy is “best.” Rather, they provide a framework and guidance. Just like a road map, they can show where you are and where you are going. 43
Steps 3 and 4: Implement and Reassess
Step 3 in Exhibit 2.6 is to implement the strategy through the design and execution of the compensation system. The compensation system translates strategy into practice—and into people’s bank accounts. Step 4, Reassess and Realign, closes the loop. This step recognizes that the com-pensation strategy must change to fit changing conditions. Thus, periodic reassessment is needed to continuously learn, adapt, and improve. The results from using the pay system need to be assessed against the objectives we are trying to achieve.
SOURCE OF COMPETITIVE ADVANTAGE: THREE TESTS
Developing and implementing a pay strategy that is a source of sustained competitive advantage is easier said than done. Not all compensation decisions are strategic or a source of competitive advantage. Three tests determine whether a pay strategy is a source of advantage: (1) Is it aligned? (2) Does it differentiate? (3) Does it add value?
Align- Alignment of the pay strategy includes three aspects, as we have already discussed: (1) align with the business strategy, (2) align externally with the economic and socio-political conditions, and (3) align internally within the overall HR system. Alignment is probably the easiest test to pass.
Differentiate some believe that the only thing that really matters about a strategy is how it is different from everyone else’s. If the pay system is relatively simple for any competitor to copy, then how can it possibly be a source of competitive advantage? The answer, according to the advocates of the strategic approach, is in how the pay system is man-aged. This rhetoric is appealing, but the evidence to support it is slim.
Are they difficult to imitate? Probably, since each strategy is woven into the fabric of the company’s overall HR strategy. Copying one or another dimensions of a strategy means ripping apart the overall approach and patching in a new one. So, in a sense, the alignment test (weaving the fabric) helps ensure passing the differentiation test. Microsoft’s use of stock awards for all employees—often worth considerably more than people’s base pay—is difficult for its competitors to copy. SAS’s work-family-balance (like Medtronic’s total-presence-at-the-workplace strategy) is difficult to copy. It may be relatively easy to copy any individual action a competitor takes (i.e., grant stock options to more employees or offer more choice in their health insurance). But the strategic perspective implies that it is the way programs fit together and fit the overall organization that is hard to copy. Simply copying others by blindly benchmarking best practices amounts to trying to stay in the race, not win it.
Add value
Organizations continue to look for the return they are getting from their incentives, benefits, and even base pay. Compensation is often a company’s largest controllable expense. Since consultants and a few researchers treat different forms of pay as investments, the task is to come up with ways to calculate the return on those investments (ROI). But this is a difficult proposition. As one writer put it, “It is easier to count the bottles than describe the wine.” 46 Costs are easy to fit into a spreadsheet, but any value created as a result of those costs is difficult to specify, much less mea-sure.
Trying to measure an ROI for any compensation strategy implies that people are “human capital,” similar to other factors of production. Many people find this view dehumanizing. They argue that viewing pay as an investment with measurable returns diminishes the importance of treating employees fairly. 48 In Chapter 1 we discussed the need to keep all objectives, including efficiency and fairness, in mind at the same time. No doubt about it, of the three tests of strategy—align, differentiate, add value—the last is the most difficult.
BEST PRACTICES” VERSUS “BEST FIT”?

The premise of any strategic perspective is that if managers align pay decisions with the organization’s strategy and values, are responsive to employees and union relations, and are globally competitive, then the organization is more likely to achieve competitive ad-vantage. The challenge is to design the “fit” with the environment, business strategy, and pay plan. The better the fit, the greater the competitive advantage. But not everyone agrees. In contrast to the notion of strategic fit, some believe that (1) a set of best-pay practices exists and (2) these practices can be applied universally across situations. Rather than having a better fit between business strategy and compensation plans that yields better performance, they say that best practices result in better performance with almost any business strategy. These writers believe that adopting best-pay practices allows the employer to gain preferential access to superior employees. These superior employees will in turn be the organization’s source of competitive advantage. The challenge here is to select from various recommended lists which are “the” best practices. Which practices truly are the best? We believe that research over the past few years is beginning to point the way to improve our choices.
Guidance from the evidence
There is consistent research evidence that the following practices do matter to the organization’s objectives. Internal alignment: Both smaller and larger pay differences among jobs inside an organization can affect results. Smaller internal pay differences and larger internal pay differences can both be a “best” practice. Which one depends on the context; that is, the fit with business strategy, other HR practices, the organization culture, and so on. External competitiveness: Paying higher than the average paid by competitors can affect results. Is higher competitive pay a “best” practice? Again, it depends on the context. Employee contributions: Performance-based pay can affect results. Are performance incentives a “best” practice? Once more, it depends on the context.
Managing compensation: Rather than focusing on only one dimension of the pay strategy (e.g., pay for performance or internal pay differences), all dimensions need to be considered together. Compensation strategy: Finally, embedding compensation strategy within the broader HR strategy affects results. Compensation does not operate alone; it is part of the overall HR perspective. 56 So, specific pay practices appear to be more beneficial in some contexts than in others. 57 Thus, best practice versus best fit does not appear to be a useful way to frame the question. A more useful question is, What practices pay off best under what conditions? Much of the rest of this book is devoted to exploring this question.
VIRTUOUS AND VICIOUS CIRCLES
A group of studies suggests specific conditions to look at when making strategic pay decisions. One study examined eight years of data from 180 U.S. companies. The authors reported that while pay levels (external competitiveness) differed among these companies, they were not related to the companies’ subsequent financial performance. However, when combined with differences in the size of bonuses and the number of people eligible for stock options, then pay levels were related to future financial success of the organizations. This study concluded that it is not only how much you pay but also how you pay that matters. Think of pay as part of a circle. Exhibit 2.9 suggests that performance-based pay works best when there is success to share. An organization whose profits or market share is increasing is able to pay larger bonuses and stock awards. And paying these bonuses fairly improves employee attitudes and work behaviors, which in turn improves their performance. The circle gains upward momentum. Employees receive returns that compensate for the risks they take. And they behave like owners, since they are sharing in the organization’s success. Additionally, there are several studies that analyzed pay strategies as part of the “high-performance workplace” approaches discussed earlier. This research focused on specific jobs and workplaces, such as sales and service representatives in call-service centers and jobs in factories. 62 They indicate that performance-based pay that shares success with employees does improve employee attitudes, behaviors, performance—especially when coupled with the other “high-performance” practices. One study even reported that the effects of the compensation strategy equaled the impact of all the other practices [high involvement, teams, selective hiring, and training programs] combined. 63 These findings are near and dear to our hearts. So other “high-performance” HR practices also become factors that support improved performance and the virtuous circle. It cannot have escaped your attention that circles can also gain momentum going downward to become a vicious circle. As shown in Exhibit 2.9, when organization performance declines, performance-based pay plans do not pay off; there are no bonuses, and the value of stock declines—with potentially negative effects on organization performance. Declining organization performance increases the risks facing employees—risks of still smaller bonuses, demotions, wage cuts, and even layoffs. Unless the increased risks are offset by larger returns, the risk-return imbalance will reinforce declining employee attitudes and speed the downward spiral. Unfortunately, we do not yet know what compensation practices can be used to shift an organization caught in a downward spiral into an upward one. Perhaps we believe so strongly that pay matters and that studying it in the workplace is beneficial, that this is what we see—believing is seeing. So, caution and more evidence are required. Nevertheless, these studies do seem to indicate that performance-based pay may be a best practice, under the right circumstances. (Could performance-based pay sometimes be a “worst practice”? Yes, when incentive systems don’t pay off and they alienate employees or lead to government investigation of possible stock option manipulation.) Additionally, we do not have much information about how people perceive various pay strategies. Do all managers “see” the total compensation strategy at Merrill Lynch or Google the same way? Some evidence suggests that if you ask 10 managers about their company’s HR strategy, you get 10 different answers. If the link between the strategy and people’s perceptions is not clear, then maybe we are using evidence to build on unstable ground.