Module 4
Compensation
In order to compete for employees, every
company has to devise a reward system that
entices people to work for them. People want to
be rewarded for their effort, and compensation
systems provide those rewards in organizations.
But how does this work? What are the
psychological processes through which people
are motivated to work for the pay they receive?
Are some kinds of pay more motivating than
others?
In this module, we’ll examine the way that pay
functions to motivate employees. First, we will
talk briefly about two theories of motivation and
how they apply to compensation: Expectancy
Theory and Equity Theory. Then, we will look at
Southwest’s pay system to see how the
principles of these two theories are applied in
organizational life.
First, though, it is important to recognize that
Southwest Airlines does not pay its employees a
particularly high wage. Southwest spends only
28% of its revenue on labor costs, one of the
lowest rates in the airline industry. This occurs
despite the fact that Southwest employees are
83% unionized.1 Southwest has implemented a
compensation policy that maintains positive
labor relations and still keeps salaries low.2
1
Sunoo, B. P. (1995, June). How fun flies at Southwest
Airlines. Personnel Journal, v74#6, p. 62+.
2 Lederer, J. L., & Weinberg, C. R. (1995, April). Equitybased pay: The compensation paradigm for the reengineered corporation. Chief Executive, #102, p. 36+.
CLICK ON labor costs: Labor
costs include the salary paid to
employees plus money spent
on employee-related expenses
such as health benefits and
retirement plan contributions.
SIDEBAR: FAST FACT: In 1994,
more than 78% of Southwest
pilots agreed to a unique and
precedent-setting labor
agreement: it was designed to
last for 10 years, and pay was
frozen for the first 5 years in
exchange for stock options in
the company. Later, the flight
dispatchers’ union approved a
12-year labor contract with the
company.
Expectancy Theory
To understand the concept of motivation, let’s
begin with a fundamental question: why do
people work? The answer is that they believe
they will get both intrinsic and extrinsic rewards
for their effort. Victor Vroom’s Expectancy
Theory shows us how this psychological process
works.3
Expectancy Theory states that people do certain
things because they believe that their effort will
result in an outcome and that they will be
rewarded for that outcome. As the graphic
illustrates, three criteria need to be met before
someone is motivated to act. These are:
1-Effort leads to Performance: Expectancy.
People first have to believe that their effort will
produce a result. In some instances, simply
working hard is enough to produce the desired
result. On the other hand, if people lack a
particular skill or don’t have the required
equipment to complete a task, they will not be
motivated to put forth much effort because they
know they won’t accomplish much.
2-Performance leads to Reward: Instrumentality.
Once people know that they can perform a task,
what motivates them to do so? The answer is
that they believe that their performance will be
rewarded in some way. They see their
performance as instrumental to obtaining a
reward. The challenge for managers is to define
performance expectations carefully so
employees know exactly what behaviors will
lead to rewards. Wherever possible,
performance appraisal systems should include a
description of the actual behaviors that
3
Vroom, V. H. (1964). Work and motivation. New York:
Wiley.
GRAPHIC: ATTACHED
constitute excellent and poor performance.
Then, the company’s compensation system
should reward the top performers routinely so
workers see the link between performance and
rewards.
3-Attractiveness of the Reward: Valence. Even
if workers believe they can perform a task, and
believe that they will be rewarded if they do so,
they are not likely to exert effort if the reward is
unattractive to them. An additional challenge for
employers is to devise a reward system that
meets the individual goals and needs of most
workers. The most common outcomes offered
are salary and fringe benefits, such as medical
insurance and retirement plans. Other rewards
might be found in relationships developed on the
job or feeling good about the work that is done.
It makes sense that people would seek jobs that
provide the kind of rewards they value most.
For example, someone whose top priority is a
high salary might join a company that does not
provide health insurance if that person received
a higher rate of pay. Logically, then, companies
would tend to attract, hire and retain people who
valued similar things. Recent research confirms
that employees within a single company have
remarkably similar values and needs, and that
their similarity may increase the longer they stay
with the organization. Because of this,
companies will tend to attract, hire and retain
new employees who are fundamentally similar to
their current personnel.4 People who share
basic values and desires are likely to find the
same kinds of rewards attractive, and
consequently, motivating.
Equity Theory
One of the most important ways that people
evaluate the valence, or attractiveness, of the
4
Schneider, B., Goldstein, H. W., & Smith, D. B. (1995).
The ASA framework: An update. Personnel Psychology,
48, 747-773.
SIDEBAR: One way that
Southwest tries to recognize
the individual needs of their
workers is through its flexible
benefit plan. Under this plan,
employees are given a set
amount of money that the
company will spend on their
benefits each year. They can
choose to allocate that money
toward whatever benefit
programs they prefer,
choosing between various
types of medical and dental
insurance, life insurance, and
similar programs. However,
all employees enjoy one of the
most popular benefits the
company offers: free flights on
Southwest Airlines for
themselves and their families.
rewards they receive is by measuring their pay
against the effort they expended. The
underlying premise of Equity Theory is
deceptively simple: people want fair treatment.
Specifically, J. Stacey Adams’5 version of Equity
Theory says that people actively evaluate the
ratio between the amount of effort they put into a
situation and what they get out of it. In the work
environment, this means that they determine the
relationship between how hard they work and
how much they are paid. They then compare
their ratio to that of “referent others,” or other
people who are important to them. If people
believe that their ratio of inputs (work) to outputs
(pay) is the same as referent others’, then a
state of equity exists and the arrangement is
judged as fair and equitable for the employee.
These comparisons can result in three different
perceptions: equity, under-rewarded inequity, or
over-rewarded inequity. In the first situation,
equity, the ratios are judged to be similar and
the overall sense of the work arrangement is
that it is fair. On the other hand, should you
believe that someone is doing less work and
receiving more pay than you are, you would
experience inequity and see yourself as underrewarded. Your most likely emotional response
to this situation would be frustration or anger.
Finally, if you think that someone else works
harder than you do and yet receives less pay,
you would also experience inequity but see
yourself as over-rewarded. Here, the likely
emotional result is guilt.
How do people respond to inequity?
Regardless of people's exact emotional
response to feelings of inequity, research
demonstrates that they are usually motivated to
change situations that they view as unfair.
Those who feel that they are overpaid relative to
5
Adams, J. S. (1965). Inequity in social exchange. In L.
Berkowitz (Ed.), Advances in experimental social
psychology (Vol. 2, pp. 267-299). New York: Academic
Press.
SIDEBAR: People can choose
to compare themselves with a
number of other people to
make equity judgments. The
choice of a referent other is
personal, and depends on who
the individual thinks is the
most important source of
comparison. In making equity
judgments, you might choose
to compare your work input
and salary output to people in
your work group, to others in
your class, or perhaps to
members of your family. As
you can imagine, the choice of
a referent other for
comparison is critical. You
might get very different results
if you compared your work
input and salary output to
someone your own age or a
CEO of a large company.
other people may choose to work harder,
providing more input for the same amount of
compensation. Those who feel underpaid may
choose to work less, thereby putting in less
effort for the same output. It is also likely that
people who perceive inequity would simply
adjust their mental state by picking another
referent other for comparison.
What should employers do to be fair?
Research based on Equity Theory suggests
some practical tips for employers who want to
design an effective compensation system:6
1.
When people are paid for the amount of
time that they work (vs. payment for the
amount they produce), they will work harder
when they are overpaid. As we noted, people
who perceive overpayment inequity may feel
guilt, prompting them to increase their inputs to
make the input/wage ratio more even. However,
when people are paid for the amount of time that
they work and perceive that they are underpaid,
they will work less hard and produce less output.
2.
When people are paid based on the
amount they produce, over-rewarded
employees will produce fewer products, but they
will be of higher quality. On the other hand,
when people in this pay system are underrewarded, they will produce more goods but of
lower quality. In this way, they can get more
output (pay) from the organization because they
made more products, but they haven’t had to
work that hard to make them so their inputs
have been reduced.
SIDEBAR: Research
demonstrates that people who
perceive pay inequities are
more likely to steal from their
employers. For example, in
one study employees in a
manufacturing plant were
asked to take a temporary pay
cut for 10 weeks. During that
time, employee theft of
company property increased
dramatically. Once salaries
were returned to their pre-cut
level, theft rates declined to
their normal level.7
SIDEBAR:
Ironically, Southwest’s “pay for
seniority” system violates this
principle. For example, in their
system two baggage loaders
who work side by side on the
runway might make
significantly different hourly
wages if one has been with
the company longer than the
other. It may be that
Southwest’s culture offers
other rewards for new
employees that compensate
for their relatively low pay.
Despite what Equity Theory
tells us, people put up with
wage disparities at Southwest.
Why do you think this might be
the case?
3.
Treat employees equally wherever
possible. If people are doing the same work,
they should receive the same pay.
7
6
Goodman, P. S., & Friedman, A. (1971, September). An
examination of Adams’ theory of inequity. Administrative
Science Quarterly, 271-288.
Greenberg, J. (1990).
Employee theft as a reaction
to underpayment inequity: The
hidden cost of pay cuts.
Journal of Applied Psychology,
75, 561-658.
Pay at Southwest: Expectancy and Equity
Theories at Work
First, to see how an effective reward system
works through the Expectancy Theory lens, let’s
examine Southwest’s incentive program for its
Field and Product Marketing Division. Like all
Southwest employees, everyone who joins this
division receives extensive training. Recruits
are carefully evaluated to make sure they have
what it takes to do the job they’re hired for, and
once they are on the job workers are given the
autonomy and freedom to complete their work
as best they can. So the first stage of the
Expectancy Theory model is met: people believe
that their effort will result in performance
because they are given the skills and tools
necessary to do their jobs.
SIDEBAR: The hallways of
Southwests’ offices are filled
with photographs of
employees doing their job,
receiving awards, and
engaged in various company
activities. Kelleher says,
“Those pictures show that
we’re interested not in potted
palms or in Chinese art, but in
our people. It’s another kind
of celebration, and it’s
something that costs very
little.”8
But exactly what performance should they
display? In other companies, marketing and
sales-oriented departments are compensated on
the basis of individual sales goals: people
receive a commission, or percentage of each
sale, to reward them for completing it. This
practice effectively motivates people to complete
sales transactions. However, it has a downside.
People may focus on completing sales to the
exclusion of other marketing-related activities
that also benefit the company. These systems
also tend to promote competition among
workers because they are rewarded individually
for performance. Neither of these are desirable
performance outcomes for Southwest Airlines.
So, the company has designed a compensation
system that rewards the behaviors they believe
are most important in their marketing
department. Employees receive “bonus points”
for a variety of activities that include, but are not
limited to, completing sales. These might
include taking the time to set up special events
for frequent fliers or helping develop new
advertising campaigns. Second, though
Southwest’s marketing employees earn points
individually, the entire sales district must qualify
8
Gruner, S. (1998, May).
Have fun, make money. Inc.,
v20# 6, p. 123+.
for an award before any one individual receives
additional compensation. So, rather than
promoting competition, the system rewards
performance based on teamwork and
cooperation. Because this framework is clearly
and consistently communicated to employees,
the second step in Expectancy Theory is met:
people understand what performance will lead to
which rewards.
Finally, we have to ask if the rewards have
positive valence for employees. Do they like
what they receive? Is it fair? If the answer can
be found in terms of job satisfaction and high
performance, the answer certainly is a
resounding yes. Southwest has found one of
the important benefits of equity-based
compensation plans that reward all members of
the team equally: they align the interests of
companies, shareholders, and employees so
that everyone works together toward a common
goal.
SIDEBAR: Paychecks at
Southwest are signed, “From
Our Customers.” As Kelleher
puts it, “The check doesn’t
come from a piece of
corporate paper called
Southwest Airlines...it comes
from the people that we deal
with every day, our
passengers, and they’re the
ones that supply the
wherewithal for our
employees’ livelihood.”9
Equity on a Grand Scale: Profit Sharing at
Southwest
On a larger scale, Southwest’s profit-sharing
plan also contributes to a feeling of teamwork
and company loyalty among its personnel.
Southwest started the airline industry’s first
profit-sharing plan in 1974, and because the
company has made a profit each year,
employees reap the benefits in terms of
additional compensation. Each person receives
the same percentage of their base
compensation as a salary bonus every year that
the company makes money. In 1998,
Southwest employees received an additional
13% of their pay through this program. The
profit sharing plan makes the profitability of the
entire company important to each individual
employee. And, because the percentage
awarded is the same for everyone, the system is
perceived to be equitable and fair.
SIDEBAR: Companies like
Southwest that have a
significant amount of
employee ownership tend to
outperform their industry
peers.10
9
Kelleher, H. (1998,
May/June). Customer service:
It starts at home. The
Secured Lender, v54n3, pp.
68-73.
10 Lederer, J. L. & Weinberg,
C. R. (1995, April). Equitybased pay: The compensation
paradigm for the reengineered corporation. Chief
Executive, #102, p. 36+.
Additionally, we cannot overlook the importance
of non-monetary compensation at Southwest.
As we’ve already established, people tend to
join Southwest for reasons other than money.
The compensation system is just one more tool
in Southwest’s management arsenal for
motivating employees to work hard and well for
the airline.
SIDEBAR: People who work
for Southwest Airlines may not
enjoy high salaries, but they
do receive rewards that they
value as much if not more. As
one of their middle managers
put it, “The reason most
people are working here is not
monetary or material.
Culturally, having a working
atmosphere that is fun and
flexible is what motivates us
most.”11
11
Hein, K. (1999, January).
Rewarding relationships.
Incentive, v173#1, p. 114.