OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURG
BEIJING NORMAL UNIVERSITY
Prof. Dr. Birgitta Wolff, Marjaana Rehu, M.A.
Otto-von-Guericke-University, Germany
II. Human Resource Management
Variable or Fixed Salary
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
1
Recap Session I
„... three critical aspects of organization:
• The assignment of decision rights within the company
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals
and business units“
(BSZ 5)
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
2
Outline
1. Incentive Problem
2. Compensation Contracts
3. Output-Based Pay
4. Input-Based Pay
5. Incentive Pay
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Source: www.msn.de
Beijing, Sept. 2002
3
1. Incentive Problem
Coordination and Motivation Problem
Task
Coordination
Who does what,
when,...
Motivation
Individual
Allocation of Input
Resources
Distribution of
Output
How do I get somebody
to perfom a task,
improve the quality,...
=> Incentive Problem
Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
4
1. Incentive Problem
Why do Incentive Problems Exist?
Why do Incentive problems exist?
• Employee and employer have different interests
– Employer would want the employee to take actions that maximize
the profit of the firms, but the employee might rather like spending
his time with his/her family or play golf
– All actions of the employee cannot be monitored and/or controlled
by contracts (risk for the employer)
– Employers have to compensate employees for doing undesirable
tasks
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
5
1. Incentive Problem
How can Incentive Problems be Solved?
• Incentive Problems can be solved through effective compensation
contracts
• Compensation contracts have two functions
– Motivate employees
– Share risk more efficiently
Source: www.euro.fi
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
6
2. Compensation Contracts
Compensation Contracts
Variable Pay
Fixed Salary
Payment by Output
Payment by Input
Objective
Performance
Measures
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Subjective
Performance
Measures
Objective
Performance
Measures
Beijing, Sept. 2002
Subjective
Performance
Measures
7
2. Compensation Contracts
Payment by Input versus Payment by Output
Variable Pay
(payment by output)
• Compensation depends on measure
of what comes out
• Amount of time spent on work does
not affect workers‘ compensation
Straight Salary
(payment by input)
• Compensation depends on the amount
of time or effort spent on an activity
• Independent of output consideration
Problem:
 Output not always easy to measure
Problem:
 Input also not always easy to measure
• Time at work as a proxy in order to
assess worker‘s effort
Examples:
Examples:
• Agricultural workers: piece rates p. tray
• A salesperson on straight commission
• Compensation of top executives by
stocks or stock options
• Wage per work hour
• Monthly salaries
• Annual salaries
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
8
2. Compensation Contracts
How can the Performance of an Employee be
Measured?
•Objective Performance Measure:
– Measure that is easily observable and quantifiable, e.g. parts
produced, hours worked etc.
•Subjective Performance Measures:
– An evaluation which is based on personal opinion of a supervisor,
customer, peers, etc.
Type of evaluat.
objective
subjective
Output
revenue, dividend
customer satisfaction
Input
time
qualification
Database
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
9
2. Compensation Contracts
Examples of Different Variables as a
Basis of Output-Related Pay
Basis
Variables for output-based pay
Quantity of production
pieces, weight, size/height
Quality of production
Rejects, grade, customer‘s satisfaction,
individual targets
Input reduction
Reduction of input factors: raw material,
energy, work time
Capacity utilization
slack-, repair- and waiting periods
Be on schedule
Timeliness vis à vis internal and external
customers
Value of the firm
stock price, economic value added
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
10
3. Output-Based Pay
Advantages of output-based pay
Selection effect
Motivation effect
• efficient workers with a high
productivity will join the firm/stay
• inefficient workers with a low
productivity will not join/leave the firm
• output-based pay motivates workers
to put forth more effort
Source: www.kone.fi
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
11
3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople
Offered compensation scheme
Labor costs of 10 sets; Cost per set
What type of salesperson
will stay with the firm?
Labor costs of 3 sets; Cost per set
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
World Book
Britannica
variable pay: W = $ 100 . x
fixed salary: W = $ 500
$ 1,000  $ 100 per set
$ 500  $ 50 per set
high productive sp.
x  5
low productive sp.
x  5
$ 300  $ 100 per set
$ 500  $ 166,67 per set
Beijing, Sept. 2002
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3. Output-Based Pay
Selection Effect: An Example of
Compensating Salespeople (cont.)
W ...Weekly
Pay
A (World Book)
500
300
B (Britannica)
3
5
x ... Number of
encyclopedia
 Higher-productivity workers will leave Britannica,
because they will earn more at World Book. Only lower-productivity workers will
stay at Britannica
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
13
3. Output-Based Pay
Disadvantages of Output-Based Pay
• Disadvantage of piecework: Variations of output can be beyond the worker‘s control
Variable pay
Straight salary
• Variable pay depends on invested effort
and exogenous risks – risky form of
compensation
 Firm should smooth out exogenous risks
from workers‘ compensation
 Firm should bear exogenous risks but
endogenous risks should remain with
workers
• Fixed salary doesn‘t depend on exogenous factors – low-risk form of
compensation
 Workers are insured against volatilities
 Firm provides the insurance for risks
• Trade-off: More riskhigher compensation
• Opportunity: participate in good economic
development
• Stronger incentives
• Lower compensation level
• Can not participate in good economic
development
• Weaker incentives
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
14
3. Output-Based Pay
Risk in Output-Based Pay
• The firm should bear the largest portion of risk because of risk pooling
abilities
• Workers with a high average compensation should bear more risks than
workers with a low average compensation.
Source: www.kone.fi
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
15
4. Input-Based Pay
• In spite of all the advantages of output-based schemes: A large
proportion of workforce is paid by input
• Compensation depends on the amount of time or effort spent on an
activity
• Independent of output consideration
 Time at work as a proxy to assess worker‘s effort
Source: www.euro.fi
Examples: wage per work hour, monthly salaries, annual salaries
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
16
4. Input-Based Pay
Benefits of Input-Based Pay
Problems of output-based pay solved by time-based (input-based) pay
• Finding the right output measure
• Costs of measurement
• Overemphasizing quantity, reduction of quality
• Risk aversion of workers
• Promoting long-run performance
However, in many cases output-based schemes could be used if only they were
designed correctly!
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
17
Compensation Schemes
Balancing Quantity and Quality
• Piece rates could induce workers to focus on high numbers of low quality
products meeting only the sufficient quality level to ‚count‘
 Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page Price p. page Minutes p. page Revenue per hour
0
$8
20
$ 24
1
$7
15
$ 28
2
$5
12
$ 25
3
$3
10
$ 18
4
$0
9
$0
5
$0
8
$0
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
18
4. Input-Based Pay
Using the Appropriate Time Unit
Input-based pay
Hourly wages
• Production workers
• Clerical workers
Tasks: experienced and
easy to prescribe
• High correlation between
effort and time invested
• Time input as a pretty
good indicator for effort
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Monthly salary
Annual salary
• Managerial workers
• Top Management
Tasks: less experienced and
not easy to prescribe
• Low correlation between
effort and work time
• Time input = bad measure for
effort  overinvestment in
easy (pleasant) tasks
Beijing, Sept. 2002
Tasks: not experienced and
difficult to prescribe; often
to be defined by top manager
• Undefined set of tasks (goal),
discretion over work
• Importance of other incentives to motivate for effort
(long-term, e.g. stock options)
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5. Incentive Pay
Optimal Level of Variable Pay
• Since employees do not diversify their risk
– Large exogenous risks should be born by owners
Fixed salary
• However, employees are motivated by pay for performance
Variable Pay
Part of the pay should be fixed and part variable
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
20
5. Incentive Pay
Forms of Incentive Pay
• Rewards do not need to be monetary, they can consist of anything that
employees value
• E.g
 Piece rates and commissions
 Bonuses
 Parking spots
 Days off
 Promotion
 Training
 Stock ownership
 Health care plan
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.




Housing
Education for kids
Retirement Plan
Party
Beijing, Sept. 2002
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5. Incentive Pay
Criticism to Incentive Compensation
• Often heard critics to incentive compensation:
– Money does not motivate
– It is difficult to design effective incentive schemes
• Incentives certainly entail costs
• The major problem is to design incentive schemes where the benefits
exceed the costs
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
22
Furter Readings
Brickley, J. A./Smith, C. W. Jr./Zimmerman, J. L. (2001): Organizational
Architecture, 2nd ed., Irwin Book Team.
Lazear, E. P. (1998): Personnel Economics for Managers, New York (John
Wiley & Sons)
Prof. Dr. Birgitta Wolff
Marjaana Rehu, M.A.
Beijing, Sept. 2002
23