Compensation & Organizational
Performance:
Theory, Research & Practice
Luis R. Gomez-Mejia; Pascual Berrone and
Monica Franco-Santos
M E Sharpe Inc, New York (2010),
pages
ISBN: 978-0-7656-2251-8
Theme of the Book
Compensation is the largest single cost in most organisations. This book addresses
compensation and rewards from a strategic perspective. Coupled with the fact that
Incentive systems are a doubleedged sword: they can help the
organisation achieve its strategic
objectives or they can channel
people’s efforts in the wrong
direction, perhaps into an abyss.
pay is the most important single expense in most
organisations, in the long term organisational
performance depends on whether or not the
compensation system is used effectively.
This up-to-date, research-oriented textbook focuses on the relationship between
compensation systems and firm overall performance. This book addresses
compensation and rewards from a strategic perspective.
It examines how the use of compensation influences the behaviour of employees
and decision makers, and the implications this has for firm performance.
This book summary selectively highlights aspects of the book which are most
likely to appeal to practising managers; it is not intended to cover all aspects
of this comprehensive book.
Cranfield School of Management
Compensation & Organizational Performance
Key Learning Points
•
Compensation is the largest single cost in most organisations. Hence, the
extent to which these resources are allocated effectively is likely to have a
major beneficial impact on organisational performance.
•
The design of the compensation system influences strategic choices
made by top executives as well as how those choices are eventually
implemented throughout the entire firm.
•
Compensation strategy is the deliberate utilisation of the pay system as an
essential integrating mechanism through which the efforts of various
subunits and individuals are directed toward the achievement of an
organisation’s strategic objectives.
•
Each firm faces a repertoire of pay choices concerning criteria used to
distribute rewards, options for the design of the compensation package,
and type of policies and procedures governing the organisation’s
compensation system.
•
Two major strategic compensation patterns have emerged from research,
labelled experiential and algorithmic, with most firms falling somewhere
between those two poles.
•
Different corporate and business unit strategies are associated with
varying pay strategy configurations.
•
There are ten key policy choices that should be considered when
designing compensation programmes for top management teams.
•
A crucial issue is the pay mix of the compensation package, or the relative
importance of different items in total pay received by the incumbent.
•
The pay mix communicates what the organisation values, and it signals to
the executive the type of performance that is desired and rewarded.
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Introduction
Organisational members from the highest to the lowest levels in the pyramid respond
to how they are rewarded, and hence, the design of the compensation system
influences strategic choices made by top executives as well as how those choices
are eventually implemented throughout the entire firm. Coupled with the fact that pay
The way compensation moneys are
is the most important single expense in most
allocated sends a powerful symbolic
organisations, in the long term firm
message throughout the organization
performance depends on whether or not the
of what is and is not valued.
compensation system is used effectively.
The strategic perspective on compensation is based on two underlying assumptions.
First, the pay system cannot be analysed in isolation because its effectiveness
depends upon how responsive it is to internal and external forces on the
organisation. The second assumption is that the organisation has the discretion to
choose from a large variety of pay policies and procedures, and each of these may
have strategic implications.
Compensation strategy is the deliberate utilisation of the pay system as an essential
integrating mechanism through which the efforts of various subunits and individuals
are directed toward the achievement of an organisation’s strategic objectives. When
properly designed, it can be an important contributor to the firm’s performance.
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Compensation & Organizational Performance
Repertoire of Strategic Pay Choices
Each firm faces a repertoire of pay choices. The authors identify 18 strategic pay
choices broken down into three broad categories, reflecting the common themes
underlying each set of choices. These choices cluster around:

How to distribute rewards

Assembling the compensation package

Administering the system
Criteria Used to Distribute Rewards
The strategic pay choices listed under this category are concerned with the most
salient factors or criteria used to distribute rewards.
Job versus Skills-based
Performance versus Membership
Individual versus Aggregate
Performance
Short-term versus Long-Term Orientation
Risk Aversion versus Risk Taking
Corporate versus Division Performance
External versus Internal Equity
Hierarchical versus Egalitarian
Pay dispersion versus Pay
Homogeneity
Qualitative versus Quantitative Performance
Measures
Assembling the Compensation Package
This dimension of compensation strategy concerns the design choices facing the
firm when assembling a compensation package.
Compensation versus Market
Frequency of Rewards
Fixed Pay versus Incentives
Monetary versus Non-Monetary Rewards
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Administering the Compensation System
This dimension of compensation strategy concerns the policies and
procedures that govern the organisation’s compensation system.
Centralisation versus Decentralisation
Participation versus Non-Participation
Open versus Secret Pay
Bureaucratic versus Flexible Pay Policies
The degree of success associated with each of these depends on two factors. The
first is how well the alternative(s) selected enable the organisation to cope better with
contingencies affecting it at a given point in time. The second is the extent to which
the pay choices made are synchronised with the firm’s overall strategic direction.
Pay Choices & Organisational Strategies as an Interrelated Set of Decisions
Pay choices are not formulated in a vacuum. They are affected by internal and
external contextual factors that require distinctive pay mechanisms. Moreover,
strategic pay choices seldom occur in isolation; rather, they tend to form meaningful
clusters or patterns. Likewise, the organisational strategies driving these pay
choices also form strategic groupings.
Two major strategic compensation patterns have emerged from research, labelled
experiential and algorithmic, with most firms falling somewhere between those two
poles. In short, algorithmic strategies emphasise mechanistic, predetermined,
standardised, repetitive procedures whereas the experiential pattern is flexible and
adaptive.
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The key distinguishing features of the algorithmic pay pattern are as follows:
1. Heavy reliance on traditional job evaluation procedures
2. Seniority as an important criterion in pay adjustments
3. A short-term performance orientation with appraisals conducted at the
individual, rather than group, level
4. Minimal risk sharing between employees and the firm
5. A corporate strategic focus with an emphasis on internal equity and
hierarchical position as the basis to distribute rewards
6. Monitoring of behaviours rather than outcomes
7. Heavy reliance on base salary and benefits in the pay mix with minimal
variable compensation
8. Above-market pay with high job security
9. More bureaucratic, formalized pay policies
This creates an organisational climate that promotes commitment and discourages
employee attrition. Because behaviours, rather than outcomes, are measured in the
appraisal process, superiors exercise much judgment and subjectivity in assessing
the performance of subordinates. This means that the reward system encourages
high dependence on superiors with a top-down, decision-making structure. The
administrative framework is highly centralised, pay secrecy is enforced, employee
participation is not encouraged, and compensation policies and procedures are
carefully defined.
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The experiential pattern emphasises:
1. Skills and personal attributes, rather than job evaluation procedures focusing
on work tasks, as a basis for pay determination
2. Demonstrated performance, rather than tenure, as a basis for pay
progression
3. Performance assessments at multiple levels, including individual, team,
business unit, and corporate levels
4. Multiyear considerations in the distribution of rewards, particularly for top-level
managers
5. Extensive risk sharing between employees and the firm
6. A greater emphasis on assessing division performance, rather than overall
corporate performance, for firms with several business units
7. More sensitivity to the market, rather than internal equity concerns, in setting
pay levels
8. De-emphasis of hierarchical structures in favour of more egalitarian pay
schemes
9. Greater reliance on outcomes, rather than supervisory judgments, of
performance for divisional managers, resulting in less dependence on
corporate superiors
10. Lower pay relative to the market (“follow market” policy) yet offers an
attractive pay package. The package incorporates substantial incentives and
premiums on top of fixed salary and benefits and makes greater use of
deferred income, in addition to cash incentives for a broad cross section of
employees.
11. Multiple rewards given at frequent and sometimes unpredictable intervals.
Money is used explicitly as a mechanism to influence employees’ behaviour
and creates a calculative, utilitarian employment relationship.
The administrative framework of the experiential pay pattern is decentralised, and
lower organisational levels and local units have much discretion in allocating
compensation moneys. Pay policies are flexible and can change depending on
situational factors rather than simply following rules of the book.
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Empirical research strongly suggests that different corporate and
business unit strategies are associated with varying pay strategy
configurations. For instance, a more experiential pay pattern is evident in
single- or unrelated-product firms, multi-business or conglomerate-type
companies, firms that grow rapidly through aggressive acquisitions, and those firms
at the growth stage of their life cycles. At the other extreme, a more algorithmic
orientation in the pay system is associated with dominant- and related-product firms
with a vertically integrated chain of businesses. This orientation is also evident where
all businesses relate to a single core strength or
characteristic, companies that expand through internally
generated diversification, firms with a
rationalization/maintenance strategy, and companies at a
Different corporate and
business unit strategies are
associated with varying pay
strategy configurations
mature or decline life-stage.
Executive Compensation
There is a compelling need for close linkage between compensation and
organisational strategies at the top executive level for the three following reasons.
1. Strategic decisions affecting the entire firm are normally made by top executives.
Evidence suggests that the reward system plays a major role in how those
decisions are made because executives are very responsive to what they
perceive will lead to a personal payoff. As a result, a pay package designed to
reinforce the wrong strategic choices (e.g., rewarding short-term results at the
expense of long-term performance) will be highly detrimental to the firm’s future
success.
2. Senior management provides general guidelines as to the form of the
compensation package and payment criteria for all employees. Executives will set
priorities for subordinates and reward those activities they perceive as consistent
with their own incentive system. Consequently, goals and objectives built into the
executive compensation plan are likely to have a multiplier effect on the entire
workforce.
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3. Third, as a corollary to the previous point, executive compensation is critical to
the firm’s HRM subsystem because its incentive properties eventually filter down
in the organisation and signal to all employees those behaviours that will be
conducive to personal success.
Policy Choices, Strategic Design of Executive Compensation Programmes &
Implementation
Executive pay is perhaps the most crucial strategic factor at the organisation’s
disposal. It can be used to direct managerial decisions and indirectly channel the
behaviour of subordinates. Mechanisms used to reward executives are likely to have
an enormous effect on the company’s future.
Key Policy Choices
There are ten key policy choices that should be considered when designing
compensation programmes for top management teams. These choices are:
1.
Degree of Exclusivity
The number of management levels to be included in executive compensation
programmes is an important decision because it affects the firm’s decision to
develop a hierarchical or more egalitarian culture. If the CEO pay package is
clearly separate from that of the rest of the staff, it can be personalized more
easily but it will tend to reinforce a more authoritarian, centralised, elitist type of
reward system.
2.
Opportunity Costs
The incentive system may be designed to penalize the executive for leaving the
firm prior to a stipulated period of time. By increasing the opportunity cost of
leaving, the firm may prevent the executive from being pirated by other
organisations.
3.
Level of Analysis
The evaluation criteria used for most top executives are generally based on the
entire organisation’s performance. But it may also be important from a strategic
perspective to consider behavioural performance measures when dispensing
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executive pay. Exclusively relying on organisation-wide criteria may lead to an
inordinate amount of attention being paid by the executive to a “beat the
numbers game.”
4.
Performance Measurement
One of the most controversial issues in executive compensation revolves around
how firm performance should be measured. The most commonly used
organisation-wide performance criteria consist of accounting measures of
performance but it may be wiser to base rewards on all measures (profitability,
market-based, and social measures).
5.
Control Mechanisms
Boards of directors should be the primary mechanisms for monitoring managerial
actions. If boards are weak, the only alternative is to tie the executive’s income
to that of the firm through incentive alignment. Ideally, however, both monitoring
and incentive alignment should work in tandem not as substitutes for each other.
6.
Type of Governance
This concerns the process to be used in designing executive pay packages and
the selection of individuals to participate in these decisions. It is imperative to
develop mechanisms that prevent conflicts of interest from arising. This requires
a governance system that is riddled with checks and balances so that executive
pay decisions are independently made and beyond reproach.
7.
Time Horizon
Ideally executive pay should be based on a combination of short- and long-term
performance.
8.
Degree of Risk
The relative risk to the CEO of the firm’s compensation policies can be analysed
in terms of three dimensions
• Variability. The degree of risk is lower when the executive pay package is
designed so that a substantial portion of income is received on a stable,
relatively fixed, predictable basis over time with minimum uncertainty.
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• Downside risk. The amount of risk is lower when the executive’s pay
package has a downside hedge against poor firm performance e.g.
‘golden parachute’
• Long-term orientation. The longer the time horizon involved, the greater
the amount of uncertainty (and, therefore, risk) in the pay schedule faced
by the executive, because the number of unforeseen and uncontrollable
events increases accordingly.
The relative risk of the executive compensation package should be unique to
each type of firm, depending upon such factors as strategic goals, stage in life
cycle, and environmental conditions.
9.
Degree of Consistency
A challenge faced by large, complex firms with diverse business units or
divisions is how to compensate executives with any degree of consistency
across these units. Should the same formula be used for all executives, or
should a separate deal be made with each executive responsible for a business
unit or division? Use of the same formula for different parts of the organisation
can be easier to control administratively. More importantly, it promotes a greater
sense of equity across units.
On the other hand, since each unit is generally confronted by its own unique
contingency factors and operates autonomously, a custom-made executive pay
package on a case-by-case basis makes the most sense. As a general
principle, the more independent and dissimilar the business units, the more
appropriate custom-made executive packages would be.
10. Tax Rules
Unquestionably, tax rates can make a major difference in an individual’s takehome pay, particularly at higher income levels. Thus, tax rates must be taken
into account when designing executive pay packages. Tax reduction, however,
should not become an overwhelming goal.
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The Pay Mix
A crucial issue is the pay mix of the compensation package, or the relative
importance of different items in total pay received by the incumbent. In the broadest
sense, pay mix can be analysed in terms of a fixed component (salary and benefits)
and a variable dimension (bonuses and long-term income). The pay mix
communicates what the organisation values, and it signals to the executive the type
of performance that is desired and rewarded. From a strategic perspective, it is
essential that designers of executive compensation programmes ask themselves
what type of behaviour is most likely to be expected, based on the set of rewards
being proposed.
•
Base Pay
A key characteristic of base pay is that it has minimal downside risk to the
executive. All things considered, a heavy reliance on base pay in the pay mix
may be dysfunctional because it is not easily adaptable to contingencies such
as changes in organisational objectives and market conditions. Furthermore,
because base pay is generally taken for granted by the executive, it has less
motivational value.
•
Benefits
The rationale for these types of non-monetary rewards is that perks are great
motivators that help retain irreplaceable employees. Yet, from a strategic
perspective, many of these benefits may be difficult to justify. They are provided
to the executive as a condition of employment, but they are seldom contingent
on the achievement of strategic objectives.
•
Bonuses
Bonuses are short-term incentives linked to specific annual goals. Since it is
variable in nature, the bonus carries more risk to the executive than base pay.
The actual degree of risk depends on the criteria that must be met to receive the
bonus, and these vary widely.
•
Long-term Incentive Plans
In the most general sense, long-term incentive plans can be divided into two
major groups: those that make the executive part owner in the firm and those
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that combine cash with equity-based compensation. Because
strategy is innately oriented to the long term rather than focused on
tactical short-term considerations, there is perhaps no other
compensation programme where organisational and pay strategies
come closer together than the so-called long-term income plans.
Conclusion
The traditional compensation model tends to be inward oriented, with the implied
assumption that a system that enables a firm in an orderly fashion to “attract, retain,
and motivate employees” will help it become “the employer of choice” and thus
accumulate and utilise the best available human capital. While this may be true, it is
only part of the story. Firms can only outperform others when they have a successful
business strategy and the compensation system helps support it from the highestpaid executive (whose decisions are very responsive to incentives) down to the
lowest-paid employee.
About the Authors
Luis R. Gomez-Mejia is a Council of 100 Distinguished Scholar, holder of the
Heritage Chair, and Regent’s Professor at Arizona State University.
Pascual Berrone is Assistant Professor in Strategic Management at IESE Business
School
Monica Franco-Santos is a Senior Research Fellow and Director of the Business
Performance Roundtable at Cranfield School of Management. Monica's research
broadly concerns the design, implementation, and management of performance
measurement systems. In particular, Monica is interested in the relationship between
performance measurement systems and reward systems in both private and public
sector organisations. Monica has participated in EPSRC and CIMA funded research
looking at how organisations manage through measures, what impact performance
measurement systems have on business results; and what effects bonus
performance targets have on individual behaviour. Monica is a reviewer for several
academic journals and practitioner publications.
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