Walter A. Haas School of Business
University of California, Berkeley
UGBA105:
Organizational Behavior
Professor Jim Lincoln
Week 11: Motivation II
Compensation & Appraisal
Readings for this week
• Lecture:
– Pfeffer: “Six dangerous myths about pay”
– “Low loyalty, high turnover is the norm in some
industries”
• Discussion:
– “Brainard, Bennis, and Ferrell”
2
This week:
• Today
– Ways of paying employees
• Upside and downside consequences
• Lincoln Electric video
• Wednesday
– Given its history, culture, structure, and
competitive strategy, how should Brainard
appraise the performance of its lawyers and
compensate them?
3
Compensation
• Pay is the most standardized, measurable, and
controllable reward
– Sends a strong signal both inside and outside the organization
• Like reorgs and layoffs, shifts in compensation policy
are closely monitored by Wall Street and other external
constituencies (Pfeffer)
4
Theories of extrinsic motivation
(What are the managerial implications?)
• Homo economicus (Taylor, Theory X, principal/agent)
M=f(R)
– People are rational but selfish, opportunistic, & risk- and effortaverse. They need strong incentives & close monitoring
• Expectancy/path-goal (Vroom) M = E(Ri) = S(pi)Ri
– People are rational and goal-directed. They map paths to the
attainment of rewards. Extrinsic rewards motivate only when the
perceived probability of attainment is high
• Learning theory (Skinner)
– People are not rational or goal-directed. Random behavior that is
rewarded is reinforced. Behavior that is punished is extinguished
• Equity theory: M = f(Rs/Es - Ro/Eo)
– People benchmark the value of their extrinsic rewards on those of
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others. Perceived inequity may be motivating or demotivating
Theories of intrinsic motivation
(What are the managerial implications?)
• Theory Y (McGregor, Marx)
– People find meaning & fulfillment through work (intrinsic rewards)
• Motivation/hygiene (Herzberg)
– Extrinsic rewards reduce dissatisfaction; intrinsic rewards motivate
• Hierarchy of needs (Maslow)
– People have needs that both intrinsic and extrinsic rewards fulfill.
Intrinsic rewards motivate only after a sufficient level of extrinsic
reward is attained
• Cognitive dissonance (Festinger)
– People as rationalizers: need consistency in cognitions & behavior
• Too much extrinsic reward makes work less intrinsically rewarding
• Too little extrinsic reward makes work more intrinsically rewarding
6
Let’s start with the basics:
How should employees be paid?
Economic theory says pay a person’s marginal
product.
– But that doesn’t work in practice. Why?
– So employers instead:
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1. Pay for human capital (education,
training, skill, experience)
• Upsides?
• More measurable than performance
• May be better signal of long-term value-added
• Downsides?
• Ability  performance
• Change: skills may erode
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1a. Seniority pay
• Upsides?
– Long term commitment/motivation effect
– (For firm) Underpay in early career
– (For employee) Security of rising income
• Downsides?
– Weak performance incentive/reward
– Inequity
– (For firm) Overpay in late career
2. Pay according to need
• Common outside the U. S.
• In-kind transfers in U. S.
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2. Pay for the job. Set pay rates by:
– Job evaluation
– Collective bargaining
Upsides?
Fit better people to higher value jobs
Downsides?
–
–
–
–
–
–
Screening costs
Selection errors
Change in person’s fitness for job
Rigidity and complexity of job classifications
May proxy age/seniority
“Peter Principle”
• Solution: skill/experience grading independent of job content
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Assigning Hay points to jobs
Job rated on various dimensions:
–
–
–
–
Type & complexity of knowledge required
Number of employees supervised
Amount of capital overseen
Type & unpleasantness of working conditions
These measures are combined to form a
one-dimensional scale of “value” to the firm
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3. Pay the market wage (do wage surveys)
• Upsides?
• Measure the market price
• Equity
• Downsides?
• Determining the appropriate labor market
• Upsides of pricing above or below market
4. Pay “efficiency” wages; i.e., above market
• Upsides?
• Economize on screening and attract better workers
• Gain in motivation, retention, & productivity
• Low wages = high turnover, low productivity, low quality
– SFO airport security $6/hr →100% turnover every six weeks
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Costco lowers labor costs by
increasing labor rates
In addition to offering some of the best wages and benefits in the retail
industry, Costco rewards employees with bonuses and other incentives.
It promotes from within, encourages workers to make suggestions and to
air grievances and gives managers autonomy to experiment with their
departments or stores to boost sales or shave expenses as they see fit.
The result: People line up to work there, and once hired, they stay. Annual
turnover for full- and part-time hourly workers on the job more than a year
is 6 percent, compared with an industry average of 59 percent.
It’s the same story for executives. The 13 member senior management
team has stayed virtually unchanged since its birth in 1983.
"What they’re doing is creating a competitive advantage through people,"
says Fred Martels, president of People Solution Strategies, a St. Louis
retail industry consultancy. "It lowers costs and increases productivity."
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5. Pay for performance
– Individual
– Group
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5a. Pay for individual performance
$$
• Upsides?
–
–
–
–
–
–
Closest to marginal productivity ideal
Creates strong incentives
Ideally, rewards best people; punishes worst
Ideally, more equitable
Ideally, increases average pay and productivity
Better than promoting people for performance
• Downsides?
–
–
–
–
–
–
–
Disincentive to cooperation and teamwork
Inherently zero-sum
May lower intrinsic motivation
May misalign & distort incentives (Sears)
May foster a short-termism & risk aversion
Increases inequality & may increase inequity
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Neglects performance multidimensionality (quality/productivity)
Measuring Performance
Objective metrics
– Examples: piece rates, commissions
– Upsides?
• Hard metrics, clear, reliable
– Downsides?
• “Rewarding A while hoping for B”
Subjective metrics (for discussion section)
–
–
–
–
–
Trait rating
Forced ranking
Behaviorally-anchored rating scales (BARS)
Management by objectives (MBO)
360 degree appraisals
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Should performance pay be in base or bonus?
– Base pay upsides?
• More value to employee; greater retention effect
– Base pay downsides?
• Less variable
• Dilutes incentive
– Bonus upsides?
• Makes pay more variable
• Closer link to behavior
– Bonus downsides?
• May become entitlement
Most incentive pay systems are a combination
– Incentive pay above a target threshold
• Upsides?
– Lowers risk to worker
• Downsides?
– Management has an incentive to raise target
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Lincoln Electric’s compensation system
• Wages based solely on piecework
• Starting pay lower than average
– And work is harder than average
• Year-end bonus based on productivity/quality/teamwork
– Individual’s bonus determined by semiannual merit rating
• Dependability, quality, output, ideas & cooperation
– Could equal or exceed annual regular pay
• Congruence issues
– Guaranteed employment for all workers
• Removed disincentive to increase efficiency
– Family culture (privately-held family-owned firm)
– Employees guarantee own quality
– Low top-to-bottom inequality
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‘s incentive
compensation for sales clerks
* Guaranteed base wage $9.45/hour
* Target sales per week:
– 40 hrs x $140 sales per hour = $5600
* Commission rate: 6.75% above target
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5b. Pay for group performance
• Types
– Team competitions (quality, productivity, innovation)
– Gain-sharing (Scanlon plan)
– Profit-sharing
• Organization design alignment issues
– ESOPs
– Stock options
• Upsides?
$$
– Incentive to teamwork
• Downsides?
– Weak incentive effect
– Free rider problem
– Shifts risk to employees
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Nobel Prize economist Gary Becker on ESOPs
The advantages of employee ownership have been oversold, and its
disadvantages have been overlooked. The number of employee-owned
companies …grew from a handful in 1974 to 5,000 now because of tax
advantages introduced during this period.
It is possible that ownership does indirectly motivate employees, but the direct
incentive is weak: almost all the additional profit created when an employee
works harder goes to fellow employees and other owners of stock.
Employee stock ownership increases workers’ exposure to risk from fluctuations
in the fortunes of their companies.
ESOPs often become a management tool to fend off unfriendly takeovers and
other efforts to oust current managers.
A General Accounting Office study found no evidence that profits and
productivity increase after companies introduce ESOPs.
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Employee stock ownership:
a disaster at Lucent
1. Workers bought stock through the employee stock purchase
plan, deducting up to 10 percent of their pay toward stock
purchases at a 15 percent discount.
2. Workers could invest in Lucent shares through their 401(k)
retirement plans, and some invested entirely in Lucent. Bluecollar workers received the company's voluntary 401(k)
matching contribution in Lucent stock.
3. Many Lucent workers received incentives and pay in options
and more options to buy stock, contracts now largely
worthless. Almost every rank-and-file Lucent worker received
stock options.
22
Stock options for executives
• Corporate governance considerations
– The Berle and Means “agency” problem
• Aligning incentives of executives with those of stockholders
• A cause of the Enron, etc., scandals?
23
Michael Eisner takes no bonus in 1999
Disney Chief Executive and Chairman Michael Eisner didn't receive a
bonus in fiscal 1999… The entertainment and media giant's fiscal
fourth-quarter earnings fell to $85 million, or four cents a share, from
$296 million, or 14 cents a share a year earlier.
Eisner did receive his annual salary of $750,000 in 1999. In fiscal
1998, Mr. Eisner's bonus came to $5 million. His total compensation
in 1998 came to $575.6 million thanks to $569.8 million in stock
options he exercised. He received a bonus of $9.9 million in 1997.
In 1999, Mr. Eisner acquired 1.9 million shares of options that
realized a value of $49.9 million when exercised, the filing said. As of
Sept. 30, Mr. Eisner held 24 million in unexercised options valued at
$68.4 million.
WSJ 1/5/2000
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CEO annual compensation in 2005
William McGuire, UnitedHealth: $1 Billion
Lee Raymond, Exxon: $405 Million
Bob Nardelli, Home Depot: $250 Million
Hank McKinnell, Pfizer: $99 Million
Franklin Raines, Fannie Mae: $90 Million
Phil Purcell, Morgan Stanley: $66 Million
Fortune, July 10, 2006
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What exactly is motivating about
$$$money$$$?
“Status is of great importance in all human relationships.
The greatest incentive that money has, usually, is that it is a
symbol of success... The resulting status is the real incentive.
Money can be an incentive to the miser only.”
John F. Lincoln, CEO Lincoln Electric
“Mr. Bachelder, who has been negotiating CEO contracts for
26 years, points to another factor: big paydays for athletes,
entertainers and money managers. "It's the Michael Jordan
principle," Mr. Bachelder says. "If he can get $30 million, I
have to get it.“
WSJ, 2005
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The cost of stock options
Many of Silicon Valley's high-tech companies … have
heavily on options to motivate their employees
relied
Santa Clara-based Yahoo is one example of how the true cost of
stock options is eroding the bottom line of many of America's
best-known companies.
…(E)arnings per share of Yahoo, Network Appliances,
Mercury Interactive, Palm, and Autodesk Inc. were cut by at
least half once the cost of options was included. For Yahoo, a
profit of 10 cents per share profit turned into a loss of 50 cents
per share, or a fall of 600 percent.
WSJ, 2000
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Executive compensation change in
response to corporate scandals
The Sarbanes-Oxley Act, passed in 2002:
1. More timely disclosure of executive-pay deals
2. CEOs to return compensation based on financial results that were later restated.
3. Outlawed "backdating" of stock options.
By 2003, the average option grant fell nearly by half to $3.3 million. Average CEO
compensation declined, to $8.7 million in 2003, from $12.8 million in 2000.
In 2004, accounting rules were changed to require stock-option grants to be treated
as an expense.
Corporate boards began substituting restricted stock for options.
Unlike options, restricted stock retains its value even if share prices decline.
“Behind Soaring Executive Pay, Decades of Failed Restraints,” WSJ, October 12, 200628
Do Americans care about
income inequality?
Unlike the lucky crowd at the top of the income
scale - hedge fund managers, media superstars,
lawyers, strategy consultants, rock stars, sports
heroes, and, yes, CEOs - a majority of Americans
haven't been reaping the rewards of globalization.
Even as benefits shrivel, real median wages have
stagnated since 2000, while real median family
incomes have fallen four years running.
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Takeaways on pay
• Managers should not rely entirely on pay systems for motivation but
should design intrinsic rewards into jobs and control systems
• Every method of pay has its drawbacks. A combination of individual
and group systems is ideal
• Don’t overdo it on individual incentives. Group incentives have
many Upsides!
• Alignment is critical! Make sure that the pay system is congruent
with the people, the tasks, the technology, the structure, and the
culture!
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Performance appraisal
• “The experience of performance appraisal systems of all kinds
over at least a century of trying in government and business has
been uniformly bad.” (Wall Street Journal, Nov. 19, 1996)
• A 1996 Institute of Management Accountants survey found only
15% of respondents’ measurement systems were effective at
supporting top management’s business objectives; 43% of
respondents felt their systems did a poor job in this regard.
Why should this be the case?
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What should performance appraisal do?
• Communicate strategy, values, expectations
• Build the culture
• Evaluation
– Current job (e.g., salary and bonus)
– Future jobs (e.g., promotion, training)
• Development and feedback
• Legal defense
– Hiring, promotion, retention decisions
– Validation (e.g., of selection criteria)
• Equity and fairness
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Problems in rating performance
•
•
•
•
•
•
•
•
•
Halo effect
Stereotypes
Overweight negative information
Lack of sufficient observation
Memory: primacy/recency
Leniency
Central tendency
Justification for salary
Reticence to write things down
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Evaluating rating formats
Rating Format
Trait
Forced
BARS
Rating Ranking
MBO
360
Degree
1. Acceptability, poor
feedback
poor
good
good
very
good
2. Appropriate
for Rewards
fair
good
good
good
good
3. Accuracy,
Validity
poor
fair
good
good
very
good
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Salary premiums associated with performance ratings
and frequency distribution of performance ratings for
2,841 managers in a large manufacturing firm
Performance
rating
Salary premium
relative to lowest
performance
rating
Percent of sample
receiving
performance
rating
Unacceptable
0
0
Minimum
acceptance
0
0
Satisfactory
0
1.2
Good
1.8
36.6
Superior
3.6
58.4
Excellent
6.2
3.8
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BARS: Behaviorally anchored rating scale
Selects nursing activities and
delegates responsibilities to
make the most efficient use
of time and personnel
available
Customarily makes and carries
out a satisfactory work plan
to handle daily assignments
10 Checks orders for medication to be given
during the day and attempts to maintain a
daily schedule for distributing medication
When short of linen, rearranges work
assignments to accommodate bedridden
patients first
6 If aides had completed their normal work
assignments during night shift, would have
them help clean equipment during
remaining time on shift
Makes a routine check for paper supplies
available on unit
Approaches daily work
assignments without
foresight or systematic
planning
3 Spends most time charting and very little
time with patients and aides
Frequently leaves important work undone
so that he or she can leave on time37
0
360 Degree Feedback
Peers
Internal
Customers
External
Customers
Me
Self
Appraisal
Boss
Skip-level
Reports
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Morgan Stanley 360° Criteria
 Marketing/Professional Skills
 problem solving, initiative, communication, versatility
 Management and Leadership
 People management, development, coaching, fairness
 Commercial Orientation
 Client relationships, revenue contribution, deal execution
 Teamwork/One Firm Contribution
 Cross-division projects, business team activity, recruitment
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Benefits of 360 Degree Appraisal
•
•
•
•
•
•
•
•
•
Validity and accuracy
Better acceptance by people rated
Promotes equity
Legal protection
Diversity
Useful when spans of control are large
Better for knowledge workers
More appropriate for team-based system
Appropriate for empowered cultures
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Takeaways on appraisal
Make sure that the process is related to job
performance and meets legal requirements
– Standards communicated to employees
– Evaluations based on specific dimensions
– Dimensions defined in behavioral terms
• Supported by objective, observable evidence
– Raters should be trained and validated
– When possible, multiple raters are used
– Appraisal fits the cycle of work
– Documentation of extreme ratings is done
– Formal appeal process is available
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