BA105:
Organizational Behavior
Professor Jim Lincoln
Week 11: Motivation II
Compensation and appraisal
Week’s agenda
• Today
– Lecture on pay and appraisal
• Thursday
– Lincoln Electric video
– Discuss Brainard case
• Which lawyers do you think deserve the most compensation points?
• Defend your choice in terms of each lawyer’s contribution to the
performance criteria you believe are most critical to the firm’s
success
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Compensation
• Pay is the most standardized, measurable, and
controllable reward
– Sends 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)
3
Let’s start with the basics:
How should employees be paid?
Economic theory says pay the employee’s
marginal product.
– But that can’t be observed. So, in practice, firms:
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1. Pay for human capital
(education, training, skill, experience)
• Advantages?
• More measurable than performance
• May be better signal of long-term value-added
• Problems?
• Ability  performance
• Change: skills may erode
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1a. Seniority pay
• Advantages
– Long term commitment/motivation effect
– Makes sense if skills are firm-specific and
grow with experience in firm
– (For firm) Underpay in early career
– (For employee) Security of rising income
• Problems?
– Weak performance incentive/reward
– Equity issues
– (For firm) Overpay in late career
2. Pay according to need
• Common outside the U. S.
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• In-kind transfers in U. S.
2. Pay for the job. Pay rates set by:
– Job evaluation
– Collective bargaining
• Advantages?
• Fit better people to higher value jobs
• Problems?
–
–
–
–
–
–
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)
• Advantages
• Measure the market price
• Equity
• Problems?
• Determining the appropriate labor market
• Advantages of pricing above or below market
4. Pay “efficiency” wages; i.e., above market
• Advantages
• Economize on screening; attract better workers
• Gain in motivation, retention, & productivity
• Low wages = high turnover, low productivity, low quality
– SFO airport security $6/hr >> turnover every six weeks
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5. Pay for performance
– Individual
– Group
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5a. Pay for individual performance
$$
– On the increase
– Advantages?
•
•
•
•
•
•
Best approximates the marginal productivity ideal
Creates strong incentives
Ideally, rewards best people; punishes worst
Ideally, more equitable
Ideally, increases average pay and productivity
Superior as incentive to promoting people for good performance
– Problems?
•
•
•
•
•
Disincentive to teamwork, sharing
Inherently zero-sum (increases competition)
May lower intrinsic motivation
May foster a short-term orientation; reluctance to innovate or take risks
Raises inequality, may raise inequity, both of which demotivate
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• Measuring performance. First, objective metrics
(then discuss subjective performance appraisal)
– Examples: piece rates, commissions
– Advantages:
• Reliable (quantitative metrics)
– Problems:
• Validity problems: “rewarding A while hoping for B”
(Reward quantity at expense of quality, service, etc.)
• Incentive distortions: “what gets measured gets done”
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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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Lincoln Electric’s compensation system
• Wages based solely on piecework
• Starting pay lower than average and work harder than average
• Year-end bonus based on productivity
– Individual’s share of bonus pool determined by semiannual merit rating
• Dependability, quality, output, ideas & cooperation
– Can equal or exceed annual regular pay
• Alignment issues
– Guaranteed employment for all workers
• Removed disincentive to increase efficiency
– Family culture (privately held family-owned firm)
– Employees guarantee own quality; not paid for defective work until repaired
on their own time
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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
– ESOP’s
• Stock options
• Advantages
$$
– Incentive to teamwork
– Team may be performing unit
• Problems?
– 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’s 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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The stock option trap
On most options, workers must pay ordinary income tax on the
difference between the price they paid for the options and the price of
the stock on the day they exercised the options. At the same time, their
company takes a tax deduction equal to this amount, known as the
spread. In recent years, this has significantly reduced or even
eliminated tax bills at immensely profitable companies like Microsoft
and Cisco Systems.
While stocks were roaring higher, individuals viewed these tax bills as
a relatively low price for potential wealth. As stocks have plunged,
many employees have found themselves in the ninth circle of tax hell.
Those who kept their shares instead of selling when they exercised are
paying huge taxes on stock gains they never realized and that have
turned into losses. Many have been forced to file for bankruptcy.
WSJ 4/15/01
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Employee stock ownership:
a disaster at Lucent
Management encouraged employees to invest in the company:
1. Workers could buy 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 had their plans entirely invested in
Lucent. Blue-collar 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.
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The cost of stock options
Many of Silicon Valley's high-tech companies … have relied
heavily on options to motivate their employees..
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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Stock options for executives
– Corporate governance considerations
• The Berle and Means agency problem
– How to align the incentives of executives with those of
stockholders?
– A cause of the Enron, etc., scandals?
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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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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 performance rating
•
•
•
•
•
•
•
•
•
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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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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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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Example of 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 time28
0
360 Degree Feedback
Peers
Internal
Customers
External
Customers
Me
Self
Appraisal
Boss
Skip-level
Reports
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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 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 advantages!
• 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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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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