Strategic Reward Systems I
HR Management
MBAO 6030
MBAO 6030 Human Resource
Management
Strategic Reward Systems I:
Pay for Performance
Reward Systems consist of the following
elements:
Financial Rewards – Compensation
1. Base Salary
2. Pay Incentives
3. Employee Benefits
Non-financial Rewards
1. Intrinsic Rewards – centers on the work itself
2. Praise, recognition, time off and other rewards
given to the employee by peers or superiors.
MBAO 6030 Human Resource
Management
Strategic Reward Systems I:
Pay for Performance
Reward Systems in most cases should be
consistent with other HR systems.
The Reward System is a key driver of:
 HR Strategy
 Business Strategy
 Organization Culture
MBAO 6030 Human Resource
Management
Strategic Reward Systems I:
Need for Consistency with Other HR Systems
Skill-based pay
Training
Culture
Overtime
pay rules in
contract
Labor
Relation
s
Sign-on Bonus
Merit pay reinforces
performance culture
Rewards
Performance
Management
Employment
Merit Pay
MBAO 6030 Human Resource
Management
Strategic Reward Systems I
Critical Thinking Question:
1. Should pay policies “lead” or “lag” the
development of other HR systems?
MBAO 6030 Human Resource
Management
Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)
Assumptions:
 People develop beliefs about what is a fair
reward for one’s job contribution - an exchange
 People compare their exchanges with their
employer to exchanges with others-insiders and
outsiders called referents
 If an employee believes his treatment is
inequitable, compared to others, he or she will
be motivated to do something about it -- that is,
seek justice.
MBAO 6030 Human Resource
Management
Theoretical Models of Pay and Performance:
Equity theory (Adams, 1963)
Is/Os
versus
Ir/Or

O = Outcomes: the type and amount of
rewards received

I = Inputs:
employee’s contribution to
employer

R = Referent:
comparison person

S = Subject:
the employee who is judging
the fairness of the exchange
MBAO 6030 Human Resource
Management
Equity Theory – Exchange Scenarios



Case 1: Equity -- pay allocation is perceived to
be to be fair - motivation is sustained
Case 2: Inequity (Underpayment) -- Employee
is motivated to seek justice. Work motivation is
disrupted.
Case 3: Inequity (Overpayment) -- Could be
problem. Inefficient. In other cultures
employees lose face.
MBAO 6030 Human Resource
Management
Consequences of Inequity


The employee is motivated to have an equitable
exchange with the employer.
To reduce inequity, employee may…




Reduce inputs (reduce effort)
Try to influence manager to increase outcomes
(complain, file grievance, etc.)
Try to influence co-workers’ inputs (criticize others
outcomes or inputs)
Withdraw emotionally - or physically (engage in
absenteeism, tardiness, or quit)
MBAO 6030 Human Resource
Management
Equity Theory Implications




There is tension between internal and external
pay equity: Decide where to place the
emphasis. Example: “In and out” versus
“lifelong” employment system
Let employees know who their pay referents are
in the pay system: identify pay competitors and
internal pay comparators.
Strive for consistent pay allocations
Monitor internal pay structure and position in the
labor market for consistency.
MBAO 6030 Human Resource
Management
Agency Theory



Agency theory is a theory of governance in the
workplace.
It tries to solve the problem of separation of
ownership (atomistic shareholders) and control
(professional executives and non-owners)
It also tries to solve conflicts of interest between
managers and employees with delegated
responsibilities.
MBAO 6030 Human Resource
Management
Agency Theory
1. Principals = owners or managers who delegate
responsibilities
2. Agents = managers or employees who manage
firm assets for owners or other principals.
3. Information asymmetry = managers or other
agents have greater access to strategic
information than principals, who are not willing
to bear the cost of directly monitoring the
agents due to steep agency costs.
MBAO 6030 Human Resource
Management
Agency Theory
4. Risk Preferences – principals are risk neutral
and willing to bear greater risks than agents
because their asset wealth is more likely to be
diversified between corporate assets and other
equities/investments. Agents are more risk
averse than principals, because most of their
wealth is concentrated in the firm and received
in the form of pay and opportunities for
promotion.
MBAO 6030 Human Resource
Management
Agency Theory
5. Moral Hazard – agent is tempted (and some
cases succeeds) in taking advantage of
information asymmetry with principal and act
opportunistically (defined as making decisions
not aligned with principal’s interests) and use
the firm resources to maximize wealth of the
agent (often at the expense of the principal).
MBAO 6030 Human Resource
Management
Agency Theory
6. Agency Contract – provides solution to moral
hazard/agency problem, by establishing “rules
of the game” to control agent opportunism –
agent’s performance will be judged by
outcomes (often financial benchmarks) not
behaviors (which require direct supervision of
agent’s actions). These outcomes will reflect
principal’s goals and risk preferences.
MBAO 6030 Human Resource
Management
Agency Theory
7. Incentive alignment – the agency contract will
specify a compensation plan that aligns the
interests of the principal and agent. This
agency contract will be a type of pay for
performance plan. Meeting or exceeding preagreed upon financial or non-financial
outcomes triggers various forms of
compensation (individual or group-based) for
the agent. Some agency costs are borne by
the principal in the form of financial incentives
for the agent.
MBAO 6030 Human Resource
Management
Tournament Theory
1. Tournaments are competitions between peers to
achieve a promotion to a higher rank along with
the pay and perks that go with it.
2. Tournaments are likely to result in a “winner
take all” outcome.
3. Managers who enter the tournament must
forego other alternatives (such as jobs with
other firms, start own business, receive more
pay with an alternative opportunity) to compete
in the tournament.
MBAO 6030 Human Resource
Management
Tournament Theory
4. A high pay differential (such as the CEO
receiving much greater pay than any
subordinates) attracts more “players” to the
tournament.
5. Players must “invest” (work long hours, accept
less pay, show loyalty to their boss) to enter the
tournament – firm captures value from these
players, more than what it gives up to the
“winner” for the prize.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
1. Single Mindedness – “you get what you pay
for” – no more, no less. The activities that are
rewarded get done, to the exclusion of other
activities that are not rewarded. Example: The
dysfunctional behaviors that are observed when
a sales representative is put on straight
commission.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
2. Control – externalities can control the
outcomes, positive or negative. There can be
windfall affects (the bull market improving the
stock value of all stock options) or negative
externalities (a bear market or recession that
lowers the value of all stocks). Employee
performance results may be magnified or
diluted by these effects.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
3. Measurement error – some measures can be
“gamed” or manipulated and may not reflect
“true” performance. Sales reps can withhold
sales and report it in a different period so they
are not penalized by a cap on sales
commissions. Managers can use “creative
accounting” measures to report greater profits
than were actually experienced by the firm.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
4. Inflexibility – managers or employees may
resist change of the basis of compensation
because they are comfortable with current
basis for pay and want to avoid risk of taking
reduction in earnings in new system.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
5. Misalignment of incentives – if pay emphasis is
on a goal that is no longer relevant, that goal will
continue to be emphasized until the pay system
places emphasis on a different objective.
For example, managers may emphasize short-term
goals, even if long-term goals are more relevant,
until the pay system recognizes long-term goals
to a greater extent than short-term goals. The
reward mix for complex jobs with several goals
must reflect the relative value of attaining the
mix of goals.
MBAO 6030 Human Resource
Management
Controversies that Surround Pay for
Performance Plans
6. Line of Sight problem - division performance
and corporate performance should be reflected
in the pay system. If division performance and
corporate performance are closely linked than
both division and corporate performance should
contribute incentives to the managers’ pay for
performance plan. If division performance is
independent of corporate performance, then the
emphasis should be on rewards for meeting
division goals.
MBAO 6030 Human Resource
Management
Some Suggestions for More Effective Pay For
Performance Plans
Pay and Performance should be Loosely
Coupled – this gives managers more flexibility
to make changes when new situations arise.
Example: a formula with a bonus based on a
moving average of a 3-year historical
performance period. A 3-year period smoothes
out performance over a longer cycle.
MBAO 6030 Human Resource
Management
Some Suggestions for More Effective Pay For
Performance Plans
It is Necessary to Nurture the Belief that
Performance Makes a Difference – there are
important cultural values that are supported with
pay for performance even if the accuracy of the
performance metrics and the fairness of the pay
allocations fall short of an ideal situation.
Abandoning pay for performance may be more
problematic than having an imperfect pay
system.
MBAO 6030 Human Resource
Management
Some Suggestions for More Effective Pay For
Performance Plans
Pay for Performance systems should be
designed to fit each firm’s unique situation –
imitation of other firm’s plans should be avoided
MBAO 6030 Human Resource
Management
Six Myths about Pay (Pfeffer, 1998)
1. Labor rates and labor costs are the same thing.
2. Labor costs can be reduced by lowering labor
rates.
3. Labor costs are a significant portion of total costs.
4. Low labor costs are a potent source of competitive
advantage.
5. The most effective way to work productively is
through individual incentive compensation.
6. People work primarily for money.
MBAO 6030 Human Resource
Management
Critical Thinking Questions
1. Sears Roebuck Auto Center paid its auto mechanics
a commission based on the volume of services sold
to each customer. This basis of pay resulted in law
suits filed against Sears by angry customers who
claimed they were over-charged for services they
did not need. Sears was forced to pay millions of
dollars of penalties to these customers which hurt
its reputation. Pfeffer believes that Sears’ mistake
was that it should have realized that individual pay
incentives are dysfunctional. Do you agree with
this conclusion?
MBAO 6030 Human Resource
Management
Critical Thinking Questions
2. Charles Schwab, the discount broker, does not
use commissions as pay incentives for its
brokers, bucking financial services industry pay
practices. Why do you think Schwab did this?
3. Do you think that the point of view of the author
(of the “6 Myths of Pay”) would work at a Wall
Street investment bank such as Morgan Stanley?
4. The author of the “6 Myths of Pay” article prefers
group-based pay for performance rather than
individual pay for performance plans. What is
the reason behind this? Do you agree?
MBAO 6030 Human Resource
Management