Supplemental Material for Chapter 12 by niusheng11


									CHAPTER 12

Chapter Summary
This chapter focuses on the design and administration of programs to reward individuals for their
contribution to organizational success. The design often amounts to combinations of ind ividual,
group, and organiza tional incentives. Rewards must also be designed for the particular organi-
zation and the needs and motives of its employees. Benchmarking (examining other
organizations’ practices) may be useful, but these practices must be implemented while
considering the unique needs of the organization. Since pay is a powerful motivator (although
certainly not the only one), pay systems’ design is critical to organization success. Process—that
is, communicating and administering the process fairly ensures that employees will perceive the
pay system as equitable.

Learning Objectives
After studying this chapter, the student should be able to:

  1.   Describe the fundamental pay programs for recognizing employees’ contributions to the
       organization’s success.
  2.   List the advantages and disadvantages of the pay programs.
  3.   List the major factors to consider in matching the pay strategy to the organization’s
  4.   Explain the importance of process issues such as communication in compensation
  5.   Describe how U.S. pay practices compare with those of other countries.

Extended Chapter Outline
Note: Key words appear in boldface and are listed in the “Chapter Vocabulary” section.

Opening Vignette: Pitfalls in Paying for Performance
Prudential Insurance had to cover charges from a class-action settlement to compensate aggrieved
customers. The settlement stems from a deceptive sales practice called churning, where
customers with long-standing life insurance policies that had built up cash values were persuaded
to take on new, larger policies with the assurance that the new policies would not cost any more.
Another company, Saturn has been dealing with a critical issue dealing with bonus plans, where
collective bargaining agreements with United Auto Workers (UAW) has resulted in a unique pay
structure compared to other GM plants. First, base pay is 12 percent less than UAW workers at
other GM plants receive. Second, a 12 percent at-risk component of pay structure depends on
training, quality, and team skills. If these skills are met, Saturn employees are paid the same as
GM employees. In 1997, Saturn announced bonuses of $2,000, which means Saturn employees
will earn $4,000 less than GM employees due to decreased demand for Saturns and a resulting
cutback in production. As a result, Saturn employees voted on the issue of either to keep the
UAW agreement or change to the more traditional contract covering all other UAW members at
GM. In March 1998, the workers voted 2 to 1 to keep their unique contract.

I.    Introduction—Typically, individuals working in an organization and having the same job
      do not receive the same rate of pay (unless there is a single-rate system, as in many
      unionized environments). Differences in performance (by an individual, group, or the
      organization), seniority, or skills determine the pay. In determining a pay program
      relative to individual reward, an employer must consider the cost, expected return on
      employee motivation, and whether the incentive plan fits with the overall human resource

II.   How Does Pay Influence Individual Employees? Besides the equity theory, described in
      the previous chapter, there are other theories that influence compensation’s effects.

      A. Reinforcement Theory—In Thorndike’s Law of Effect, a response followed by a
         reward is more likely to recur in the future. The importance of a person’s actual
         experience in receiving the reward is critical. If high performance is followed by a
         reward, high performance is likely to be repeated.

      B. Expectancy Theory—Compensation has an impact mostly on instrumentality, the
         perceived link between performance and pay.

      C. Agency Theory—This theory focuses on divergent interests and goals of the
         organization’s stakeholders and the ways that compensation can be used to align
         these interests and goals. Today, most stockholders are removed from the day-to-day
         operations of the organization. This separation has many advantages, but it also
         creates costs—the interests of the principals (owners) and their agents (managers)
         may not converge. Agency costs are as follows:

          1. Management may be spending money on perquisites (e.g., executive perks) or
             empire building (enhancing the image or power of the executive without adding
             value to the business).

          2. Managers are more averse to risk since they cannot diversify their holdings as
             shareholders can.

          3. Decision-making horizons may differ, since managers will likely emphasize
             short-term gains to ensure promotion and visibility, perhaps at the cost of long-
             term success.

          4. Agency costs may be minimized by the principal choosing a contracting scheme
             that helps align the interests of the agent with the interests of the principals.
             These approaches can be behavior oriented (e.g., merit pay) or outcome oriented
             (e.g., stock options, profit sharing, commissions). Outcome-oriented approaches
             link the rewards of the organization and individual. However, agents are often
             risk-aversive and may demand a compensating wage differential. Behavior-
             oriented contracts do not transfer risk and therefore do not require a
             compensating wage differential. Deciding what to use is based on the following:

             (a) Risk aversion among agents makes outcome-oriented contracts less likely.

             (b) Outcome Uncertainty—If risks are high for desired outcomes, such as
                 profits, agents will be less willing to have outcome-oriented contracts.

                    (c) Job Programmability—As jobs become less programmable (i.e., less routine)
                        outcome-oriented contracts are more likely.

                    (d) Measurable Job Outcomes—When outcomes are more measurable, outcome-
                        oriented contracts are more likely.

                    (e) Ability to Pay—Outcome-oriented contracts            contribute   to   higher
                        compensation costs because of the risk premium.

                    (f) Tradition—A tradition of using (or not using) a certain type of contract will
                        make it more likely (or less likely) that it will continue.

III.       How does pay influence Labor Force Composition? — It is hypothesized that different
           pay systems will have an effect on a work force (e.g., organizations that link pay and
           performance will have higher performers). Also, organizations that link pay to individual
           performance will have more individualistic employees, and organizations that rely on
           team rewards attract more team-oriented employees.

                                  A related reading from Dushkin’s
                               Annual Editions: Human Resources 99/00:

                        “Six Dangerous Myths About Pay” by Jeffery Pfeffer

                               Competing through Globalization:
                         Using Pay for Performance to Compete Globally

       Entering the global market requires that companies continually search for ways to be more
       competitive. One response in countries where pay for performance has not been traditional
       is to move in that direction. For example in Japan at Fujitsu Ltd., their workers are among
       the highest paid in the world; however, talented workers in the international arena are not
       rewarded salaries they deserve because employer often offer pay scales that reward talent
       in order to keep good employees. Many other companies in Japan are cutting back from
       seniority pay in order to increase the importance of performance as well as increasing the
       use of merit-based pay. Also, Japanese companies are realizing the threat of American and
       European rivals bidding for their services, loyalty among their present employees will not
       be enough so they are offering other pay systems to retain their employees. The same
       changes are occurring in the German market, where they are beginning to use performance-
       based pay, which will lower base pay but add stock options and other programs that link
       compensation to financial performance.

IV.   Programs—Table 12.1 in the text provides an overview of some programs and potential
      consequences. Programs differ by payment method, frequency of payout, ways of
      measuring performance, and choice of which employees are covered. Contingencies that
      may influence whether a pay program fits the situation are organization structure,
      management style, and type of work.

      A. Merit pay programs link performance-appraisal ratings to annual pay increases.
         The focus is on identifying individual differences in performance. The majority of
         information on performance is collected from the immediate supervisor. There is then
         a process of linking pay to performance results. Feedback tends to occur infrequently
         and the flow of feedback is unidirectional, from supervisor to subordinate.

                           A related reading from Dushkin’s
                        Annual Editions: Human Resources 99/00:

              “Emerging Model for Salary Management” by Howard Risher

         1. The size and frequency of pay increases are most often determined by
            performance rating (since better-performing employees should be rewarded more
            than low performers) and position in range (compa-ratio). Compa-ratio is used to
            control compensation costs and maintain the integrity of the pay structure. Table
            12.2 and TM 12.1 demonstrate an example of a merit increase grid using the
            performance rating and compa-ratio. Table 12.3 indicates how compa-ratio
            targets and performance ratings might be combined.

         2. A disproportionate number of high-performance ratings can inflate compensation
            costs as well as allow a high compa-ratio. Many organizations limit the
            percentage of employees who can be placed in top categories.

         3. Critics of merit pay include Deming, who argues that it is unfair to rate
            individual performance because “apparent differences between people arise
            almost entirely from the system that they work in, not the people themselves.”
            Examples are co-workers, the job, materials, customers, management, and
            supervision. These factors are the responsibility of management.

             a. Deming also argues that the focus on merit pay discourages teamwork.

                 Example: U.S. Healthcare, Inc., a health maintenance organization (HMO),
                 links doctors’ pay to patient satisfaction. The main concern with this program
                 is that doctors may work together less as colleagues and be more individually

             b. Deming suggests that the link between individual performance and pay
                should be eliminated. The consequence of this might be that high performers
                would leave the organization. An appropriate balance between group and
                individual incentives should be designed.

             c. Another criticism is the way performance is measured. If this is not done
                fairly and accurately, employees will perceive the whole process to be unfair.
                Some of the most important aspects of justice that employees assess are
                distributive (based on how much they receive) and procedural (what process
                was used to decide how much). Table 12.4 lists questions involved in
                procedural justice and pay decisions.

             d. A last criticism is that merit pay may not really exist. In the late 1980s and
                early 1990s, merit budgets were approximately 4 to 5 percent. The difference
                between a high performer’s pay increase (e.g., 6 percent) and a moderate
                performer’s (3 to 4 percent) might mean little dollar difference in the
                paycheck. In fact, many employees do not believe that there is any payoff to
                higher levels of performance (Figure 12.1 and TM 12.2). Communication
                should be used to indicate that small differences can equate to large
                differences over time.

               Competing through High-Performance Work Systems:
                Supporting Sears’ Turnaround with Compensation

Sears’ strategic vision is one of being a compelling place to shop, work , and invest. The
compensation system they use reinforces the vision by linking pay not only to financial
performance, but also to customer satisfaction and employee satisfaction. Sears’
employees are paid above the market and annual increases were largely unrealated to how
well the company performed, but based on the employees’ performance. To encourage
people, incentive programs were implemented like short-term, cash-based annual bonuses
and stock options, where 50 percent of bonuses depend on store performance and 50
percent depend on company performance. However, Sears has not offered stock options to
all of their employees because they feel that there is not sufficient line of sight for stock
options to create value by changing behavior among this group of employees.

     B. Individual incentives reward individual performance, but payments are not rolled
        into base pay, and performance is usually measured as physical output rather than by
        subjective ratings. Monetary incentives increased production by 30 percent in a study
        by Locke, et al. Individual incentives are, however, relatively rare because:

                     A related reading from Dushkin’s
                  Annual Editions: Human Resources 99/00:

         “Let the Evidence Speak: Financial Incentives are Effective”
                      by Nina Gupta and Jason D. Shaw

   1. Most jobs have no physical output measure.

   2. There are many potential administrative problems (e.g., setting and maintaining
      acceptable standards).

   3. Individual incentives may do such a good job of motivating employees that they
      do whatever they get paid for and nothing else.

   4. Individual incentives typically do not fit in with the team approach.

        Example: At Lantech, a small manufacturing company, the incentive pay system
        ignited “gang warfare” in which individuals and departments tried to make others
        look bad to make their own numbers look good. They finally abandoned
        individual and division performance pay, and relied instead on a profit-sharing
        plan in which all employees get bonuses based on salary. Source: “Incentive Pay
        Can Be Crippling” by P. Nulty, Fortune, November 13, 1995.

                     A related reading from Dushkin’s
                  Annual Editions: Human Resources 99/00:

                 “Compensating Teams” by Perry Pascarella

   5. They may be inconsistent with goals of acquiring multiple skills and proactive
      problem solving.

   6. Some incentive plans reward output at the expense of quality.

C. Profit Sharing and Ownership

   1.   Under profit sharing, payments are based on a measure of orga nization
        performance (profits), and payments do not become a part of base pay.

     a. Advantages are that profit sharing may encourage employees to think more
        like owners and take a broad view of what needs to be done, labor costs are
        reduced in difficult economic times, and organizations may not have to rely
        on layoffs. There is a downside risk in that there may be no profits in a given

     b. Whether profit sharing contributes to better organization performance is not
        yet clear. For example, profits at Ford were much higher over several years
        than profits at General Motors, although their plans were identical. It is likely
        that something else besides the profit sharing caused Ford’s profitability.

     c. The drawback is that workers may perceive their performance has little to do
        with profit but is more related to top management decisions over which they
        have little control. Therefore, most employees are unlikely to see a strong
        connection between what they do and what they earn under profit sharing
        (instrumentality perceptions are not likely to be reinforced). They may also
        be disturbed when plans do not pay out when no profit is made.

     d. Another motivational problem is that most plans are deferred (paid to
        employees in some future time period). Dupont eliminated a profit-sharing
        plan when employees in some divisions received less than those in
        comparable divisions and returned to a system of fixed base salaries with no
        variable (risk) component. An alternate solution is to have plans that contain
        upside, but not downside, risk (i.e., base salaries are not reduced when a plan
        is implemented). When profits are high, employees share, but when profits
        are low, they are not penalized. This, of course, eliminates the advantage of
        controlling labor costs in difficult economic times.

     e. In summary, profit sharing may be useful to enhance identification with
        broad organizational goals, but it may need a supplement of incentives that
        are individually oriented.

2.    Ownership also encourages employees to focus on the success of the
      organization as a whole, but, like profit sharing, may not result in motivation for
      high individual performance. Employees may not realize gain until they sell
      their stock, often when they are leaving. Reinforcement theory suggests, since
      rewards may not be directly experienced, that motivation would not be greatly

     a. One method to achieve employee ownership is through stock options, which
        give employees the opportunity to buy company stock at a fixed price. For
        example, if a share is offered to employees at $10 a share and a few years
        later the value is $30, an employee can “exercise his or her options” and sell
        the stock at a profit (if stock goes down, there is no financial gain). Stock
        options are typically reserved for executives, although more companies have
        offered options to all employees, such as Pepsi-Cola and Hewlett-Packard.
        Some studies suggest that higher organization performance occurs when
        executives are eligible for long-term incentives, although results are not clear
        relative to lower-level employees.

   3.    Employee stock ownership plans (ESOPs), under which employers provide
         employees with stock in the company, are the most common form of employee
         ownership. The number of employees in such plans increased from 4 million in
         1980 to over 10 million in 1999.

        a. On the negative side, ESOPs can carry significant risk for employees. ESOPs
           must, by law, invest at least 51 percent of their assets in the company’s stock.
           This results in less diversification and more risk, so if the company does not
           do well and pensions are funded by an ESOP, employees risk significant

        b. ESOPs can be attractive to organizations since they have tax and financing
           advantages and can serve as a takeover defense, assuming that employee
           owners are “friendly” to management.

        c. Some degree of participation is mandatory on certain decisions, but there
           appears to be a great deal of range in employee decision making between
           plans. Some studies suggest that more participation will lead to more
           perceived ownership in the company.

        d. Costs of ESOPs have received surprisingly little attention. If stock is
           distributed and the real value of the company remains the same, then the
           value of a share of stock is reduced.

D. Gainsharing programs offer a means for sharing productivity gains with employees.
   They differ from profit sharing in that instead of using an organization-level
   performance measure (profits), they measure group or plant performance. This is
   likely to be seen as more controllable by employees, and it is therefore more moti-
   vating. Also more motivating is that payouts are distributed more frequently and are
   not deferred. Studies indicate positive results on performance.

   1. Table 12.5 and TM 12.3 provide an example of one kind of gainsharing, the
      Scanlon plan. This plan provides a monetary bonus to employees (and to the
      organization) if the ratio of labor costs to the sales value of production is kept
      below a certain standard. The example indicates that the standard is $240,000 (20
      percent of $1.2 million). Because actual labor costs were $210,000, there is a
      savings of $30,000. The organization receives half and employees receive the
      other half.

   2. Gainsharing often includes more than monetary reward. There is a strong
      emphasis on employee participation in problem solving through meetings, teams,
      and suggestion plans to improve the production process.

   3. Conditions that should be in place for gainsharing to be effective include
      management commitment, the need to change or a process of continuous
      improvement, management’s acceptance and encouragement of employee input,
      high levels of cooperation and interaction, employment security, inf ormation
      sharing on productivity and costs, goal setting, commitment of all involved
      parties to change and improvement, agreement on a performance standard, and a
      calculation that is understandable and perceived as fair and closely related to
      managerial objectives.

             Example: Panhandle Eastern Corp.’s gainsharing plan calls for all employees to
             receive a bonus of 2 percent of their salary at year-end if the company earns at
             least $2 a share. If Panhandle earns $2.10 or more a share, the bonus climbs to 3
             percent. The company says the plan has turned employees into cost-cutting
             vigilantes. Source: “Gas Company’s Gain-Sharing Plan Turns Employees into
             Cost-Cutting Vigilantes” by E. Nelson, The Wall Street Journal, September 29,
             1995, p. B1.

         4. Group incentives and team awards typically pertain to a smaller work group than
            plantwide (which is used in gainsharing). While gainsharing measures physical
            output, group incentives tend to measure performance in terms of a broader array,
            such as cost savings, successful completion of product design, and meeting dead-
            lines. Drawbacks are that individual competition may be replaced by competition
            between teams. In addition, dimensions must be perceived as fair by employees
            and include all important factors, such as quality.

     E. Balanced Scorecard—Some companies design plans that combine various elements
        of the above programs that are appropriate to the situation. If only merit
        pay/individual incentives are used, there may be high motivation but too much
        individualistic competition and a lack of focus on organizational goals. If only profit
        sharing and gainsharing are used, on the other hand, there may be more cooperation
        and attention to organizational goals, but individual work motivation might be low.
        (See Table 12.7 in text and TM 12.4 for an example of a Balanced Scorecard
        incentive program).

         Example: Herman Miller is a furniture manufacturer that has been using a pay plan
         since 1950 that combines gainsharing and profit sharing. Quarterly bonuses are paid
         based on company profits, market share, and efficiency in using noncash assets.
         Quality is heavily emphasized and customer surveys are regularly used. Suggestions
         are rewarded through the quarterly bonus so that idea hoarding and individual
         competition will not occur. Monthly, videos are distributed that explain the
         calculation of the bonus and the rationale and that show executives discussing
         operational and marketing strategies.

V.   Managerial and Executive Pay—Because of their significant ability to influence
     organization performance, top managers and executives are a strategically important
     group whose compensation warrants special attention. The previous chapter focused on
     what the pay level is for this group, while this chapter focuses on how executive pay is
     determined. One concern appears to be that in some companies rewards for executives
     are high regardless of organizational performance.

                      A related reading from Dushkin’s
                   Annual Editions: Human Resources 99/00:

         “Challenging Behaviorist Dogma: Myths About Money and
                        Motivation” by Alfie Kohn

A. Executive pay can be linked to organizational performance (from agency theory) by
   making some portion of executive pay contingent on company profitability or stock
   performance. This means less emphasis on non-contingent pay (e.g., base salary) and
   more emphasis on outcome-oriented contracts, both short-term and long-term. In the
   Business Week survey, average base salary plus a short-term bonus of $2.2 million
   accounts for less than 28 percent of average total executive compensation of $7.8
   million. The remainder includes stock options and other long-term compensation.

B. Organizations vary a great deal in the extent to which they use both short-term and
   long-term incentive programs. Greater use among top-and middle-level managers
   was associated with higher levels of profitability (Table 12.8).

C. There has been increased attention to executive pay from regulators. The Securities
   and Exchange Commission (SEC) recently required companies to more clearly report
   executive compensation levels and the company’s performance relative to that of
   competitors over a five-year period. The Omnibus Budget Reconciliation Act of
   1993 eliminated the deductibility of executive pay that exceeds $1 million. Table
   12.9 shows how the balanced scorecard can be used to balance shareholder,
   customer, and employee satisfaction.

    Example: Because of economic problems, several of Japan’s leading corporations
    have announced pay cuts for their executive groups. For example, at Fujitsu, Ltd.,
    some executives’ compensation has declined by 35 percent. While some U.S.
    companies are doing the same, there are still significant differences in executive pay.
    For example, the highest paid Japanese executive, Hiroshi Yamauchi of Nintendo,
    received $6.3 million in 1991. Thomas F. Frist of Hospital Corp. of America
    received $127 million (with stock options). For 1991, Japanese CEOs averaged
    $872,646, which is about one-fourth of the average pay of U.S. CEOs. Japanese
    CEOs earn 32 times the pay of the average factory worker, while American CEOs
    earn 157 times the average factory worker (although bonuses for workers are not
    included and this can boost salaries by a third). Perks may be significant in Japan, but
    consultants say these fail to match the millions more that American CEOs are paid,
    and the perks may actually be fairly similar in the United States. The lower pay of the
    Japanese may be attributed to the perception that business results are a joint effort
    and rewards should be shared. On the other hand, American CEOs may carry 90
    percent of the responsibility for making decisions attached to the office. In Japan that
    is rarely the case, since so much of the burden is distributed among subordinates.
    (Adapted from: “Executive Pay: The Party Ain’t over Yet,” Business Week, April
    26, 1993, pp. 60-79.)

                    Competing by Meeting Stakeholders’ Needs:
             An Active Board Tries to Set Things Right at Columbia/HCA

  Hospitals receive monthly scorecards from headquarters telling them how they performed
  in admissions, earnings, supply costs, and several other financial categories. Missing from
  the score cards was the measure of quality patient care and included a section called “Case
  Mix Index,” which showed the severity of the procedures billed to Medicare and thus the
  dollar level of reimbursement received from Medicare. One suspicion when hospitals meet
  their Case Mix Index is that they have chosen to “up code” medical procedures to show
  additional medical problems to achieve their budgeted objective and thus obtain larger
  reimbursements from Medicare. Columbia/HCA’s founder realized that the firm’s
  reputation and shareholders’ financial interests were increasingly being put at serious risk
  as the government’s investigation grew and that action needed to be taken. The first step
  was to ban the use of compensation bonuses and give managers straight salaries until the
  company was restructured and ensure that top executives would not leave during the
  difficult times the company made a special grant of stock options to several top executives.

VI.   Process and Context Issues—These issues represent areas of significant company
      discretion and pose opportunities to compete effectively.

      A. Employee participation in decision making relative to design and implementation of
         pay policies has been linked to higher pay satisfaction and job satisfaction. Agency
         theory suggests that employees may set goals in their own favor; however,
         monitoring would be less costly and more effective since employees know their
         workplace best.

           Example: C&S Wholesale Groceries, Inc. empowered its employees to design an
           incentive plan. Employees from various departments have designed incentives for
           their particular departments. Teams design the plan and set their own standards with
           input from human resources and finance. About 75 percent of the 1,000 employees
           are covered by an incentive plan. Standards are perceived as flexible since business
           conditions and goals are always changing. Product damage has been reduced by 50
           percent, and the company’s productivity is twice the industry average.

      B. Communication is critical since any change will engender anxiety and rumors.
         Videotapes from officers are used frequently, as are brochures and focus group
         sessions where small groups of employees are interviewed about communication
         (and the programs).

      C. Pay and Process: Intertwined Effects—It is suggested that changing the way workers
         are treated may boost productivity more than the way they are paid; that is, using
         participation with a particular pay plan may increase nonpay rewards as well as
         productivity and profitability.

VII.       Organization Strategy and Compensation Strategy: A Question of Fit—One should
           consider how the pay strategy will enhance organizational strategy. Table 12.11 suggests
           some matches of strategies; for example, a prospector organization’s (see Chapter 2)
           emphasis on innovation, risk taking, and growth is linked to a pay strategy that shares
           risk with employees but also provides them with the opportunity for high future earnings
           by having them share in whatever success the organization has. Fixed compensation is
           low, but the use of bonuses and stock options can pay extremely well. Defender
           organizations will use a very different pay plan.

Chapter Vocabulary
These terms are defined in the “Extended Chapter Outline” section.

       Reinforcement Theory
       Expectancy Theory
       Agency Theory
       Merit Pay Programs
       Merit Increase Grid
       Individual Incentives
       Profit Sharing
       Stock Options
       Employee Stock Ownership Plans (ESOPs)
       Group Incentives

Discussion Questions
  1.     To compete more effectively, your organization is considering a profit-sharing plan to
         increase employee effort and to encourage employees to think like owners. What are the
         potential advantages and disadvantages of such a plan? Would the profit-sharing plan have
         the same impact on all types of employees? What alternative pay programs should be
         The advantages are that employees will be more inclined to think like owners and will
         probably broaden their view about job duties and what needs to be done. Labor costs will
         decline in poor economic times, and layoffs may not be necessary. Disadvantages are that
         employees may not believe that they have much power to control outcomes and will be
         disenchanted when there is no profit and therefore no profit sharing.

     The plan would not have the same impact on all employees. Of particular concern would
     be high performers with high-achievement motivation. They may find the plan frustrating,
     since they are not rewarded for individual effort.
     Alternatives might be programs such as stock options or ESOPs. The company might add
     some component of individual and/or group incentives such as gainsharing.
2.   Gainsharing plans have often been used in manufacturing settings, but can also be applied
     in service organizations. Discuss how performance standards could be developed for
     gainsharing plans in hospitals, banks, insurance companies, and so forth?
     Performance standards should be developed with the help and teamwork of managers and
     employees. These standards must be perceived as fair, reasonable, and equitable. Costs are
     possible to measure in some departments, but other departments may need to rely on
     measures that are oriented to process, including components of quantity, quality, and
     timeliness of service. In service organizations, customer satisfaction with service would be
     extremely important.
3.   The “Opening Vignette” to the chapter described incentive plans that had unintended
     consequences and were discontinued. Would you have eliminated the plans? Are there any
     modifications that could have been made to salvage the incentive plans?
     Modifications to the plans might have been more useful than elimination, since sales are
     important. In the vignette, it appears that sales was the only factor rewarded, and therefore
     employees did not pay attention to other factors. An incentive system should combine
     quantity, quality (perhaps measured by errors and/or return of cars that were not
     satisfactorily fixed), timeliness, and, of course, customer satisfaction.
4.   Your organization has two business units. One unit is a long-established manufacturer of a
     product that competes on price and has not been subject to many technological
     innovations. The other business unit is just being started. It has no products yet, but it is
     working on developing a new technology for testing the effects of drugs on people via
     simulation instead of through lengthy clinical trials. Would you recommend that the two
     business units have the same pay programs for recognizing individual contributions? Why
     or why not?
     No, the plan should not be the same, since the business and risk are very different.
     Incentives for the new organization might include stock options, since salaries and benefits
     may need to be low in start-up. In other words, employees, to be attracted to join, may be
     willing to take risk for the possibility of a large reward. There may also be a plan in place
     PTO reward individual research efforts that result in large profits, patents, and so on, by a
     share of the proceeds (this is labeled “intrapreneurship” ).
5.   Compare U.S. and Japanese approaches to recognizing individual contributions with the
     pay system. Would any of the Japanese practices be of help in U.S. organizations? What
     cautions should be raised when considering importing practices from other countries?
     A high percentage of pay in Japan consists of bonuses (26 percent of direct pay) compared
     to the United States (.5 percent). Employment security is very high, so if there are poor
     economic times, the work force is reduced from contingent labor, not permanent. There are
     certainly moves in the United States to use incentive systems more, but there seems a
     reluctance to increase promises of job security. The Japanese system appears balanced in
     terms of what workers give up (bonuses) and what they get (security). Any plan used in the
     United States would have to consider these balances and whether they will appeal to the
     American worker.

Web Exercise
Students are asked to visit American Compensation Association’s web site and read stock option
articles and identify potentia l problems with such reward option.


End-of-Chapter Case
At Northwest, An ESOP in Name Only
Northwest Airlines sold a third of it’s company to employees to overcome bankruptcy, which in
turn started a relationship between workers and managers. However, today labor relations at
Northwest Airlines are the worst in the industry due to strikes from pilots to mechanics to flight
attendants. Northwest’s experience shows what it takes for ESOPs to be successful which
include genuine employee input into corporate decisions. The reason the company’s ESOP did
not work is the stakes of many of its employees don’t vary with the stock price. The only
employees that were able to convert to common stock were the pilots because they earned the
bigger income. Also, the company and workers failed to change how the company was run. At
United, employees bought 55 percent of the company, compared to 33 percent of Northwest, and
the employees share in the stock and its progress, have a say in the operations of the business, and
can vote in company decisions. Northwest needs to change their relations with their employees.

  1.   Is money alone sufficient to make an ESOP effective?
       Money is not the one and only thing to make an ESOP effective because it takes changing
       the culture to offer more of a feeling that the employees are actually involved in the
       operations of the company. After all, their money is in the hands of the management so
       they like to see it succeed and be able to decide on issues that could affect the stock prices.
       This feeling of belonging is essential to make ESOPs work because all the employees will
       be more able to work together to reach the goals of the company.
  2.   How do the ESOPs at Northwest and United differ?
       At Northwest, the employees only hold a third of the company’s stocks, whereas at United
       employees hold 55 percent of stock. Also, at Northwest the employees don’t have a
       feeling of ability to have say in company decisions. At United, employees have a say in
       running the company, workers can vote on proposed items affecting the company, and the
       use of meditation resolves many issues. Northwest has more occurrences of strikes among
       its employees than United does.
  3.   Would you suggest any changes be made to the Northwest ESOP?
       Yes, Northwest should let their employees feel that they do have a say as to what happens
       in the company. True feeling of ownership comes from participation and involvement.
       They should be able to vote on major issues and be a part of operational decisions.

Additional Activities
Teaching Suggestions
Students will typically be quite interested in this chapter, since they tend to see significant
personal career implications. Beyond the discussion, research, and case suggestions below, an
instructor might use a problem solving approach by groups to discover what students would like
to learn about and design projects that evolve from such discussions.

  1.   Risk aversion was one factor discussed regarding agency theory. You might introduce a
       discussion with students about individual perceptions regarding risk taking. They are likely
       aware of the high failure rate of small businesses. What do they personally consider

      “acceptable risk”? What factors would their personal perception of acceptable risk depend
      on (e.g., spouse, children, etc.)? What type of employee do they believe a high-risk
      possibility for a high-profit situation would attract, and what are the motivational
 2.   One student project would be for students to benchmark human resource strategies through
      rewards. Student groups may each interview a manager responsible for compensation to
      describe nontraditional rewards (those different from merit plans or general increases).
      Groups could report back to the class the “benchmark” strategy they discovered, as well as
      any evidence that may be available on its success (this will likely provide an opportunity to
      discuss the difference between anecdotal and empirical evidence).
 3.   A resource is the Harvard Business School case on Merck and Co., Inc. (9-491-005 and
      teaching note 5-491-008) by K. J. Murphy. Merck and Co., Inc., a major pharmaceutical
      company, is in the process of reviewing and evaluating its personnel policies and practices.
      Employee interviews revealed that rewards for excellent performance were not adequate:
      outstanding performers received salary increases that were, in many cases, only marginally
      better than those given to average performers. In many cases, outstanding performance was
      not even clearly identified. The objective is to have students wrestle with a common
      malady of performance-appraisal systems: the tendency of managers to assign uniform
      ratings to employees regardless of performance. Alternative appraisal systems should be
      suggested and discussed.
      Another resource is the case of Merck and Co., Inc. B (9-491-006) by K. J. Murphy,
      teaching note (5-491-008) and supplement (9-491-007). In late 1986, Merck revised its
      performance review and pay practices. The most important change was a shift from an
      absolute rating system to a forced-distribution system in which managers were forced to
      adhere to a given distribution of performance ratings. Other major changes included
      revised rating categories, revised performance categories, and a shift in timing of
      performance evaluations. A discretionary award program was also introduced. The
      objective is to have students discuss the costs and benefits of the revised performance plan,
      paying particular attention to the relative performance-evaluation aspects of the new plan.
      Is it better than the plan it replaced? Is pay more closely related to performance under the
      new plan?

Discussion Questions
 1.   Should the performance appraisal and salary administration system have been revised?
      Why or why not?
 2.   Consider your student group to be the Employee Relations Review Committee. What
      changes in the performance appraisal and salary administration system would you
      recommend? How should changes be implemented? Carefully consider the consequences
      of your recommendations.
 3.   What did you learn about managing human resources from reading and analyzing this
 4.   Case: Direct Response Group Restructures. Direct Response Group (DRG) was a direct
      response insurance company with work structured for the mass market. DRG competed
      with insurance and financial services companies such as Prudential and Allstate. DRG
      offered a full line of life and health insurance and property and casualty insurance to
      individuals via mail, phone, television commercials, newspaper inserts, and other response
      methods. Between 85 percent and 150 percent of a product’s first-year premium was spent

     in marketing costs before a single policy was sold. DRG had identified and developed
     several target markets, including veterans, credit card holders, credit union members, and
     senior citizens. For the past several years, margins had declined due to underwriting risks
     and higher costs to acquire new customers. Sales were no longer enough to offset lapsed
     policies, let alone grow the business. As a result, DRG felt that they had to redefine how
     they approached their customers from both a sales and service perspective.
     Currently, customer interactions suffered from the curse of departmentalization. The
     business was handed off one stage at a time until someone got back to the customer. Since
     there was a lack of responsibility for any individual customer, interactions with customers
     were seldom used to find out more about the customer and to probe for unmet needs. DRG
     has started to implement a customer management team (CMT) concept. The CMT is
     viewed as the centerpiece of the customer-driven strategy—a component that would enable
     DRG to move from its product-driven, mass marketing strategy, to a customer-driven
     strategy of “caring, listening, satisfying, one by one.”
     The first CMT provides sales and service to a group of 40,000 customers from the
     veterans’ business in 16 states where DGR marketed life, health, and property and casualty
     products. The CMT sells customers new products, provides some services directly, such as
     policy changes, and acts as an interface and advocate while other departments provide
     services, such as claims and underwriting. CMT members were selected and trained
     specifically for this program. Employees are paid market wage rates. They can receive a
     bonus for “up selling” customers (getting them to take on additional coverage or purchase
     new products). The team consists of 10 managers who had worked in the telemarketing
     area and were licensed to sell insurance products. In addition to the 10 agents, the team
     includes one member from the marketing, operations, and systems areas. Teams are
     expected to be self-managing. They control goal setting, allocating work assignments, and
     You are overseeing the new CMT. You notice that employees tend to resist sharing
     information with one another that could be helpful in serving customers. Some employees
     are being too enthusiastic in trying to sell new products to customers who are not
     interested. From a compensation perspective, what do you think needs to be done to make
     the CMT work?
     Suggested Approach: Students should focus both on individual incentives and group
     incentives (for example, directed to the level of the self-managed team). Sales should be
     rewarded, of course, but there clearly must be a mechanism to trace and reward service to
     the customer.
5.   Case: Wells Fargo Employee Recognition Program. Wells Fargo Bank had a year of
     record-breaking profits in 1988. Throughout the company, bottom-line oriented managers
     and their staffs were steeped in the importance of “return to the shareholder.” A renewed
     focus on the customer was evident in ambitious new customer service standards. Extra
     effort and constant change became the norm. A decision was made to implement an all-
     employee reward program for the final quarter of 1988. The objectives of this program
     included the following:
        To recognize contributions made by employees as a group.
        To recognize individuals who had made exceptional contributions.
        To reinforce the qualities most valued in Wells Fargo employees.
        To have fun.

   To retain an awareness and an appreciation for the program over an extended period of
Wells Fargo developed a program with several elements phased in over about eight
months. The program involved three phases: all-employees cash awards, peer recognition
through cash bonuses, and corporate recognition of those receiving the most peer
recognition. The theme of the program, “In Good Company,” was chosen because it was
upbeat and positive and recognized the importance of the team effort as well as the effort
of individuals.
To recognize all employees as a group, the program design included a $550 pretax cash
award to be given to every salaried employee (16,000 employees) below the senior vice-
president level with at least one year of service. An award of $50 (pretax) was given to
3,000 hourly employees with a year of service. The cash awards were announced and given
to employees by managers in staff meetings. Managers had no prior knowledge of the
event. Each employee also received the first issue of the “In Good Company” newsletter
with the check. The newsletter explained the $500 and announced the peer recognition
phase of the program. Most of the newsletter focused on the qualities most valued in a
Wells Fargo employee. To answer employee questions about the awards, an “In Good
Company” hotline took calls throughout the duration of the program.
The peer recognition part of the program involved giving a coupon worth $35 to each
employee with a year of service. With the coupon were instructions for awarding $35 to a
co-worker. The rules provided were that an employee could not award the coupon to
themselves, no coupons could be given to employees who were senior vice-presidents or
above, and coupons could not be awarded to contract workers or temporaries. Any other
employee could be given a coupon, even those who did not have a year of service and had
not qualified for any other part of the program. On each coupon, employees were asked to
mark the valued quality that the awardee had demonstrated (e.g., “this coupon is a way of
saying thanks for inspiring me to excel”). Employees were given three weeks from the date
of distribution to return the coupons to payroll for payment. Coupons received after that
date were paid, but were not counted for the corporate recognition part of the program.
Coupon recipients were tracked by Social Security number to calculate the number of
coupons each received and to determine qualifications for corporate recognition.
Employees who received the most coupons were singled out for additional recognition.
Most of those who qualified were from the administrative/clerical ranks of the company.
Employees who received the most coupons qualified to select a gift from “101 Awards.”
The awards list was constructed to appeal to a wide variety of tastes, lifestyles, and
priorities. Examples of the awards included a week off with pay, payment of an
individual’s mortgage for a month, grooming for a pet for a year, and four movie tickets a
month for a year. The “101 Award” winners were recognized at a cocktail party and dinner
hosted by the CEO, president, vice-chairman, and group heads in each winner’s reporting
1. What are the strengths and weaknesses of the Wells Fargo recognition program? What
    improvements would you suggest?
2. What part of the program has the strongest link to employee motivation? Why?
3. Assume Wells Fargo has now experienced a year of losses. Cash is not available for
    the recognition program. How could the program be modified or changed to continue
    to meet the program objectives?

        (The example on ARPs may be very helpful for students in addressing this case).
        Source: Adapted from J. McNitt, “In Good Company: An Employee Recognition Plan
        with Staying Power,” Compensation and Benefits Management, Spring 1990, pp. 242-
6.   Students may debate the issue of executive compensation with the additional information
     provided. In addition, the following presents a position against executive compensation as
     it is now managed:
     The argument against the current system of executive compensation consists of two points.
     First, American CEOs are paid too much and their salaries bear no relation to the
     performance of their companies. Second, critics suggest that the irrational system of
     executive incentives saps the competitiveness of U.S. companies and is a major contributor
     to U.S. economic woes. The average pay of an American CEO is $2.4 million a year. Only
     a paltry 4 percent of the salary differential among executives can be explained by the
     performance of their companies. Graef Crystal, author of In Search of Excess: The
     Overcompensation of American Executives, says that CEOs get paid hugely in good years,
     then merely wonderfully in bad years. For example, Crystal points to option-repricing
     schemes in which the price at which an option can be exercised (“the strike price”) is
     lowered as the stock falls. These schemes reward managers even when the performance of
     the company slips (Frank Lorenzo of Texas Air received this type of option). In Crystal’s
     view, American CEO compensation is an insider’s game; everyone wins except the
     shareholders. CEOs tend to control their compensation by appointing friends to the board
     of directors, paying them handsomely, and having the favor returned when it is time to
     ratify a compensation plan. The Business Week article cited did note that there is now more
     resistance on boards to this sort of activity; however, this resistance appears minimal when
     one views the 1993 salary increases.
     1. What position do you hold about executive compensation? Why?

     2. Formulate a “pro” position for current executive compensation.

     3. What type of compensation plan should executives be provided that would motivate
         them to do the best possible job for the shareholders? Do you believe that this
         accountability is the only one that executives have?

         Source: Adapted from A. R. Brownstein, and M. J. Panner, “Who Should Set CEO
         Pay? The Press? Congress? Shareholders?” Harvard Business Review, May/June 1992,
         pp. 28-32+.

7.   Have students discuss the advantages and disadvantages of Employee Stock Ownership
     Plans (ESOPs). One good source for reference is “Avis Employees Find Stock Ownership
     Is Mixed Blessing” by J. Hirsch, The Wall Street Journal, May 2, 1995, p. B1.


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