Changing Pay Practicesby Jodi Starkman
Faced with the need to survive in the global economy, U.S. companies have reconfigured their jobs, making them more broad-ranging, versatile, and autonomous. With those changes have come the need to reimagine how pay is delivered. In this issue of IRConcepts, we examine the changing compensation scene. We start by tracing how pay practices evolved, including a review of traditional approaches to compensation—still used by many companies, and still often making sense. We then turn to the events of the past two decades, looking more closely at the factors pushing for changes in compensation policies andpractices, and then at the new approaches themselves.
Whatever the type of society, people must be remunerated for their efforts. In ours, compensation usually takes the form of wages and salaries. Employers have tried to use wages and salaries—possibly their single largest operating expense—to influence employee behavior and attitudes toward helping achieve company goals. Indeed, for a growing number of organizations, influencing employee behavior has become the most crucial role of pay. And that has led to significant changes in the way people are rewarded for their work.
Why the changes in compensation systems? As we look for explanations, we find as the underlying one the economic malaise that overtook the United States in the 1970s. Economic growth slowed, inflation heated up to double-digit levels, the rate of productivity improvement plummeted, and companies faced intensifying competition, domestic and foreign. They encountered problems in marketing, product quality, and costs of production. American companies had to respond if they were going to survive.
The introduction of computer-based technology was a major feature of the drive to restore competitiveness. It provided the flexibility needed to respond quickly to market shifts that called for rapid changes in product lines. But the new technology upset traditional organizational structures, cutting across responsibilities of existing units, requiring greater interdepartmental cooperation, redrawing jurisdictional lines of authority, and creating flatter structures. It also profoundly affected the nature of jobs and the ways in which work is organized. With the scope of their jobs expanding, workers had to be more versatile, work in teams, and make their own decisions in the production process.
As companies began to introduce these work changes, they discovered that these new broadened jobs did not fit into existing compensation structures, many of which had minutely defined jobs with fixed wage rates. With decision making pushed downward, employee initiative and performance became crucial to successful operations, but existing compensation systems failed to encourage either. What was needed were policies and practices that emphasized flexibility rather than rigidity, both in the amount of pay and the ability of workers to shift from one job to another, and in a greater emphasis on pay for performance rather than seniority or job title. So in the early 1980s many employers began to seek ways of linking employees’ economic well-being with the company’s. The strategies they adopted took employee pay, which had been fixed, and divided it into base earnings plus a variable portion based on performance. And thus began the latest chapter in the long history of pay for labor, which has always undergone structural change when the nature and societal context of work have changed.
Evolution of Pay
With the advent of capitalist industrialism and the free labor market, under which the productive services of human beings were bought and sold in the same way as commodities, economists tried to explain why wages were what they were. At the outset of the Industrial Revolution in Britain, wages were extremely low and the lot of workers very harsh. British economists’ explanations for these conditions were far from optimistic—earning for economics the appellation “the dismal science.” The first generally accepted theory of wages was offered by David Ricardo in 1817, according to which “the natural price of labour is that price which is necessary to enable the labourers, one with another, to subsist and to perpetuate their race, without either increase or diminution.” By adding the Reverend Robert Malthus’s principle of population, that population tends to press upon the means of subsistence, Ricardo’s theory became an “iron law” of wages, leaving no room for improvement in the conditions of workers’ lives.
The real world, however, did not conform to the iron law. In fact, workers’ lives were getting better as real wages rose. So Ricardo’s theory was replaced, in the middle of the nineteenth century, by a new “wages fund” theory, which viewed wages as a function of capital: Out of each year’s production certain amounts must go for equipment, raw materials, and the entrepreneurs’ profits; what’s left goes to pay for labor. If more goes to labor, there is less to reinvest, and the decline in the rate of capital growth undermines the size of the wages fund. But critics disagreed with the notion that there was a fixed stock from which to make wage payments, and viewed production as a flow of goods and services, with workers being paid out of the current flow, which varied over time. They claimed there was no predetermined wages fund, and that an increase in the current flow of production could lead to higher wages.
Then there was the “surplus value” theory of wages espoused by Karl Marx, which was never accepted by any significant number of Western economists, liberal or conservative. Marx identified human effort as the source of all value, with other factors of production only representing the labor that is embodied in them. In the Marxian view, profit is simply “surplus value” expropriated from the workers. This theory was even more dismal than the subsistence theory, since it posited a deterioration of wages as the capitalists accumulated ever-greater surplus value from the workers. History proved Marx’s theory as wrong as the subsistence and wages-fund theories, for real wages have risen, and very dramatically, in the past century and a half.
The fault with all these theories is that they stressed the supply of labor but overlooked the role of demand in determining wages. So a new theory of wages, “marginal productivity,” was developed in the late nineteenth century as part of the generally accepted theory of pricing under competitive conditions. Accordingly, private businessmen hire workers only if they can thereby increase their own earnings. The proprietor of a retail store, for example, will hire an additional salesperson at a salary of $150 a day provided she can sell enough goods to increase the employer’s daily revenues by more than $150; he will continue to add salespeople as long as they increase his net earnings. In the language of economics, a firm will hire additional labor up to the point at which the added (marginal) cost of that labor is equal to the added money returns (marginal revenue) that its hire will generate. In a competitive market, in which the price of the product is given, a company’s demand for labor is determined by consumer demand for its product and the marginal physical product of labor.
The principle of marginal productivity not only tells us how many workers a firm will hire, but it also explains wage rates in the entire economy. In a competitive situation, labor will be allocated in the most efficient manner; if workers of a given quality are paid differently among industries, they will move from lower- to higher-paying industries until their marginal product is equal in all. The theory is also supposed to ensure that the market clears—that is, all demands for labor at the market price are filled, and all workers willing to work at the market wage are hired. In practice, this has not always been the case, for not all the requirements of a competitive situation have been present. Even so, the marginal productivity theory remains the best approximation of reality.
We still must explain why real wages (nominal wages plus price increases, which together determine purchasing power) have risen dramatically over time. The answer lies in our explanation of marginal productivity theory: Labor’s price and its marginal physical product determine its marginal revenue. If output per worker rises, wages go up, since a greater output with the same resource—in this case, labor—provides more units of output to be distributed. This was demonstrated in the late 1990s, when real wages, stagnant for many years, finally started to climb again as output per manhour rose more rapidly.
The successive theories of wages were attempts to understand—or develop—underlying rules for successive changes that were occurring in actual labor markets.
When the United States was founded, the vast majority of people both here and abroad were engaged in agriculture, and most farmers were small independent entrepreneurs. Even with the rise of industry, the Jeffersonian emphasis on an independent yeomanry heavily influenced U.S. workers’ attitudes, which were much more individualistic than those of workers abroad. The nation’s first free workers were journeymen craftsmen who, in effect, acted as independent contractors and were paid piece rates they negotiated with the master craftsmen, first individually and later by workers’ combinations (guilds and trade unions). Although there were conflicts between journeymen and masters, they were knit together in a common system and did not regard themselves as superiors and inferiors. As the factory system spread, however, distinctions between employer and employee grew, and working for wages seemed to contravene the concept of a nation of equals. Labor radical George E. McNeill proclaimed, “We declare an inevitable and irresistible conflict between the wage-system of labor and the republican system of government.”
“It is outrageous to work for wages”: As that line from an old labor protest song says, American workers did not like the pay system that came into being in the nineteenth century—indeed, they called it “wage slavery.” The first major labor federation, the Knights of Labor, which was powerful in the mid-1880s, called for replacing the wage system with producer cooperatives, eliminating the growing separation of labor from ownership of that labor’s product. This aversion to wage labor is not so strange when considered within the context of American history. Differences between American and European labor attitudes, particularly the rejection of socialism in the United States, can be traced to the absence of a feudal tradition and the concept in the United States of human equality (at least for whites).
But in time, American workers became reconciled to the wage system. The hardheaded American Federation of Labor, composed of unions of skilled craftsmen of a given type, replaced the reform-oriented Knights of Labor as the dominant labor organization. The AFL unions accepted the wage system, but using their power—the monopolization of a scarce resource, the skills of their members—they sought to control jobs and to regulate wages. The rapid economic expansion of the late nineteenth century required a huge increase in the industrial workforce, and a major portion, largely for unskilled jobs, came from new immigrants from southern and eastern Europe who had no familiarity with the Jeffersonian yeomanry tradition.
Traditional Approaches to Pay
Through much of the nineteenth century, most firms did not have to worry about their wage structures. Since companies were small and operated in competitive markets, the pay for each grade of labor was determined by the market, that is, the interaction between the demand and supply of labor. The shortage of labor that began in colonial times, when the population was sparse and land was available for farming, continued to the twentieth century, as economic growth outstripped the domestic supply of labor. So in the early years the small supply of free laborers received relatively high wages, probably double those paid similar workers in England. As a result, the labor conditions wrought by the Industrial Revolution, while far from idyllic, were never as harsh as in England. Contributing to continued scarcity of labor was the fact that the United States was expanding. As young people struck out West in search of fortune, the labor shortage persisted (despite growth in the U.S. population), and the farther west one went, the scarcer the labor supply and the higher the wages. The nation was thus always dependent on immigration to staff its mines and factories.
Even when giant corporations with large-scale operations came into being, the situation did not change very much—plants paid what was necessary to attract the workforce they needed. When they needed fewer workers during economic downturns, they cut wages. The influence of supply and demand is illustrated by events at the Ford Motor Company before World War I. In response to heavy labor turnover on his new assembly line, Henry Ford introduced the $5 day, a dramatic increase in pay that made workers want to keep their jobs (and provided them with the wherewithal to buy Ford cars). There was no internal logic; Ford paid all his production workers the same $5 a day regardless of their specific jobs, and since that pay scale was so high, the more skilled workers did not object.
The rise of large-scale corporations, however, meant that they no longer operated in perfectly competitive markets. That fact, along with imperfections in the labor market, meant that large firms had the power to exercise discretion with respect to whom to hire and what to pay. In order to attract and retain qualified and efficient personnel, employers realized in time that they had to establish wage policies. Wage and salary programs, the embodiments of those policies, control the total compensation dollars and their distribution. They were designed to ensure a “fair wage for a fair day’s work” and to keep labor costs within an established budget. Wage policy embraced both the internal (relationships among jobs) and external (the relationship to what other organizations were paying) wage structures.
Company wage administrators sought to ensure that their companies’ internal wage structures were rational—that jobs that were more important, required greater skill, and entailed greater effort were rewarded commensurately. From its founding in 1926, Industrial Relations Counselors, Inc., which played a major role in the development of management policy and procedures on compensation, promoted job evaluation as an instrument through which to rationalize company wage structures and promote internal equity. Its efforts gained momentum in the 1930s as IRC recognized that through job evaluation, management, no longer able to control wage levels, could maintain control of the wage structure under collective bargaining. Job evaluation eventually became widespread in the United States.
Job evaluation entails the establishment of a hierarchy of jobs according to such constituent factors as education, skill, experience, working conditions, responsibility, and effort. Job classification would involve analysis of work being performed, establishing major job classes or grades, and then assigning the various jobs to these grades. Unions did not greet job evaluation with enthusiasm, but they learned to live with it and sometimes cooperated in establishing job evaluation systems—as seen, for example, in the joint efforts of the United Steelworkers and the major steel producers following World War II.
Job evaluation has not been without its problems, which have included the changing mix of skill requirements for jobs resulting from new technology. More recently, job evaluation programs have been accused of unfairly rating jobs held by women below those of typical male jobs, which led to the call for “equal pay for work of equal value.” Obviously, jobs cannot be measured independently of the marketplace, but the agitation did lead to better job evaluation systems. Women, moreover, have been moving into all types of occupations, and the sharp distinctions between “male” and “female” jobs have been fading.
Competing in the Labor Market
Another important factor shaping an organization’s wage policy is the competition it faces in the labor market. Companies must relate their internal pay structure to the external one. Thus, the wage rates, salary scales, and personnel practices prevalent in the community must be considered, particularly for firms and industries that compete directly for similar types of labor. Competitors for labor may not just be in the same line of business, but may include organizations seemingly far afield. The hospitals in New York City, for example, compete not just with each other but with the hotel and restaurant industry for filling the bulk of their manual jobs—making beds, feeding people, and so forth. The extent of the labor market also may vary; for most production and clerical jobs it is local, for professional and managerial ones regional or national, and for esoteric occupations, e.g., symphony orchestra conductors, international.
Maintaining parity with other employers presumably permits an organization to attract and retain qualified personnel. The major source of information for the organization in determining how its wages and salaries compare with those of its competitors for labor are surveys of prevailing rates of pay, in a community for certain jobs or nationally for others. Some firms, seeking to attract the best-qualified workers available, follow the practice of not merely meeting prevailing wages in a community but surpassing them.
Since companies employ different types of labor, they may have many wage structures, traditionally one each for production workers, clerical employees, and professional and managerial employees. Having several independent but interrelated pay structures enables the company to take into account the varying requirements of different types of jobs in setting scales of values. It may also allow the company to keep pace with competitive labor market conditions and hire and retain strategic personnel (say, computer scientists), by raising their pay without creating an inflationary cycle of wage increases that are passed along to all employees.
Changes Upsetting Traditional Approaches to Pay
The economic problems that began in the 1970s upset these traditional compensation policies. American industry, long the world leader, was being challenged, with imports accounting for a larger share of domestic consumption (one third of U.S. auto sales). Factors ranging from inferior quality to poor marketing explain why domestic goods became less competitive, but prices too were involved. Contributing to the higher prices were American labor costs, higher than those elsewhere, partly because of rising wages but mostly because of low productivity growth.
Americans started looking to the suddenly successful Japan for practices to emulate, from just-in-time production to quality circles. Japanese firms also seemed to possess a pay advantage. Their pay was not much lower, but their compensation systems provided flexibility, with fixed pay that was modest but employees sharing in a company’s good fortune through group- or companywide bonuses. American companies, in contrast, had rigid pay scales, no matter how well or poorly they were doing. So first they sought to reduce overextended wage rates, which was largely achieved even in unionized situations through what became known as concessionary bargaining. Then they looked for a greater degree of flexibility in compensation.
The changes in compensation structures were linked to the computerized technology being embraced by American industry. The technology provided the flexibility to respond to market shifts—when consumers decide they want small widgets, a manufacturer of large widgets, using computerized technology, can rapidly switch production rather than suffer a drop-off in sales. Computerized technology favors decentralization of control, since highly automated plants require more integration and coordination at lower levels, pushing decision making downward. Information, formerly monopolized by managers, becomes available to plant-floor workers, enabling them to act on their own. Complex technology is subject to breakdown and system interruptions that are extremely costly, but workers who are given authority to act can make adjustments on the spot, so production is not halted.
That has changed the nature of work. Employees have to “do” less but “think” more. When planning and doing were separate endeavors, workers fulfilled management’s minimal expectations, doing their jobs and nothing more. But when given the opportunity to be self- or work-group directed, workers rise to the occasion. Finally realizing the importance of people to efficient operations, many companies provided workers with the authority to correct mistakes on their own, to order parts when necessary, and the like. Jobs were expanded, and employees were trained to be more versatile and afforded greater responsibility and control over their work.
But these broadened jobs ran up against the minute division of labor ushered in with mass production, which had a multiplicity of job classifications, each with a fixed wage rate. Workers had more responsibility and more to do, but existing pay practices could be a roadblock to the new ways of operating, as fixed pay scales provided no means of rewarding better performance.
New Approaches to Compensation
American business confronted a new environment as it struggled to operate more efficiently and turn out high-quality products. The global economy, with companies subject to rapid market and technological changes and unable to pass cost increases on to customers, led to changes in values, organizational structures, work cultures, and economic strategies. Companies had to move from a mechanistic to a more open organic structure.
The mechanistic structure, which had been compatible with a more stable situation, was characterized by highly specialized and separate jobs, coordination by a hierarchic supervisory authority, knowledge concentrated at the top, primarily vertical integration, and work behavior governed by supervisors’ instructions. When market conditions were stable, companies could provide steady employment and workers could expect to spend their careers with one organization. Companies sought to promote employee loyalty by promising security, and their compensation systems were designed to that end—workers moved up the ladder as long as they performed adequately. One problem with this system is that it meant that there were a lot of mediocre performers.
The organic structure is more adaptable to rapid change. It is characterized by greater decentralization, coordination by mutual adjustment, knowledge located anywhere regardless of authority, lateral flow of information, and communication in the form of information and advice. In a work environment in which the ability to conceptualize is more important than being able to do specific tasks, “knowledge” workers—for example, scientists and engineers who devise and apply new techniques—have become key organizational assets. These employees (particularly those in research and development) dislike bureaucracy. Looking for autonomy on the job and a sense of achievement, they have responded most positively to the more open structure. Lower-level employees also like the new setup.
But existing compensation policies and practices had been constructed to fit the mechanistic model. They had to change if companies were to control costs and foster improved performance. The IRC study Computerized Manufacturing and Human Resources (Lexington Books, 1988) found that an early step in getting away from the mechanistic model was to reduce the number of separate jobs so that workers could perform wider and more complex tasks. In general, consolidation improved management’s flexibility to make work assignments, and despite higher wage rates in cases of greater job responsibilities, total labor costs were cut.
Another early response to changed technology and work organization was the advent of skill-based pay—basing compensation on what employees can do rather than on the particular jobs to which they are currently assigned. Skill-based pay works very well with quality circles and work teams. IRC’s study of computerized manufacturing brought us to a plant that had replaced pay for the job the employee was performing with pay based on the number of skills the employee had mastered and thus the different jobs he or she could perform. Employees worked in autonomous teams, and on a given process a senior operator was in charge of both production and training members for additional duties. The teams determined (largely by written examination and by performance) whether a member was competent to perform an additional task.
Multiskill pay systems, useful in situations where team members rotate among jobs, have also spread. In one such program in a unionized plant, the workers in an operation were divided into autonomous teams. They were placed in one new higher grade, with no differences in job titles, duties, and pay. Everyone was trained to operate the system and to make repairs to keep it functioning. Teams decided who was responsible for what each day, from sweeping the floor to monitoring the system. Because everyone could perform the most important tasks, there was less downtime and none of the problems normally associated with absenteeism. Companies that cross-train employees often find that when there is a temporary spurt in production they can cope with it without adding personnel.
Basing pay on skill is a motivational approach designed to affect behavior by encouraging employees to grow in value to the organization. By acquiring new skills, they also enhance their sense of self-esteem and job security. But pay should be limited to skills that lead to improved organizational performance. With skills that are of value but rarely used by the individual on the job, it may be wise to pay extra only when the person performs the additional task, as has been the case with multiskilled craftsmen. The organization should also stop paying for skills that become obsolete, while still using the pay system to induce employees to learn new skills. This is paramount with respect to professional employees in fields in which new knowledge keeps pouring out—engineering and computer science are but two examples.
Implicit in the idea of a “learning” organization is that members continually become more competent. Competency-based pay, a variant of skill-based pay, adds such factors as knowledge, behavior, and personal attributes to the measures of rewardable criteria. This system is forward looking, concerned with employees’ long-term performance. The company is able to communicate to employees, at higher levels, what types of behavior are valued, e.g., customer relations, communications abilities, technical expertise, leadership, and “innovativeness.” In this system profiles that describe both technical and behavioral competencies are drawn up for major functions or work processes. The program is administered not centrally by the Human Resource department but by the line supervisors who are most familiar with their subordinates’ performance.
Competency-based pay seeks to deal with the problems arising from the elimination of career ladders and vertical movement that former hierarchical structures had afforded. With a flatter structure, many competent people compete for fewer higher-level openings, leaving most of them unhappy. This new pay system offers a means to compensate employees for horizontal growth. People are rewarded for demonstrating cross-functional abilities, making it easier and more attractive for an employee to change jobs or to join a temporary project team.
One of the problems with this system is the difficulty of defining and measuring competencies, particularly the personal skills and behaviors that underlie competent performance. There also is the question of the relationship between competence and successful task performance—the ability to do something does not always translate into actually doing it or doing it properly.
With the advent of flatter structures has come a movement toward broadbanding—creating a few job classifications and collapsing what had been the host of former ones into the few. Employees still get promoted and move up in the organization, but the focus shifts from rising in the hierarchy to being rewarded for the ability to contribute toward organizational goals by learning new skills. Broadbanding facilitates flexibility by being able to move workers around. A competency-based pay system can be adapted to the broader bands; in fact, it is often called competency-based broadbanding.
In place of numerous job categories, organizations may have one band each for production, clerical, technical, professional, and managerial employees. Others consider that too confining and have multiple bands. Broadbanding is typically used for salaried exempt employees, less often for the salaried nonexempt group, and even less for hourly workers, particularly if they are organized. (Though compressed job classifications have been negotiated in many organized operations, some unions fear that broadbanding will promote favoritism.)
Employees do move from one band to another, particularly into the management band, but most spend their careers within one band. Although movement is horizontal rather than vertical, employees can increase their pay within a band by learning new skills, assuming greater responsibilities, and achieving improved performance. Broadbands stretch over a long salary spread, so employees must recognize that many of them, no matter how well they perform, will never reach the top of the band.
Companies that use broadbanding still rely on market data for managing pay, generally choosing among three methods. The first, the cluster model, groups similar positions into clusters and then applies a cluster reference range, rewarding those who perform above average. The second establishes market value for as many jobs as possible and provides each with an individual reference range. The third places positions in a zone within the band, with a minimum and maximum for each. This system’s credibility and acceptance by employees depends on a number of judgment calls as to job comparabilities within and among ranges.
There is also a growing emphasis on variable pay, which meets the need for flexibility—higher when the company does well, but containing costs in less ebullient periods. Some companies have abandoned automatic annual pay hikes and moved from rigid pay formulas applied uniformly across the organization to those that respond to varying conditions, contingencies, and individual situations. While adhering to this concept in theory, other organizations have not been able to wean themselves from annual increases for all.
The major new compensation development has been incorporating some kind of variable pay formula into the existing pay structure. Dividing pay into a fixed base plus a variable portion gives an organization some flexibility. For example, instead of laying people off or cutting base pay when production and profits decline, the company can adjust the total cash it spends on labor. More importantly, variable pay is a means of motivating employees to perform better and of aligning their interests with those of the organization. (Money, of course, isn’t the only reward offered, but we concentrate here on monetary compensation.)
Under traditional pay systems, the focus was on the value of the job, with compensation rising as one progressed through a job classification. In practice, pay hikes were based on length of service, and every increase was built into pay ad infinitum; in effect, it became an annuity for tenure. Even compensation systems that added merit bonuses to base pay continued to reward people for past performance without ensuring that that performance would continue. Under the new approach, a portion of total cash compensation is truly variable—it is awarded on the basis of how people perform, and performance must be sustained each period.
It is, of course, easier to establish a variable pay system in a new operation. Base pay can be set to be moderately competitive and the savings in base pay used to offer employees the opportunity to earn above that level. Even in an existing operation, it may be possible over time to position oneself differently with respect to the competitive labor market, moving, say, from the 60th to the 50th percentile. Employees progress up to what had been the old midpoint of a range, but further progress is conditioned on increased responsibility and performance. And with a variable pay system the competitive labor market can be different for each component business unit, allowing the organization to hire people with skills in short supply without ratcheting up its entire salary structure. In fact, this is being done within business units, by having separate programs for people in such occupations as information technology, for which demand exceeds supply.
There are caveats to establishing a variable compensation system. The organization must guard against attempts to boost current performance results in order for managers to receive more money at the expense of holding down expenditures, such as for research and development, that are essential for future success. The desire to achieve results, moreover, may make people less willing to take risks lest they fail. Care is also needed in setting targets—they should not be so low as to virtually guarantee large payouts, nor so high as to be almost unattainable, which would discourage rather than motivate employee performance. In learning organizations, however, goals can be raised over time as employees become more proficient.
Suddenly shifting to a variable pay system is not easy. The organization must determine what it is trying to accomplish and how the compensation system can be aligned with its overall strategy. To this end, it must determine which jobs are most vital to its strategic goals and make them the focus of variable pay.
How Much Variable Pay? What amount of total pay should be variable? Base pay should be fair—that is, market based—and the variable portion should not instill in the employee feelings of economic insecurity. If it is to induce improved performance, however, it must be of some consequence—the opportunity to earn 2 percent extra is unlikely to elicit much of a response, but 10 percent will.
The degree of variable pay varies by job and/or pay level, for two reasons. First, the lower one’s compensation, the more of it goes for necessities and the less one can afford sharp fluctuations in pay. As pay rises, so does discretionary income, so employees can afford to trade off some guaranteed pay for the opportunity to earn more: While the variable portion may represent 10 percent of lower-level employees’ pay, it may be 25 percent for higher-level ones. The second reason is tied to the purpose of variable pay, which is to motivate better performance; the higher up in the organization the individual is, the more the improved performance will affect overall organizational achievement. Production workers can hold down costs and improve quality, which, while very important, make only modest contributions to overall performance, and so are rewarded accordingly. Higher-level employees can make decisions that have great effect—moving the company into new markets with possibilities of much greater returns—and they too are rewarded accordingly, with greater variable compensation.
These observations are even more cogent when applied to the most drastic type of variable pay, known as pay at risk, which transfers to employees a share of the organization’s financial risk. In this case, even a portion of base pay becomes contingent upon improved performance, with the employee suffering a reduction in earnings if predetermined standards are not met. Some employees are more risk-averse than others, and this too tends to be truer the lower one’s compensation, and so pay-at-risk plans are usually limited to those in the higher echelons. Even at these levels, if employees are to be motivated to excel, the payout has to be substantial; the generally agreed-upon ratio of reward to salary cut is at least two to one.
Forms of Variable Pay. Incentive systems that reward individual achievement have a long history and have involved employees at all levels, from piece rates for production workers to stock options for CEOs. With the advent of integrated rather than discrete production processes, individual incentive systems may no longer be applicable. Since employee effort is still important to efficiency and employees are working as parts of teams, variable pay is often provided on a group basis.
A team is a group of people working toward a common goal. It is often synonymous with the natural work group, but also covers project, functional, cross-functional, and customer service teams. A team may be short term, established to develop and/or implement a new product, or ongoing, as exemplified by a work group. Many teams are self-managed. Organizations moving toward teamwork and greater employee involvement provide special training in interpersonal as well as technical skills.
Among the group incentive plans through which shop-floor employees share the benefits of productivity gains is the Scanlon Plan, which involves union-management cooperation and workers sharing in the savings in labor costs based on their suggestions and efforts. A variant, the Rucker share-of-production plan, is based on the ratio of labor costs to value added. Under Improshare plans, workers receive bonuses when it takes less time to produce an item than the established standard. Unions tend to favor formula-based plans as objective and free of managerial discretion, and hence of possible favoritism.
There is no typical incentive plan for teams of managerial and professional/technical employees. A plan may be based on performance related to defined criteria, e.g., sales, customer services; to some overall criterion; and to achievement of predetermined organizational and team objectives. The “free rider” problem—some team members not pulling their weight—may be overcome by peer pressure. There are cases, however, in which people don’t want to judge each other, so peer pressure alone won’t ensure performance. Payout from a group incentive plan can be related to each member’s basic pay or distributed to all in an equal dollar amount. Recent studies indicate that teams operating with a portion of their rewards based on team results outperform those where only individual rewards are used.
Variable pay can also take the form of profit sharing, with all employees rewarded for overall company financial success. Profit sharing is a tried and true means of identifying the interests of employees with those of the company, but it fails to provide individuals with specific goals. Employee stock ownership plans (ESOPs) share gains through issuance of stocks and dividends to employees. Another approach is stock options, which were originally designed to give executives a stake in the company and enable them to see things from the shareholder’s viewpoint, but in recent years have been extended to more of the workforce. Stock options provide an opportunity to purchase company common stock at some point in the future but at the current market price. If the company does well in the period, as reflected in a rise in price of its stock, being able to buy the stock at below its then-current price rewards employees. Stock options were popular during the stock market boom of the 1990s, particularly in start-up companies, but have created problems and engendered resentment with the recent market decline.
Variable pay can be distributed in different ways, as a salary increase or in a lump sum. The period covered can be anything from a week, to a month, to semiannually or annually. Or the period might be the time that it takes to complete a particular project, which is more typical of professional employee teams. Whatever the time period, it should be close enough to the achievement that the payment is clearly recognized as a reward for it.
In Summary: New Ways to Pay for a New Kind of Workforce
American companies may have been slow to react to the stagnating economy of the 1970s, but when they did it was in very dynamic ways. Facing an environment of rapid change, intense competition, and great uncertainty, they tried to cope in all sorts of ways. They restructured, reengineered, downsized. But one overriding need dominated—companies recognized that they had to be more flexible. So they moved from highly mechanistic organizational structures to more open organic ones. This, in turn, demanded a shift from traditional rigid compensation systems to ones that recognize the role that employees can play in advancing company interests, which has brought to the fore expanded jobs and variable pay.
Not every company has switched to the new approaches to compensation and, even among those that have, not all their operations have been involved. In many cases that makes sense. In a situation in which a plant continues to turn out thousands of identical widgets, with the pace of production determined by the machinery and not the workers, the older compensation systems suffice.
But in most operations the nature of work organization has been revolutionized. Accordingly, the new organizations demand more flexible compensation systems that focus less on the job an employee holds and more on the employee’s ability to perform and to contribute to organizational goals. Adding a variable pay component to base pay has been the order of the day. Those companies that traditionally paid above-market rates continue to do so, but they have redistributed the overage. Those employees who perform only adequately receive the market rate, but those who perform better are rewarded, so that their pay surpasses the market rate by an even greater amount. In fact, some companies that paid above-market rates have raised the percentage over the average, because pay for performance has raised production accordingly.
Experience clearly shows that performance-related compensation has achieved desired results in many cases. To be successful, however, it must be based on the organization’s business strategy, for that determines what behaviors employees are expected to display. The criteria governing variable pay rewards must be clear to employees and accepted by them, and the means of achieving goals attainable and under their control.
A well-structured and -managed performance-related compensation program is a win-win situation: The organization functions more efficiently, while the employees enjoy more satisfying work, and possibly more satisfying earnings.