Planning the compensation strategy

Planning the compensation strategy

Most senior managers wish, at least at times, that they could ignore compensation. No other organisational system is so weighed with values and emotions, so visible to employees or so much the subject of internal dissent. Nearly everyone has opinions—usually strong opinions—about rewards. Any change in compensation usually attracts loud complaints from employees who feel disadvantaged by the change.

The topic of rewards is rife with myths that are widely accepted but contradicted by extensive research. In view of these difficulties, can busy senior managers safely take the easy way out and leave compensation decisions to their compensation specialists? Or should they devote significant personal attention to compensation? Senior managers should be heavily involved in getting the strategic direction for compensation, and there are some fundamental choices senior managers need to make during this process.

Compensation systems demanded less senior management attention only a few years ago. At that time, senior managers generally left the design of employee compensation systems to technical specialists. This was possible partly because professionally managed compensation systems looked very much alike from one company to another.

For most firms, the goal of compensation design was simply to avoid a competitive disadvantage by keeping labour costs in line with those of competitors and the goal of compensation administration was to keep employee noise down.

The picture has changed greatly during the past decade, as companies throughout the economy have begun to rethink their compensation systems in search for competitive advantage.

Base pay, incentives, benefits and pay for corporate performance all have changed dramatically. Studies of Fortune 1000 firms (Lawler, Mohrman and Ledford) from 1986 to 1997 show large increases in the percentage these companies using a variety of compensation innovations.

For example, there has been a 50 percent increase in companies using pay for skills, knowledge and competencies. A 50 percent increase in companies using work group or team incentives and a 100 percent increase in firms using flexible benefit systems.

The strategic demands of new competitive forces, new organisational forms, and increase in knowledge work and recognition of the importance of compensation to organisational effectiveness have largely driven these changes. Top managers can no longer afford to leave compensation solely in the hands of compensation professionals.

There are some basic principles of compensation strategy senior managers need to understand. The alignment of compensation with business needs, the goals of the compensation system, reward system levers and basic choice managers need to make are among these principles. A foundation of knowledge will help senior managers use compensation as an important tool for managing the business.

Myths about rewards that never die #1: Money doesn’t motivate, it’s only a hygiene factor. Bad ideas about compensation never die, they just recirculate.

The idea that money doesn’t motivate employees has been around since decades. It received its most famous formulation in the work of Fredrick Herzburg. He claimed that intrinsic sources of motivation rising from the design of work are much more important than the extrinsic sources, such as pay, in determining the level of employee motivation. In Herzberg’s view extrinsic sources are “hygiene” factors that can have a negative effect but not a positive effect on motivation, while intrinsic sources are true motivators. However, while Herzberg is remembered for his emphasis on the importance of intrinsic motivation, contemporary motivation and scholars almost universally reject his claim that extrinsic rewards do not motivate.

A more recent view is expressed by Alfie Kohn, a polemicist whose highly biased and incomplete review of the reward literature might have remained obscure had it not been excerpted in the Harvard Business Review. Kohn argues that extrinsic rewards cannot work for several reasons. He argues that extrinsic rewards such as pay need not be provided continually to be effective, whereas intrinsic rewards such as work design are available to employees without continuous management action.

However, we are unimpressed with the discovery that you can’t pay employee for performance just once—you have to keep paying them.

Kohn rehashes Herzberg’s discredited arguments about motivators and hygiene factors.

Myths about rewards that die #2: A happy worker is a productive worker. One of the most enduring myths about rewards systems is “a happy worker is a productive worker.” That is, if we just make employees happier (or more modestly, if we just increase job satisfaction), productivity will follow as day follows night.

This myth dates back to at least to the dawn of the industrial revolution. It has great appeal for a number of reasons. It lets managers ignore pay system issues altogether. Why bother with costly, complicated pay systems if a friendly management style or an employee-centered culture or generous benefits can make workers both happier and more productive? In fact, management may hope that employees will work for less money if they are happier (while being more productive).

Employees also adopt this myth and use it to turn the tables on management, arguing that any improvement in pay or working conditions will reward management with higher productivity, ultimately making the added rewards “free”. This is like asking Santa Claus for presents. Seemingly no one has to pay for them.

Unfortunately, the popular belief that happiness leads to productivity is not supported by any evidence. Literally, hundreds of studies have examined the relationship between employee attitudes such as job satisfaction and productivity. (Of course, satisfaction is not the same thing as happiness, but the two obviously are closely related).

In every decade since the 1950s a major review of this ever-growing literature has reached the same conclusion: that is, the relationship between satisfaction and productivity is detectable, but too small to be of practical significance. Though the relationship exists, it may well be because more productive people tend to be rewarded for their higher performance, and this happiness may be the indirect result rather than the cause of productivity. Making people happier makes them stay in the organisation longer—that is, it reduces turnover—but it does not necessarily make them more productive.

Excerpt from ‘Strategy Power Plays’. Reproduced with permission © 2007, Tata McGraw-Hill Publishing Company Limited. Price: Rs 299. E-mail: