UGBA105: UGBA105: Organizational BehaviorOrganizational Behavior

Professor Jim LincolnProfessor Jim Lincoln

Week 11: Week 11:

Motivation II: Compensation & Appraisal Motivation II: Compensation & Appraisal

Walter A. Haas School of BusinessUniversity of California, Berkeley

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Compensation

Pay is the most standardized, measurable, and controllable rewardSends strong signal both inside and outside the organization

Like reorgs and layoffs, shifts in compensation policy are closely monitored by Wall Street and other external constituencies (Pfeffer)

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Theories of extrinsic motivation(What are the managerial implications?)

• Homo economicus (Taylor, Theory X, principal/agent) M=f(R)– People are rational but selfish, opportunistic, & risk- and effort-averse.

They need strong incentives & close monitoring

• Expectancy/path-goal (Vroom) M = E(Ri) = (pi)Ri

– People are rational and goal-directed. They map paths to the attainment of rewards. Extrinsic rewards motivate only when the perceived probability of attainment is high

• Learning theory (Skinner)– People are not rational or goal-directed. Random behavior that is

rewarded is reinforced. Behavior that is punished is extinguished

• Equity theory: M = f(Rs/Es - Ro/Eo) – People benchmark the value of their extrinsic rewards on those of others.

Perceived inequity may be motivating or demotivating

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Theories of intrinsic motivation(What are the managerial implications?)

• Theory Y (McGregor, Marx)– People find meaning & fulfillment through work (intrinsic rewards)

• Motivation/hygiene (Herzberg)– Extrinsic rewards reduce dissatisfaction; intrinsic rewards motivate

• Hierarchy of needs (Maslow)– People have needs that both intrinsic and extrinsic rewards fulfill. Intrinsic rewards motivate

only after a sufficient level of extrinsic reward is attained

• Cognitive dissonance (Festinger)– People as rationalizers: need consistency in cognitions & behavior

• Too much extrinsic reward makes work less intrinsically rewarding• Too little extrinsic reward makes work more intrinsically rewarding

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Let’s start with the basics:How should employees be

paid?

Economic theory says pay a person’s marginal product. – But that doesn’t work in practice. Why? – So employers instead:

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1. Pay for human capital (education, training, skill, experience)• Advantages?• Problems?

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1a. Seniority pay•Advantages•Problems?

2. Pay according to need •Common outside the U. S. •In-kind transfers in U. S.

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2. Pay for the job. Pay rates set by:– Job evaluation– Collective bargaining

Advantages?Problems?

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Assigning Hay points to jobs

Job rated on various dimensions:– Type & complexity of knowledge required– Number of employees supervised– Amount of capital overseen– Type & unpleasantness of working conditions

These measures are combined to form a one-dimensional scale of “value” to the firm

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3. Pay the market wage (do wage surveys)• Advantages?

• Problems?

4. Pay “efficiency” wages; i.e., above market• Advantages?

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Costco lowers labor costs by increasing labor rates

In addition to offering some of the best wages and benefits in the retail industry, Costco rewards employees with bonuses and other incentives.

It promotes from within, encourages workers to make suggestions and to air grievances and gives managers autonomy to experiment with their departments or stores to boost sales or shave expenses as they see fit.

    The result: People line up to work there, and once hired, they stay. Annual turnover for full- and part-time hourly workers on the job more than a year is 6 percent, compared with an industry average of 59 percent.

It’s the same story for executives. The 13member senior management team has stayed virtually unchanged since its birth in 1983.

    "What they’re doing is creating a competitive advantage through people," says Fred Martels, president of People Solution Strategies, a St. Louis retail industry consultancy. "It lowers costs and increases productivity."

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5. Pay for performance – Individual– Group

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5a. Pay for individual performance• On the increase

• Upsides?

• Downsides?

$$

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Objective metrics

– Examples: piece rates, commissions– Advantages? – Problems?

• Subjective metrics (for discussion section)– Trait rating– Forced ranking– Behaviorally-anchored rating scales (BARS)– Management by objectives (MBO)– 360 degree appraisals

Measuring Performance

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Should performance pay be in base or bonus?– Base pay advantages?– Base pay problems?– Bonus advantages?– Bonus problems?

Most incentive pay systems are a combination– Incentive pay above a target threshold

• Advantages?

• Problems?

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Lincoln Electric’s compensation system• Wages based solely on piecework • Starting pay lower than average and work harder than

average• Year-end bonus based on productivity

– Individual’s share of bonus pool determined by semiannual merit rating done by foremen

• Dependability, quality, output, ideas & cooperation– Could equal or exceed annual regular pay

• Alignment issues– Guaranteed employment for all workers

• Removed disincentive to increase efficiency

– Family culture (privately-held family-owned firm) – Employees guarantee own quality; not paid for defective work until

repaired on their own time

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‘s incentive compensation for sales clerks

* Guaranteed base wage $9.45/hour

* Target sales per week:– 40 hrs x $140 sales per hour = $5600

* Commission rate: 6.75% above target

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5b. Pay for group performance • Types

– Team competitions (quality, productivity, innovation)

– Gain-sharing (Scanlon plan)– Profit-sharing

• Organization design alignment issues

– ESOPs– Stock options

• Advantages? • Problems?

$$

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Nobel Prize economist Gary Becker on ESOPs

The advantages of employee ownership have been oversold, and its disadvantages have been overlooked. The number of employee-owned companies …grew from a handful in 1974 to 5,000 now because of tax advantages introduced during this period.

It is possible that ownership does indirectly motivate employees, but the direct incentive is weak: almost all the additional profit created when an employee works harder goes to fellow employees and other owners of stock.

Employee stock ownership increases workers’ exposure to risk from fluctuations in the fortunes of their companies.

ESOPs often become a management tool to fend off unfriendly takeovers and other efforts to oust current managers.

A General Accounting Office study found no evidence that profits and productivity increase after companies introduce ESOPs.  

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Employee stock ownership: a disaster at Lucent

1. Workers bought stock through the employee stock purchase plan, deducting up to 10 percent of their pay toward stock purchases at a 15 percent discount.

2. Workers could invest in Lucent shares through their 401(k) retirement plans, and some invested entirely in Lucent. Blue-collar workers received the company's voluntary 401(k) matching contribution in Lucent stock.

3. Many Lucent workers received incentives and pay in options and more options to buy stock, contracts now largely worthless. Almost every rank-and-file Lucent worker received stock options.

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Stock options for executives

• Corporate governance considerations– The Berle and Means “agency” problem

• How to align the incentives of executives with those of stockholders

• A cause of the Enron, etc., scandals?

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 Michael Eisner takes no bonus in 1999

Disney Chief Executive and Chairman Michael Eisner didn't receive a bonus in fiscal 1999… The entertainment and media giant's fiscal fourth-quarter earnings fell to $85 million, or four cents a share, from $296 million, or 14 cents a share a year earlier.

Eisner did receive his annual salary of $750,000 in 1999. In fiscal 1998, Mr. Eisner's bonus came to $5 million. His total compensation in 1998 came to $575.6 million thanks to $569.8 million in stock options he exercised. He received a bonus of $9.9 million in 1997.

In 1999, Mr. Eisner acquired 1.9 million shares of options that realized a value of $49.9 million when exercised, the filing said. As of Sept. 30, Mr. Eisner held 24 million in unexercised options valued at $68.4 million.

WSJ 1/5/2000 

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CEO annual compensation in 2005

William McGuire, UnitedHealth: $1 Billion

Lee Raymond, Exxon: $405 Million

Bob Nardelli, Home Depot: $250 Million

Hank McKinnell, Pfizer: $99 Million

Franklin Raines, Fannie Mae: $90 Million

Phil Purcell, Morgan Stanley: $66 Million

Fortune, July 10, 2006

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What exactly is motivating about $$$money$$$?

“Status is of great importance in all human relationships. The greatest incentive that money has, usually, is that it is a symbol of success... The resulting status is the real incentive. Money can be an incentive to the miser only.”

John F. Lincoln, CEO Lincoln Electric

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The cost of stock optionsMany of Silicon Valley's high-tech companies … have relied heavily on options to motivate their employees Santa Clara-based Yahoo is one example of how the true cost of stock options is eroding the bottom line of many of America's best-known companies.

…(E)arnings per share of Yahoo, Network Appliances, Mercury Interactive, Palm, and Autodesk Inc. were cut by at least half once the cost of options was included. For Yahoo, a profit of 10 cents per share profit turned into a loss of 50 cents per share, or a fall of 600 percent.

WSJ, 2000

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Executive compensation change in response to corporate scandals

The Sarbanes-Oxley Act, passed in 2002:

1. More timely disclosure of executive-pay deals 2. CEOs to return compensation based on financial results that were later restated. 3. Outlawed "backdating" of stock options.

By 2003, the average option grant fell nearly by half to $3.3 million. Average CEO compensation declined, to $8.7 million in 2003, from $12.8 million in 2000.

In 2004, accounting rules were changed to require stock-option grants to be treated as an expense.

Corporate boards began substituting restricted stock for options. Unlike options, restricted stock retains its value even if share prices

decline.

“Behind Soaring Executive Pay, Decades of Failed Restraints,” WSJ, October 12, 2006

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Do Americans care about income inequality?

Unlike the lucky crowd at the top of the income scale - hedge fund managers, media superstars, lawyers, strategy consultants, rock stars, sports heroes, and, yes, CEOs - a majority of Americans haven't been reaping the rewards of globalization.

Even as benefits shrivel, real median wages have stagnated since 2000, while real median family incomes have fallen four years running.

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• Managers should not rely entirely on pay systems for motivation but should design intrinsic rewards into jobs and control systems

• Every method of pay has its drawbacks. A combination of individual and group systems is ideal• Don’t overdo it on individual incentives. Group

incentives have many advantages!

• Alignment is critical! Make sure that the pay system is congruent with the people, the tasks, the technology, the structure, and the culture!

Takeaways on pay

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Performance appraisal

• “The experience of performance appraisal systems of all kinds over at least a century of trying in government and business has been uniformly bad.” (Wall Street Journal, Nov. 19, 1996)

• A 1996 Institute of Management Accountants survey found only 15% of respondents’ measurement systems were effective at supporting top management’s business objectives; 43% of respondents felt their systems did a poor job in this regard.

Why should this be the case?

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What should performance appraisal do?

• Communicate strategy, values, expectations• Build the culture • Evaluation

– Current job (e.g., salary and bonus)– Future jobs (e.g., promotion, training)

• Development and feedback• Legal defense

– Hiring, promotion, retention decisions– Validation (e.g., of selection criteria)

• Equity and fairness

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Problems in performance rating

• Halo effect• Stereotypes• Overweight negative information• Lack of sufficient observation• Memory: primacy/recency• Leniency• Central tendency• Justification for salary• Reticence to write things down

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Evaluating rating formats

Trait Forced BARS MBO 360 Rating Ranking Degree

1. Acceptability, poor poor good good very feedback good

2. Appropriate fair good good good good for Rewards

3. Accuracy, poor fair good good very Validity good

Rating Format

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Salary premiums associated with performance ratings and frequency distribution of performance ratings for 2,841 managers in a large manufacturing firm

Performance rating

Salary premium relative to lowest performance rating

Percent of sample receiving performance rating

Unacceptable 0 0

Minimum acceptance

0 0

Satisfactory 0 1.2

Good 1.8 36.6

Superior 3.6 58.4

Excellent 6.2 3.8

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Example of Behaviorally Anchored Rating ScaleSelects nursing activities and delegates

responsibilities to make the most efficient use of time and personnel available 

  Customarily makes and carries out a

satisfactory work plan to handle daily assignments 

  Approaches daily work assignments without

foresight or systematic planning     

10 Checks orders for medication to be given during the day and attempts to maintain a daily schedule for distributing medication

  When short of linen, rearranges work assignments to

accommodate bedridden patients first

6 If aides had completed their normal work assignments during night shift, would have them help clean equipment during remaining time on shift

  Makes a routine check for paper supplies available on unit

3 Spends most time charting and very little time with patients and aides

  Frequently leaves important work undone so that he or she

can leave on time 0

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360 Degree Feedback

Me

Skip-levelReports

SelfAppraisal

Boss

InternalCustomers

ExternalCustomers

Peers

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Marketing/Professional Skills problem solving, initiative, communication, versatility

Management and Leadership People management, development, coaching, fairness

Commercial Orientation Client relationships, revenue contribution, deal execution

Teamwork/One Firm Contribution Cross-division projects, business team activity, recruitment

Morgan Stanley 360° Criteria

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Benefits of 360 Degree Appraisal

• Validity and accuracy• Better acceptance by people rated• Promotes equity• Legal protection• Diversity• Useful when spans of control are large• Better for knowledge workers• More appropriate for team-based system• Appropriate for empowered cultures

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• Make sure that the process is related to job performance and meets legal requirements

– Standards communicated to employees– Evaluations based on specific dimensions– Dimensions defined in behavioral terms

• Supported by objective, observable evidence– Raters should be trained and validated– When possible, multiple raters are used– Appraisal fits the cycle of work– Documentation of extreme ratings is done– Formal appeal process is available

Takeaways on appraisal