HR 202 Chapter 07

1. Compensation
Chapter 07
Defining Competitiveness
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Compensation Strategy: External Competitiveness
External competitiveness is expressed in practice by:
• Setting a pay level that is above, below, or equal to competitors.
• Determining the pay mix relative to those of competitors.
External competitiveness refers to the pay relationships among
organizations – pay relative to competitors.
Pay level is the average of the array of rates an employer pays.
Pay mix is the various types of payments, or pay forms, that
make up total compensation.
Pay level and pay mix focus on two objectives.
• Control costs and increase revenues.
• Attract and retain employees.

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Pay-Level and Pay-Mix Objectives
Control Costs and Increase Revenues.
Labor Costs = (pay level) X (number of employees).
• The higher the pay level relative to competitors, the greater the
relative costs to provide similar products or services.
Attract and Retain the Right Employees.
• Companies often set different pay-level policies for different job
families.
• How a company compares to the market depends on what
competitors is compares to and what pay forms are included.
• Comparison of base wage may show one factor but a look at total
compensation may show a different pattern.
• There is no single “going mix” of pay forms.

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Exhibit 7.4:
Two Companies –
Same Total
Compensation,
Different Mixes

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What Shapes External Competitiveness?
Competition in the labor market for people with various skills.
Competition in the product and service markets, which affects
the financial condition of the organization.
Characteristics unique to each organization.
• Such as business strategy, technology, and the productivity and
experience of its work force.
These factors act in concert to influence pay-level and pay-mix
decisions.

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How Labor Markets Work
There are two basic types of markets.
• Quoted price – Amazon is a quoted price market, price is known.
• Bourse – eBay is an example of a bourse market, allows haggling.
Theories of labor markets begin with four basic assumptions.
• Employers always seek to maximize profits.
• People are homogeneous and interchangeable.
• Pay rates reflect all costs associated with employment.
• Competitive markets give no advantage in paying non-market rate.
Labor markets work with supply and demand of labor.
• Demand focuses on the actions of employers.
• Supply looks at potential employees.
• The market rate is where labor demand and labor supply cross.

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Exhibit 7.6: Supply and Demand for Business
School Graduates in the Short Run

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Labor Demand
If $40,000 is the market rate for business graduates, how many
graduates will a specific employer hire?
• The answer requires an analysis of labor demand.
In the short term, an employer cannot change any factor of
production except by changing the level of human resources.
A single employer’s demand for labor coincides with the
marginal product of labor.
• Which is the additional output associated with the employment of one
additional person, with other production factors held constant.
The marginal revenue of labor is the additional revenue
generated from employing one additional person.
• With other production factors held constant.

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Marginal Product and Marginal Revenue
Diminishing marginal productivity results when each new worker
has a progressively smaller share of production factors available.
• Until fixed production factors change, each new hire produces less than
the previous hire.
• The amount each hire produces is the marginal product.
Marginal revenue is the money generated by sale of the marginal
product, the additional output from one additional person.
• Employers will hire until marginal revenue equals the cost associated
with employing that person.
• The level of demand that maximizes profits is that level where marginal
revenue is equal to the wage rate for that hire.

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Exhibit 7.7: Supply and Demand at the Market
and Individual Employer Level
Jump to long image description.

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Labor Supply
The behavior model assumes potential employees:
• Are seeking jobs.
• Possess accurate information about all job openings.
• Have no barriers to mobility.
Just as with labor demand, these assumptions simplify reality.
• As the assumptions change, so does the supply.
• The upward sloping supply assumes that as pay increases, more
people are willing to take a job.
• If unemployment is low, higher pay many not increase supply.
• Competitors may match offers of higher pay, keeping supply stable.

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Modifications to the Demand Side
Compensating Differentials.
• Employers offer higher wages if a job has negative characteristics.
Efficiency Wage.
• This theory holds that high wages increase efficiency and lower labor
costs if they attract high-quality applicants, lower turnover, increase
worker effort, reduce shirking, and reduce the need for supervision.
• Utility theory can help compare costs and benefits of pay level policies.
• An organization’s ability to pay is related to the efficiency wage model.
• Rent is a return on activities in excess of the minimum.

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Sorting and Signaling
Additional modifications to the demand side.
• Sorting is the effect pay strategy has on who is attracted and who is
retained in a job.
• Signaling holds that employers design pay levels and mix to a signal of
kinds of behaviors they seek.
Signaling works on the supply side of the model as suppliers of
labor signal to potential employers.
• Those better trained, better educated, and with more experience
signal they are likely to be better performers.
• Both characteristics of the applicant and organization decisions about
pay level act as signals of communication.

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Modifications to the Supply Side
Reservation Wage.
• Economists believe job seekers have a wage level below which they will
not accept a job, no matter how attractive the other attributes.
• Some believe job seekers take the first job offer whose pay meets their
reservation wage.
• May be above or below market wage.
Human Capital.
• The theory holds that higher earnings flow to those who improve their
potential productivity by investing in themselves.
• It assumes people are paid at the value of their marginal product.
Other factors include geographic barriers, union requirements,
lack of information, the risk involved and the unemployment rate.

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Product Market Factors and Ability to Pay
The two key product market factors that affect the ability of an
organization to change what it charges for its products are:
• Product demand.
• The product market caps the pay level an employer can set.
• Degree of competition.
• Employers in competitive markets are less able to raise prices.
Other factors include the productivity of labor, the technology
employed, and the level of production relative to plant capacity.

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Ability to Pay
Managers show how economic factors translate to pay decisions.
• Unemployment rate makes little difference.
• Profitability is a factor for higher management to set the pay budget.
• Poor management results in turnover, not inadequate compensation.
Recently, unemployment is high and companies make pay cuts.
• They may also reduce 401k contributions.
• Or impose pay freezes.

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Segmented Supplies of Labor and Going Rates
People Flow to the Work.
• A hospital staffs and pays its nursing positions with different methods
and associated costs.
• Segmented supply results in nurses working the same jobs on the
same shift, but earning different pay and/or benefits.
Work Flows to the People.
• Some companies can staff a project with employees who are on-site,
off-site, or off-shore – mixing and matching its people with sources.
Points to remember.
• Reality is complex and theories abstract.
• Segmented labor requires understanding various markets conditions.
• Managers must know the jobs so they can bundle them out.

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Organization Factors
Industry and Technology.
• The industry influences the technology used.
• Labor-intensive industries pay lower than technology-intensive.
• New technology within an industry influences pay levels.
Employer Size.
• Large organizations tend to pay more than small ones.
People’s Preferences.
• Better understanding employee preferences of pay forms is important
in determining external competitiveness.
Organization Strategy.
• A variety of pay-level and pay-mix strategies exist.
• Higher pay satisfaction is an observable benefit of higher wages.

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Relevant Markets
Defining the relevant markets is a big part of figuring out how
and how much to pay.
Each organization operates in many labor markets, each with
unique demand and supply.
Managers must define the markets relevant for pay purposes
and establish appropriate competitive positions in the markets.
Three factors usually used to determine relevant labor markets:
• Occupation – skill or knowledge required.
• Geography – willingness to relocate, commute, or become a virtual
employee.
• Competitors – other employers in the same product or service and
labor markets.

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Defining the Relevant Market
Two studies focus on how employers choose relevant markets.
• Managers look at both competitors and the jobs.
• Depending on its location and size, a company may be a relevant
comparison even if it is not a product market competitor.
Data from product market competitors likely receive more
weight when:
• Employee skills are specific to the product market.
• Labor costs are a large share of total costs.
• Product demand is responsive to price changes.
• The supply of labor is not responsive to changes in pay.

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Globalization of Relevant Labor Markets
Work flowing to lower wage locations or across national border
is not new.
Job characteristics than can increase susceptibility to offshoring.
• Easily routinized.
• Inputs or outputs easily transmitted electronically.
• Little need for interaction with other workers.
• Little need for local knowledge.
Savings from offshoring may be difficult to ignore.
• Offshoring in now happening to lawyers and financial services jobs.
Other factors to consider are lower average productivity, risks to
intellectual property, customers’ reactions, and sustainability of
the cost advantage.

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Competitive Pay Policy Alternatives
There are three pay-level policies.
• To lead.
• To meet or match.
• To follow competition, or lag.
Newer policies emphasize flexibility.
What difference does the pay-level policy make?
• Competitiveness of pay may affect the organization’s ability to achieve
its compensation objectives, and in turn, affecting performance.
Pay-level research focuses on base pay and ignores bonuses,
incentives, options, employment security, benefits, or other
forms of pay.

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Pay With Competition (Match)
The most common policy is to match rates paid by competitors.
A pay-with-competition policy tries to equal wage costs to those
of its competitors.
• Its ability to attract applicants will be approximately equal to its labor
market competitors.
Classical economic models predict that employers meet
competitive wages.
• While it avoids placing the employer at a disadvantage in pricing
products, it may not provide a competitive advantage in its labor
markets.

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Lead Pay-Level Policy
A lead pay-level policy maximizes the ability to attract and retain
quality employees and minimizes employee pay dissatisfaction.
An entire industry can pass high pay rates on to consumers is pay
is a relatively low proportion of total operating expenses.
Research links high wages to ease of attraction, reduced vacancy
rates and training time, and better-quality employees.
There is no simple relationship between pay-level and financial
performance.
A lead policy can have negative effects.
• It may force the employer to increase wages of current employees too.
• It may mask negative job attributes that contribute to high turnover.

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Lag Pay-Level Policy
Paying below market rates may hinder a firm’s ability to attract
potential employees.
If a lag pay-level policy is coupled with the promise of higher
future returns, this may increase employee commitment and
foster teamwork, increasing productivity.
• How long this promise works, is unknown and unmet expectations can
have negative effects.
It is possible to lag on pay-level but lead on other work returns.

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Different Policies for Different Employee Groups
Many employers go beyond a single choice and may:
• Vary the policy for different occupational families.
• Vary the policy for different forms of pay.
• Adopt different policies for different business units facing different
competitive conditions.

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Exhibit 7.16: Pay-Mix Policy Alternatives
Jump to long image description.

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Pay-Mix Strategies
Some obvious alternatives include performance driven, market
match, work/life balance, and security.
• Incentives and stock ownership make up a greater percentage of total
compensation in performance driven policies.
• The market match simply mimics the pay mix of competitors.
Emerging alternatives focus on total returns from work and
offering people choices among these returns.
Pay-mix alternatives exist among companies in other countries.
• Apache Footwear in China builds a community so people stay.
• Top Form Undergarment Wear, located in the same region, pay each
worker more and let them decide what is best.

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Employer of Choice / Shared Choice
Some companies compete based on overall reputation.
Employer of choice corresponds to the brand or image a
company projects as an employer.
Shared choice begins with the lead, meet, or lag alternatives.
• It adds a second part, to offer employees choices in the pay mix.
• The “employee-as-customer” is not new in the U.S.
• Does offering people choices matter?
• One risk is employees make the “wrong” choice.
• Offering too many choices may lead to confusion, mistakes, and
dissatisfaction.

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Pitfalls of Pies
Thinking about the mix of pay forms as pieces in a pie chart has
limitations.
• These are particularly clear when the value of stock is volatile.
• The mix can change without the company changing its pay strategy.
• Possible volatility in the value of different pay forms needs anticipated.
Some companies prefer to report the mix using a “dashboard.”
• Changes the focus to comparing each form by itself to the market.
The mix employees receive differs at different levels in the
internal job structure.
While percentages vary, greater emphasis on performance at
higher levels is common practice among organizations.

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Exhibit 7.17: Volatility of Stock Value Changes
Total Pay Mix

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Exhibit 7.18: Dashboard – Total Pay Mix
Breakdown vs. Competitors*

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Consequences of Pay-Level and –Mix Decisions
Efficiency.
• No research suggests when managers should choose which pay-mix.
• Beyond opinions, there is minimal evidence of the consequences of
different policy alternatives.
Fairness.
• Satisfaction with pay is directly related to pay-level, more is better.
Compliance.
• In addition to pay-level, various pay forms are regulated such as
pension and health care plans.

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Appendix 7-A: Utility Analysis
Utility is the dollar value created by increasing revenues and/or
decreasing costs by changing one or more HR practices.
Compensation decisions can be analyzed by modeling the cost
and value created by different pay-level and pay-mix strategies.
To estimate utility in a basic approach, model it as a function of
several parameters.

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Basic Utility Analysis Formula
u is the utility (revenue – cost) per hire per year.
r is the validity coefficient, the correlation between criterion, y,
and one or more pre-employment assessments.
SDy is the standard deviation of the dollar value of different
employee performance levels.
Z is the mean standard score of those hired.
C is the cost per applicant.
SR is the selection ration, which is hires/applicants.
C/SRZSDyru 

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Utility Analysis Example
When filling a position with a salary of $100,000 under our new
selective hiring approach (versus $90,000 under the old system).
• If we increase Z from .80 to 2.06 through selective hiring and assume
the average cost per applicant is $200, this is the comparison.
Old Selection Strategy.
• SR = .50 (Z = .80), r = .40, SD = $40,000, cost = $200.
New Selection Strategy.
• SR = .05 (Z = 2.06), r = .40, SD = $40,000, cost = $200.
re$12,400/hi$200/.50.80x$40,000x.40u 
re$28,950/hi$200/.05-2.06x$40,000x.40u 

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End of Chapter 07.