Strategic Remuneration - Using remuneration to enhance business performance

Strategic Remuneration

1.      Introduction:

Numerous influences, both good and bad, have led to dynamic developments within the remuneration discipline, as well as other aspects of conducting business.

A number of philosophies and strategies have been applied in businesses in order to become a "world player", or perhaps even in some cases, just to ensure the survival of the business.

Historically these have included downsizing, flattening and re-organising, but the most recent, and also perhaps the most successful, has been "re-engineering", which many large organisations have implemented with some success.

I say "some success" not because re-engineering has failed, but because it has been determined that re-engineering that does not reduce costs and increase performance, productivity and output, adds no value to the organisation or its employees.

Attaining acceptable levels of productivity has long been a problem, and in recent times, the focus has been on methods to encourage performance and productivity by means of compensation.

Previously this thinking was taboo. "Why pay an employee more for something they are paid to do anyway?” It is necessary to revisit this stance, as performance based compensation offers many benefits for both the employee and the organisation, and has been applied successfully in many organisations.

It is true that due to the current economic conditions, in most cases employees are having difficulty in making ends meet and providing the basic essential needs of their households.

The compensation methods utilised by most employers have not enabled employees to attach value to the effort required from them, or to identify their ability to influence the reward that they receive for their effort, and therefore a situation exists whereby employees perform at the absolute minimum required from them to hold their jobs. Obviously, this results in mediocre performance.

The employer in turn experiences unacceptably high production costs due to the poor productivity, and therefore, in order to remain competitive, is unable to increase rewards for the work performed.

A vicious cycle therefore exists where employees do as little as possible, and employers pay a little as possible, to get the job done.

In order to set a framework against which current remuneration strategy effectiveness can be measured, it is necessary to consider the evolution of pay strategies.

These strategies have evolved through a number of distinct phases, most of which are present in South African companies today, albeit in a variety of formats.

The most common remuneration strategies employed are examined below.

2.      Market Based Remuneration:

This strategy is probably practised to some extent in most organisations, although by applying this strategy, compensation concerns pertaining to legitimacy or fairness are inappropriate, since the system is a consequence of market related forces, and as such, is not capable of "causing" anything.

This method assumes that all employees occupy equal positions as ascertained via job evaluation systems that relegate jobs to a grade, and that people with similar qualifications and experience tend to have the same worth. Generally, where any category or position is in lesser or greater supply than demand, then these values are adjusted up or down.

The result of this approach is that an employee's pay is a function of the social and organisational positions that they occupy, as determined by the job evaluation system. Each job comes with an assigned pay level, relatively fixed (min/max scales), regardless of how well the job is performed, or the real value that the performance produced for the company.

The focus is on internal parity, to the extent that individual performance is affected detrimentally.

Limiting factors of this strategy are:

·         Cost:

It can become too expensive for organisations that need to conserve resources in order to remain competitive.

·         Equity:

This strategy is neither equitable nor fair.

·         Productivity:

There is very little, if any, link between an employee's compensation and their contribution. It is thus insufficient to motivate high performance.

·         Entrepreneurial:

Employees are not adequately rewarded for creating new sources of business.

In addition to the above, the following disadvantages of this strategy exist:

·         It promotes a bureaucratic management style;

·         It implicitly specifies what not to do;

·         It reinforces hierarchy;

·         It depersonalises value orientation;

·         It fosters an internal focus;

·         It impairs strategic orientation;

·         It discourages organisational change;

·         It encourages grade grabbing;

·         It erodes honesty/credibility;

·         It inflates pay system operating costs;

·         It fails to encourage skills development;

·         It makes promotion too important; and

·         It rewards the wrong behaviour.

These factors led to a change in the thinking applied when determining pay levels, i.e. away from position (status), to performance, (contribution), which resulted in the following strategies.

3.      Merit Pay:

Using this strategy, base salary is defined by ranking a job within an overall salary structure.

It reflects the perception of the company determining how much it should pay in order to get someone to do the job, with some adjustments for internal parity and to ensure that comparable jobs have similar positions in the structure.

Merit increases, calculated as a percentage of base pay, are then determined by judgements about the employee's performance and contribution.  (These increases are not necessarily consolidated into base pay, and may be payable for a specific term, e.g. one year, and may either be paid monthly or periodically, e.g. quarterly, so as to have maximum effect.)

Merit pay, in principal, accepts and preserves the status and category distinctions defined by the organisation that determines base pay. It also retains, and in many instances enhances the power of superiors over subordinates, as "judgements" are delivered from "superior" positions.

From a corporate perspective, it is consistent with traditional ideology.

The assumption that pay should reflect worth, and pay increases should be based primarily on performance, with the individual being held solely responsible for their fate, wins out over competing principals like equality.

Research has shown that performance based reward is not only fairer, but also encourages higher levels of productivity as employees supposedly learn that they will get more if they give more.

This however, is only theory, because research has shown that employees who are remunerated according to a merit pay strategy consistently fail to believe that their pay is indeed based on their performance. (Longitudinal Data Bank Studies over 18 years involving 250000 employees in the U.S.A.).

The reasons for this are entrenched in the limiting factors pertaining to a merit pay strategy that are as follows:

·         Difficulty is experienced making the necessary performance distinctions required in merit pay plans. For example, a general increase for an average performance of 8%, compared to a merit increase of 10% for an above average performing employee produces little distinction;

This benefit is not viewed as being worthwhile compensation in terms of physical and mental effort required to be labelled as above average;

·         The following limitation is closely associated. With single digit inflation, the minimal merit increases granted (e.g. 2% above), are meaningless as a reward for contributions over and above the call of duty. Research has indicated that meaningful merit increases should range from 5 to 10%;

·         The determination of merit pay is also a limiting factor.  In order to be perceived as fair by the recipients, the link between pay and performance has to be clearly established and published.

In most instances this determination is difficult to achieve, or requires a costly and elaborate measurement system. As the cost of monitoring and measuring performance can be so high, many organisations rely on supervisor ratings in a subjective performance appraisal process, with dubious reliability.

An employee's earnings then depend on the opinion of "hierarchical superiors" rather than pertaining to performance and contribution. A fair amount of cynicism about favouritism and potential abuse floats around organisations that adhere to this paternalistic practice, leading to opposition from employees and their trade unions;

·         Conflict between superior and sub-ordinate, always latent in authority relationships, can be equalled by the conflict between peers within a pay for performance system that forces a differentiation of individuals in the same work unit.

The basis of many merit pay systems is that the individual component of joint output can be singled out, which can pit members of the same team against one another in a competition for scarce rewards;

·         Psychological research shows unequivocally that too much difference amongst team members produces conflict. The only solution to this is to keep the determination secret, which in turn causes the known relationship between pay and performance to be weakened. The result is that employees are not motivated to support the system; and

·         More and more employees are questioning the top-management compensation structures that seem to be based on status rather than achievement or performance.

The same criteria applied in measuring the average worker's performance would need to be seen to apply in the determination of management remuneration.

In view of the above, it can be seen that the result of this strategy is that it could end up discouraging high performance in practice.

It also does not offer the two key attributes of any pay system, namely:

·         Employees do not necessarily perceive it as fair; and

·         It does not necessarily keep costs down for the company.

This has led to the following strategies which assume that there should be an equal opportunity for all employees to share in the gains realised from any enhanced performance, to which all presumably contributed.

The argument of how to motivate people to do more has been linked with the employer’s cost concerns to realise a solution.

Allow employees to share in increased profits, but reduce guaranteed pay in the process.

Instead of providing high wages, automatic increases and guaranteed bonus schemes, let employees share in the profits of the company, whilst also providing them the ability to improve their rewards through their contribution.

4.      Profit Sharing/Gain Sharing:

Profit sharing is an arrangement whereby portions of the net profits, for a specific period of operation, are distributed to employees.

This distribution may be immediate or deferred, and some or all employees may benefit. In this way, pay is pegged to performance, both for the company and the individual.

One-time performance awards, spot bonuses and profit sharing plans limit guaranteed compensation, whilst holding out the promise of extra earnings for those who really contribute, (add value).

These one-time payments do not raise base pay, nor do they affect other allowances that are determined by base pay.

It is suggested that the implementation of such a scheme is done at the same time as the implementation of general wage reviews. This may be accompanied by a basic wage freeze, or even a decrease, thereby reducing the direct cost of labour.

This approach, by making reward reflect company performance, could be a cure for what Martin Weitzman described as "stagflation" which is the present situation in the RSA economy.

This could lead to companies creating jobs, because a large component of what the additional workers are paid will be in proportion to the value they add and the income they generate for the company.

There is little doubt that properly designed and managed employee "ownership" schemes can affect corporate success positively.

Profit sharing has been taken one step further by a practice known as "gain sharing", which provides for the sharing of gains between employer and employee to the extent that the adopted standard is exceeded.

This is not profit sharing because it is not profits that are shared, but rather income generated by gains achieved measured against a particular standard, (production efficiencies, production costs, scrap reduction, quality, safety etc.)

Gain sharing however can include profit sharing where the level of profits is adopted as the standard. 

However, gain sharing is usually related to productivity and not profitability, based on the assumption that increased productivity automatically results in increased income for the organisation.

With gain sharing it is attempted to calculate, (via reasonably elaborate formulae), the specific contributions of specific teams/groups of employees, with their applicable reward being based on the varying results.

Although the basis of the calculation can vary from system to system, they agree on two important principals:

·         What is important is that the reward recognises the value of groups rather than individuals, (based on the theory that teams and collective effort are what count); and

·         The rewards and the basis for their distribution must be based on definite objectives and measurable characteristics, (everyone can determine what is owed and when).

Historically, profit sharing and gain sharing schemes have mostly been restricted to management level, and this limited use can only be ascribed to the major changes required in hierarchy-based organisations.

To make this strategy work, a particular organisational structure and corporate culture are required.

This includes open discussion of the plan in order to gain employee acceptance, the establishment of task groups to develop the plan, and the adoption of suggestion systems.

Gain sharing plans require more transparency and open communication regarding the company goals and performance than which is traditionally the norm.

Management must be ready to accept some serious challenges and changes when it comes to negotiate gain sharing. The prior state of labour relations and union involvement are pertinent indicators for success or failure.

Where these systems have failed, it is often because of the complexity of the administration or poor implementation.

Whilst research has shown that almost 33% of these schemes fail, phenomenal success has been shown in other cases.

An average of 5 - 15% productivity improvements are normally visible in the first year of the scheme, whilst better work attitudes, product design improvements, and improved product quality, are other benefits to be enjoyed.

Limiting factors influencing a scheme such as this are:

·         Labour problems due to less than expected bonuses and internal disputes due to inconsistent treatment of different groups;

·         What happens when the company reduces production due to market demand, and/or has regular losses, and wage concessions have been made? Production levels may also not warrant the payment of performance-based income, resulting in a reduction in income for the employees over which they have no control;

·         By treating everybody equally and distributing across-the-board bonuses to large units, the team is strengthened but the individual pay and performance link is weakened;

·         Profit sharing in which all share equally in total company performance weakens even further the relationship of compensation to the employee's own performance;

·         Determining the standards that are to be applied is vital to the success of the scheme; and

·         The final "goal" of the organisation must be determined accurately beforehand, (which needs to be realistic and achievable), as it is virtually impossible to move the goalposts once the scheme is operational.

Predetermined intermediate "targets" should be set whilst working toward the goal, at which stage certain compensation will be paid. This would retain interest and allow the benefit to be acknowledged.

The limiting factors of this type of scheme, and a need to encourage employee contribution in areas of strategic importance have caused certain companies to consider incentives for     individual achievements as a supplementary compensation strategy.

5.      Individual Performance Bonuses

This approach has been linked to the old factory piecework system. Whilst there are some similarities, the variants today are both more complex and innovative.

Commissions and bonuses for sales staff are reasonably standard practice, but what has changed is the amount that employees can earn, (doubled salaries?), the greater number of employees who can earn them, and the proliferation of ways in which the bonuses can be earned.

Spot bonuses and special awards are increasingly used to focus behaviour on strategic targets.

Motivation for performance bonuses and incentive pay has a dual purpose, i.e. firstly to stimulate productivity specifically targeted to key organisational goals, and secondly as a retention orientation to keep employees by allowing them ample opportunity to take the initiative and increase their own earnings.

This type of reward may be targeted at various behaviours, e.g.

·         Increased performance;

·         Exceptional work;

·         Educational achievements;

·         Reduction in accidents;

·         Quality improvements;

·         Generation of new business leads;

·         Multi-skilling; and

·         New venture returns.

Limiting factors for this pay strategy are twofold, namely:

·         Complicated to administer

·         Focuses on short-term behaviour only.

6.      Conclusion:

This concludes the overview of current remuneration strategies, from which it can be seen that contribution/performance based pay systems have several virtues:

·         They increase perceived system fairness when they give employees a share of increased company performance;

·         They help companies keep fixed payroll costs relatively low;

·         They help raise productivity; and

·         They steer behaviour toward strategic goals.

However, these types of systems also create tensions and dilemmas within the organisation. Some of these are:

·         Within the entrepreneurial organisation, employees may regularly earn more than their superiors. In traditional organisations, this is not acceptable and is usually prevented;

·         The powers of relationships are shifted, because the existence of objective measures of contribution aids equalisation. The source of dependency is reduced and power becomes more equalised once high performance is established; and

·         The jealousy potential inherent in some contribution-based formats of pay is an explicit problem.

However, it is not necessary to choose one particular strategy.

A combination of these practices could result in remuneration being made up of a number of components. Although complex, a typical multifaceted pay cheque could look as follows:

·         A guaranteed base amount determined on organisation level and position; plus

·         An individual merit component; plus

·         A group or division gain sharing component; plus

·         An overall company profit sharing component; plus

·         Periodic one-off short-term bonuses and recognition awards for exemplary individual or team contributions may also supplement all of the above from time to time.