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WORKFORCE BRIEF # 5
Prepared by the National Alliance of Business
NEW PAY: Compensation as a Strategic Tool
INTRODUCTION
To remain competitive, workplaces are implementing a variety of
changes: self-managing units have job boundaries that cut across
traditional organizational lines, empowered workers with broad and
varied knowledge are actively participating in organizational
decision making, and new production methods are resulting in a
greater variety of low-volume customized products.
************************************************************
* In a survey of 531 large and mid-sized companies, 91% *
* reported making significant changes in their corporate *
* culture, but only 47% realigned pay programs to support *
* the changes. Respondents reported that changes are *
* needed in salary programs (73%), short-term incentives *
* (84%), and long-term incentives (74%). - Hay Group *
************************************************************
While the work companies do and how they do it have shifted
significantly, companies' reward and salary structures have remained
largely the same. Job classification schemes too often reinforce
limited technical skills in narrowly defined jobs, piece-rate pay
systems reward high-volume runs of a limited number of standard
products, and many performance evaluation systems support minimal
cooperation between departments.
A properly designed compensation/pay system can be a strategic
tool to enhance a firm's competitiveness. New approaches to pay more
closely tie pay to performance, rather than to tenure and
entitlement. They encourage organizational performance and enhance a
closer connection between employee and organizational goals by
enabling employees to more fully share in the rewards and risks of
the enterprise. Variable pay, a core element in new pay approaches,
also helps companies promote long-term employment security by
providing for pay reductions during economic downturns. Through
variable pay, "pain" is spread throughout the organization, rather
than concentrated in specific job losses.
The strategic use of compensation systems involves developing
compensation programs that support the business strategy, reinforce
organizational structure, and enhance the desired culture of the
organization. While some companies are transforming their
traditional compensation practices to support the changes in
strategy, structure, and culture in the new workplace, many are not.
************************************************************
* If you answer "yes" to these questions, you are ready *
* for new pay! *
* *
* * Do you think that your traditional pay system is not *
* getting the job done and must be changed? *
* *
* * Are you willing to move from a culture of tenure and *
* entitlement to one of performance, empowerment, *
* employee involvement, teamwork, and organization- *
* employee partnership? *
* *
* * Are you ready and willing to focus on the group, *
* instead of the individual, as the unit of *
* measurement, and on variable pay as the primary *
* focus of your total compensation strategy? *
* *
* * Can you accept that indirect pay bears little *
* relationship to desired performance and therefore *
* is of secondary value to the total compensation *
* strategy? *
* *
* * Are you willing to tie pay to organizational *
* success so that employees and the organization *
* have a vested interest in each other's success? *
* *
* * Are you willing to permit active involvement by *
* employees in organizational issues that affect them? *
************************************************************
This Workforce Brief will show that:
* Innovative companies are adopting new pay practices to support
their workplace transformations and increase company
flexibility. These new pay practices revolve around changes in
base pay, variable pay, and indirect pay.
* Two new pay approaches - skill-based pay and group variable pay
plans - exemplify innovations in base pay and variable pay. New
approaches to indirect pay are widely popular, as all companies
attempt to contain their benefit costs.
* New pay practices are not right for every company. Four simple
steps can help you determine if they're right for your company
and get you started using compensation as a strategic tool.
TRADITIONAL AND NEW APPROACHES TO PAY
Innovations in pay revolve around three key elements: base pay,
variable pay, and indirect pay.
Base Pay
Base pay is the base salary or wage paid to an individual for
his or her work. Base pay represents what the organization will pay
to fill jobs or hire people with the proper skills.
* Traditional Approach: Base pay is established using a job
evaluation methodology that establishes internal equity across
positions in the company. A person is paid for the content of
the job or the specific tasks that are performed. Labor market
wage surveys on a sample of jobs are used to anchor the entire
wage system to the external labor market.
* New Approach: Employees are paid base pay according to the
economic, market, or strategic value that their individual jobs
and skills have to the organization. External equity - market
wage - is a driving factor. Internal equity is of concern within
broad job functions. Base pay changes affect positions or
individuals and reflect changes in the economics of the labor
markets in which the organization elects to compete for talent.
This gives management more flexibility to hire and retain people
in the positions that make the greatest contributions to the
firm's strategic objectives.
Variable Pay
Variable pay is any form of direct pay that is not folded into
base pay and that varies according to performance. Variable pay is
used to reward individual, team, business unit, and/or
organizational performance results that change from performance
period to performance period.
* Traditional Approach: Individual variable pay is emphasized and
applied to a limited class of employees, primarily executives or
upper-level managers. Piece-rate systems may be implemented at
the shop floor level.
* New Approach: Coverage under variable pay plans is expanded,
ideally to include all classes of employees. Group performance,
rather than individual performance, becomes the basis of
variable pay. This enables management to flexibly reward
employees for performance that makes the organization successful
and control pay costs when the organization is less successful.
Indirect Pay
Indirect pay, or benefits, include retirement and health plans,
paid leave, and other miscellaneous benefits.
* Traditional Approach: Benefits surveys of competitive companies
are used to determine appropriate benefits and benefit levels.
The primary goal is to provide sufficient benefits to remain
competitive in the labor market. This approach generally results
in spending more money on employee benefits with no expectation
of a measurable return on investment.
* New Approach: Analysis starts by defining the level and cost of
benefits the company is willing to provide. Within these limits,
the company strives to provide a basic level of employee
protection and benefits, emphasizing benefits that are
attractive to the organization's employees, rather than similar
to those offered by other employers. The primary goal is to
contain indirect pay costs through active cost management and
cost sharing with employees in order to free dollars to spend on
direct pay, particularly variable pay.
************************************************************
* Compensation Trends: 1995 *
* *
* * Bonuses are expected to be given at 30% of companies *
* this year, up from 25% last year. *
* - Towers Perrin *
* *
* * Forty-two percent of the companies responding to a *
* compensation practices survey plan to implement *
* performance-based alternative reward systems in the *
* next two years. *
* - Wyatt Company *
* *
* * Almost half of companies will change their *
* compensation program over the next two years. *
* Profit sharing was the most popular change in 1994; *
* for 1995, broadbanding (combining job *
* classifications) and team pay are the most likely *
* changes. *
* - Coopers & Lybrand *
************************************************************
NEW PAY SYSTEMS
Organizations that want to encourage employee performance and
gain a competitive advantage through their pay systems are lessening
job classifications, truncating pay structures, and terminating
individual incentive pay systems. These firms are adopting
innovations in both base pay (such as skill-based pay) and variable
pay (such as gain sharing and profit sharing).
Base Pay: Skill-Based Pay
Skill-based pay, or pay for knowledge, compensates employees
for the range, depth, and types of skills they possess. It
represents one of the fastest growing innovations in compensation. A
recent survey conducted by the Center for Effective Organizations
shows that half of the Fortune 1000 firms are using skill-based pay
with at least some of their employees, and expect to increase usage
in the next two years.
The centerpiece of skill-based pay is the flexibility to link
pay to a wider range of tasks and skills than is possible in a pay
program that focuses only on the duties and responsibilities of a
job. Skill-based pay systems provide explicit rewards for
participation in training programs and skill acquisition, and thus
they provide incentives for employees to acquire more knowledge.
The typical implementation of a skill-based pay system involves
a number of components. These include:
* Identify Skills. A list of all needed skills in an area is
generated through employee involvement in skills identification
and a skill audit by a team of experts. These processes identify
both the specific skills that are needed to perform the required
work and the varying levels of complexity and application in
these skills. (Current efforts to determine industry skill
standards may provide a foundation for identifying skills.)
* Create Skill Blocks. Skills are arranged in skill blocks based
on how they will be performed by employees. There are three
major dimensions on which skill blocks can be created:
--> Depth:
Deeper knowledge and proficiency in the specific skills
pertaining to one work area, e.g., learning more advanced
manufacturing techniques or more machine operations in a
particular area.
--> Vertical: Administrative and leadership skills for upward
advancement in the organization's hierarchy, e.g., learning
more about production/inventory control, record keeping
responsibilities, SPC analysis, leading team meetings, etc.
--> Horizontal: Developing skills in other work areas in the
company for lateral movement among the skilled jobs.
************************************************************
* New Pay Systems in Cin-Made *
* *
* In 1985, Cin-Made and the United Paperworkers *
* International Union instituted profit-sharing and pay- *
* for-knowledge systems in the small, Cincinnati-based *
* packaging company. Contract wages were locked at 1984 *
* levels, and a merit increase system was instituted to *
* reward employees for attaining additional skill levels. *
* In the first year, 18% of pre-tax operating profits *
* were distributed to employees based on hours worked. *
* Sales increased from $41,000 per employee in 1985 to *
* $103,000 per employee in 1992. Over time, fixed wage *
* costs fell as a percent of payroll. Cin-Made's average *
* profit-sharing bonus for the last three years was 36% *
* of base wages. *
************************************************************
* Establish Training Program. A program must be developed to
ensure that employees are given adequate opportunities for
training and rotation. Issues to consider include skill-block
sequencing, minimum and maximum completion times required for
training, training materials and procedures, and the extent to
which the organization will assume responsibility for providing
skill-acquisition opportunities.
* Establish Testing and Certification Program. Most skill-based
programs pay employees for demonstrated skill gains. Thus the
system must have tests or measures to determine if an individual
has learned a skill, and certification and record keeping
systems to track skill acquisition.
* Determine Pay Rates for Skill Levels. The foundation of skill
based pay is paying more as employees demonstrate that they are
obtaining and using more and more skills valuable to the
organization. Determin-ing the appropriate wage level can be
difficult, since traditional wage setting procedures are not
based on skills. However, the market value of skills in a skill
based pay program can be established by assembling skill blocks
into "jobs" and comparing these to job pricing systems, or
pricing skill blocks and adding up the "economic value."
Whatever method is used, employee perceptions that skill-based
pay is fair compared to what others outside and inside the
organization receive for comparably skilled performance is
critical to the plan's success.
Paying workers under a skill-based pay system for simply
acquiring skills and knowledge only makes sense if the more
skilled workers can be used effectively in the production
process. For this reason, skill-based pay is usually implemented
in concert with much larger and more profound changes in
production systems that require increases in employee knowledge
and skills.
Variable Pay: Gain Sharing and Profit Sharing
Organizations that want to remain competitive must control base
pay and reward performance with variable pay. Wherever practical,
new variable pay plans focus on groups of employees. Two of the most
common group variable pay plans follow:
* Gain Sharing. Gain sharing plans pay dividends to groups of
employees who are instrumental in bringing about improvements in
productivity, cost, quality, and financial measures. Under a
typical gain sharing plan, a base level of output and wages is
determined, along with a method for valuing any improvements. In
general, award distribution in gain sharing is either a common
dollar amount per employee, a common percentage of base pay, or
a common amount per hour worked. Some gain sharing plans reduce
employees' wages if productivity or quality fall or costs rise.
* Profit Sharing. Profit sharing is similar to gain sharing in
that it links pay to firm performance, although in this case the
outcome variable is profit rather than productivity gain. Profit
sharing distributes a portion of an organization's profit to
each employee, with amounts being calculated as a percentage of
each employee's base pay. Distribu-tions can be made in cash or
in company stock or can be deferred in a qualified trust, the
latter usually earmarked for retirement.
Implementing a poorly designed or ill-suited variable pay plan
can do more harm than good because employees will inevitably
receive mixed, even conflicting, messages from the organization
about its values and priorities. A number of elements should be
taken into consideration when designing a variable pay plan in
order to avoid perceptions of exploitation and manipulation.
These elements include the following:
* Purpose and Eligibility. A clear purpose - be it to improve
group performance, increase employee involvement, or enable pay
to vary with performance - linked to the business plan, is
critical to effective design and implementation. A clear
statement of purpose should help identify the group(s) that will
participate in the variable pay plan.
* Measures. Measuring improvement is the core of new variable pay
because it provides the justification for sharing money with
employees. Potential improvement measures include profit,
financial ratios, quality, customer satisfaction, and
productivity. The measures selected will partially determine
where the money will come from to fund the variable pay plan.
Acceptable measures of performance should be:
--> Relevant to both the organization and the employees, i.e.,
the organization wins measurably if goals are made, and
goals are within the influence of the plan participants;
--> Simple enough for the employees who participate in the plan
to understand them, while still being accurate and
appropriate; and
--> Easily communicated, i.e., employees know what they are
asked to do to earn the rewards and how they are progressing
toward the rewards.
* Payout. There are a number of technical questions that must be
addressed regarding the payout of any reward. These include:
--> How will awards be distributed once performance measures
are attained?
--> Over what period should performance be measured and
evaluated?
--> How often should awards be granted?
Both gain sharing and profit sharing require and reinforce a
partnership between the organization and its employees. The
partnership is solidified if there is a "win" when the plan is first
implemented. This means that a variable pay plan should be
practical, workable, and likely to produce positive results.
************************************************************
* Skill-Based Pay in an Automotive Components Supplier *
* *
* In establishing its skill-based pay system, a joint *
* labor-management steering committee at an automotive *
* components supplier identified 17 non-exempt *
* occupational areas and designed skill blocks for each. *
* The number of advancement opportunities in the design *
* varies from two levels for security guards and supply *
* room attendants to five levels for jobs in the press *
* and machine maintenance departments. The company *
* certifies five types of skills within each work area *
* skill block: quality, cost, delivery, morale, and *
* safety. Skills are certified through demonstrations, *
* interviews, and/or record reviews. A review team *
* consisting of a work area leader, individuals from the *
* next two levels of management, and a work area peer *
* observes and assesses demonstrations of skill *
* proficiency. Employees must wait 12 months between *
* applications for certification at an additional skill *
* level. *
************************************************************
Indirect Pay
The constant increases in costs have made almost all companies
advocates of new approaches to indirect pay. These approaches try to
enhance the value of benefits to employees while simultaneously
lowering their costs. Illustrative changes under new approaches to
pay include helping employees purchase benefits on a pre-tax basis;
using health maintenance organizations or preferred provider
networks; allowing employees to purchase additional life insurance;
establishing a single paid time off account covering sick, vacation,
and holiday time; including indirect pay goals in gain sharing plans
(e.g., savings in sick and disability days); and establishing
flexible benefit plans that allow employees to select the benefits
of most value to them.
STEPS TOWARD NEW PAY
Compensation strategies should support and enhance
organizational change. Attempts to improve performance simply by
manipulating compensation packages have proven counterproductive.
However, reorganizing work processes to capitalize on employee
skills and participation has improved performance, especially when
combined with employment security, gain sharing, and incentives to
take part in training. Although new approaches to pay are not likely
to be the only factor that will help move a company toward a more
positive future, they are clearly the only way to make employee pay
a constructive catalyst for this change. Four steps can start you on
your way to using compensation as a strategic tool:
* Clarify Your Compensation Goals.
Organizations that decide to implement a new pay plan need to be
clear about the goals and expectations for the program.
Top management, in particular, should provide a clear statement
delineating the appropriateness of new pay approaches to the
business direction and goals of the organization. Managers
should articulate how new pay plans contribute to ongoing
organizational changes, reinforce specific short-and long-term
company goals, and/or help ensure a strong customer focus.
The various elements of new pay systems should be put together
in ways that are appropriate to your company. There is no set
package of elements and no fixed schedule for implementing a new
pay system.
************************************************************
* Harford Systems, Duracool Division, Gain Sharing Plan *
* *
* The Harford gain sharing plan was designed by a cross *
* section of employees from all levels in the plant. *
* Each month, actual performance is calculated based on *
* performance levels for productivity, quality, safety, *
* and finance. Net performance change from an existing *
* baseline is used to establish the dollar value added to *
* the employee pool. (Fifty percent of the performance *
* improvement goes to the company and 50% to the *
* employees.) A 20% reserve is deducted from the *
* employee pool to cover payout if performance is up *
* but profits are down, and the balance is paid out. *
* The payout is distributed quarterly. Each *
* participating employee receives the same dollar amount *
* and everyone, except the president, participates in the *
* plan after a minimum tenure at the company. *
************************************************************
* Assess Your Company Culture.
New approaches to pay create a partnership between the
organization and its employees, a partnership that requires
increased levels of employee participation, involvement in
decisions, and empowerment to affect the work environment.
Employee readiness and a culture supportive of employee
involvement are critical to establishing this partnership. To
determine an organization's readiness for new approaches to pay
(or to identify what must be done to facilitate new pay
systems), look at the levels of:
--> Communication (upward, downward, and horizontally) within
the organization,
--> Employee understanding and support of the mission, goals,
and objectives of the organization,
--> Belief that employees themselves improve productivity,
quality, and results,
--> Teamwork and collaboration within the organization,
--> Employee trust in management, and
--> Employee understanding of how the organization's products or
services fit into the market and are perceived and used by
the customer.
The greater the understanding, support, and teamwork, the more
easily a partnership can be formed and employees can help the
organization be successful.
* Start a Partnership.
The new view of pay provides that organizations effectively use
all elements of pay to form a partnership between the
organization and its employees. Through this partnership,
employees can understand the goals of the organization, know
where they fit in accomplishing these goals, become
appropriately involved in decisions affecting their contribution
to the goals, and receive rewards to the extent that they help
the organization attain the goals. A good way to begin this
partnership is to form an employee-management task force, with
employees selecting their representatives, to design the new pay
system.
In a unionized work setting, it is important to engage the labor
organization as a partner, recognizing the legitimate role of
the union leadership as a change agent. The collective
bargaining agreement serves as the basis for any examination of
compensation and benefits, and any changes in compensation and
benefits must be negotiated through the collective bargaining
process.
* Communicate.
Communication must occur on at least three fronts. Top
management must clarify how the change in pay fits into the
organization's mission, strategies, and goals, and must
demonstrate support for the change. The new pay system
development task force must communicate the design of the new
program, answer questions, and support the change. Employees'
supervisors must ensure that employees understand the change and
lead employees to accept the program and work toward achieving
the program's goals.
************************************************************
* Research Results: Variable Pay *
* *
* * Firms that introduced a specific gain sharing plan *
* demonstrated an average cumulative productivity *
* improvement of 15% three years after initial *
* implementation, compared with an average 6% *
* increase in comparable manufacturing firms without *
* gain sharing. *
* - Kaufman, 1992. *
* *
* * The U.S. General Accounting Office found that those *
* firms with gain sharing plans in place for more than *
* five years averaged an annual 29% reduction in labor *
* costs. *
* *
* * A review of 27 formal econometrics studies found that *
* the use of profit sharing was generally associated *
* with 3.5 to 5% higher productivity, measured through *
* value added or sales per employee. The productivity *
* increase for small and mid-sized firms was over 11%. *
* The estimated effects also were greater for plans in *
* firms where payouts were more generous and were made *
* immediately. *
* - Kruse, 1994. *
* *
* * Forty-four percent of 432 compensation plans examined *
* in one study showed gains from profit sharing. The *
* annual gains per employee reported ranged from $370 *
* to $8,880, with an average return of $1.34 for every *
* dollar invested (34% return). *
* - American Compensation Association. *
************************************************************
Further information on the issues presented in this brief can be
obtained from:
American Compensation Association and M.J. Wallace, Jr. 1990.
Rewards and Renewal: America's Search for Competitive Advantage
through Alternative Pay Strategies. Scottsdale, AZ: American
Compensation Association.
American Compensation Association. Capitalizing on Human Assets.
Scottsdale, AZ: American Compensation Association.
Belcher, J.G. 1987. Productivity Plus. Houston, TX: Gulf.
Blinder, A.S. 1990. Paying for Productivity: A Look at the
Evidence. Washington, DC: The Brookings Institution.
Kalish, G. 1989. ESOPs: The Handbook of Employee Stock Ownership
Plans. Chicago: Probus Publishing Co.
Kruse, Douglas. 1994. Profit Sharing: Does It Make a Difference?
Kalamazoo, MI: Upjohn Institute.
Lawler, E.E., III. 1990. Strategic Pay. San Francisco: Jossey-Bass.
Ledford, G., Jr. and E. Lawler. 1994. "Reward Systems that Reinforce
Organizational Change." Los Angeles: Center for Effective
Organizations.
MacAdams, Jerry and Elizabeth Hawks. Organizational Performance and
Rewards: 663 Experiences in Making the Link. Scottsdale, AZ:
American Compensation Association.
Mericle, Kenneth and Dong-One Kim. 1994. Skill-Based Pay and Work
Reorganization in High Performance Firms. National Center for the
Workplace, Research Report.
Olson, Craig A. and Susan Moeser. 1994. "An Overview of Innovative
Pay Practices." National Center for the Workplace, Theme Paper.
Profit Sharing Council of America. 1991. Profit Sharing in Action.
Chicago: Profit Sharing Council of America.
Schuster, Jay R. and Patricia K. Zingheim. 1992. The New Pay:
Linking Employee and Organizational Performance. New York:
Lexington Books.
Wilson, T. 1995. Innovative Reward Systems. New York: McGraw-Hill.
- Stephen Mitchell, 1995
The National Workforce Assistance Collaborative builds the capacity
of the service providers working with small and mid-sized companies
in order to help businesses adopt high-performance work practices,
become more competitive, and ultimately advance the well-being of
their employees. The Collaborative was created with a $650,000
cooperative agreement grant from the Department of Labor to the
National Alliance of Business. Current partners on the project
include the Council for Adult and Experiential Learning, the
Institute for the Study of Adult Literacy at The Pennsylvania State
University, the Maryland Center for Quality and Productivity, and
the National Labor-Management Association. The Collaborative
provides assistance in four areas: employee training, labor-
management relations, work restructuring, and workplace literacy.
For more information on the Collaborative, contact Bernice Jones at
the National Alliance of Business, 202/289-2915.
Bundles of 25 copies of this brief are available for $7.75 (includes
postage and handling) by contacting the National Alliance of
Business, Distribution, P.O. Box 501, Annapolis Junction, MD 20701,
phone: 1-800-787-7788, Fax: 301-206-9789.
.