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OTTO-VON-GUERICKE-UNIVERSITY MAGDEBUR G BEIJING NORMAL UNIVERSITY. Prof. Dr. Birgitta Wolff, Marjaana Rehu, M.A. Otto-von-Guericke-University, Germany. II. Human Resource Management. Variable or Fixed Salary. Recap Session I. „... three critical aspects of organization: - PowerPoint PPT Presentation
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Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 1
II. Human Resource Management
Variable or Fixed Salary
OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURGBEIJING NORMAL UNIVERSITY
Prof. Dr. Birgitta Wolff, Marjaana Rehu, M.A.Otto-von-Guericke-University, Germany
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 2
„... three critical aspects of organization:
• The assignment of decision rights within the company
• The methods of rewarding individuals
• The structure of systems to evaluate the performance of both individuals and business units“
(BSZ 5)
Recap Session I
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 3
Outline
1. Incentive Problem
2. Compensation Contracts
3. Output-Based Pay
4. Input-Based Pay
5. Incentive PaySource: www.msn.de
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 4
1. Incentive Problem
Coordination and Motivation Problem
Distribution of Output
Task
Individual
Allocation of Input Resources
Source: Wolff/Lazear (2001): Einführung in die Personalökonomik, Stuttgart: Schäffer-Poeschel, S. 51
Coordination
Who does what, when,...
Motivation
How do I get somebody to perfom a task,
improve the quality,...
=> Incentive Problem
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 5
1. Incentive Problem
Why do Incentive Problems Exist?
Why do Incentive problems exist?
• Employee and employer have different interests
– Employer would want the employee to take actions that maximize the profit of the firms, but the employee might rather like spending his time with his/her family or play golf
– All actions of the employee cannot be monitored and/or controlled by contracts (risk for the employer)
– Employers have to compensate employees for doing undesirable tasks
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 6
1. Incentive Problem How can Incentive Problems be Solved?
• Incentive Problems can be solved through effective compensation contracts
• Compensation contracts have two functions
– Motivate employees
– Share risk more efficiently
Source: www.euro.fi
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 7
2. Compensation Contracts
Variable Pay Fixed Salary
Compensation Contracts
Payment by Output Payment by Input
Subjective Performance
Measures
Objective Performance
Measures
Subjective Performance
Measures
Objective Performance
Measures
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 8
Variable Pay(payment by output)
Straight Salary(payment by input)
• Compensation depends on measure of what comes out• Amount of time spent on work does not affect workers‘ compensation
Problem: Output not always easy to measure
Examples:
• Agricultural workers: piece rates p. tray• A salesperson on straight commission• Compensation of top executives by stocks or stock options
• Compensation depends on the amount of time or effort spent on an activity• Independent of output consideration
Problem: Input also not always easy to measure• Time at work as a proxy in order to assess worker‘s effort
Examples:
• Wage per work hour• Monthly salaries• Annual salaries
2. Compensation Contracts
Payment by Input versus Payment by Output
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 9
2. Compensation Contracts
How can the Performance of an Employee be Measured?
•Objective Performance Measure:
– Measure that is easily observable and quantifiable, e.g. parts produced, hours worked etc.
•Subjective Performance Measures:
– An evaluation which is based on personal opinion of a supervisor, customer, peers, etc.
Type of evaluat.
Databaseobjective subjective
Output revenue, dividend customer satisfaction
Input time qualification
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 10
Basis Variables for output-based pay
Quantity of production pieces, weight, size/height
Quality of productionRejects, grade, customer‘s satisfaction, individual targets
Input reductionReduction of input factors: raw material, energy, work time
Capacity utilization slack-, repair- and waiting periods
Be on scheduleTimeliness vis à vis internal and external customers
Value of the firm stock price, economic value added
2. Compensation Contracts
Examples of Different Variables as a Basis of Output-Related Pay
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 11
Advantages of output-based pay
Selection effect Motivation effect
• efficient workers with a high productivity will join the firm/stay
• inefficient workers with a low productivity will not join/leave the firm
• output-based pay motivates workers to put forth more effort
3. Output-Based Pay
Source: www.kone.fi
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 12
World Book Britannica
Offered compensation scheme variable pay: W = $ 100 . x
fixed salary: W = $ 500
Labor costs of 10 sets; Cost per set
$ 1,000 $ 100 per set $ 500 $ 50 per set
What type of salesperson will stay with the firm?
high productive sp.x 5
low productive sp.x 5
Labor costs of 3 sets; Cost per set $ 300 $ 100 per set $ 500 $ 166,67 per set
3. Output-Based Pay
Selection Effect: An Example of Compensating Salespeople
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 13
500
A (World Book)
B (Britannica)
W ...Weekly Pay
x ... Number of encyclopedia
53
300
Higher-productivity workers will leave Britannica, because they will earn more at World Book. Only lower-productivity workers will
stay at Britannica
3. Output-Based Pay
Selection Effect: An Example of Compensating Salespeople (cont.)
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 14
• Disadvantage of piecework: Variations of output can be beyond the worker‘s control
Variable pay Straight salary
• Fixed salary doesn‘t depend on exoge- nous factors – low-risk form of compensation Workers are insured against volatilities Firm provides the insurance for risks
• Lower compensation level• Can not participate in good economic development• Weaker incentives
• Variable pay depends on invested effort and exogenous risks – risky form of compensation Firm should smooth out exogenous risks from workers‘ compensation Firm should bear exogenous risks but endogenous risks should remain with workers
• Trade-off: More riskhigher compensation • Opportunity: participate in good economic development• Stronger incentives
3. Output-Based Pay
Disadvantages of Output-Based Pay
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 15
3. Output-Based Pay
Risk in Output-Based Pay
• The firm should bear the largest portion of risk because of risk pooling abilities
• Workers with a high average compensation should bear more risks than workers with a low average compensation.
Source: www.kone.fi
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 16
• In spite of all the advantages of output-based schemes: A large proportion of workforce is paid by input
• Compensation depends on the amount of time or effort spent on an activity
• Independent of output consideration
Time at work as a proxy to assess worker‘s effort
Examples: wage per work hour, monthly salaries, annual salaries
4. Input-Based Pay
Source: www.euro.fi
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 17
4. Input-Based Pay
Benefits of Input-Based Pay
• Finding the right output measure
• Costs of measurement
• Overemphasizing quantity, reduction of quality
• Risk aversion of workers
• Promoting long-run performance
However, in many cases output-based schemes could be used if only they were designed correctly!
Problems of output-based pay solved by time-based (input-based) pay
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 18
• Piece rates could induce workers to focus on high numbers of low quality products meeting only the sufficient quality level to ‚count‘
Appropriate compensation schemes could solve this problem
Example: Typist‘s compensation
Errors p. page Price p. page Minutes p. page Revenue per hour
0 $ 8 20 $ 24
1 $ 7 15 $ 28
2 $ 5 12 $ 25
3 $ 3 10 $ 18
4 $ 0 9 $ 0
5 $ 0 8 $ 0
Compensation Schemes Balancing Quantity and Quality
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 19
Hourly wages Monthly salary Annual salary
Input-based pay
• Production workers• Clerical workers
• Top Management• Managerial workers
Tasks: experienced and easy to prescribe
• High correlation between effort and time invested• Time input as a pretty good indicator for effort
• Low correlation between effort and work time• Time input = bad measure for effort overinvestment in easy (pleasant) tasks
Tasks: less experienced and not easy to prescribe
• Undefined set of tasks (goal), discretion over work• Importance of other incen- tives to motivate for effort (long-term, e.g. stock options)
Tasks: not experienced and difficult to prescribe; often
to be defined by top manager
4. Input-Based Pay
Using the Appropriate Time Unit
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 20
5. Incentive Pay
Optimal Level of Variable Pay
• Since employees do not diversify their risk
– Large exogenous risks should be born by owners
Fixed salary
• However, employees are motivated by pay for performance
Variable Pay
Part of the pay should be fixed and part variable
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 21
5. Incentive Pay
Forms of Incentive Pay
• Rewards do not need to be monetary, they can consist of anything that employees value
• E.g Piece rates and commissions Bonuses Parking spots Days off Promotion Training Stock ownership Health care plan
Housing Education for kids Retirement Plan Party
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 22
5. Incentive Pay
Criticism to Incentive Compensation
• Often heard critics to incentive compensation:
– Money does not motivate
– It is difficult to design effective incentive schemes
• Incentives certainly entail costs
• The major problem is to design incentive schemes where the benefits exceed the costs
Prof. Dr. Birgitta WolffMarjaana Rehu, M.A.
Beijing, Sept. 2002 23
Furter Readings
Brickley, J. A./Smith, C. W. Jr./Zimmerman, J. L. (2001): Organizational Architecture, 2nd ed., Irwin Book Team.
Lazear, E. P. (1998): Personnel Economics for Managers, New York (John Wiley & Sons)