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Strategic pay level decisions are among the most important of organizational decisions. Indeed, even a cursory review of any business publication will likely uncover some organization’s attempt to improve performance by changing its pay levels. Interestingly, although changes in pay levels make sense only to the extent they positively contribute to organizational performance, their implications are seldom easily determined. Moreover, as pay level decisions have implications in terms of both their cost and profit implications, these are decisions with profound implications that are only foolishly taken lightly. Thus, since pay level decisions have such important implications, this research-paper will explore fundamental compensation decision-making questions regarding pay level determination including why firms may choose to pursue particular pay level options, how firms arrive at these options, and what facets of compensation firms consider when enacting and evaluating these decisions.
When we discuss strategic pay level decision making, we are considering what is known as a firm’s external competitiveness strategies or relative wage levels. Relative wage level represents a firm’s average compensation level relative to the compensation paid by other competing organizations (Gerhart & Milkovich, 1992). External competitiveness strategies are often expressed as leading, lagging, or matching the market (Milkovich & Newman, 2007). In practice, many organizations pursue more than one external competitiveness strategy. These organizations may vary their external competitiveness strategies for different groups of jobs. For instance, some organizations may lead for positions deemed critical, whereas for less significant positions they may match or lag the market (Milkovich & Newman, 2007).
This research-paper will discuss the theoretical and practical facets of establishing external competitiveness strategies. However, before we do this, we must begin our discussion of external competitiveness with an initial consideration of compensation and its strategic implications. Indeed, before we can consider external competitiveness, we must first lay some groundwork on the strategic implications of compensation practices. Importantly, this foundation will help us understand why compensation practices such as external competitiveness strategies have the potential to effect organizational performance. Most simply we must establish why compensation and external competitiveness strategies matter.
Following this, the research-paper will continue with a consideration of external competitiveness and various external competitiveness strategies. Initially, we will discuss theoretical perspectives important in understanding external competitiveness and the various external competitiveness strategies. In particular, we will focus on understanding why firms might choose to pursue particular strategies. After this, we will discuss technical facets of establishing an external competitiveness strategy. Specifically, we will consider how firms determine and evaluate external salary levels such that they establish appropriate salary levels for positions consistent with their external competitiveness strategies. Next, we will consider the components of compensation important in implementing external competitiveness strategies. When establishing external competitiveness strategies firms frequently think in the context of base cash compensation alone. Although base cash compensation is significant to the degree it represents the compensation employees can reliably depend upon in budgeting expenditures, there are other components of compensation, and these will be the focus of this section. Lastly, we will conclude with some potential direction for further consideration. The goal of this research-paper is to provide an overview of external competitiveness decision making which will be helpful in understanding and further considering this topic.
Strategic Compensation Management
The notion of strategic human resource management has evolved relatively recently (i.e., within the last 25 years) in the field of management. Indeed, strategic human resource management has largely evolved because of the revelation that human resource management practices likely represent a source of organizational competitive advantage (Wright & McMahan, 1992). Sources of competitive advantage are facets of organizations that allow firms to more effectively compete versus other organizations. Thus, human resource management practices that represent a source of competitive advantage are those that have the potential to create value for a firm versus competing organizations. For instance, to the degree that a firm’s human resource practices allow it to attract and retain better employees, that firm’s human resource practices represent a source of competitive advantage, which allows the firm to more effectively compete versus other firms.
Although the concept of strategic human resource management has evolved only recently, this should not be construed to mean that human resource practices have not always existed in organizations—rather, the notion of strategic human resource management has evolved only recently. In the past organizations had departments tasked with the traditional human resource management functions of compensation, staffing, and training. However, in the past, these departments were primarily concerned with the technical rather than the strategic facets of their areas of expertise. Indeed, the adoption of the phrase human resource management to cumulatively describe these functions implicitly recognizes the strategic facet of human resource management practices and the potential for these activities to contribute as sources of competitive advantage. Today, we not only recognize the importance of strategic human resource management, but we also have evidence supporting its importance as research has found that firms’ human resource management practices have significant implications for organizational performance.
Interestingly, of the three human resource management practices, compensation systems have been shown to play one of the more significant roles in human resource practices’ affects on organizational level results (Becker & Huselid, 1998). Indeed, among the key aspects of compensation systems likely of strategic significance are those decisions related to external competitiveness. External competitiveness strategies are significant because they are critical to developing, implementing, and maintaining a compensation plan and, thus, are likely to affect important organizational outcomes and are inexorably linked to organizations’ successes or failures. Illustrating the strategic significance of external competitiveness, a large consumer electronics retailer recently decided to replace its highest paid sales employees with lower paid employees. News reports suggest this occurred because managers believed these employees’ contributions did not merit their high pay levels. Strategically, this organization feels their performance will be enhanced by dismissing high-performing employees and replacing them with lower paid employees. Examples such as this illustrate the complexity of external competitiveness decision making, which will be addressed in the remainder of this research-paper.
External Competitiveness Strategies
Firms may pursue a lead, lag, or match external competitiveness strategy. By pursing a lead strategy firms choose to lead prevailing market wages and pay employees more than the wages being paid to similar employees in other organizations. Conversely, firms with a lag strategy choose to lag prevailing market wages. Lastly, firms that adopt a match strategy simply match prevailing market wages. The decision whether to lead, lag, or match market wages depends upon a host of organizational and employee characteristics, which will be described in the next sections.
Lead Relative Wage Strategy
Firms will choose to pay market leading wages when the value of employees’ organizational contributions are deemed to justify wages above those provided by competing organizations. One theory that is particularly useful in understanding these decisions is efficiency wage theory, which proposes that high wages may generate a host of organizational benefits. Beyond generating large applicant pools that allow organizations to be more selective when hiring, organizations that pay high wages experience increases in both employee and organizational efficiency because they are able to attract and retain the most capable employees (Akerlof & Yellen, 1986; Williams & Dreher, 1992). Illustrating this, Raff and Summers (1987) included this perspective as one explanation for Henry Ford’s 1914 decision to pay employees above market wages. Although, Raff and Summers questioned the overall benefit of Ford’s market wages, they do note its effectiveness in increasing Ford’s employee attraction and retention.
In those cases where organizations pay high relative wages, they have likely concluded that employees’ potential contributions outweigh the cost of their heightened wages. Indeed, some employee positions may be of such significance that organizations choose to pay leading wages to attract the best and brightest employees to these positions. Examples of this include the exorbitant compensation received by the top executives of some organizations. In these organizations, high wages may be pursued to attract and retain the “cream of the crop” of top management talent. These organizations likely believe that paying high wages allows them to attract and retain top executive talent that will positively influence organizational performance. Indeed, while some top executive pay packages may seem exorbitant, it is still important to recognize that the incumbents in these positions make financial decisions with consequences far in excess of their compensation. Thus, while they may seem overpaid, their high wages may make sense in the context of their organizational contribution.
Beyond organizational contribution based reasons for paying high wages, some organizations may choose to pay high wages to increase employee effort and decrease employee shirking behavior (Akerlof & Yellen, 1986). Shirking behavior is when employees perform at low levels. In particular, some organizations may choose to pursue a lead relative wage strategy in situations where employee monitoring and supervision are problematic or expensive (Cappelli & Chauvin, 1991). In these cases, organizations may find that through paying high wages employees are motivated to perform appropriately even though their performance is not being monitored. Efficiency wage theory suggests that in these circumstances high relative wages improve employee and organizational efficiency by decreasing employees’ unproductive or shirking behavior (Akerlof & Yellen, 1986). Indeed, when relative wages are high, employees who shirk will suffer personal economic costs from involuntary turnover (Akerlof & Yellen, 1986). Personal costs result because employees who lose their jobs may have a difficult time finding other jobs with similarly high wages (Akerlof & Yellen, 1986; Capelli & Chauvin, 1991). For example, some organizations in the computer industry choose to pay highly skilled employees wages significantly above the prevailing industry wage for similar employees. One explanation for this, beyond the attraction and retention benefits of the high wages, may be these organizations recognition that these employees are performing activities that are difficult and expensive to monitor from a performance perspective. These employees likely possess skills and abilities that may be unique in their organizations—thus, gauging the quality of their work is highly problematic. However, by paying high relative wages, the organization creates an environment in which these employees are motivated to perform effectively absent direct supervision. Specifically, employees will be motivated to perform effectively as they desire to maintain their current wages, realizing that these wages exceed those they might receive from another organization should they lose their jobs. Consequently, a lead relative wage strategy, in addition to being useful from an attraction and retention perspective, is also useful from the perspective of employee motivation.
Related, although not considered part of efficiency wage theory, Lazear (1979) used a similar explanation to demonstrate why employees might be compensated lower than their marginal productivity (i.e., the value of their organizational contributions) early in their careers and higher than their marginal productivity later in their careers. Delayed compensation, as this is called, is attributed to the positive employee agency effects (i.e., employees acting in the best interest of their organizations) associated with these increasing wage profiles. The prospects of higher wages (i.e., efficiency wages) keep employees motivated and focused on tasks at hand and discourage unproductive activities. Prospective future higher wages are motivational because employees realize that current poor performance will eliminate their opportunities to receive higher wages in the future.
Norm-gift exchange models provide a final efficiency wage theory based explanation for relative wage practices’ effects on employee and organizational efficiency. Normgift exchange models assert that, because of employee-firm exchanges, employees acquire sentiments for their firms and feel obliged to maintain equity in these exchanges. Therefore, when inequity occurs employees feel motivated to alleviate the inequity. Accordingly, one explanation for high relative wages’ positive influence is that they create disequilibrium in the employee-firm relationship, resulting in increases in employee effort and efficiency. Alternatively, Yellen (1984) described this mechanism as firms paying “workers a gift of wages in excess of the minimum required, in return for their (workers) gift of effort above the minimum required” (p. 204).
To summarize, each of these explanations suggests market leading wages will generate a host of organizational benefits. Specifically, market leading wages may positively contribute to increased employee and organizational efficiency and firms may thus choose to pursue a lead relative wage strategy to positively influence organizational performance.
Lag Relative Wage Strategy
Although efficiency wage theory suggests firms will find a lead relative wage strategy most advantageous, not all organizational situations lend themselves to the use of this strategy. Indeed, while some positions may justify high wages because of their potential organizational contributions, other positions may conversely not justify high wages due to their lack of organizational contribution. Illustrating this, some jobs may give employees few opportunities to contribute meaningfully to organizational performance. In these positions, employees’ efforts and abilities make little difference in the context of the organizational benefits of their performance. Typically, in these are simple, limited complexity jobs, differences in performance have little consequence in terms of organizational performance. Accordingly, paying high wages in these positions generates little organizational benefit. Moreover, not only leading wages are unjustified but even wages that match the market are likely unjustified. The crux of these positions is that increases in organizational contribution associated with differences in employee effort and ability are so narrow that increases in performance beyond those of even the poorest performer are not justified. Simplistically, in these jobs, the compensation required to garner employee performance beyond that deemed minimally acceptable is not justified by associated increases in organizational performance.
Further supporting the effectiveness of a lag relative wage strategy, research investigating the usefulness of utility analysis in compensation decision making has demonstrated how a lag strategy may be more effective than other strategies at low organizational levels (Klaas & McClen-don, 1996). In this research, other strategies were found to be inappropriate in lower level organizational positions because the impact of average or above average employees is limited by characteristics inherent in these positions. These characteristics include the limited discretion and lack of consequence for organizational goals associated with performance in these positions. Moreover, research also suggests that productivity differences based on employee quality significantly increase as job complexity increases (Hunter, Schmidt, & Judiesch, 1990). Employee productivity likely increases as more qualified employees’ greater ability helps them effectively manage the discretion and autonomy that frequently accompanies more complex jobs. Unfortunately, in positions with limited organizational impact, increased wage costs beyond the lowest wage necessary to attract employees are not justified. High wages are not justified because these positions do not offer the organizational impact necessary to justify higher paid employees’ greater skills and ability. Consequently, the lag strategy is more appropriate in lower impact positions as the costs associated with offering greater pay in these positions are greater than the associated benefits.
Match Relative Wage Strategy
The final relative wage strategy available to organizations is to match prevailing market wages. In practice, a match strategy is the most common relative wage strategy (Klaas & McClendon, 1996; Milkovich & Newman, 2007). Predictably, by virtue of their matching wage levels, firms pursuing a match relative wage strategy will experience similar wage level based attraction and retention benefits as competing organizations (Milkovich & Newman, 2007). Unfortunately, these firms deprive themselves of opportunities to generate relative wage strategy based sources of competitive advantage as their market consistent wages represent a poor source of competitive advantage (Milkovich & Newman, 2007). Thus, although a match relative wage strategy does guarantee employee attraction and retention, it nevertheless fails to afford organizations the opportunity to strategically adapt pay levels for organizational benefit.
External Salary Level Determination
Before firms can pursue a particular external competitiveness strategy, they must first assess the prevailing wage level for a specific position. The next section will consider various facets of the process of determining appropriate prevailing wage levels upon which to base an external competitiveness strategy. Simplistically, the question at hand in this section is determining an appropriate wage level to lead, lag, or match in the context of external competitiveness.
Among the most important steps in determining an appropriate salary level for external competitiveness purposes is collecting useful salary data from the external environment. This step in the process of establishing an external competitiveness strategy has come to be known as conducting a salary survey. Although some firms conduct their own salary surveys, simplicity and restraint of trade considerations lead many firms to either hire a consulting firm to collect this data or to purchase prepared salary survey datasets. Since the most common method of collecting data seems to be prepared salary survey datasets, these sources will be the focus in this section. However, as many of the questions that must be considered when evaluating a prepared salary dataset are also pertinent to conducting a salary survey, much of the next section is equally applicable in the context of salary survey design and administration.
While prepackaged datasets appear an easy solution to determining the appropriate wage level for a particular position, effectively using them is largely a function of making appropriate comparisons in evaluating salary data across employers. Simplistically, the goal in these comparisons is to make appropriate comparisons across organizations. Although many jobs are largely similar across organizations, others are significantly different and the development of an effective external competitiveness strategy requires a careful consideration of these similarities and differences.
The most effective technique to evaluate similarities and differences among jobs across organizations is to compare their respective job descriptions. Most salary survey datasets provide generic job descriptions for the positions included in the dataset. By evaluating these job descriptions versus the job description of the position being priced, similarities and differences between salary survey jobs and the positions of interest can be determined. Once the jobs under consideration seem similar, the next task becomes one of determining how appropriate across firm comparisons are.
Evaluating the appropriateness of across firm job comparisons involves a consideration of the size, location, and industry of the organizations whose jobs are included in the survey. Although jobs may be quite similar in terms of their job descriptions, significant salary differences may exist based upon a firm’s size, location, or industry. For instance, in terms of location, some positions are recruited on a local or regional level, whereas other positions are recruited on a national or international level. Thus, a firm hiring administrative assistants in Boston would most appropriately consider salary data for administrative assistants in Boston or New York as administrative assistants are typically recruited on a local or regional level. Conversely, when setting wages for jobs recruited on a national or inter-national level more appropriate comparisons are similar jobs wherever they are located. Consequently, when recruiting a CEO in Boston salary comparisons to CEOs working in Los Angles or even Hong Kong now make more sense. Additionally, when making comparisons at the national or international level, consideration must also be given to cost of living differences as these differences may potentially influence the accuracy of comparisons. For instance, even though they are both large cities, substantial differences in the cost of living exist between Chicago and London (i.e., one of the most expensive cities in the world for business) and these differences must be considered when establishing externally competitive wages.
Beyond location, considerations of firm size and industry are also important in terms of determining appropriate salaries for comparison purposes. In terms of size, large firms typically pay higher wages than smaller firms pay. Thus, when performing external salary comparisons, firm size (which is typically included in most salary survey datasets) should also be considered. Lastly, the industry in which comparisons are being made must also be considered. For instance, firms in high-tech industries typically pay higher wages than firms in less technologically intensive industries pay. Thus, a technologically intensive firm wishing to hire a computer programmer should cautiously consider salary data on computer programmers derived from nontechnology intensive industries as these firms’ salaries may be lower than those of technologically intensive industries.
Components Of Compensation
Having considered potential external competitiveness strategies and considered how firms determine external salary levels, this research-paper will next consider how firms implement their external competitiveness strategies in the context of the various components of compensation. Indeed, as firms have sought to effectively manage their external competitiveness strategies to increase their competitive advantage significant attention has begun to be focused not only on the external competitiveness strategy itself but also on components of the strategy (Milkovich & Newman, 2007). Typically, this mix of compensation components is referred to as an organization’s pay mix. Pay mix data is included in most salary surveys and salary survey datasets.
When we consider the components of a firm’s external competitiveness strategy, we are evaluating the various types of compensation that make up employees total compensation. Indeed, just as firms my lead, lag, or match the market in terms of base compensation, they may also lead, lag, or match the market in terms of the other components of compensation. In the next section, this research-paper will discuss the various potential types of compensation and how firms might choose to strategically manage these (i.e., lead, lag, or match) in the context of their external competitiveness strategies.
The components of pay can be broadly thought of in terms of cash and noncash components. Cash components of pay include both base salary and incentive or bonus pay. Noncash components of pay include both income protection benefits (e.g., health insurance, retirement benefits, etc.) and work-life balance components (e.g., sick leave, vacation, etc.). Although issues of external competitiveness are often thought of only in terms of base pay, the other components of pay also have significant implications in terms of external competitiveness decision making.
An employee’s level of base pay describes the consistent pay employees receive for performing a job on some periodic basis. Base pay is the fundamental compensation employees receive for performing a job. Typically, base pay is determined prior to an employee’s beginning a job. Employees’ base pay changes over time due to modifications made to accommodate increases in the cost of living or to reward employees for good performance. From an external competitiveness perspective, base pay is among the most pertinent of all elements of employee compensation. Base pay is important in the context of external competitiveness because with a few exceptions (e.g., high-level managerial/ professional employees, employees compensated largely in terms of commission) it frequently represents the largest component of employee compensation and thus has the greatest impact on employees. Consequently, to the extent a firm pursues a particular external competitiveness strategy the strategy will often be enacted in terms of employees’ base pay.
Although an organization’s decisions in terms of base pay are likely the most significant components of a firm’s external competitiveness strategies, the importance of the other components should not be underestimated. For instance, beyond base pay, incentive compensation is also important in the context of external competitiveness. Incentive compensation represents the component of employees’ cash compensation that is not fixed over time. Typically, incentive compensation varies over time based upon employee performance. Incentive compensation is interesting from an external competitiveness perspective as firms’ choices to pursue particular external competitiveness strategies may indicate particular behaviors they desire from employees. Indeed, it is common for firms to pursue external competitiveness strategies in terms of incentive compensation that differ from their strategies in terms of base pay.
External competitiveness strategies in which a firm pursues different strategies for various components of compensation are known as hybrid external competitiveness strategies. For instance, a firm that wants to motivate particular behaviors may enact a hybrid external competitiveness strategy with market leading incentive compensation but market lagging base wages. Examples of firms that might pursue this strategy include those pursing a sales-driven organizational strategy. These organizations might choose to compensate employees largely in terms of commissions and thus focus on incentive compensation while de-emphasizing base compensation. These firms emphasize incentive compensation to elicit the behaviors being incentivized. Conversely, firms less interested in incentivizing behavior might provide either no incentive compensation or incentive compensation that merely lags the market. In the case of the lagging incentive compensation, the low incentive compensation usefully drawing employees’ attention to the incentivized behavior while nevertheless not influencing their behavior as profoundly. Illustrating this, some firms that compete against sales-driven organizations may instead choose to pursue a customer service driven strategy. In the context of their strategy, these firms may choose to de-emphasize sales-driven incentives believing customer service is better fostered when employees are less focused on sales. Thus, these organizations, while lagging on incentive compensation, might choose to lead on base compensation to attract high-quality employees who will excel in terms of customer service. Ultimately, the key issue with incentive compensation remains the degree to which a firm wishes to incentive particular behaviors in the context of its incentive compensation.
The noncash or benefits components of compensation include the tangible rewards employees receive beyond the cash components of their compensation. The benefits components of compensation can be broken down into income protection and work-life balance components (Milkovich & Newman, 2007). The purpose of income protection elements is to assure employees’ health and income. Typically, income protection benefits include elements beyond those mandated by the government (e.g., social security, Medicare/Medicaid, and workers compensation insurance) such as health insurance and retirement benefits. Work-life balance benefits are those benefits designed to help employees balance their work and family obligations. Typically, work-life balance elements include benefits such as sick leave, child-care assistance, and vacation.
Just as firms’ may choose to pursue particular pay strategies with the other components of pay, firms may also choose to pursue specific strategies in terms of their benefits. Firms may choose a particular external competitiveness strategy in terms of their income protection and work-life balance offerings for a host of strategic or economic reasons. For instance, to increase employee attraction and retention, firms may signal they are an organization that cares about employees by leading the market in terms of their income protection offerings. Similarly, large firms may chose to offer lucrative health care benefits as their large size allows them to efficiently purchase employee health care benefits. Indeed, large organizations may be able to offer employees substantial cost savings in terms of some benefits (e.g., health insurance, life insurance, etc.) versus the costs employees would incur if purchasing these benefits individually.
Increasingly, some firms have started offering employees significant choices in terms of their benefits. Plans where employees are allowed to choose among their benefits options are known as cafeteria plans (Milkovich & Newman, 2007). The notion behind cafeteria plans is that employees will be more satisfied when they are able to select those benefits that they deem most appropriate to their particular circumstances. Although intuitively compelling, cafeteria plans must be cautiously considered, as they may be both administratively complex and expensive. Moreover, to the degree that they offer employees the opportunity to choose potential benefits, cafeteria plans may also be troublesome as employees can make costly and problematic mistakes in their benefits choices (Milkovich & Newman, 2007).
In terms of the work-life balance components of compensation, some firms may offer their work-life balance components to attract a particular group of employees. For instance, working parents may find employment challenging as it conflicts with their child rearing responsibilities. However, organizations that provide child care services may alleviate the role conflict associated with working parents multiple responsibilities.
Ultimately, the key to understanding employee benefits from an external competitiveness perspective is recognizing firm’s potential cost effectiveness in providing these benefits and their usefulness in attracting, retaining, and motivating employees.
External competitiveness is but one part of an organization’s overall compensation strategy. In addition to external competitiveness considerations, issues of internal salary alignment, the design of pay for performance plans, and the administration of the overall pay system are also important. Of these areas, internal salary alignment seems a particularly pertinent area of consideration for those interested in further expanding their knowledge of compensation topics beyond external competitiveness.
Internal salary alignment considers pay relationships between employees inside an organization versus the external relationships considered by external competitiveness. Whereas external competitiveness considers salary comparisons across organizations for employees performing similar work, internal alignment considers salary comparisons inside organizations for employees doing different types of work. Moreover, just as external competitiveness has significant implications for individual and organizational performance, internal alignment has equally important implications.
Knowledge of internal salary alignment is particularly useful in the context of external competitiveness as these two facets of a compensation system simultaneously interact to explain the compensation employees receive.
Although it is possible to determine employees’ compensation based solely on external salary data, doing so neglects the importance of internal pay relationships and the effects these relationships have on individual and organizational performance. Thus, individuals wishing to further their knowledge of compensation would be well advised to delve into the literature on internal salary alignment.
This research-paper has considered theoretical and technical facets of the strategic pay level decision-making process. Strategic pay level decisions are those made in the context of organizations’ external competitiveness strategies. Various external competitiveness strategies and techniques useful in arriving at appropriate external competitiveness strategies have been presented. External competitiveness strategy options presented include those of either, leading, lagging, or matching prevailing market wages. The research-paper notes that external competitiveness strategies may be enacted at either the organizational or the job family level. Moreover, the research-paper also observes that external competitiveness strategies may vary across the components of compensation. The components of compensation considered include monetary (e.g., cash and incentive compensation) and nonmonetary elements (e.g., income protection benefits and work-life balance benefits). The research-paper closes with a suggestion that those with a further interest in this topic next consider the internal alignment facet of compensation systems as this literature, in combination with external competitiveness considerations, further elucidate the performance implications of employee compensation.
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