Summary by Lorrie Ramirez
Master of Accountancy Program
University of South Florida, Summer 2002
The purpose of this article is to shed light on six misconceptions about compensation, why many managers fall prey to these myths and to provide some recommendations about pay.
Myth and Reality
1. Labor rates and labor costs are the same thing. - Labor costs are a combination of wages and productivity.
2. You can lower your labor costs by cutting labor rates. - To lower labor costs, a company needs to address both pay and productivity.
3. Labor costs constitute a significant portion of total costs. - True sometimes, but frequently not. Labor costs just appear to be the easiest to cut.
4. Low labor costs are a potent and sustainable competitive weapon. - Labor costs are perhaps the least sustainable competitive weapon. Better strategies include quality, customer service, innovation and technological leadership.
5. Individual incentive pay improves performance. - Individual incentive pay undermines performance.
6. People work for money. - Sure, people need money to live on, but more importantly people work to provide meaning in their lives and to have fun.
Why the Myths Exist
Myths about labor costs and rates exist because labor rates are an easy target for managers looking to make an impact. What you pay your employees can be easily compared with the pay rates of your competitors as well as with those of companies around the world. In addition, it appears that the easiest way to control costs is to cut wages instead of redesigning processes or changing the corporate culture, for example. Managers believe that labor costs are the lever closest at hand and thus, has the most leverage.
We have economic theory to blame for the myths about incentive pay and monetary motivation. Further, the economic model of human behavior taught in business schools can be pinpointed. The model presumes that human behavior is rational, therefore driven by the best information available at the time and designed to maximize individual self-interest. According to the model, expected financial return is what motivates people to accept jobs and this determines the level of effort they are willing to expend in those jobs. The theory states that people who are not paid based on their level of performance won’t devote enough attention and energy to their work.
Additional problems arise from other concepts, such as agency theory and transaction-cost theory. Agency theory states that there are differences in preferences and perspective between employers/owners and employees. Transaction-cost economics tries to identify those transactions that are best organized by markets and those by hierarchies. Both concepts contain the notion that people not only seek self-interest but do so on occasion with "guile and opportunism."
Compensation-consulting firms also play a key role in perpetuating these myths. This industry has numerous incentives to feed these misconceptions, some are listed below:
1. Compensation is their bread and butter, despite the expansion into other areas of service.
2. It is easier for managers to change the pay system than it is to change an organization’s culture, the way it is organized, or the trust and respect that the system already exhibits.
3. Changes in the compensation system bring about new problems, giving the consultants new work.
From Myth to Reality: A Look at the Evidence
Evidence exists that companies are driven by these myths about compensation - basing their decisions to cut costs on false information. Take into consideration the changes made by Ford and General Motors in the 1990’s. Ford decided not to award merit raises to suffice a new cost-cutting program. General Motors wanted to move more of its work to non-union, lower-wage suppliers to reduce labor costs and increase profits. Both companies believed that labor costs and labor rates were the same thing and that labor costs represent a large portion of total costs. Fortune reported that a survey of 1000 companies between 1987 and 1993 showed that the percentage of those companies using individual incentives for at least 20% of their workforce increased from 38% to 50% while those using profit-sharing decreased from 45% to 43%. In addition, studies show that between 1981 and 1990, the number of sales people receiving straight salary declined by 13%.
Evidence challenges the myth about the effectiveness of individual incentives. Despite its popularity, this practice has been shown to undermine teamwork, encourage employees to focus on the short term, and lead people to link compensation to political skills and ingratiating personalities rather than to performance. (These are the reasons that Deming and other quality experts argued against the use of such practices.) Numerous surveys conducted by consulting companies reveal problems associated with individual incentives. Consulting firm, William M. Mercer, concluded that most performance-based pay plans share two qualities:
1. they absorb large amounts of management time and resources, and
2. they make everyone unhappy.
Some Advice About Pay
Pfeffer’s suggestions include:
Managers should be sufficiently aware of the difference between labor rates and labor costs. Only labor costs are the basis for competition and not necessarily a large component of total costs. It’s not what you pay people it’s what they produce.
To test the myth about individual incentives, managers should include a large amount of collective rewards in their employee compensation package and study the results.
Managers should de-emphasize pay and not portray it as the main incentive for working at a particular company. Take for example Tandem Computer who, if asked, told potential employees that they paid good, competitive salaries, but would not be specific. Their philosophy was that if you came for the money, then you would leave for the money.
Pay has substantive and symbolic components. Pay reflects and helps determine the organization’s culture, thus, it is important for managers to be sure that the messages implied by pay practices are intended.
Companies should make information on pay available and not kept secret. Secrecy suggests to an organization’s employees that they are not trusted or that the company has something to hide.
Breaking With Convention to Break the Myths
Though many organizations spend vast amounts of time trying to redesign their pay systems, they still remain unhappy with the results. Methods are unproductive and companies feel trapped with no way to approach compensation. Pfeffer suggests that people are afraid to challenge the myths that exist about pay. It is easier to sit back and watch what others are doing and then follow their lead rather than pursuing something better, even if it is unconventional. If it were easy to achieve high organizational performance through innovative pay practices, then it wouldn’t provide the level of competitive leverage that it does. It is up to managers to break with common practice. Those who do will see that their organization’s compensation practices contribute rather than detract from building high performance management systems.
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