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Compensation
Case Study: Loafers at Lakeside Utility Company

Intan Maulida S. Tri Febrianti

120120110060 120120110061

STUDY PROGRAM MAGISTER MANAGEMENT OF SCIENCE FACULTY OF ECONOMICS

PADJADJARAN UNIVERSITY BANDUNG 2011

Chapter 1 Case Loafers at Lakeside Utility Company

Lakeside Utility Company provides electrical power to a country with 50.000 households. Pamela Johnson is a manager in charge af all repair and installation crews. Each crew consists o approximately seven employees who work closely together to respond to calls concerning power outages, fires caused by electrical malfunctions, and installation of new equipment or electric lines. Fourteen months ago Johnson decided to implement a team-based incentive system in which an annual bonus would be provided to each crew that met certain performance criteria. Performance measures included such indicators as average length of time needed to restore power, results of a consumer satisfaction survey, and number of hour required to complete routine installation assignments successfully. At the end of the first year, five crews received an average cash bonus of $12,000 each, with the amount divided equally among all crew members. Soon after Johnson announced the recipients of the cash bonus, she began to receive a large number of complaints. Some teams not chosen for the award voiced their unhappiness through their crew leader. The two common complaints were that the teams working on the most difficult assignments were penalized (because it was harder to score higher on the evaluation). And that crews unwilling to help out other crews were being rewarded. Ironically, members of the crews that received the awards also expressed dissatisfaction. A surprisingly large number of confidential employee letters from the winning teams reported that the system was unfair because the bonus money was split evenly among all crew members. Several letters named loafers who received more than their share because they were frequently late for work, took long lunches and frequent smoking breaks, and lacked initiative. Johnson is at a loss about what to do next. Critical Thinking Question 1. What major issues and problems concerning the design and implementation of pay-for-performance systems does this case illustrate? Explain 2. Are team-based incentive appropriate for the type of work done by Johnsons crews? 3. Might it be desirable to use a combination of team-based and individual incentives at Lakeside Utility Company? How might such a plan be structured?

Chapter 2 Literature of Compensation

2.1 Definition According to the American Compensation Associations (1995) compensation can be defined as cash and non-cash remuneration provided by an employer for services rendered (ACA, p. 9; Cheryl Zobal, 1998). On journal of Compensation and control sales policies, and sales performance: the field sales managers points of view by Ines Kuster and Pedro Canales compensation can be defined as the economic reward for performing a task. Compensation refers to all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship. 2.2 A Pay Model

POLICIES

TECHNIQ UE

OBJECTIV ES

ALIGNMENT

Evaluation Work INTERNAL / Analysi Description Certificatio STRUCTUR s s E n

EFFICIENCY
Performance Quality

Market Difinitions Surveys COMPETITIVENESS

Policy Lines

PAY STRUCTURE

Customerr and Stockholder Cost

CONTRIBUTIONS

Seniority Performance Merit INCENTIVE Based Based GuidelinesPROGRAMS

FAIRNESS

COMPLIA NCE
Cost MANAGEMENT Communication Change EVALUATION

2.3 Strategic Choices Strategy refers to the fundamental directions that an organization chooses. A Strategic perspectives focuses on those compensation choices that help the organization gain and sustain competitive advantage. 2.4 Incentive Pay Systems Incentive pay plans design to relate pay directly to performance or productivity, often used in conjunction with a base wage and salary system. ( There are two basic requirements for an incentive plan. The first concerns the procedures and methods used to appraise employee performance. The second requirement is that the incentives (rewards) must be based on performance. Individual-based incentive plan require that employees perceive a direct relationship between their own performances and their subsequent rewards. Group-based plan require employees to perceive a relationship between groups performance and the subsequent rewards of the groups member. 2.4.1 Individual Incentive Individual incentive is an incentives based on individual performance. At nonmanagerial levels in an organization, individual incentives are usually based on the performance of the individual. At managerial levels, individual incentives are often based on the performance of the managers work unit (Byars & Rue, 2004). Type Individual Incentive Method of Rate Determination Units production time period Pay constant function of production level Relationship between Production Level and Pay Pay varies as function of prodction level (1) Straight piecework plan (3) Taylor differential piece-rate system Merrick multiple piece rate system of Time period per per unit of production (2) Standard hour plan (4) Halsey 50-50 method Rowan plan Gantt plan

4 1. Cell 1: The most frequently implemented incentive system is a straight piecework system. Rate determination is based on units of production per time period, and wages very directly as a function of production level. the major advantage of this type of system are that it is easily understood by workers and perhaps consequently, is more readily accepted than some other incentive systems. 2. Cell 2: Two relatively common plans set standards based on time per unit and tie incentives directly to level of output: (1) standard hour plans and (2) Bedeaux plans. A standard hour plan is a generic term for plans setting the incentive rate based on completion of task in some expected time period. A Bordeaux plan provides a variation on straight piecework and standard hour plans. Instead of timing an entire task, a Bordeaux plan requires division of task into simple actions and determination of the time required by an average skilled worker to complete each action. After the more detailed time analysis of tasks, the Bordeaux system function similarly to a standard hour plan. 3. Cell 3: The two plans included in cell 3 provide for variable incentives as a function of units of production per time period. Both the Taylor plan and the Merrick plan provide different piece rates, depending the level of production relative to the standard. The Taylor plan establishes two piecework rates. One rate goes into effect when a worker exceeds the published standard for given time period. This rate is higher than the regular wage incentive level. A second rate is established for production below standard, and this rate is lower than the regular wage. The Merrick system operates in the same way, except that three piecework rates are set: (1) high for production exceeding 100 percent of standard; (2) medium for production between 83 and 100 percent of standard; and (3) low for production less than 83 percent of standard. 4. Cell 4: The three plans included in cell 4 provide for variable incentives linked to a standard expressed as a time period per unit of production. The three plans include the Halsey 50-50 method, the Rowan Plan, and the Gantt Plan. The Halsey 50-50 method derives its name from the shared split between worker and employer of any savings in direct cost. An allowed time for a task is determined via time study. The savings from completion of a task in less than the standard time are allocated 50-50 (most frequent division) between the worker and the company. The Rowan Plan is similar to Halsey Plan in that an employer and employee both share in savings resulting from work completed in less than standard time. The major distinction in this plan, however is that a workers bonus increases as the time requiered to complete the task decreases. The Gantt Plan differs from both the Halsey and the Rowan plans in that the standard time for a task is purposely set at a level requiring high effort to complete. Any worker who fails to complete the task in the standard time is

5 guaranteed a pre-established wage. However, got any task completed in standard time or less, earnings are pegged at 120 percent of the time saved.

Advantages and Disadvantages of Individualized Incentive Plans Advantages: 1. Substantial impact that raises productivity, lowers production costs, and increases earnings of workers. 2. Less direct supervision is required to maintain reasonable levels of output than under payment by time. 3. In most cases, systems of payment by results, if accompanied by improved organizational and work measurement, enable labor costs to be estimated more accurately than under payment by time. This helps costing and budgetary control. Disadvantages: 1. Greater conflict may emerge between employees seeking to maximize output and managers concerned about deteriorating quality levels. 2. Attemps to introduce new technology may be resisted by employees concerned about the impact on production standards. 3. Reduced willingness of employees to suggest new production methods for fear of subsequent increases in production standards. 4. Increased complaints that equipent is poorly maintained, hindering employee efforts to earn larger incentives. 5. Increased turnover among new wmployees discouraged by the unwillingness of experienced workers to cooperate in on-the-job training. 6. Elevated levels of mistrust between workers and management. 2.4.2 Group Incentive Group Incentive is an incentives based on group rather than individual performance. Under a group incentive plan, all members of specified group receive pay based on the performance of the entire group. (Byars & Rue, 2004) Group incentive plans are designed to encourage employees to exert peer pressure on group members to perform. An advantages of group incentive is that: (Milkovich & Newman; 2008) 1. Positive impact on organization and individual performance of about 5 to 10 percent per year. 2. Easier to develop performance measures than it is for individual plans. 3. Signals that cooperation, both within and across groups, is a desired behavior. 4. Teamwork meet with enthusiastic support from most employees. 5. May increase participation of employees in decision-making process.

6 A disadvantage of group incentive is that: 1. Line-of-sight may be lessened, that is employees may find it more difficult to see how their individual performance affects their incentive payouts. 2. May lead to increased turnover among top individual performances who re discouraged because they must share lesser contributors. 3. Increases compensation risk to employees because of lower income stability. May influence some applicants to apply for jobs in firms where based pay is larger compensation component.

Byars & Rue (2004)have an argument that a disadvantage of group incentive is that the members of the group may not perceive a direct relationship between their individual performances and that of the group. Another potential disadvantages is that different groups can become overly competitive with one another to the detriment of the entire organization. Types of Group Incentives Plans 1. Organizationwide incentives Incentives that reward all members of the organization based on the entire organization. 2. Gain sharing Programs also known as profit sharing, performance sharing, or productivity incentives; generally refer to incentive plans that involves employees in a comon effort to achieve the companys productivity objectives. Based on the concept that the resulting incremental economics gains are shared among employees and the company. Keys element issues in designing a gain-sharing plan. (Milkovich & Newman, 2008): Strength of reinforcement: What role should pay assume relative to incentive pay? Incentive pay tends to encourage only those behaviours that are rewarded. Productivity standard: What standard will be used to calculate whether employees will receive an incentive payout? Sharing the gains split between management and workers: Part of the plan must address the relative cuts between management and workers of any profit or savings generated. Scope of the formula: Formulas can vary in the scope of inclusions for both the labor inputs in numerator and the productivity outcomes in the denominator. Perceived fairness of the formula: One way to ensure the plan is perceived as pair is to let employees vote on whether implementation should go forward. This and union participation in program design are two elements in plan success.

7 Ease of administration: Sophisticated plans with involved calculations of profits or costs can become too complex for existing compny information systems. Production variability: One of the major sources of problems in group incentives plans is failure to set targets properly. 3. Scanlon-type plans Organizationwide incentive plan that provides employees with a bonus based on tangible savings in labor cost. (Byars & rue, 2004). Scanlon plans are designed to lower labor cost without lowering the level of a firms activity. Incentives are derived as afunction of theratio between labor cost s and sales value on production (SVOP). The SVOP includes sales revenue and the value of goods in inventory. (Milkovich & Newman, 2008): 4. Employee Stock Ownership Plans (ESOPs) Form of stock option plan in which the organiztion provides for purchase of its stock by employees at a set time period based on the employees service and salary and the profits of the organization.

8 2.5 Types of Variable- Pay Plans: Advantages and Disadvantages Plan Type Cash profit sharing What Is It Advantages Disadvantages Why?

Award based on Simple, easily organizational profitability understood Shares a percentage of profits Low administrative costs (typically above a target level of profitability) Usually an annual payout Can be cash or deferred Stock Award of stock shares or Option awards have ownership options minimal impact om the or options financial statements of the company at the time they are granted If properly communicated, can have powerful impact on employee behavior Tax deferral to employee Balance Award that combine financial Communicates Scorecard and operating measures for organizational priorities organization, business unit, and/or individual performance Award pool based on achieving performance targets Multiple performance measures may incude: 1. Nonfinancial/ operating: quality improvements, productivity gains, customer service improvements 2. Financial: EPS, ROE, ROA,

Profit influenced by many To educate employees factors beyond employee about business control operations May be viewed a an To foster teamwork or entitlement one-for-all environment Limited motivational impact Indirect pay/ performance To recruit top-quality link employees when organization has highly Employees may be uncertentain future (i.e. required to put up money start-ups, high-tech, or to exercise bio-tech industries)

Performances criteria may To focus employees on be met, but if financial need to increase targets are not met, there shareholder value may be areduced payout To focus employees on or no pay out at all organization, division, Can be complex and/or individual goals To link payouts to a specific financial and/or operational target

9 revenues Productivit Awards that share economic y/ benefits of improved Gain productivity, quality, or other sharing measurable results Focus on group, plant, department, or division results Design to captilized on untapped knowledge of employees Team/gro up incentives Awards determined based on team/group performance group performance goals or objectives Payout can be more frequent than annual and can also extend beyond the life of the team Payout may be uniform for team/group members

Clear performance-reward links Productivity and quality improvements Employees knowledge of business increases Fosters teamwork, cooperation Reinforces teamwork and team identity/results Effetive in stimulating ideas and problemsolving Minimizes distinctions between team members May better reflect how work is performed

Can be administratively To support a majr complicated productivity/quality initiative (such as TQM Unintended effects, like or reengineering) drop-off in quality To foster teamwork Management must open environment the books Payout can occur even if To reward employees for improvements in companys financial activities that they performance is poor control May be difficult to isolate To demonstrate an impact of team organizational commitment to teams Not all employees can be placed on team To reinforce the need for employees to work Can be administratively together to achieve a complex results May create a team competition Difficult to set equitable targets for all teams

Source: Kenan S. Abosch, Variable Pay: Do we have the Basics in Place? 30 (4) 1998, pp.12-22 ;(Milkovich & Newman, 2008, 300-301)

10 The Choice between Individual and Group Plans Characteristi c Performance measurement Choose an Individual Plan when Good measures of individual performance exist. Task accomplishment not dependent on performance of others. Individual performance standard are stable. Production methods and labor mix relatively constant. Choose a Group Plan when Output is a group collaborative effort. Individual contributions to output cannot be assessed.

Organizational adaptability

Organizational commitment

Union status

Commitment strongest to individuals profession or superior. Supervisor viewed as unbiased and performance standards readily apparent. Nonunion; unions promote equal treatment. Competition between individuals inhibits fraternal spirit.

Performance standard for individuals change to meet environmental pressures on relatively constant organizational objectives. Production methods and labor mix must adapt to meet changing pressure. High commitment to organization built upon sound communication or organizational objectives and performance standards. Union or nonunion; unions less opposed to plan that foster cohesiveness of bargaining unit and which distribute rewards evenly across group.

Source: Milkovich & Newman, 2008, 302

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Chapter 3 Discussion
1. What major issues and problems concerning the design and implementation of pay-for-performance systems does this case illustrate? Explain. Pay structure model:

Major issues is about group-based incentive that employee doesnt perceived fairness and bad communication between one group and other groups. Why employee doesnt perceived fairness? Because Lakeside Utility Company used merit guidelines for determination to group incentive. So, employee in the same group will received same rate incentive. Thats why someone in the group can be motivated or more lazy to do their job. The diligent ones in the group would try to pursuing higher incentive. So the lazy ones will depend on the diligent, thats happened in the company. In other problem, one and other group had different difficult level of assignment. However, the standardized of the assignment is same, thats make not fair for the group who get assignment more difficult. What happened with the communication?

12 The relationship between one group to another group had not cooperative. Because of the feeling unfairness about the policy of contributions that different difficult level of assignment get the same standard assessment. Thats why the best group in fact doesnt necessarily give the largest contribution to the company and the best performance in doing his job. 2. Are team-based incentive appropriate for the type of work done by Johnsons crews? Yes, because based on characteristic of their job that repaired and installation electrical power. They need collaborative of their cooperation, in example when power outages happened to some household, the team will divided their job in different task that can handle every problem that happened in every household. 3. Might it be desirable to use a combination of team-based and individual incentives at Lakeside Utility Company? How might such a plan be structured? Cheryl Zobal (1998) design the ideal team compensation systems that compensation have to link with: business strategy; the performance management system; and compensation system. In the compensation have to link with compensation systems not only compatible with other systems but also must congruent internally(lawler,1990, 1995). For instance, Lawler claims that for pay practices to be successful they must align three critical component: 1. Value (i.e. core beliefs such as pay for performance) 2. Process design features (i.e. communication policies, decision making practices, etc.) 3. Specific pay practices and structures (i.e. gain sharing) In the specific pay team there are a model of how to pay team differentiated by: (Montemayor, 1994) task interdependence (i.e. the extent to which individual works contributions are integrated into team results); Level of supervisions; and diversity of task requirements. Montemayor conclude that: the more task interdependence, the greater the need for team oriented compensation; the less supervision, the more the need for collaborative pay systems; and the more diverse the tasks (due to education or experience) the last the need for equal payout. Lakeside Utility Company should use combination of team-based and individual incentives because based on London and Oldham (1977) research, the result

13 showed that the individual incentive would increase the other employees performance in the workgroup. Gain sharing plan is used for team compensation. Programs also known as profit sharing, performance sharing, or productivity incentives; generally refer to incentive plans that involves employees in a common effort to achieve the companys productivity objectives. Based on the concept that the resulting incremental economics gains are shared among employees and the company. Keys element issues in designing a gain-sharing plan. (Milkovich & Newman, 2008): Strength of reinforcement: Incentive pay tends to encourage only those behaviors that are rewarded. In this case, each employee must have a certain behavior such as controlling every week in every household in the county to check there are no breakage power. Or the company give reward for the employee who can done the difficult assignment based on categories of the difficultness assignment. Productivity standard: The standard will be used to calculate is based on historical standard but the standard wont be hard to achieved that would be appropriate to the conditions of their company. Sharing the gains split between management and workers: Part of the plan must address the relative cuts between management and workers of any profit or savings generated. Scope of the formula: Formulas can vary in the scope of inclusions for both the labor inputs in numerator and the productivity outcomes in the denominator. Perceived fairness of the formula: In this case, we didnt use vote from employee to know whether the plan design is succeed or not. We used categorical of difficultness task and time period to solve the problem to design of incentive pay plan. Ease of administration: Sophisticated plans with involved calculations of profits or costs can become too complex for existing company information systems. Increased complexities also require more effective communications and higher levels of trust participants. Production variability: One of the major sources of problems in group incentives plans is failure to set targets properly. In this case, the Lakeside Utility Company need to make appropriate target that can be achieved every team.

Straight piecework system is used for individual incentive. Rate determination is based on units of production per time period. In this case, the problem is in a group, there are some workers who work diligently and give more effort than others that envious to other workers who work standard and give less effort but receive the same incentive. So, in individual performance with straight piecework system, supervisor will decide the rate incentive based on performance.

14 This situation can be done because the job characteristic of installation assignment have a same guidelines and the supervisor knows the characteristic of standard appraisal of performance. In the other side, individual incentive is better than the groups incentive as long as (1) the other workers did not get benefit from the subjects performance by receiving a higher pay level than he deserved or (2) the subject did not receive a lower pay rate because of the other workersa low performance. (London ang Oldham, 1977).

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REFERENCES
Byars, Lloyd L. and Leslie W. Rue. 2004. Human Resource Management 7th ed. McGraw-Hill/Irwin: Singapore. London, Manuel and Greg Oldham. 1977. A Comparison of Group and Individual Incentive Plans. Academy of Management Journal: JSTOR, Vol. 20, No. 1 pg. 34-41. Milkovich, George T. and Jerry M. Newman. 2008. Compensation 9th ed. McGraw-Hill/Irwin: Singapore. Zobal, Cheryl. 1998. The Ideal Team Compensation System an overview: Part I. Team Performance Management: MCB University Press, Vol. 4, No. 5 pp 235-249. Zobal, Cheryl. 1998. The Ideal Team Compensation System an overview: Part II. Team Performance Management: MCB University Press, Vol. 5, No. 1 pp 23-45.