Prof. Dr. Birgitta Wolff

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OTTO-VON-GUERICKE-UNIVERSITY MAGDEBURG BEIJING
NORMAL UNIVERSITY
Prof. Dr. Birgitta Wolff, Marjaana Rehu,
M.A. Otto-von-Guericke-University, Germany
II. Human Resource Management
Variable or Fixed Salary
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Recap Session I

• ... 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)

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Outline

• 1. Incentive Problem
• 2. Compensation Contracts
• 3. Output-Based Pay
• 4. Input-Based Pay
• 5. Incentive Pay

Source www.msn.de
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1. Incentive Problem Coordination and Motivation
Problem
                   
 
Task
Coordination Who does what, when,...
Motivation How do I get somebody to perfom a
task, improve the quality,... gt Incentive Problem
Distribution of Output
Allocation of Input Resources
Individual
Source Wolff/Lazear (2001) Einführung in die
Personalökonomik, Stuttgart Schäffer-Poeschel,
S. 51
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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

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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
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2. Compensation Contracts
Compensation Contracts
Variable Pay
Fixed Salary
Payment by Output
Payment by Input
Subjective Performance Measures
Subjective Performance Measures
Objective Performance Measures
Objective Performance Measures
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2. Compensation Contracts Payment by Input versus
Payment by Output
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

• 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
  workers effort

Examples
Examples

• Wage per work hour
• Monthly salaries
• Annual salaries

• Agricultural workers piece rates p. tray
• A salesperson on straight commission
• Compensation of top executives by stocks or
  stock options

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2. Compensation ContractsHow 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. Database objective subjective
Output revenue, dividend customer satisfaction
Input time qualification
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2. Compensation Contracts Examples of Different
Variables as a Basis of Output-Related Pay
Basis Variables for output-based pay
Quantity of production pieces, weight, size/height
Quality of production Rejects, grade, customers satisfaction, individual targets
Input reduction Reduction of input factors raw material, energy, work time
Capacity utilization slack-, repair- and waiting periods
Be on schedule Timeliness vis à vis internal and external customers
Value of the firm stock price, economic value added
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3. Output-Based Pay
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

Source www.kone.fi
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3. Output-Based Pay Selection Effect An Example
of Compensating Salespeople
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
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3. Output-Based Pay Selection Effect An Example
of Compensating Salespeople (cont.)
W ...Weekly Pay
A (World Book)
500
B (Britannica)
300
3
x ... Number of encyclopedia
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? Higher-productivity workers will leave
Britannica, because they will earn more at
World Book. Only lower-productivity workers will
stay at Britannica
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3. Output-Based Pay Disadvantages of Output-Based
Pay

• Disadvantage of piecework Variations of output
  can be beyond the workers control

Variable pay
Straight salary

• 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 risk?higher compensation
• Opportunity participate in good economic
  development
• Stronger incentives

• Fixed salary doesnt 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

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3. Output-Based PayRisk 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
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4. Input-Based Pay

• 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 workers
  effort

Source www.euro.fi
Examples wage per work hour, monthly salaries,
annual salaries
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4. Input-Based PayBenefits of Input-Based Pay

• Problems of output-based pay solved by time-based
  (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!
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Compensation Schemes Balancing Quantity and
Quality

• 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 Typists 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
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4. Input-Based Pay Using the Appropriate Time Unit
Input-based pay
Hourly wages
Monthly salary
Annual salary

• Production workers
• Clerical workers

• Top Management

• Managerial workers

Tasks not experienced and difficult to
prescribe often to be defined by top manager
Tasks less experienced and not easy to prescribe
Tasks experienced and easy to prescribe

• Low correlation between effort and work time
• Time input bad measure for effort ?
  overinvestment in easy (pleasant) tasks

• High correlation between effort and time
  invested
• Time input as a pretty good indicator for
  effort

• Undefined set of tasks (goal), discretion
  over work
• Importance of other incen- tives to motivate
  for effort (long-term, e.g. stock options)

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5. Incentive PayOptimal 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

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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

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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

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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)