Chapter 7.

COMPENSATION STRATEGY: EXTERNAL COMPETITIVENESS

In external competitiveness, (the second pay policy) comparisons are made outside the
organization – comparisons with other employers that hire the same kinds of
employees.
External competitiveness is expressed in practice by (1) setting a pay level that is
above, below, or equal to that of competitors, and (2) determining the mix of pay forms
relative to those of competitors.

External competitiveness refers to the pay relationships among organizations – the

organization’s pay relative to its competitors.
Pay level refers to the average of the array of rates paid by an employer:
(base + bonuses + benefits + options) number of employees
Pay forms are the various types of payments, or pay mix, that make up total
compensation.

Both pay level and pay mix focus on two objectives: (1) control costs, and (2) attract and
retain employees.

Control Costs
The higher the pay level, the higher the labor costs:
Labor costs = pay level x number of employees
The higher the pay level relative to what competitors pay, the greater the relative costs
to provide similar products or services. So you might think that all organizations would
pay the same job the same rate. However, they do not.

Attract and Retain Employees

Different employers set different pay levels. They deliberately choose to pay above or
below what others are paying for the same work. Not only do the rates paid for similar
jobs vary among employers, but a single company may set a different pay level for
different job families. Exhibit 7.1 illustrates this point. However, when total
compensation (bonuses, stock options, and benefits) is looked at, the pay rate for the
position might be further below or actually above the market rate. For example, an
engineer is 2% below the market rate when only his base wage is observed. But when
total compensation is taken into consideration, he might be 30% below the market rate.

The exhibit makes two points. First, companies often set different pay-level policies for
different job families. Second, how a company looks in comparison to the market
depends on the companies it is compared to and the pay forms included in the
comparison. Even though people love to talk about “market rates,” there is no single
“going rate” in the marketplace.

There is no single “going mix” of pay forms, either. Exhibit 7.2 compares the mix of pay
forms for the same job. Both companies offer about the same total compensation. Yet
the percentages allocated to base, bonuses, benefits, and options are very different.

WHAT SHAPES EXTERNAL COMPETITIVENESS?

Factors that affect a company’s decision on pay level and mix: (1) (LABOR MARKET
FACTORS) competition in the labor market for people with various skills; (2)
(PRODUCT MARKET FACTORS) competition in the product and service markets,
which affects the financial condition of the organization; and (3) (ORGANIZATION
FACTORS) characteristics unique to each organization and its employees, such as its
business strategy, technology, and the productivity and experience of its work force.

These factors act in concert to influence pay-level and pay-mix decisions.

LABOR MARKET FACTORS

Economists describe two basic types of markets: the quoted price and the bourse.
Stores that label each item’s price or ads that list a job opening’s starting wage are
examples of quoted-price markets (Amazon). Bourse markets allow for haggling to
occur over the terms and conditions until an agreement is reached (e-Bay). In both the
bourse and the quoted market, employers are the buyers and the potential employees
are the sellers. People and jobs match up at specified pay rates.

How Labor Markets Work

Theories of labor markets usually begin with four basic assumptions:

Employers always seek to maximize profits
People are homogeneous and therefore interchangeable; a business school graduate is
a business school graduate is a business school graduate.
The pay rates reflect all costs associated with employment (e.g., base wage, bonuses,
holidays, benefits, even training).
The markets faced by employers are competitive, so there is no advantage for a single
employer to pay above or below the market rate.

Understanding how markets work requires analysis of the demand and supply of labor.
The demand side focuses on the actions of the employers: how many employees they
seek and what they are able and willing to pay those employees. The supply side looks
at potential employees: their qualifications and the pay they are willing to accept in
exchange for their services.

Look at Exhibit 7.4 The point where the lines for labor demand and labor supply cross
determines the market rate.

Labor Demand
How many people will a specific employer hire? The answer requires an analysis of
labor demand. In the short term, an employer cannot change any other factor of
production (i.e., technology, capital, or natural resources. Under such conditions, a
single employer’s demand for labor coincides with the marginal product of labor.

The marginal product of labor is the additional output associated with the employment of
one additional human resource unit, with other production factors held constant.
The marginal revenue of labor is the additional revenue generated when the firm
employs one additional unit of human resources, with other production factors held
constant.

Marginal Product

Diminishing marginal productivity results from the fact that each additional employee
has a progressively smaller share of the other factors of production with which to work.
In the short term, other factors of production (e.g., office space, number of computers,
telephone lines) are fixed. As more business graduates are brought into the firm without
changing other production factors, the marginal productivity must eventually decline.

Marginal Revenue

Marginal revenue is the money generated by the sale of the marginal product, the
additional output from the employment of one additional person. Therefore, the
employer will continue to hire graduates until the marginal revenue generated by the
last hire is equal to the costs associated with employing that graduate. Because other
potential costs will not change in the short run, the level of demand that maximized
profits is that level at which the marginal revenue of the last hire is equal to the wage
rate for that hire.
A manager using the marginal revenue product model must do only two things: (1)
determine the pay level set by market forces, and (2) determine the marginal revenue
generated by each new hire. This will tell the manager how many people to hire.
The model provides a valuable analytical framework, but it oversimplifies the real world.
In most organizations, it is almost impossible to quantify the goods or services produced
by an individual employee, since most production is through joint efforts of employees
with a variety of skills.
So neither the marginal product nor the marginal revenue is directly measurable.
However, if compensable factors define what organizations value, then job evaluation
reflects the job’s contribution and may be viewed as a proxy for marginal revenue
product.

Labor Supply
This model assumes that many people are seeking jobs, that they possess accurate
information about all job openings, and that no barriers to mobility (discrimination,
licensing provisions, or union membership requirements) among jobs exist. If
unemployment rates are low, offers of higher pay may not increase supply – everyone
who wants to work is already working. If competitors quickly match a higher offer, the
employer may face a higher pay level but no increase in supply.

MODIFICATIONS TO THE DEMAND SIDE

When we change our focus from all the employers in an economy to a particular
employer, models must be modified to help us understand what actually occurs. A
particularly troublesome issue for economists is why an employer would pay more than
what theory states is the market-determined rate. Exhibit 7.6 looks at three
modifications to the model that address this phenomenon: compensating differentials,
efficiency wage, and signaling

Compensating Differentials

If a job has negative characteristics then employers must offer higher wages to
compensate for these negative features. Such compensating differentials explain the
presence of various pay rates in the market. Although the notion is appealing, it is hard
to document, due to the difficulties in measuring and controlling all the factors that go
into a net-advantage calculation.

Efficiency Wage

According to efficiency-wage theory, high wages may increase efficiency and actually
lower labor costs if they:

Attract higher-quality applicants

Lower turnover
Increase worker effort
Reduce “shirking” (what economists say when they mean “screwing around”)
Reduce the need to supervise employees (academics say “monitoring”

Basically, efficiency increases by hiring better employees or motivating present

employees to work smarter or harder. The underlying assumption is that pay level
determines effort – again, an appealing notion that is difficult to document.

In one study, higher wages were associated with lower shirking. Shirking was also lower
where high unemployment made it more difficult for fired or disciplined employees to
find another job.
Do higher wages actually attract more qualified applicants? Research says yes. But
higher wages also attract more unqualified applicants. So an above-market wage does
not guarantee a more productive work force. Does an above-market wage allow an
organization to operate with fewer supervisors? Some research evidence says yes.

NOTICE: Discussion dealt only with pay level

Signaling

Signaling theory holds that employers deliberately design pay levels and mix as part of
a strategy that signals to both prospective and current employees the kinds of behaviors
that are sought. An employer that combines lower base with high bonuses may be
signaling that it wants employees who are risk takers. Its pay policy helps communicate
expectations.

A study of college students approaching graduation found that both pay level and mix
affected their job decisions. Pay level was most important to materialists and less
important to those who were risk-averse. So applicants appear to select among job
opportunities based on the perceived match between their personal dispositions and the
nature of the organization, as signaled by the pay system. Both pay level and pay mix
send a signal.

Signaling works on the supply side of the model, too, as suppliers of labor signal to
potential employers. People who are better trained, have higher grades in relevant
courses, and/or have related work experience signal to prospective employers that they
are likely to be better performers.

MODIFICATIONS TO THE SUPPLY SIDE

Reservation Wage

Noncompensatory – job seekers have a reservation-wage level below which they will
not an accept a job offer, no matter how attractive the other job attributes. If pay level
does not meet their minimum standard, no other job attributes can make up for this
inadequacy. Job seekers-satisfiers- take the first job offer they get where the pay meets
their reservation wage. A reservation wage may be above or below the market wage.
The theory seeks to explain differences in workers’ responses to offers.

Human Capital

The theory of human capital, perhaps the most influential economic theory for
explaining pay-level differences, is based on the premise that higher earnings flow to
those who improve their potential productivity by investing in themselves (by acquiring
additional education, training, and experience). The theory assumes that people are in
fact paid at the value of their marginal product. Improving productive abilities by
investing in training or eve in one’s physical health will increase one’s marginal product.

Researchers also find that different types of education get different levels of pay.
However, job seekers with degrees in education, languages, and the arts will earn the
same as or even less than what they would have earned if they had not gotten their
degrees but had gained work experience instead.

PRODUCT MARKET FACTORS AND ABILITY TO PAY

Any organization must, over time, generate enough revenue to cover expenses,
including compensation. It follows that an employer’s pay level is constrained by its
ability to compete in the product/service market. So product market conditions to a large
extent determine what the organization can afford the pay. Product demand and the
degree of competition are the two key product market factors.

Product Demand – the product market puts a lid on the maximum pay level that an
employer can set. If the employer pays above the maximum, it must either pass on to
consumers the higher pay level through price increases or hold prices fixed and allocate
a greater share of total revenues to cover labor costs.

Degree of Competition – Employers in highly competitive markets are less able to raise
prices without loss of revenues. At the other extreme, single sellers are able to set
whatever price they choose. However, too high a price often invites the eye of political
candidates and government regulators.

A Dose of Reality: What Managers Say

Managers pay depending on whatever the C.F.O. says they can afford. Managers feel it
is shortsighted to pay less, even if market conditions would permit the lower pay. In
direct contradiction to efficiency-wage theory, managers believed that problems
attracting and keeping people were the result of poor management rather than
inadequate compensation.

More Reality: Splintering Supply of Labor

St. Luke’s faces a splintered labor supply. This means it uses multiple sources of
nurses, from multiple locations, with multiple employment relationships. The level and
mix of cash and benefits paid each nurse depends on the source. The splintered supply
results in nurses working the same jobs side by side on the same shift but earning
significantly different pay.
Work Flow to the People – On Site, Off-site, Offshore

Which source is included in a bid depends on many factors:

Customer preferences
Time schedules
The nature of the project.

Work flowing to lower-wage locations, presuming similar levels of output and quality, I
not new. Work flows across national borders were first low-skill; low wage jobs (T-shirts
and sneakers) to China and Central America. , then higher paid blue collar (electronics,
appliances, cars), now its service and professional (accounting, engineering). Vastly
improved communications and software connectivity has accelerated these dynamics.

Three Points (“so whets’) to take from this discussion:

1. Reality is complex; theory abstract. It is not that our theories are useless. They simply
abstract away the detail. Theories of market dynamics, the interaction of supply and
demand, form a useful foundation.
2. The splintering of labor supplies means that determining pay levels and mix
increasingly requires understanding market conditions in different locations, even
worldwide locations.

3. Managers also need to know:

The jobs required to the work

The tasks to be performed, and
The knowledge and behaviors required to perform them

So that they can bundle the various tasks to send to different locations.

ORGANIZATION FACTORS

Although product and labor market conditions create a range of possibilities within
which managers create a policy on external competitiveness, organization factors
influence pay level and mix decisions, too.

Industry

The industry in which an organization competes influences the technologies used.

Labor intensive industries such as education and health care tend to pay lower than
technology intensive industries. The introduction of new technology within an industry
influences pay levels.
Qualifications and experience tailored to particular technologies is important in the
analysis of labor markets.

Employer Size

There is consistent evidence that large organizations tend to pay more than small ones.
This relationship between organization size, ability to pay, and pay level is consistent
with economic theory. It says that talented individuals have a higher marginal value in a
larger organization because they can influence more people and decisions, thereby
leading to more profits. However theories are less useful in explaining why practically
everyone at bigger companies is paid more.

People’s Preferences

Better understanding of employee preferences is increasingly important in determining

external competitiveness. Markets involve both employers’ and employees’ choices.
However, there are substantial difficulties in reliably measuring preferences.

Organization Strategy

A variety of pay-level and mix strategies exist. Some employers adopt a low-wage, no-
services strategy; they compete by producing goods and services with the lowest total
compensation possible. i.e. Nike and Reebok.

Low wage, high-service = Marriott

High-wage, high-service = Medtronic

RELEVANT MARKETS

The market determines wages. Defining the relevant markets is a big part of figuring out
how much to pay and what mix of pay forms to offer.

What is the right pay to get the right people to do the right things?

Managers must define the markets that are relevant for pay purposes and establish the
appropriate competitive positions in these markets.

The three factors usually used to determine the relevant labor markets are:

The occupation (skill/knowledge required),

Geography (willingness to relocate, commute or become virtual employees), and
Competitors (other employers in the same product/service and labor markets).
Defining the Relevant Market

If the markets are incorrectly defined, the estimates of competitors pay rates will be
incorrect and the pay level and mix inappropriately established. (see reference on page
204)

Managers look at both competitors – their products, location, and size –and the jobs ---
the skills and knowledge required and their importance to the organizations success. So
depending on its location and size, a company may be deemed a relevant comparison
even if it’s not a product market competitor.

The data from product market competitors (as opposed to labor market competitors are
likely to receive grater weight when:

1. Employee’s skills are specific to the product market.

2. labor costs are a large share of total costs
3. product demand is responsive to price changes
4. the supply of labor is not responsive to changes in pay
Relevant markets are shaped by pressures from the labor and product market and the
organization.

COMPETITIVE PAY POLICY ALTERNATIVES

Pay levee is the average of the array of rates inside an organization. There are three
conventional pay-level policies:
1. to lead
2. to meet, or
3. To follow competition.
Newer policies emphasize flexibility, among policies for different employee groups,
among pay forms for individual employees and among elements of the employee
relationship that the company wishes to emphasize in the external competitiveness
policy.

What Differences Does the Pay Level Policy make?

The basic premise is that the competitiveness of pay will affect the organization’s ability
to achieve its compensation objectives and this in turn will affect the organizations
performance.

Base pay represents only a portion of compensation.

Many managers believe they get more bang for the buck by allocation dollars away from
base pay and into variable forms that more effectively shape employee behavior.
Pay with competition (Match)

Given the choice to match, lead, or lag, the most common policy is to match rates paid
by competitors. A pay-with-competition policy tries to ensure that an organizations wage
costs are approximately equal to those of its competition and that its ability to attract
applicants will be approximately equal.

Classical economic models predict that employers meet competitive wages.

Lead Policy

A lead policy maximizes the ability to attract and retain employees and minimizes
employee dissatisfaction with pay. Several studies found that variable pay (bonuses and
long-term incentives) is related to an organizations improved financial performance but
that pay level is not.

A lead policy can also have negative effects. It may force the employer to increase
wages of current employees to avoid internal misalignment. A lead policy may mask
negative job attributes that may lead to high turnover.

Lag Policy

A policy of paying below market rates may hinder a firm’s ability to attract potential
employees. It is possible to lag competition on pay level but lead on other returns from
work (e.g. hot assignments, desirable location, outstanding colleagues, cool tools,
work/life balance).

Flexible Policies

In practice many employers go beyond a single choice month the three policy options.
They may vary the policy for different occupational families, different business units etc.

Limited attention has been devoted to pay-mix policies. Some obvious alternatives
include: see exhibit 7.9 page 208.
Performance driven
Market driven
Work/life balance
Security

Compared to the other three incentives and stock options make up a greater percent of
total compensation in performance –driven policies.
Employer of choke/Shared Choice

Some companies compete based on their overall reputation as a place to work, beyond
pay levels and mix. I.e. IBM

Shared choice begins with the traditional alternative of lead, meet, or lag. It adds a
second part which is to offer employees choices (within limits) in the pay mix. The
employee-as –customer offers choices on health insurance etc. Do offering people
choices matter? One risk is hat employees will make wrong choices. That will
jeopardize their financial well-being.

Pitfalls of Pies

The mix of pay forms as pieces in a pie chart may have limitations. The appropriate
analysis must take place to ensure the correct interpretation.

CONSEQUENCES OF PAY-LEVEL AND MIX DECISIONS

External competitiveness has to major consequences:

1. operating expenses
2. employee attitudes and work behaviors

The competitiveness policy directly affects the compensation objectives of efficiency,

fairness and compliance.

Efficiency

Compensation represents an expense.

Some recommend lead polices to diminish shirking and permit hiring better qualified
applicants.

Marginal productivity theory recommends matching.

Utility model supports a lag policy.

Virtually no research suggests under what circumstances managers should choose

which-pay-mix alternative.

What policy Achieves competitive Advantage

Research on the effect of pay-level policies is difficult because companies stated

policies often do not correspond to reality.
Competitiveness of total compensation

Contain operating expenses (labor costs)

Increase pool of qualified applicants
Increase quality and experience
Reduce voluntary turnover
Increase probability of union free status
Reduce pay-related work stoppages

Beyond opinions, there is little evidence of the consequence of different policy

alternatives

Fairness

Satisfaction with pay is directly related to the pay level. Employee’s sense of fair is
related to how others are paid.

Compliance

Provisions of prevailing wage laws and equal rights legislation must be met. In addition
to pay levels, various pay forms are also regulated.

No matter the competitive pay policy it needs to be translated into practice.

The starting point is measuring the market through use of a salary survey.