M5 - Pay for Performance and Salary Budgeting

Question 1

Pay for Performance

Answer 1

Pay for Performance Three Stage Process:

1. Establish measures
2. Communicate links between measures and assessment
3. Assess performance against measures

Question 2

Pay for Performance - Step 1 - Establish Measures

Answer 2

Establish Measures

Types of measurements – Measures may be financial or non-financial.

Performance measurement systems:

• Balanced Scorecard: focuses on financials (shareholders), customers, internal processes, plus innovation and learning.
• Economic Value Added: combines results, which are readily measurable, with enablers, some of which are not.
• Shareholder Value Added: incorporates the cost of capital into the equation.
• Activity Based Costing and Cost of Quality: focuses on the identification and control of cost drivers (non-value-adding activities and failures, respectively), which are themselves often embedded in the business processes.
• Competitive Benchmarking: involves taking a largely external perspective, often comparing performance with that of competitors or other best practitioners of business processes.

No one-size-fits-all approach

• Multiple, seemingly conflicting, measurement frameworks and methodologies exist because they all add value. They provide unique perspectives on performance and offer managers a different set of perspectives by which to assess the performance of individuals, teams and organizations.
• Under some circumstances, one particular perspective will be exactly right for an organization, whereas in another circumstance, it would be counterproductive. The key is to recognize that there is no single best way to view business performance.

Question 3

Pay for Performance - Step 2 - Communicate Links

Answer 3

Communicate Links

Communication is the key to any successful pay for performance program. If communication is inadequate, employees will not understand what they are being measured against and what is important to the organization.

The organization must communicate the links between established measures and performance assessment.

Question 4

Pay for Performance - Step 3 - Assessment

Answer 4

Assessment

The third component to pay for performance systems is the assessment. Basically, organizations (managers) will assess employees against the measures established. Assessment usually comes in three different forms:

• Individual: How did the individual perform based on the measures determined for the job?
• Team: How did the team perform based on objectives? When assessing team performance, it is important to look at how the team performed and how individuals participating on the team performed.
• Organization: Did the organization achieve desired results (both financial and non-financial)?

How does an organization assess employees?

• Formal
• Informal
• Performance appraisals
• 360 Feedback
• Coaching / mentoring

Question 5

Compensation Strategy and Philosophy

Answer 5

Compensation Strategy and Philosophy

Where does base pay fit within the organization’s business strategy? To answer this question, an organization must first understand its compensation strategy and philosophy.

Compensation strategy: The principles that guide design, implementation and administration of a compensation program at an organization. The strategy ensures that a compensation program,
consisting of both pay and benefits, supports an organization’s mission, goals and business objectives. It may also specify what programs will be used and how they will be administered.

Compensation philosophy: A defined compensation philosophy is a statement of what the organization believes about how people should be paid. It should support the business strategy and be a good fit with the organization’s culture. A key component is how the organization intends to pay relative to its competitors for people – i.e., the desired market position

• Lag the market: The company will consciously set its pay equal to current market levels at the beginning of the year. The company’s pay philosophy will then “lag” the market as the year progresses.
• Lead the market: The company will consciously set its pay at anticipated market level. The company’s pay philosophy will then “lead” the market until the start of the next year.

Question 6

Compensation Philosophy

Answer 6

The compensation philosophy is a roadmap that organizations use to assist in the development of compensation programs. Not all organizations have a written compensation philosophy.

A compensation philosophy should cover the following components:

• Market position
• Basis of job value
• Pay mix
• Reward focus
• Structure
• Administration

It is not:

• A be all, end all
• A simple statement that proclaims, “We’re a 50th percentile payer.”

Question 7

Using a Compensation Philosophy

Answer 7

Using a Compensation Philosophy

Bounce new ideas: Bounce new plans, or modifications, against the philosophy to see if changes fit desired results

Proactive evaluation: Proactively evaluate existing plans against compensation philosophy to look for gaps in desired results

Possible needs: Evaluation will highlight possible needs for program changes to address gaps

Remember:

• A well-articulated compensation philosophy helps employees understand the intentions and beliefs of senior leaders.
• Employees actually understand why certain programs are in place, which leads to a more engaged workforce and a higher-performing organization.

Question 8

Examples of Comp Philosophy

Answer 8

Attract the best available talent, while being competitive in the market place on base pay and above market on variable / incentive compensation. In order to retain our employees, yet still be financially responsible we will pay below market on benefit contributions – focusing more on pay for performance, for team-based project completion.

Provide training and development opportunities to new employees, to teach them the XYZ Way. We will pay less then market – based upon our world-class training opportunities. Advancement opportunities will be provided as employees learn new skills and exhibit the XYZ Way. We will offer market benefits for full time (40 hour) exempt store employees.

Question 9

Principles of Merit Pay Programs

Answer 9

Principles of Merit Pay Programs

In regards to pay for performance and base pay, merit pay is one of the most frequently used methods.

Objective: The essential goal of a merit pay program is to link pay to performance in a manner that is consistent with the mission of the organization. There are two required conditions:

• Variations in employee performance must be measurable and measured.
• Managers must be provided with the necessary tools to determine the appropriate rewards.

Size: To motivate employees most effectively to meet or exceed performance standards, the absolute size of the merit increase must be significant enough to make a noticeable difference to employees (e.g., the increase must not be so trivial as to be deemed inconsequential).
-A successful merit pay program will ensure that increases awarded to the best contributors will be substantially greater than increases awarded to average or less-than-average performers.

Timing: anniversary-date versus common (focal-point) review

Implementation: Under traditional merit pay programs, merit increases are built into employees’ salaries for as long as they remain with the organization. Hence, the increases are permanent and their values are compounded over time as additional increases are granted.
-One alternative to base pay increases is the use of lump-sum payments. Lump-sum payments are one-time payments made in lieu of traditional base pay increases and typically are delivered annually via the merit pay program.

Question 10

Factors Affecting the Success of Merit Pay

Answer 10

Factors Affecting the Success of Merit Pay

Managerial factors:

• Executive support for the increases
• Managerial capabilities in planning and appraisal
• Supervisor / subordinate trust levels
• Managerial fortitude

Organizational factors:

• Cost of measuring performance
• Competitiveness of pay structures
• Width of pay ranges
• Equitable internal-pay relationship among jobs
• Organization’s pay-performance linkage
• Organizational culture
• Effective communication

Individual employee factors:

• Measurable differences in performance
• Performance appraisal
• Employee belief in fairness of appraisals and increases

Question 11

Considerations in the Amount of Increase

Answer 11

Considerations in the Amount of Increase

Current pay level / position in range
-Where is the employee’s pay in the current range (first quartile, second, third, etc.)?

Performance rating
-How well is the employee performing?

Merit increase guidelines
-What form of merit guidelines does the organization follow?

Increase history
-What has the employee received historically as an increase?

Performance improvement
-Has the employees performance improved since last merit increase?

Scarcity of particular skills
-Is the employee considered a “critical talent” or has a “hot skill?”

Individual potential
-What is the individual potential for this employee?

Many “pay-for-performance” organizations say they consider only current pay, performance and merit increase guidelines. However, they may informally consider other factors. Does the performance message get diluted when supervisors and managers take other items like potential into consideration?

Question 12

The Base Pay Investment

Answer 12

The Base Pay Investment

One of the decisions that must be made in the development of a merit pay system is whether to link base pay to performance and timing. Most organizations continue to link base pay with performance over time. As a result, it is worthwhile to examine the criteria that may be used to differentiate pay levels under a performance-based pay approach.

Career stages: Pay levels within the range typically vary depending on an individual’s career stage. Organizational expectations at the differing career stages need to be identified. An example of career stages positioned within a pay grade is summarized on the graphic.

• New to role (does not fully meet standards) – learning; not yet performing full scope of job requirements.
• Emerging (meets standards) – deep into learning curve; developing competencies; productivity gaining; continuing to require some direction
• Established (exceeds standards) – fully functioning in role; demonstrating desired competencies and behaviors; productive; using sound judgment; mastering functions, serving as a mentor
• Expert (consistently outstanding) – mastering the job function; performing complex responsibilities; credible reputation; unique talent; highly productive; may be serving in a leadership role; consistently exceeds standards over an extended period of time.

Evolution of the employee role – Organizations “invest” in the potential of new employees in the hope that over time they will develop into valuable assets.

Question 13

Position in Range – Pay Progression within Range

Answer 13

Position in Range – Pay Progression within Range

Another way to view the base pay investment and advancement through career stages is to add the factor of time to achieve a particular range penetration. Note that in this system (depicted on the slide) range penetration is truncated depending on performance. It is possible to be rated “Meets Standards” for many years and not reach the maximum.

There are two key decisions:

• How far should a particular performance level take an employee into the range?
• How long should it take?

Question 14

Range Penetration

Answer 14

Range Penetration

Another way to calculate where an employee is positioned in the range is to calculate range penetration.

Formula:
Pay Rate - Minimum / Maximum - Minimum

Examples: Pay rates of 2.850 and 2,725 in the following salary range:
Maximum = 3.100
Midpoint = 2,850
Minimum = 2,600

(2850-2600)/(3100-2600) = 250/500 = 50%

(2725-2600)/(3100/2600) = 125/500 = 25%

Range penetration does not focus on the middle or midpoint of range.

Question 15

Compa-Ratio Calculations

Answer 15

A useful concept relative to pay ranges, position in range and salary increase budgets is compa-ratio. Compa-ratio is another way of calculating where an employee is positioned in the range. It is the ratio of actual pay to structure midpoint, expressed as a percentage. The term can also be used to indicate the ratio of actual pay to competitive pay, although usually it is referred to as the market index.

Compa-ratio usually is, but not always, compared to 100.

Formulas:

Salary / Midpoint = Individual Compa-ratio (actual to structure)

Weighted Avg Salary / Midpoint = Unit/Organizational Compa-ratio (actual to structure)

Weighted Avg Salary / Weighted Market Avg. = Market Index (actual to market)

Question 16

Control Point

Answer 16

Control Point

Another way to determine where an employee is positioned in the range is to calculate the control point. The control point is the point within a given job’s pay range or broadband that is targeted for fully qualified, satisfactorily performing job incumbents. It can also be determined for multiple jobs:

• In a traditional salary structure, the control point is most commonly the midpoint of the range, but variable control points higher or lower than the midpoint may be used to respond to the market.
• For broadbands, there are often many control points within one broadband.

To monitor employee pay against control points, most companies divide actual employee pay by the control point (similar to the calculation of a compa-ratio).

Example of Control Point – As Applied to Broadbanding
Market rates for three senior level engineer jobs differ. The company’s policy is to set control points for each job to monitor individual pay against competitive market rates.

Question 17

Merit Increase Guidelines

Answer 17

Merit Increase Guidelines

Once the amount of increase and the timing are decided, the merit increase guidelines can be established.

Performance only
-Employee receives a merit increase based solely on the individual performance

Increase as a percent of midpoint
-Employee receives merit increase based upon individual performance as a percent of the range midpoint

Performance and position in range
-Employee receives a merit increase based both on individual performance and location of their salary within the range

Question 18

Performance Only – Increase as Percent of Base Pay

Answer 18

Performance Only – Increase as Percent of Base Pay

With this method (and with increase as percent of midpoint) the employee increase is based on performance. In the example above, the increase is based solely on the performance of the employee, with no additional factors “added-in.”

Advantages:

• Simple and understandable
• Employees with same performance receive same percent increase.

Disadvantages

• Larger amounts go to people higher in the range for the same performance.
• Employees with same performance receive different amounts / increases.

Option
The amount of increase may also be based on the midpoint of the range (or on a control point), as shown in the next example.

Question 19

Increase as Percent of Midpoint

Answer 19

Increase as Percent of Midpoint

With this method, an employee will receive an increase, not based upon his or her current compensation, but on the midpoint of the range.

For example, a current year increase for “meets standards” equals 4% of midpoint.

This process can allow high performers lower in the range to accelerate more quickly through the range, while slowing down employees that have reached midpoint or above. This method is most commonly used in a situation with broadbanding and control points.

Question 20

Performance and Position in Range

Answer 20

This method introduces another factor – position in range. This method has several results:

• It causes the rates for employees with the same performance to converge on a target quartile or point (based on the salary range profile).
• Employees who are farther from the target point are moved more quickly (below that point they are more vulnerable to competitor “pick-off”), and employees who are near the target point are slowed down. Employees above the control point receive 0%.

Typically an employee learns rapidly during the first year on the job. Organizations recognize this in pay programs by providing larger increases as a percentage of base pay to newer job incumbents.

Question 21

Strategy for Determining Merit Payouts

Answer 21

Strategy for Determining Merit Payouts

Step 1: Anticipate distribution of performance ratings.
-Estimate the percentage of employees that will be receiving each rating

Step 2: Determine anticipated mean performance rating.
-By determining the anticipated mean performance rating, you will be able to determine where to place specific merit percentages relative to anticipated ratings.

Step 3: Develop two-dimensional matrix of increases.
-Utilizing both the anticipated distribution and anticipated mean, populate your merit matrix with desired percentages.

Step 4: Determine payout.
-Based upon anticipated distribution and percent of employees in each quartile, determine the total payout for this merit matrix.

Step 5: Revise if necessary
-If you determine your overall budget figure is too high (or too low) adjust the merit percents until the desired percentage is reached.

Question 22

Strategy for Determining Merit Payouts

Step 1: Anticipate Distribution

Answer 22

Strategy for Determining Merit Payouts
Step 1: Anticipate Distribution

Historical information

• One way to anticipate the distribution would be to review historical distributions.
• By using historical distributions you can observe what has happened with performance appraisals and observe any fluctuations that may have occurred.

Speak to raters
-Another method of anticipation is to speak to the raters in each department, to determine how they feel about their employees’ performance.

Review definition of each rating
-By reviewing the organizational definition and expectation of each rating, the rater will have a better understanding of what the organization is expecting for an employee receiving each rating.

Question 23

Strategy for Determining Merit Payouts

Step 2: Determine Anticipated Mean Performance Rating

Answer 23

Strategy for Determining Merit Payouts
Step 2: Determine Anticipated Mean Performance Rating

By determining the anticipated mean, you establish a set guideline. This mean will show how high or low the distribution will fall within the ratings. Calculating this mean is the same as determining a weighted average.

Question 24

Strategy for Determining Merit Payouts

Step 3: Develop Two-Dimensional Matrix for Increases

Answer 24

Strategy for Determining Merit Payouts
Step 3: Develop Two-Dimensional Matrix for Increases

The simplest way to construct a merit matrix is to utilize the anticipated distribution of performance ratings and actual employee percent breakdown within the range.

For the example on the following pages we will assume the following:

5. 5% = Budget
6. 70 = Mean rating

Determine what the targeted increase in the most populated cell should be.

Determine which cells will get no increases.

Decide if there should be minimal increases.

If performance is a more important determinant of salary increase than position in range, show more differentiation there.

Start with the budgeted increase where your organization has determined it should be located based on organizational factors and base pay philosophy (lead / lag, etc.).

Determine which cells get no increase, then build the relationship between the cells based on your pay philosophy and reward for performance.

Question 25

Strategy for Determining Merit Payouts

Step 4: Determining Total Payout

Answer 25

Strategy for Determining Merit Payouts
Step 4: Determining Total Payout

Cell Contribution Payout = (P x C x G)

If 45% of employees received a performance rating of 4, and 35% of them are in the lower quartile of their range with a guideline increase in the cell of 7.5%, what is the cell contribution payout?

P = Proportion in performance rating category - .45
C = Proportion in position-in-range category = .35
G = Guideline percent increase in cell = 7.5

Which cell matches the correct answer?
.45 x .35 x 7.5 = 1.181

Payout = 2.423 + 1.332 + 1.164 + .612 = 5.531%
Budget = 5.5%

Question 26

Strategy for Determining Merit Payouts

Step 5: Revise If Necessary

Answer 26

Strategy for Determining Merit Payouts
Step 5: Revise If Necessary

Occasionally, the matrix will not equal your projected merit budget. If this is the case, you will need to revise your percentages in each box.

Increase Percentages:
If you notice that your projected merit budget is smaller than your actual merit budget, you will need to increase the merit projections in the matrix.

Decrease percentages:
If you notice that your projected merit budget is larger than your actual merit budget, you will need to decrease the merit projections in the matrix.

The merit matrix process contains an element of trial and error with the percentages, however, it is a valuable tool in the merit distribution process.

Question 27

Salary Budget

Answer 27

Salary Budget

Although pay policy is a major factor, it does not represent the complete picture. We have already discussed merit pay, but merit pay is but one component in a salary budget. We ask the questions: Where would I like my pay practice to be relative to the market? How much will that cost? And, do I want to pay that cost?

Pay Policy
-Company’s desired pay relative to market (competitive) pay at year end

Market-Based Salary Increase Budget
-Budget necessary to achieve pay policy by year end

Recommended Salary Increase Budget
-Budget recommended based on all internal and external factors, in addition to company pay policy

The difference between market-based and recommended salary increase budget is based on applying discretionary considerations to the market results.

Question 28

Components of Market-Based Salary Budget

Answer 28

Components of Market-Based Salary Budget

I. Percent necessary to match market as of January 1 ____%

II. Anticipated percent of next years market movement + ____%

III. Desired position above or below the market (pay policy) + ___%

Total market based salary increase budget ___%

(add the three together)

Question 29

Steps of Market Model Analysis

Answer 29

Steps of Market Model Analysis

• Collect survey data
• Age survey data to start of plan year
• Develop a market model which describes the relation between aged external survey data and internal grades for benchmarked jobs

Other considerations:
-When multiple surveys are used, aging percent may differ based on the date each survey was conducted.

• The quality of the market model increases when
• Survey matches are good
• Sampling is representative of the company’s population
• Characteristics of the market model method:
• The model integrates internal value with external value.
• Because of the linkage of the external pay to internal grades, the method is not too sensitive to fluctuations, caused by the inclusion or exclusion of a few benchmark jobs from one year to the next.
• The method assumes that the model is a good estimator of the pay for all jobs within each grade, including those not surveyed.
• The method assumes you have an internal grading or classification system that assigns internal value to jobs.

Question 30

Data We Will Need

Answer 30

Data We Will Need

Benchmark job data
-Market and company data for surveyed jobs

Historical competitive pay movement during the year surveys were conducted

Anticipated competitive pay movement during the new plan year

Company pay policy

Assume you want to pay 5% ahead of competition

Question 31

Benchmark Job Data

Answer 31

Benchmark Job Data

For aging purposes, assume a 3% historical competitive pay movement during the year surveys were conducted.

Sample Calculation:
2000 x (1+ 3%/2) = 2000 x 1.015 = 2030

Question 32

Develop Market Model

Answer 32

Develop Market Model

Using regression analysis techniques create a model

• Aged survey averages are the dependent variable
• Grades are the independent variable

Plot the data

• Identify the relationship
• If a straight line, calculate the regression line

The regression line becomes the market model
y = -78.42 + 150.33x

Question 33

Recommended Salary Budget

Answer 33

Modify market-based salary increase budget by internal and external factors
10.5% – Budget based on competitive (market) factors only
What about economy?
What about business results?

Question 34

Consider

Answer 34

Business plans of the company
Management style
Maturity of the company
Industry practices
Financial ability of the company
Union contracts
Past practices
Inflation and the state of the economy

Question 35

Q1: Which of the following is one of the performance management systems used today? A) Balanced Scorecard B) Dashboard Metrics C) Performance Analytics

Answer 35

A) Balanced Scorecard

Question 36

Q2: Which of the following is not one of the three types of compensation philosophy? A) Lead-lag B) Pay behind the market C) Lead the market

Answer 36

B) Pay behind the market

Question 37

Q3: What best describes an objective of a merit pay program? A) To link pay to performance in a manner consistent with the mission B) To ensure that everyone in the organization receives a pay increase C) To guarantee that unacceptable performers advance to the midpoint of the range D) To annualize compensation costs for the organization

Answer 37

A) To link pay to performance in a manner consistent with the mission

Question 38

Q4: Which statement is most accurate regarding the range penetration and progression for an employee who consistently “meets standards”? A) The employee will reach 100% range penetration in two years. B) The employee will never rise above 25% range penetration.
C) The employee’s range penetration will typically be about 50%. D) The employee is demonstrating desired competencies, but may not be awarded a merit increase.

Answer 38

C) The employee’s range penetration will typically be about 50%.

Question 39

Q5: Which of the following statements concerning Method A is most accurate?
Method A:
Performance Ratings: Outstanding / Acceptable / Unacceptable
Increase (% of salary): 15% / 7% / 0%

A) It is the most costly. B) It is the most defensible. C) It is the most difficult to explain. D) It requires the least refined performance-rating distinctions.

Answer 39

D) It requires the least refined performance-rating distinctions.

Question 40

Q6: Which of the following statements concerning Method C is most accurate?
Method C:
Performance Rating: Outstanding / Very Good / Acceptable / Marginal / Unacceptable
1st Quartile Increase: 18% / 13% / 9% / 6% / 0%
2nd quartile increase: 16% / 11% / 7% / 4% / 0%
3rd quartile increase: 14% / 9% / 5% / 2% / 0%
4th quartile increase: 12% / 7% / 3% / 0% / 0%

A) It could be difficult to explain initially. B) It is the most costly of the three methods. C) It is the most defensible of the three methods. D) It would be the easiest to explain to employees.

Answer 40

A) It could be difficult to explain initially.

Question 41

Q7: If the organization has a large percentage of employees in the upper part (4th quartile) of the ranges, and the typical performance rating is “Outstanding,” which method would require the largest salary increase budget?

A) Method A B) Method B C) Method C D) All methods will produce the same cost.

Answer 41

A) Method A

Question 42

Q8: What data is needed to create a market-based salary budget?
A) Job descriptions B) Organization chart C) Turnover rate D) Company pay policy

Answer 42

D) Company pay policy