Defining Internal Alignment

By Milkovich, G.T., Newman, J.M., Gerhart, B.

Edited by Paul Ducham

ORGANIZATION STRATEGY AND COMPENSATION

Lockheed decided that six levels of engineering work would support the company’s strategy of researching, designing, and developing advanced technology systems.

WORK FLOW

Work flow refers to the process by which goods and services are delivered to the customer. The pay structure ought to support the efficient flow of that work and the design of the organization. For example, financial service firms in the United States traditionally offer investment advice and products through client centers. At Merrill Lynch, customer associates used to take all calls from clients or new prospects and route them to financial advisors (FAs). If the caller wanted a specific transaction, such as purchasing a stock, mutual fund, or certificate of deposit, the customer associate passed the information on to an FA who was legally certified to make the purchase. No one at Merrill Lynch “owned” a client. Personal long-term relationships were not emphasized.

But Merrill Lynch recognized that its clients’ investment needs varied, depending on their net worth, among other factors. Ultra-high-net-worth individuals with more than $25 million to invest were not interested in CDs or stock transactions. They wanted advice specific to their circumstances from someone they knew and trusted. And rather than waiting for calls from these people, the FAs should initiate calls to them. That would help build the long-term relationship around adding value to clients’ investments.

Merrill Lynch also noticed that meeting the needs of these high-net-worth clients was very profitable (i.e., higher margins on the fees and the products). So Merrill Lynch redesigned the flow of work to better reflect its clients’ needs—and increase its profits.

Merrill Lynch divided its clients into five groups based on net worth: investor, emerging affluent, affluent, high net worth, and ultra high net worth (the “whales”). Then it revamped its job structure to match. The work of financial advisor now has five levels, ranging from assistant vice president, investments (AVPI), to senior vice president, investments (SVPI). These new job levels are defined by the amount of client assets the advisor manages and the expertise and knowledge the advisor possesses. Building those long-term relationships with the “whales” requires complex interactions. The “investor” clients with $250,000 or less to invest are still buying stocks, bonds, and CDs through the financial advisor centers. Newly trained and experienced FAs are now building relationships with individuals in the various client groups. In addition to the financial advisor centers, Merrill Lynch also created private banking hubs to serve clients with at least $10 million. So far over 300 of its 15,000 advisors have trained to work with the high-net-worth and the ultra-net-worth clients, with more to come.

To support the new financial advisor job structure, Merrill Lynch designed a new pay structure. Base pay ranges from $125,000 for FA1 to about $1 million for the SVPI. Aggressive bonus and stock incentives are a substantial part of the new pay structure. These incentives range from around 30 to 90 percent of total cash compensation. The pay difference between FA1s, AVPIs, and SVPIs was a major issue—just as it is for Lockheed engineers, the cast of CSI, and the laborers in the vineyard.

INTERNAL PAY STRUCTURES

Internal pay structures are part of the network of returns: pay increases for promotions, more challenging work, and greater responsibility as employees move up in the structure. The challenge is to design structures that will engage people to help achieve organization objectives. Merrill Lynch financial advisors work to meet the specific needs of their clients by building long-term relationships. Lockheed engineers work together to share knowledge with each other and with their customers. Is taking on a “bigger” job worth it? Does it pay off to take more training to get promoted? It will in a well-designed pay structure.

The structure ought to make clear the relationship between each job and the organization’s objectives. This is an example of “line-of-sight.” Employees should be able to “see” the links between their work, the work of others, and the organization’s objectives. And the structure ought to be fair to employees. The vineyard owner’s internal pay structure may have been aligned with his business strategy, but the employee dissatisfaction raises concerns about its fairness to employees.

COMPENSATION LEVELS

One feature of any pay structure is its hierarchical nature: the number of levels and reporting relationships. Some are more hierarchical, with multiple levels; others are compressed, with few levels. The stated goal of GE Healthcare is to provide “transformational medical technologies and services that are shaping a new age of patient care.” One of their many product lines is magnetic resonance imaging (MRI). In comparison to Lockheed’s six levels for engineering alone (Exhibit 3.1), GE Healthcare uses five broad levels, described in Exhibit 3.2 , to cover all professional and executive work, including engineering. GE Healthcare would probably fit the Lockheed Martin structure into two or three levels.

EXHIBIT 3.1 Engineering Structure at Lockheed Martin

Engineer

Limited use of basic principles and concepts. Develops solutions to limited problems. Closely supervised.

Senior Engineer

Full use of standard principles and concepts. Provides solutions to a variety of problems. Under general supervision.

Systems Engineer

Wide applications of principles and concepts, plus working knowledge of other related disciplines. Provides solutions to a wide variety of difficult problems. Solutions are imaginative, thorough, and practicable. Works under only very general direction.

Lead Engineer

Applies extensive expertise as a generalist or specialist. Develops solutions to complex problems that require the regular use of ingenuity and creativity. Work is performed without appreciable direction. Exercises considerable latitude in determining technical objectives of assignment.

Advisor Engineer

Applies advanced principles, theories, and concepts. Contributes to the development of new principles and concepts. Works on unusually complex problems and provides solutions that are highly innovative and ingenious. Works under consultative direction toward predetermined long-range goals. Assignments are often self-initiated.

Consultant Engineer

Exhibits an exceptional degree of ingenuity, creativity, and resourcefulness. Applies and/or develops highly advanced technologies, scientific principles, theories, and concepts. Develops information that extends the existing boundaries of knowledge in a given field. Often acts independently to uncover and resolve problems associated with the development and implementation of operational programs.

Exhibit 3.2

 

DIFFENTIALS

The pay differences among levels are referred to as differentials. If we assume that an organization has a compensation budget of a set amount to distribute among its employees, there are a number of ways it can do so. It can divide the budget by the number of employees to give everyone the same amount. The Moosewood Restaurant in Ithaca, New York, adopts this approach. But few organizations in the world are that egalitarian. In most, pay varies among employees. Work that requires more knowledge or skills, is performed under unpleasant working conditions, or adds more value is usually paid more. Exhibit 3.3 shows the percent differentials traditionally attached to Lockheed Martin’s engineering structure. Northrup Grumman uses a similar sixlevel engineering structure with similar differentials. One intention of these differentials is to motivate people to strive for promotion to a higher-paying level. As Exhibit 3.3 shows, the same basic structure, in terms of percent differentials, can be paired with different pay level policies. For example, although a lead engineer gets paid more in the structure on the right, the percent differential between the lead engineer and systems engineer is the same in both (28 percent).

Ex-3.3

RELATIVE CONTRIBUTION

Work content and its value are the most common bases for determining internal structures. Content refers to the work performed in a job and how it gets done (tasks, behaviors, knowledge required, etc.). Value refers to the worth of the work: its relative contribution to the organization objectives. A structure based on content typically ranks jobs on skills required, complexity of tasks, problem solving, and/or responsibility.

In contrast, a structure based on the value of the work focuses on the relative contribution of these skills, tasks, and responsibilities to the organization’s goals. While the resulting structures may be the same, there are important differences. In addition to relative contribution, external market value may also be included (i.e., what competitors pay for this job). Or it may include rates agreed upon through collective bargaining, or even legislated rates (minimum wage). In centrally planned economies such as Cuba, job values in all organizations are set by a government agency. Following the now-discarded approaches of the former Soviet Union and China, Cuba’s government dictates a universal structure: 8 levels for industrial workers, 16 levels for technical and engineering work, and 26 levels for government employees.
 

USE VALUE AND EXCHANGE VALUE

Use value reflects the value of goods or services an employee produces in a job. Exchange value is whatever wage the employer and employee agree on for a job. Think about IBM software engineers living in Bangalore, Kiev, and Purchase, New York. Their work content is very similar across all locations. Now think about them working together on the same project—same company, same job content, same internal job. They have the same use value. Wage rates in Bangalore and Kiev are a lot less than in Purchase, New York. The jobs’ exchange value varies. For promotions, IBM treats these jobs as being at the same level in the structure. But the external markets in India, the Ukraine, and the United States yield very different pay rates.

The difference between exchange value and use value also surfaces when one firm acquires another. IBM’s acquisition of PricewaterhouseCoopers (PWC), where consultants were the lifeblood of the company, is a case in point. At the time, IBM was moving from being a computer company to a provider of information technology solutions whose applications were broader than the IT department. PWC consultants could help IBM’s marketing teams engage with clients at a higher organization level. The use value of the PWC consultants within IBM differed from their use value within PWC (how they contributed to IBM or PWC objectives). So, similar marketing jobs in two different companies may be valued differently based on how they contribute to organization objectives. Alternatively, the same work content in the same company (IBM’s software engineers) may have different exchange value based on different geographies.

PERSON BASED STRUCTURES

A job-based structure relies on the work content—tasks, behaviors, responsibilities. A person-based structure shifts the focus to the employee: the skills, knowledge, or competencies the employee possesses, whether or not they are used in the employee’s particular job. The engineering structure at Lockheed Martin (Exhibit 3.1) uses the work performed as the criterion. GE Healthcare (Exhibit 3.2) uses the individual employees’ competencies/knowledge required at each level of work.

In the real workplace, it is often hard to describe a job without reference to the jobholder’s knowledge and skills. Conversely, it is hard to define a person’s job-related knowledge or competencies without referring to work content. So rather than a job- or person-based structure, reality includes both job and person.

ECONOMIC PRESSURES

Adam Smith was an early advocate of letting economic market forces influence pay structures. He was the first to ascribe both an exchange value and a use value to human resources. Smith faulted the new technologies associated with the Industrial Revolution for increasing the use value of labor without a corresponding increase in exchange value (i.e., higher wages).

Karl Marx took this criticism even further. He said that employers unfairly pocketed the surplus value created by the difference between use and exchange value. He urged workers to overthrow capitalistic systems to become owners themselves and reap the full use value of their labor.

A countering theory put forth in the last half of the 19th century, marginal productivity, says that employers do in fact pay use value. Unless an employee can produce a value equal to the value received in wages, it will not be worthwhile to hire that worker. One job is paid more or less than another because of differences in relative productivity of the job and/or differences in how much a consumer values the output. In the short run especially, interesting things can happen. For example, some nurses (specifically, nurse anesthetists) now earn $140,000 to $170,000 per year, more than many family practice and pediatrics doctors. These nurses earn less than physician anesthesiologists ($300,0001), but can perform many of the same tasks, Not surprisingly, they are in high demand. Surgeons may be fine with the situation because it removes a possible constraint on being able to do surgery. One wonders about the views of primary care doctors. Hence, differences in productivity provide a rationale for the internal pay structure.

In addition to supply and demand for labor, supply and demand for products and services also affect internal structures. Turbulent changes, either in competitors’ products/services (as in the rise of the Internet for making purchases) or in customers’ tastes (as in the popularity of fuel-efficient vehicles), force organizations to redesign work flow and force employees to continuously learn new skills. Unpredictable external conditions require pay structures that support agile organizations and flexible people.

MINIMUM WAGE RATES

In the United States, equal employment legislation forbids pay systems that discriminate on the basis of gender, race, religion, or national origin. The Equal Pay Act and the Civil Rights Act require “equal pay for equal work,” with work considered equal if it requires equal skill, equal effort, and equal responsibility and is performed under equal working conditions. An internal structure may contain any number of levels, with differentials of any size, as long as the criteria for setting them are not gender, race, religion, or national origin.

Much pay-related legislation attempts to regulate economic forces to achieve social welfare objectives. The most obvious place to affect an internal structure is at the minimums (minimum-wage legislation) and maximums (special reporting requirements for executive pay). But legislation also aims at the differentials. A contemporary U.S. example is the “living wage.” A number of U.S. cities require minimum hourly wage rates well above what federal law requires. The anticipated outcome of such legislation is a flatter, more compressed structure of wage rates in society.

EXTERNAL STAKEHOLDERS

Unions, stockholders, and even political groups have a stake in how internal pay structures are determined. Unions are the most obvious case. Most unions seek smaller pay differences among jobs and seniority-based promotions as a way to promote solidarity among members. In the United States, the AFL-CIO uses information on the pay differences between top executives and employees to rally support for unions and influence public opinion (see www.afl-cio.org ).

Stockholders are also interested in the differences between what executives make compared to others within the organization. Estimates vary by what data are used, but they range from CEO pay that is 110 times to over 500 times the pay for manufacturing jobs. These estimates focus on differences averaged across many companies in the U.S. economy. But internal alignment focuses on pay relationships within an organization. So Disney stockholders are interested in CEO Robert Iger’s $12 million in 2005, which is about 282 times the union rates of between $20 and $27 an hour for employees who play Mickey or Minnie Mouse. (Yes, Mickey, Minnie, Pluto, and Goofy, even Snow White, are Teamsters.)

The AFL-CIO website ( www.afl-cio.org ) has a tool called Executive Pay Watch that allows one to estimate how long at his or her wage it would take to match a CEO’s annual pay. For example, it reports that Kenneth Lewis, CEO of Bank of America, earned $9.9 million in 2008 and that a worker paid $30,000 per year would need to work 328 years to earn as much. (Would clean living, a good diet, and exercise be enough?)

JUST WAGE DOCTRINE

National Public Radio host and author Garrison Keillor defines culture by what songs we know in common—camp songs, religious hymns, the big hits of the year we were fifteen. A General Mills executive says culture is the foods we eat. A more academic definition of culture is “the mental programming for processing information that people share in common.” Shared mind-sets may judge what size pay differential is fair. In ancient Greece, Plato declared that societies are strongest when the richest earned a maximum of four times the lowest pay. Aristotle favored a five-times limit. In 1942, President Franklin Roosevelt proposed a maximum wage: a 100 percent tax on all income above 10 times the minimum wage.

Historians note that in 14th-century western Europe, the Christian church endorsed a “just wage” doctrine, which supported the existing class structure. The doctrine was an effort to end the economic and social chaos resulting from the death of one-third of the population from plague. The resulting shortage of workers gave ordinary people power to demand higher wages, much to the dismay of church and state. Market forces such as skills shortages (higher exchange value) were explicitly denied as appropriate determinants of pay structures. Today, advocates of the living wage are trying to change societal judgments about what wage is just.

Even today, cultural factors play a role in shaping pay structures. Many traditional Japanese employers place heavy emphasis on experience in their internal pay structures. But pressures from global competitors plus an aging workforce have made age-based pay structures very expensive. Consequently, some Japanese employers are shifting older employees to lower-paying business units, emphasizing performance and downplaying seniority. (This change is particularly irksome; as the authors have grown older, the wisdom of basing pay on age has become more and more obvious to us!)

ORGANIZATION STRATEGY

You have already read how organization strategies influence internal pay structures. The belief is that pay structures that are not aligned with the organization strategy may become obstacles to the organization’s success. However, aligned structures today may become an obstacle tomorrow. So aligned, yet adaptable, may be required.

HUMAN CAPITAL

Human capital—the education, experience, knowledge, abilities, and skills required to perform the work—is a major influence on internal structures. The greater the value added by the skills and experience, the more pay those skills will command. Lockheed’s structure pays consultant engineers more than lead or senior engineers because the human capital required in the consultant engineer job brings a greater return to Lockheed. It is more crucial to Lockheed’s success.

ORGANIZATION DESIGN

Technology used in producing goods and services influences the organizational design, the work to be performed, and the skills/knowledge required to perform the work. The technology required to produce precision military hardware differs from that used to develop and manufacture plastics. These differences contribute to the different structures observed at Lockheed and GE Healthcare.

Multiple structures often exist within the same organization for different types of work. For example, Northrup Grumman has supervisory, engineering, technical, administrative, and non-exempt structures, each having five to six base-pay groupings/levels.

The design of organizations is undergoing profound changes. A lot of people who work in organizations are not employees of these organizations. They may be employed by either a supplier (e.g., an IT services supplier such as IBM or Hewlett-Packard or a circuit designer such as Primarion) or perhaps a temporary work supplier (e.g., Accountemps, Manpower Services). Or, they may be working under a temporary contract for a limited amount of time or on a limited project. The security guards, software engineers, or accountants may be supplied by outsourcing specialists. Pay for these employees is based on the internal structure of their home employer (e.g., IBM or Accountemps) rather than of the workplace at which they are currently located. Another major work design change is delayering. Entire levels of work have disappeared. Just weeks after arriving at Hewlett Packard, new CEO Mark Hurd began hearing complaints about HP’s sluggish response to customer needs. He discovered that internal organization layers were delaying responses. HP cut levels of management from eleven to eight and customers immediately applauded the reduced response time. Delayering can cut unnecessary, noncontributing work. It can also add work to other jobs, enlarging them. Through the use of self-managed work teams in production work, entire levels of supervisory jobs are removed and the responsibility for more decisions is delegated to the teams. This will change a job’s value and the job structure.

HR POLICIES

The organization’s other human resource policies also influence internal pay structures. Most organizations tie money to promotions to induce employees to apply for higher-level positions. If an organization has more levels, it can offer more promotions, but there may be smaller pay differences between levels. The belief is that more frequent promotions (even without significant pay increases) offer a sense of “career progress” to employees.

INTERNAL LABOR MARKETS

Internal labor markets combine both external and organizational factors. Internal labor markets refer to the rules and procedures that (1) determine the pay for the different jobs within a single organization and (2) allocate employees among those different jobs. In the organization depicted in Exhibit 3.5 , individuals are recruited only for entry-level jobs (an engineer would be hired right out of college; a senior engineer would have a few years’ experience). They are later promoted or transferred to other jobs inside the organization. Because the employer competes in the external market for people to fill these entry jobs, their pay must be high enough to attract a pool of qualified applicants. In contrast, pay for jobs filled via transfer and promotions is buffered from external forces. External factors are dominant influences on pay for entry jobs, but the differences for nonentry jobs tend to reflect internal factors.

Ex-3.5

EMPLOYEE ACCEPTANCE

Employees judge the fairness of their pay through comparisons with the compensation paid to others for work related in some fashion to their own. Accordingly, an important factor influencing the internal pay structure is its acceptability to the employees involved. Employees make multiple pay comparisons to assess the fairness of an internal pay structure. They compare both with other jobs in the same internal structure and with the pay for their job in the external market (i.e., at competing employers).

Two sources of fairness are important: the procedures for determining the pay structure, called procedural justice; and the results of those procedures—the pay structure itself—called distributive justice.

Suppose you are given a ticket for speeding. Procedural justice refers to the process by which a decision is reached: the right to an attorney, the right to an impartial judge, and the right to receive a copy of the arresting officer’s statement. Distributive justice refers to the fairness of the decision: guilty. Researchers report that employees’ perceptions of procedural fairness significantly influence their acceptance of the results; employees and managers are more willing to accept low pay if they believe that the way this result was obtained was fair. This research also suggests that pay procedures are more likely to be perceived as fair (1) if they are consistently applied to all employees, (2) if employees participated in the process, (3) if appeals procedures are included, and (4) if the data used are accurate. Nevertheless, a newer study raises a question about the usefulness of employee participation. In a low-wage company, there was no connection between employee participation and pay fairness. It may be that employees were paid so low that no amount of participation could overcome their dissatisfaction. So rather than tossing aside the idea of participation, it may be that in extreme cases (very low wages), a pay raise may trump participation.

Applied to internal structures, procedural justice addresses how design and administration decisions are made and whether procedures are applied in a consistent manner. Distributive justice addresses whether the actual pay differences among employees are acceptable.

PAY STRUCTURES CHANGE

Pay structures change in response to external factors such as skill shortages. Over time, distorted pay differences may become accepted as equitable and customary; efforts to change them are resisted. Thus, pay structures established for organizational and economic reasons at an earlier time may be maintained for cultural or political reasons. It may take another economic jolt to overcome the resistance. Then new norms form around the new structure. This “change-and-congeal” process does not yet support the continuous changes occurring in today’s economy. New norms for employee acceptance will probably need to include recognition that people must get used to constant change, even in internal pay relationships.

The pay for airport security screeners relative to other airport jobs illustrates the change-and-congeal process. Prior to 9/11, airport screeners were paid about $5.50 an hour with no benefits. Recent immigrants, some undocumented, and relatively unskilled people were hired to screen travelers and their luggage. The people working at the airport Starbucks or the newspaper shop may have been earning more than the screeners. After the 9/11 attack, the Transportation Security Administration (TSA) took over airport security and screening. Wages are now comparable to police and fire protection jobs. Entry-level pay starts at around $20 an hour plus benefits. Employees in other airport jobs have had to revise their comparisons to the security jobs.

TAILORED VERSUS LOOSELY COUPLED

A low-cost, customer-focused business strategy such as that followed by McDonald’s or Wal-Mart may be supported by a closely tailored structure. Jobs are well defined with detailed tasks or steps to follow. You can go into a McDonald’s in Cleveland, Prague, or Shanghai and find they all are very similar. Their pay structures are, too. There are seven jobs in each McDonalds (under supervisors and managers). All are very well defined in order to eliminate variance in how they are performed. Cooking french fries takes nine steps. It seems hard to make a mistake in these jobs. It is also hard to be the very best french fryer in the whole company. Differences in pay among jobs are very small. In contrast to McDonald’s, 3M’s business strategy requires constant Product Innovation and short product-design-to-market cycle times. The 3M competitive environment is turbulent and unpredictable. No steps at all are laid out. 3M engineers may work on several teams developing several products at the same time. 3M’s pay structures are more loosely linked to the organization in order to provide flexibility.

HIERARCHICAL PAY

Pay structures can range from hierarchical to egalitarian. Exhibit 3.6 clarifies the differences. Egalitarian structures have fewer levels and smaller differentials between adjacent levels and between the highest- and lowest-paid workers.

In Exhibit 3.7 , Structure A has eight different levels, with relatively small differentials in comparison to structure B, which has only three levels. Structure A is hierarchical compared to the egalitarian structure of B; the multiple levels would include detailed descriptions of work done at each level and outline who is responsible for what. Hierarchies send the message that the organization values the differences in work content, individual skills, and contributions to the organization.

Structure B can also be characterized as delayered or compressed. Several levels of work are removed so that all employees at all levels become responsible for a broader range of tasks but also have greater freedom to determine how best to accomplish what is expected of them. An egalitarian structure sends the message that all employees are valued equally. The assumption is that more equal treatment will improve employee satisfaction, support cooperation, and therefore affect workers’ performance. Costco CEO James Sinegal tries to maintain his cash compensation (base plus bonus) at 8 times the average of Costco unionized employees, and John Mackey at Whole Foods maintains his at 19 times. They believe the more compressed structure better fits their emphasis on cooperative employee teams. Both CEOs are millionaires, however, due to the value of their stock options.

Yet egalitarian structures are not problem-free. For example, Ben and Jerry’s Homemade, purveyors of premium ice cream, tried to maintain a ratio of only 7 to 1. (When the company started, the spread was 5 to 1.) The relatively narrow differential reflected the company’s philosophy that the prosperity of its production workers and its management should be closely linked. However, it eventually became a barrier to recruiting. Ben and Jerry’s was forced to abandon this policy to hire an accounting manager and a new CEO. And only when the company was acquired by Unilever did the press report the value of Ben and Jerry’s stock, which netted cofounders Ben Cohen $19 million and Jerry Greenfield $42 million—far beyond the 7-to-1 ratio.

Still, it is hard to be against anything called “egalitarian.” If we instead use the word “averagism,” as Chinese workers do when describing the pay system under socialism’s state-owned enterprises, where maximum differentials of 3 to 1 were mandated, some of the possible drawbacks of this approach become clear. Equal treatment can mean that the more knowledgeable employees—the stars—feel underpaid. They may quit or simply refuse to do anything that is not specifically required of them. Their change in behavior will lower overall performance. So a case can be made for both egalitarian and hierarchical structures.

Keep in mind, though, that the choice is rarely either/or. Rather, the differences are a matter of degree: Levels can range from many to few, differentials can be large or small, and the criteria can be based on the job, the person, or some combination of the two.

Ex-3.6

EQUITY THEORY

Employees judge the equity (fairness) of their pay by making multiple comparisons. Evidence based on a study of 2,000 school teachers suggests that teachers are more likely to feel their internal pay structures are fair when they are paid relatively highly within the structure. They will also feel pay structures are fair even when they are relatively low in the internal structure if they work in a high-paying school district.

Applying these findings to Lockheed’s engineers, advisors, and consultant engineers, we would assume they are more likely to say the internal structure is fair. Engineers at lower levels will think Lockheed’s structure is fair only if Lockheed pays more than its aerospace defense industry competitors. What we don’t know is how the lead engineer with 10 years experience will judge the pay structure if Lockheed hires new people into lead engineer jobs with only 5 years of experience. This event is unlikely to occur with unionized teachers’ pay structures, but it is very common in other organizations.

So the research suggests that employees judge the fairness of their organization’s internal pay structure by making multiple comparisons:

• Comparing to jobs similar to their own (internal alignment),

• Comparing their job to others at the same employer (internal alignment), and

• Comparing their jobs’ pay against external pay levels (external competitiveness).

The results from these comparisons depend in part on the accuracy of employee knowledge of other employees’ jobs, internal structures, and external pay levels.  Teachers’ pay schedules are generally public knowledge, but this is seldom the case in private sector organizations like Lockheed. Evidence from 30-year-old research shows employees often are misinformed about their relative standing in the pay structure. Equity Theory could support either egalitarian or hierarchical structures, depending on the comparisons and the accuracy of information about them.

TOURNAMENT THEORY

Economists have focused more directly on the motivational effects of structures as opposed to people’s perceptions of structures. Their starting point is a golf tournament where the prizes total, say, $100,000. How that $100,000 is distributed affects the performance of all players in the tournament. Compare a 3-prize schedule of $60,000, $30,000, and $10,000 with a 10-prize schedule of $19,000, $17,000, $15,000, $13,000, and so on. According to tournament theory, all players will play better in the first tournament, where the prize differentials are larger. There is some evidence to support this. Raising the total prize money by $100,000 in the Professional Golf Association tournament lowered each player’s score, on average, by 1.1 strokes over 72 holes. And the closer the players got to the top prize, the more their scores were lowered. (Note to nongolfers: A lower score is an improvement.)

Applying these results to organization structures, the greater the differential between your salary and your boss’s salary, the harder you (and everyone else but the boss) will work. If Lockheed pays its advisor engineers $125,000 and its consultant engineers $162,000, the tournament model says that increasing the consultants’ pay to $200,000 will cause everyone (except the consultants) to work harder. Rather than resenting the big bucks going to the consultants, engineers at all levels will work harder to be a “winner,” that is, get promoted to the next level on the way to becoming consultants themselves. Within limits, the bigger the prize for getting to the next level of the structure, the greater the motivational impact of the structure.

Several studies support tournament theory. One reported that giving larger raises with a promotion increases effort and reduces absenteeism. Others find that performance improves with larger differentials at the top levels of the structure. The “winner-take-all” idea springs from these studies. However, a study of the National Basketball Association revealed that once teams fail to get into the playoffs, where players would have made a lot more money, team performance drops precipitously. In fact, it can be called a “race for the bottom.” Why? The poorest teams have first-draft choice for next year’s new players. So, overnight, the reward goes to the worst record rather than best.

But most work is not a round of golf or a good jump shot. Virtually all the research that supports hierarchical structures and tournament theory is on situations where individual performance matters most (auto racing, bowling, golf tournaments) or, at best, where the demand for cooperation among a small group of individuals is relatively low (professors, stockbrokers, truck drivers).

In contrast to individual performers, team sports provide a setting where both an individ ual player’s performance as well as the cooperative efforts of the entire team make a difference. Using eight years of data on major league baseball, one study found that teams with practically identical salaries did better than those with large differentials. In addition to affecting team performance, egalitarian structures had a sizable effect on individual players’ performance, too. A mediocre player improved more on a team with an egalitarian structure than on a team with a hierarchical structure. It may also be that the egalitarian pay structure reflects a more flexible, supportive organization culture in which a mediocre player is given the training and support needed to improve.

Tournament theory does not directly address turnover. However, a study of executive leadership teams in 460 organizations concluded that executives were twice as likely to leave if the companies had large pay differentials among the leaders. For example, the CEO of medical reconstructive products maker Biomet would hardly notice if his pay envelope was switched with someone else’s on the leadership team. There is only about a 15 percent pay difference among the top five executives at Biomet. In contrast, at building materials supplier Louisiana Pacific, the CEO’s salary and bonus is about three times the total of other executives on his team. True to predictions that hierarchy breeds turnover, Louisiana Pacific had 13 changes in its five-person executive team over five years, compared to only one change on the Biomet team (a retirement). Conclusion: If executives need to operate like a baseball team, then an egalitarian structure is probably a better fit.

Cybercomp

Salaries for all the players on the major league baseball teams are listed at http://content.usatoday.com/sports/baseball/salaries/default.aspx. Pick some of your favorite teams and compare the highest- and lowest-paid players on the team. Based on the differentials, which teams do the models and research discussed in this chapter predict will have the better record?

Click on the following link to check out the team standings: http://content.usatoday.com/sports/baseball/salaries/default.aspx. Suggestion: Don’t bet your tuition on the relationship between player salary differentials on a team and the team’s performance.

INSTITUTIONAL MODEL

Sometimes internal pay structures are adopted because they have been called a “best practice.” Organizations simply copy others. Recent examples of such “benchmarking” behavior include the rush to outsource jobs, to emphasize teams, to de-emphasize individual contributions, and to shift to a competency-based pay system, often with little regard to whether any of these practices fit the organization or its employees and add value.

The institutional model predicts that very few firms are “first movers”; instead, they copy innovative practices after innovators have learned how to make the practices work. The copiers have little concern for alignment and even less for innovative pay practices.