8.5 The structure of compensation and organisational performance
The most basic choice of remuneration structure faced by a firm is the positioning on the continuum between fixed salary and pay for performance (piece rate remuneration such as commissions for sales being an extreme example). A range of studies have looked at the conditions under which pay for performance may be superior to salary, and identified that:
- Firms will pay for performance when it is cheaper to measure performance. Even where there are elements of performance that are difficult to measure in the short-term, compensation schemes that involve combinations of short-term and long-term bonuses, or penalties based on ex post evidence of poor performance, may be optimal (Horstmann, Mathewson and Quigley, 2005).
- Firms are more likely to pay for performance as the value of a worker in alternative employment approaches their value in their existing employment. If workers with alternative high-paying job options are not paid for what they produce in their current firm, then they are more likely to move to the alternative employment.
- Firms are more likely to pay for performance when they do not have good screening technologies available to identify the most promising potential employees from job applicants.
- Firms are more likely to pay for performance when hiring new workers is relatively low cost, and when it is therefore cost effective to focus investment in performance measurement and management rather than on screening of job applicants.
The structure of compensation packages has two effects. The first is on incentives for action in the short term, and the second is on the selection of staff for the firm (for a summary, see Lazear and Shaw, 2007:100). In the long term, the second effect may be at least as important as the first, because it means that the compensation system will attract those who are best able to respond to the incentives that the firm provides. A wide variety of studies has demonstrated that performance improvement resulting from performance pay arises both from incentives and the selection of staff whose productivity will respond most strongly to those incentives (for example, Lo, Ghosh and Lafontaine, 2011).
More generally, this literature supports the proposition that organisational transformation will require complementary changes in human resource management practices, particularly those relating to remuneration, recruitment and retention. Higher levels of performance or a focus on different types of performance can be obtained by introducing new approaches to human resource management. Moreover, those new approaches are most effective when a complementary set of changes is introduced—for example, team-based environments have higher output when workers are better trained, incentives are team-based, and the selection of team members ensures that individuals in the team have complementary skills.
