Performance Appraisal Tutorial | Theory of Compensation

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Theory of Compensation

Theories of Reinforcement and Expectancy

Reinforcement theory affirms that a response followed by a reward is more likely to recur in the future.  High employee performance followed by a monetary reward will make future high performance more likely. High performance not followed by a reward will make it less likely in the future. The theory emphasizes the importance of a person actually experiencing the reward. Compensation systems differ according to their impact on these motivational components.  Pay systems differ most in their impact on instrumentality. The perceived link between behaviors and pay also referred to in the pay literature as “line of sight.” Expectancy perception often has more to do with job design and training than pay systems.

Theory of Equity

Equity theory suggests that employee perceptions of their contribution to company, return they get and how their return-contribution ratio compares to others inside and outside the organization. Perceptions of inequity are expected to cause employees to take actions to restore equity.  Greenberg (1990) examined how an organization communicated pay cuts to its employees and the effects on theft rates and perceived equity. The reasons for the pay cuts were communicated in different ways to the two pay-cut groups. In the “adequate explanation” pay-cut group, Management provided a significant degree of information to explain its reasons for the pay cut and also expressed significant remorse to the adequate explanation pay-cut group. On the other hand the “inadequate explanation” group received much less information and no indication of remorse. The control group received no pay cut and thus no explanation. The control group and the two pay-cut groups began with the same theft rates and equity perceptions. After the pay cut, the theft rate was 54% higher in the adequate explanation group than in the control group. However, in the “inadequate explanation” condition, the theft rate was 141% than in the control group. In this case, communication had a large, independent effect on employees’ attitudes and behaviors.

Theory of Agency

Agency theory focuses on the divergent interests and goals of the organization’s stakeholders, and the ways that employee compensation can be used to align these interests and goals. Ownership and management are typically separate in the modern corporation.

Examples of agency costs include management spending money on perquisites or “empire building” rather than seeking to maximize shareholder wealth. The fact that managers and shareholders may differ in their attitudes toward risk gives rise to agency costs. Shareholders can diversify their investments more easily than managers can diversify risk in their pay. As a result, managers may prefer relatively little risk in their pay. Agency costs also stem from differences in decision-making horizons. Especially where managers expect to spend little time in the job or with the organization, they may be more inclined to maximize short-run performance, perhaps at the expense of long-term success.

Type of contract that an organization use depends partly on the following factors

  • Risk aversion: Risk repugnance among agents makes outcome-oriented contracts more costly.
  • Outcome uncertainty: Profit is an example of an outcome. Linking pay to profits is more costly to the extent that profits vary and so there is a risk of low profits.
  • Programmability of Job: Outcome-oriented contracts become more likely as jobs become less programmable, and more difficult to monitor. The increasing complexity of organizations and technology makes monitoring more difficult. They may help explain the growing use of variable pay programs. They are examples of outcome-based contracts. Pay levels are also higher, consistent with the idea that employees must be compensated for sharing more risk.
  • Measurable lob outcomes: Outcome-oriented contracts are more likely when outcomes are more measurable
  • Ability to pay: Outcome-oriented contracts contribute to higher compensation costs because of the risk premium.
  • Tradition: A tradition or custom of using outcome-oriented contracts will make such contracts more (or less) likely.

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