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Toward a Contingency Theory of Compensation Strategy Author(s): David B. Balkin and Luis R.

Gomez-Mejia Source: Strategic Management Journal, Vol. 8, No. 2 (Mar. - Apr., 1987), pp. 169-182 Published by: John Wiley & Sons Stable URL: http://www.jstor.org/stable/2485980 Accessed: 02/09/2010 05:29
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Strategic Management Journal, Vol. 8, 169-182 (1987)

TOWARDA CONTINGENCY THEORYOF COMPENSATION STRATEGY


DAVIDB. BALKIN
Department of Management, Louisiana State University, Baton Rouge, Louisiana,
U.S.A.

LUIS R. GOMEZ-MEJIA
Graduate School of Business Administration, University of Colorado, Boulder, Colorado, U.S.A.

This paper develops several propositions that link compensation strategy and the effectiveness of the compensation systenm. The underlying argument is that effectiveness at realizing intended pay strategies depends significantly on the existence of a match between compensation strategies, organization and environment. These propositions are tested in a samiple of 33 high.tech and 72 non-high tech firms or business units in the Boston Route 128 area. Respondents are nmanagers responsible for compensation policies in these firms or business units. The relationships among compensation strategies, organization characteristics and environment are explored. Thefindings nmay help researchers conceptualize, and practitioners manage, the relationship between reward processes and strategy in organizations.

The consistency with which systematic relationships have been discovered between organizational characteristics and strategy at the overall firm level would lead one to expect the existence of a similar relationship with the organization's compensation system. To date, very little work has been done in developing a contingency theory that ties the pay system to the organization's operating objectives and strategies. This is surprising in view of the fact that labor costs comprise more than half of total costs in most organizations, and that pay systems are pivotal in terms of the motivation, attraction, and retention of human resources (Lawler, 1981). As argued by Milkovich and Newman most compensation research tends to emphasize techniques 'where the mechanics become the focus, ends in themselves . . . the purposes of the pay system are often forgotten . . . to date we really do not know enough to recommend [pay] policies under different conditions' (1984: 11). The purpose of this paper is to take some first steps in the development of a contingency theory of compensation strategy at the orgainizational level. The decision to concentrate on the macro0143-2095/87/020169-14$07.00 (C 1987 by John Wiley & Sons, Ltd.

level rests on two assumptions. First, this would require a smaller, less complex set of variables than would be the case if differences in organization subunits (e.g. by function) are considered. Second, and equally important, it was believed that over the long run a firm could not be successful in its compensation strategies as the subunit level unless these are designed to reinforce the strategies adopted by the entire organization. For example, a business firm may consist of a young, high tech subunit that is rapidly growing and a mature, manufacturing subunit that is profitable and slowly growing. The overall company strategy may involve using some of the profits from the mature subunit to finance the research and development and expansion of the high tech subunit. To support the strategy, each subunit may need to implement different forms of compensation packages. After a review of the relevant literature this paper develops a set of propositions regarding the choice and effectiveness of compensation strategies under various conditions. These propositions are then tested in a sample of 33 high tech and 72 non-high tech firms or business units
Received 4 February 1985 Revised 10 March 1986

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the Japanese in a global marketplace, and the changing world of a high-technology, servicebased economy have placed increased emphasis on improved human resource management as a means of restoring the competitive edge for U.S. corporations (Miles and Snow, 1984). This strategic human resource management perspective views people,-as much as capital, buildings or equipment-as an important source of strategic opportunities and constraints, and it recognizes that a firm's human resources have certain strengths and weaknesses that should be factored into corporate strategies (Dyer, 1983). One of the weaknesses of human resources professionals in some organizations is their focus on solving operational, day-to-day problems and a lack of understanding of broader, strategic business issues that look at the long-run situation (Tichy, 1983). Consequently, human resources departments in these organizations are reactive, firefighting departments and are not as effective as they could be. Compensation is considered an important part of the strategic thrust of human resource management. In the recent work of Beer et al. (1985) compensation (referred to as reward systems) is one of four major policy areas of human resources about which all general managers must become knowledgeable. The other policy areas are employee influence, human resource flow and work systems. Human resource management practices (including compensation) may give a competitive advantage to one corporation over its rivals (Schuler and MacMillan, 1984). For instance, People Express and Lincoln Electric use compensation practices to gain a cost-efficiency advantage over their competitors. At Hewlett-Packard, on the other hand, entrepreneurial behavior and innovation are stimulated by using incentive compensation policies that reward success (Schuler and MacMillan, 1984). In both of these situations the compensation policies help drive the overall business strategy, which may be dominated by cost-efficiency at Lincoln Electric or innovation at Hewlett-Packard. For the most part, neither stream of research noted above focuses its attention on macroorganizational factors affecting pay strategies and how the interaction impacts the effectiveness of the compensation system. It is the authors' contention, discussed throughout the rest of this

in the Boston area. The article concludes with an assessment of the potential significance of contingency theories of compensation and next steps involved in the development of such theories.

THEORETICAL HYPOTHESIS

FRAMEWORK

AND

Perhaps the oldest line of inquiry focusing on the relationship between organizational strategies and reward systems may be found in the executive compensation literature (e.g. Baumol, 1959; McGuire, Chiu, and Elbing, 1962; Roberts, 1959). Economic research linking organization performance with executive compensation has led to mixed results (Fox, 1980; McEachern, 1975; Rich and Larson, 1984). Many behavioral scientists have contended that it is crucial for executives to be motivated by an appropriate reward package to further company goals (e.g. Lawler, 1986; Salter, 1973). Unfortunately, compensation packages intended to motivate executives frequently fail (Patton, 1972; Pearce, 1986). Some of the reasons executives are not motivated to perform in harmony with corporate objectives are due to flaws in the design of the compensation system or poor administration of the rewards. It has been argued that certain conditions must be taken into account when designing such a system. For example, executive performance is more effective when the reward package strikes a balance between long-term and short-term goals (Rappaport, 1978); recognizes the executive who takes risks (Salter, 1973); takes into consideration executives' preferences for direct pay, deferred income and benefits (Lewellen and Lanser, 1973); and relates executive pay to meaningful financial measures of corporate performance (Murthy and Salter, 1975). A broader and more recent literature advocates that human resource strategy (including pay) should be treated as an integral component of corporate strategy. Changes in the business environment have made it necessary for top executives to elevate the status of human resource departments and include a human resource management perspective in the formulation of corporate policies (Devanna, Fombrun, and Tichy, 1981). The challenge of competing with

Contingency Theory of Compensation Strategy


paper, that a contingency framework can deepen our understanding of this process. The conceptual root of the contingency perspective is that effectiveness at realizing intended strategies depends significantly on the existence of a match among strategy, organization and environment. Originally advanced by Chandler (1962), such a contingency approach has been extended and reinforced by such researchers as Anderson and Zeithaml (1984), Fouraker and Stopford (1968), Lawrence and Lorsch (1967), Rumelt (1974), and Vancil (1980). Of the contingency variables investigated to date at the macro-level, most attention has been devoted to the product life cycle. Research in marketing as well as in strategic management indicates that stage in the product life cycle is a fundamental variable affecting organizational strategy and its effectiveness (see Anderson and Zeithaml, 1984; Rink and Swan, 1979; and Day, 1981, for a comprehensive review of this literature). Hofer (1975) developed the most extensive theoretical profile of the product life cycle as it affects business strategy. Two propositions suggested by Hofer have received widespread empirical support: The most fundamental variable in determining an appropriate business strategy is the stage in the product life cycle (1975: 798). Major changes in business strategy are usually required during three stages of the product life cycle: introduction, maturity and decline (1975: 795). Organizations whose main products are at the growth stage are faced with high rates of technological change (Hofer, 1975), suffer from high mortality rates (Bell, 1982), are highly dependent on new product innovations to get established in particular industries (Tilles, 1966), and more responsive to market trends and shifts since fixed costs involving standardized technology are relatively high as compared to more mature firms (Morison, 1966). These firms also face an uncertain environment requiring greater willingness to take risks and greater tolerance for ambiguity (Gupta and Govindarajan, 1984). In their socio-technical system, firms at the growth stage are more likely to attract younger, more risk-taking managerial and technical personnel (Ettlie, 1983). These firms are

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normally led by entrepreneurs who set the tone for the organization. They are risking their capital and assests in a fledgling business, and would rather work with other individuals who are willing to trade off job security and immediate rewards for the expected utility of anticipated growth. When firms enter the mature stage, leading entrepreneurs tend to remove themselves from the operational functions of the business and allow professional managers to take over and develop a more routine administrative system. New products as a percentage of sales declines, and product research and development expenses as a percentage of revenues drop rapidly from growth to maturity (Anderson and Zeithaml, 1984). The task environment becomes more predictable, market share is relatively stable, there are greater economies of scale, and the rate of change in the state of the art is much lower (Hofer, 1975). The stage in the life cycle is likely to be a key determinant of compensation strategies and their effectiveness in achieving organizational goals. One would expect those firms at the growth stage to pay employees more in the form of an incentive basis and less in the form of salary and benefits. Such a policy would allow a growing business to shift some of its compensation costs from a fixed expense to a variable expense. The advantage of this strategy is that the firm receives float from employees and pays a portion of its compensation costs when it is in the best financial position to do so. The incentives are paid to employees when the financial or other strategic objectives have been reached. As a result, the growing firm can secure greater flexibility to invest heavily in research and development, new technology, expansion of capacity, marketing and advertising (instead of additional compensation) to fuel the growth. Employees, under an incentive compensation policy, are invited to be risk-takers and share in the anticipated profits of future growth with the owners. Thus, incentive pay policies for firms in the growth stage of the product life cycle function not only to finance future growth but also to motivate individual and group performance. Further, firms at the growth stage are expected to find pay incentives to be more effective than those at the mature stage of the product life cycle. Firms with mature products are more likely to be operating in more stable environments

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centralization and standardization. With the exception of top executives, each position in a larger company tends to be remunerated based on a fixed scale corresponding to its place in the job evaluation hierarchy. In terms of company culture, smaller firms are more entrepreneurial and individuals less concerned with security (Ettlie, 1983). Such an organizational climate is more receptive to a reliance on variable rather than a fixed compensation strategy. This is the rationale for propositions 3 and 4: Proposition 3: The proportion of fixed compensation costs in the total pay package will increase as a function of organizational size. Propositioni 4: The effectiveness of an incentive-based reward strategy will be inversely related to company size. Compensation strategies are likely to be influenced not only by firm characteristics (e.g. stage in life cycle and size) but also by industry traits. One key industry factor is the extent to which technological innovations and R&D success are necessary for survival in a highly competitive environment. In this paper we will focus our attention on the high tech industries in relation to non-high tech industries, and develop a set of propositions based on characteristics of these two different clusters of industries. High tech was selected because of its unique compensation practices (Balkin and Gomez-Mejia, 1985) and its human resource departments are involved in the formulation of corporate strategy (Miles and Snow, 1984). High tech includes firms or business units engaged in the production of computers, silicon chips, telecommunications, computer software, artificial intelligence, technical instruments and bioengineering products. The Boston Route 128 area, where the data for this study were collected, has a heavy concentration of computerand electronics-related companies. Many of these firms were started by former MIT students or faculty. The Massachusetts High Tech Council, an employers' association for many Boston high tech firms, defines high tech as a firm that spends 5 percent or more of its annual sales revenues on R&D. While the decision to spend resources on R&D is a combination industry trait and strategic decision within the firm, the investigators decided to use the Massachusetts High Tech Council method of identifying high tech due to

where risk and anticipated growth are reduced. Mature firms are more apt to set up an administrative structure for the compensation system which is less based on incentives and more mechanistic, emphasizing the fixed pay components (salary and benefits) established through a formal job evaluation process. In other words, a greater reliance on incentives for growing firms should be more effective than in mature companies (whose markets and products are stable) since an emphasis on unit and individual performance fits in with the organization's strategy and the risk taking nature of its sociotechnical system. This is the rationale for propositions 1 and 2: Proposition 1: Incentive pay as a proportion of the total compensation package will be greater for firms at the growth stage of the product life cycle. Proposition 2: An incentive-based reward strategy will be more effective for firms at the growth stage of the product cycle. A second variable which is likely to affect the choice and effectiveness of compensation strategies is the size of the firm. Financially, smaller firms are less able to afford fixed cost expenditures. By providing a lower base compensation (which is a significant fixed cost in the short run) in exchange for an array of incentive pay programs, smaller companies can buffer themselves against short-term financial pressures. Such a policy enables smaller firms to compete against larger firms in the product market, without weakening their cash flow position. Administratively smaller companies can institute and manage incentive systems more efficiently than larger firms. For these smaller firms the number of positions are fewer, pay comparisons are simpler, operations are normally in a single plant or location, and performance indicators easier to obtain. As the firm grows in size it also becomes more complex in terms of salary grade levels, management structure, product and market differentiation, and geographical dispersion, so that incentive systems are more difficult to design, implement and control. Larger firms tend to develop bureaucratic job evaluation schemes, where individual pay decisions are made within a systematic and algorithmic framework emphasizing consistency,

Contingency Theory of Compensation Strategy


its simplicity and general acceptance within a significant portion of the high tech industries. Also, this criterion led to meaningful results when the empirical analysis was conducted (see Results section). High tech firms are characterized by (a) a high proportion of scientists and engineers in the work force; (b) geographic concentration in corridors such as Silicon Valley or Route 128 in Boston; (c) high expenditures on research and development focused at products at the cutting edge of technology; (d) rapid rates of technological change; (e) a very tight labor market for scientists and engineers, with resulting high attrition rates since there is little time for in-house training so that these individuals must be attracted from other firms. Geographic concentration adds to this problem because relocation costs are minimal; and (f) entrepreneurship, as many of these firrns are led by an entrepreneur who obtains financial support from venture capitalists who usually retain a piece of the company (Balkin and Gomez-Mejia, 1985). Incentive pay as a proportion of total compensation should be higher in high tech firms, and the use of an incentive-based strategy should be more effective in this industry. First, most high tech entrepreneurs have already relinquished a substantial portion of the firm to the venture capitalist so that equity sharing is already an established practice. It would be reasonable for the owner to provide employees with some equity in the new venture to compensate them for the high risks they are assuming. Second, because of the 'pirating' problem, high tech firms must provide strong incentives to key contributors. The lure of the 'brass ring' is used in the industry to entice and retain scientists and engineers through a pay system that promises extraordinary financial benefits if the firm succeeds. (This takes place, of course, under very risky conditions to the employee because the mortality rate in the industry is exceedingly high.) Third, high tech companies often rely on venture capital for financing with an expected payback period of about 5 years, typically accompanied by an initial public offering of company stock. Rapid growth is anticipated during this period and pay incentives are expected to play an important role in motivating employees to achieve company objectives. The venture capitalists, in their role as consultants with a vested interest in the company,

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often insist that management adopt incentivebased compensation policies. They reason that their investments in the firm are less likely to go sour if persons with the skills critical to success have a substantial upside potential if they stay with the firm, through an equity interest. Among a random sample of American firms, GomezMejia, Tosi, and Hinkin (1986) found that externally controlled firms tend to pay managers more on the basis of bonuses and long-term income rather than salary. Fourth, not only should pay programs be tailored to organization strategies and objectives, but they should also be congruent with the organization's culture and values. In high tech, an entrepreneurial culture nurtures the notion that rewards should be closely tied to performance and that incentive attainments are a measure of personal achievement. Thus, in addition to the main effects of stage in the life cycle and size on compensation strategies, high tech firms will have their own unique stamp on pay policies. The above arguments are summarized in the following six propositions: Proposition 5: The compensation mix in high tech firms will contain a higher proportion of incentive rewards anid a lower proportion of fixed pay. Proposition 6: Considering all firms at the growth stage of the product life cycle, those that are high tech will have a pay mix with a greater incentive component. Proposition 7: Smaller high tech firms will have a pay mix with a greater incentive component than similar nion-high tech firms. Proposition 8: An incentive-based compensation strategy will be more effective in high tech firms than in non-high tech companies. Proposition 9: For organizations at the growth stage in the product life cycle, an incentivebased reward strategy will be most effective for high tech firms. Proposition 10: For smaller companies, an incentive-based reward strategy will be most effective for those which are high tech.

METHOD Sample and data collection procedures The sample of firms used in the study consists of high tech and non-high tech companies from

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sample and the Massachusetts High Tech Council member list as both having around 60 percent electronics and instruments-producing firms as evidence that our high tech sample is representative of the types of firms that are in the Boston Route 128 High Tech Center. While the study sample is representative of the high tech firms along Route 128, these firms are not necessarily representative of high tech firms nationwide. In particular there is a very real possibility that pharmaceutical firms, which are heavily represented in the Midwest, may well be underrepresented along Route 128. The data collection tool used in the study was developed based on an extensive library search and in-plant inverviews with over 100 managers responsible for compensation policies in these companies. The survey was pre-tested with a sample of these managers to ensure that it was complete, easy to follow, and that the items were not ambiguous. The survey, conducted through the mail in August 1983, included questions pertaining to organizational characteristics, compensation strategies, and pay effectiveness. The questionnaires were completed by 105 respondents who were responsible for compensation policies. The measures are described in more detail below. Organizational characteristics The organizational characteristics measured refer to the firm for single-business companies. For diversified companies with multiple business units, the organizational characteristics measured refer to the business unit. For example, stage in product life cycle and sales revenues refer to the participating firm if it is a one-business company, but refer to the participating business unit if it belongs to a larger diversified company. In this manner the corresponding measures for small organizations would be comparable to those of business units in larger, complex organizations. High tech vs. traditional firms A company or business unit was defined as high tech if its annual research and development budget is 5 percent or more of its sales revenues. This is the Massachusetts High Technology Council definition of a high tech firm. This measure was treated as a 0/1 dummy variable.

the Route 128 'technology center', Boston, Massachusetts. Over 150 managers responsible for compensation policies were interviewed in person and by telephone to identify a representative sample of companies in the area. The titles of these managers ranged from compensation manager and director of compensation in the larger firms to vice-president of human resources, director of human resources and vice-president of finance in the smaller firms. The latter group associated with the smaller firms did work in compensation along with a broader set of duties for their companies. Despite the broader set of demands placed on these individuals, a representative sample of respondents from small firms participated in the survey. Two hundred and twenty-three firms or business units of larger companies were chosen that met the following conditions: (a) scientists and engineers constitute at least 3 percent of the employee population in each firm; (b) all firms were physically located within a 70 mile radius to control for environmental differences, e.g., cost of living, unemployment rate, ease of mobility; (c) all firms had at least one R&D unit; and (d) cross-sectional representation in terms of stage, size, high tech status, and main product lines. Of the 223 firms or business units selected for the study, 105 (47 percent) agreed to participate in the project in exchange for a free copy of the tech report. All participants were promised strict confidentiality of any information provided to the researchers. The resulting sample distribution consisted of 33 'high tech' and 72 'traditional' (non-high tech) firms or business units. This distinction was used to test those hypotheses pertaining to the unique effects of industry traits on compensation strategies and their effectiveness. The sample of 33 high tech companies was representative of the types of high tech product lines produced in the Boston Route 128 High Tech Center. The high tech sample consisted of 64 percent firms whose product lines were in the electronics or technical instruments industries and only 36 percent firms whose product lines were drugs, chemicals or 'other'. An analysis of the membership list of the Massachusetts High Tech Council, an employer association that represents all high tech industries in Massachusetts, revealed that 62 percent of its members were producing either electronics or technical instrument products. We view the fact that the high tech

Contingency Theory of Compensation Strategy


Stage in product life cycle This variable was defined in a manner similar to that of Hambrick (1981, 1983) and Hofer (1975). A company or business unit's stage was coded into a dummy variable according to one of the following categories (as designated by respondents): 1. Mature stage: products or services familiar to vast majority of prospective users. Technology and competitive structure are reasonably stable. 2. Growth stage: sales growing at 20 percent or more annually in real terms. Technology and competitive structure are still changing.

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Scale Company or business unit size was measured as annual sales revenues. It had a correlation of 0.21 with stage in the product life cycle (with no significance at the 0.05 level). With a common variance of only 0.04 we can assume these two measures are fairly independent. Profitability This measure was used as a control variable in the study since it may affect the compensation mix (Gomez-Mejia, Tosi, and Hinkin, 1986) or levels (Agarwal, 1981). It was defined as the ratio of net income to sales. While it is recognized that this measure of profitability is flawed due to the lack of control for the amount of capital required to produce a given level of sales and profits, the sample chosen for this study tends to minimize this problem. Many of the firms or business units selected for this study are members of the electronics industry and have similar capital requirements. The more robust profitability measure, return on assets, was not available for many of the business units in our sample. Compensation strategies Pay strategy was conceptualized in terms of pay mix or the relative importance of variable (incentive) and fixed (salary, fringe benefits) components of the compensation package. Pay mix was measured as the average ratio of incentive payments, salary and fringe benefits

over total compensation for each firm. This operational definition was used by Gomez-Mejia, Tosi, and Hinkin (1986) when analyzing the effects of type of firm ownership on compensation mix. The pay policies in this study refer to the pay of scientists and engineers in research and development units. While the scientists and engineers may be at different levels in the organization (for example, associate engineer, senior engineer, consulting engineer, etc.), the engineers and scientists are usually treated as a team with respect to compensation policies. Interviews with high tech managers revealed that scientists and engineers often work together as a team on projects with senior and junior people coordinating their efforts. A pay incentive that is given only to senior people (such as a bonus) would be demoralizing to junior-level contributors and may lower the quality of team performance. Therefore, most pay incentive policies in the organizations in our sample allow all the scientists and engineers in the R&D unit, regardless of level, to participate in the incentive program. The employee sample in the 'traditional' (nonhigh tech) firms refer to scientists and engineers working in the smaller, less important R&D units of these companies. Pay effectiveness Pay effectiveness was conceptualized in terms of the extent to which the compensation system contributes to the achievement of organizational goals. Important pay dimensions were first identified through an extensive literature search and interviews with managers responsible for compensation policies. Twenty-three items are identified in this manner. Next, these managers were asked to evaluate the effectiveness of their compensation system along each dimension, by responding to the question 'How satisfied are you with the way current pay practices in your company contribute to the attainment of organizational objectives'. The response format consisted of the 1-5 Likert scale of the Minnesota Satisfaction Questionnaire, ranging from (1) 'extremely dissatisfied' to (5) 'extremely satisfied'. The item responses of the 105 managers responsible for compensation policies were factor analyzed by the principal axis method with the squared multiple correlation as the estimate of

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to the attraction of a sufficient number of top-quality employees. Factor 3: pay as a motivationi tool. This factor measures the extent to which pay practices reward and induce higher productivity. Factor scores were then calculated by: (a) selecting only the items with salient loadings on each factor and multiplying the salient factor loadings by the standardized responses for those itenms(this, in effect, weights the responses by the factor loadings); and (b) adding the weighted responses into a total score. This approximation procedure for computing factor scores is recommended by leading authorities in the field (Gorsuch, 1974; Schmidt, 1971; Wackwitz and Horn, 1971). It tends to produce factor scores that intercorrelate, yet have stable interrelationships across independent samples, whereas exact procedures (Gorsuch, 1974) tend to be less stable and generalizable across different samples. In addition to the three factors described above, actual attrition data were used as a fourth effectiveness measure. For most firms, retention is an important criterion of success of a compen-

communality. The resulting factor solution was then rotated via the varimax criterion. Three factors reached the standard criterion of an eigenvalue of 1.0 or greater. Table 1 shows the items that loaded highly on each factor (defined as 0.40 or higher). The three effectiveness measures were tested for reliability and found to be internally consistent with coefficient alphas of 0.95, 0.76, and 0.83 (Nunnally, 1967). The three factors are as follows: Factor 1: general pay effectiveness. This is a global factor measuring the extent to which current compensation practices contribute to organizational goals. It encompasses a broad spectrum of interrelated pay dimensionissuch as pay level as compared to other companies, frequency of pay increases, pay as compared to the cost of living, pay as compared to that of newcomers into the company, and pay received as compared to employees' expectations. Factor 2: pay as a recruitment tool. This is a specific factor measuring the extent to which current compensation practices conitribute

Table 1. Loading

Pay effectiveness factorsa Items


(ot = 0.95)

Factor 1: General Pay Effectiveness

0.87 0.78 0.69 0.93 0.79 0.74 0.43 0.81 0.84 0.86 0.63 0.47 0.73 0.74 0.50 0.36
a

Pay as compared to employee's outcomes Present pay levels Pay as compared to newcomers' pay level Pay levels as compared to other companies Rapidity of pay raises Size of pay increases Benefits as compared to other companies Pay compared to the cost of living Pay for key scientists and engineers Pay policies that retain employees Pay that attracts top-quality employees Pay that attracts sufficient quantities of employees Pay policies that motivate employees Pay policies that reward high-quality contributions Effectiveness of job evaluation system Effectiveness of merit pay policy

Factor 2: Pay as a recruitment tool (a = 0. 76)

Factor 3: Pay as a motivation tool (ot = 0.83)

Obtained from principal axis method with squared multiple correlation as estimate of communality and rotated via the varimax procedure.

Contingency Theory of Compensation Strategy


sation system (Belcher, 1974; Milkovich and Newman, 1984). This is particularly true for high tech firms since retaining high performers in R&D laboratories is critical to the firm's survival, and replacement of these people (most of whom are performing tasks requiring extended project specific training) is both expensive and difficult. Since attrition may have a curvilinear relationship with performance (Jackofsy, 1984), a logarithmic transformation of this measure was used as a dependent variable. The pay effectiveness measures have some obvious limitations. The major limitation is, that with the exception of the attrition rate, the other three indicators of pay effectiveness measure the attitudes of managers towards the pay policies they administer. Alternative measures of pay system effectiveness would be R&D unit performance measures such as commercial and technical success of the product, or meeting product deadlines (Mansfield and Wagner, 1975; Katz and Allen, 1985). However, the investigators' choice to sample a broad cross-section of high tech firms and business units precluded the availability of these alternative effectiveness measures. R&D performance data are proprietary information for many of these organizations. Most of the high tech firms are not willing to share sensitive performance information with outsiders, and have explicit policies that restrict the kind of information available to outsiders. While our pay effectiveness measures are softer than some of the alternative effectiveness measures, they were the best data available that managers in 105 organizations were willing to share with the investigators. Another possibility for an objective effectiveness measure is profitability. While we considered profitability, we rejected it as an effectiveness measure for this study because it would be biased against newer, entrepreneurial high tech firms that were not generating profits due to their lack of maturity. New, high tech ventures may be highly effective, yet unprofitable because all the available resources are fueling research and development, advertising and promotion and growth. Profits may not even be planned for the firm until growth goals are met. One other possible measure of R&D unit effectiveness is the number of patents granted (Keller and Holland, 1982; Packer, 1983). The number of patents granted was not chosen as an

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effectiveness measure, because of the heterogeneous mix of technology represented in the sample of firms. This measure would be more useful if the sample of firms all represented a common technology such as genetic engineering. It should be noted in passing that many compensation experts (e.g. Belcher, 1975; Milkovich and Newman, 1984) have argued that in the end the acceptability of the compensation system as perceived by its users may be the best indicator of its utility and that more 'objective' indices (e.g. percentage of applicants accepting offers, per capita productivity) are not necessarily cleaner Criterionmeasures. In fact, objective effectiveness measures such as productivity or return on assets tend to be more contaminated and difficult to interpret than subjective measures (Steers and Ungson, 1986; Deckop, 1986). Empirical support for the use of 'soft' pay effectiveness measures based on user reactions over 'hard' effectiveness measures was documented in an extensive longitudinal study by Gomez-Mejia, Page and Tornow (1982). This suggests that while the pay effectiveness scales used in this study have obvious limitations, they are perhaps no worse than would be the case if 'objective' measures were readily available. Analysis Multiple regression was used to test each of the 10 hypotheses. The first set of equations was calculated for each of the separate compensation components (incentive, salary and fringes) as a percentage of the total pay package. This was done in two steps. Step 1 tested for the main effects of stage (proposition 1), scale (proposition 3), and high tech (proposition 5) on compensation mix. Profitability was used as a control variable. Step 2 tested for the interaction effects of stage! high tech (proposition 6), and scale/high tech (proposition 7) on pay mix. A second set of regressions was calculated with the four effectiveness measures as dependent variables. This was done in three steps. Step 1 tested for the main effect of high tech, incentives, base salary, and benefits on the four dependent variables. Step 2 tested the two-way interaction term for stage/incentive mix (proposition 2), scale/incentive mix (proposition 4), and high tech/ incentive mix (proposition 8) on the effectiveness measure. Finally, step 3 tested the three-way

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high tech and incentive pay show positive coefficients for all four effectiveness measures, with base salary and benefits showing positive coefficients for the first two factors. Step 2 supports propositions 2, 4, and 8, with the exception of the attrition measure. In other words, stage/incentive (proposition 2), scale/ incentive (proposition 4), and high tech/incentive (proposition 8) exhibit significant relationships with the first three effectiveness measures. The results of the three-way interactions in Step 3 show that the high tech/stage/incentive (proposition 9) and high tech/scale/incentive (proposition 10) interaction terms are significant for the general pay effectiveness factor. Descriptive data for each compensation mix item, broken down by high tech and non-high tech firms nested within stage and scale, are shown in Table 4. The entries in the matrix refer to the average percentile score of each compensation mix item corresponding to those firms in each cell. For example, a score of 70 in the first cell indicates that, on the average, 70 percent of all firms in the sample score lower on incentive mix than high tech firms at the growth stage of the life cycle. The pattern of scores in the matrix shows that high tech firms rely on incentive compensation more than traditional

interaction term for high tech/stage/incentive mix (proposition 10) on pay effectiveness.

RESULTS Table 2 summarizes the regression findings for the determinants of compensation strategies. Results in Step 1 show that stage and high tech are inversely related to salary and benefits as a percentage of total compensation, and positively related to incentive mix. This supports propositions 1 and 5. Scale, on the other hand, behaves in an opposite manner with salary and benefits having positive coefficients, and incentive mix having a negative coefficient. This supports proposition 3. Profitability as a control variable is positively related to salary and benefits, a finding congruent with previous research (GomezMejia, Tosi, and Hinkin, 1986). Step 2 shows that propositions 6 and 7 are supported for salary and incentive mix. The interaction terms stage/ high tech and scale/high tech show negative coefficients for salary and positive coefficients for incentive mix. Table 3 summarizes the regression results with the effectiveness measures as dependent variables. Step 2 depicts the main effects. Both

Table 2.

Determinants of compensation strategies (N = 105 firms) Compensation mix (item . total compensation) Incentives Salaryt Benefits

Independent variables Step 1 Stage (Proposition 1) Scale (Proposition 3) High tech (Proposition 5) Profitability (Control) Step 2 Stage x high tech (Proposition 6) Scale x high tech (Proposition 7)

-0.340** (0.154) 0.336** (0.131) -0.234** (0.109) 0.320* (0.165) R2 = 0.32 -0.318* (0.162) -0.311* (0.156) R2 = 0.35

-0.166** (0.075) 0.185** (0.081) -0.171* (0.083) 0.174* (0.091) R2 = 0.32 0.196 (0.138) 0.184 (0.121) R2 = 0.33

0.159 * (0.042) -0.143* (0.072) 0.155** (0.057) 0.145 (0.094) R2 = 0.34 0.140** (0.061) 0.1611* (0.070) R2 = 0.38

*p > 0.05; **p > 0.01; ***p < 0.001. a Standard errorsappearin parentheses.

Contingency Theory of Compensation Strategy


Table 3. Determinants of pay effectiveness (N = 105 firms) General pay effectiveness

179

Independent variables Step I High tech Incentive Base salary Benefits

Recruitment

Motivation

Attrition

0.623* (0.310)a 0.211** (0.083) 0.205 (0.112) 0.186* (0.087) R2 = 0.29 0.221* (0.124) 0.234* (0.121) 0.192 (0.103) R2 = 0.35 0.025* (0.013) 0.031* (0.015) R2 = 0.43

0.455* (0.208) 0.155* (0.081) 0.146 (0.136) 0.163* (0.075) R2 = 0.36 0.153* (0.081) -0.168 (0.145) 0.174* (0.082) R2 = 0.39 0.009 (0.008) 0.018 (0.015) R' = 0.40

0.813** (0.285) 0.132** (0.052) 0.135 (0.149) 0.145 (0.139) R2 - 0.27 0.139* (0.074) 0.152* (0.077) 0.146** (0.052) R2 = 0.38 0.007 (0.012) 0.011 (0.010) R2 = 0.41

0.084* (0.047) 0.034* (0.018) -0.042 (0.053) -0.028 (0.035) R2 = 0.28 -0.027 (0.029) -0.039 (0.044) -0.033 (0.202) R2 = 0.30 -0.002 (0.003) -0.005 (0.004) R2 = 0.32

Step 2 Stage x incentive (Proposition 2) Scale x incentive (Proposition 4) High tech x incentive (Proposition 8) Step 3 Stage x high tech x incentive (Proposition 9) Scale x high tech x incentive (Proposition 10)
*p - 0.05; **p : 0.01; *p '< 0.001. \ Standard errors appear in parentheses.

Table 4. Average percentile scores for compensation mix items broken down by stage, scale, and high techW (N = 105 firms) Stage Growth Compensation items Incentive Salary Benefits Mature Small Scale' Large

High tech Traditional High tech Traditional High tech Traditional High tech Traditional 70 20 24 46 53 64 15 34 65 13 87 77 78 18 03 50 86 28 59 27 55 06 73 93

Decimal points have been omitted. Firms below the median in annual sales are designated as 'small', those above the median are designated as 'large'.

firms, and that smaller firms at the growth stage of the life cycle tend to rely less on fixed pay (salary and benefits) and more on variable pay (incentives).

For the sake of simplicity, Table 5 summarizes the study's findings by proposition. It indicates the text of each proposition and the extent to which the data support the proposition.

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Table 5.

D. B. Balkin and L. R. Gomez-Mejia


Summary of results by proposition Findings Strong support Strong support Strong support Moderate support Strong support Strong support Strong support Strong support Moderate suipport Moderate support

Propositions 1. Incentive pay as a proposition of the total compensation package will be greater for firms at the growth stage of the product life cycle. 2. An incentive-based reward strategy will be more effective for firms at the growth stage of the product cycle. 3. The proportion of fixed compensation costs in the total pay package will increase as a function of organizational size. 4. The effectiveness of an incentive-based strategy will be inversely related to company size. 5. The- compensation mix in high tech firms will contain a higher proportion of incentive rewards and a lower proportion of fixed pay. 6. Considering all firms at the growth stage of the product life cycle, those that are high tech will have a pay mix with a greater incentive component. 7. Smaller high tech firms will have a pay mix with a greater incentive component than similar non-high tech firms. 8. An incentive-based compensation strategy will be more effective in high tech firms than in non-high tech companies. 9. For organizations at the growth stage in the product life cycle, an incentive-based reward Etrategy will be most effective for high tech firms. 10. For smaller companies, an incentive-based strategy will be most effective for those which are high tech.

CONCLUSION If contingency theories of compensation strategy can be successfully developed, their implications are both obvious and important. At a minimum they should help improve the effectiveness of the compensation pay practices by imTiproving strategy choices made by different organizations. This, of course, should lead directly to greater accomplishment of overall organization goals. Such theories might also have a strorng impact on the entire field of compensation by ensuring that job evaluation procedures and techniques are designed to reinforce the strategies adopted by these organizations. This article has developed a number of propositions about how compensation strategy and effectiveness vary as a function of stage in the life cycle, scale of the firm, and industry characteristics. The underlying argument is that effectiveness at realizing intended pay strategies depends significantly on the existence of a match among compensation strategies, organization and environment. The study presented in this paper has lent empirical support to these normative expectations along at least a few key dimensions. Its results can be summarized as follows. Small firms at the growth stage of the life cycle with a high

proportion of R&D expenditures tend to rely on incentive rewards, and this compensation strategy makes a greater contribution to effectiveness for firms sharing those characteristics. The effectiveness variable that was most difficult to predict is attrition. This may be in part a function of the data-gathering procedures since the information came directly from company records. Because there were no exit interviews, then it is impossible to determine whether a 'leaver' quit because 'the grass was greener', or to avoid being terminated, or because a spouse moved, or in response to a better pay package. An obvious limitation of this study has been its exclusive reliance on self-report measures by managers responsible for compensation policies, particularly those dealing with pay effectiveness. The authors believe that the data-collection procedures and psychometric analysis discussed earlier argue for sufficient confidence in these measures, but that a similar study with multimethod, multi-rater measurements and additional objective data should yield more powerful results. Arguably the most significant limitation of this study has been its focus on only a few variables pertaining to both compensation strategy and firm/industry characteristics. It may also be difficult to generalize the results of this study beyond the Route 128 population due to the

Contingency Theory of Compensation Strategy


possible skewness of the high tech population there. Many questions still remain unanswered that should be dealt with in the future. For example: What types of incentives (short- vs. long-term, individual vs. group) are most effective under different conditions? Do organizations trying to achieve a low cost position require a different compensation strategy as compared to those whose primary concern is the upgrading of product features/performance rather than cost reduction? Do incentive-based rewards for scientists and engineers in high tech actually increase the rate of innovation and profitability of the firm? Do the compensation mix and the stage in the life cycle affect each other? Which environmental variables affecting compensation strategies (e.g. labor market competition) are most significant for each stage of the life cycle? Are there any differences in the background, personal characteristics, and quality of employees who are attracted to organizations that rely on incentive strategies? Obviously much work remains to be done before a contingency theory of compensation is fully developed. Future research should include an extension of this study to a different sample of firms. Efforts such as these will take a number of years to complete. However, the degree of success achieved in this task will significantly impact the quality of the resource allocation decisions in organizations.

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