Congruence between pay policy and competitive strategy in high-performing firms

Congruence between pay policy and competitive strategy in high-performing firms

Edilberto F. Montemayor

The idea that pay policies have strategic impact has become a major theme within the compensation literature since the mid-1980s. Notable volumes concerned with compensation strategy include Lawler’s Strategic Pay (1991), Schuster and Zingheim’s The New Pay (1992), and Gomez-Mejia and Balkin’s Compensation, Organizational Strategy, and Firm Performance (1992). This strategic perspective on compensation is based on the fact that organizations differ in pay policies and the belief that matching pay policies to business strategy results in higher organizational performance (Milkovich, 1988).

Except for the work by David Balkin and Luis Gomez-Mejia (Balkin & Gomez-Mejia, 1987; 1990; and Gomez-Mejia, 1992), the strategic impact of pay policy has received little empirical attention. Building on the executive compensation literature, Balkin and Gomez-Mejia have published a series of analyses dealing with the relationship between pay policy and organizational diversification or lifecycle stages.

However, the portion of strategic compensation theory that addresses the link between pay policy and business-level competitive strategies has not been tested. Such theory appears in the work of Carroll (1987), Miles and Snow (1984), Miller (1986), Schuler and Jackson (1987), and Tichy, Fombrum and Devanna (1982).

The present study adds to the empirical base for strategic compensation theory by examining which pay policies have a positive relationship with firm performance for different business strategies. Because pay policies are clearly under management control and are the most visible elements of an organization’s motivation and reward system, the results of this investigation will help management develop coherent pay systems that support business strategy. In addition, this study makes two methodological contributions. First, it demonstrates a procedure for evaluating contingency models through the joint analysis of organizational strategy, pay policy and performance. Second, this study shows an approach for measuring compensation policy in terms of “hard” objective indices, instead of the perceptual data typically used in the past research.

Analytical Framework and Hypotheses

Strategic compensation theory is a contingency theory (Gomez-Mejia & Balkin, 1992). Its fundamental premise is that matching pay policy and business strategy impacts firm performance (Milkovich, 1988). That is, high-performing firms adopt pay policies congruent with their strategy and deviations from strategically-indicated pay policies have a negative effect on organizational performance. This is not an academic argument only. Leading compensation professionals consider that their most important challenge is to align compensation systems and business strategy (Gomez-Mejia & Balkin, 1990; McNally, 1992).

In order to test such a contingency view, it is necessary to establish which compensation policies have strategic significance, how can organizations be classified into dominant strategic types, and the different sets of compensation policies that support each type of competitive strategy.

The Performance Impact of Matching Pay Policy and Business Strategy

This research concentrates importantly on high-performing finns because the pay policies that fit a particular strategy will be most evident among high-performing finns. According to the contingency perspective in strategic compensation theory, a good match between an organization’s strategy and all its systems will result in superior performance (Gomez-Mejia & Balkin, 1992). That is, all high-performing organizations should have strategy and pay policies that match each other. On the other hand, not all lesser-performing organizations will suffer from a mismatch between strategy and pay policy. Lesser performance may be the consequence of a poor match between strategy and systems other than compensation. For this reason, a major portion of the analyses reported ahead examines the difference in pay policies between high-performing organizations that pursue different business strategies. Other strategy researchers have also focused on the subset of high-performing organizations in their samples (Thomas, Litschert & Ramaswamy, 1991; Venkatram, 1990).

Leading strategic compensation scholars propose an organization’s performance will suffer when its pay policies deviate from those policies which ideally fit the organization’s strategy (Gomez-Mejia & Balkin, 1992). In addition, strategy scholars recommend the use of multiple approaches when studying the performance impact of matching strategy and organizational systems (Venkatraman, 1990). For these reasons, this study will also examine the correlation between deviations from strategically-indicated pay policies and organizational performance. Because firm performance depends on many factors besides compensation, it is expected that such deviations will have a negative, although modest, correlation with performance. Nonetheless, finding that deviations from strategically-indicated pay policies correlate with performance would provide additional support for the contingency view in strategic compensation theory.

Compensation Policies with Strategic Significance

This study considers the five aspects of pay policy more frequently mentioned in strategic compensation theory: (1) compensation philosophy; (2) external competitiveness; (3) incentive-base mix; (4) individual (merit) pay increases; and (5) pay administration.

Compensation Philosophy. This study measures organizational pay philosophy in terms of the importance assigned to three kinds of objectives: (a) labor cost control, (b) employee attraction and retention, and (c) employee motivation. The compensation system has strategic impact through its effect on these three areas which represent the traditional goals for pay policy design. As explained ahead, an organization’s business strategy will determine the relative importance of these three kinds of objectives. Moreover, the pay policies that support different objectives may conflict with each other. Consequently, strategic compensation requires a philosophy, based on the importance of these objectives, to provide direction and purpose to specific pay policies (Lawler, 1991).

External Competitiveness. This policy area refers to the level of pay an organization offers relative to that of its competitors. It has a critical impact on attraction/retention and labor cost objectives. The higher the pay level, the better the organization’s ability to acquire a competent workforce. Clearly, increasing the pay level raises total labor costs. However, raising the pay level may lead to improved labor costs per unit. An emerging view in labor economics, known as efficiency wage theory, contends that paying above market levels can promote employee motivation that would offset any increment in labor costs (Holzer, 1990).

Incentive-Base Mix. This policy relates to the distinction between incentive (variable) and base (fixed) pay. It has strategic implications. Increasing the portion of pay that is variable has been advocated as an effective mechanism for linking employee rewards and business performance (see for example Mitchell, Lewin & Lawler, 1991). Besides a clear fit with motivation objectives, a high incentive-to-base pay ratio makes some labor costs variable and may help to attract and retain hard-working, risk-taking employees.

Individual (Merit) Pay Increases. Policies dealing with increases to individual base pay have a direct impact on employees and, consequently, have strategic implications (Milkovich & Broderick, 1991). Merit pay, a highly debated policy, represents the most prevalent system for deciding individual pay increases. Surveys find that 80 percent of private sector employers, most state governments, and about one-half of the local governments have merit pay plans (Heneman, 1992). Organizations differ in policies concerning the size of merit raises. This study will examine the average and range of merit raises awarded. Organizations may also differ in employee eligibility for merit pay. To measure the scope of merit pay, this study will examine the extent to which nonexempt employees participate in merit pay plans. Typically most or all exempt (professional and managerial) employees participate in merit pay plans. However, organizations differ in the extent to which nonexempt (operations and administrative support) employees participate in merit pay plans.

Pay Administration. This study will examine policies concerning “openness” (the amount of information provided to employees) and “participation” (the degree to which employees may question or challenge pay decisions). These policies are generally accepted as having strategic importance because of their effect on employee satisfaction and acceptance of pay decisions (Milkovich & Broderick, 1991; Gomez-Mejia & Balkin, 1992).

Classifying Organizations by Business Strategy

Business-level strategy, the initiatives by which organizations seek a competitive advantage, determines the kind of employee contributions and, therefore, the human resource and compensation policies that organizations require to succeed (Schuler & Jackson, 1987; Miles & Snow, 1984). Unfortunately, business-level strategy has received minimal attention in strategic compensation research. In the only published research including business-level strategic variables, Balkin and Gomez-Mejia (1990) focus on growth and maintenance strategies.

In contrast, strategic compensation theory is based on Porter’s and/or Miles and Snow’s typologies. This study merges the two typologies based on conceptual and empirical considerations. Porter’s classification distinguishes cost-oriented from differentiation-oriented strategies. However, Porter’s typology neglects those organizations competing through intense product or market development (Miller, 1986; Walker & Ruekert, 1987). On the other hand, Miles and Snow’s typology distinguishes between Defenders operating in stable product and market domains, Prospectors that constantly seek to develop new markets or products, and an intermediate type called Analyzers. Unfortunately, Miles and Snow’s typology minimizes the differences between Defenders that compete through low cost and those competing by setting themselves apart from their competition.

Moreover, Segev (1989) applied multidimensional scaling to 31 variables describing environment, strategic content, strategic decision-making process, and organizational characteristics to show the two typologies can be synthesized along a “proactiveness” dimension. Segev’s results suggest the three types of business-level strategy used in this study:

* Cost Leadership (Defenders or Analyzers);

* Differentiation (Defenders or Analyzers); and

* Innovation (Prospectors).

As discussed in the next section, this synthetic classification allows integrating the theory that deals with the link between compensation policy and competitive strategy.

Compensation Policies That Support Different Business Strategies

Different organization, human resources and compensation systems will support each of the three types of business strategy discussed here. Such differences are summarized in Figure 1 and discussed ahead. Miller (1986) theorizes that firms pursuing a Cost Leadership strategy require mechanistic, bureaucratic structures geared to maximize efficiency, while firms pursuing an Innovation strategy require organic structures that foster communication and collaboration among employees in different departments. In a similar vein, Arthur (1994) studied non-integrated steel mills, finding a Cost Leadership strategy is best supported by “control” human resource systems which are conservative and focus on improving efficiency through formalized rules and procedures while a Differentiation strategy is best supported by “commitment” human resource systems which seek to link employee and organizational goals. Finally, Gomez-Mejia and Balkin (1992) report that a Cost Leadership (Defender) strategy should be supported with “algorithmic” compensation systems whose features include heavy reliance on base pay with minimal incentives and bureaucratic administration of pay policy. These authors add that an Innovation (Prospector) strategy should be supported with “experiential” compensation systems whose features include substantial incentives and open, decentralized administration.

The preceding ideas coupled with existing strategic compensation theory – contained in the work by Carroll (1987), Miles and Snow (1984), Miller (1986), Schuler and Jackson (1987), and Tichy et al.(1982) – suggest the following theoretical propositions:

P1: The pay philosophy of Cost Leaders will emphasize “labor cost” objectives more than the philosophy of Differentiators or Innovators.

Cost Leaders emphasize stable job assignments and traditional management practices. These firms are characterized by tight cost controls, overhead minimization, and require employees to contribute repetitive, predictable behavior with very little risk taking (Miller, 1986; Schuler & Jackson, 1987).

P2: Innovators will have a pay philosophy that places more emphasis on “attraction/retention” objectives than Cost Leaders or Differentiators.

Innovators need to orchestrate the contributions of externally-trained specialists with diverse expertise (Miller, 1986). Therefore, Innovators rely heavily on external staffing and need to ensure external competitiveness for a diversity of skills (Miles & Snow, 1984).

P3: The pay philosophy of Differentiators will emphasize “motivation” objectives more than the philosophy of Cost Leaders or Innovators.

Organizations pursuing a differentiation strategy need to stress goal-setting and achievements based on organization-wide criteria (Miller, 1986). Compared with Cost Leaders, Differentiators require a higher degree of employee cooperation and commitment to organizational goals such as quality and customer service (Schuler & Jackson, 1987).

P4: With respect to pay level, Cost Leaders will be more likely to lag their labor market competitors and Innovators will be more likely to lead their labor market competitors.

Because of their emphasis on cost containment, Cost Leaders are expected to take a more conservative stance in labor markets. Arthur (1994) reports that Cost Leaders offer significantly lower wages than Differentiators. In contrast, because of the need to acquire talent, several authors concur in hypothesizing that Innovators should lead the market in their pay level (Carroll, 1987; Miles & Snow, 1984; Schuler & Jackson, 1987).

P5: Differentiators (and perhaps Cost Leaders) will have a higher incentive-to-base ratio than Innovators.

Tichy et al. (1982) postulate a differentiation strategy requires linking employee rewards to organizational results. On the other hand, the literature provides conflicting hypotheses concerning the use of incentives by Cost Leaders. Carroll (1987) theorizes Cost Leaders should use rewards based on quantitative measures of organizational performance, such as gainsharing, to promote efficiency. In contrast, Miles and Snow (1984), Schuler and Jackson (1987), and Gomez-Mejia and Balkin (1994) call for Cost Leaders to adopt conventional, base-pay policies with little emphasis on incentives. Finally, Innovators are expected to make less use of incentives because the side-effects of incentive pay are contrary to their compensation philosophy. The focus on quantitative measures that characterize most incentive plans may inhibit risk-taking and foster a short-term focus. Further, because of their long-term focus, Innovators benefit from a strong commitment from their employees. However, an emphasis on incentive pay creates a merchant-like culture diminishing organizational commitment among employees (Kerr & Slocum, 1987).

P6: Innovators will make more extensive use of merit pay than Cost Leaders and Differentiators.

Innovators need a high degree of creative behavior, greater risk-taking, and a longer-term focus among their employees (Schuler & Jackson, 1987). Carroll (1987) suggests Innovators should stress qualitative performance measures and increase their use of merit pay. Schuler and Jackson (1987) also call for Innovators to employ individualized, flexible compensation systems. These ideas suggest that Innovators are best suited for extensive use of merit pay than Cost Leaders or Differentiators.

P7: Innovators, and to some extent Differentiators, will be more open and participative in the administration of their pay policies than Cost Leaders.

Cost Leaders are considered best suited for centralized, mechanistic organization modes where employee participation is minimal (Miles & Snow, 1984; Miller, 1986). In contrast, Innovators and, to a lesser extent, Differentiators are best suited for organic approaches where employee participation will reinforce employee motivation and organizational commitment (Schuler & Jackson, 1987).

Methods

Sample

The American Compensation Association (ACA) funded this study with the purpose of examining the relationship between organizational characteristics, pay policies, and firm performance. Questionnaires were mailed to a randomly selected set of 1400 ACA members with executive responsibilities. A random sample was used because ACA seeks to ration the number of questionnaires mailed to its members. These respondents have direct knowledge of their firms’ strategy and pay policies (Balkin & Gomez-Mejia, 1990).

The questionnaire was mailed to a multi-industry sample to provide for generalizable findings that are consistent with the tenor of strategic compensation theory. Theories dealing with the strategic role of human resource systems require empirical support from studies of multiple industry contexts (Arthur, 1994). Using a multi-industry sample yields results which have interest and applicability for compensation professionals regardless of industry. Further, Porter’s typology applies to competition within an industry, but Miles and Snow’s typology transcends industry boundaries. Thus, the synthetic strategy classification used here should be applicable to a multi-industry sample. Moreover, and most importantly, the hypotheses discussed before apply across industries because strategic compensation theory does not stipulate any industry-level variables that may moderate those hypotheses.

Two hundred and eighty-two usable questionnaires were returned for a response rate of 20%. This sample size is usual in studies of business-level strategy and pay policy (Balkin & Gomez-Mejia, 1990; Gomez-Mejia, 1992). The current sample includes a diversity of organization: 17 (6%) non-profits, 81 (29%) in financial services, 93 (33%) in manufacturing, and 90 (31%) in other service sectors including Health Care, Communications, Transportation, and Utilities. The industry mix in this sample reflects the growing business diversity in the American economy.

Measures

The questionnaire used builds on the research cited here and was pretested with a group of eight human resources executives. It collects information on organizational performance, strategy, and pay policies.

Performance. Because organizational performance can be evaluated from the perspective of multiple constituencies such as employees, customers and shareholders (Hitt, 1988; Kaplan & Norton, 1992), this study considers three dimensions of organizational performance: effort performance, market performance, and financial performance. Factor analysis of responses to the items discussed below confirmed the existence of three distinct dimensions of organizational performance and indicated common method variance did not contaminate these measures (Podsakoff & Organ, 1986).

The performance measures used here are based on participant ratings. In principle, more objective measures would be preferred. However, the participants in this study are aware of business performance because of their executive position. Past studies of business policy and strategy have shown that ratings by knowledgeable respondents provide valid measures of firm performance (Conant, Mokwa & Varadarajan, 1990; Dess & Robinson, 1984; Venkatram & Ramanujam, 1986).

Based on the elements of extra-role behavior identified by Pearce and Gregersen (1991), a measure of effort performance ([Alpha] = .75) was formed by asking participants to estimate the percent of employees in their organization that manifest four kinds of extra-role behavior: consistently exceeding work quality standards, going out of their way to help others, working outside regular hours to finish tasks, and asking for additional responsibilities in spite of the resulting increase in their work load.

In addition, participants rated their organization’s standing compared with same-industry competitors on a five-point scale (1 = better than 20%, 2 = better than 40%, 3 = better than 60%, 4 = better than 80%, 5 = better than 95%) for three elements of market performance ([Alpha] = 0.87): product or service quality, customer satisfaction, and customer retention; and for three elements of financial performance ([Alpha] = .84): dollar sales per employee, return on assets, and profits.

Strategy. Participants in this study are high-ranking compensation or human resources executives who tend to have a clear understanding of their organizations business strategy (Balkin & Gomez-Mejia, 1990; Broderick, 1986; Gomez-Mejia, 1992). Therefore, participants were asked to rate the importance of nine competitive methods for their overall business plan on a five-point scale (1 = not at all important, 5 = extremely important). The nine competitive methods whose importance was rated are based on the work by Dess and Davis (1984). There were three competitive methods for each type of business-level strategy discussed before. The scale for Cost Leadership ([Alpha] = 0.67) consists of: innovation in manufacturing or service process, improving current products or services, and quality control. The scale for Differentiation ([Alpha] = 0.64) consists of: advertising, brand identification, and innovation in marketing programs and techniques. Finally, the scale for Innovation ([Alpha] = 0.68) consists of: development of new products and services, ability to deliver specialty products or services, and customer retention.

Using three items per scale may have resulted in the moderate reliability exhibited by the strategy measures. The level of random, measurement error associated with such reliability may reduce the power to detect significant results, but cannot bias the results reported ahead.

Compensation Policy. To measure pay philosophy, participants reported the importance of nine objectives that are typically discussed in compensation textbooks. Participants rated these objectives on a scale ranging from zero to 100 points. Factor analysis indicated three distinct sets of objectives:

1. Labor Cost objectives ([Alpha] = .55) indicated by the importance assigned to three objectives:

* reducing labor costs;

* keeping labor costs in line with industry levels; and

* staying in line with labor market practices.

2. Attraction/retention objectives ([Alpha] = .84) indicated by the importance assigned to two objectives:

* attracting new employees; and

* retaining current employees.

3. Motivation objectives ([Alpha] = 0.61) indicated by the importance assigned to four objectives:

* supporting flexibility in job assignments;

* rewarding job performance;

* motivating skills or knowledge; and

* improving unit results.

Again, these moderate reliability levels signify measurement error which may attenuate the statistical significance, but should not bias the results reported ahead.

Participants were also asked to provide quantitative data describing their organization’s pay policies. Such data, all measured as percentages, include:

4. pay level policy (percentile position in the relevant market),

5. incentive-to-base pay ratio,

6. average merit raise,

7. range of merit raises awarded,

8. percent of nonexempt employees eligible for merit pay,

9. percent of employees who receive information about decisions on pay levels and pay raises, and

10. percent of employees who can question job evaluations and pay raises.

In theory, the use of self report measures brings about the potential for “hypothesis-guessing” bias should participants try to provide logically consistent, although invalid, responses. This bias poses a threat to the validity of research findings (Cook & Campbell, 1979). Such bias, however, is a very unlikely threat to this study. All of three unlikely conditions are necessary for the possibility of hypothesis-guessing bias in this study. First, respondents would need to know which of the nine competitive methods represents each of the three strategic types used in this study. Second, respondents would also need a clear, intimate understanding of the theoretical propositions discussed before. Third, respondents would need to misrepresent their organizations’ pay policies in terms of “hard” objective indices like the percent of incentive pay or the percent range in merit raises they offer. Given these three considerations, it is clear that hypothesis-guessing bias does not represent a significant threat to the validity of this research.

Data Analysis

Responding organizations were classified by strategy and by performance level. Organizations were categorized by their dominant strategy into three groups – Cost Leaders, Differentiators, and Innovators – depending on which of the three measures of strategy importance received the highest score. Clearly, organizations may pursue multiple generic strategies (Hill, 1988; Murray, 1988; White, 1986). However, the organizations’ human resources and compensation policy are likely to be influenced most by their most important (i.e., dominant) strategy. Classifying by dominant strategy resulted in exclusion of twenty-one organizations. No single type of strategy was more important than the others for those twenty-one organizations. Such organizations may correspond to what Miles and Snow call “Reactors” and Porter labels “Stuck in the middle.”

Further, organizations are also categorized here as “high-performance” or “low-to-average performance.” Organizations are designated as “high performance” if they rank above the median for two of the three performance dimensions: effort performance, market performance relative to same-industry competitors, and financial performance relative to same-industry competitors. As discussed earlier, the contingency perspective adopted here implies the pay policy profile that fits a particular strategy will be most evident among high-performing organizations.

This study investigates the association between strategic group membership and multiple independent variables. The propositions (concerning a contingent relationship between organizational strategy, pay policy, and performance) stated earlier refer to a variety of pay policies. To test these hypotheses, one could use repeated univariate analyses of variance, with each pay policy as the independent variable and strategic group as the criterion. Unfortunately, such approach entails considerable risk of type II error. Multivariate analyses are not subject to this problem (Betz, 1987), and have been recommended for research based on contingency models (Venkatram, 1990). Data analysis in this study starts with Multivariate analysis of variance (MANOVA) followed by canonical discriminant analysis. MANOVA can establish the statistical significance of group differences in whole profiles of predictor variables. Provided significant MANOVA results, discriminant analysis can, in turn, establish the significance of group differences for specific predictor variables (Betz, 1987; Bray & Maxwell, 1982). Discriminant analysis has been used elsewhere to examine multivariate connections between organizational strategy and pay policy (Balkin and Gomez-Mejia, 1990).

However, ordinary discriminant analysis yields sample-specific results which may capitalize on chance (Huberty, 1984; Hsu, 1989). The discriminant coefficients and standard error estimates reported here represent an average from discriminant analyses for twenty-six jackknife pseudo-samples. Each pseudo-sample was obtained by dropping four cases from the sample of high-performing firms. This process, jackknife multicross-validation reduces bias and provides robust estimates (Chant & Dalgleish, 1992; Efron & Gong, 1983).

To end the present investigation, the discriminant functions are applied to all organizations in the sample regardless of performance level. The Euclidean distance, between each organization’s canonical scores and the centroid for its dominant strategy, measures the lack of alignment between pay policy and strategy (Thomas et al., 1991; Venkatraman, 1990). This Euclidean distance is then correlated with the three performance indices – effort performance, market performance, and financial performance – to find the extent to which deviations from strategically-indicated pay policies affect organizational performance.

Results

Table 1 reports means, standard deviations, and intercorrelations (multiplied by 100). When applicable, Cronbach’s alphas are reported on the diagonal. Correlations among the three performance indices – effort performance, market performance, and financial performance – are moderate ranging between 0.23 and 0.46. This shows the three indices measure different facets of organizational performance. Also, correlations among the three measures of strategy importance range between 0.23 and 0.55. This suggests the relative independence of the three types of strategy and confirms that organizations can be categorized by their dominant strategy. Moreover, the other correlations reported in Table 1 are all moderate in magnitude. This indicates common method variance is not likely to be a problem in this study. The three sets of variables of interest – performance indices, measures of strategy importance, and pay policy measures – appear quite independent from each other. The correlations between performance and strategy measures range from 0.05 to 0.18, correlations between performance and pay policy measures range from -0.11 to 0.18, and those between strategy and pay policy measures range from -0.09 to 0.20.

Differences in Pay Policies Between High-Performing Organizations with Different Dominant Strategies.

Table 2 reports means for the ten pay policy measures. Means are reported for the whole sample, for the subsample of 104 high-performing organizations, and for high-performing organizations in each of the three strategy groups. Overall, there are few differences between the subsample of 104 high-performing organizations and the whole sample. Compared with the entire sample (second column), high-performing organizations (third column) differ only in that they use a more aggressive pay level policy and are more open and participative in pay administration.

In contrast, high-performing organizations in each strategic group differ substantially in their pay policy profiles. Multivariate analysis of variance (MANOVA), performed using the ten measures of pay policies as predictors and dominant strategy group as the criterion, show these profile differences are significant (F value for Wilk’s lambda = 1.74, p = 0.03). Subsequent univariate analyses of variance suggest significant differences, between high-performing organizations with different strategy, in pay philosophy (motivation objectives), relative share of incentive pay, and merit pay policies (range of raises and participation of nonexempt employees).

[TABULAR DATA FOR TABLE 1 OMITTED]

[TABULAR DATA FOR TABLE 2 OMITTED]

Canonical discriminant analysis, with the ten pay policy measures as independent variables and strategic group as the dependent variable, clarifies differences between strategic groups in terms of specific pay policies. Results of this analysis are reported in Table 3. Canonical correlations show both discriminant functions are significant. Standardized discriminant coefficients, which are analogous to multiple regression coefficients (Huberty, 1984; Hsu, 1989), reflect the contribution of each predictor variable to distinguishing between strategic groups. These coefficients, reported in Table 3, indicate marked differences between high-performing organizations from the three strategic groups. These discriminant coefficients provide evidence concerning the propositions advanced earlier.

Further, centroid scores for the three strategic groups establish the meaning for each discriminant function. The first discriminant function separates high-performing Cost Leaders (negative scores) from high-performing Innovators (positive scores). The second discriminant function separates high-performing Differentiators (negative scores) from high-performing innovators (positive scores). Thus, a negative discriminant coefficient in the first function indicates high values of that particular variable are characteristic of Cost Leaders and a positive coefficient indicates high values characterize Innovators. Similarly, for the second discriminant function, a negative coefficient indicates high values are characteristic of Differentiators and a positive coefficient indicates high values are characteristic of Innovators.

[TABULAR DATA FOR TABLE 3 OMITTED]

The first three coefficients in each discriminant function (column) relate to pay philosophy. These coefficients show that Cost Leaders and Innovators have a very similar philosophy concentrated on labor cost and attraction/retention objectives, while Differentiators adopt a philosophy focused on motivation objectives. These results provide only partial support for P1 and P2. In agreement with P1, Cost Leaders do assign significantly more importance to labor cost objectives than Differentiators. However, contrary to Proposition 1, Cost Leaders do not differ from Innovators in the importance assigned to labor cost objectives. In agreement with P2, Innovators assign significantly more importance to attraction/retention objectives than Differentiators. But, contrary to P2, Innovators do not differ from Cost Leaders in the importance assigned to attraction/retention objectives. In contrast, P3 was fully supported. The importance of motivation objectives is greater for Differentiators than for Innovators, and for Innovators than for Cost Leaders.

The results for pay level policy provide partial support for Proposition 4, which postulated Innovators would lead their market competition while Cost Leaders would adopt a more conservative, lag policy. Indeed, Innovators have a more aggressive pay level policy than Differentiators. However, contrary to P4, Cost Leaders are more aggressive than Innovators in their pay level policy.

Proposition 5 was supported. High-performing Differentiators have a significantly larger portion of pay in the form of incentives than Innovators (and Innovators more than Cost Leaders). Table 3 also provides support for Proposition 6 dealing with the value of merit pay for Innovators. Innovators use a wider range of merit raises and extend the merit pay plan to a larger portion of nonexempt employees. Although the average merit raise is smaller for Innovators than for Cost Leaders or Differentiators, these differences are minimal. Table 2 shows there is a 0.2 percent difference on the sample mean for average merit raise between Cost Leaders and Innovators.

Finally, the results in Table 3 provide mixed support for P7 concerning pay administration. As hypothesized, Innovators are more open with respect to pay information. However, Cost Leaders allow employees a greater degree of participation in pay decisions.

Table 4 shows results from classifying the subsample of high-performing firms with the discriminant functions reported in Table 3. The discriminant functions classify correctly 56% of the high-performing firms. This is a high percent of correct classification for an application of discriminant analysis in organizational studies and is considerably better than that expected by chance (33%). The z-statistic suggested by Huberty (1984) to measure whether the observed hit rate is better than that expected by chance is 4.77 (p [less than] 0.01). Moreover, the results in Table 4 correspond to a reduction in error of 33.5%. This reduction in error index is analogous to portion of explained variance statistics. Thus, without knowing any other organizational characteristics, knowledge of pay policy alone accounts for one third of the difference between random and perfect classification of high-performing firms.

Correlation Between Firm Performance and Deviations from Strategically-Indicated Pay Policies

The discriminant functions reported in Table 3 were applied to all 261 organizations in the sample (despite performance level). The lack of alignment between an organization’s pay profile and the profile typical of high-performing organizations with the same strategy was measured by the Euclidean distance between each organization’s canonical scores and the centroid for its strategy group (Thomas et al., 1991; Venkatraman, 1990). This Euclidean distance was then correlated with the three performance indices. All the resulting correlations were negative: -0.11 (p = 0.09) with effort performance, -0.11 (p = 0.07) with market performance, and -0.06 (p = 0.34) with financial performance. The magnitude of these correlations is comparable to those reported in other research on compensation and strategy by Gomez-Mejia (1992). These moderate correlations show that departures from strategically-indicated pay policies are associated with reduced organizational performance and provide further support for the contingency view in the strategic compensation theory used in this study.

Table 4. Classification Results(a)

Predicted Group

Actual Group I II III Total

I. Cost Leaders 24 10 4 38

II. Differentiators 10 18 6 34

III. Innovators 7 9 16 32

104

Note: a. 56% hit rate

Conclusions

This study examines theory dealing with the link between business-level competitive strategy, pay policy, and firm performance. Seven theoretical propositions concerning such link were obtained from a literature review. A national sample from a cross-section of industries provided data to evaluate those propositions. In turn, multivariate analyses demonstrated significant differences in pay policy profiles between high-performing organizations with different dominant strategy and showed that inferior firm performance is associated with the lack of fit between pay policy and business strategy.

This study makes three contributions to the growing literature on strategic pay systems. First, this study identifies systematic differences in pay policies between high-performing organizations whose strategy is dominated by cost leadership, differentiation, or innovation tactics.

The pattern of these differences, cross-validated through a jackknife process, closely conforms to theoretical expectations. In all, three of seven theoretical propositions were fully supported and the other four received partial support. The following theoretical expectations were supported: (1) Cost Leaders emphasize labor cost objectives more than Differentiators; (2) Innovators assign more importance to attraction/retention objectives than Differentiators; (3) the importance of motivation objectives is greater for Differentiators than for Innovators, and for Innovators than for Cost Leaders; (4) Innovators are highly aggressive in their pay level policy; (5) Differentiators offer more variable pay than Innovators, and Innovators more than Cost Leaders; (6) Innovators use a wider range of merit raises and extend merit pay to a larger portion of nonexempt employees; and (7) Innovators are more open with respect to pay information than Differentiators. These results clearly support a contingency approach to choosing pay policies that are compatible with an organization’s strategy and drive its performance.

The major discrepancies between the present findings and strategic compensation theory concern Cost Leaders. According to strategic compensation theory, Cost Leaders and Innovators require diametrically opposed pay policies because Cost Leaders and Innovators belong at opposite extremes of the mechanistic-organic structure, control-commitment human resources system, and/or algorithmic-experiential compensation system continua [ILLUSTRATION FOR FIGURE 1 OMITTED]. However, evidence from this study indicates that Cost Leaders and Innovators assign the same importance to labor cost and to attraction/retention objectives. Further, Cost Leaders are as aggressive in pay policy as Innovators. Moreover, Cost Leaders allow more employee participation in pay decisions than the other two strategic groups.

These findings suggest an alternative basis for strategic compensation theory because the theoretical extremes portrayed in Figure 1 are similar to each other and different from the middle category, Differentiators. Perhaps, strategic compensation theory should be formulated in terms of the internal-external focus of business strategy. Cost Leaders and Innovators have a strategic thrust based on internal issues: Cost Leaders seek to maximize production efficiency, while Innovators seek to change the organization’s output. On the other hand, the strategic thrust of Differentiators resides is external: Differentiators seek to maximize their marketing effectiveness. Of course, refraining strategic compensation theory in terms of this internal-external focus dimension requires more conceptual and empirical work.

The second contribution of this study derives from the use of a thorough methodology that involves the three fundamental types of variables in contingency models of strategy: organizational strategy, pay policies, and performance. Given that many management, technological, economic, and human factors affect organizational performance, it is worth noting that pay policies account for one-third of the forces that discriminate between high-performing Cost Leaders, Differentiators, and Innovators. It is also worth noting that departures from strategically-indicated pay policies are negatively and significantly related to firm performance.

The third contribution of this study to past research on strategy and pay relates to the use of quantitative measures such as percentages in incentive pay, merit raises, employee participation, and the like. These objective measures complement the more common Likert-type ratings and should help reduce problems of common method variance in surveys focusing on strategy and compensation.

The cross-sectional sample used here cannot support any conclusions regarding causality. In the future, researchers should explore causality relationships among business strategy, pay policy, and firm performance. Such future research could examine performance changes in samples of organizations which change their pay policies seeking a better match with business strategy. Other research could follow organizations that shift business strategy without adjusting pay policies. These naturally occurring experiments should provide data to assess whether changes in firm performance follow changes in fit between business strategy and pay policy.

Also, the present study deals with pay policies that apply to all employee groups. In contrast, Milkovich (1988) theorized pay policy for various employee groups (such as managers, professionals, sales, and operations) may differ in strategic relevance. Therefore, future research should deal with any theoretical differences and/or similarities in strategic pay policy for different employee groups. It may be that different findings would occur once research accounts for organizational differences in administrative intensity, proportion of professional employees, etc.

Finally, future research could expand or further develop the hypotheses used here. For instance, this study examined the relative size of variable (incentive) pay but failed to consider the types of incentive plans used. Different business strategies may call for different kinds of incentive plans. Differentiators may require gainsharing plans that focus on specific operational measures over a short time span. On the other hand, Innovators may require deferred profit-sharing or Employee Stock Ownership Plans that stress global firm performance over the long run. Consequently, future research could distinguish between current and deferred, and/or between operational and profit-based incentives.

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