Reward and incentive compensation and organisational performance: evidence from the semiconductor industry

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1 Reward and incentive compensation and organisational performance: evidence from the semiconductor industry Chin-Ju Tsai University of Warwick Abstract: The link between reward and incentive compensation and organizational performance has attracted increasing research interest in recent years. This paper examines that link by testing two sets of hypotheses: organizational performance is positively associated with (1) the use of reward and incentive practices, such as profitrelated payment schemes, employee share-ownership schemes, profit-sharing schemes and group performance-related pay schemes; and (2) the effective use of reward and incentive compensation practices. The hypotheses were tested empirically using data collected from interviews with 25 HR managers and surveys of 21 senior operations managers and 1129 employees in Taiwanese semiconductor companies. The results of the statistical analysis demonstrate that companies using profit-related payment schemes outperform other companies; and the effective linking of reward and incentive compensation to employee performance is positively related to organizational performance. Keywords Reward; variable pay; organizational performance; Taiwan. The need for organizations to develop a performance-enhancing system capable of facilitating the best management and development of their employees, and increasing their competitiveness, has made the links between HRM and organizational performance an important agenda item in the field of HRM. Across the core areas of HR practices such as recruitment, training and development, performance management, employee involvement and rewards, the association between rewards and performance is one of the most studied subjects in the management literature. It is commonly believed that if rewards are used effectively, they can motivate individuals to perform and thus can have a positive effect on organizational performance. Taiwan s semiconductor industry ranks as one of the most innovative and successful global industries. It has the world s largest contract manufacturer of semiconductors and the second largest semiconductor design industry. Like many high-tech companies in western countries, Taiwan s semiconductor firms have implemented many new types of reward scheme, such as profit sharing, profit-related payment, and employee shareownership plans. This raises the issue of whether the industry s reward and incentive compensation practices have contributed to it achievements. 1

2 To examine the relationship between reward systems and organizational performance, this study empirically tests the association between organizational performance and (1) the use of certain reward and incentive compensation practices, and (2) the effective use of reward and incentive compensation practices in the context of a newly industrialized economy, Taiwan, with a focus on its semiconductor design industry. The study aims to address the following two questions: First, is the use of certain reward and incentive compensation practices positively related to organizational performance? Secondly, is there a link between organizational performance and the effective use of reward and incentive compensation practices? Theoretical and empirical background and research hypotheses The effectiveness of skilled employees is likely to be limited if they are not motivated to perform. One of the means that organizations can use to enhance employee motivation and performance is to provide performance-related compensation (Delaney and Huselid, 1996). A reward and compensation system is based on the expectancy theory, which suggests that employees are more likely to be motivated to perform when they perceive that there is a strong link between their performance and the reward they receive (Fey and Bjorkman, 2001; Guest, 2002; Mendonca, 2002). In other words, the compensation system (e.g. profit sharing) contributes to performance by linking the interests of employees to those of the team and the organization, thereby enhancing effort and performance (Kalleberg and Moody, 1994; Huselid, 1995; Kling, 1995). Four commonly used variable pay schemes are profit-related payment, employee share- ownership plans (ESOP), profit-sharing schemes, and group performance-related schemes. Profit-related pay schemes provide employees with tax-free payments linked to the profitability of their companies. An ESOP allows employees to take a stake in the company they work for through shares of stock that are awarded to them. A profit-sharing plan rewards employees with a part of a company s profits for their contribution to the company s success. The reward can be in the form of cash, shares or a combination of both. Group performance-related schemes reward a group or team of employees with a cash payment for achieving an agreed target. These schemes are all designed to enhance company performance by aligning the interests of employees with the financial performance of their companies. Several studies have revealed the positive effects of reward and incentive systems on organizational performance. Banker and Lee s (1996) empirical research, which is based on data from 34 stores of a major retailer over 77 months, supports the theoretical prediction that stores that implement an incentive plan will experience a positive impact on sales, profit and customer satisfaction. A study based on data from the US National Organizational Study, conducted by Kalleberg and Moody (1994), also found that profit sharing is positively correlated with product quality, product development, profit, customer satisfaction, and growth in sales. Cook (1994 in Kling, 1995) found that the use of profit sharing was positively associated with higher productivity in an analysis of 841 manufacturing establishments. Drawing on the above empirical and theoretical studies, we hypothesize: 2

3 Hypothesis 1: There will be a positive relationship between organizational performance and (a) the use of a profit-related payment scheme; (b) the use of an employee share-ownership scheme; (c) the use of a profit-sharing scheme; (d) the use of a group performance-related pay scheme. Hypothesis 2: There will be a positive relationship between organizational performance and the effective use of reward and incentive compensation practices. Methods Sample The companies under study are Taiwan s semiconductor design companies. The sample was drawn from the Taiwan Semiconductor Suppliers Directory (Chen, 2001). Companies were included in the sample frame if they employed more than 80 employees at the time of conducting the fieldwork. The fieldwork began by negotiating access in January 2003 and ended in August 2003 when the collection of survey questionnaires was completed. The decision to include only companies employing more than 80 employees was based on the results of previous empirical research into Taiwan s HRM practices (e.g. Huang, 2000; Zhu et al., 2000), which indicate that the larger the firm the more likely it is to have a formal organizational unit dealing with human resources. The sampling criterion of companies with more than 80 employees was in fact adjusted from an initial criterion of 200 as the semiconductor design companies were later found to include a few large firms and many small firms. Data sources Interviews and the survey method were the two main approaches used for collecting data in the study. Interviews Data on reward and incentive compensation practices were collected from semi-structured interviews with HR managers. Of the 74 semiconductor design companies listed in the directory, 38 were suitable for inclusion. 36 companies were excluded because five companies had closed down and 31 companies employed less than 80 employees. Of the 38 companies in the sample frame, interviews were conducted with 25 HR managers. It was impossible to gain access to the other 13 companies: six companies refused to take part in the study; four were unable to establish effective contact; and three had merged with other companies. The response rate for the eligible cases was thus 65.8 per cent. An analysis of the structural characteristics of the companies in the sample frame shows that the interviewed firms did not significantly differ from them in terms of the number of employees employed, ownership, company status, and company activity. HR managers were asked to indicate whether certain reward and incentive compensation practices had been implemented in the companies, the 3

4 reasons and purposes for employing or not employing certain practices, and the approaches they used to implement certain practices. Survey questionnaires In addition to interviews, three different questionnaires were used to collect data: (1) the Company and Employee Profile Questionnaire (CEPQ); (2) the Management Practices and Organizational Performance Survey (MPOPS); and (3) the Employee Opinion Survey (EOS). The CEPQ was designed to gain information about each company s foundation year, company ownership, the employee profile, etc., and was completed by HR managers at the end of the interviews. Organizational performance data were collected through the use of the MPOPS, which was completed by a senior operations manager in each company. Senior operations managers are suitable informants because they should have a better knowledge than other managers about organizational performance as in most cases they are accountable for their companies sales and profits. In addition to organizational performance data, the MPOPS was designed to collect information relating to the state of market competition. To assess whether reward and incentive compensation practices have been implemented effectively, we used a separate questionnaire, the EOS, to collect data on employees evaluation of the effectiveness of reward and incentive compensation practices in their companies. Employee assessment is capable of providing objective information as it collects responses from many employees rather than one response from a single manager in each company. Furthermore, employees are more likely to provide accurate evaluation than managers as they are the main subjects of reward practices implementation. Following previous studies (e.g. Cully et al., 1999; Wright et al., 1999; Barnard and Rodgers, 2000) that focused the investigation of a particular key job or the largest group of employees, employees with the job title engineer (e.g. software engineer, layout engineer), regardless of their job level and job nature, were chosen to be the respondents for the EOS. Engineers were chosen because they are the core workforce directly involved in producing the primary goods or services of the organization, and because they are the largest occupational group in the semiconductor design companies. Information collected from the CEPQ shows that engineers compose around 70 to 80 per cent of the total employee population in each surveyed company. The interviewed HR managers played a crucial role in the overall achievement of the fieldwork outcomes. At the end of the interviews, each interviewee was asked to fill in the CEPQ; a total of 25 CEPQs were completed. HR managers were also invited to ask a senior operations manager who was familiar with company s overall operations results to complete a MPOPS and then post this back to the researcher. After several follow-up phone calls, 21 sets of MPOPS were returned. In addition, the 25 HR managers were invited to participate in the employee opinion survey. Managers in 10 companies agreed to do so. With the help of the researcher s friends and their friends who worked in the companies, employee surveys were conducted in a further six companies. This amounted to a total of 16 companies participating in the employee survey. In total, 2,188 sets of questionnaires were distributed to employees in the 16 companies. The number of questionnaires distributed in each company was determined by calculating the sample size required for a 95 per cent confidence level (Anderson et al., 1994; Devore and Peck, 1994). After a period of follow-up, 1,261 questionnaires were returned; and, after 4

5 eliminating those questionnaires with more than 20 per cent of questions unanswered and those completed by non-engineers, there were 1,129 questionnaires useable for analysis, which yielded a response rate of 51.6 per cent. Measures Dependent variable -- organizational performance The measurement of organizational performance includes two subjective assessment dimensions: perceived financial performance and perceived non-financial performance. The former includes market share, growth in sales, and profitability; and the latter covers the quality of the product or service, the development of a new product or service, and customer satisfaction. These aspects were adapted from previous studies including Kalleberg and Moody, 1994; Dyer and Reeves, 1995; Delaney and Huselid, 1996; Harel and Tzafrir, 1999; Huang, 2000; Fey and Bjorkman, A total of six questions were designed to assess the dependent variable. Senior operations managers were asked to evaluate how their companies were performing compared with competing organizations doing the same work. The answers to the questions were recorded on a five-point Likert scale ranging from 1 (a lot worse than average) to 5 (a lot better than average). There are four reasons for using subjective data. First, the use of such data permits an analysis of companies for which objective performance data are not available/accessible. Secondly, subjective measures of performance are used in similar types of research, and the use of such measures has been shown to be fruitful (see, for example, Delaney and Huselid, 1996; Youndt et al., 1996; Cully et al., 1999; Bae et al., 2003). Thirdly, the managers perception of organizational performance might be more valid than accounting data because of the problem of inconsistency in accounting measurement (Cully et al., 1999). Finally, the collection of subjective performance data provides a broad perspective on organizational performance so that we can include not only financial but also nonfinancial dimensions of performance indicators. Independent variable (1) ---the presence of reward and incentive compensation practices During the interviews, HR managers were asked to indicate whether they have employed the following four practices: profit-related payment, employee shareownership scheme, group performance-related pay and profit sharing. Their answers were recorded as 1 if companies had implemented certain policies and practices and 0 if they had not done so. Independent variable (2) ---the effectiveness of reward and incentive compensation practices The Employee Opinion Survey (EOS) was designed to collect information relating to the effectiveness of an organization s reward and incentive compensation practices. Employees were asked to assess the effectiveness of the practice in their companies on a 1-5 Likert scale, where 1 = strongly disagree and 5 = strongly agree. An instrument of eight items was designed to investigate whether the company s reward and incentive compensation practices were effectively linked to employees performance. 5

6 The reward and incentive compensation practices cover both financial aspects such as pay, and non-financial aspects such as recognition and praise. The eight questions are: a. There is a strong link between how well I perform my job and the likelihood of my receiving.recognition and praise. high performance appraisal ratings. an increase in pay/salary. promotion. b. I am satisfied with the amount of recognition I receive when I do a good job. c. Pay increases are based on group performance rather than personal performance. d. Generally, I feel this company rewards employees who make an extra effort. e. The company s reward and incentive compensation scheme/package strongly emphasizes employees performance. Control variables Eight control variables were included in this study in order to control the sources of potential extraneous variance: the size of the firm; the age of the firm; ownership; the number of managers as a percentage of all employees; the unionization level; the number of competitors; the degree of market competition; and the current state of the market. The first five sets of data were drawn from the CEPQ, completed by HR managers, and the rest were from the MPOPS, completed by senior operations managers. It is to be noted that the control variable for the level of unionization was later excluded from the statistical analysis as the findings from fieldwork interviews revealed that there have been no trade unions in Taiwan s semiconductor industry. Analyses and results The relationships between organizational performance and the use of reward and incentive compensation practices (H1) Hypotheses 1 (a)~(d), which propose positive relationships between organizational performance and the use of reward and incentive compensation practices, were tested by matching and analyzing data collected from senior managers perceptions of company performance, and interviews with HR managers. The six organizational performance indicators were classified into two categories: financial performance (including market share, growth in sales, and profitability) and non-financial performance (including quality of product or service, development of new product or service, and customer satisfaction). The scale reliability Cronbach α of the financial performance and non-financial performance was 0.78 and 0.67 respectively. Each reward and incentive compensation practices was coded as a dummy variable, with 1 indicating that the company had implemented the practice, and 0 indicating that the company had not done so. These hypotheses were first tested by computing correlation and then regression. However, hypothesis H1(c) was not tested, because all the surveyed companies had profit-sharing 6

7 schemes in place. Table 1 presents descriptive statistics and Spearman correlations for all variables. The results of correlation analysis show that the use of an employee shareownership scheme is significantly but negatively correlated with non-financial performance (r = -.48, p<.05). 7

8 Table 1 Means, standard deviations and correlations for all variables Variables Mean s.d Financial performance Non-financial performance ** 3 Profit-related payment Employee share-ownership scheme * Group performance-related pay scheme ** Log of total employment Log of company age Ownership No. of managers as % of total employees Number of competitors Degree of competition * Current state of market N= 21 ** Correlation is significant at the 0.01 level (2-tailed). * Correlation is significant at the 0.05 level (2-tailed). 8

9 The results of correlation analysis provided preliminary observations for hypotheses-testing. Each of the hypotheses was further tested using ordered probit regression analysis. This method serves as an appropriate framework for statistical analysis because of the ordinal character of the dependent variables (Daykin and Moffatt, 2002; Greene, 2002; Kennedy, 2003; Koop, 2004). To see whether the null hypotheses of no association with performance could be rejected, the following two-step procedures were used in the six regressions, three predicting financial performance and three predicting non-financial performance. In the first step, the set of control variables and each of the three reward and incentive compensation practices were entered into a regression equation. The results for these regressions are reported in Table 2. Table 2 Summary of ordered probit regression results for organizational performance (1) Variable Financial performance Non-financial performance Coef. St.Err. b/st.er. Coef. St.Err. b/st.er. Profit-related payment scheme Employee share-ownership scheme Group performance-related pay scheme N= 21 ** Significant at the 0.01 level. * Significant at the 0.05 level (2-tailed). The regressions include the following control variables: total number of employees, company age, ownership, the number of managers as a percentage of all employees, number of competitors, degree of competition, and current state of the market. The regression results show a different picture from the results of correlation analysis presented earlier. Of the six possible combinations, none is statistically significant. The results show that those independent variables we hypothesize as having a positive association with performance turn out to be statistically insignificant. One possible reason for this is that some control variables pick up the effect of these independent variables. To see whether this is the case, in the second step, we repeated the analyses in step one after removing those control variables with b/st.er<1 in the resulting equations at step one. As can be seen in Table 3, two variables are shown to be statistically significant: the use of a profit-related payment scheme is positively and significantly related to both financial performance (coef. = 2.66, b/st.er. = 2.10, p<.05) and nonfinancial performance (coef. = 3.15, b/st.er. = 2.23, p<.05).thus, hypothesis H1(a) is supported. The rest of the hypotheses are not supported, because their relationships are too weak or/and are not in the hypothesized direction to allow us to reject the null hypotheses. 9

10 Table 3 Summary of ordered probit regression results for organizational performance (2) Variable Financial performance Non-financial performance Coef. St.Err. b/st.er. Coef. St.Err. b/st.er. Profit-related payment scheme 2.66* * Employee share-ownership scheme Group performance-related pay scheme N= 21 ** Significant at the 0.01 level. * Significant at the 0.05 level (2-tailed). The regressions for financial performance include the following control variables: total number of employees, company age, the number of managers as a percentage of all employees, and current state of the market (profit-related payment); company age and current state of the market (employee share-ownership scheme); total number of employees, company age, the number of managers as a percentage of all employees, and current state of the market (group performance-related pay scheme). The regressions for non-financial performance include the following control variables: total number of employees, company age, the number of managers as a percentage of all employees, and current state of the market (profit-related payment); total number of employees, company age and the number of managers as a percentage of all employees (employee share-ownership scheme); total number of employees (group performance-related pay scheme). The relationships between organizational performance and the effective use of reward and incentive compensation practices (H2) The data used for the measures of the effectiveness of reward and incentive compensation practices were drawn from employee opinion surveys in 16 companies. The descriptive statistics and scale reliability of the dependent variables and independent variables are shown in Table 4. The scales all have Cronbach s Alphas above 0.7, except for one item, non-financial performance, which is slightly below 0.7. The survey results show that employees were positive in their evaluation of reward and incentive compensation practices in their companies. They record a mean score of Table 4 Descriptive statistics and scale reliabilities for the dependent and independent variables Scale names Number of items Cronbach Alpha Mean s.d. Financial performance Non-financial performance Reward and incentive compensation Notes: The figures for dependent variables (financial performance and non-financial performance) are based on 16 senior operations managers perceptions of company performance. The figure for independent variable (reward and incentive compensation) is based on responses from 1,113 employees. 10

11 To examine the association between organizational performance and individual-level assessment of reward and incentive compensation practices, the ideal approach -- before analyzing the data - - is to aggregate individual-level data to the company level. However, there are two reasons why this study does not follow this procedure. First, in our analysis of how individual characteristics and company-level factors are associated with employees assessment of the effectiveness of reward and incentive compensation practices, it was found that employees evaluation of the effectiveness of the practices was affected not only by company-level factors such as company size, but also by employees individual characteristics such as age and length of service. The divergent assessments within a company would make the aggregation approach unjustifiable. It has been suggested that a minimum degree of consensus among the respondents in the group should be ensured to perform aggregation (James, 1982; Joyce and Slocum, 1984). Secondly, as the 1,129 returned, usable questionnaires were collected from only 16 companies, the statistical significance may be less reflective of the real significance because of the small sample size (Hair et al., 1998). Due to the above considerations, cross-tabulation analysis rather than regression was employed to analyze the data. The cross-tabulation analysis was combined with the Spearman R test to uncover the strength of association between dependent variables and independent variables (Siegel and Castellan, 1988). It is to be noted that the question items for each scale were transformed to a summary measure to suit cross-tabulation analysis. The results of hypotheses testing are summarized and shown in Table 5. Of the two tests, a positive and significant correlation is found between financial performance and reward and incentive compensation (r =.165, p<.01). Based on the statistical result, partial support is provided for Hypothesis H2, as the practices proposed in the hypothesis is correlated with only one dimension of organizational performance. Table 5 The results of Spearman correlation tests on organizational performance and employees evaluation of the effectiveness of reward and incentive compensation practices Variables Spearman R Sig. Level Financial performance/ Reward and incentive compensation.165 ** Non-financial performance/ Reward and incentive compensation ** Significant at the 0.01 level. * Significant at the 0.05 level. 11

12 Discussion This study tests two sets of hypotheses that propose a positive association between organisational performance and (1) the use of reward and incentive compensation practices; and (2) the effective use of reward and incentive compensation practices. The results of the statistical analysis show that, in the context of the Taiwanese semiconductor design industry, the use of a profit-related payment scheme is positively and significantly related to organizational performance; and that the effective use of reward and incentive compensation is positively related to financial performance. The results of the study indicate that companies using a profitrelated payment scheme are more likely to perform better in terms of both financial and nonfinancial performance than companies that do not use such a scheme; and, that companies which are effective in the use of reward and incentive compensation perform better than other companies. The research findings support the commonly held notion that the effective use of reward practices has the potential to increase organizational performance; thus, it is recommended that managers should give special attention to how best to employ such practices to attract and retain talented individuals; and how to effectively incorporate performance-based payment into their reward system to strengthen the ties between pay and employees performance. Nevertheless, some scholars suggest that performance-linked compensation practices have their drawbacks. The findings of Deci s (1976) extensive experimental research on the association between rewards and motivation show that monetary rewards do not always increase people s motivation to perform. He indicates that contingent monetary payments are an extrinsic control system that makes people less willing to perform in the absence of external rewards, as monetary rewards have been perceived as the reason for performing tasks. By contrast, intrinsic rewards, such as positive feedback, praise, interpersonal supportiveness, motivate people to perform through ego-involvement and a desire to perform competently (Deci, 1976: 71). Lawler (1983) also indicates that performance-linked monetary rewards are based on extrinsic rather than intrinsic rewards, which might have a negative impact on workforce stability and a company s long-term development. Indeed, many HR managers indicated that a high employee turnover rate is a serious issue in the industry, as profitable firms are more likely than less profitable firms to operate incentive compensation schemes that cater for the interests of employees. Therefore, it is recommended that, in addition to rewarding employees with a good pay package, companies should also apply non-monetary rewards to recognize good performers in order to promote employees self-esteem and organizational commitment. Areas like achievement, recognition, responsibility, job discretion and personal growth are examples of non-financial rewards (De Cenzo and Robbins, 1994; Lewis, 2001) that can provide employees with intrinsic rewards and can have a profound impact on employee behaviour. As with any empirical research, the present study has some limitations. We identify three main limitations and wish to propose some suggestions for future research. The first limitation of this study is that causality cannot be definitively determined. Due to the cross-sectional research design, the direction of the relationship between variables is uncertain. To gain a clearer understanding of the causal relationship between reward and incentive compensation practices and organizational performance, a longitudinal design is ideally required for future research. The 12

13 second limitation concerns the potential generalizability problems. Since the study investigates only a single sector, the findings may only reflect the sector under study and may only be valid for hi-tech economies. We suggest that similar research is needed for other industries in Taiwan and other countries, both hi-tech and non hi-tech, in order to extend the findings of this study. A further area of limitation concerns the measurement of the dependent variable. This study has relied on senior operations managers perceptions of organizational performance. Such a subjective measurement might suffer from potential response bias, although it did at least allow us to include companies where objective financial data were not available or accessible, and to measure not only the financial dimension of corporate performance but also non-financial performance indicators including customer satisfaction, the development of new products or services, and the quality of products or services. Future research should, where possible, incorporate both self-report data and objective financial data in order to make the measure of organizational performance more comprehensive and reliable. 13

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