Jim Sinegal’s statement that having a person earning a hundredfold of the average person on the floor is wrong, is too simpleminded. The academic literature is in an ongoing argument over which compensation system and pay structure allows for the greatest employee motivation, performance, and organizational effectiveness. To critically discuss Mr. Sinegal’s statement, a multi-faceted response is needed. Even though Costco is following a relatively egalitarian – or flat – pay structure, high wage dispersion can be found throughout several organizations in multiple industries. This essay will argue that the CEO of Costco is making a profound mistake in generalizing about the negative effects of hierarchical and high wage dispersion. In order to prove this, it is vital to firstly look at the effect of monetary reward on employee motivation and performance. I will then move on to argue that an organization’s pay structure should be a well-balanced policy which includes both, wage dispersion and relatively compressed wages. Whereas inter-departmental wage dispersion is viable, if not necessary, wages within a department should be on a similar level and person – not job-based. Finally, there are also a number of moderators which must be considered. Not only is the industry and nature of work important in deciding the pay structure, but also the business strategy and predominant culture of the employees. Certain pay structures tend to attract different kinds of individuals and different cultures tend to place different levels of importance on monetary rewards.
To be able to analyze the effect of different pay structures on an organization’s employee, it is integral to understand the importance of pay for the individual. Mr. Sinegal’s statement is partially correct as an unequitable treatment of employees can have negative consequences for the organization, such as a decrease in organizational citizenship behavior, which can be defined as a combination of discretionary effort, cooperation and commitment (Cowerd et al. 1992, p.305). However, the CEO of Costco seemed to neglect in his statement, that pay is a powerful motivator (Rynes 2003) and can incentivize employees and positively influence individual as well as group performance. It is furthermore understood to be the case that Deci & Ryan’s Cognitive Evaluation Theory (CET), in which it is argued that intrinsic motivation – which is the case when an individual performs an activity without apparent reward – is negatively affected by rewards when the receiver perceives the reward as a challenge to competence, has been disproven by Gerhart and Rynes in 2003. More importantly however, making monetary reward variable and dependent upon an individual or organizational achievement has proven to make that specific goal more easily realized – therefore increasing performance (Gerhart 1990). All in all, it is correct that large disparities in pay between employees on a similar level can lead to discouragement; however, pay dispersions cannot be discredited as a whole. Apart from pay for performance schemes and variable pay having motivational effects on high-performing employees and legitimizing pay differences (Shaw, 1998), there are several theories which suggest that big differences in pay foster individual and organizational performance.
It is furthermore of importance to swiftly outline the core theory behind the reasoning for high wage dispersions. Lazaer and Rosen’s tournament theory suggests that it makes economic sense to pay the individuals at the top end of a pay structure a wage that exceeds their marginal contributions (Guthrie 2007; Lazaer 1989). Even though this tournament theory has mostly been tested in the context of high-performing sportsman and women, it can be applied to other industries as well. Albeit Mr. Sinegal’s opposition to this pay structure, which is also partially supported by academics such as Bloom, who argued that more egalitarian pay structures benefit group performance (Bloom, 1999), pay dispersions can be applied throughout organizations with care.
Paying an individual 100 or 200 or 300 times the amount of the average person is not wrong as long as it is not the case within a department. This so-called horizontal dispersion is ought to have negative implications. As “organizations are emotional hotbeds fueled by continual social comparison” (Cowherd 1992, p. 305), a horizontal dispersion can lead to feelings of unfairness and a decrease in individual performance (Shaw, 1998). In this case, compressed wages are necessary. Pfeffer and Langton support this line of argument with their testing of effects of pay dispersion on a sample of more than 1,700 faculty from more than 600 US academic departments (Pfeffer, 1993). This study showed that a high wage dispersion within a department leads to lower levels of satisfaction and less productivity and collaboration from an individual. However, a vertical – or inter-departmental – dispersion will not experience the same problems due to a higher number of factors which could explain the differences in pay: differences in status, social class or job title. Additionally, such vertical dispersion is necessary to attract and retain high-performers (Brown, 2003).
A Costco-like, egalitarian pay structure is only necessary within departments as it helps to increase group performance, team-oriented behavior and boost the morale (Bloom, 1999). However, within one department wages should still slightly be different based upon the individual. It is of importance however, that wages are on a similar level. A person-based, as opposed to job-based, wage will on the one side help to retain experienced, well-performing employees, and on the other side not cause similar problems to that of a large-scale intra-departmental wage dispersion policy. Even though a person-based salary would still be a dispersion, wages staying on a comparable level within the department and the differences being justified through education or experience will have a smaller effect on the organizational performance (Pfeffer, 1993). In fact, as long as employers are perceived as operating equitably by the employees, performance levels should not drop (Torrington, 2014). Jim Sinegal’s statement is correct when looking at one department as but a firm-wide wage compression is not thought to be beneficial for organizational performance.
Ultimately, there are a number of moderators, which must be considered when deciding upon the pay structure of an organization. The industry and nature of work is vital for determining whether a hierarchical pay structure should be adopted. Whereas egalitarian pay structures are linked with higher levels of team performance and are thought to be most appropriate for interdependent tasks, the tournament system, or hierarchical pay structures, have ‘considerable motivational properties’. (Bloom, 1992, Becker, 1992) Such hierarchical pay structures can also help to overcome the moral hazards in the principal-agent theory (Fernie, 1999). The moral hazard in this theory is that one party of the contract be certain whether the other party is honoring the contract terms. In Fernie and Metcalf’s example, the horse owner is unsure whether the jockey is giving his best to win. A hierarchical pay structure, in which the jockey receives part of the prize money and earns a multiple of the other employed people, ensures that he/she is giving his best (Fernie, 1999). Brown’s efficiency wage theory extends this argument as it states that organizations with higher pay levels can expect increases in individual-level and team-level performance because they are more able to attract and retain high-performers (Brown, 2003). High wages in executive positions, no matter how they compare to the rest of the organization, are the most effective solution for attracting and retaining talent. Nonetheless, a hierarchical pay structure and great wage dispersions have to be handled with care and cannot be applied to every job. Becker and Huselid have proven that tournament systems increase individual performance, however, it has also come to light, that such systems increase individual inappropriate behavior (Becker, 1992). Even though they received their data from car racers, inappropriate behavior in a traditional working environment might lead to counterproductive work behavior.
Finally, culture is the last moderator. As different cultures place a different value on monetary rewards and organizational citizenship behavior, it can be argued that neither pay structure has a particular negative or positive effect on a certain culture. In the Chinese culture, a hierarchical pay structure and high wage dispersions would not be seen de-motivating nor would they decrease organizational performance, as the higher management levels are understood to earn a hundredfold of the simple worker (Steers, 2003).
In conclusion, it cannot be said that having a person who is being paid 100 or 200 or 300 more than the average person is wrong. Apart from the fact that extrinsic motivation, such as salary, is integral to individual and organizational performance, a hierarchical pay structure with big wage dispersions cannot be generalized. It would be a mistake to argue that such structure is wrong. Instead, I would like to offer the option of arguing that such a pay structure is viable and necessary, but it has to come with certain conditions. Not only do the wage dispersions need to be vertical, but within one department wages have to be on a similar level. A person-based wage is acceptable and would most likely also be accepted by coworkers if it is justified through more experience or education. I find it furthermore to be important that the pay structure is dependent on the industry, nature of the job and culture the organization is in.