What Is Skill Based Pay?

Definition Skill‐based pay (SBP) is a compensation system that rewards employees with additional pay in exchange for formal certification of the employee’s mastery of skills, knowledge, and/or competencies. Skill is acquired and observable expertise in performing tasks. Knowledge is acquired information used in performing tasks.

Competencies are more general skills or traits needed to perform tasks, often in multiple jobs or roles. In SBP systems, employees receive additional pay only after they demonstrate the skills, knowledge, and/or competencies that the system rewards.

Thus, SBP is a person‐based system, because it is based on the characteristics of the person rather than the job. In more common job‐based pay systems, pay is based on the job, which employees are entitled to receive even if they are not proficient in their position.
Background

Skill‐based pay is one of the most widely‐implemented, poorly understood and under‐researched human resource practices in use today. Part of the problem is that “skill‐based pay” is not a single system, but rather a family of loosely related pay

Heather Jefferson is the HR manager at a manufacturing plant for Mother Nature’s Best, a food processing company in the United States. Competition in her industry is fierce, and executives have pulled every lever they can in order to increase productivity and enhance profitability. They have upgraded technology, adopted new information systems, tightened the supply chain, and begun “lean six sigma” initiatives. Now, senior executives are asking the human resource function to help in innovative ways. Some executives have suggested that a skill‐based compensation system for hourly employees would increase performance, based on successes reported from other companies in their industry. They suggest that this particular facility be a pilot to determine whether such a plan would work for the entire company. What should Ms. Jefferson say to these executives? systems that have different origins, distinct traditions, and suitability to different types of organizations. Opinions about skill‐based pay often miss the mark because they apply to one form, without appreciation that other forms may be appropriate for a given organization. Because there is so much confusion about skill‐based pay, we begin with a detailed discussion of its different forms and purposes.

Figure 1 depicts the different forms that skill‐based pay can take. One dimension is the type of skills, knowledge or competencies that the system can reward: depth (gaining greater expertise in existing skills); breadth (increasing one’s range of skills); and self‐management (gaining skills that might previously have been reserved for higher levels in the organizations, such as planning, training, budgeting, etc.). The second dimension focuses on whether the reward offered is a bonus or base pay increase. Different types of SBPs have different configurations associated with different traditions, and goals and implementation processes differ across the different SBP types.

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Depth©Oriented Base Pay Systems
One type of SBP is old and familiar (System A in Figure 1) in the United States and elsewhere. Depth©oriented plans reward employees for gaining greater expertise on existing skills. Apprenticeships for skilled trades date to antiquity, and the modern skilled trades system dates to the Middle Ages in Europe. In these systems, employees build skills for years, receiving only one or two promotions during their career. Blue collar skilled trades may receive pay increases as they are move from apprentice to journeyman to master craftsman as, for example, an electrician, millwright or toolmaker. The analogous white©collar system is the dual career ladder, which rewards deeper levels of expertise rather than advancement through the management hierarchy. The goals of these systems are building critical specialized skills, attracting talent and retaining employees over the long period needed to build specialized skills.

The highest paid members of the dual ladder, frequently designated as Fellows, may be world©class experts in their specialties. The dual career ladder is common in such industries as aerospace, pharmaceuticals, high technology, and others where specialized expertise is a competitive necessity. Professors often find such systems appealing partly because their own career system is directly analogous to medieval trades system. An academic career is encompassed by the three job titles of Assistant Professor, Associate Professor and Professor, with each promotion taking years of work, marked by formal certification of achievement.

The disadvantage of these systems is that they can create overly©specialized employees who identify more with their craft or profession than with the mission of the organization. In the skilled trades, sharp jurisdictional lines between crafts has led to jokes about how many journeymen it takes to replace a light bulb. (One answer is three: a mechanic to hold the ladder, a pipefitter to confirm that no plumbing is involved, and an electrician to screw in the bulb). Over the past 20 years, the strong trend in the United States has been toward multi©crafting, in which employees gain proficiency in two or more trades. Such systems add a breadth dimension and look more like System B, which we will consider next.

Breadth©Oriented Base Pay Systems
System B in Figure 1 indicates the type of system that is most often recognized as ¡°skill©based pay.¡± The goals are to reward an appropriate balance between employee flexibility through skill breadth (the ability to do different jobs in the organization); skill depth; and self©management skills (such as training, hiring and performance appraisal) that are critical in systems with few or no supervisors. This type of system is most common in manufacturing, but is also used in some other types of organizations that require high employee skill and employee involvement (such as call centers, help desks, back office processing operations in insurance and financial services, and even specialized retail).

This pay system originated in Procter & Gamble in the 1960s in ¡°Greenfield high involvement plants,¡± which were marked by a high level of employee involvement, a de©layered hierarchy, use of self©managed teams, high levels of training, and extensive communication of business results. This type of system became the norm in P&G as the high involvement model became diffused throughout the company. SBP worked because it helped facilitate the overall organizational design. Employees learned the technical, social and managerial skills that they needed to manage complex technical systems with little or no managerial support.

In the developed world, manufacturing and back office operations increasingly require employees to act as knowledge workers rather than button pushers. Low©skill operations are being automated or sent to low©wage locations in the developing world. The jobs that remain typically require higher skills, flexibility to do different jobs, the ability to work without close supervision, and a high level of training. Employees must understand the overall production or service delivery process and respond quickly when problems arise. None of this is possible if employees know only one job and therefore one small part of the overall process.

In the past two decades, the rise of lean systems has accelerated these trends. Lean demands much more of employees, including self©inspection, involvement in cost reduction efforts, teamwork, cross©training, and rapid adjustment to changes in market demand for different products. SBP is often used to motivate employees to acquire these capabilities.

A related but historically distinct tradition has been the use of competency based pay for managers and professionals, originally an outgrowth of work on competencies by psychologist David McClelland. In many cases, competency pay plans are a natural extension of the efforts of companies to build distinctive competencies that meet organizational needs. Different plans may emphasize breadth, depth, or a combination of both, but these typically go beyond the technical skills orientation of the dual career ladder. For example, a food processing company created a competency pay plan for all managers that based pay increases on two traditional managerial competencies (leading for results and leveraging technical and business systems) and two competencies that reinforced major corporate talent management and quality initiatives (building workforce effectiveness and meeting customer needs). One area in which competency systems have become very widespread is education (see sidebar).

The limited data on SBP usage indicates greater use than many observers realize. A survey of Fortune 1000 firms by the Center for Effective Organizations in 2002 found that 56% used SBP (broadly defined), and that the percentage of firms using it had been relatively unchanged since 1993. However, the vast majority of users covered less than half their workforce with SBP. A study by the International Public Management Associations for Human Resources found that 22% of public sector organizations used SBP in 2007. A 2007 Towers Perrin study of over 600 managers in 21 countries found that 27% of cases base salary increases on competencies (defined as proficiency in core knowledge or behavior) for executives, 36% of cases for managers and professionals, and 28% of cases for non©management. In addition, increases were skill©based (defined as acquisition of new skills) in 9% of cases for executives, 15% for managers and professionals, and 18% for non©managers. Finally, the prevailing Japanese salary system incorporates a high degree of SBP. Typically, one pay grade schedule covers all employees, including executives, and job grade is based on all the jobs and responsibilities the employee is able to do, not what the worker is actually doing. A study by American and Japanese researchers found that ¡°knowledge and skill¡± is one of three roughly co©equal factors (along with effort and cooperation with supervisors) in determining pay. This reflects the Japanese emphasis on job rotation, cross©training and gaining identification with and understanding the needs of the company as a whole.

Academic research on SBP is limited and much of it is not current, but the available studies focus on what we have called Type B systems. The available data are quite positive in indicating that there is a payoff from adopting such plans. For example, a study of 97 skill©based pay plans sponsored by the American Compensation Association found that two©thirds to three©quarters of these plans were rated as successful on a wide range of outcomes, including reduced staffing, increased flexibility, increased productivity, higher quality, and lower turnover, despite higher average wages. That is, SBP users had fewer, more highly paid, and more productive employees. A follow©up study several years later found that the plans had a high survival rate and generally enjoyed continued success. Finally, a rigorous case study in an auto component plant found that the plant had 58% greater productivity, 16% lower labor cost per part despite paying higher wages, and 82% reduction in scrap versus a comparison plant.

Bonus Systems
The armed forces of the United States are covered by a unique bonus SBP system that is almost unknown outside the military. This is shown as System C in Figure 1. Covering 1.5 million military personnel, this is the most widely used SBP system in the United States. As far as we know, this system has not been the subject of academic research; descriptions of it are limited to obscure federal publications. The first author learned about this system while consulting to a Quadrennial Review of Military Compensation in 1996.

The goal of the system is to manage attraction and retention in particular occupational specialties. An HR group in the Pentagon monitors the degree to which the services have been able to fill each of hundreds of occupational specialties. If the services have difficulty attracting and retaining qualified personnel, a temporary enlistment and/or reenlistment bonus is offered. This may be modest ¨C most such bonuses appear to be less than $10,000 ¨C but it is possible to offer up to $40,000 for enlistment bonuses and $150,000 in reenlistment bonuses. Reenlistment bonuses are higher partly because it is easier to verify the skills of veteran personnel. Bonuses are used for both officers (for example, aircraft pilots and medical personnel) and enlisted personnel (for example, Special Forces). The nephew of the first author, a Marine helicopter mechanic, was offered a $70,000 bonus to reenlist for two years at the height of the Iraq war. This in effect would have doubled his cash compensation. Enlistment and reenlistment bonuses are used sparingly, and disappear as soon as staffing levels for particular specialties are filled. The specialties for which bonuses are paid and the amounts of the bonuses change frequently, indeed so frequently that the military does not announce them.

A Congressional Budget Office report (2007) found evidence that reenlistment bonuses were an important retention tool but that enlistment bonuses were not especially cost©effective. This may be because it is easier to fill many critical specialties by retaining incumbents, rather than by finding qualified civilian candidates. In addition to attraction and especially retention, there are many advantages of this system for the military. The system is targeted exactly to the specialties with a labor supply shortage, and these can change as often as needed. The very flat, time© and rank©based military salary system, which is important to military culture, can be preserved while in fact making available the compensation needed to attract specialists. Finally, salary costs draw close political scrutiny while bonus costs typically do not.

We believe that this type of pay system should be considered more often by non©military organizations. In particular, organizations in shifting labor markets or with shifting skill needs, such as high technology firms, may find it advantageous. The only two case examples of SBP failure to be publicly reported are both in high tech (Intel and Motorola). In both cases, the constantly shifting technological and business environment made base pay systems cumbersome and difficult to implement. Bonus oriented systems can be created much more quickly, targeted more selectively, and changed or terminated much faster than typical base pay plans. However, quickly changing bonus systems may be difficult to communicate and manage, and bonus SBP systems may invite sloppy designs because the cost of error appears to be so low.

We know of no bonus©oriented systems that reward skill breadth or self management skills. However, bonuses in principle could be used to reward any type of skill development. We believe that skill©based bonuses are greatly underused given the continual, rapid change of the U.S. economy and labor force, which may lead to paying permanent salary increases for skills that become obsolete over time. Figure 2 summarizes our key points about the different forms of SBP. It depicts the type of skill emphasized, the goals, and the organizational conditions that best fit each type.

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