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Raising Havoc

The right--and wrong--way to give employees raises

What's wrong with this picture? You've just nailed down a major new contract, and to celebrate you gather your employees together and tell them they'll all be getting a 10 percent raise effective immediately.

Sound familiar? Probably, because this approach to raises is the small-business norm--and, of course, employees are quick to applaud it. But compensation experts don't. In fact, according to them, just about everything is wrong with this picture.

That's because impulsive generosity is not a good motivation for giving pay raises. "You need to think about raises before you hand them out--long before," says N. Elizabeth Fried, a Dublin, Ohio, compensation consultant. "But small companies are usually unsystematic in their approach to pay raises--and that can be costly to the bottom line."

Horror stories abound of bosses who failed to think before acting. For instance? Fried recalls one boss who concocted a spur-of-the-moment salary-plus-bonus plan for his sales manager--whose compensation soon soared well into the six figures, an amount far above what the owner had anticipated. "He just hadn't given much thought to it," says Fried.

In other cases, employee turnover is mammoth because the business doesn't pay market rates (which can be obtained from the Bureau of Labor Statistics and, often, local chambers of commerce). Workers stay just long enough to pick up a skill--in effect, using the business as a school that pays them--then bail out to join better-paying competitors.

"To stay in business, you've got to think through the long-term impact of your compensation decisions," says Fried. "The main point is that compensation and pay raises have to be linked to the business's overall objectives. That's something too many entrepreneurs neglect--to their detriment."

Then you have to link company objectives with those of individual employees--and the place to do that is in employee performance reviews. Besides telling workers how you feel they are performing, tell them-in as much detail as possible--what they need to do to win a pay raise, says Novato, California, management consultant Christopher Hegarty. "A raise should be the outcome of a strategy the boss and employee have agreed on," he says, adding that you should tell employees the critical tasks that, once learned, will make them more valuable to the company.

Which critical tasks? You know your business and where each employee can most impact the bottom line. Those are his or her critical tasks, so spell them out. "Be as specific as possible. You want to take the mystery out of pay raises," says Hegarty.

In fact, demystifying the compensation system is crucial. "What do employees most want in compensation? Fairness. That's the answer we always hear," says Oakland, California, business consultant Charles Garfield. The better workers understand the system, the less apt they are to believe raises are rooted in favoritism or arbitrary decisions.

Besides fairness, employees also want a degree of generosity--a fact vividly documented in research conducted by Atul Mitra, an assistant professor of management at Lyon College in Batesville, Arkansas. According to Mitra, "Small raises can hurt employee motivation and morale." The reason? "Employees lose faith in the system. They stop thinking there's a link between pay and performance."

How small is small? Any raise significantly below 6 percent, says Mitra. "Unless a raise is that high," he says, "it won't produce the desired results in terms of employee productivity." But the good news is that bigger isn't always better. A 7 percent raise is likely to get Joe fired up--but a 14 percent raise probably won't get him doubly fired up. If raises are big enough to be considered raises, Mitra found any extra money will yield few additional motivational benefits.

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This article was originally published in the February 1996 print edition of Entrepreneur with the headline: Raising Havoc.

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