Compensation-in-Professional-Service-Firms

HARVARDBUSINESSSCHOOL9-905-039REV,MARCH2,2006ASHISHNANDALAURENPRUSINERCompensationinProfessionalServiceFirmsCompensationservesseveralfunctions.Itisaleverthatrewardspasteffort,providesincentivesforfutureeffort,influencesretention,andpromotesadesirableworkenvironment.Thatsaid,compensationisonlyonemotivationallever.Substitutesforcompensationincludepromotion,recognition,power,andnonmonetaryperks.Inthisnote,Idiscusscompensationofprofessionalsandsubordinates,aswellaspartners.Ialsodiscusshowcompensationrelatestootherleversthatmotivateprofessionals.CompensatingProfessionalEmployees1Source:Casewriter.ValueFigureAValue-Compensation-OutsideOfferRelationshipIRV:Valuecontributedbyprofessional0:OutsideoptionR:Professional'scompensationP:FirmprofitfromprofessionalP=(V-R)E:Professional'sefficiencywageOE=(R-O)IIIVpEIncompensatingprofessionals,professionalservicefirm(PSF)leadersmustconsiderthreeelements,illustratedinFigureA.Vrepresentsthevaluecontributedbytheprofessional;0istheoutsideoffer,thecompensationthattheprofessionalcouldearninthelabormarketoutsidethefirm;andRistheprofessional'scompensationwithinthefirm.2Thedifferencebetweenthecompensation(R)andtheoutsidevalue(0)isequaltoefficiencywageE,whichistheadditionalcompensation(overwhatthelabormarketisoffering)thattheprofessionalearnsfrombeinginthefirm.Prepresentstheprofessional'scontributiontofirmprofit.Itisequaltothevaluecontributed(V)lessthecompensationgiven(R).1ThissectiondrawsuponhelpfulconversationswithProfessorsGeorgeBakerandBrianHaJJ.2Representingcontributionandrewardonasingledimensionisagrosssimplification.However,thisgrosssimplificationhelpsconveysomeimportantconcepts.Oncethoseconceptsareclear,wecancomebacktothissimplificationanddiscusshowweakeningtheassumptionsofthismodelmightchangeitsresults.ProfessorAshishNandapreparedthisnotewiththeassistanceofResearchAssociateLaurenPrusinerasthebasisforclassdiscussion.Copyright©2004PresidentandFellowsofHarvardCollege.Toordercopiesorrequestpermissiontoreproducematerials,call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto(FigureB).Professionalsareencouragedtobringtheirmarketvaluetotheirleaders'notice.ThePSFleadersthenpaytheprofessionalsacompensationthatismarginallyovertheirmarketvalue.FollowingthisapproachallowsPSFleaderstousecompensationasaleverforretention.Butcompensationbecomesineffectiveasaleverformotivatingperformance.Insteadofattemptingtoimproveperformance,professionalsinPSFsfollowingsuchacompensationapproachfocusonincreasingtheirmarketvaluetoraisetheircompensation.Ratherthanimprovingtheireffectivenessinusingthefirmplatform,theprofessionalsfocusonpolishingtheirresumes.Theyinvestindevelopinggeneric,marketableskillsratherthanfirm-specificskills.ProfessionalspayattentionnottoincreasingtheV-Ogapbutinsteadtoincreasingtheirlabormarketvalue(0).Overtime,as0increasesfollowingprofessionals'effortsbutVdoesnotincreasecommensurately,theprofitcontributedbytheprofessionals(P)decreases.FigureBPeggingCompensationtoOutsideOffersValueIIVp=t=~Source:Casewriter.Instead,PSFleaderscanchoosetosharethereturnstofirm-specificinvestment(thev-odifference)withtheprofessionals.Suchacompensationsystemdoesnotyieldthemaximumprofitspossibleintheshortterm.ButitallowsthePSFleadertousecompensationtomotivatevalueenhancement.Forexample,thePSFleadercanmaketheprofessionals'efficiencywage(theR-Odifference)anincreasingfunctionofthefirm-specificreturns(V-O),therebyencouragingtheprofessionaltoinvestinincreasingtheV-Ogap.Overtime,professionalsinvestinincreasingtheV-Ogap,leadingtoanincreaseinbothPandE.CompensatingStarsvs.SolidCitizensFigureCCompensatingStarsVS.SolidCitizensFigureCcomparesstarprofessionalstosolidcitizens.Astarprofessionalcontributesgreatervaluetothefirm,butbecausesheisastar,outsidersrecognizehergreatercontribution,pushinguphermarketvalueandtherebyhercompensa­tion.SinceVand0areclosetoeachotherandRhastobebetweenthetwo,neitherPnorEisveryhigh.Thestardoesnotcontributemuchtooverallfirmprofitability,noristhefirmabletomotivatehermuchthroughcompensation.V=t=~:1IVIRI0Asolidcitizen,incontrast,islowerthanthestaronbothVand0(seeFigure2StarsSource:Casewriter.112SolidcitizensCompensationinProfessionalServiceFinns905-039C).Hedoesnotcontributeasmuchvalueasthestar,buthisrewardandmarketvaluearealsolower.TheV-Ogapmightbelargerforasolidcitizenthanforastar.Asolidcitizenmight,therefore,contributemoretotheprofitofafirmthanastar(P