The impact of human resource practices and compensation design on performance: an analysis of...

A sample of 168 family-owned fast growth small and medium enterprises (SMEs) was used to empirically examine the consequences of five human resource practices on sales growth performance. The results suggest that training and development, recruitment package, maintaining morale, use of performance

appraisals, and competitive compensation were more important for high sales-growth performing firms than for low sales-growth performing firms. In addition, we examined the use of incentive compensation in the form of cash, noncash, and benefits and perks for four different levels of employees in family-owned SMEs. The findings suggest that high sales-growth performing firms used more cash incentive compensation at every level in the organization.

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Small and medium enterprises (SMEs), the majority of which are family-owned, play an important economic and societal role in the United States (Shanker and Astrachan 1996). Family-owned businesses account for 60 percent of total U.S. employment, 78 percent of all new jobs, more than 50 percent of gross domestic product, and about 65 percent of all wages paid (Family Firm Institute 2002). When asked about the principal challenges facing them as they grow their firms, family and nonfamily SMEs alike, point to human resource concerns (Hoover and Hoover 1999; Deshpande and Golhar 1994) While both groups identify labor shortages a primary concern, family-owned SMEs state that attracting and retaining strong nonfamily executives and dealing with insufficient or poorly trained human capital are significant barriers to business success and growth. Despite the importance of family-owned SMEs to our economy and to job growth, there is little empirical research to assist managers and CEOs facing some rather daunting human resource challenges (Heneman, Tansky, and Camp 2000; Upton and Heck 1997). Instead, much of the work done with regard to human resource management (HRM) practices and performance focuses on large organizations and not on the SMEs that are so prevalent in the marketplace today. Literature on the relationship between human resource practices and performance in small, family-owned businesses is virtually nonexistent (Upton and Heck 1997). There is considerable need then, for empirical, comparative examination of the relationships between determinants of performance, such as human resource practices, and ownership structure (Westhead and Cowling 1998). Further, Sharma, Chrisman, and Chua (1997, p. 18) suggest, "... determinants of performance hold the most promise for contributing to the advancement of the [family business] field."

This research responds to the need for empirical, comparative analysis of the factors effecting family-owned SME performance. We compare HRM practices within a sample of high and low performing family-owned SMEs split based on sales growth. We examine the effects on performance by primary HRM practices, such as recruitment package, performance appraisal, compensation and benefits, maintaining morale, and training and development. First, differences in importance placed on each of these human resource areas are explored and then their relationship to performance is determined. Finally, differences in the use of various forms of compensation (that is, cash incentives, noncash incentives, and benefits and perks) across four different organizational levels (CEO to total employees) and their effect on performance are explored.

We begin by providing an overview of HRM practices and their link to organizational performance. Next, the importance of the HRM issues and compensation design is discussed. Although very little research examines HRM practices at family-controlled SMEs, the extant literature is reviewed and hypotheses are put forward. We then empirically examine differences in HRM practices for high and low performing family-owned SMEs. Next, we look at the design of incentive compensation systems across high and low performing family-owned SMEs. Finally, based on the results, we discuss practical implications for the management of family SMEs and for future research.

HRM Practices and Performance

There are few studies that identify HRM practices in SMEs and even fewer that focus on the relationship between HRM practices and performance (Heneman, Tansky, and Camp 2000). Over the past decade, several studies have reported the relationship between HRM practices and performance in large organizations. While there is some debate as to the extent to which we can apply the HRM practice/performance results from large to small firm, these findings are of interest and provide the basis for theoretical examinations of the smaller firm (Chandler and McEvoy 2000; Deshpande and Golhar 1994).

HRM practices such as employment security, selectivity in recruiting, high wages, incentive pay, employee ownership, participation and empowerment, promotion from within, training, and skill development are just a few of the practices acknowledged as having great value to the organization (Pfeffer 1994). Recent research has empirically shown the positive relationship between HRM practices and important organizational outcomes such as productivity, turnover, and firm performance (Delaney and Huselid 1996; Huselid 1995; Arthur 1994). These studies persuaded many in the management sciences that an explicit set of HRM "best practices" or as Huselid (1995, p. 635) termed them--"high performance work practices"--exist. Subsequent studies seem to support the notion that there are a bundle of HRM practices that can impact a firm's performance (Huselid, Jackson, and Schuler 1997; Delery and Doty 1996).

In this study, five HRM "best practices" are considered: training and development, performance appraisals, recruitment package, maintaining morale, and setting competitive compensation levels.

Perceived Importance of HRM Functions

The strategic use of human resources is important for the performance of the organization. Further, the adoption of a set of best practices for managing employees is believed to have a positive effect on organizational performance (Wright and Snell 1998; Applebaum and Batt 1994; Pfeffer 1994). In a recent study, human resources was identified as an area of significant importance to an organization's success (Heneman, Tansky, and Camp 2000). Thus, the importance placed on an HRM function in an organization might demonstrate how critical that function is to a given organization. We identify five strategic best HRM practices for this research: training and development, performance appraisals, recruitment package, maintaining morale, and setting competitive compensation levels.

An overview of HRM research suggests that these five HRM practices have an influence on organizational performance. Specifically, greater training hours have been linked to higher performance (Gowen and Tallon 2003; Huang 2001; Huselid 1995; MacDuffie 1995). A strong positive relationship has been found between performance appraisals and enhanced organizational performance (Chang and Chen 2002; Delery and Doty 1996; Huselid 1995). Effective practices for recruiting and selection, especially those considering the compensation element are related to performance (Ichniowski and Shaw 1999; Huselid 1995). Employee motivation has been shown to have a significant impact on productivity and performance (Gelade and Ivery 2003; Huselid 1995). Finally, design of compensation systems including the consideration of external equity has been linked with performance (Mak and Akhtar 2003; Youndt et al. 1996; Huselid 1995).

HRM Practices and Performance in the Family Firm

Little is known concerning human resource practices in family-owned firms and their effect on performance (Reid et al. 2002). Anecdotal evidence suggests that family businesses, rife with nepotism, eschew human resource practices (Gersick et al. 1997). However, two national surveys that focused on family firms conducted under the auspices of Mass Mutual (1993/1994), did not support this notion. They discovered that about half of the respondents reported that they used written job descriptions, set compensation plans, provided formal and regular employee reviews, and had a written employee manual. An in-depth analysis of the MassMutual data by Astrachan and Kolenko (1994) found significant differences in HRM practices for family versus nonfamily employees. They found that employee reviews, compensation plans, appraisal, and personal development plans were used significantly more frequently in family firms for nonfamily employees than for family members.

Poza, Alfred, and Maheshwari (1997) studied 26 family businesses as part of the Discovery Research program at Case Western. They found that nonfamily managers were significantly less satisfied with the management's ability to handle growth and the extent to which the necessary processes were in place to facilitate growth. Further, the nonfamily managers were significantly less satisfied with the fairness of the compensation system and more satisfied with feedback from performance appraisals.

Reid and Adams (2001) found significant differences between family and non-family SMEs in Northern Ireland. Labor costs for the nonfamily business was much higher and nonfamily SMEs were more professional in their HRM practices. For example, it was significantly more likely that a nonfamily business would have an HRM manager, use appraisal systems, set merit/performance related pay for managers, and keep detailed HRM records. Although both family and nonfamily businesses reported that employee training and development was their most important challenge, family businesses reported spending significantly less on training (as a percentage of total salaries and wages) than nonfamily businesses.

Although there is ample evidence that HRM practices influence performance, within the family business literature there is little research which support these links or examine its implications. However, there persists a belief that HRM in family-owned businesses could be a significant competitive advantage (Habbershon, Williams, and Kaye 1999). Ward (1988) proposes that family businesses may have a unique ability to create a more family-oriented workplace, which leads to greater employee loyalty. Astrachan and Kolenko (1994) found a positive correlation between HRM practices and gross revenues in family-owned businesses. Similarly, Leon-Guerrero, JcCann, and Haley (1998) found a positive relationship between family business revenues and the use of formal HRM practices, such as formal employee reviews, written job descriptions, and incentive compensation plans.

Based on these findings, we propose that the importance placed on specific HRM practices by the firm will be related to higher performance and offer the following hypotheses:

H1: The importance placed on training and development will be positively related to performance.

H2: The importance placed on performance appraisals will be positively related to performance.

H3: The importance placed on designing competitive compensation systems for recruitment package will be positively related to performance.

H4: The importance placed on maintaining morale will be positively related to performance.

H5: The importance placed on setting competitive compensation levels will be positively related to performance.

Compensation Design

Pfeffer (1994) argued that one of the elements of what effective firms do with people is the use of incentive pay. The design of compensation systems in terms of the form of incentive compensation used is critical to the success of the organization. In fact, empirical evidence has found that pay mix is related to financial performance (Gerhart and Milkovich 1990). More specifically, in examining human resource practices, the use of incentive compensation is positively related to organizational performance (Huselid 1995; Delaney and Huselid 1996). The theory suggests that using incentive compensation better motivates individuals to perform than by simply relying on fixed rewards.

In a recent study, Stevens and Hill (2001) focused on differences in executive compensation in large organizations. They found that low performing firms use higher fixed salaries and fewer incentives while high performing firms use lower fixed salaries and a greater percent of overall compensation is incentive pay. This would suggest that higher performing firms are using various forms of incentive compensation such as cash incentives, noncash incentives, and benefits and perks more than low performing firms.

Furthermore, the family business literature has examined the relationship between pay and performance within the agency theory context. Gomez-Mejia, Tosi, and Hinken (1987) reported that family business owners prefer pay to be tied to performance. However, family firms are less likely to share ownership with employees (Stoy Hayward 1990), as this would dilute the family's control. Thus, it is more likely that family firms will use some form of incentive that does not give up control. This will allow for incentives to be tied to performance and yet still retain family control, which has been associated with higher firm performance (McConaughy et al. 1998). Therefore, while little research that focuses on family-owned SMEs exists, the little evidence available would suggest that the higher performing firms are more likely to use some form of incentive compensation system.

Based on this research, we predict that those organizations that are high performing are more likely to offer a greater amount of incentives in order to address motivation and retention issues. Thus, we offer the following hypotheses for family-owned SMEs:

H6: Cash incentives will be positively related to performance.

H7: Noncash incentives will be positively related to performance.

H8: Benefits and perks will be positively related to performance.

Methodology

Sample

Data were drawn from the 1998 Survey of Innovative Practices administered by the Kauffman Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation, Ernst & Young LLP, and the Entrepreneur of the Year Institute. The survey is completed by companies selected from the membership of the Entrepreneur of the Year Institute. Companies completing the survey are sales-growth-oriented, as this is one of the judging criteria. Data gathered on the firms spanned the years 1995 through 1998. Details of the data gathering process are detailed in Survey of Innovative Practices (Cox and Camp 1999).

Sample Selection. There is a lack of consensus regarding how much ownership is necessary to qualify a firm as a family business. Ward and Dolan (1998) suggest that ownership be measured by voting power, as it is a better indicator of "family business behavior and structure than relative economic interest." Chua, Chrisman, and Sharma (1999) state that there is no specific delineation of how much ownership is necessary to qualify the firm as a family business. Ward (1986), however, defines control by percent ownership of stock with 50 percent ownership considered in control for privately held firms and 30 percent for publicly held firms. Following this categorization, family ownership was determined by the percent of stock that was held by the CEO or CEO's family members. Those that were greater than 50 percent were included in the sample. Furthermore, in order to focus on SMEs, only those organizations with less than 500 employees were included. Finally, the sample was split into thirds based on performance and the middle group was dropped. This resulted in a sample of 168 family-owned firms.

Variables

Importance of HR Function. In order to determine the importance placed on each function, the respondents were asked how their ability to manage the function impacted the growth of the firm. This perceptual question was reported on a five-point Likert scale with anchors of no impact (1) to big impact (5). Four items were asked to assess the importance placed on the different HRM functions: training and development, appraising employee performance, maintaining morale, and setting competitive compensation levels. A fifth question dealt with the recruitment package as it focused specifically on how designing competitive compensation impacted the firm's ability to recruit and retain key employees.

Compensation Design. The respondents were asked to provide the actual percentage of compensation expense broken down by base salaries, cash incentives, noncash incentives, and benefits/perks with the total to equal 100 percent. They did this a total of four times, once for each of the following: total employee compensation, CEO compensation, key sales managers, and other key managers.

Performance. Within entrepreneurship literature, sales growth is considered the best growth measure because it reflects both short and long-term changes in the firm, is easily obtainable, and is a common performance indicator among entrepreneurs themselves (Barkham et al. 1996; Hoy, McDougall, and Dsouza 1992). Davidsson and Wiklund (2000) provide an in-depth analysis of growth measures in research and advocate sales growth as the performance indicator of choice when examining activities such as HRM. However, the traditional measure of growth: g = ([S.sub.t1] - [S.sub.0])/[S.sub.t0] is biased toward initial size of the firm. The bias is in favor of firms that initially had a smaller size. To overcome this bias, the Sales Growth Index was used. This is calculated by multiplying the average annual increase in sales volume by the average rate of change in sales revenue. Cox and Camp (1999) note that the sales growth index is not biased toward either initially large or small firms and represent a better measure of entrepreneurial growth. In order to best represent differences in performance, the sample was split into thirds with the top third representing the high performing firms, and the bottom third representing the low performing firms.

Results

As illustrated in Table 1, the high performing firms were about the same age as the low performing firms, and were larger as measured by sales and report about the same CEO tenure. The average age of the firms were similar; with the high performing group being an average of 23 years and the low performing 26 years old. Although the average sales of the high performing firms is much higher than that of the low performing firms, the use of the sales growth index minimizes the size differential. The tenure of the CEO in the high performing firms (13.5 years) was slightly shorter than that of the low performing firms (14.9 years). Low performing firms pay out significantly more in base salary (p < .001) to total employees than high performing firms. Results for the variables of interest are reported further.

The hypothesized relationships of interest were tested using LOGIT regression. To test H1 through H5, each of the HRM practices was used as an independent variable and performance was used as the dependent variable. The results for these regressions can be found in Table 2. H1, the relationship of training and development with performance, was supported. Thus, high performing firms placed more importance on training and development than did low performing firms. H2 was supported as the relationship between the importance placed on performance appraisals and performance was significant. The relationship of designing competitive compensation for recruitment and performance (H3) was supported. This would suggest that placing emphasis on designing competitive compensation in recruiting is more common for high performing firms. H4 was supported, as the impact of maintaining morale was significantly different for high and low performing firms. Thus, higher performing firms placed more emphasis on maintaining morale in their organization than did low performing firms. Finally, H5 was supported, as the importance placed on setting competitive compensation levels was greater for those organizations that were high performers.

To test H6 through H8, LOGIT was also used with the same dependent variable of performance. However, in this case, each hypothesis was tested four times, one for each particular set of employees that was examined. Thus, the impact of percentage of incentives on performance was examined four times: (1) CEO, (2) sales managers, (3) other key managers, and (4) total employees. This was repeated for cash incentives, noncash incentives, and benefits/perks. The results can be found in Table 3. H6, which examined cash incentives, was supported across all four groups. Thus, the use of cash incentives for all levels of the organization was significantly related to higher performing firms. H7 and H8, the examination of noncash incentives and benefits and perks with performance, was not supported. Across all four sets of employees the use of both noncash incentives (H7) and benefits and perks (H8) was not significantly related to performance.

Discussion

Based on previous human resource research, we hypothesized that five critical human resource practices would be positively related to performance in family-owned firms. Our findings revealed that importance placed on each of these five human resource issues--training and development, performance appraisals, recruitment package, maintaining morale, and setting competitive compensation levels--were all areas in which high performing family firms placed significantly greater importance than low performing family firms. These findings suggest that these human resource activities do in fact have a positive impact on performance.

These findings are consistent with existing research of several national surveys in which family firms identified recruiting and training and development as two HRM areas of critical importance to business success (Hoover and Hoover 1999). High performing family firms are significantly more likely to recognize and prioritize these areas. Further, this is consistent with research of large organizations, which has shown that these human resource practices are critical to organizational success (Huselid 1995). This research extends previous research by demonstrating that these previous findings hold for family-owned SMEs.

The second aspect of our study examined the design of compensation structures and their impact on performance for family-owned SMEs. Across four different levels of the organization (CEO, key managers, sales managers, and total employees) the results supported the importance of using cash incentive-based forms of compensation. However, the results did not support the use of noncash incentives, and benefits and perks. Thus, this research would suggest that in family-owned SMEs, cash incentives in compensation across all levels of employees might well lead to higher performance.

While nonfamily firms may use equity to recruit, retain and motivate employees, family businesses are prone to keep stock within the family. Therefore, they must devise other ways to reward high-performing managers. According to this research, high performing family firms are effectively rewarding employees with cash incentives.

The current research provides a number of contributions to the existing research relating human resources and family-owned firms. First, the clear need to address human resource issues in family firms is addressed by providing an empirical examination of these issues on performance (Upton and Heck 1997). Second, a range of human resource functions is considered providing a rich perspective of the relationship of HRM practices and performance in family-owned firms. Finally, by looking at three different forms of incentive pay and across four different levels of the organization, we get a broad picture of the extent to which the use of cash incentives is critical for company success.

As with all research there are also some limitations of the current study. First, we used single item measures of the HRM practices which may not have captured the many facets involved in each of the practices. Second, the sample is one of convenience: fast-growth SMEs. As such, the findings may not be generalized to all family firms or all SMEs. However, for those SMEs that hold fast growth as a strategic goal, these findings may be of some benefit. Third, family firms may pursue different goals than nonfamily firms (Greenwald and Associates 1993/1995). However, in this sample, all the firms are sales-growth-oriented. These findings may not generalize to family firms that are pursing other growth goals.

Future Research

Future research needs to focus on determining what specific activities are associated with the HRM areas identified and how those specific activities impact performance. Reid and Adams (2001) reported that although nonfamily and family businesses believe training and development is their most important challenge, family businesses spent less on this. It would be interesting to see if training and development expenditures are significantly different between high and low performing family businesses as previous research has found a link between development expenditures and performance, influenced by ownership structure (Hill and Snell 1989). Further, development of higher-order variables or clusters of human resource variables, which may serve as discriminators between high and low performing organizations, warrant future attention.

Another avenue for future research is to examine how high performing family firms disburse base salary as compared to cash incentives. We do not know if there is a "family effect" going on in which lower base salaries and higher cash incentives are distributed. In other words, are low performing firms paying family members differently than high performing firms? If so, what effect is this having on performance?

In conclusion, human resource management is a complex set of activities that are enacted within the organization to support overall corporate strategies. Our study is focused on a sample of high and low performing family SMEs. While we examine several HRM practices, it may be that some are more effective than others within certain industries or corporate strategies. That said, by placing importance on the human resource aspect of the firm, a family-owned SME might be able to effectively use HRM such that it has a positive impact on performance.

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Dawn Carlson is associate professor of management, Hankamer School of Business, Baylor University.

Dr. Upton is employed in her family oil and gas business as president and chief operating officer.

Dr. Seaman is professor of decision sciences, Graziadio School of Business & Management, Pepperdine University.

Address correspondence to: Dawn Carlson, One Bear Place #98006, Department of Management, Baylor University, Waco, TX 76798. E-mail: Dawn_Carlson@baylor.edu.

Table 1 Descriptive and Summary Statistics

                Low Performing              High Performing
Variable     Mean           S.D.           Mean           S.D.

Age of Firm          25.89          17.54          23.34           17.56
  (Years)
Tenure of            14.91          10.18          13.52            9.53
  CEO
  (Years)
Sales ($)    12,841,627     19,299,011     52,054,709      53,898,578
Sales        -2,410,194     21,688,954     59,378,824     389,158,093
  Growth
  Index
  ($)

Table 2 Logit Regressions to Determine If Human Resource Management
Practice Impact Performance

Intercept        1.39**    1.28***   1.09*     1.35*     1.44**

Training and     -0.34**
  Development    (0.0471)
Performance                -0.36**
  Appraisals               (0.0129)
Recruitment                          -0.28*
  Package                            (0.0812)
Maintain Morale                                -0.31*
                                               (0.0910)
Competitive                                              -0.36**
  Compensation                                           (0.0478)

(a) Estimated coefficients are listed first; p-values below in
parentheses.
*indicates significance at the ten-percent level.
**indicates significance at the five-percent level.
***indicates significance at the one-percent level.

Table 3 Logit Regressions to Determine If Compensation Design Impacts
Performance

A. Cash Incentives
Intercept               0.46**            0.23
CEO                    -0.02 (0.0104)**
Key Managers                             -0.02 (0.0648)*
Other Managers
Total Employees

B. Noncash Incentives
Intercept               0.08              0.03
CEO                     0.00 (0.8743)
Key Managers                             -0.09 (0.1424)
Other Managers
Total Employees

C. Benefits and Perks
Intercept              -0.08              0.00
CEO                     0.01 (0.2016)
Key Managers                             -0.01 (0.4437)
Other Managers
Total Employees

A. Cash Incentives
Intercept               0.46*              0.43*
CEO
Key Managers
Other Managers         -0.04 (0.0076)***
Total Employees                           -0.04 (0.0065)***

B. Noncash Incentives
Intercept               0.06               0.04
CEO
Key Managers
Other Managers          0.00 (0.9433)
Total Employees                           -0.04 (0.4508)

C. Benefits and Perks
Intercept              -0.23               0.08
CEO
Key Managers
Other Managers          0.02 (0.3022)
Total Employees                           -0.01 (0.6058)
(a) Estimated coefficients are listed first; p-values in parentheses.
*indicates significance at the ten-percent level.
**indicates significance at the five-percent level.
***indicates significance at the one-percent level.