Compensation: Breaking down the concept

If you pick the right people and give them the opportunity to spread their wings - and put compensation
and rewards as a carrier behind it - you almost don’t have to manage them.”— Jack Welch

Most of us would have heard the term “compensation” in the context of getting paid for the work that
we do. The work can be as part of full time engagement or part time in nature. What is common to them
is that the “reward” that we get for expending our energy not to mention the time is that we are
compensated for it.

From the perspective of the employers, the money that they pay to the employees in return for the work
that they do is something that they need to plan for in an elaborate and systematic manner. Unless the
employer and the employee are in broad agreement (We use the term broad agreement as in many
cases, significant differences in perception about the employee’s worth exist between the two sides), the
net result is dissatisfaction from the employee’s perspective and friction in the relationship.

It can be said that compensation is the “glue” that binds the employee and the employer together and in
the organized sector, this is further codified in the form of a contract or a mutually binding legal
document that spells out exactly how much should be paid to the employee and the components of the
compensation package. Since, this portion is intended to be an introduction to compensation
management, the art and science of arriving at the right compensation makes all the difference between
a satisfied employee and a disgruntled employee.

How people view the compensation affects how they behave. It does not mean the same thing to
everyone. The needs of human beings are quite diversified and variable in nature. There are certain
theories about human needs, which consider and classify these needs in different levels ranging from
lower to higher order. Some of the most important theories include:

Maslow’s hierarchy of needs:

Abraham Maslow classified human needs into a hierarchy and indicated that these needs range in
definite order from the most essential for survival to the least important. He identified five levels of
needs in his hierarchy

1. Physiological needs (Air, water, good health, avoidance of pain, rest)

2. Safety/Security needs ( Personal, financial, well-being, health, against accident)
3. Social needs (Friendship, family, Love, belongingness, intimacy)
4. Esteem needs (Confidence, achievement, respect)
5. Self-actualization needs (Morality, creativity, leadership, problem solving)
This theory is represented by an inverted pyramid at the lower end of which lies low order needs
(Money, fame, dominance) and goes on increasing in levels (creativity, social needs, leadership) as we
move up the pyramid. Though Maslow’s Need Hierarchy Theory talks about compensation being at the
middle to lower rung of the pyramid and the other factors like job satisfaction and fulfilment being at the
top, for a majority of employees, getting the right compensation is by itself a motivating factor. Hence,
employers need to quantify the employee’s contribution in a proper manner if they are to get the best
out of the employee.

Douglas McGregor’s Theory X and Y:

In his 1960 book, The Human Side of Enterprise, Douglas McGregor proposed two theories by which to
view employee motivation. He avoided descriptive labels and simply called the theories Theory X and
Theory Y. Both of these theories begin with the premise that management's role is to assemble the
factors of production, including people, for the economic benefit of the firm. Beyond this point, the two
theories of management diverge.

Theory X
Theory X assumes that the average person:

 Dislikes work and attempts to avoid it.

 Has no ambition, wants no responsibility, and would rather follow than lead.
 Is self-centered and therefore does not care about organizational goals.
 Resists change. Is gullible and not particularly intelligent.
 Essentially, Theory X assumes that people work only for money and security.

Theory Y
Douglas McGregor argues that when a need is satisfied it no longer motivates. People working for low
order needs such as money are no longer motivated when this need is satisfied and they just seem to get
by and look busy in an organization. The higher-level needs of esteem and self-actualization are
continuing needs in that they are never completely satisfied. As such, it is these higher-level needs
through which employees can best be motivated.

Theory Y makes the following general assumptions:

 Work can be as natural as play and rest.

 People will be self-directed to meet their work objectives if they are committed to them.
 People will be committed to their objectives if rewards are in place that address higher needs
such as self-fulfillment.
 Under these conditions, people will seek responsibility.
 Most people can handle responsibility because creativity and ingenuity are common in the
population.

Expectancy Theory
Victor Vroom of Yale University proposed expectancy theory. This theory emphasizes the needs for
organizations to relate rewards directly to performance and to ensure that the rewards provided are
deserved and wanted by the recipients. Vroom introduces three variables within the expectancy theory,
which are:
Expectancy Refers to the strength of a person’s belief about whether or not a particular job
performance is attainable

Instrumentality A belief that if you perform well, a valued outcome will be received. This reward may
come in the form of a pay increase, promotion, recognition or sense of accomplishment

Valence It refers to the emotional orientations, which people hold with respect to rewards. The depth
of the want of an employee for extrinsic (money, promotion, free time, benefits) or intrinsic (satisfaction,
recognition, feedback) rewards.

Management must discover what employees appreciate. For the valence to be positive, the person must
prefer attaining the outcome to not attaining it.

Hertzberg’s Motivation/Hygiene Theory

Hertzberg’s motivation, hygiene theory that is another motivational theory refers to two factors
“Motivators” and “Hygiene” causing satisfaction and dissatisfaction on the job. Motivator factors comes
inside of the job such as style of supervision, company’s policy, leadership, job itself etc. While, hygiene
factors comes from outside the job such as rewards, job location, compensation plans etc. The hygiene
factors are necessary to be maintained at every cost to ensure that the employees are not dissatisfied.

 These factors alone do not contribute to “quantum” jumps in employee satisfaction. Rather, the
absence of these factors makes employees dissatisfied.

 The point here is that if a fair and just compensation is provided, the employee has the
“baseline” requirements met which ensures that he or she is now in a position to go for higher
things like job satisfaction and fulfilment.

 However, if compensation is found to be lacking, the employee might very well be unhappy and
dissatisfied with the company leading to attrition and other such negative outcomes.

 Hence, having the right compensation is the first step in getting the best of employees.

There are myriad other theories about motivation and how it works in relation with the employee’s
performance on the job whether monetary or non-monetary terms. The point to take home is that
motivation in a variety of situations is directly linked with compensation. The amount of money a worker
receive at the completion of what is expected of him/her determines the performance and quality of
work.

The provision of monetary value in exchange for work performed forms the basis of compensation and
how this is managed using processes, procedures and systems form the basis of compensation
management.

As the module progresses, readers would be introduced to other aspects of compensation management
like the components of compensation management, types of compensation, inclusion of variable pay,
the use of Employee Stock Options etc. The aspect of how skewed compensation management leads to
higher attrition is discussed as well. This aspect is important, as studies have shown that a majority of
the employees who quit companies give inadequate or skewed compensation as the reason for their
exit. Hence, compensation management is something that companies must take seriously if they are to
achieve a competitive advantage in the market for talent.

Perspectives about Compensation

As it is mentioned earlier compensation is not viewed as the same thing by everyone, so there are a
variety of perspectives about compensation. Some perspectives are mentioned below:

Society
Society views compensation as a measure of justice. They assert on equitable not equal pay standards.
For instance, comparison of earnings between men and women highlights what many consider
inequities in pay decisions. The gender pay gap in the United States after adjustment for difference in
education, experience, and occupation narrowed down from 36 percent in 1980 to 13 percent in 2006.
There are however, certain variations as well. For people age 21 to 35 who live alone and have no
children, this gap is close to zero but, it is a very small segment of the labor force. Evidences show that
this gap however, persists.

Benefits an employee receives as part of the compensation package is also seemed as a reflection of
justice in the society. Almost 46 million in the United States do not have health insurance, eighty percent
of these are employees working in small businesses.

Some attributes job losses or gains in the society to differences in compensation. People in the United
States complain about losing manufacturing jobs to Mexico, China, and other nations where the wage
rate is low and companies has outsourced to lower their labor costs for production purposes.

There is however, a consumer side to this whole picture and increasing wage rates means increase in
prices for a consumer, hence they do not believe that high labor costs benefit them.

Stockholders
Stockholders are also interested in how employees are paid. Some believe that using stocks to pay
employees create a sense of ownership that will improve performance, which will in turn increase
stockholder’s wealth, but others argue that granting employees too much ownership dilutes
stockholder’s wealth. Google’s stock plan cost the company $600 million in its first year of operations.
Therefore, people who buy Google’s stock are betting that this amount will motivate employees to
generate more than $600 million in extra revenues.

Stockholders are interested in executive pay. Linking executive pay to company’s performance is
supposed to increase stockholder’s returns. Unfortunately, this does not always happen. See the
following exhibit and try to contemplate how stockholder’s returns are related to the change in executive
pay at a few companies in recent years like Verizon, Gap, Whole Foods, Pfizer, McGraw-Hill, Texas
Instruments etc.
 IV I
Stock Fell Stock Rose
CEO’s Pay Rose CEO’s Pay Rose

III II
Stock Fell Stock Rose
CEO’s Pay Fell CEO’s Pay Fell

Managers
For Managers, compensation influences their success in two ways. First, it is a major expense.
Competitive pressures, both global and local, force managers to consider the affordability of their
compensation decisions. Labor costs can account for almost 50 percent of the total cost in some
industries. In other industries, such as financial, professional and educational services this figure is even
higher. However, even within an industry, labor costs as a percent of total cost vary among individual
firms.

Beyond treating pay as an expense, a manager also uses it to influence the behavior of an employee and
to improve the organizational performance. The way people are paid affects the quality of their work,
their attitudes towards customers, their willingness to be flexible, to learn new skills, and suggest
innovations. On the other hand, workers may become interested in unions or legal actions against their
employers based on how they are paid.

Employees
The pay individuals receive in return for the work they perform is usually the major source of their
financial security. Hence, pay plays a vital role in a person’s economic and social well-being. Employees
may see compensation as a return in an exchange between their employer and themselves, as an
entitlement for being an employee of the company or as a reward for the job well done. Describing
compensation as a reward may sound farfetched to anyone who has reluctantly rolled out of bed to go
to work. So, if an employee sees the compensation as a reward is open to questions.

Global views about Compensation

In English Compensation means something that counterbalances, offsets, or makes up for something
else. However, if we look at the origin of the work in different languages we get a sense of richness of the
meaning, which combines entitlement, return and reward, therefore, compensation refers to all forms of
financial returns, tangible services and benefits employees receive as part of an employment contract .
 Forms of Pay
Consider the following diagram first, to better understand this topic.

Total Returns

Total Compensation Relational Benefits

Recognition

Cash Employment security

Benefits
Compensation

Challenging work
Base Income Protection

Merit/Cost of living Learning opportunities

Work/life balance

Short-term Incentives

Allowances
Long-term Incentives

Base Pay
A cash compensation that an employer pays for the work performed. For instance, the base pay or base
wage for a machine operator is $20 per hour. However, some individual receive comparatively more
because of their extra skills, experience, and performance on the job. This pay system is common for
engineers and teachers (visiting faculty members). A distinction is often made in the United States
between wage and Salary, Salary refers to pay for employees who are exempt from regulation of the Fair
Labor Standards Act (FLSA) and hence do not receive overtime pay. Managers and professionals usually
fits this category. Their pay is calculated on monthly basis, rather than hourly or daily basis.
Merit Pay/ Cost of Living Adjustments
Periodic adjustments to the base wages may be made based on changes in what other employers are
paying for the same work, changes in the overall cost of living, or changes in experiences and skills. Merit
increases are given as increments to the base pay in recognition of past work behavior. According to
surveys, 90 percent of the firms use merit pay increases. Some assessment of past performance is made,
or even without a formal performance evaluation program, and the size of the increase is varied with
performance. Thus, outstanding performers could receive a 6 to 8 percent merit increase 8 months after
their last increase normally. This rate however, varies from organization to organization. In contrast to
merit pay, cost of living adjustments give the same increase to everyone, regardless of performance.

Incentives
Incentives tie pay increases directly to performance. However, incentives differ from merit adjustments.
First, incentives do not increase the base wage, and so must be re-earned each pay period. Second, the
potential size of the incentive payment will generally be known beforehand. Whereas merit pay
programs evaluate past performance of an employee and then decide on the size of the increase.
Incentives can be tied to individual performance, team performance, a total business unit, or some
combination of all. The main objective is to influence performance, future behavior, customer
satisfaction, revenue growth, ROI and increase in stock value. The possibilities are endless. Incentives can
both be for short term and long-term i-e ranging up to years to create a sense of ownership in employee
and to make him feel interested in the long-term health of organization.

Benefits
Income Protection
Compensation package also includes benefits as shown in the figure. Some income protection programs
are legally required such as investing into a fund that provides income replacement for workers who
become disabled or unemployed. There is a variety of income protection programs like medical
insurance, retirement programs, life insurance, saving plans etc., the companies provide these benefits
cheaper than the employees can obtain them for themselves.

Work/Life Balance
Programs that help employees better integrate their work and life responsibilities include time away
from work such as vacations, access to services to meet specific needs like drug counseling, financial
planning, referral, child or elder care etc. Flexible work arrangements, time offs and responding to the
changing demographics of the work force are important steps taken by any organization that seeks to
provide resources to mind, heart, spirit and body.
Allowances
Allowances often grow out of whatever is in short supply. In Vietnam and China, housing and
transportation allowances are frequently part of pay package. Sixty years after the end of World War 2—
induced food shortages, some Japanese companies still continue to offer a “Rice allowance” to its
employees. There are different form of allowances, such as communication allowance, advance salary
allowance, hard area allowance etc.

Considering that the current trend in many sectors (particularly the knowledge intensive sectors like IT
and Services) is to treat the employees as “creators and drivers of value” rather than one more factor of
production, companies around the world are paying close attention to how much they pay, the kind of
components that this pay includes and whether they are offering competitive compensation to attract
the best talent. In concluding this discussion, it is pertinent to take a look at what Jack Welch had to say
in this regard: As the quote (mentioned at the beginning of this article) says, if the right compensation
along with the right kind of opportunities are made available to people by the firms in which they work,
then work becomes a pleasure and the manager’s task made simpler leading to all round benefits for the
employee as well as the employer. The topic of compensation management and the “right” kind of
compensation goes a long way in making employees motivated and happier.

If we take a look at the components of a compensation system, we find that employers decide on what is
the right compensation after taking into account the following points.

1. The Job Description of the employee that specifies how much should be paid and the parts of
the compensation package.

a. The Job Description is further made up of responsibilities, functions, duties, location of

the job and the other factors like environment etc.

b. These elements of the job description are taken individually to arrive at the basic
compensation along with the other components like benefits, variable pay and bonus.

 It needs to be remembered that the HRA or the House Rental Allowance is

determined by a mix of factors that includes the location of the employee and
governmental policies along with the grade of the employee.

 Hence, it is common to find a minimum level of HRA that is common to all the
employees and which increases in proportion to the factors mentioned above.

2. The Job Evaluation that is a system for arriving at the net worth of employees based on
comparison with appropriate compensation levels for comparable jobs across the industry as
well as within the company.

a. Factors like Experience, Qualifications, Expertise and Need of the company determine
how much the employer is willing to pay for the employee.

3. It is often the case that employers compare the jobs across the industry and arrive at a particular
compensation after taking into account the specific needs of their firm and in this respect salary
surveys and research results done by market research firms as to how much different companies
in the same industry are paying for similar roles.
The components of compensation that have been discussed above are the base requirements for any HR
Manager who is in charge of fixing the compensation for potential employees.

There are other variables as well that would be discussed later on. Here we introduced several concepts
around the topic of components of compensation and these concepts are crucial for HR professionals as
well as those aspiring management professionals who want to make a career in the corporate world.

Before concluding, it needs to be remembered that exit interviews have shown that over 70% of
employees who quit their jobs do so because they are dissatisfied with the compensation that they are
getting. Hence, all HR professionals and managers must take this aspect into account when they
determine the compensation to be paid to employees

In this part, we shall look at some components of compensation like Basic and Variable Pay (including the
sub-components of variable pay) and discuss how these are fixed by the firms when they sign off on the
compensation packages to their employees.

To take the first component that is common to all packages at all levels (hence the term basic - however,
it is not the same for all levels).

 Basic pay is the base on which the compensation package rests. This is the equivalent of the
base of the pyramid and the other components are usually fixed as a percentage of the basic
pay. It is common to find components like HRA (House Rental Allowance) and Additional Pay as a
certain percentage (say 20% or 30%) of the Basic.

 There are many companies that have introduced the concept of Variable Pay where this
particular component of the compensation is not fixed, but is a percentage of the Basic that is
paid out according to the performance of the company, group and the individual. Hence, the
term performance linked pay is also used for variable pay.

If we take the three sub-components of the Variable Pay -

a. The company performance linked pay is as the term implies paid out as a percentage of
the Basic that is tied to the performance of the company as a whole. So, if a company
performs exceedingly well in the given quarter, then the employee might get a large
percentage (say 100% or 150%) of the base of the component. If a company does do not
well or does only moderately better, then the employee might get a lower percentage of
the base (say 50% or 75%).

b. The group performance linked pay is paid out in a similar manner but the point of
reference in this case is the performance of the group or the division in which the
employee works.

c. Finally, the most important sub-component is the Individual Performance Linked Pay
that is paid out according to the performance of the employee and hence is entirely tied
to the way in which the employee performs as determined by the rating that he or she
gets at the end of the performance cycle.

The rationale for these components is that an employee would be better motivated to perform
individually, contribute to the group to which he or she belongs and finally, perform well keeping in view
the overall growth of the company. Hence, these sub components of compensation have been designed
to spur the employee to excel not only in an individual capacity but as a team member and finally, a
responsible employee of the company. The idea here is to discourage silo-based performance and
instead concentrate on all round performance.

Factors Affecting Compensation

In the previous sections, we looked at the components of the compensation and how each is used to
assess the relative importance of an employee as far as remuneration is concerned. In this article, we
look at some of the factors that determine how much compensation is to be paid out to the employee by
looking at the issue from the perspective of the employer. The subsequent article would take a look at
how the employee can influence the compensation setting process with negotiation and bargaining.

From the perspective of the employer, the factors that affect compensation are:

 The Overall Macroeconomic situation where in the state of the economy of the country in which
the firm is situated plays a major role in determining the compensation to be paid. For instance,
if an economy is booming or is in a high growth trajectory, chances are that the employers would
pay the employees more and conversely, if the economy is in a downward trajectory, chances are
that the employers would pay the employees less. We often hear about how because of the
recession, salary hikes have been deferred or cut down. This is a direct result of the linkage
between firm performance and the performance of the economy.

 The Demand for a particular skill weighs heavily on the way in which the employer fixes the
compensation for the employee. For instance, premium skills like Consulting and Accountancy
are paid more as are the Technology Professionals who might be experts in their chosen field. As
discussed in earlier articles, it is the expertise and the relative scarcity of such experts that
determines how much the employer is willing to pay.

 The Position of the company in the Business Cycle often determines how much the company is
willing to offer to the employee. For instance, if a company is a start-up, chances are that the
company would pay more because of the need to get the best possible talent into the company.
Further, many start-ups give their employees ESOP’s or Employee Stock Option Plans wherein
the employees can redeem their stocks after the lock-in period.

 Finally, the urgency of the firm in filling up the position plays an important role in determining
how much the employer is willing to pay the employee and in many cases, if the time to get on
board the employee is less, staffing managers along with the line manager in charge of hiring the
employee might decide to pay more because they want the employee to come on board as
quickly as possible.

These are some of the factors that determine the compensation to be paid to the employee from the
perspective of the employer. This is not an exhaustive list but an indicative one and as the module
progresses, we shall be revisiting some of these factors along with adding additional information. The
next article would talk about how employees can negotiate with the employer for better compensation
and perks. Of course, there are several kinds of negotiation with the employer. For instance, the
employee can negotiate at the time of the hiring process or can negotiate at the time of the appraisal
cycle. In this article, we consider the strategies available to the employee at the time of the hiring
process.

There are several parts to the employee’s strategy to negotiate with the employer. Some of them are:

 Plan and Communicate: The most important part of the employee’s strategy must be to
research the compensation trends in the market and then negotiate with the employer based on
how much the other companies are willing to pay for a similar role combined with the fact that
the company hiring him or her pays for the same role. Hence, it is advisable for the employee to
keep in touch with compensation trends in the marketplace and also talk to other employees
before he or she decides to communicate his or her expectations to the prospective employer.

 Timing makes the difference: In any negotiation process, time is the key element and hence
timing the negotiation process is important. The best possible option for the employee would be
to wait for the company to make an offer and then pitch in his or her expectations about the
compensation. There is something called overkill, which must be avoided, and the employee
must avoid going overboard. At the same time, the employee must also ensure that he or she
does not start the negotiation process early on in order not to miss the offer. Hence, the timing
of the pitch makes all the difference.

 Consider the Alternatives: When you are deciding about prospective offers, ensure that you
make the pitch for your expected compensation level after taking into account all the
alternatives and not simply rush into something that does not value your experience and
expertise adequately. At the same time, do not harangue the prospective employers though you
might have several alternatives available to you. The point to be noted is that different
companies react to compensation negotiations in different ways and hence you must play the
field according to these points.

Many a time, prospective employees missed compensation either because they asked too high or asked
too late. At the same time, they should also remember not to coerce the employers. The best possible
strategy is where you are confident about yourself and your worth as measured by the employer must
reflect your own sense of self-worth. When there is a meeting point between these, then you can rest
assured that you have arrived at the ideal compensation for yourself.

Negotiation in Compensation Management

It is impossible to talk about compensation management without referring to the process of negotiation
and bargaining that is an integral part of compensation management. As anybody who has worked in the
formal or even the informal sector knows, the process of negotiating one’s salary and perks are
fundamental to the process of hiring and selection. In this article, we look at some of the strategies
employed by professionals’ world over when they negotiate with their prospective employers regarding
their compensation.

Have a Plan in Place

The first element of negotiation is to plan for the process by deciding on how much more you want and
how much you think the employer is willing to give. The fine art of knowing how much you should ask
for and at what point should you strike the deal is something that experienced professionals know and
rookies should learn. Without having a clear idea of the target level of compensation that you are aiming
for, the negotiation process would turn out to be an exercise in futility.

Communicate Your Needs

Once you have arrived at a figure that you think you deserve, the next step is to communicate the same
to the prospective employer immediately. The important point to note here is that the way in which you
articulate your needs is as important as the need to drive a bargain. For instance, without expressing
yourself clearly to the HR manager of the prospective employer, there is little chance that he or she
would understand your needs and respond appropriately. Hence, once you have sorted out the target
compensation that you want, you should also have a strategy to communicate it to the employer.

Timing is everything

You need to remember that there is something called being too early when you negotiate and too late as
well. Hence, the timing of your articulation forms the basis for a successful negotiation. For instance, if
you start your demands early on in the hiring process, the prospective employer might stall the process
or even put a stop to your hiring. On the other hand, if you put forward your demands as you are about
to join the firm, there is precious little anyone can do about your demands. Hence, you should have a
keen eye for when you should communicate your demands.

The three aspects of having a plan, communicating the need and then timing it in such a way as to derive
maximum advantage are essential to the negotiation process. Of course, there are many firms that do
not entertain any sort of negotiation and there are firms that put up pretence of negotiation when in
reality, they do not budge at all. In these cases, it is better to adopt a wait and watch policy and make
your move once they get into the details of your compensation.

In conclusion, a successful negotiation hinges on the willingness of both the parties to hear each other
and an ability to arrive at a common denominator in a spirit of accommodation. Hence, do not be
overtly rigid and at the same time do not give in to the employer totally.

Pay model
The pay model shown in the following exhibit serves as both a framework for examining current pay
systems and as a guide. It contains three basic building blocks.

1. The compensation objectives

2. The policies that form the foundation of the compensation system
3. The techniques that make up a compensation system
 POLICIES TECHNIQUES OBJECTIVES

Work Analysis, Descriptions,

Alignment
Evaluation/Certification, Internal Structure

EFFICIENCY

 Performance
 Quality
Market Definition, Surveys, Policy lines, Pay  Customer and
Competitiveness
structures Stockholders value
 Cost

FAIRNESS

Seniority based, Performance based, Merit

Contributions
guidelines, Incentive programs

COMPLIANCE

‘
Management Cost, Communication, Change, Evaluation
Compensation Objectives
Pay systems are designed to achieve certain objectives. The basic objectives, shown at the right side of
the model, include efficiency, fairness and compliance with laws and regulations.

Efficiency
Traditionally efficiency refers to producing more with the minimum use of resources. It can be stated
more specifically as:

1. Improving performance, increasing quality, delighting customers and stockholders

2. Controlling labour costs

The perspective differs from company to company and business to business, these perspectives are
deeply ingrained in the strategies of a company. Some companies emphasize on improving
performance and minimizing their business costs, others put their efforts in commitment to offering
something extra, special and unique to their customers regardless of how cost intervenes in the
whole process. Some companies have a major concern for increasing shareholder’s value. Thus, the
objective of compensation depends upon the perspective and positioning of an organization.

Fairness
Fairness is another fundamental objective of pay system. In some companies, the term “Fairness” means
to ensure fair treatment, others might see the objective of fairness to recognize personal and family well-
being. Pay objectives in some companies is discussed as a “shared fate”, they link the compensation
process to the performance of teams and employees have some say about who is on their team. The
fairness objective calls for fair treatment for all employees by recognizing both employee contributions
(higher pay for greater performance, experience, and training) and employee needs (fair wage as well as
fair procedure). Procedural fairness refers to the process used to make pay decisions. It suggests that the
way pay decisions are made may be as important to employees as the results of the decision.

Compliance
Compliance as a pay objective means conforming to federal and state compensation laws and
regulations. If laws change, pay systems may need to change, too, to ensure the continued compliance.
In case of global companies, they should comply with the laws of all countries in which they operate.

Objectives serve several purposes. First, they guide the design of the pay system. If an objective is to
increase customer’s satisfaction, then incentive programs and merit pay might be used to pay for
performance. Another employer’s objective may be to develop innovative new products. Job design,
training and team building may be used to reach this objective. The pay system aligned to this objective
may include salaries that are at least equal to those of competitors and that go up with increased skills
and knowledge (internal alignment).
Ethics
Asian philosophy of Yin and Yang has given us an insight about compensation and its objectives which
entails that all the three objectives of a compensation plan must be achieved simultaneously. It is not
efficiency, or fairness or compliance alone. The tension of working toward all the objectives at the same
time creates a fertile ground for ethical dilemmas.

Ethics means the organization cares about how its results are achieved. Scan the websites or lobby walls
of corporate headquarters and you will inevitably find statements of key behaviours, “our values”,
“Codes of conduct”. The challenge is to put these statements into daily practice. Managing pay systems
sometimes create ethical dilemmas. Manipulating results to ensure executive bonus pay-outs, misusing
statistics used to measure competitors pay rates, re-pricing or backdating stock options to increase their
value, encouraging employees to invest a portion of their wages in company stock while executives are
bailing out, offering just enough pay to get a new hire in the door while ignoring the relationship to co-
workers’ pay, and shaving the hours recorded in employee time cards are all too common examples of
ethical lapses.

Objectives, thus, guide the design of pay systems. They also serve as a standard for judging the success
of the pay system. If the objective is to attract and retain the best and the brightest, yet skilled
employees are leaving for higher paying jobs elsewhere, the system may not be working effectively.
Although there may be some non-pay reasons for turnover.

Four Policy Choices

Every organization must address the policy decisions shown on the left side of the pay model. These
policy decisions are:

1. Internal Alignment
2. External Competitiveness
3. Employee Contributions
4. Management of the Pay system

Internal Alignment
The term internal alignment refers to comparisons among jobs or skill levels inside a single organization.
Job and people skills are compared in terms of their relative contributions to the organization’s business
objectives. For instance, does the work of a programmer compare with the work of the systems analyst,
the software engineer and the software architect? Does one actor’s role require more knowledge or
experience than another’s does? Internal alignment pertains to the pay rates both for employees doing
equal work and for those doing dissimilar work. In fact, the main challenge to internal alignment are the
employees doing dissimilar work in the organization.

Pay relationships within the organization affect all the three compensation objectives. They affect
employee’s decisions to stay with the organization, to become more flexible by investing in additional
training, or to seek greater responsibility. By motivating employees to choose increased training and seek
greater responsibilities such as dealing effectively with a customer, internal alignment indirectly affects
the capabilities of the workforce and efficiency of the entire organization. Compliance is affected by the
basis used to make internal comparison. Paying based on race, gender, age or nationality is illegal in
United States.

External Competitiveness
External competitiveness means comparison of pay with the competitors. How much do we wish to pay
in comparison to what other organizations pay? In addition to how much to pay, external
competitiveness also includes pay mix. What mix of pay forms—base, incentives, stock, benefits do our
competitors use in comparison to pay mix we use.

Many organizations claim that their pay systems are market-driven, that is, based almost exclusively on
what competitors are paying. Market-driven is translated into practice in different ways. Some employers
may set their pay levels higher than their competition, hoping to attract the best applicants. Of course,
this assumes that someone is able to identify and hire the best from the pool of applicants. What is the
appropriate market? Should international pay rates be considered? Should the pay of software engineers
in New Delhi or Minsk influence pay for engineers in Silicon Valley or Boston?

External competitiveness has a twofold impact on the objectives of compensation. First to ensure that
the pay is sufficient to attract and retain employees? If employees do not perceive their pay system
competitive in comparison with other employers offering for similar work, they may be more likely to
leave. Secondly, to control labour costs so that the organization’s prices of products or services can
remain competitive in a global economy. Thus, external competitiveness directly affects both efficiency
and fairness, and it must do so in an ethical way that complies with relevant legislation.

Employee Contributions
How much emphasis should there be on paying for performance? Should one programmer be paid
differently from another if on has better performance and/or greater seniority? Or should there be a flat
rate for programmers? Should the company be sharing any profits with employees? Share with all, part-
time as well as full-time?

The emphasis to place on employee contributions is an important policy decision since it directly affects
employees’ attitudes and behaviours. Motorola use pay to support other “High performance” practices
in their workplace, use team-based pay and corporate profit sharing plans. Starbucks emphasizes stock
options and sharing the success of corporate performance with the employees. Performance based pay
affects the fairness in that employees need to understand the basis for judging performance in order to
believe that their pay is fair.

Management
A policy regarding management of the pay system is the last building block in our model. Management
means ensuring that the right people get the right pay for achieving the right objectives in a right way.
The greatest system designed in the world is useless without competent management. Managing
compensation means answering the “So what” question. For instance, so what is the impact of this
policy or technique? Managing pay systems in the organization is now covering more ground and goes
back to organizational strategic thinking. The concept of pay is shifting from expense to better
understanding and analysing the impact of this system on employee’s behaviour.
Strategy: The totality of decisions
Strategy refers to the fundamental directions that an organization chooses. It gives organizations ability
to trade off I-e choosing what to do and what not to. Secondly, strategy allows organizations to create a
fit among its primary and secondary activities and to position the company in a unique manner with
respect to its competitors in the industry. The ultimate objective of the strategy is to gain a competitive
advantage for an organization and sustain it. Strategy also brings compensation plans into the fold. At
the functional level, the strategic choice is that how, should a total compensation help this business gain
and sustain competitive advantage. Conventionally, the most popular strategic choice is to tailor
compensation system in such a manner that it aligns well with the organization’s overall business
strategy. The rationale behind it is based on contingency notions. The underlying premise is that the
greater the alignment or fit, between the organization and the compensation system, the more effective
the organization.

Developing Total Compensation Strategy: Four Steps

Developing total compensation strategy involves four simple steps, while the steps are simple, executing
them is a complex process on the other hand. Trial and error, experience, and insight play major role in
the process. One cannot deny the importance of research evidences while formulating and
implementing the process.

Step: 1 Assess Total Compensation Implications

Think about any organization’s past, present and future. What factors in its business environment have
contributed to the company’s success? Which of these factors are likely to become more or less
important as the organization moves forward? Some of the most common factors are:

Competitive Dynamics:
This step includes an understanding of the specific industry in which the organization operates and how
it plans to compete in that industry. Two important decisions are to be taken in account in this step.
What business should an organization be engaged in, and how to win in that business? Secondly, to cope
with the turbulent competitive dynamics, focus on what factors in the business environment, for
instance, changing customer needs, competitors’ actions, changing labour market conditions, changing
laws, globalization etc. are important today. What will be important in the future? What is the company’s
strategy? How does an organization compete to win? How should the compensation system support that
strategy?

Competitive dynamics can be assessed globally. However, comparing pay among nations is a complex
process. There are differences in hourly labour costs and productivity issues among countries, they also
differ on the average length of the workweek, the average number of paid holidays, the kinds of national
health care and retirement programs. Managers need to be knowledgeable about competitive
conditions both globally and locally.
Culture/Values
A pay system reflects the values that guide an employer’s behaviour and underlie its treatment of
employees. The pay system mirrors the company’s image and reputation. Most companies publish their
values statements on their web sites. Certain values statements represents the work/life balance
programs, security, incentive plans and stock ownership programs to share the company’s success and its
positive notions for employee’s wellbeing.

Social & Political Context

Context refers to a wide range of factors, including legal and regulatory requirements, cultural
differences, changing workforce demographics, expectations and the like. These also affects
compensation choices. Managers may find an increasingly diverse workforce and increasingly diverse
forms of pay. They need to add value through the compensation process, which is difficult for the
competitors to imitate.

Because governments are major stakeholders in determining compensation, lobbying to influence laws
and regulations can also be a part of a compensation strategy. Therefore, from a strategic perspective a
compensation manager may try to shape the socio-political environment as well as be shaped by it.

Employee Preferences
The simple fact that employee differ is too easily overlooked and taken for granted in formulating a
compensation strategy. Individual employees join the organization, make investment decisions, interact
with the customers, develop new products, assemble components and so on. Individual employee
receives the pay. A major challenge in the design of next generation pay system is how to better satisfy
individual needs and preferences.

Offering more choice is one approach. Older, highly paid workers may wish to defer taxes by putting their
pay into retirement funds, while younger employees may have high cash needs to buy a house, car,
support the family, or finance an education. Major proportions of the pay are also invested in childcare,
insurance plans, financial counselling and other benefits. Employees who have younger children or
dependent parents may desire dependent care coverage.

Contemporary pay systems in the United States do offer some choices to the employees. Flexible
benefits and choices among health care plans and investment funds for retirement are examples. Some
companies offer stock ownership and allow employees to swap their salaries for stock awards. The major
belief is that offering employees choices may add value and is difficult for other companies to imitate.
However, some people do not choose well quite often and too many choices simply confuse them. Thus,
the value added by offering choices and satisfying preferences may be offset by the expense of
communicating and simply confusing the employees.

Unlimited choices would be a challenge to design and manage. In addition, too many choices may result
in disapproval from the Govt. for instance, health benefits are not viewed by IRS as income. Offering
greater choices to employees in different nations would open a bewildering maze of codes and
regulations.
Union Preferences
Pay strategies need to be adapted to the nature of the union management relationship. The influence of
unions on pay system is significant. Union preferences for different forms of pay such as, protecting
retirement and health care plans and their concerns with the job security affect pay strategy. Union
preferences may differ, sometimes the pay systems are developed collaboratively with the unions such
as school teachers union, lawyer unions, fire-fighter unions etc. and the formulation of pay system is
subjected to the voting power of the unions.

Prominence of Pay in overall HR strategy

The pay strategy is also influenced by how it fits with other HR systems in the organization. If the
organization is decentralized and emphasizes flexibility, the centralized and confidential pay system
controlled by a few people in a corporate unit will not work. The importance of fit between pay and
other HR functions is illustrated in “High performance” systems. High performance systems generally
include three features

1. High skill/knowledge requirements

2. Work designed so that employee teams enjoy discretion in making decisions and continue to
learn
3. Pay systems based on performance

Pay can be a supporting player, as in the high-performance approach, or it can take the lead and tend to
be a catalyst for change. Whatever the role compensation is embedded in the total HR approach.

Step 2: Mapping total compensation strategy

The compensation strategy is made up of the elements in the pay model: Objectives, and the four policy
choices of alignment, competitiveness, contributions and management. Mapping these decisions is step
two in developing compensation strategy.

Mapping is often used in marketing to clarify and communicate a product’s identity. A strategic map
offers picture of a company’s compensation strategy. It can also clarify the message that what the
company is trying to deliver with its compensation system. In the mapping process, the objectives of the
compensation plan are further divided into sub-parts or descriptors and are rated on importance. These
descriptors used under each of the strategy dimension can be modified and moulded as a company sees
fit.

Objectives:
Prominence: How importance is the total compensation in the overall HR programs? Is it a catalyst,
playing a lead role? Or is it less important, playing a more supporting character to other HR programs?

Internal Alignment: This is described as the degree of internal hierarchy. For example, how much
does pay differ among job levels and how well does compensation support career growth?
External Competitiveness: This includes comparisons on two issues. How much are our
competitors paying, and what forms of pay are they using? The importance of work/life balance
achieved via benefits and services is also part of external competitiveness. According to the strategy
map, Microsoft’s competitive position is critical to its pay strategy, while SAS competes on work/family
balance in family-oriented benefits such as private schools and doctors on the company’s campus.

Employee contribution: These two companies i-e Microsoft and SAS, take a very different
approach to performance based pay. SAS uses only limited individual-based performance pay. This is
consistent with its overall egalitarian approach. Microsoft is a heavy user of pay based on individual and
company performance.

Management: Ownership refers to the role non-HR managers play in making pay decisions.
Transparency refers to the openness and communication about pay. As one might expect, both Microsoft
and SAS rate high on the use of technology to manage the pay system, and Microsoft offers greater
choices in their health care and retirement investment plan.

Each company’s profile on the strategy map reflects its main message or “Pay brand”. In contrast to the
verbal description earlier in this chapter, strategic maps provide a visual reference. They are useful in
analysing a compensation strategy that can be more clearly understood by employees and managers.
Maps do not tell which strategy is best. Rather they provide a framework and guidance. Just like a road
map, they can show where you are going.

Step 3 and 4: Implement and Reassess

Step 3 is to implement the strategy through the design and execution of the compensation system. The
compensation system translates strategy into practice, and into people’s bank accounts.

Step 4 reassess and realign, closes the loop. This step recognizes that the compensation strategy must
change to fit changing conditions. Thus, periodic reassessment is needed to continuously learn, adapt,
and improve. The results from using the pay system need to be assessed against the objectives we are
trying to achieve.