BUDGETS AND ADMINISTRATION

Financial planning is a part of compensation management. The actions such as increasing merit pay, instituting
gain sharing, and updating the pay structure is found to be essential in making effective decisions. Trade offs
are required for creating a compensation budget. It occurs over pay increases contingent on performance Vs
seniority, over short-term Vs long-term incentives and over cash compensation Vs benefits. Financial planning
is also necessary in analyzing the potential returns. Returns are nothing but productivity increase expectation
from a new profit sharing plan and by making addition of expected value by motivating merit increases to the
top performers. At present, expected returns have become more common than costs.
Contract System – Was popular for its effectiveness during 90’s. The employer provides the contractor with
floor, facilities, space, light, power, necessary material and equipment and the contractor provided highly
skilled workers. This system though cost effective to the employer, eventually led to dissatisfaction and
grievances was wide spread due to pay inconsistencies for the same work, contractor hiring his relatives and
friends. Such decentralised approaches led to corruption and financial manipulations etc.
To avoid such discrepancies and achieve the objectives of the pay model: efficiency, fairness and compliance
managers need to focus on management of budget and administration includes 1. Managing labour cost 2.
Understanding embedded controls 3. Analysing value added returns 4. Communication 5. Designing the
compensation department.
There are various factors that affect labour costs. They are updating the pay structure, increase in merit pay,
instituting gain sharing etc. The figure below represents three main factors that are used to control and manage
labour costs.
Figure: managing Labour costs - PPT
From the above model, the three important factors are employment i.e., number of employees and the number
of hours they work, average cash compensation i.e., wages, bonuses and average benefit costs. All the factors
are essential in managing labour costs efficiently.
Approaches in Budget Administration
The most common approach that are used to manage labour cost are,
(i) Controlling Employment: Cost of employment is the first important component used to manage labour costs.
To enhance the understanding of labour cost, competitor’s pay and staffing information is more useful.
In most of the European countries, it is very difficult to reduce wages or staff. It is because they have
legislations as a part of their social contracts that does not allow the companies to reduce wages or staff. In this
situation, managing labour costs becomes a struggle.
The companies have unfavourable long-term effects when they make announcement of layoffs and plant
closing. They may loose trained employees, and unrealized productivity. However, they can expect lower costs
and improved cash low in short-run. Which is favourable?
Employers, with a view to safeguard employees from layoffs, maintain different type of relationship with
different groups of employees. The figure below represents different group of employees.
Figure (2): core and contingent employees
From the figure, core employees are the ones with whom the employers wish to maintain a long-term
relationship. Contingent workers are those who are engaged in employment agreements for short specific
period. The employers do not expand or contract the core workforce rather; they expand and contract the
contingent workforce to achieve flexibility and to control labour costs. Apart from the above, companies
employ the workers coming from different sources. The reason behind this is to compensate variable costs to
different employees.
Example:
St. Luke’s Hospital has different segment of nurses such as regular, registry, pool and traveller nurses. These
nurses are paid in different ways. Some nurses avail benefits directly from St. Luke’s and few from contracting
agencies and so on. Here the tradeoffs in managing costs involve nurse to patient ratios, quality of care,
balancing patient loads and cost of alternative sources. In this case, the factors effecting labour costs are,
Labour cost = Employment x (Average cash compensation + average benefits) + Agency fee
Hours
Hours of work are more often used to define employment instead of number of employees. Another method can
be used to manage costs of labour is evaluate overtime hours or to hire more employees, whichever is effective.
The three main factors of labour cost model are dependent on some or the other factors. They are employment,
cash compensation and benefit costs.
Example
Providing retirement incentives may cut down employment but at the same time the company will loose most
expensive and experienced employees. Similarly, overtime require higher wages but also avoids the cost of
benefits to the newer employees.
Thus, it is necessary to monitor employment regulations along with understanding wage differences.
(ii) Controlling Average Cash Compensation
Average cash compensation comprises average salary level plus variable compensation payments like gain
sharing, bonuses, or profit sharing. Average salary level can be adjusted using two ways. i.e.,
(a) Top Down
In this, the higher-level management decides upon the amount of money to be spent on pay and subsequently
assigns it “down” to every subunit for the plan year.
(b) Bottom Up
The pay for a planed year is estimated for individual employees and an organisation wide salary budget is
created.
Top Down Budgeting method for controlling salary level
The first step in top down budgeting is the forecasting done by top management relating to pay increase budget
for the whole organization. After deciding the total budget, it is being distributed among each manager who
plans the distribution pattern among subordinates. Top down budgeting involves many approaches i.e., the
planned pay-level rise is equal to percentage increase in average pay for the unit that planned to exist. The
proportionate increase in the average pay level for the next period is influenced by many factors such as
average increase/rise in the present year, ability to pay, competitive market forces, turnover effects and cost of
living.
Rise in Present Year
Rise in present year is the percentage of average wage changed in the previous year. It is mathematically
expressed as follows,
Percent level rise = 100 × Average pay at the end of the year – Average pay at the beginning of the year /
Average pay at the beginning of the year
Ability to Pay
The decision relating to increase in average pay level is one of the functions of organization. The financially
sound employers retain their competitive positions in labor market or distribute their success by way of bonuses
and profit sharing. Whereas it is quite opposite in case of financially unsound employers.
Competitive Market Pressures
The distribution of market rates for benchmark jobs was gathered and evaluated to make a single average wage
for each benchmark. The average market wage transforms into going market rate, which annually changes in
accordance with the different factors in the external market.
Turnover Effects
At times, turnover effect is referred as “churn” or “slippage” which identities the fact that when people leave
the organization by layoffs, quitting and retiring, their positions are replaced by employees with low wages.
The turnover effect can be calculated mathematically as follows,
Turnover effect = Annual turnover × Planned average increase
Cost of Living
There is not much research about cost of living. It is referred as comparison made by employees between pay
increase and changes in their living costs. It has been argued by unions that increasing living costs signifies
increasing pay.
There are three related concepts, which need to be differentiated i.e., the cost of living, changes in prices
prevailing in product and service markets and changes in wages prevailing in labour markets. The changes in
wages taking place in labour markets are evaluated through pay surveys; price changes in product and service
markets are evaluated through various government indexes like consumer price index. Whereas cost of living is
the expenditure pattern of individual relating to goods and services.
Figure: Three Distinct but Related Concepts and Their Measures
The Consumer Price Index (CPI)
Consumer Price Index (CPI) is referred to as cost of living index - changes in process over time and it is used
for pay policy or union pressures relating to wages. CPI does not indicate cost of living of an individual
employee. It only calculates the changes in prices over time. Changes in CPI effects public interest by changing
labour contracts, social security payments, central and military pensions and food stamp eligibility.
Bottom-up budgeting method for controlling salary level
Unlike top down budgeting where managers are aware of their salary budget, the bottom up budgeting initiates
with instructing managers in compensation policies and techniques.
Figure: compensation Forecasting and Budgeting cycle
1. Training Managers
Managers should be guided in using compensation policies and techniques. Training must be given to managers
on the concepts of pay-for performance policy and in standard company compensation techniques like using of
pay increase guidelines and budgeting techniques. Information about market and the salary ranges should be
clearly communicated to managers.
2. Circulate Forecasting Instructions and Worksheets
The forms and instructions, which are required to pre plan increases, should be circulated among managers. In
majority of the firms, managers are facilitated with computer software to help managers in carrying out
analyses/forecasts.
3. Offer Consultation Services
On request of managers, advice and salary information is provided to managers. It becomes much simple to
request and implement such guidance through online approach of Dell.
4. Verify Data and Assemble Reports
The increases forecasted are checked to make sure that pay increases are not more than pay guidelines and fall
in between the specified/appropriate ranges. The data is then utilized to provide feedback on the results of pay
forecasts and budgets.
5. Examine Forecasts
The forecasts made by each manager are evaluated and suggestions for alterations are made depending upon
the inequities observed among different managers.
6. Revaluations and Revision of Forecasts and Budgets with Management
Seek advice from managers concerning the analysis and any suggested modifications. Even approval of
forecasts must be obtained from top-level management.
7. Carrying Out Feedback with Management
Each department sorts out the forecasted data and goals set for each department.
8. Observe Budgeted Versus Actual Increases
The differences between forecasted increase and actual increase is observed and periodic status is submitted to
management.
The outcome of forecasting cycle provides budget for each organization for upcoming plan year and the
forecasted pay treatment for each employee. It does not restrict the manager to stick exactly to the
recommended budget, but it indicates a plan and deviations caused because of unexpected changes or
modifications like performance improvements and unexpected promotions.
Pay managers are held with the responsibility to plan the pay treatment of employees and the compensation
manager plays the role of advisor.
Managing compensation ethically
Managing compensation ethically is a complicated task, if professional code of behaviour and values are not
available.
Especially compensation managers, finds it difficult to manage compensation ethically. The complexity in
compensation ethics is due to many reasons,
Firstly, pay matters a lot to everyone. Secondly, the increase of pays based on achieving the expected targets act
as a pressure on employees. However, it is difficult to evaluate the results, sometimes has “smoke and mirror”
feel to it.
At time, ethical dilemmas are created while managing the pay. Some of the ethical lapses in compensation are,
(a) Misusing statistics, which are used to measure competitors, pay rates. Financial performance reports do not
provide a gold standard. They can be managed.
(b) Encouraging the employees to invest a part of their wages into company stock.
(c) In order to increase the value, reprising or backdating stock options is done.
(d) Misrepresenting the results in order to assure executive bonus payouts etc.
In some cases, even compensation professionals do not protest against ethical misconduct. This is one of the
reason many employees leaving and searching for higher paying jobs elsewhere. It is the responsibility of
compensation managers to look at their own ethics and behaviour to maintain efficiency, effectiveness and
fairness in pay system.
Various embedded control techniques
The embedded control techniques also control the managers pay decision by providing guidelines to managers
towards the achievement of pay system objectives of compensation process in two different ways 1. Controls
that are inherent in the design of the techniques (Job analysis, job evaluation, policy lines, 2. The formal
budgeting process. Some of the control techniques are discussed as follows,
(i) Range Maximums and Minimums
Maximum and minimum ranges are set for different types of work. Maximum range is an important control
technique. It signifies the highest value set for an output of the work.
Green Circle Pay Rates
When employees are paid below minimum pay rates for their pay ranges it is called as green circle pay rates.
Below minimum pay range rates are the green circle rates. Trainees and outstanding employees who receive
several rapid promotions and pay increase have not kept up. These pay rates are brought to normal range as
quickly as possible by both employer and the employee taking essential measures to cover deviation and
eliminate the deficiencies in skill or experience that reduced the pay range to minimum.
Red Circle Pay Rates
These are the pay rates, in which the organization pays more than the maximum rate for the productive
employees. Employers ‘freeze’ Red circle pay to retain efficient employees and restrict them from going to the
competitor who offers good pay to the employees. Red circles are also applied in case of job demotions to offer
more than the employees current job pays.
Broad bands
Broad bands are defined as bringing together the jobs of significant differences or worth or value within one
brand. IT offers greater flexibility compared to a grade- range design. Usually Broad bands are accompanied by
external market references that guide managers to make better career and pay decisions.
Compa-ratios
It is an index, which is the proportional of competitiveness of internal pay rates based on pay range midpoints
that reflects the pay policy line of the employer’s relationship with the external market. To Asses how managers
pay employees in relation to the mid points, an index called compa-ratio is calculated:
Compa-Ratio = average actual pays rate/ Pay range mid point
Interpretation of Compa-ratio
1. A compa-ratio of 1 means that the employee pay rate is equal to pay range mid point. (For example, market
match companies have compa-ratio of equal to 1).
2. A compa-ratio < 1 represents that an employee pay rates is lower than the competitive pay rate for the job.
(For example, market lag companies have compa-ratio of less than 1).
3. A compa-ratio >1 means an employee pay rates is more than the competitive market rate. (For example,
market lead companies have compa-ratio of more than 1).
(ii) Variable Pay
The significance of variable pay is that it can be re-earned in each period. As the ratios of contingent to core
workers and variable to base pay increases, the variable component of labour cost increases along with the
chances available to control variable costs. Though variable pay helps in controlling labour cost It can have an
adverse impact on fair management of employees and their financial well being, especially low paid workers.
(iii) Analyzing Costs
Analysis of the cost of wage proposals basically made before carrying out collective bargaining for pay
increases commercial compensation software is used to analyze assist compensation information. This software
also assists in evaluating salary survey data and at the same time simulating the impact of cost of incentive and
gain sharing criteria.
(iv) Analyzing Value Added
Companies supported by the consultants and researchers are trying to analyze the value added of pay decisions.
Compensation decisions are taken depending upon the analysis of the return on investments. Commercial
compensation software is available to analyse every aspect of compensation information. It can simulate
alternate wage proposals and compare their potential effects. It can also help evaluate salary survey data and
simulate the cost impact of incentives and gain sharing options. This supports analytical literacy of managers
treating compensation as investment and employees as human capital (without ignoring the fairness objective).
Out of 600 organizations around 200 organizations focuses on completing cost and value added by their pay
programs. According to value-added analysis conducted by a company explains that about top 10 percent of
employees increase returns around 2% to 5% of their average salary. The company is focussing mainly on two
aspects of value added they are,
(i) Execute a bonus plan on the basis of the balanced score cards for individual managers.
(ii) Higher rates of differentiation between top performers and average performers.
Making information useful: Compensation software plays a very important role in embedded control
techniques. This software helps in transforming data into information and helps in decision-making. This also
enables the employees like it does to managers to access personal information and make choices about health
care coverage value investment funds etc.
Refer Exhibit 19.9 – value addition analysis, p 568, Compensation - Milkovich
Compensation Communication Cycle
Compensation communicates about the importance of pay system in a firm. Revised pay systems also
communicate a powerful message. Most of the employees receive their pay through paybacks and by formal
communication.
According to Watson Wyatt survey, which is done on 13,000 employees among them only 35 percent can
recognize the link of their job performance with their pay. In addition, in another survey consisting of 6,000
employees in which only one-third of them are able to determine their pay ranges.
The information relating to pay is communicated because of two reasons. The first reason discusses that
important resources are allotted for the purpose of designing a fair and equitable system with the aim to attract
and retaining qualified employees and motivates performance. Moreover, the second reason explains that
employees have some misconception regarding the pay system and they often believe that the pay structure is a
compressed one. Even though, the employers in companies having open pay policies tries to show their
satisfaction regarding their pay and pay system.
According to World at work, the compensation communication cycle involves six-stages. They are,
Figure: compensation communication cycle
Step 1: Defining the Objectives - What are the goals?
In the initial stage of compensation communication cycle the aim of the communication program is define
objectives apart from which different brochures, websites etc., need to be designed.
Step 2: Obtaining the Information - What is the current situation?
In second step, the information is collected by means of online opinion surveys and focus groups to determine
problems faced in understanding compensation system. From executive’s managers and employee’s
information is collected in order to analyze the subject and their perceptions and attitudes.
Step 3: Developing the Strategy – What is the best overall strategy?
A communication program provides the information, which is required for achieving the goal. In addition, there
is no specific approach based on which strategy can be developed. But some organizations choose marketing
approach, which comprises consumer attitude surveys about different products irritable advertisement of pay
policies etc., It mainly emphasis on the strategy values and benefits of policies.
Step 4: and 5: Determining the Media and Conducting the Session – what tools are most appropriate? And how
should the session be implemented?
Here, the effective media is ascertained in the communication process. The formal communication sessions for
several audiences suggests the fine-tuning of the message in detail based on the audience, Executives, managers
and employees. In compensation program, compensation components are communicated to all audiences such
as job descriptions, job evaluation, Market and salary analysis, pay structure, benefit plans, incentive plan
design, Performance appraisal system, salary administration and benefit plans.
Step 6: Evaluating the Program – Was the program successful?
In this final step of communication process, the program is evaluated and examined whether the program is
successful or not. Employees rationalize a set of relationships that exist between their pay and the perceived
pay and efforts of others. In order to get correct information, these perceptions need to be adjusted.
Pay as a change Agent
It is a known fact that whenever an organization goes for restructuring it clearly indicates that the organizations
compensation strategy would also be changed.
Pay is considered as one of the strong signal/sign of change. Making changes in the pay of people would help
in drawing/seeking their attention. In restructuring, pay changes plays two roles. One as “follower of change”
and second one as a “Leading Catalyst” for change.
Example
The company named “Microsoft” shifted from its uniquely aggressive stock option to less risky stock awards.
It shifted it change in pay approach from “workaholic-get rich quick” to a “work hard - get paid well”
approach.
Irrespective of the type of change, loading catalyst or follower of change, the managers are required to learn
how to implement and manage the change. Besides this, they must also know how to resolve disputes, bargain,
develop team and empower employees. Further, they should also have a good idea regarding the strategic and
technical aspects of compensation.
Structuring of compensation function
Compensation professionals in a firm determine the location wherein design and administration of pay systems
can be done. The structuring of compensation function can be described as follows,
(i) Centralization-Decentralization
In an organization structure decentralization plays a key role in structuring the function. The ‘decentralization’
is explained as a strategy wherein different organization unit are used for designing and administering the
systems.
The concept of centralized strategy is also known as ‘shared service centre’s. It is used for locating the design
and administering responsibility in a single unit. For instance, 3M and IBM are said to have large corporate
staffs, which can formulates pay policies and design the systems.
Decentralized organizations like Eaton and GE have small corporate compensation staffs, which are held with
responsibility to manage the systems where the executives and the corporate staff are paid. Here, the
professionals manage the other organization subunits, which as a result employ compensation specialist.
Whereas, AES an electric power company has no compensation unit and an HR department as well.
(ii) Flexibility Within Corporate Wide Principles
The corporate principles vary for every technique of pay. For instance, GE’s business units all over the world
have flexibility in designing incentive plans related to different business unit’s strategies and cultures. It
focuses mainly on improving financial and business objectives and maintaining its reputation.
(iii) Reengineering and Outsourcing
Value chain analysis and six sigma are the techniques, which are used for improving quality and to make sure
that whether the value is being added by each technique at every stage in a process.
Outsourcing is said to be an important alternative as about one third of over 1,000 firms has outsourced their
high responsibilities related to pay and benefit administration. Whereas, cost savings are known to be short-
term benefits of outsourcing. Moreover, less responsiveness towards different employee-manager problems,
less control over decisions are known to be major disadvantages of cost-savings. There is high possibility of
leaking of information to rivals and competitors