Items Description of Module

Subject Name Human Resource Management

Paper Name Performance and Compensation Management
Module Title Architecture of Compensation Management
Module Id Module No. – 25
Pre- Requisites Basic understanding of Compensation
Objectives To develop effective understanding about the compensation management
architecture
 Keywords Stakeholders of compensation, Wage Determination Models, determinants of
Compensation

QUADRANT-I

1. Module 25: Architecture of Compensation Management

2. Learning Outcomes
3. Introduction
4. Stakeholder of Compensation Management
5. Wage Determination Models
6. Determinants of Compensation
7. Summary

1. Module 25: Architecture of Compensation Management

2. Learning Outcomes:
By the end of this module, students will be able to
 Understand the concept of compensation management
 Identify determinants of compensation
 Know about different wage determinants models

3. Introduction
The dictionary meaning of architecture is the structure and design of a building in the narrowest form
of the word. In generic terms especially in the reference that we are using architecture we wish to
define it as the structure of the compensation management system. By now it has been clear in our
concepts that compensation and its management are crucial for the sustenance of employees and
hence for the overall growth and sustainability of the organization. The stakeholders of compensation
management play a very important role in designing and execution of the compensation systems.
This module discusses almost all possible stakeholders of compensation management. The second
part of the module talks about the various models that are used for the determination of compensation
of different levels of the employees. The last section talks about the determinants of the
Compensation levels.
4. Stakeholders of Compensation Management
Management of compensation is a vibrant and complex issue. In today’s organizational set up, human
resource play a very significant role. Nowadays, compensation is not merely organization to
employee transaction process. It is a broader and vital system with multiple stakeholders as discussed
below:
4.1. Organization: Organization is the key stakeholder of compensation management. Organizations
pay employees not only to compensate them for the work performed by them but also to
encourage employees to improve their performance and productivity so that the organization can
achieve its goals easily and effectively. In the absence of proper compensation, employees will
not perform properly and this will negatively affect efficiency and effectiveness of the
organization.

Organisation

Manager Employees

State Trade Union

Labour
Customer
Market

4.2. Managers: Managers play a crucial role in supervising and guiding the employees so that they
perform in the best possible manner. They motivate and appraise performance of employees on a
daily basis and recommend compensation increase to employees. If the managers are biased or
incompetent then the employees will feel depressed for not getting fair compensation or rewards.
Therefore, through compensation review, managers help to improve performance of employees
and help to retain them for a longer time in the organization.

Source: https://www.linkedin.com/pulse/20140711183838-121819687-gossip-about-my-manager
4.3. Employees: Employees work in an organization not only to meet their basic needs but also to
get a sense of satisfaction and achievement from the work they perform. If the employees are not
satisfied with the compensation offered to them then they will not complete their work in time.
Moreover, if an employee feels that his compensation is low as compared to market rates or peer
groups then he starts feeling dissatisfied and start searching for jobs in other organizations which
offer better compensation and facilities. Therefore, employees are key stakeholders of
compensation management without whom compensation management is not possible.
4.4. Labour Market: Labour market refers to the place where people who are willing and able to
work search out jobs. According to classical economists, compensation rate depends upon
demand and supply of workforce. Other factors influencing compensation rates are changes in
the standard of living of employees, changes in productivity, changes in income distribution, etc.
therefore, labour markets play a very important role in compensation management. When
demand for labour is more than the jobs available then compensation levels get depressed and
vice-versa.

Source: https://guyanachronicle.com/2015/10/10/critical-labour-market-information-to-be-
available-shortly-govt-resuscitates-coordinating-committee
4.5. State: The state regulates compensation levels and makes timely amendments in compensation
mandates and frames policies for minimum wages, equal remuneration, social security and
statues affecting bargaining power of union. Indian government has enacted various labour laws
on compensation like Payment of Wages Act,1965, Minimum Wages Act,1948, Equal
Remuneration Act,1976, Payment of Bonus Act,1965. Thus, state plays a very important role in
compensation by ensuring protection from exploitation of employees.
4.6. Trade Unions: Trade unions are representative body of employees who work for the benefits of
employees. Employees as individuals are not always able to negotiate their compensation after a
limit. Through collective bargaining, employees can negotiate for better compensation deals.
With the help of collective bargaining, compensation of different classes of employees is
 mutually agreed at organizations, industry and national level. Organizations which have string
trade union can bargain hard with employees and therefore can get maximum compensation and
benefits for the employees. Trade unions also put pressure on government to revise minimum
wages for employees from time to time. In many cases the governments have had to revisit their
policies related to labour and compensation after the forced requests of the trade unions.

Source: https://www.linkedin.com/pulse/should-role-outsiders-restricted-indian-trade-unions-
anamika-kishore
4.7. Customers: Davis and Landa (2000) observed that “customer loyalty, the outcome of superior
customer service, and investor loyalty, the outcome of protected and enhanced shareholder
value, are each dependent upon the business gaining the commitment and loyalty of its
employees.” Therefore, if an organization compensates its employees well then it is in the
position to provide better customer service and can retain its customers for a longer period of
time.
Hence from the above discussion, we can conclude that compensation is not only limited to
employee-organization relationship in the form of an employment contract, but extends to large
number of other key stakeholders.
5. Wage Determination Models
Wage formation is very important for understanding economic development in almost every
dimension including equality, employment, productivity and welfare. Since labour market institutions
largely determine wage formation, therefore many models have been developed to explain how wages
are set.
 Insider-Outsider Model Internal Labour Market Model
Wage Determination
Models
Matching Models Human Capital Model

5.1. Internal Labour Market Model: The theory of Internal Labour Markets originated from
sociology. The internal labour market refers to set of careers and relatively detailed defined
career paths that in turn lead to long-term attachments and is characterized by administrative
rules. It is different from the external labour market of conventional economic theory in which
decisions related to pricing, allocation and training decisions are controlled directly by economic
variables. These two markets are interconnected, however the movement between them occurs at
certain job classifications, which constitute ports of entry and exit to and from the internal labour
market.The remaining jobs within the internal market are taken care of through transfer and
promotion of employees within the organization. As a result, these jobs are not affected from the
direct influence of competitive forces in the external market.
One of the important decisions for organizations is to decide whether to hire existing employee
from within the organization or some outsider with some specific skill sets for a job opening.
Employees are mostly hired from outside at specific ports of entry. But internal job flows also
motivates internal employees to perform better. In the tournament model (Lazer and Rosen,1981),
the compensation level and other non-pecuniary rewards that come with the jobs of highly-ranked
employees acts as a motivator for all lower-ranked employees within the organization. The final
reward in the tournament model is the opportunity of becoming CEO. The other view pertains to
viewing employees as human capital which is valued by the current organization. Organizations
and employees will invest in organization-specific training only if they feel that they will be able
to gain substantially in some form or the other from that training. Organization-specific human
capital makes employees less likely to switch to other organizations, since turnover will lead to
the loss of human capital. Therefore, these employees have a basic incentive to follow a career
inside an organization.
5.2. Human Capital Model Human capital theory can be largely attributed to economists from the
1950s such as Nobel-prize winner Gary Becker. In his 1992 Nobel lecture, Becker(1997) states:
“until the 1950s economists generally assumed that labour power was given and not
augmentable. The sophisticated analyses of investments in education and other training by Adam
Smith, Alfred Marshall, and Milton Friedman were not into discussion of productivity. Then,
 T.W. Schultz and others began to pioneer the exploration of the implications of human capital
investments for economic growth and related economic questions”.
Human capital consists of all the skills that people possess. The skills are not static; these skills
can be enhanced by making investment in human capital such as teaching some new courses,
techniques, on-the job training,etc. Human capital is of two types: (a) general and (b)
organization specific. General human capital refers to human capital that is equally valued by all
the organizations and is completely transferable from one organization to the other. Organization
specific human capital refers to knowledge that is valued by current organization and will be lost
if the employee transfers to another organization. This difference not only affects on-the-job
training decisions but also affects turnover decisions. Employees invest in human capital only
after making a fair assessment of trade-off between their benefits (monetary and non-monetary
gains) and costs (monetary expenses as well as the value of time spent on training).
Becker (1964) derives two main insights. First, the returns and costs of investments in
organization-specific human capital will be shared between organization and employees. After
the training is completed, employees will receive compensation above the level they would earn
elsewhere since the productivity in other organizations has not changed. (Voluntary) turnover will
thus be reduced since employees will then lose the return on their investments. Second,
organizations will be unwilling to invest in the training of general human capital in a competitive
labour market, since they will be unable to capture the returns.
Hence, compensation attached to jobs and jobs assigned by seniority can derive efficient
outcomes of carriers and compensation structure.Task assignment models are another extension
and explain the distribution of compensation within organization as an outcome to the problem of
assigning jobs to employees. Besides compensation, promotion is also important as it signals the
employee’s ability to other organizations and will make potential organizations bid up the
compensation of the promoted employees (i.e. compensation increase upon promotion).
Employees who would perform marginally better in a more senior job are not promoted because
of the imposed compensation increase. In general, human capital theory introduces an argument
for the existence of internal labour markets and shows how organization specific human capital
explains long tenure
5.3. Matching Models A different set of models in economics that focuses on employee’s ability is
based on the combination of search and matching aspect. The search model (e.g. Stigler, 1961;
Burdett,1978; Jovanovic,1979) uses the assumption of heterogeneous abilities across employees.
Employees ‘shop’ around and search for the best match jobs, that is, those offering the highest
compensation. Job mobility in a search model implies a positive relationship between experience
 and compensation since more experienced employees had more time to search the labour market
for organizations that fits them best. Early models (e.g. Stigler,1961) portray employees as
optimizing the trade-off between time and resources spent on searching for job opportunities and
the uncertain returns to job search in terms of compensation attached to the job selected.
Burdett’s (1978) model shows that besides the search behavior of unemployed people, employed
people too will search for better paying jobs, i.e. on-the-job search. At the beginning of a job,
there is a lack of information about the match quality between an employee and the job. The
employee’s output is observed by both the employee and the employer and is seen as a signal of
the quality of the match. Overtime, more information is revealed and prior expectations about the
match quality are updated. This information leads to either job continuance(good match) or
employee turnover(mismatch). In human capital theory, a good match potentially leads to a
promotion.
Both matching models concentrate on separations and explains, for example, why employees
tend to have a high rate of turnover in the first year of their career. The implications of the
models are different. On the one hand, the search model predicts that the probability of a job
separation declines when general labour market experience increases. More experience (and thus
more opportunity to gather and evaluate outside compensation offers) will lead to higher
compensation and thereby a falling probability that the subsequent compensation offer is high
enough to lead to a switch. On the other hand, the matching model predicts that the probability
of separation declines with on-the-job tenure. Bad matches, whose information is revealed in an
earlier stage of the work relationship, will lead to a switch declines as function of tenure.
5.4. Competitive Model: The neo-classical interpretation of wage differentials emphasizes two
aspects of wage behaviors: (a) Since labour demand is determined by the value of the marginal
product, wage differentials must correspond to productivity differentials and(b) the free market
forces will ensure that labour of the same quality will be paid the same wage.
There are basically three types of considerations under which wage differentials remain consistent
with a competitive interpretation of the labour market: transitory differences, compensating
differentials, and unmeasured labour quality. The last two are related to measurement problems.
In the first place, changes in labour demand could produce transitory wage differentials for
equally productive employees, differentials that will tend to narrow over time as the labour
market return to equilibrium. A second expansion focuses on compensating differentials that arise
as higher wages are needed to compensate employees for job attributes of the industry. In this
case, wage differentials are essentially a measurement error, since the compensation does not take
 into account differences in non-pecuniary costs of employee employment. Finally, wage
differentials may reflect the existence of unmeasured labour characteristics.
These differentials could arise because different industries employ different technologies which
in turn are sensitive to employee ability in different degrees. The differential ability is known by
the employee and the organization but is unobserved by the econometrician. An alternative
explanation is that the competitive model is prevented from prevailing, owing to external imposed
rigidities.
5.5. Insider-Outsider Model: Assar Lindbeck and Dennis Snower (1986) attribute wage rigidity to
the successful efforts of existing employees or insiders to maintain their pay at the expense of
unemployed jobs seekers or outsiders who would work for less. The insiders are quite powerful
in the sense that they keep the turnover costs away and the organization has the confidence that
all systems and procedures are known as the employee is already in the system. In this manner
the presence of unemployed outsiders does not exert much downward pressure on compensations
within the organization because a pay cut would induce many insiders to quit, taking their
valuable organization specific human capital with them; those that stayed may not cooperate
well with the new recruits. Two-tier pay scales would also pose problems for the organization
because the insiders will fear their eventual replacement by their lower paid new co-employees
and would once again refrain from cooperating. Even in a cyclical decline, the insider pay may
respond little, if at all, because a pay drop is not something the insiders will accept.
Consequently, employees are laid off. If insiders know that the organization will lay off
employees on the basis of efficiency, then a majority of the more efficient employees will
oppose a pay cut.
6. Determinants of Compensation
Nowadays one of the biggest challenges faced by business leaders is to search out effective methods
of compensating employees. Rewards for productive work have been considered key motivators for
efforts and achievements. In olden days, the rewards came in the form of food and endurance; but
with the introduction of money as a medium of exchange, these rewards have taken form of
compensation. With time the modes and methods have evolved in numerous ways in cash and kind.
Compensation policies, strategies and practices of an organization are influenced by a number of
factors which are discussed below:
 HRM Policies Personal Characteristics

Determinants of
Compensation

Organisational
Characteristics, Strategy and Types of Work
Policy

6.1. Personal characteristics: Personality is an important element of behavior and behavior is the
foundation stone of the structure called attitude, motivation and the performance of all
employees. Personality is shaped by different internal and external factors and it affects the
behavior and actions of the employees and finally their job performance. The following
dimensions of personal characteristics affect an individual’s approach towards compensation:
a) Extroversion: Extrovert individuals are self-regulating in nature and therefore they feel more
satisfied with their job because work gives them self satisfaction. Such employees need very
little supervision and often respond positively to performance linked rewards. On the other
hand, introvert individuals are relatively less satisfied with their job due to too much
stimulation. They do not respond positively to performance linked rewards.
b) Emotional Stability: Employees who are highly emotionally stable are likely to be more
committed towards their goals,respond positively towards negative feedback, work hard to
overcome obstacles in performing tasks and are highly result oriented. Such employees are
generally motivated and respond positively to pay for performance programme.
c) Openness: Individuals with high mental ability would be more anxious to compensation and
promotions as motivators.
d) Conscientiousness: Conscientious individuals often perform in an ethical manner and are
often regular to work which enables them to get better rewards and compensation.
e) Acceptability: Employees who are good acceptors are always good followers and so seldom
reach to higher positions whereas those who voice their opinions move high up in ranks.
Such employees value high rewards to excel in their job.
6.2. Type of Work: The type of work has a deep and direct impact on outlook towards compensation
depending upon the physical or mental abilities and terms of employment needed for satisfactory
completion of a job.Expectations of employees shall be high for jobs which require greater skills,
mental ability & competencebut for jobs which require lesser skills, mental abilities,
expectations of employers are lower.Furthermore, for manual jobs which involve huge risks to
 accidents and injuries, the compensation level shall be kept higher than the jobs which involve
lower risk. Jobs which are temporary or contractual in nature, compensation should be kept
lower than regular jobs. For e.g. labour intensive industries like garment exports or seasonal
businesses employ people on contractual basis andtry to minimize labour costs. Thus, there are a
lot of factors which affect compensation and the conditions of work, nature of job and
availability of specific skill sets are critical to compensation fixation.
6.3. Characteristics, Strategy and Policy of Organization: Organizations play a key role in
determining compensation of employees. Its features, plans and policies drive compensation
management process.
6.3.1. Organizational Characteristics: Compensation is affected by the following organizational
characteristics:
a) Industrial Sector: Generally service industry pay higher compensation to employees
as compared to manufacturing organizations because their competitiveness depends
entirely on motivation, efforts and outcomes of employees. Whereas the success of
manufacturing organizations depends more on nature of product, quality of product,
price, etc, rather than on the qualifications of employees, therefore they offer
relatively lesser compensation to employees.
b) Size: Big organizations have sufficient resources and therefore they use
compensation to control behavior of employees. But smaller organizations have
limited resources so they have direct access to employees for monitoring their
activities.
c) Technology: Organizations which use high technology offer relatively higher
compensation to attract highly skilled and professional employees.
d) Age: Newly set up organizations generally keep their compensation level high
because their manpower requirement are high and urgent. Whereas, organizations
which are well established have better capacity to negotiate compensation and can
wait for a longer time period. People are willing to work with well established
organizations even at a lower compensation.
e) Organizational Life Cycle Stage: The organizational life cycle also directly
influences compensation as organizations in growth stage need highly skilled and
talented workforce and therefore they offer better compensation to attract and retain
talented employees. Whereas, organizations in decline phase already have low profits
and cannot afford to pay high compensation and therefore, they offer comparatively
 lower compensation. Therefore, compensation policies vary depending on the life
cycle stage of organization.
6.3.2. Organizational Strategy: Nowadays, organizational strategy focuses more on human
resources than on financial resources. No doubt managing financial resources effectively is
very important for every organization but most of the organizations have realized that
capital is not the one that constraints growth (Barlett& Ghoshal, 2002). For e.g. Michael
porter observed that there is a surplus of capital which chase the scarcity of talented people
and the knowledge they possess. They can create value for the organization. Therefore,
organizations have been shifting their focus from financial capital to human capital.

Exhibit : The Evolving Focus of Strategy

Competition for products Competition for resources Competition for talent
and market and competencies and dreams
Strategic defensible product market Sustainable competitive Continuous self-renewal
objective positions advantage
Major tools  Industry analysis;  Core competencies 
Vision and values
competitor analysis  Resource based 
Flexibility and
 Market segmentation strategy innovation
and positioning  Networked  Frontline
 Strategic planning organization entrepreneurship and
experimentation
Key strategic Financial capital Organizational capability Human and intellectual
resource capital
Source: Bartlett, C.A. and Ghoshal, S., “Building Competitive Advantage Through People”, Sloan
Management Review, Vol. 43, No.2, Winter 2002, pp. 34-41.

Organizations which formulate their strategy around financial capital will lag behind
organizations which formulate strategies focusing on human resources. Generally
organizations which focus more on financial capital pay less to employees in the form
compensation. Whereas, organizations which tret their employees as an asset give higher
compensation to its employees in exchange for their talent, skills, competencies and
commitment which will produce value for the organization through improved processes,
innovation and excellence.

6.3.3. Organizational Policies: With the help of job evaluation, organizations assign different
worth to different jobs. An organization has three policy choices while compensating
employees lead, match or lag. According to lead policy, the compensation paid by
organizations is higher than the rates prevailing in the labour market. Organizations adopt
 this policy to attract and retain talented employees for longer period of time in the
organization. Under matching policy, organizations pay as per prevailing labour market
rate. But under lag policy, an organization pays lesser than the market rates. Thus, the
number and quality of personnel viable in an organization depend largely upon
compensation policy adopted by a firm.

Summary

The architecture of Compensation Management plays a very important role in defining the strategy
related to compensation in the organization. This very architecture is solely responsible for the
implementation of the compensation system within the organization. So if this architecture has been
meticulously planned the compensation system as a whole will be fruitful in sustaining, satisfying and
motivating the employees of the organization. It is also important to mention that if the architecture is
flawless and strong the whole system will function flawlessly.