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Introduction To Compensation: Definition of Compensation, The Pay Model, Strategic Pay

Policies, Strategic Perspectives of Pay, Strategic Pay Decisions, Best Practices vs. Best Fit
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Module 2: (6 Hours)
Defining Internal Alignment: Definition of Internal Alignment, Internal Pay Structures,
Strategic Choices In Internal Alignment Design, Which Internal Structure Fits Best
Introduction To Compensation: Definition of Compensation, The Pay Model, Strategic Pay
Policies, Strategic Perspectives of Pay, Strategic Pay Decisions, Best Practices vs. Best Fit
Options

Introduction to Compensation Management


Understanding compensation is a key to understanding compensation management. The
compensation policies are driven by each companys philosophy of how best to compensate their
people. The complexity of compensation programs drive the complexity of compensation
management and in turn drives the compensation systems. Compensation management and
compensation administration are used synonymously in this book.
Whatiscompensation?
The dictionary defines compensation as, Something, such as money, given or received as payment
or reparation, as for a service (or loss). So for the purposes of the book, well assume that an
employee works for an employer by providing a service (their job), and the employer, in turn,
compensates the employee.

1.1

Compensation Management: Practices and Principles

Compensation is sensitive to everything that affects businesses. For example, there are a number of
global issues today that can affect jobs and, therefore, the compensation related to those jobs.
There are a number of basic principles of compensation management that you should understand in
order to get the most out of this book. Everything around us impacts our compensation. Its like the
butterfly effect. Butterfly effect refers to the idea that a butterfly's wings might create tiny changes in
the atmosphere that ultimately cause a tornado to appear (or prevent a tornado from appearing). The
flapping wing represents a small change in the initial condition of the system, which causes a chain of
events leading to large-scale phenomena. Had the butterfly not flapped its wings, the trajectory of the
system might have been vastly different. A small change in the employees work environment can
significantly impact compensation. The figure represents an employees work environment.

Figure 1.1 The World of the Employee


The work environment factors can be grouped into different categories and their impact can be
understood in parts.
1.1.1

Todays Global Macro Factors

The world is changing. Global warming has suddenly become a critical problem, so there is a
growing demand for renewable energy which in turn increases the need for people in this profession.
This in turn will increase the demand and compensation of people in this industry.

Countries are changing and re-defining themselves. The national boundaries are no longer
constraints in the European Union. People from EU country can move easily into another for work.
This in turn will change the dynamics of demand and supply and hence the compensation of people.

Apart from political changes, the economy of the country also impacts the compensation of the
employee. Worries of recession will make the companies retain the status quo on employee
compensation till the economic climate becomes better.

The industry in which an employee belongs also dictates their compensation. A long term downturn
in an industry such as Finance can result in lower salaries and in some cases even job loss.

A companys performance has a more direct impact on employees compensation. If a company


does good, they will tend to reward the employees and provide generous compensation and vice
versa. Some of the dot com companies are doing good and provide very generous compensation
whereas others in the same field might be just providing the bare minimum compensation to retain the
employees.

There are also more localized issues that can affect compensation.
1.1.2

Micro Factors:

The employees profession is the key to their compensation. Some of the jobs are phasing out and
new ones are emerging. IT profession has been doing good so have others. If a profession has the
likely hood of getting outsourced, the profession will have adverse impact in the country which is
losing the jobs and positive impact in the country gaining the jobs. A century ago, the economy was
based on agriculture. Then came the industrial revolution and the economy was driven on

manufacturing jobs. Currently it is a service oriented economy where a lot more jobs are in the service
sector. There is always a quest for the next wave, next big thing that will change the economy that will
provide better opportunities to the employees.
The employee is responsible for their own compensation in cases of pay-for performance. The
better the employees performance, the better can be their compensation.

These are just a few examples which might impact the overall compensation of an employee.
It feels like the world is becoming smaller due to technological advances, workers are more aware of
things that are happening around them.
They can see what is happening in other countries and how things can impact them. Many of them
have come to an understanding that jobs are not constant and they might have to keep updating their
skills to remain competitive in the job market.
The majority of the workforce is becoming knowledge based, which means workers are using their
brains more than their physical faculties. So, it has become more difficult to measure the work done
by a knowledge worker as compared to a manufacturing worker. Not only does this shift affect how to
evaluate employees, it also affects how to compensate them. Knowledge workers have different
motivation factors than physical workers (assuming some statement like this is true[m1] ).
Motivation
There are many theories related to employee motivation. Companies adopt compensation practices
that they think will work for their workforce. Some of the significant theories that directly or indirectly
impact compensation practices are:
1.

Maslows Hierarchy of Needs

2.

Herzbergs Two-factor Theory

3.

McClellands Four Modes for Success

4.

Alderfers Three-level Hierarchy

Figure 1.2 Some of the Motivation Theories


The overall gist of the matter is that a person will move from left to right as shown in the chart in
Figure 1.2. For example, once the physiological needs are met, the person will strive to meet safety
and security needs, and so on. Although each person is different, so a sales person might be more
motivated if their compensation has larger commission incentives, while an administrative assistant
might be more motivated if they are given a larger salary. The compensation programs are designed
with different components and each has a target that is applicable for an employee who has at-par
performance:
1.

Salary increase normally in the target is 3%

2.

Variable pay- Also referred to as bonus and the target is 20%

3.

Long term incentive- Mostly refers to stock options and varies significantly from company to
company.
The employees could earn more for better performance. If the company has performed very well, it
could benefit everyone by company increasing the compensation by 10% to what they would get.

Compensation Management encompasses designing, implementing, and administering compensation


to attract and motivate employees to be productive in achieving companys vision, objectives and
goals.
We can group Compensation management into 3 parts as shown in Table 1.1.
<><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><><
><><><><><><><><><>
Component
Description
Compensation
Strategy

How to attract and retain employees that will help


the company achieve business results. HR
practices vary across the world. In US,
employment-at-will is the de facto norm where in
European and Asia Pacific countries, employee
protection is a norm. In some countries, employee
needs to be given 6 months notice period before
they are let go. There are some countries where
13 month pay is a norm. In other countries, if a
particular bonus payment is made for more than 2
consecutive years, it becomes an entitlement that
cant be taken away later. Compensation strategy
can be defined at a global level but local
compensation plans need to tailor on local drivers.

Tactical

Creating local compensation plans to implement


the compensation strategy.

Administrative

Administer the compensation plans on a day-today basis

In recent years, compensation management has evolved into a broader approach known as total
rewards management. Compensation management deals with direct compensation provided to the
employee. There is also a significant portion of reward the employee is provided in the form of health
benefits, paid holidays, company cars, education allowance, training, and so on.
The essentials of compensation management include the following kinds of compensation:

Compensation benchmarks by Internal/ External Job Survey & Analysis

Direct cash compensation- Basic wages & salary, promotional increases

Short term incentives- Annual Bonus

Long term incentives- Stock options

Globally compensation is essentially similar, although there are differences due to a number of
factors, including:
Legal reasons- In some countries, if a particular bonus is given to an employee for 2 consecutive
years, it becomes an entitlement and must be given subsequently.

Cultural reasons- Team incentives are more acceptable than individual incentives.

Compensation System:

Compensation system is the backbone of compensation management. It needs to be flexible as well


as reliable to deliver the needs of an organization.
There has been a great deal of evolution is compensation system. Largely many of the computer
systems were based on spreadsheets. The spreadsheet based systems are easy to start-up but have
a high degree of maintenance and are not as flexible as one would expect. The employee data is not
real-time i.e. the employee who just left might still continue to appear of spreadsheet till someone
either notices it or updated ones are distributed again. The spreadsheet systems are difficult to
replace since a lot of time and effort has already been spent by the compensation team and they dont
want to let go of it to create a new one.
There are a whole host of advantages to having a compensation system that is integrated with your
HR systems. Some of these include:

Real-time employee data

A better user interface

Complete data consistency

Integrated to payroll to distribute compensation in timely manner

Currency calculations

Multiple language support

Compensation management provides the eligible employee population with guidelines on what they
should be awarded and a mechanism for the managers to award and approve. The actual payment is
executed by Payroll Department, however, so its very important to ensure that your compensation
and payroll processes are aligned.
Administration of compensation packages will become more and more critical. There will be different
kind of packages that will be required to provide for the differentiation. The compensation packages
could change regularly. Also the jobs are more dynamic and they will change more often. This will
make it a necessity that the administration be easy and flexible.
Stock options have been very popular form of compensation and employees have reaped the benefits
of this. This type of compensation has been very effective for growth companies since there is a lot of
potential for the stock price to raise and in turn give employee a windfall. These are classified as long
term incentives since there is no immediate gain but can have a substantial future value.
Approval of compensation is also one of the big items. Depending on a company culture, more
decentralized the company the greater authority is given to the manager. Also the levels of approvals
are limited. In certain cases, multiple approvals are needed. With current issues with executive
compensation, management boards are actively involved in approving executive compensation.

Figure 1.3 Cause and Effect Diagram

1.2
1.2.1

New Trends in Compensation Management


Market driven compensation

Compensation management has evolved in conjunction with human resource management. What
should an employee be paid? The jobs are internally assigned points based on the authority and
responsibility that they carry. The higher the points, more is the compensation.
Market pricing came along with similar jobs being compared across an industry, sector or geographic
location. There is a bell-curve. There are some jobs that have least impact due to compensation
management. On one end of the spectrum are jobs with collective bargaining agreements where
compensation is pretty much locked down. On the other end of the spectrum are CEO salaries that
have been widely publicized recently as being overboard and excessive. But the majority of the
employee population under the bell curve fall under the merit based compensation. This is true in
most of the countries with some exceptions where life-time employment, loyalty, long services,
seniority still play a huge role.
Compensation management has traditionally been a manual process and until recently was based on
spreadsheets. There are many companies that provide comparative data for each job in a company.
The awards are calculated and information is passed to the payroll providers.
Annual bonus is a type of incentive plan that is offered by most of the companies that pay for
performance.
1.2.2

HR Outsourcing

HR outsourcing has become more prevalent as HR departments want to focus on strategic aspects
and leave the administration to third parties. HR wants to focus on their core competency and
outsource administrative chores to vendors who specialize in it.
The outsourcing phenomenon forces to companies to document their processes and also assimilate
disparate systems. Internal systems have more flexibility but this also is a bane since systems
proliferate. All the additional functionalities have to go through a more thorough cost-benefit analysis.
HR outsourcing will make the compensation management will need to balanced between flexibility
and more streamlined processing.
1.2.3

Globalization

Globalization has brought in many different aspects. There is a greater need to standardize
compensation practices and also carefully ensuring that local practices are followed to attract and
retain talented employees.
Globalization also brings to fore the differences in compensation systems and need to harmonize
them to be able to standardize and report in real-time.
Globalization also means that there might be more people moving from one country to another and
their compensation needs to be adjusted accordingly. Global leaders of the future will need this kind of
exposure to lead global companies.
Globalization means that compensation department will need to reach out to their peers across the
world to come up with effective strategies to keep the company competitive.

1.3

The Future of Compensation Management

Compensation management continues to evolve. As we continue to develop new theories about what
motivates employees well continue to see new approaches to compensation.
The key intent of compensation and compensation management is to attract and retain talent. Of
course, money is always considered a primary motivator, but the debate continues over just how
much. Monetary compensation definitely has some effect but according to most studies, it varies
among different types of workers. Some groups thrive on just commissions such as sales
representatives; some prefer a fixed salary such as manufacturing workers, while others prefer a fixed

salary plus an incentive plan, particularly management. There is a limit, however after which
increasing pay doesnt give proportionately increasing returns.
Based on this, tactical compensation programs are created. The plans are designed to deliver the
maximum impact. Compensation packages are developed to include different compensation
programs to entice employees and reward them appropriately. Depending on the environment,
compensation packages are developed to attract and retain talented employees. There is no direct
way to measure what an individual would like but compensation packages typically include:

Cash compensation

Short term incentive compensation (Bonus programs)

Long term incentive compensation (Stock programs)

There are other compensation types that we will not cover in this books:

Non-monetary compensation, such as Anniversary awards

Perquisites like Club memberships

Health benefits

Pension schemes

Sales incentives & commissions

Compensation is not the only motivation that was previously believed. Motivation also comes from
growth opportunities, acceptance and recognition, opportunity to international travel, etc With
globalization, blending different kinds of compensation packages has become more art than science.
Instead of compensation, many companies are now addressing it as total rewards and in future it
might even become Motivation Packages.
Executive compensation is a field in itself. This population though small is also very critical. The
administration of this small group is critical and sometimes requires a lot of exception handling. They
impact all aspects of compensation and payroll.
The concept of broad banding has been adopted by many large companies to avoid proliferation to
multiple ranges. It also provides managers with the flexibility.
Each chapter needs to be its own document and it should end with a Summary

1.4

Summary

A lot of effort goes into developing compensation programs that helps in achieving the goal of
attracting and retaining people. Various factors impact compensation and managing compensation
can be complex based on an organizations philosophy. In any case, compensation systems needs to
effectively and efficiently support the management of these compensation programs.

Definition:
Compensation is the total amount of the monetary and non-monetary pay provided to
an employee by an employer in return for work performed as required.
Compensation is based on:

market research about the worth of similar jobs in the marketplace,

employee contributions and accomplishments,

the availability of employees with like skills in the marketplace,


the desire of the employer to attract and retain a particular employee for the
value they are perceived to add to the employment relationship, and
the profitability of the company or the funds available in a non-profit or public
sector setting, and thus, the ability of an employer to pay market-rate
compensation.
Compensation also includes payments such as bonuses, profit sharing, overtime
pay, recognition rewards and checks, and sales commission. Compensation can also
include non-monetary perks such as a company-paid car, stock options in certain
instances, company-paid housing, and other non-monetary, but taxable, income
items.