Chapter 9: Direct Financial Compensation Compensation: An Overview Compensation is the total of all rewards provided to employees in return for their services. The overall purposes of providing compensation are to attract, retain, and motivate employees. The three major types of compensation: Direct financial compensation: Wages, salaries, bonuses, and commissions. Indirect financial compensation (benefits): All other financial rewards, such as health care insurance. Nonfinancial compensation: Satisfaction from job itself or from psychological and/or physical environment in which employee works.
The Components of Total Compensation Program External Environment Internal Environment 9-4 Compensation Direct Wages Salaries Commissions Bonuses Indirect (Benefits) Legally Required Benefits Social Security Unemployment Compensation Workers Compensation
Discretionary Benefits Payment for Time Not Worked Health Care Life Insurance Retirement Plans Disability Protection Employee Stock Option Plans Employee Services Premium Pay
Voluntary Benefits The Job Meaningful and Satisfying Job Recognition for Accomplishment Feeling of Achievement Possibility of Increased Responsibility Opportunity for Growth and Advancement Enjoy Doing the Job Job Environment Sound Policies Capable Managers Competent Employees Congenial Coworkers Appropriate Status Symbols Working Conditions
Workplace Flexibility Flextime Compressed Workweek Job Sharing Telecommuting Part-time Work Financial Nonfinancial Equi t y Theor y Equity theory states that a persons motivation is in proportion to the perceived fairness of the rewards he or she receives for the amount of effort he or she exerts, and that this is also compared with what others receive. According to the theory, individuals are motivated to reduce any perceived inequity and will strive to make the ratios of outcomes to inputs equal. As such, equity is a very important factor in compensation.
9-5 Eq u i t y i n F i n a n c i a l Co mp e n s a t i o n Financial equity is the perception that there is fair pay for employees. Firms and individuals view fairness from several perspectives. Ideally, compensation will be fair to all parties concerned and employees will perceive it as such. However, this is a very vague goal. External equity exists when a firms employees receive pay comparable to workers who perform similar jobs in other firms. Compensation surveys help organizations determine the extent to which external equity is present.
E q u i t y i n F i n a n c i a l C o m p e n s a t i o n ( c o n ) Internal equity exists when employees receive pay according to the relative value of their jobs within a single organization.
Employee equity exists when individuals performing similar jobs for the same firm receive pay according to factors unique to the employee, such as performance level or seniority.
Team equity is achieved when teams are rewarded based on their productivity. However, achieving equity may be a problem because not all team members contribute equally to the outcomes.
Primary Determinants of Direct Financial Compensation Compensation theory alone has never been able to provide a completely satisfactory answer as to what an individuals job is worth. Therefore, organizations typically use a number of factors including the organization, the labor market, the job, and the employee to determine any given individuals financial compensation.
Primary Determinants of Direct Financial Compensation 9-9 Organization Compensation Policies Organizational Level Ability to Pay Labor Market Compensation Surveys Expediency Cost of Living Labor Unions Economy Legislation Employee Job Performance Skills Competencies Seniority Experience Organization Membership Potential Political Influence Luck Job
Pricing Direct Financial Compensation Job Job Analysis Job Descriptions Job Evaluation Organization as a Determinant of Direct Financial Compensation Managers tend to view financial compensation as both an expense and an asset. It is an expense in the sense that it reflects the cost of labor. However, financial compensation is clearly an asset when it helps recruit good people and encourages them to put forth their best efforts and to remain in their jobs.
9-10 Compens at i on Pol i c i es A compensation policy provides general guidelines for making compensation decisions. An organization often establishes compensation policies that determine whether it will be a pay leader, a pay follower, or strive for an average position in the labor market (market rate).
9-11 Compensation Policies (con) Pay leaders: Pay higher wages and salaries to attract high-quality, productive employees and thus achieve lower per-unit labor costs Market rate, or going rate: Pay what most employers pay for same job Pay followers: Pay below market rate because of firms poor financial condition or belief that it does not require highly capable employees 9-12 Organizational Level The organizational level in which compensation decisions are made can also have an impact on pay. Upper management often makes these decisions to ensure consistency (evenness). However, organizations are increasingly pushing these decisions to lower levels in an effort to retain top performers.
Ability to Pay An organizations assessment of its ability to pay is also an important factor in determining pay levels. Financially successful firms tend to provide higher-than- average compensation.
9-14 Labor Market as Determinant of Direct Financial Compensation Potential employees located within the geographic area from which employees are recruited consist the labor market. Labor markets for some jobs extend far beyond the location of a firms operations. An aerospace firm in St. Louis, for example, may be concerned about the labor market for engineers in Fort Worth or Orlando, where competitors are located. As global economics increasingly sets the cost of labor, the global labor market grows in importance as a determinant of financial compensation for individuals.
Compensation Surveys A compensation survey is a means of obtaining data regarding what other firms are paying for specific jobs or job classes within a given labor market. Virtually all compensation professionals use compensation surveys that are purchased, outsourced to a consulting firm, or conducted by the organization itself.
Expediency (convenience) Although standard compensation surveys are generally useful, managers in highly technical and specialized areas occasionally need to use nontraditional means to determine what constitutes competitive compensation for scarce talent and niche positions. They need real-time information and must rely on recruiters and hiring managers on the front lines to let them know what is happening in the job market. 9-17 Cost of Living The logic for using cost of living as a pay determinant is both simple and sound: When prices rise over time and pay does not, real pay is actually lowered. A pay increase must be roughly equivalent to the increased cost of living (inflation rate) if a person is to maintain his or her previous level of real wages.
L a b o r U n i o n s The National Labor Relations Act established legislative support for the right of employees to organize and engage in collective bargaining to determine compensation. The areas of mandatory collective bargaining between management and unions are defined as wages, hours, and other terms and conditions of employment. Cost-of-living allowance has been disappearing.
The Economy The economy affects financial compensation decisions. For example, a depressed economy generally increases the labor supply, and this serves to lower the market rate. A booming economy, on the other hand, results in greater competition for workers and drives up the price of labor.
9-20 Compensation Legislation Federal and state laws can also affect the amount of compensation a person receives ( minimum wages, regulations for overtime pay, and standards for child labor, etc).
9-21 Job as Determinant of Direct Financial Compensation Job itself is a determinant factor, especially in firms that have internal pay equity as primary consideration. Organizations pay for value they attach to certain: Duties Responsibilities Other job-related factors, such as working conditions 9-22 Job Analysis and Job Descriptions BEFORE an organization can determine the relative value of its jobs, it must first define their content. This is done through job analysis. The primary by- product of job analysis is the job description.
9-23 J o b Ev a l u a t i o n Job evaluation is a process that determines the value of one job in relation to another and to the company. The primary purpose of job evaluation is to eliminate internal pay inequities. The four traditional job evaluation methods are: - Ranking - Classification - Factor comparison - Point methods Another option is to purchase a proprietary method such as the Hay guide chart-profile.
Ranking Method The ranking method is the simplest method Raters examine description of each job being evaluated and arrange the jobs in order according to their value to the company.
9-25 Cl as s i f i c at i on Met hod The classification method involves defining a number of classes or grades to describe group of jobs. Compare job description with class description Class description that most closely agrees with job description determines job classification
Factor Comparison Method The factor comparison method assumes that there are five universal job factors: - - Mental requirements, - Skills, - Physical requirements, - Responsibilities - Working conditions. The evaluator makes decisions on these factors independently. An evaluation committee creates a monetary scale, containing each of the five universal factors, and ranks jobs according to their assessed value for each factor.
Point Method In the point method, raters assign numerical values to specific job factors, such as knowledge required, and the sum of these values provides a quantitative assessment of a jobs relative worth.
Hay Guide Chart-Profile Method The Hay guide chart-profile method is a version of the point method used by approximately 8,000 public- and private-sector organizations worldwide to evaluate clerical, trade, technical, professional, managerial, and executive-level jobs. It uses the factors of know-how, problem solving, accountability, and other job-related elements.
Job Pricing Job pricing results in placing a dollar value on a job. It takes place after a job has been evaluated and the relative value of each job in the organization has been determined. Firms often use pay grades and pay ranges in the job-pricing process.
9-30 Scatter Diagram of Evaluated Jobs Illustrating Wage Curve, Pay Grades, and Pay Ranges 9-31 100 200 300 400 500 17.20 $19.80 18.50 15.90 14.60 14.00 13.30 12.90 12.00 Average Pay per Hour (Current Rates or Market Rates) Evaluated Points 1 2 3 4 5 Pay Grades 1 2 3 4 5 Pay Ranges for Pay Grades 0- 99 1 $12.00 $13.30 $ 14.60 100-199 2 13.30 14.60 15.90 200-299 3 14.60 15.90 17.20 300-399 4 15.90 17.20 18.50 400-500 5 17.20 18.50 19.80 Evaluated Points Pay Grade Minimum Midpoint Maximum Summary Pay Ranges Minimum and maximum pay rate with enough variance between to allow for significant pay difference Generally preferred over single pay rates Need to develop a method to advance individuals through the range
9-32 Pay Gr ades A pay grade is the grouping of similar jobs to simplify pricing jobs. For example, it is much more convenient for organizations to price 15 pay grades than 200 separate jobs. Similar to a universitys practice of grouping grades Grades of 90100 are an A Grades of 8089 are a B, etc. Plotting jobs on a scatter diagram (disperse diagram) 9-33 Wage Curve A wage curve is the fitting of plotted points to create a smooth progression between pay grades. The line drawn minimizes the distance between all dots and the line. Although the line of best fit may be straight or curved, a straight line is often the result when the point system is used.
9-34 Si n g l e Ra t e Sy s t e ms Pay ranges are not appropriate for some workplace conditions, such as assembly-line operations. For instance, when all jobs within a unit are routine, with little opportunity for employees to vary their productivity, a single-rate system may be more appropriate. When single rates are used, everyone in the same job receives the same base pay, regardless of productivity.
Adjusting Pay Rates Good management practice is to correct pay inequities for underpaid employees as rapidly as possible. Overpaid jobs present a different problem. Promotion is a possibility if the employee is qualified for a higher-rated job and a job opening is available. Another possibility is to freeze the rate until across-the-board pay increases bring the job into line. Bad idea to cut pay
Employee as Determinant of Direct Financial Compensation In addition to the organization, the labor market, and the job itself, factors related to the employee are also essential in determining an individuals compensation. These factors include:
Performance-Based Pay The goal of performance-based pay is to link pay and performance. It recognizes that some workers are just better than other workers at performing the same job.
Merit pay Variable pay Bonuses Spot bonuses Piecework M e r i t P a y Merit pay is a pay increase added to employees base pay based on their level of performance. It has historically been merely a cost-of-living increase in disguise. The recession of 2008-2010 may have created a compensation revolution with regard to merit pay. Pay increases where everyone is treated essentially the same, with only small differences between the best performers and mediocre ones, are a thing of the past. Although many companies continue with traditional merit pay plans, some companies are starting to quietly freeze or cut pay for some so as to be able to reward others.
Variable Pay (Bonuses) Companies are increasingly placing a higher percentage of their compensation budget in variable pay as they embrace the concept of pay for performance. The most common type of variable pay for performance is the bonus, a one-time annual financial award based on productivity that is not added to base pay. Use of bonuses is a winwin situation. 9-40 Spot Bonuses Spot bonuses are relatively small monetary gifts provided to employees for outstanding work or effort during a reasonably short period of time. If an employees performance has been exceptional, the employer may reward the worker with a one-time bonus ranging from $100 or $500 to perhaps as much as $5,000. According to a World at Work Survey, 45 percent of companies use spot bonuses.
9-41 Piecework Piecework is an incentive pay plan in which employees are paid for each unit they produce. For example, if a worker is paid $8 a unit and produces 10 units a day, the worker earns $80. Sometimes a guaranteed base is included in a piece-rate plan, meaning that a worker would receive this base amount no matter what the output. Piecework is especially prevalent in the production/operations area.
Skill-Based Pay Skill-based pay is a system that compensates employees for their job-related skills and knowledge, rather than the present job. The system assumes that employees who know more are more valuable to the firm and, therefore, they deserve a reward for their efforts to acquire new skills. This presents some challenges for management because the firm must provide adequate training opportunities or else the system can become de-motivating. 9-43 Co mp e t e n c y - Ba s e d Pa y Competency-based pay is a compensation plan that rewards employees for the capabilities they attain. It is a type of skill-based pay plan for professional and managerial employees. Today, there are many alternatives from which to choosecore, organizational, behavioral, and technical competencies. This approach requires that considerable time be spent determining the specific competencies needed for the different jobs. Blocks of competencies are then priced.
9-44 Other Determinants of Pay Seniority: Length of time an employee has been with the company Experience: Has a significant impact on performance Potential: Used to attract prospective talent Political influence: May affect pay and promotion decisions Luck: Being in the right place at the right time
9-45 Salary Compression: Why Is the New Guy Making What I Am Making? Salary compression occurs when less experienced employees are paid as much as or more than long- time employees due to a gradual increase in starting salaries and limited salary adjustment for long-term employees. As workers discover inequities in their pay, anger and lower productivity may follow.
T e a m- Ba s e d Pa y Changing a firms compensation structure from an individual-based system to one that involves team-based pay can improve efficiency, productivity, and profitability. Team incentives have both advantages and disadvantages. On the positive side, firms find it easier to develop performance standards for groups than for individuals. A potential disadvantage for team incentives is that exemplary performers may feel unrecognized and under- rewarded. Company-Wide Pay In sports, you do not judge the team based on one player, but on its overall winloss record. In business, company-wide pay plans based on the firms: - Profit sharing - Gain sharing - Scanlon plan Offer a possible alternative to the incentive plans previously discussed.
Profit Sharing Profit sharing is a compensation plan that results in the distribution of a predetermined percentage of the firms profits to employees. Normally, most full-time employees are included in a companys profit-sharing plan after a specified waiting period.
Gain sharing Gain sharing plans are designed to link employees to the firms productivity and to provide an incentive payment based on improved company performance. The goal of gain sharing is improving efficiency, reducing costs, and improving profitability. Gain sharing helps align employees with the organizations strategy.
Sc anl on Pl an The Scanlon plan provides a financial reward to employees for savings in labor costs resulting from their suggestions. If the company is able to reduce payroll costs through increased operating efficiency, it shares the savings with its employees.
9-51 Pr o f e s s i o n a l Co mp e n s a t i o n Professional employees perform work requiring advanced knowledge in a field, normally acquired through an extended course of specialized instruction. Their pay, initially, is for the knowledge they bring to the organization. Gradually, however, some of this knowledge becomes obsolete. Maturity curves are used to reflect the relationship between professional compensation and years of experience. These curves are used primarily to establish rates of pay for scientists and engineers involved in technical work.
Sales Representative Compensation The straight salary approach is one extreme in sales compensation. In this method, salespersons receive a fixed salary regardless of their sales levels. At the other extreme is straight commission, in which the salespersons pay is entirely determined as a percentage of sales. If the salesperson working on straight commission makes no sales, this salesperson receives no pay. Between these extremes are endless varieties of part-salary, part-commission combinations.
Contingent Worker Compensation Contingent workers are employed through an employment agency or on an on-call basis and often earn less than traditional, permanent employees. Flexibility and lower costs for the employer are key reasons for the increased use of contingent workers. In most cases, contingents earn less pay and are far less likely to receive health or retirement benefits than their permanent counterparts.
Ex e c u t i v e Co mp e n s a t i o n The pay gap between the most affluent executives and the average worker has become enormous. It is difficult for workers who make $12 to $18 an hour to appreciate why these executives are making such outrageous salaries. On the other hand, the skills possessed by executives largely determine whether a firm will survive or fail. Thus, a companys program for compensating executives is a critical factor in attracting and retaining the best available talent. Organizations typically tie salary growth for executives to market rates and overall corporate performance, including the firms market value.
Types of Executive Compensation The basic elements of executive compensation: Base salary Bonuses and performance-based pay Stock option plans Perquisites (perks) 9-56 Bas e Sal ar y Although it may not represent the largest portion of the executives compensation package, the base salary provided is obviously important. It is a factor in determining the executives standard of living and may also determine the amount of bonuses and certain benefits. U.S. tax law does not allow companies to deduct more than $1 million of executives salary.
Bonuses and Performance-Based Pay As shareholders become increasingly disappointed with high levels of executive compensation for insignificant accomplishments, performance-based pay is gaining in popularity. This shift reflects a belief that cash bonuses, based only on achieving meaningful performance goals, can provide real incentives to senior level employees.
Stock Option Plans Stock option plans give executives the option to buy a specified amount of stock in the future at or below the current market price. The stock option is a long-term incentive designed to integrate the interests of management (executives) with those of the organization. 9-59 Per qui s i t es Perquisites (or perks) are any special benefits provided by a firm to a small group of key executives and designed to give the executives something extra. Perks might include a company car, limousine service, and use of company plane or yacht. In 2007, the Securities and Exchange Commission lowered the threshold for disclosure of executive perks from $50,000 to $10,000. 9-60 Golden Parachute Contract A golden parachute contract protects executives in the event that another company acquires their firm or the executive is forced to leave the firm. Golden parachute contracts and severance (separation) agreements are negotiated prior to executives being hired. 9-61 Executive Severance Pay Excessive severance has slowed considerably, and executives are walking away with much less severance pay. 9-62 Clawback Contract Provision The contract terms allows company to recover compensation if subsequent review indicates that payments were not calculated accurately or performance goals were not met. 70% of country's 100 largest companies have implemented clawback provisions.