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Compensation Plans: An Overview

All organizations have a compensation plan, written or unwritten, formal or informal. For some organizations, the purpose of that plan may be merely to meet compliance requirements. For other organizations, the goal of the compensation plan may be to attract qualified employees, to retain those employees, and to motivate employees to direct their efforts towards achieving the goals of the organization. Regardless of the goal, size and complexity of a compensation plan, there are generally many easily-identified elements to any compensation plan. This commentary reviews these elements, poses questions management can use to determine the stance it would like to take regarding compensation, and offers some advice and recommendations on implementing these ideas. The topics that will be covered are development of a compensation philosophy, objectives of a base pay program, developing rates of pay for jobs, pay rates and increases, performance appraisal, maintaining and auditing a compensation plan.

Development of a Compensation Philosophy

Before an organization actually develops a compensation plan, there are several questions that need to be answered. Taking the time to consider and answer these questions will make the both the process of developing and administering a compensation plan much easier and will result in the development of a compensation plan that more closely matches the organization's goals and objectives.

What is the goal of the organization's compensation system? In addition to attracting and retaining qualified employees, is there an intent to reward employees for good performance, motivate good performance, and/or create or reinforce a particular type of organizational climate?

What is the communication policy? How is the organization going to communicate the compensation plan to employees once it has been developed? Is the organization prepared to evaluate the effectiveness of any such communication? If so, how?

How will decisions regarding pay be made? Who will be involved in these decisions? What decision guidelines will need to be developed?

What is the organization's desired market position relative to pay? Will the organization choose to pay market rates, above market or below market? How does the desired market position fit with other strategic goals? Are there any competitive factors involved that will determine the pay strategy?

What is the desired mix between benefits and cash? Since benefits are an important form of compensation, how does an organization use them to maximize the effectiveness of the compensation plan?

What does the organization pay for? Does it pay for performance or seniority or some combination of the two?

What is the role of performance appraisal in the organization? How important is performance appraisal and why?

How will the organization manage change to the compensation plan once it has been developed? What systems need to be in place to implement any changes including deciding when change is necessary and who will make these decisions?

How does the compensation philosophy and plan fit with the rest of the organization? How can the compensation practices reinforce other overall management philosophies and objectives?

Objectives of a Base Pay Program
Before delving into the details of how actually to pay people, there are many factors that impact a base pay program that an organization must consider. In general, every organization's base pay program has certain objectives. The principal ones are as follows:

internal equity.
external equity (or competitiveness),
individual equity,
process equity,
performance or productivity incentives,
maximum use of financial resources,
compliance with laws and regulations, and
administrative efficiency.
As will be shown in the following, all of these objectives must be balanced in the development of a sound base pay program. As these points are being reviewed, management should ask the following questions:

Is this point important to this organization? If so, how important?

What are the implications of this point to the current or desired practices?

Internal Equity - Internal equity deals with the perceived worth of a job relative to other jobs in the organization. All employees compare their jobs to other jobs within the organization. Generally, they consider skill, effort, responsibility and working conditions in this comparison in order to determine the value of their jobs relative to other jobs. Likewise, management must often determine the "worth" or "value" of one job in relation other jobs for the purpose of pay programs. Maintaining appropriate pay relative to value or worth is achieving internal equity.

External Equity - External equity deals with the issue of market rates for jobs. An employer's goal should be to pay what is necessary to attract, retain and motivate a sufficient number of qualified employees. This requires a base pay program that pays competitively. Among others, internal data such as turnover rates and exit interviews can be helpful in determining the competitiveness of pay rates.

Employees also compare their jobs and pay to the jobs and pay in other organizations. Generally, employees consider much more than base pay in determining external equity. Depending on the individual employee, serious consideration may be given to employee benefits, job security, physical work environment, commuting distance, opportunity for advancement and the employee relations practices of the employer in determining external equity issues. In the Pacific Northwest, a frequent consideration is also lifestyle and quality of life.

An important issue to employees in determining external equity is the transferability of their skills. If an employee's skills are valued more highly in a different type of job or industry in the area, the employee may believe that s/he is being treated inequitably.

Note: An organization may choose to place the primary emphasis of its base pay program on internal equity, external equity or a blend of the two. There are important ramifications to this decision that should "fit" with other organizational structure issues and overall management objectives.

Individual Equity - Individual equity deals with how individuals perceive how they are being paid relative to other individuals within the organization and perhaps within the same position. This focus of individual equity is on the merits of the person filling a job, as opposed to the job itself. In simple terms, employees want to feel that the rewards they receive for how they do their work are comparable to the rewards received by others for the same amount of effort or output, all other factors being equal. How merit rewards or increases are given strongly impacts perceptions of individual equity.

Process Equity - How employees perceive the fairness or equity in the administration of the compensation system is process equity. Process equity, in the perceptions of employees, is strongly influenced by the openness of the system, communication of the system to employees, participation in design or administration of the system and a grievance appeal procedure.

Performance Incentives - A significant element of a base pay program is to encourage higher or increased levels of employee performance. Pay systems need to be designed to improve organizational performance.

Maximum Use of Financial Resources - Since an organization does not have unlimited financial resources, the base pay program needs to be designed to maximize the value to the organization with minimum use of these limited resources. In order to accomplish this, pay programs have a variety of tools such as pay range maximums, pay increase budgets, authorization procedures, compensation committees or various internal auditing procedures available to help accomplish this objective.

Compliance with Laws and Regulations - While not the primary objective of a pay program, one of the objectives of a pay program needs to be to keep the organization in compliance with various state and federal laws and regulations.

Administrative Efficiency - Due to the limited financial resources in an organization, one of the objectives of a pay program should be to have a pay program that is easy to administer, flexible, and cost-effective. Developing Rates of Pay for Jobs

The basis for most pay programs is a pay structure - a hierarchy of jobs with pay ranges and/or rates assigned. Pay structures are designed so that the greater the worth of a job (as determined by internal or external equity), the higher the pay grade and range. Developing a pay structure is a process with a series of steps:

job analysis,
job documentation,
development of a job worth hierarchy,
labor market data collection and analysis, and
establishment of pay rates and/or ranges.
Job Analysis - This involves collecting and evaluating relevant information about jobs. Any data collected should clarify the nature of the work being performed (principal or essential tasks, duties and responsibilities), the level of the work being performed, the extent and types of knowledge, skill, mental and physical effort and requirements, and responsibility required for the work being performed. There are five primary sources of data for collection of job information: questionnaires, interviews, logs or diaries, direct observation and work plans. All of these methods have advantages and disadvantages and the organization must choose the method that will provide comprehensive data with administrative efficiency and cost-effectiveness.

Job Documentation - There needs to be a formalized way to document job content. In most organizations, a job description is the means used to accomplish this. Job documentation is used to evaluate job content, provide objective criteria for making pay comparisons, ensure that jobs are classified according to content as opposed to individual personalities, effectively communicate the job duties to both supervisors and employees, and help the organization defend itself against charges of discrimination. Who should write job descriptions? That will depend on the resources available to the organization, but they should always be reviewed by line management.

Development of a Job Worth Hierarchy - A job worth hierarchy is the result of job evaluation, the overall process of comparing jobs. There are 6 major methods of comparing jobs in order to develop the job worth hierarchy. The first three methods are "whole-job" evaluations and are non-quantitative in nature. These include ranking, classification and slotting. The second three are "factor" evaluation and are quantitative in nature. These include point factor, factor comparison, and scored questionnaires.

Labor Market Data Collection and Analysis - Before an organization begins the process of collecting labor market data, it must first define its relevant labor market. This may include similar organizations in the same labor market, all employers in the local market, similar organizations in the regional or national market, and/or all employers in the regional or national market. The goal of labor market data collection is to find data from employers with whom the organization competes for employees. For clerical employees, this may be all employers in the local labor market. For high level management positions or certain specialized positions, this may be all employers in the national market. Once the data has been collected, it must be analyzed. The simplest analysis involves comparing the going market rate and approximating this rate within the organization's own pay structure. Other methods involve using advanced statistics to study relationships among certain items in a specific job or market group. An organization may find pay range information, as well as weighted average of actual pay, very helpful.

Establishment of Pay Ranges and/or Rates - In order to actually establish a pay structure, an organization needs to set rates of pay for the jobs in the job hierarchy. Before doing this, an organization needs to ask, and answer, the following questions:

How should the organization's pay level relate to the external market? Should the organization be a pay leader, match the market or pay less than market?

What is the organization willing to pay for: job content, seniority, performance, skills, cost of labor, or some combination of all of these?

How does the organization pay its employees: based on a single rate structure (all employees in the same job receive the same pay), based on seniority, based on merit, based on productivity (piece work), based on new skills (skill-based pay), or based on some combination of these factors? Are short term or long term incentives provided?

What steps does the organization need to take to ensure that pay is administered in a manner free of bias and discrimination?

If an organization decides to use pay ranges (or grades), it will have to determine how many ranges to have. This will depend on the number of different levels of relative job value that are recognized by the organization and the difference in pay between the highest and lowest paid jobs in the pay structure. The focal point of a pay range is the mid-point as this is generally the "going" rate for jobs assigned to that range. From the mid-point, an organization can determine the range minimum and maximum. The range minimum is the usually the lowest pay rate for any job in that range and is usually the pay rate given to people hired in that range who meet minimal qualifications only. Occasionally an organization will pay a "training" rate that is below that minimum. The maximum of a range is the highest rate an employer is willing to pay for jobs in that pay range. Other important range issues include the range width and the degree of overlap between ranges.

The end result of all of the above is a pay structure that should accomplish the organization's objectives with regards to a pay program, and should reflect the organization's philosophy on how it wishes to relate its pay program to the market. Also, this pay structure should demonstrate the internal job values of positions, and how the organization wishes to mix base pay, benefits and incentives.

Pay Rates and Pay Increases

Creating a pay structure is not the final step in the creation of a compensation plan. An organization must also decide how to administer this compensation plan. This means deciding how to pay new employees, how and when to give employees increases, including how to move existing employees from the minimum to the maximum of their assigned pay grades, how to determine the pay increase for an employee being promoted from one job to another and what influence, if any, cost of labor increases will have on the determination of pay increases for employees. In addition, an organization must develop policies and procedures that will implement the results of these decisions in a consistent manner.

Starting Pay for New Employees - In order to avoid paying new employees the same as more experienced employees, most employers choose to start new employees closer to the minimum of the pay range. In general, an employee with minimum qualifications should be paid the minimum of the range. This general rule is not true when a new hire has skills which are in great demand or has skills or other expertise substantially above the minimum.

Employee Increases - There are several different types of base pay increases: general (across-the-board) increases, cost-of-living/labor increases, promotion increases, step increases (based on longevity), and merit increases.

General increases are diminishing in popularity because they are not consistent with the idea of pay for performance. With a general increase, employees in a certain group based on established requirements are eligible for a certain monetary or percent increase to their base pay.

A cost-of-living increase is a type of general increase given to all eligible employees. This type of increase may happen as a result of union contract negotiation. Some companies choose to track benchmark positions over a period of time and modify other positions based on changes in the ranges of benchmark positions.

Promotion increases are given when an employee is moved from one job to another with a higher pay grade and range. The size of the increase will be influenced by the difference between the old and new pay ranges, and the pay of the newly promoted person's peers, superiors and subordinates, if any.

Step increases can be based solely on longevity or some combination of longevity and performance. Step increases alone are inconsistent with pay for performance.

Merit increases are also known as pay for performance. To be successful, an organization must be able to measure differences in job performance and these differences must be significant enough to merit the time and effort required to measure them and pay accordingly. Merit increases also affect other components of the compensation plan in that the pay range must be wide enough to allow for significant differences based on performance, supervisors and managers require training in performance planning and appraisal, and control mechanisms must be in place to successfully administer a merit increase program.

Performance Appraisal
If an organization chooses to pay for performance, the compensation plan must include a well-designed and properly administered performance appraisal system in order to be complete. Following are some questions that will help determine if an organization's current performance appraisal system meets this criteria.

Is performance appraised on the direct measurement of an employee's output or results? Does the performance appraisal system consider only job-related behavior rather than personality traits?

Are supervisors and managers trained in the performance appraisal process?

Are the criteria used to measure performance as objective and quantitative as possible? Or are the criteria open to subjective interpretation?

Have objective job standards been developed? Have the employees had input into the development of these standards? Are they communicated to the employees at the beginning of the appraisal period? Are job standards reviewed regularly to ensure relevance and importance to the department and organization?

Is the employee actively involved in the performance appraisal process? Or is a performance appraisal something that is "done" to the employee?

Maintaining and Auditing a Compensation Plan

Changes in the external market or internally within the organization can cause one or more parts of a compensation plan to become outdated. Part of the challenge in creating a compensation plan is to build in mechanisms that facilitate change when necessary, yet maintain control on a regular basis. Some actions an organization can take to maintain an updated compensation plan include regular review of job descriptions, monitoring of compensation levels versus companies with which there is competition for employees, and regular review of the pay structure including pay ranges and pay increase budgets.

An audit is an excellent means to ensure that a compensation plan is being properly administered and maintained. When planning to audit a compensation plan, an organization needs to consider the following:

Process measures - Are procedures and practices in place to ensure the compensation plan is being administered smoothly and efficiently?

Policy compliance - Are there procedures or other mechanisms in place to ensure that the compensation plan is being administered in accordance with policy?

Documentation adequacy - Is there adequate documentation in place to ensure that the administration of the compensation plan and compliance issues can be audited?

Overall results - Are there measures that can assess how well the compensation plan is achieving its goals and objectives?

After reviewing audit results, management can make recommendations on any improvements that may be necessary, allocate the necessary resources and follow-up to make sure the work is completed.


Success of a compensation plan includes an overall pay philosophy as well as the policies and procedures that govern operation of the compensation plan.

Because organizations have limited resources, excessive time and money should not be expended in pay program administration. The costs of administration should be balanced against achieving the other objectives of the pay plan.

An organization must decide how it will move employees through the pay range once a pay-range structure has been developed. An organization may utilize the following:

Individual performance as a basis for movement
Automatic or step progression based on employee tenure
Cost of living increases
If an organization chooses to implement a performance-based pay program, then compensation professionals must ensure that their merit-pay programs measure performance objectively and management must carefully evaluate performance to make judgments regarding pay differentials.

Organizations find that an audit of the compensation plan is a useful tool for educating management, thus increasing their understanding and support of the pay program. It is recommended to conduct a comprehensive audit at least every two years in order to identify problem areas and resolve them as soon as possible.


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