What is the Employee Compensation?

Explore the essential components of employee compensation, including wages, incentives, and benefits. Understand its significance in Human Resource Management, its impact on employee satisfaction, motivation, and organizational success. Learn about key objectives, factors that influence compensation, and theories shaping modern remuneration practices.

What are the Components of Employee Compensation?

Compensation is a critical function of Human Resource Management (HRM) that significantly impacts both employees and employers.

For employees, compensation is their primary source of income, influencing their standard of living, social status, motivation, loyalty, and productivity.

For employers, compensation serves as a tool to attract, retain, develop, promote, and motivate employees, ultimately leading to effective results. Compensation also represents a substantial portion of a business’s operating costs, and disputes over it often lead to strikes and lockouts. Therefore, organizations must formulate and implement well-considered compensation policies.

Employee Compensation: An Introduction

Designing an effective compensation program in today’s environment of cost constraints, increasing demands, and professional expertise requires creativity and foresight. Compensation packages have evolved significantly, with a greater diversity of offerings. Historically, public sector organizations were often the highest payers, with distinct pay structures in both state-level public sectors and the private sector.

The question of whether money matters is unequivocally “yes.” Money provides the means for a more affluent lifestyle, including better clothes, vacations, and education. Our earnings often influence our self-perception and social standing. In the workplace, money motivates behavior when it fairly rewards performance and contributions, and when management is perceived as equitable. Interestingly, different components of pay hold varying values for individuals; younger employees often prioritize cash, while older employees may favor benefits and workplace flexibility. Therefore, compensation is perceived differently at various life and career stages.

Employee satisfaction with pay is crucial. Research indicates that pay satisfaction is a result of the input-outcome ratio, where inputs include effort, skill, education, and experience, and outcomes encompass pay, promotions, and recognition. Employees also compare their input-outcome ratio with others, and a perceived sense of fairness in compensation increases satisfaction. This satisfaction directly correlates with organizational commitment and trust in management, and inversely relates to absenteeism, lateness, job searching, termination, and theft.

Meaning of Employee Compensation

Compensation is a vital HRM activity with significant implications for both employees and employers. It is the primary source of livelihood for employees, determining their standard of living, social status, motivation, loyalty, and productivity. For employers, it is a mechanism for attracting, retaining, developing, promoting, and motivating employees to achieve effective results.

Compensation also constitutes a substantial operating cost for businesses, frequently leading to industrial disputes. Given its importance, organizations must develop and implement sound compensation policies. Compensation planning and management, also known as wage and salary administration, involves establishing a systematic and robust compensation structure. Without a clear policy, wages may be based on arbitrary decisions rather than a well-defined structure. Key aspects of wage and salary administration include wage and salary surveys, job evaluation, merit rating, and incentives.

Compensation broadly refers to all financial and non-financial rewards employees receive for their services. This includes wages, salaries, and benefits such as paid vacations, insurance, maternity leave, travel facilities, and retirement benefits. Monetary payments are a direct and powerful motivator for employees.

A robust compensation system is essential for several reasons:

• (i) It attracts capable employees.
• (ii) It motivates employees for better performance.
• (iii) It helps retain employees, reducing turnover.

Definitions of Employee Compensation

The term “compensation” originates from “compensate,” meaning to pay or make up for something. In an employment context, it refers to payment for services rendered. Most people associate “compensation” with payment for work, whether full-time or part-time, as a reward for their energy and time.

Here are some definitions for a clearer understanding:

According to Jack Welch, “If you pick the right people and give them the opportunity to spread their wings and put compensation and rewards as a carrier behind it – you almost don’t have to manage them.”

Compensation can also be defined as “the return that an employee received from the organization for the work he does for it. Compensation occupies an important place in life of every employee.”

Gary Dessler defines compensation as “all forms of pay going to employees and arising from their employment. It has two main components namely (i) Direct financial payment, and (ii) Indirect financial payment.”

From an employer’s perspective, compensation is “the money that they pay to the employees in return for the work that they do is something that they need to plan for in an elaborate and systematic manner. Unless the employer and the employee are in agreement, the net result is dissatisfaction from the employee’s perspective and friction in the relationship.”

Other Definitions

Compensation acts as the “glue” binding employees and employers. In the organized sector, this is formalized through contracts that specify payment details and compensation package components.

While Maslow’s Need Hierarchy Theory places compensation at the lower to middle rung of needs, for many employees, fair compensation is a strong motivating factor in itself. Employers must accurately quantify employee contributions to maximize their potential. Monetary value exchanged for work is the fundamental basis of compensation.

Compensation essentially means something that offsets or makes up for something else. The current trend in progressive sectors is to view employees as “creators and drivers of value.” Companies worldwide are meticulously reviewing their pay structures, components, and competitiveness to attract top talent.

Concept of Employee Compensation

Compensation is an earning for employees, a cost for employers, and a potential source of taxes for the government. It reflects an individual’s capabilities and suitability for an organization and job, influencing their remuneration. Simultaneously, it is the largest source of purchasing power, impacting the socio-economic values of a locality, state, region, or nation.

It is a reward, monetary and/or beneficial, for an individual’s physical and/or mental efforts in performing a job, aiming to motivate and satisfy them in the workplace. Thus, compensation is the reward for work or services offered to an organization or institution. For some, it represents the value of their personal skills and abilities; for others, it’s the return on their education or training. It can also signify their worth in a specific role based on qualifications, training, skills, and expertise. The form, type, and disbursement pattern of compensation are integral to the employment agreement.

In essence, compensation encompasses all financial and tangible services or benefits an employee receives from an organization as part of their employment.

Associated

Several terms are associated with compensation, defining it for various employee classes, professionals, and workers:

• Wages: Hourly, daily, weekly, or monthly payments to workers for their efforts. Stroud’s Judiciary Dictionary defines wages as “personal earning of the labourers and artisans.” Government influence on wage fixation has led to many types of wages.
• Salary: Remuneration paid monthly to staff (clerical, ministerial, secretarial, administrative, security, etc.) or executives/managerial personnel.
• Gross Salary: The total agreed-upon amount paid to staff/executives, including all monetary values for compensation, benefits, and facilities. It can be claimed monthly or annually.
• Take-home Salary: The amount an employee receives after statutory deductions.
• Fees/Commission: Compensation to an individual/agent for efforts made to accomplish work through them or for their involvement as a special service.
• Labour Charge: Payment to an individual for physical efforts requested for a specific period or purpose, such as packing, loading, digging, or shifting materials.

Modern compensation management also employs the following definitions:

• Pay Package: The total emoluments assured to an individual upon accepting employment, covering direct and indirect payments, allowances, and incentives.
• Compensation: A modern term for wage/salary, emphasizing equity and an individual’s sense of worth for their services or efforts in a specific job or position.

12 Important Objectives of Employee Compensation

The objectives of compensation are:

1. To recruit and retain qualified employees.
2. To increase or maintain employee morale and satisfaction.
3. To motivate employees for enhanced performance.
4. To attract and retain skilled and talented workforce.
5. To establish basic wages and manage salary administration.
6. To achieve internal and external equity.
7. To ensure equal pay for equal work, meaning fair pay for similar jobs.
8. To support, communicate, and reinforce an organization’s culture, values, and competitive strategy.
9. To reduce turnover and foster company loyalty.
10. To reward exceptional job performance through plans like bonuses, commissions, profit sharing, stocks, and gain sharing.
11. To control costs, as a rational compensation system helps organizations acquire and retain workers at a reasonable expense.
12. To comply with legal regulations, as a sound wage and salary system considers government-imposed legal requirements to ensure employee compliance.

Compensation directly impacts morale and job satisfaction. A balance (equity) must be struck between the employer’s willingness to pay and the employee’s sense of worth. Employers may freeze salaries to save costs, potentially sacrificing satisfaction and morale. Conversely, to reduce turnover, an employer might increase salaries.

5 Main Characteristics of Employee Compensation

The following characteristics are crucial for any compensation program to attract, motivate, and retain competent employees:

1. Internal Equity: This measures how an organization values its jobs relative to each other. Internal equity exists when wages align with the internal value of each job.
2. External Competitiveness: This compares an organization’s wage and salary structure to that of its competitors in the job market for similar businesses. External equity is achieved when an employer pays a wage rate comparable to the prevailing rate in external labor markets.
3. Affordability: Pay structures must be formulated responsibly to prevent labor costs from exceeding the organization’s capacity to pay.
4. Legal Obligations: Any compensation program must conform to existing wage-related legislation to ensure fairness in employee payment.
5. Flexibility: Pay programs are essential tools for competing in the labor market and should be flexible enough to adapt to changing requirements.

Top 4 Components of Employee Compensation

The components of compensation are:

1. Wage and Salary

Wages and salaries are the most fundamental components of compensation, essential for all organizations. Wages typically refer to remuneration for workers, often paid hourly. While salaries denote remuneration for white-collar employees, including managerial personnel. Wages and salaries are paid for a fixed period and are generally not directly tied to an employee’s immediate productivity.

2. Incentives

Incentives are additional payments to employees beyond their wages and salaries. They are often linked to productivity, such as higher output or cost savings, or both. Incentives can be provided on an individual or group basis.

3. Fringe Benefits

Fringe benefits encompass advantages provided to employees that can have a long-term impact (e.g., provident fund, gratuity, pension), cover specific events (e.g., medical benefits, accident relief, health and life insurance), or facilitate job performance (e.g., uniforms, canteens, recreation).

4. Perquisites

Perquisites are typically offered to managerial personnel to either aid their job performance or to retain them within the organization. Examples include company cars, club memberships, free residential accommodation, paid holiday trips, and stock options.

4 Important Factors Affecting Compensation

Generally, the following factors influence compensation:

1. Individual factor
2. Organizational factor
3. Competitive factor
4. Product cost factor

1. Individual Factor:

Employees are concerned about their compensation worth, and differentiations in pay depend on sex, skill, experience, and level of competition. In designing compensation structures, an individual’s skill, knowledge, expertise, attitude, sex, work environment, and experience are crucial for aligning job levels with job descriptions and individual personalities. Similarly, the creativity, innovation, and imitation required for a specific job also play a role. These factors determine an employee’s worth for a particular job and contribute to wage/salary differentiations.

2. Organizational Factor:

Organizational earnings are dependent on employee productivity and efficiency, which in turn indicate the company’s ability to pay. Additionally, the size and technology required for tasks, and the span of control, are influenced by the organization’s size and nature. The financial strength of the company, its size, nature, number of levels, and the cost of technology used also determine its capacity to pay.

3. Competitive Factor:

The level of pay is determined by the organization’s mission and vision – whether it aims to lead, develop competitiveness, or adapt to changing environments. This helps establish minimum and maximum salary ranges for entry-level, middle-level, or higher-level positions, and for retaining existing talent.

4. Product Cost Factor:

This involves converting the job’s value into a monetary reward for the employee performing or intending to perform that job. The process includes job analysis, job pricing, considering wage/salary surveys and government legislation, assessing organizational capacity to pay, and developing pay packages for different employee levels.

Other Factors Influencing Compensation Design:

Beyond the common factors, the following considerations require careful analysis for effective wage or salary structure administration and management:

• Company’s objective and mission: Every organization, regardless of size, nature, or technology, has its own objectives and HR policy, potentially having varying grades or structures to achieve its mission.
• Marketing rates and trends to fulfil objectives of external equity: With evolving business environments, market rates and employee expectations constantly change. To design an acceptable compensation structure, employers must understand prevailing market conditions and trends.
• The organizational ability to pay to maintain the commitments: While employers are generally expected to pay market rates, some may face constraints in paying higher or even comparable wages due to their size, technology, and employee numbers. The capacity to pay is thus a crucial factor in designing pay structures.
• Supply and demand elasticity to view the future conditions of market values: Supply and demand fluctuate at regional, state, or national levels. When designing compensation structures, the impact of demand and supply elasticity in the relevant area cannot be overlooked, as rates will vary accordingly.
• Cost of living in the region: The cost of living and standard of living vary geographically, a factor to consider when designing the variable component of compensation to provide an adequate buffer for rising living expenses.

Other things

• Productivity linked performance: Every employer’s primary goal is to earn returns on investment, and employee compensation is an investment in human resources. Therefore, they view compensation as a company cost and seek returns on their investment. Productivity-linked performance is thus an important factor in designing pay packages.
• Strengths of unions and their pressure on compensation: Trade unions act as wage fixation mechanisms. Their bargaining power depends on membership numbers and leadership. Stronger unions can sometimes exert pressure for faster pay revisions or higher pay packages, irrespective of productivity. Therefore, their strength is also a factor in designing wages or salaries.
• Company’s goodwill and image in the market: Depending on a company’s market image and earned goodwill, some companies may need to consider higher pay structures to differentiate themselves.
• Various Government legislations to protect the interests of the employees: Government policies and socio-economic plans consider employment rates and the protection of vulnerable workers and their welfare. The government periodically reviews and enacts legislation to regulate employment conditions and compensation structures.
• Tribunals’ judgments on compensation disputes: Labor courts and tribunals established by the government to resolve employer-employee disputes issue orders that serve as guidelines for designing compensation structures to prevent future conflicts.

7 Important Theories of Employee Compensation

1. Wage Theories:

The determination of employee wages has been a long-standing topic of discussion, dating back to when individuals first began working for others. Initially, compensation was in kind, then shifted to monetary payments. However, the exact amount to pay for services rendered remains a subject of debate. Many economists have explored this, developing various wage theories. It’s important to remember that most of these theories originated before the full development of modern industry and technology, but some core ideas are still relevant today.

2. Wages Fund Theory:

Propounded by Adam Smith, this theory suggests that wages are paid from a fund of wealth accumulated by a rich person through savings. Once this fund is available, the rich person employs labor for assigned work. The quantum of wages depended on the size of this fund; a larger fund meant higher wages, and a smaller fund, lower wages.

This theory finds some relevance in present-day Indian organizations. When a company is performing well and generating higher profits, employers often readily pay higher wages. Conversely, during losses, they try to minimize labor expenses. Business owners also consider the total wage bill as a percentage of total production cost (e.g., 2-5%), and if it increases, they try to cut it down. While this theory suggests employers control wages based on available resources, it’s not the sole basis for their decisions, as other factors also play a role.

3. Subsistence Theory:

Based on the assumption of a constant labor force, this theory, by David Ricardo, states that “laborers are paid to enable them to subsist and perpetuate the race without increase or diminution.” Ricardo believed that higher wages would lead to an increase in workers, subsequently driving wages down. Lower wages would then reduce the number of available workers.

This phenomenon is still observed today. When there’s a shortage of manpower in a particular field, wages are higher. This attracts more people to that vocation. When a large number of workers become available, organizations reduce wages. A classic example is computer programmers in India. In the 1960s, they were rare and highly paid (Rs. 2500-3000/month), compared to university lecturers (Rs. 600-700/month). As a result, many learned computer programming, leading to a surplus today where programmers earn less than university lecturers. Thus, this theory holds some relevance for contemporary industry.

4. Surplus Value Theory:

Karl Marx’s significant contribution to wage theories argued that workers were commodities bought at low cost. Industrialists or capitalists profited by not adequately paying workers, using the generated savings for their own expenses. In essence, capitalists exploited workers by paying them less than what was due for their time and effort.

While this may be less prevalent in large, organized sectors today due to increased worker awareness and protective labor legislation, exploitation still occurs in the unorganized sector, where workers might not even receive minimum wages or mandated benefits. Bonded labor is a stark example of such exploitation. Governments and social organizations are actively working to eliminate labor exploitation, and such instances are rare in large, organized sectors.

5. Marginal Productivity Theory:

This theory posits that wages depend on the demand for and supply of labor. Wages are determined by the supply and demand of workers, and their contribution must be economically useful. Factory owners or promoters retain a portion of the labor’s contribution. They stop hiring additional labor when it ceases to be profitable. Furthermore, if labor becomes uneconomical, employers seek better technology or automation. In simple terms, employers utilize labor only as long as it contributes to organizational earnings, ceasing to hire when it no longer does.

Originating from Philips Henry Wicksteed and John Bates Clark, this theory remains relevant today. Management avoids employing uneconomical labor and readily replaces it with machinery whenever possible.

6. The Bargaining Theory:

According to John Davidson’s theory, worker wages are determined by the bargaining power of labor unions and employers or their associations. Strong unions can force organizations to meet their demands, potentially leading to operational shutdowns. Conversely, strong employers can compel unions to drop their demands. Numerous instances demonstrate wages being determined on this basis. A recent example is the strike by government hospital nurses, which resulted in a wage increase of Rs. 2000 or more per month after their demands were met.

7. Behavioural Theories:

Behavioral scientists explore factors motivating higher worker productivity, where wages play a crucial role. However, wages sometimes take a backseat when a worker joins an organization for its reputation or accepts a job with greater social prestige, even if it offers lower wages.

Nonetheless, the motivating power of money cannot be denied. Even senior-level employees are attracted by salary and corresponding perquisites. Money provides individuals with necessities to meet various needs, including ego and status. Thus, employers attract desired employees through better wages and salaries, while also creating other organizational attractions that might appeal to employees at lesser wages.

Types of Employee Compensation

Compensation is a crucial human resource function, often representing the largest single cost for many organizations. An effective compensation system reinforces core corporate values and helps achieve organizational objectives.

Total compensation packages are broadly categorized into two main types:

1. Direct Compensation:

(i) Base Pay:

This is the primary component of executive remuneration, determined through job evaluation based on the skill, effort, and responsibility required for the job, and working conditions. While paying a wage is standard, competitive advantage comes from offering a higher amount.

(ii) Bonus:

A bonus is an occasional gift to reward exceptional performance or mark special occasions. It’s vital in today’s competitive executive payment programs, showing employer appreciation and rewarding good performance or special events. These are typically short-term (annual) incentives based on performance or profit sharing.

The New English Dictionary defines Bonus as “a boon or gift over and above what is normally due as remuneration to the receiver and which is therefore, something wholly to be good.”

There are four main types of bonuses:

• (a) Production bonus,
• (b) Bonus as an implied term of contract,
• (c) Customary bonus for festivals, and
• (d) Profit bonus.

Profit bonus is legally recognized under the Payment of Bonus Act, with its quantum linked to the year’s profit. Executives deserve bonuses because they have greater opportunities to influence organizational success than non-managerial staff.

(iii) Long-Term Incentives or Stock Options:

Defined as the right to buy a piece of the business, these are given to employees to reward excellent service. While bonuses are short-term, stock options are long-term benefits for executives. An executive receives the right to purchase company shares at a fixed price, which is valuable as long as the share price rises. An employee with a stake in the business is more likely to go the extra mile.

(iv) Perks or Perquisites:

Perks form a significant income source for executives. Besides standard perks like provident fund and gratuity, executives enjoy benefits such as vacation travel, club memberships, and furnished housing. Companies often cover servants, telephone bills, and even car fuel.

While monetary incentives are strong motivators, many non-financial factors can also capture attention and encourage action. These non-financial incentives represent desirable “things” within the organization’s disposal. Their creation is limited only by a manager’s ingenuity and ability to identify what individuals find desirable and what falls within their jurisdiction.

2. Indirect Compensation:

In a tight labor market, indirect compensation gains increasing importance. Businesses unable to compete with high cash wages can offer individualized alternatives that meet employee needs.

Some indirect compensation alternatives include:

• (i) Flexible working schedules
• (ii) Elder care
• (iii) Retirement programs
• (iv) Moving expenses
• (v) Insurance (health, eye, dental)
• (vi) Subsidized housing
• (vii) Paid leaves (sick/holiday/personal days)
• (viii) Subsidized utilities
• (ix) Tickets to events (ball games, concerts)
• (x) Magazine subscriptions
• (xi) Boots and clothing
• (xii) Laundry services
• (xiii) Company parties
• (xiv) Use of machinery, farm produce goods/meals
• (xv) Cellular phones/pagers
• (xvi) Child care.

Non-monetary benefits include challenging job responsibilities, competent supervision, supportive leadership, and comfortable working conditions.

Importance of Employee Compensation

Compensation is the most critical element in the employment relationship, holding equal significance for the employer, employee, and government.

• To the employer: Compensation represents a substantial cost, is increasingly vital for employee performance and competitiveness, and impacts their ability to recruit and retain a quality workforce.
• To the employee: It is fundamental to their standard of living and measures the value of their services or performance.
• To the government: It influences macroeconomic stability aspects like employment, inflation, purchasing power, and overall socio-economic development.

Employees perceive compensation as fair if it’s based on systematic components. Various compensation systems have evolved to determine job values, often sharing common elements like job descriptions, salary ranges/structures, and written procedures.

1. Job description: A crucial component of both compensation and selection systems, job descriptions formally define job responsibilities, requirements, functions, duties, location, environment, conditions, and other aspects. Descriptions can be developed for individual jobs or entire job families.
2. Job analysis: The process of analyzing jobs from which job descriptions are developed. Techniques include interviews, questionnaires, and observations.
3. Job evaluation: A system for comparing jobs to determine compensation levels for individual jobs or job elements.
4. Pay structure: Useful for standardizing compensation practices. Most pay structures include several grades, each with a minimum salary/wage and either step increments or a grade range. Step increments are common in unionized positions where pay is predetermined through collective bargaining.
5. Salary surveys: Collections of salary and market data, including average salaries, inflation indicators, cost of living indicators, and salary budget averages. Companies can purchase survey results from vendors or conduct their own.
6. Policies and regulations: This includes fair compensation policies, comprising a system of components designed to maintain internal and external equity.

International Compensation (With Benefits)

In recent years, globalization, the rapid growth of emerging markets, and the need to develop global managers have necessitated the international movement of managers through short-term or long-term assignments. For instance, an overseas training program might last a year, while taking on projects could involve a long-term assignment. Decisions regarding expatriate compensation are crucial for retention and motivation.

Managing a growing number of individuals from developed and developing countries at different career stages makes a single remuneration system challenging. It is well-known that the cost of sending an employee abroad far exceeds just their salary. Companies must also consider airfares for the employee and their family, accommodation, relocation expenses, language training, and school fees.

Expatriate assignments sometimes fail, often due to adjustment or relocation problems faced by the employee or their spouse. Adapting to a different culture is time-consuming and can lead to costly failures. A pre-assignment trip to the host location is advisable, allowing the expatriate and family to assess their ability to live there and adjust to the culture. Language tuition and independent financial counseling are also typically arranged for expatriates.

Expatriate salaries usually begin at their home-based rate, with local market rates also considered.

Several other factors also operate:

• (i) Reason for the assignment (managerial, developmental, skill-based),
• (ii) Nationality of expatriates and the developing countries they are sent to, and
• (iii) Duration of the assignment.

Besides salary, special allowances are paid to cover living costs, relocation, etc. In some cases, a hardship allowance is included for potential discomfort or difficulty in the host country, such as extreme climate, health hazards, or poor communication. This allowance is usually integrated into the salary package to make it more attractive.

Benefits of International Compensation:

Various allowances are offered as benefits. Housing allowances might be built into the package or paid separately, with some employers providing free accommodation while others offer an allowance. Allowances for utilities like electricity, water, and gas are also provided in some countries, often with usage ceilings to prevent extravagance. A car allowance is another common benefit, either as a monetary payment or a company car. Practices vary by city and continent. 

Most companies typically cover school fees for expatriates’ children in the host country. Club membership fees and subscriptions are often paid by the employer if there’s a strong business case, as the social environment is seen as vital for settling in and for business contacts, especially in developing countries. In some instances, companies cover annual or biennial trips to the expatriate’s home country for them and their family, though practices vary. Pensions and health insurance for expatriates are also generally provided.