A comprehensive overview of compensation systems, exploring their design, characteristics, objectives, importance, types, and new approaches. Learn how effective compensation systems can enhance employee performance, ensure fairness, and drive organizational success.
Compensation System: Design, Characteristics, Objectives, Importance, Types, Essentials, and New Approaches
A compensation system encompasses all financial returns and benefits employees receive, including salary and incentives. It supports organizational strategy, ensures fairness, attracts talent, and boosts motivation. Effective design requires adherence to equity principles and compliance with laws, aiming to improve employee performance and maintain a competitive edge.
Compensation System Design
It refers to all financial returns, tangible services, and benefits employees receive from an employment relationship. It includes base salary, short- and long-term incentives, insurance, paid vacations, and employer discounts. A well-designed compensation system is crucial for an organization’s competitive advantage, supporting strategic plans, reinforcing corporate values, and also achieving objectives. It reflects how employees are valued.
Compensation practices are regulated by various laws such as The Equal Pay Act, Fair Labor Standards Act, and The Employment Retirement Income Security Act, covering pay issues like discrimination, minimum wages, overtime, and also benefits like pensions and unemployment compensation. Organizations must comply with these laws to avoid costly lawsuits.
Effective compensation design requires understanding its forms, vision, and direction. A well-designed plan helps achieve strategic goals, while a poorly designed one can demotivate employees. Experience shows that compensation can be a strong driver of employee behavior when properly designed, especially when pay variability is significant and linked to key performance factors. While top performers may not significantly improve, middle and bottom performers offer considerable opportunity for change with a new compensation plan.
Key steps in designing a compensation plan include:
Focusing on Strategic Objectives: The primary goal is to support organizational strategy and ensure the system fits the structure. Before designing, consider:
Organization’s rate, mission, and existence.
Strategic goals for the next five years.
Employee skills to meet objectives and how they will be rewarded or developed.
Organizational strategy (individual vs. team work, employees as costs vs. investments).
Comparison of current total compensation (including benefits, retirement, time off) with the market and the desired pay in relation to the market.
Appropriate balance between external market equity and also internal worth. Once these questions are answered, policy guidelines reflecting thinking, values, and strategies can be prepared and set by top management.
Ensuring Commitment through Communication and Participation: Executive management must be fully committed to the process, results, and implementation. Techniques for participation and communication include advisory or steering committees. A compensation review committee can identify issues, provide ideas, and offer valuable feedback.
Analyzing Job Functions: A thorough job analysis provides relevant information on the type, scope, and responsibility of each job. This is fundamental for job descriptions, market comparisons, establishing baseline information on job responsibility and qualifications, and also ensuring legal compliance.
Writing Job Descriptions: Information from job analysis is used to prepare job descriptions, which summarize the general nature of work, specific tasks, responsibilities, and required competencies. These should be reviewed and accepted by both the employee and supervisor before finalization.
Other Key steps:
Determining Internal Pay Equity: This ensures fairness within the organization, meaning employees perceive their pay as equitable. Internal equity is determined using job evaluation techniques like whole job ranking and factor comparison.
Determining External Pay Equity: This refers to the perceived fairness of pay compared to what other employers offer for similar labor. Market pricing is a recommended method for external equity and involves surveying competitors’ pay rates. Steps for a survey method include establishing a timeline, selecting benchmark positions, targeting participants, designing questionnaires, using other market data sources, and verifying answers.
Designing Salary Structure: After collecting market data and establishing a hierarchical order of positions, a salary structure can designed. This involves grouping jobs of equal value into grades with competitive salary ranges (minimum to maximum). Positions assigned based on job content, market equity, and internal equity, with the midpoint representing the market rate.
Typical compensation design problems include:
Failure to link pay closely to objective and realistic performance measures.
Lack of regular performance measurement and also feedback.
Insufficient pay variances related to performance to motivate employees.
Over-reliance on salary as the sole significant financial reward.
Characteristics of a Compensation System
A sound and effective compensation system should adhere to certain principles.
Key characteristics include:
Proportionality to Efficiency: Compensation should directly correlate with efficiency and results, with higher efficiency leading to higher pay.
Realistic Efficiency Standards: Standards should set considering a normal worker and normal working conditions, not excessively high.
Job Evaluation Basis: Compensation should be based on job evaluation.
Fairness: The system must be fair to both employer and employee, based on scientific time-and-motion studies to ensure standard output for the employer and fair wages for the employee.
Guaranteed Minimum Wage: Employees should assured of a satisfactory minimum wage regardless of work done.
Well-Defined and Uniform: The system should clearly defined, uniform, and generally applicable.
Skill-Based Pay Differential: Skilled employees should paid more to compensate for their efforts in acquiring skills.
Equal Pay for Equal Work: The system must ensure equal pay for equal work.
Minimal Exceptions: Exceptions to the system should be rare.
Flexibility: The system should be flexible to allow necessary changes over time.
Reduced Turnover and Absenteeism: It should minimize employee turnover, absenteeism, and late attendance.
Clear Communication: The system must clearly communicated and understood by all employees, enabling them to calculate their own compensation.
Simplicity: The system should be simple for easy implementation.
Motivation, Not Penalty: It should induce slow employees to achieve higher efficiency rather than penalizing them, and efficient employees should paid proportionally.
Other Key characteristics include:
No Penalty for Uncontrollable Reasons: Employees should not penalized for reasons beyond their control.
Non-Exploitative: The system should not be based on employee exploitation.
Boost Morale and Cooperation: It should raise employee morale, efficiency, and cooperation by being just, fair, and providing satisfaction.
Legal Compliance and Union Acceptance: It must be consistent with labor laws and accepted by trade unions through agreement.
Adherence to Union Agreements: It must not violate any local or national trade union agreements.
Organizational Capacity to Pay: The system should correlate with the organization’s capacity to pay.
An effective compensation system also typically:
Attracts and retains qualified workers.
Complies with government regulations.
Motivates employees, fosters equity, and directs efforts.
Communicates and reinforces the organization’s culture, values, and competitive strategy.
Has a cost structure reflecting the organization’s ability to pay.
Traditional compensation approaches focused on attraction, retention, and legal compliance, with pay linked to hierarchical position rather than contribution. Newer models aim to balance these objectives with increased attention to motivating performance and aligning pay with organizational goals.
Objectives of a Compensation System
Compensation systems are designed to streamline activities and effectively convert, allocate, and transfer a portion of organizational income to employees as rewards for their efforts. This can include on-hand wages/salaries, future payments (retirement, disabilities), and extra payments for additional work or annual appreciation. Non-monetary compensation like medical facilities, transportation, housing, and gifts also motivate employees.
Strategic compensation policies and working cultures play a vital role in increasing competitiveness, cooperation, and team cohesion by communicating employee value and the organization’s willingness to share revenue. A compensation system ensures fairness in determining worker worth, defining wage/salary differentiations, and outlining career growth plans to motivate better performance. Formalized compensation goals guide managers in achieving the system’s intended purpose.
Common objectives of a sound compensation system include:
Attracting Qualified Personnel: Compensation must be competitive enough to attract competent individuals, responding to labor market demand and supply.
Retaining Existing Competent Employees: Competitive and equitable compensation is crucial for retaining employees, as satisfaction often stems from comparing benefits with others.
Rewarding Desired Behavior and Maintaining Motivational Levels: The system should adequately reward performance, loyalty, experience, and other desirable behaviors to reinforce and incentivize them.
Maintaining Salary Equity: It should strive for both internal equity (pay related to job worth within the organization) and external equity (pay comparable to similar jobs in other organizations).
Controlling Costs: A rational system helps acquire and retain employees at a reasonable cost, preventing over- or underpayment and aiding payroll budgeting.
Improving Union-Management Relations: A fair system fosters smooth collective bargaining, reduces wage-related grievances, and finds favor with employees and unions.
Improving Public and Professional Image: A suitable system sends a positive signal to the job market, enhancing the organization’s image and demonstrating compliance with labor laws.
The two primary objectives are:
Equity:
Internal Equity: Pay related to the relative worth of a job, ensuring similar jobs receive similar pay.
External Equity: Paying workers comparably to what other firms in the labor market offer for similar roles, established through wage and salary surveys.
Individual Equity: Equal pay for equal work. The most important objective of any pay system is fairness or equity.
Efficiency:
Linking compensation to productivity, profit, and individual performance.
Attracting, rewarding, motivating, and retaining highly capable and efficient employees.
Maintaining market competitiveness.
Ensuring compliance with laws and regulations.
Building employer brand.
Other objectives of compensation planning include:
The compensation system plays a vital role in a business organization because employees are the most important factor in production and business processes. Workers, with their expectations and ambitions, contribute significantly and expect a fair share of the business/production process.
A fair compensation system provides the following benefits:
Positive Impact on Efficiency: Encourages employees to perform better and achieve standards.
Enhanced Job Evaluation: Improves the process of job evaluation, leading to more realistic standards.
Well-Defined and Uniform Application: Ensures a clear, consistent system applied at all organizational levels.
Simplicity and Flexibility: Allows employees to easily compute their compensation and adapts to changes.
Ease of Implementation and Ethical Treatment: Simple to implement and prevents worker exploitation.
Improved Morale and Cooperation: Raises morale, efficiency, and cooperation by being just and fair.
Legal Compliance: Helps management comply with various labor laws.
Dispute Resolution: Solves disputes between employee unions and management.
Equal Pay Principle: Adheres to the principle of equal pay.
Motivation and Growth: Motivates high performers and provides opportunities for those who wish to excel.
Peaceful Employer-Employee Relations: Fosters harmony between employers and employees.
Healthy Competition: Creates healthy competition and encourages hard work and efficiency.
Growth and Advancement: Offers growth and advancement opportunities to deserving employees.
Satisfied Workforce and Stability: Creates a happy, satisfied workforce, minimizing labor turnover and promoting organizational stability.
Talent Retention: Retains top talent by offering adequate compensation.
Organizational Expansion and Growth: Supports organizational expansion and growth with a skilled, talented, and happy workforce.
Hallmark of Success: A sound compensation system is a hallmark of an organization’s success and prosperity, measured by the pay packages offered to employees.
Types of Compensation Systems
Organizations primarily compensate employees on an individual basis. Some common pay systems include:
Piece Rate System:
Description: Employees are paid based on the number of units manufactured within a time period. Organizations use output data and time-and-motion studies to set minimum unit targets.
Disadvantages: Employees may feel management prioritizes productivity over welfare, leading to distrust and “go-slow” techniques to prevent layoffs.
Modified Example: Lincoln Electric combines piece rate with a merit-rating-based bonus system, improving product quality as workers strive for good ratings for higher bonuses.
Commission System:
Description: Employees whose productivity can be quantified (e.g., sales professionals) are paid commission based on achievements (e.g., sales). This motivates them.
Advantages: Objective and efficient for salespersons.
Disadvantages: May lead to unethical techniques to increase sales and commission.
Bonus System:
Description: A lump-sum payment given at year-end for achieving productivity or performance targets.
Advantages: Employees feel content with a large sum, which may not be the case if spread over months. It’s a successful and reliable system.
Skill-Based System:
Description: Employees are paid based on the number of skills they possess, learned on the job. They are trained in various job activities to develop expertise.
Purpose: To train employees in various aspects of a job.
Adoption: Used by organizations with high-performance work systems and self-managed work groups (e.g., IT industry).
Merit Pay System:
Description: A pay hike given to employees after annual performance reviews, commensurate with their performance in the previous year.
Major Problem:Organizations commit to these cumulative increments, which can be costly in the long run, even during losses.
Bias Risk: Dependent on supervisor merit ratings, which can have an element of bias and lead to unfair ratings. Despite problems, it is widely used.
Essentials of an Equitable and Ideal Compensation System (Factors)
An ideal compensation system depends heavily on the following factors:
Demand and Supply Position: If demand for specific skills is high and supply is low, compensation will naturally be higher (e.g., scarce steno typists).
Nature of Business: Businesses yielding high profits tend to pay higher compensation (e.g., Reliance Industries, Bajaj Auto Limited).
Size of Business: Large organizations, especially multinational companies, generally offer higher compensation than smaller industries.
Government Rules: Laws like the Minimum Wages Act and various social security benefit acts aim to minimize wage disparities and ensure worker welfare.
Current State of Industry: Units within the same industry often follow similar wage levels and pay package patterns, with minor variations.
Management Thinking: Organizations with strong social responsibility and concern for employees may provide generous non-statutory benefits, leading to better compensation regardless of other factors.
Disagreeability of the Job: Jobs with demanding environments, high stress, long hours, continuous alertness, or monotony (e.g., teachers, nurses, firefighters) require attractive compensation due to lower preference and availability of suitable candidates.
New Approaches to Compensation Systems
Recent years have seen calls for major changes to reward systems, as existing ones may not fit the needs of downsized, flexible, participative, dynamic, and diverse organizations.
Four new approaches gaining traction are:
Rewarding Teams: Set a minimum performance benchmark for team reward, make team performance mandatory for individual rewards, distribute team rewards proportionally to basic pay of the grade, build a geometric progression rate for successive targets, and link individual awards to the basic pay of their grade.
Skill-Based Pay:
Description: Paying employees for the skills they possess rather than just the job they hold. This approach, historically used for production employees, is now extending to professional and management roles (sometimes called knowledge-based or competency pay).
Mechanism: Skills are grouped into “skills blocks,” and pay increases as an employee acquires each block. Skills can be horizontal (related jobs), depth (specialization), or upwardly vertical (management/professional).
Application: Can be part of base pay or contingent pay. For rapidly changing technology, it can be contingent (e.g., bonuses for in-demand skills, withdrawn when demand decreases). For less rapid changes, it can be part of base pay. Both organizations and employees must be aware of changing technologies and required skills.
Advantages:
For Organizations: Multi-skilled workforce, job assignment flexibility, leaner staffing, enhanced problem-solving, improved productivity and quality, stronger employee commitment.
For Employees: Greater self-control over earnings, self-management capacity, varied and enriched task assignments, contributing to job satisfaction.
Example: Northern Telecom’s skill-based plan for technical job families, where employees advance to higher pay by mastering skills in preceding blocks.
Flexibility: Allows movement of employees between jobs within a band without formal title/pay grade changes.
Complement to Flat Structures: Supports flat organizational structures that emphasize lateral career moves and skill development.
Recognition of Individual Performance: Broader pay spreads offer more opportunities to recognize individual differences in performance within a band, reducing reliance on promotions for pay growth.
Example: A leading HR consulting firm uses three bands (entry, proficiency, mastery), each with distinct functional and behavioral competencies. Progression to the next band requires adding competencies, while pay within a band varies widely based on individual performance and contribution.
Broad Banding:
Description: Delayering of pay structures by consolidating existing pay grades into a small number of wide bands, each with a broad minimum-to-maximum pay spread.
Traditional vs. Broad Banding: Traditional structures have tall hierarchies of narrowly defined grades, incentivizing upward career mobility for higher compensation. Broadband structures have fewer, wider bands.
Variable Pay:
Description: Financially measurable rewards paid to an individual based on their overall performance, serving as a powerful tool to enhance performance and productivity.
Mechanism: Companies reward employees for achieving annual/quarterly results, with periodic targets monitored to encourage and reward improved productivity. This creates a visible link between performance and incentives.
Team Rewards:
Description: An opportunity for team members to receive a bonus based on the team’s overall output, most appropriate when jobs are highly interrelated (a growing trend).
Challenges: Determining the extent to which individual performance should be recognized within team pay, and establishing a model team-based pay system.
Example: XEL uses a team-based variable pay system where a percentage of total payroll is set aside, and payouts are determined by team rankings based on customer ratings, quarterly objectives, and management input. Payouts are adjusted to reflect peer evaluation, allowing for individual differences within a top-ranked team.
Steps for Setting Up Team-Based Variable Reward System:
Appraised Teams: Evaluate performance against preset targets/KRAs, communicate results transparently, and measure performance monthly.
Nageshwar Das
Nageshwar Das, BBA graduation with Finance and Marketing specialization, and CEO, Web Developer, & Admin in ilearnlot.com.