7.4 Compensation Strategies and Pay Theories
Compensation Strategies
In addition to the pay level models we just looked at, other considerations might include the following:
- Skill-based pay. With a skill-based pay system, salary levels are based on an employee’s skills, as opposed to job title. This method is implemented similarly to the pay grade model, but rather than job title, a set of skills is assigned a particular pay grade.
- Competency-based pay. Rather than looking at specific skills, the competency-based approach looks at the employee’s traits or characteristics as opposed to a specific skill set. This model focuses more on what the employee can become as opposed to the skills he or she already has.
- Broadbanding. Broadbanding is similar to a pay grade system, except all jobs in a particular category are assigned a specific pay category. For example, everyone working in customer service, or all administrative assistants (regardless of department), are paid within the same general band. McDonald’s uses this compensation philosophy in their corporate offices, stating that it allows for flexibility in terms of pay, movement, and growth of employees (McDonald’s Corporation, 2011).
- Variable pay system. This type of system provides employees with a pay basis but then links the attainment of certain goals or achievements directly to their pay. For example, a salesperson may receive a certain base pay but earn more if he or she meets the sales quota.
Pay Theories
To understand which compensation package is most efficient for a company, it is important to understand pay theories of compensation. HR Managers can decide on compensation packages based on the expected outcome or behaviour of the employees.
Now that we have discussed pay systems, it is important to look at some theories on pay that can be helpful to know when choosing the type of pay system your organization will use. They help HR Manaagers understand the compensation system in a structured way.
Equity Theory
This theory was discussed briefly earlier in the chapter. A more in-depth look at the theory is discussed here. The Equity Theory is concerned with the relational satisfaction employees get from pay and inputs they provide to the organization. It says that people will evaluate their own compensation by comparing their compensation to others’ compensation and their inputs to others’ inputs. In other words, people will look at their own compensation packages and at their own inputs (the work performed) and compare that with others.
If they perceive this to be unfair, in that another person is paid more, but they believe that person is doing less work, motivational issues can occur. For example, people may reduce their own inputs and not work as hard. Employees may also decide to leave the organization as a result of the perceived inequity. In HR, this is an important theory to understand because even if someone is being paid fairly, they will always compare their own pay to that of others in the organization.
The key here is perception, in that fairness is based entirely on what the employee sees, not what may be the actual reality. Even though HR or management may feel employees are being paid fairly, this may not be the employee’s belief. In HR, we need to look at two factors related to pay equity: external pay equity and internal pay equity. External pay equity refers to what other people in similar organizations are being paid for a similar job. Internal pay equity focuses on employees within the same organization. Within the same organization, employees may look at higher level jobs, lower level jobs, and years with the organization to make their decision on pay equity.
Expectancy Theory
The Expectancy Theory is another key theory in relation to pay. The expectancy theory says that employees will put in as much work as what they expect to receive in return for it. In other words, if the employee perceives they are going to be paid favourably, they will work to achieve the outcomes. If they believe the rewards do not equal the amount of effort, they may not work as hard.
Reinforcement Theory
The Reinforcement Theory, developed by Edward L. Thorndike (Indiana University, 2011), says that if high performance is followed by some reward, that desired behaviour will likely occur in the future. Likewise, if high performance is not followed by a reward, it is less likely the high performance will occur in the future. Consider an extreme example of the reinforcement theory in the world of finance.
On Wall Street, bonuses for traders and bankers are a major part of their salary. The average bonus in 2010 was $128,530 (Smith, 2011), which does not take into account specific commissions on trades, which can greatly increase total compensation. One interesting consideration is the ethical implications of certain pay structures, particularly commission and bonus plans. Traditionally, a bonus structure is designed to reward performance, rather than be a guaranteed part of the compensation plan. Bonus and commission plans should be utilized to drive the desired behaviour and act as a reward for the desired behaviour, as the reinforcement theory states.
All these theories provide us with information to make better decisions when developing our own pay systems.
Think!
Video: “Why you should know how much your coworkers get paid” By David Burkus – TED [7:21]
Variable Pay
After a pay system has been developed, we can begin to look at specific methods of paying our employees. Remember that when we talk about compensation, we are referring to not only an actual paycheque, but variable pay or additional types of compensation, such as incentive plans that include bonuses and profit sharing. We can divide our total pay system into three categories: pay, incentives, and other types of compensation.
Pay is the hourly, weekly, or monthly salary an employee earns. An incentive, often called a pay-for-performance incentive, is given for meeting certain performance standards, such as meeting sales targets. The advantage to incentive pay is that company goals can be linked directly to employee goals, resulting in higher pay for the employee and goal achievement by the organization. The following are desirable traits of incentive plans:
- Clearly communicated
- Attainable but challenging
- Easily understandable
- Tied to company goals
Variable pay helps employees improve their behaviour on the job, keeps the company competitive, and helps to attract and retain employers. Variable pay is linked to employee performance. The variable pay is earned, generally on a yearly basis, and does not impact the base pay.
| Pay | Attributes |
|---|---|
| Salary | Fixed compensation calculated on a weekly, biweekly, or monthly basis. May/may not be paid overtime work. |
| Hourly Wage | Employees are paid on the basis of number of hours worked. |
| Piecework System | Employees are paid based on the number of items that are produced. |
| Types of Incentive Plans | Attributes |
| Commission Plans | An employee may or may not receive a salary but will be paid extra (e.g., a percentage for every sale made). |
| Bonus Plans | Extra pay for meeting or beating some goal previously determined. Bonus plans can consist of monetary compensation, but also other forms such as time off or gift certificates. |
| Profit-Sharing Plans | Annual bonuses paid to employees based on the amount of profit the organization earned. |
| Stock Options | When an employee is given the right to purchase company stock at a particular rate in time. Please note that a stock “option” is different from the actual giving of stock, since the option infers the employee will buy the stock at a set rate, obviously, usually cheaper than the going rate. |
| Other Types of Compensation | Attributes |
| Fringe Benefits | This can include a variety of options. Sick leave, paid vacation time, health club memberships, daycare services. |
| Health Benefits | Most organizations provide health and dental care benefits for employees. In addition, disability and life insurance benefits are offered. |
| Retirement Savings Plans | Some organizations provide a retirement plan for employees. The company would work with a financial organization to set up the plan so employees can save money, and often, companies will “match” a percentage of what the employee contributes to the plan.
|
Pay Decision Considerations
Besides the motivational aspect of creating a pay structure, there are some other considerations. First, the size of the organization and the expected expansion of the organization will be a factor. For example, if you are the HR manager for a ten-person company, you likely use a going rate or management fit model. While this is appropriate for your company today, as your organization grows, it may be prudent to develop a more formal pay structure.
If your organization also operates overseas, a consideration is how domestic workers will be paid in comparison to the global market. One strategy is to develop a centralized compensation system, which would be one pay system for all employees, regardless of where they live. The downside to this is that the cost of living may be much less in some countries, making the centralized system possibly unfair to employees who live and work in more expensive countries. Another consideration is in what currency employees will be paid. Most US companies pay even their overseas workers in dollars, not in the local currency where the employee is working. Currency valuation fluctuations could cause challenges in this regard (Watson, 2005).
How Human Resources communicate the pay system is extremely important to enhance the motivation that can be created by fair and equitable wages. In addition, where possible, asking for participation from your employees through the use of pay attitude surveys, for example, can create a transparent compensation process, resulting in higher performing employees.
Organizations should develop market pay surveys and review their wages constantly to ensure the organization is within expected ranges for the industry.
Total Rewards Structure Development Competencies
- Maintain knowledge of rewards structures in the organization’s sector, industry, and location
- Create equitable and effective rewards structures which include compensation, pensions, benefits, and perquisites.
- Make strategic use of rewards structure to encourage desired employee behaviour.
- Ensure the rewards structure maintains its compliance with legal requirements.
Source: HRPA Professional Competency Framework (2014), pg. 17. © HRPA, all rights reserved.
“7.4 Compensation Strategies and Pay Theories” from Human Resources Management – 3rd Edition by Debra Patterson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.
