What is Compensation?

The question of what is compensation is one of paramount importance to both the employer and the employee, and one of the central questions in the employer-employee relationship.

Compensation is the total non-cash and cash payments that an employee receives for their labor. It is usually one of the largest expenses businesses have in relation to their employees, and it may include base pay (salary or hourly wages), overtime wages, sales commissions, bonus pay, stock options, recognition or merit pay, benefits (insurances, retirement; paid vacations,), tip income, and other non-cash benefits. As such, it is a tool that management uses to achieve a variety of ends for the betterment of the company. Such ends include:

  • Increasing job performance and satisfaction
  • Recruiting and retaining quality talent
  • Achieving internal and external equity
  • Reducing turnover and encouraging company loyalty
  • Modifying (via negotiation) union practices

Compensation may be increased or decreased depending on the goals, needs, and resources of the company. A common concern for a company is balancing the amount of compensation doled out with the amount of employee morale and satisfaction this will yield. A company may try to reduce costs by freezing salaries or salary levels, but this may in turn reduce employee satisfaction, morale, and productivity. Likewise, if a company wishes to reduce employee turnover, increasing salary is one way to do it. Compensation management such as this is a business function that lets companies attract and retain good talent and enable the business to function profitably.

How to Decide Employee Compensation

The amount of compensation offered depends on many factors, such as competitor’s salaries, the skill and productivity of the employee in question, and the current and projected monetary resources of the company. In short, there are numerous ways to decide the appropriate compensation of an employee, yet regardless of how you determine it, internal equity should be considered.

Internal equity is when positions in your company are compared to ensure fair pay. To do this, you should conduct research on how other companies compensate their workers and compare your company to others in the area, paying special attention to employees that have duties and job titles similar to the ones that your employees have. To do this, you can survey businesses that are similar to yours and check online databases that allow employees to report their wages.

Employee compensation should be commensurate with their quality, or as close to commensurate as it can be. If an employee excels in their work, you can increase their compensation. If an employee has advanced training or education that is a benefit to their work, that would also be a cause for increased pay. You can also base a worker’s wages on that of their previous job, either matching it or offering an increase.

That said, one should carefully calculate what they spend on their employees. When deciding how much an employee should be compensated, one should also consider the costs of benefits and taxes, and before a pay raise or job is offered, one should be sure that the compensation plan fits the budget. In relation to this, you may be able to offer a lower base pay in exchange for desirable benefits, which employees often weigh greatly when considering an offer.

In order to be competitive in this though, learning what kind of benefits and pay are desirable in your industry is essential. Also, you need to consider the local economy and company size. For example, anyone from a CFO on down to an administrative assistant will need to be paid more if they are located in Los Angeles, California, as opposed to a small town in Nebraska.

Internally, it is also wise to reward employees based on what they contribute to the company. A star employee should make more than a slacker, even if they have the same job title; in this way you will encourage good work and productivity and discourage slothfulness. Also, morale may fall if hard-working employees see other, less hard-working ones reaping the same rewards.

From the employees’ standpoint, the rarity of their skill set and other situational factors can contribute to the amount of compensation they receive. For instance, when there is only one person in a community that has a particular skill that two or more businesses want, they may benefit from a bidding war. Conversely, when a company needs a person with a particular skill but there are two or more people with that skill, they do not need to offer as much pay. Simply put, the business with choices is not compelled to pay their desired employee more than the market’s going rate.

The kind of business that is doing the hiring can also be a factor in how much is paid. If a business has a reputation for having a terrible work environment, it may be necessary for them to pay more to attract good employees. Or, if the organization is a public sector enterprise or a nonprofit, the pay is likely to be less. In the case of unionized workplaces and government jobs, the employees may place a higher value on expected pay increases and job security in an increasingly uncertain world than on a higher wage they could get somewhere else. Also, some public sector jobs have health insurance and pension benefits, which may more than compensate for the lower pay.

Components of a Compensation System

A compensation system sets out in an orderly way how compensation is to be doled out, and employees may appreciate the transparency of such a system, of which there are many variants. One important component of selection and compensation systems is the job description, which sets out in writing the requirements, responsibilities, functions, location, duties, conditions, environment, and other aspects of the job for employees or potential employees to see. Another important component is job analysis, which uses questionnaires, observation, and interviews to create a system for comparing jobs for the purpose of determining the right compensation amount for individual job elements or jobs. There are four methods used to do this, and they are:

  • Classification.
  • Ranking.
  • The point method.
  • Factor comparison.

Such a system is useful for creating standardized compensation practices, within which the pay structure may include several grades, each grade corresponding to a salary or wage with either a grade range or step increments.

Additionally, salary surveys are used to gather market data on inflation indicators, average salaries, salary budget averages, and cost of living indicators. Businesses can buy the results of such surveys from survey vendors, or they can conduct their own surveys. If one does purchase such surveys, they should be aware that there are many different sample types the surveys can come from: a specific industry, a range of industries, a geographical region, several geographical reasons, and so on.

Planning Proper Compensation

Compensation is controlled by many federal, state, and local tax and employment laws, all of which you should be aware of. Some of them are:

  • Federal minimum wage laws, which are controlled by the Fair Labor Standards Act (FLSA).
  • State and city minimum wage laws.
  • Child labor laws, which include stipulations regarding child minimum wage and hiring teens.
  • Overtime wage laws.
  • Equal employment opportunity responsibilities and equal pay for equal work.

Compensation can also be complicated where taxes are concerned—some kinds of compensation require you to withhold taxes, but some do not. Therefore, you should be certain to know what kinds of taxes apply to each kind of compensation. Some kinds of income that taxes should be withheld on include:

  • Regular wages.
  • Overtime wages.
  • Tips.
  • Commissions.
  • Bonuses (but taxes are calculated differently on these).

Taxes should not be withheld on benefits. Additionally, there are numerous other local, state, and federal laws that control compensation, and you should be certain you understand your responsibilities related to these before you hire employees.

Once you fully understand your compensation responsibilities, you should develop a compensation program to implement this. The following list illustrates one way to do this:

  1. Develop a Program Outline
    1. Set a program objective, establish start and end dates, establish a budget.
    2. Designate a person to manage the design of the compensation program.
    3. Determine if this person will be temporary or permanent, or who will oversee the program once it is running.
    4. Determine the cost of internal, external, or consultant review.
  2. Develop a Compensation Philosophy
    1. Create a compensation committee (ideally consisting of at least one company officer) that will decide the differences in pay structure for all employee types (such as hourly, salaried, incentive-based, and non-contingent pay).
    2. Determine if the company should have salaries above, below, or at market level.
    3. Determine the balance between benefits and traditional compensation.
  3. Conduct an Analysis of All Positions
    1. Conduct a general task analysis of major departments to see who is accomplishing what tasks.
    2. Get input from senior members of company divisions (such as finance, marketing, sales, production, and administration) to decide the best structure and function of each.
    3. Interview key employees and managers to understand their specific job functions.
    4. Create model job descriptions for nonexempt and exempt positions and distribute such models to incumbents for comment and review, adjusting the descriptions as necessary.
    5. Rank the jobs within each manager’s and senior vice president’s department, then rank them amongst and between departments.
  4. Analyze the Data
    1. Compare your data to industry market data to verify you rankings, and adjust the rankings if necessary.
    2. Order a matrix organizational review and develop a matrix of job-crossing lines and departments in accordance with the forecasted business plans and required tasks.
    3. Compare this matrix with data from both the industry-wide market and the company structure.
    4. Create flow charts detailing all ranks for all departments so as to ease interpretation and assessment of the data.
    5. Present charts and data to the compensation committee for review.
  5. Create a Compensation Plan Based on the Data
    1. Determine the number of levels (such as beginner, intermediate, junior, and senior) and establish a pay grade for each one.
    2. Determine which jobs are benchmark jobs and what the standard market compensation is for them in the industry.
    3. Determine a trend line in accordance with the company philosophy (how the company wants its compensation to compare to the industry’s).
    4. Establish a salary structure.
    5. Establish the difference between each salary step and the maximum and minimum percent spread.
    6. Establish a salary administration policy.
  6. Implement the Compensation Plan
    1. Present and receive executive approval of the salary program.
    2. Communicate the program to managers and employees.
    3. Have HR determine effective implementation processes, develop the correct data input forms, and write up effective monitoring reports for managers.
    4. Monitor manager feedback related to the compensation plan and make adjustments where necessary.

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