Chapter 10 | Compensation

Introduction to Compensation

• Definition:

  • Compensation refers to the total reward an employee receives for services rendered to an organization.

  • It includes financial and non-financial rewards.

• Types of Compensation:

  • Direct Financial Compensation:

    • Includes cash-based rewards such as:

      • Basic pay

      • Allowances

      • Merit pay

      • Commission

      • Bonuses

      • Other monetary incentives

  • Indirect Financial Compensation (Benefits):

    • Additional perks given to employees to enhance financial security.

    • Includes mandatory benefits (as per law):

      • Social Security System (SSS)

      • Pag-IBIG

      • PhilHealth

    • Other company-specific benefits:

      • Medical insurance

      • Life insurance

      • Retirement plans

      • Vacation and sick leave

  • Non-Financial Compensation:

    • Beyond monetary rewards, compensation includes job characteristics and work environment factors that contribute to overall job satisfaction.

  • A satisfying job involves (Hackman & Oldham, 1976):

    • Skill variety

    • Task identity

    • Task significance

    • Autonomy

    • Feedback

• Work Environment and Satisfaction:

  • A conducive work environment is crucial for job satisfaction.

  • Factors that enhance workplace satisfaction (Herzberg, 1968):

    • Adequate salary

    • Positive relationships with supervisors and coworkers

    • Safe and healthy working conditions

    • Growth opportunities through company policies

Functions of Compensation

• Primary Objective:

  • Reward employees for services rendered.

  • Act as a tool for managing employee transitions within the organization.

• Attracting Talent:

  • Competitive compensation attracts better-quality applicants (Campbell, 1994).

  • Must be balanced with the organization’s financial sustainability to maintain long-term viability

• Employee Motivation:

  • Ensures employees’ basic financial needs are met so they can focus on work.

  • Benefits should be aligned with employees’ needs to enhance motivation.

  • Employees compare their compensation with others, making internal equity essential.

  • Internal equity is achieved through:

    • A structured salary system

    • A sound job evaluation process

• Enhancing Job Satisfaction Through Non-Financial Compensation:

  • Organizations can use job design to make work more engaging and motivating.

  • Factors that enhance motivation (Herzberg, 1968):

    • Challenging job roles

    • Positive work environment

• Retention of High-Performing Employees:

  • Compensation reinforces employee retention efforts.

  • Common reasons for turnover (March & Simon, 1958; Mobley, 1977):

    • Job dissatisfaction

    • Availability of better alternatives

  • Non-financial compensation (work environment) can prevent dissatisfaction and encourage retention.

• External Equity & Market Competitiveness:

  • Employees compare their compensation within and outside the organization.

  • Organizations must offer competitive compensation to retain talent.

  • However, wages affect production costs, so compensation must align with the company’s ability to compete in the market.

Elements of Financial Compensation

• Bases for Individual Financial Compensation:

  • Job-based pay – Compensation is based on the job role.

  • Person-based pay – Compensation depends on individual skills or competencies.

  • Performance-based pay – Compensation is tied to an employee’s performance.

• Compensation System Considerations:

  • Must align with organizational strategy and performance goals.

  • Should balance internal equity (fairness within the company) and external competitiveness (market-based salaries).

1. Job

• Job Evaluation:

  • Determines the relative importance of different jobs within the organization.

  • Focuses on the job itself, not the person performing it.

• Point Method for Job Evaluation:

  • A common approach that assigns numerical values (points) to jobs based on key factors.

• Compensable Factors (Job Characteristics That Determine Pay):

  • Skills – Required expertise and knowledge.

  • Responsibility – Level of accountability in the role.

  • Effort – Physical or mental exertion required.

  • Working Conditions – The environment in which the job is performed.

• Weighting & Scoring of Compensable Factors:

  • Each factor is assigned a weight based on its importance to the organization.

  • More important factors receive higher weights and more points.

  • Example: If effort is a key job requirement, it may have more levels/degrees compared to working conditions.

2. The Labor and Product Markets

• Determining Pay Levels:

  • Once job structure is established, organizations must set basic pay and bonuses.

  • Pay levels should align with the organization’s compensation objectives.

  • To attract and retain talent, salaries must be competitive within the industry and geographic area.

• External Equity Considerations:

  • Ensuring fairness in compensation compared to other organizations in the labor market.

  • Salary surveys help organizations assess market competitiveness.

  • Paying below market rates may result in difficulty attracting high-quality employees.

Labor Market vs. Product Market

• Labor Market (Pay Floor):

  • Sets the minimum level organizations must pay to attract qualified employees.

  • Competitive wages ensure the company can hire and retain skilled talent.

• Product Market (Pay Ceiling):

  • Determines the maximum wages a company can afford while maintaining profitability.

  • Labor costs directly impact the price of goods and services.

  • If labor costs are too high, the organization may struggle to compete in the product market.

Emphasis on Labor or Product Market?

• Prioritizing the Labor Market (Higher Pay for Talent Retention):

  • When finding specific skills is difficult.

  • When employee turnover costs are high.

• Prioritizing the Product Market (Managing Labor Costs for Profitability):

  • When labor costs make up a large portion of production costs.

  • When demand for goods is price-sensitive.

  • When employee skills are specific to the product market.

3. The Organization and Compensation Strategy

• Obligation and Strategic Use of Compensation:

  • Organizations must compensate employees for their services.

  • Beyond obligation, compensation is a strategic tool to support business objectives.

• Compensation Policies:

  • Organizations can position themselves as:

    • Pay Leaders: Offer above-market salaries to attract top talent.

    • Market Average Payors: Pay at industry average, believing they can still attract good workers.

    • Pay Followers: Pay below market rates, either due to cost constraints or lack of need for high-quality employees.

• Efficiency Wage Theory (Shapiro & Stiglitz, 1984):

  • Paying above equilibrium wages increases productivity.

  • Employees are less likely to slack because losing their job would mean a pay cut elsewhere.

  • Higher wages attract better quality and more productive workers (Campbell, 1994).

  • This can result in lower labor costs per unit of production.

Determining Compensation Levels

1. Wage Survey & Regression Analysis:

   • Uses market wage data to estimate the relationship between job evaluation points and pay.

   • Data is sourced from professional wage surveys (participation required for applicability).

2. Pay Policy Line Approach:

   • Combines wage survey data and job evaluation points to establish a benchmark pay line.

   • The organization then adjusts pay levels to be above, at, or below market rates.

3. Setting the Market Pay Line:

   • Regression analysis can be used to create a market pay line, showing the correlation between job value and compensation.

   • The organization then determines its pay policy, e.g., paying 10% above market rate as a strategic decision.

4. The Person and Compensation Structure

• Factors Affecting Pay:

  • Individual compensation considers performance, skills, competencies, and tenure.

  • Organizations adopt pay ranges instead of fixed salaries for flexibility.

• Pay Range Components:

  • Minimum: The lowest pay an organization is willing to offer for a job.

  • Midpoint: The competitive wage level aligned with the pay policy line.

  • Maximum: The highest amount an organization is willing to pay for a job.

• Variation in Pay Within a Job Grade:

  • New hires may start at the minimum of the job pay grade.

  • Differences in performance and tenure lead to salary variations.

  • Example:

    • Two employees in the same job may have different salaries due to performance (higher performer gets a raise).

    • Employees with same performance scores may still have different salaries due to tenure (longer-tenured employee earns more).

• Pay Range Considerations:

  • Market Conditions: Tight labor markets may require offering higher pay within the range.

  • Job Learning Curve:

    • Jobs that are easy to learn have a narrow pay range.

    • Jobs requiring longer mastery have a wider pay range.

  • Promotion Timeframe:

    • Lower-level jobs: More positions → Faster promotions.

    • Higher-level jobs: Fewer positions → Slower promotions → Larger pay ranges.

• Merit Increases & Range Spread:

• Organizations determine pay range size based on merit increase policies.

Managing Compensation System Objectives

• Organizations must align the compensation system with specific objectives.

• Clear communication of pay structure improves employee satisfaction and engagement.

• Employees value understanding basic pay more than total compensation.

• Managing Labor Costs

  • Salary structures include tools to control labor costs.

  • Pay grades have a minimum (floor) and maximum (ceiling) amount an organization is willing to pay.

• Green Circle & Red Circle Rates

  • Green Circle Rate: Pay below the minimum of a pay grade (underpaid).

    • Corrective action: Increase salary to at least the minimum of the pay grade.

  • Red Circle Rate: Pay above the maximum of a pay grade (overpaid).

    • Employee is earning beyond what the job is worth.

    • No room for salary increase unless promoted.

    • Possible solutions:

      • Move employee to a higher-level job (if qualified and vacancy exists).

      • Provide a merit increase as a bonus, not added to base pay.

      • Freeze salary increases until salary structure updates or promotion occurs.

  • Frequent red circle cases indicate the need for a salary structure review.

• Using Compa-Ratio for Monitoring Labor Costs

  • Compa-Ratio Formula:

    • Compa-Ratio = Average actual pay in pay grade / Midpoint of range

  • Interpretation:

    • Less than 1: Average pay is below the intended policy (may indicate poor performance, new hires, or rapid promotions).

    • Greater than 1: Average pay exceeds the intended policy.

  • Extreme deviations require management attention to align with compensation policies.

• Broad Banding for Flexibility

  • Merges multiple pay grades into broad salary bands with a minimum and maximum.

  • Allows lateral movement of employees without salary increases.

  • Useful for managing costs during downsizing and mergers.