Understanding Strategic Compensation

Creating the Right Pay Structure

Understanding Strategic Compensation - Creating the Right Pay Structure

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How much should you pay your people?

How is your pay structured? Do you get paid an hourly rate or an annual salary? Do you get performance-related pay, such as sales commissions?

Do you get a bonus? If you do, is this tied to individual performance, team performance, organizational performance, or a mixture of all three? And do you get paid more than a colleague because, essentially, you've been with the organization for longer?

There are clearly lots of ways of structuring compensation. And, given that payroll is often one of the largest operating expenditures that an organization has, it's important to ensure that this money is spent wisely. That's what strategic compensation is all about.

With it, you can start to think of how payroll can help your organization achieve its objectives, rather than simply seeing it as a cost to be minimized.

Consider the following organizational issues:

  • Staff turnover.
  • Poor performance.
  • Dishonesty.
  • Low motivation.
  • Poor customer service.

These – and many other organizational problems – can often be traced to the way that people are compensated for their work. The fact is, we do what is needed by the organization because the organization rewards us, in some way, for doing so.

What Is Compensation?

It's important to recognize that compensation is just one part of the full reward system – it's the monetary element, and it has three parts:

  • Base pay – this is our pay foundation and is usually based on time worked, whether hourly, weekly, monthly, or yearly. Hourly pay is usually referred to as "wages," and these are often paid every week. Annual "salaries" are usually divided into equal monthly payments.
  • Performance pay – this is any reward for good performance – individual or otherwise.
  • Indirect pay – this is often referred to as the "benefits package." It's typically a combination of cash and non-cash items, designed to meet a variety of employee needs.

An organization's compensation strategy deals with the mix of different types of pay, and how much is paid in total. These aren't easy decisions to take, particularly because there are non-financial elements in any reward system too. Consider the following:

  • When you have a job that offers high intrinsic reward, do you have to pay the full market rate?
  • If you offer good job security, does that mean you can pay less than organizations that don't?
  • Is enriching a job just as enticing as increasing compensation?

There's no one best way to compensate people and compensation systems within organizations also need to evolve continuously. So, to start thinking about using compensation strategically, you need to understand the choices available to you. From there you can create the compensation mix that is right for your organization and for your people.

Base Pay

Base pay is straightforward to administer. Everyone knows what to expect, and it clearly reflects the relative importance of jobs and skills within an organization. Base pay also allows for increases based on seniority and cost of living adjustments.

While simple, it does have some disadvantages:

  • It's disconnected from organizational or individual performance.
  • It's not necessarily motivating, because it's paid regardless of results.
  • There is no acknowledgement of the organization's ability to pay.
  • There is no link between organizational and individual success.

If you decide that base pay is going to be part of your compensation mix, then there are three main approaches you can use to determine the base level:

Market Pricing

Here, pay is based on what similar jobs are paying in the same market or industry. This is where most organizations start. The main advantage here is the ease of the system, but it's also a great way to keep your compensation costs aligned with market conditions.

However, what one company calls an administrative manager might be a secretary at another, so you can't rely on market information alone. Another problem is that market pricing doesn't address the internal equity of compensation: it's important to look at how the skills and responsibilities of roles contrast to ensure that the pay differentiation within your organization is fair.

Base pay is also accused of contributing to the gender gap in wages. For example, work done by women has traditionally been undervalued, and market pricing simply perpetuates these types of inequity.

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Job Evaluation

Here, you compare and contrast all of the positions within an organization, and categorize them in some meaningful way. The result is a job hierarchy and a centralized approach to compensation. The organization maintains a lot of control over compensation-related costs, and workers tend to be motivated to improve their skills to earn promotion and thus increase their pay.

It sounds like a fair and equitable process on the surface, but it can encourage a "that's not in my job description" attitude. It can also encourage people to leave the organization if, following this analysis, their jobs are less well remunerated than at other organizations.

Pay for Knowledge

With this system, workers are rewarded for their personal capabilities, and for the specific skills, knowledge, and competencies they bring to the job. This system promotes skill development and flexibility. People tend to become more proactive decision makers, as they are motivated to exercise judgment, and take action when needed, rather than "waiting for the boss to save the day".

The main disadvantage with this type of compensation is the risk that employee compensation outpaces market pricing. You hire a person to wash dishes and a year later you find yourself paying her sous chef wages, yet the dishes still need to be washed! (Proponents of the system would counter than the efficiencies you enjoy outpace the increased costs.)

Performance Pay

Performance pay is pay that is provided only when a certain performance result is achieved. This type of pay is variable, so there is no guarantee that workers will receive it. This uncertainly is what motivates people, and increases the probability that important organizational performance goals will be met.

The variability of the pay also improves an organization's ability to pay. After all, the more that compensation is tied to the meeting of strategic objectives, the greater is the likelihood that the firm will have the financial resources it needs to meet compensation obligations.

While there are many clear benefits of performance pay, most workers prefer at least part of their compensation to be predictable, so performance pay is generally only used to "top-up" base pay. Another challenge to the performance pay approach is that it encourages people to focus on those areas that are being measured and compensated. As such, if the scheme is not well aligned with organizational objectives, you risk having the wrong activities prioritized.

These general observations related to performance pay are compounded by the variety of ways you can structure performance pay. Each of these has advantages and disadvantages, and entire textbooks have been devoted to the subject. Here are some of the most popular:

Individually Based Performance Pay

Here pay is related to the worker's specific performance. Paying using a piece-rate is a system where a worker receives a fixed amount of money for each unit of output. Writers may be paid per word or per article. Dentists are paid per procedure. Graphic designers are paid per item of artwork. The system seems reasonably straightforward until you get to the point of deciding what each unit is actually worth. This often involves working pay through a base pay-type analysis and then dividing the base by the expected output. For instance, you take the average of what a worker would earn in a day, divide that by the production expected in a day, and the result is your piece rate.

This system can work well for those jobs where an individual can control his or her production. When production levels depend on inputs from others, however, then piece-rate approaches are not that effective. In today's work environment, finding jobs with enough independence is pretty difficult. Another major issue with the piece rate approach is that quality can be variable – simply because the emphasis is on quantity, not quality. There is also little incentive to help others, or to do anything that isn't directly related to individual production.

Closely related to piece rates are sales commissions. Here salespeople earn a percentage of their gross sales. In contrast to piece-rate payment, this is a very common type of performance-based pay, and it is most often used as an addition to base pay rather than a substitute for it.

Commissions are popular because they are easy to establish, and the nature of sales work is typically more independent than that of many other jobs. Most importantly, commissions are used because they are indeed motivating. The worker knows exactly what he or she has to do to earn the commission, and the link between performance and reward is undeniable. Make a sale; earn some money. Make more sales; earn more money!

There's always a downside, though. Sometimes it is hard to attract the best workers because they want (or need) more predictable compensation. It discourages salespeople from taking vacation time, which can lead to burnout. It's hard to build worker motivation in the early stages of people's employment, because they are building their customer contacts and not necessarily making sales. And, in the recent Wall Street melt-down, we've all seen the problems that can result when short term bonuses are not properly matched with long term risks or commitments.

Depending on how you structure sales commission, salespeople tend to be less committed to your organization, and can tend to look out for their own best interests instead. There are instances where the system is manipulated to the benefit of the salesperson, and the high staff turnover in sales jobs can lead to customer dissatisfaction. You might even end up with lots of sales volume, but very little sales profit!

Merit Pay is a form of individual performance pay that is very popular, and is used in combination with base pay. These payments represent a permanent increase in base pay, and are given to recognize strong job performance. Common names include merit raises, merit bonuses, and promotions. The most significant problem associated with these payments is the expectation that is built over time: merit pay doesn't have long-standing motivational value, because people come to expect merit increases regardless of actual performance.

Group-Based Performance Pay

Here the emphasis is on what the team accomplishes, rather than on individual performance. Given that teamwork is a staple in today's workforce, acknowledging teamwork is often seen as a fairer form of performance pay. Some common types of group performance pay include:

  • Gain-Sharing – when a team is able to reduce costs, then part of the associated gains are shared among the workers evenly. This type of system promotes quality improvement and decreased waste.
  • Goal-Sharing – teams receive a bonus when they accomplish an objective. Here the emphasis is on achieving strategic organizational goals, rather than improving on baseline measurements.
  • Profit-Sharing – here the organization provides bonus payments based on profitability in a certain period. The advantage here is that there is a strong link between individual, team, and organizational performance. The more money the firm makes, the more money employees get. However, this link is easily obscured by factors beyond the employees' control so it can lead to dissatisfaction if not managed carefully. In particular, it can be very de-motivating when an organization is unprofitable – such as during a recession – despite people's honest best efforts.
  • Stock Plans are another form of performance pay. Instead of being paid cash, workers are given stock in the company, or are able to purchase stock on very favorable terms. There is also a stock option plan, where workers are given the option to purchase stock in the future at a set price. As such, if the set price turns out to be less than market value at a future point in time, the worker can cash in on considerable profits. Stock plans are popular because they enhance the notion of employee ownership, and this encourages people to make decisions that maximize share value.

While all of these encourage group work, strong individual performers can be discouraged if they feel that they're "carrying" the people around them. Likewise, others may feel that they can "coast," and be carried along towards a bonus by the hard work of other members of the team.

Indirect pay is another large factor in compensation. Referred to as "employee benefits" these make up a significant portion of overall compensation. Options here are seemingly limitless – from retirement/pension plans and health insurance plans, to holiday pay and perks likes company vehicles, clothing allowances, and savings plans.

Key Points

Compensation is an operating expense that requires diligent control and examination.

Simply paying a base wage to your people may not be the most effective way to accomplish your organizational goals.

By thinking about compensation more strategically, you can figure out what it is you want to achieve and then study your organization and its people to figure out the best mix of base and variable pay.

There are many factors that influence the success of any of these approaches, and each system has its own advantages and disadvantages. Being familiar with the options available, however, will surely improve your chances of strategic compensation success.

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Comments (2)
  • Over a month ago Michele wrote
    Hi Arnoldas,

    Glad that you liked it and found some ideas that you can apply. Strategic compensation is a fascinating and specialized discipline. However you set up your compensation system, make sure that any incentives you put in place reinforce the behaviors you want to drive to achieve the organization's overall goals.

    Michele
    Mind Tools Team
  • Over a month ago Arnoldas wrote
    Nice article, found some great ideas. Thank you :)