A Classic Approach to Compensation

Purpose of Process (see below how HRSource™ can help):

The Virtual HR Department provides a practical approach to compensation management for the small to mid-sized companies, emphasizing simple and efficient processes.  This approach is practical and supports the speed in which business and jobs change.

Nonetheless, there is still value in reviewing a more classical approach to compensation. The following is an outline of a classical approach as recommended by Robert Sibson in the fifth edition of his book entitled, "Compensation." Robert Sibson is founder and former CEO of the Sibson and Company consulting firm. He has worked with over 500 clients and has written numerous books on this topic.

Steps in the Classical Approach to Compensation:

  1. Compensation Philosophy

    Compensation is a vital component of management. As such, compensation must reflect the style of management and contribute to the success of the company.

    Compensation should encourage improved business performance and support productivity improvement. One way to support business improvement is to ensure that pay is competitive. Also, the compensation system should be able to track and forecast payroll costs.

    Managers will often classify a problem as compensation-based, when the problem is really something else (e.g. poor supervision or working conditions, organizational structure problems, etc.). It takes skill and experience to determine the true nature of the problem.

    Basic compensation policies should be set by top management and reflect the values and strategy of the company. The compensation policy should address the following issues:

    • At what level should employees be paid relative to the market?
    • Does the company pay for performance?
    • What level of health and retirement benefits should the company provide and how much should the employees contribute?
    • What compensation information should be communicated to employees?
    • Do you pay for employees' time? Knowledge? Results?
    • Should some or all employees share in the success of the company?
    • How much pay, if any, should be put "at-risk" (variable compensation)?

    Keep the compensation systems simple. "The compensation program should be useful to the enterprise, helpful to managers, facilitate the achievement of reasonable employee goals, and balance the interests of all the participants in the enterprise. But it should be as simple as possible."

  2. Setting Up a Compensation System
    1. Identify the Need
      • Review the company's business plan. What changes are planned?
      • Observe compensation experiences and problems in the organization. This can range from random observations to specific questions asked in a formal manner. Consider using employee opinion surveys.
      • Consider conducting a Human Resources audit.
      • Listen to managers

    2. Translate Need into Objectives

      Translating needs into objectives requires assessing the importance of the problem or opportunity. This is an art, not a science. It relies on precedents, intuition, and judgement. Criteria to evaluate the appropriateness of a program/objective include:

      • The need must be clear and compelling beyond a reasonable doubt
      • The solution must absolutely address the needs
      • The solution must include specific goals
      • The value of the solution must be clearly greater than the cost
      • The objective must be achievable given the available time and resources

    3. Group Employees Properly

      Employees must be grouped in accordance with the Fair Labor Standards Act (FLSA). That is, they must be identified as "exempt" from the FLSA or "nonexempt" from the FLSA. Other than that, create as few groups as possible. Labor unions or certain market conditions may create the need to differentiate different types of jobs. However, the trend is toward eliminating differences in pay practices and treatment of employees.

    4. Conceptualize the Answer

      Evaluate the appropriateness of the program in light of the following:

      • Company characteristics
      • Competitive practices
      • Company culture
      • Employee reaction

    5. Test the Program Design

      Have the plan reviewed by legal, tax and finance people. Collect input from others who will be impacted by the program, such a line managers or individual employees. Consider modeling the program and results.

    6. Implement the Program

      Put the program into operation and establish procedures and a system for evaluating how the program is operating.

    7. Evaluate the Effectiveness of the Program

    8. Modify the Program as Necessary

      Modifying programs requires the skill of managing change. Sibson makes a few general comments about managing change:

      • Employees at the lower levels of companies resist change only if it reduces pay, benefits or working conditions
      • Higher in the organization there is a resistance to change for job protection reasons
      • It is easier to change programs than to change people
      • You can only manage change if you know and monitor what is changing

  3. Elements of Compensation
    1. Financial Elements
      Form of Compensation Employee Needs Company Needs
      Base Salary -Sets standard of living
      -Reflects employer's evaluation
      Key to pay competitiveness
      Premium Payments Extra income for special purchases -Sometimes a legal requirement
      -Induce employees to work longer or under difficult circumstances
      Bonuses -Reward for achievement of goal
      -Opportunity for higher income
      -Variable cost
      -Motivates short-term performance
      -Attract key personnel
      Long-Term Income -Reward for achievement of goal
      -Opportunity for higher income
      -Helps retain key employees
      -Motivates long-term performance
      Pay for Time Not Worked Rest and recreation for employees -Competitive need
      -Rejuvenated employees
      Benefits -Tax-sheltered income
      -Protection against economic risks
      -Competitive need
      -Social responsibility/public relations
      Extra Pay Plans (e.g. stock purchase, profit sharing, etc.) Extra savings Build favorable employee attitudes

    2. Non-Financial Elements

      Element Examples
      Company Environment Prestigious companies or companies with a good reputation for making quality products
      The Work Employees enjoy their jobs
      Physical Conditions Cleanliness, brightness, comfort and safety
      Work Environment Location of the company, management style, dispute resolution, friendliness of employees
      Perquisites Company cafeteria, company products sold at a discount, service awards

  4. Pricing and Surveying

    "Thirty years ago, job evaluation was...essential because it had to substitute for such unknown factors as market salary levels and the salary relationships between jobs in the marketplace. Today...there is a great deal of market data that are directly usable. Therefore, the first essential step in salary administration is to get sound market pay data."

    When surveying jobs, keep in mind the following principles:

    • "The sample of jobs [surveyed] should be a cross section by level of job. Avoid surveying all high-paid or low paid positions.
    • Jobs should be a cross section in the sense that they include all important job families."

    Select companies to survey that are most similar to your company and have a high percentage of jobs similar to jobs in your company.

    Look at salary increase trends by evaluating the past movement of salaries and the projected salary increases. Both of these items are generally provided in salary surveys.

    Also see the Salary Survey process.

  5. Salary Structure

    Salary structures serve the purpose of translating salary survey data into salary rates that are paid to employees. Salary structures also differentiate the value of jobs and can be used to determine salary increases.

    A salary structure is comprised of many levels called grades.  Grades reflects a distinguishable difference in pay for jobs, and the range of numbers for each grade is a reasonable spread of pay for individuals who work in jobs of similar scale, from the beginner to the top performer."

    "The structure reflects how the firm consciously positions salaries for its employees against the market. Thus, pay for jobs reflects the competitiveness of salaries against the market." Sibson recommends a grade structure in which there is a 10% separation between midpoints of grades, and the distance between the minimum and maximum is less than 35%. This is considerably smaller than Auxillium West's recommendation (see the process on Establishing a Salary Structure and the Sample Salary Range Structure) and results in many more grades than Auxillium West's model.

    Jobs are slotted into the grades based on which grade midpoint is closest to the market average. This is the market-pricing approach, which is by far the most popular type of job evaluation system.

    Salary structures can be set above or below the market depending on such issues as the company's pay philosophy and recruiting efforts.

  6. Job Evaluation

    Market pricing is the most common form of job evaluation used today. The more traditional form of job evaluation is now used as an alternative for slotting jobs that cannot be directly matched to other companies.

    The traditional approach to job evaluation involves "the measurement of job duties against a predetermined yardstick in order to assess, by administrative judgment, the relative worth of a job." The common types of job evaluation are:

    The Ranking System - Evaluators compare two jobs and judge which one is more difficult.
    The Classification (Rating) System - "Each job is measured against a predetermined yardstick whose various categories define the overall job value.
    The Point System - "Various factors that measure a job are selected and defined. A separate yardstick for different degrees of each factor is prepared. A job is then rated against every yardstick."
    Factor Comparison - "Factors are also identified as in the Point System. However, a ranking system rather than a classification system is used."
    Combination Systems - These are the most common in which two or more of the above systems are used, especially common are Point Factor Systems.

    Job evaluation systems must be maintained and reviewed on an on-going basis, especially in areas where job duties rapidly evolve. The focus of the job evaluation is on the job and not the individual performing the job. Communication of the compensation system is important because the system is ultimately what the employees perceive it to be.

  7. Individual Salary Actions

    The basic question in determining individual salary actions is what factors should be considered in making salary increase decisions. There are four basic approaches to granting individual salary increases:

    The Single-Rate Approach - Single rates of pay are used in situations where there is a short learning time on the job, employees work at the same pace and attain the same standard, such as in a day-work system.
    Automatic Approach - Salaries increase automatically with time.
    Informal Approach - Individual salary increase decisions are made by a supervisor without a formal system.
    Merit Pay Approach - Differences in pay increases are related to differences in work performance. This is a form of "pay for performance."

    Other types of salary actions include promotions (moving from one job to another in a higher pay grade), demotions, and reevaluation and equity increases.

    "Reward for performance is a critical element of compensation management...Failure to reward excellence properly is the single most important problem in the field of compensation." If a company does not pay for performance and its competitors do, then the company is overpaying low performers and underpaying high performers.

    Pay for performance systems recognize position in the range, giving higher increases for those low in the range and lower increases for those high in the range. The biggest challenge of pay for performance systems is determining performance.

  8. Planning Control and Administration

    "Planning of salaries involves budgeting, the development of salary increase guides, ...assistance to managers in making sound salary increase decisions, and...management of payroll costs."

    One or more of the following methods can control salary increase costs:

    Control Curves - indicate a dollar amount of salary increase for each person and provide a total dollar salary increase budget for each operating unit.
    Review and Approval - Higher level managers review and approve salary increases.
    Monitoring Results - A supportive rather than authoritarian form of control. Items that are monitored include, amount spent on salary increases, average and range of salary increases, quality of performance appraisals, etc. Monitoring should be performed regularly using computer-generated data whenever possible. The goal is to identify matters that should be reviewed in greater detail.

    See also the process on Establishing a Salary Increase Budgeting, Salary Reviews, and Promotions and Salary Adjustments.

Process Tips:

There are more similarities than differences between the classic compensation approach and the practical compensation approach recommended by Auxillium West. The classic approach is more detailed and rigorous at the planning and pre-implementation part of the process. Planning is valuable, but estimating is often more practical. The classic approach suggests creating many narrow salary ranges (grades), versus Auxillium West's recommendation of fewer broad salary ranges.

How HRSource™ Can Help:

HRSource™ can help track and manage salary structure in several ways:

  • Store salary ranges
  • Track and report salary range (or grade) by job
  • Compare salary survey averages with range midpoints to help determine how to much to move the salary ranges
  • Report where employees' pay falls within the salary range to facilitate midpoint control
  • Provide data on how salary increases have been spread among employees and whether spending has been within the budget

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