CHAPTER 1
FOUNDATION OF COMPENSATION ADMINISTRATION
CHAPTER OVERVIEW
Compensation administration of Human Resource Management is considered as the heart of the
Human Resource function because of its complexity in developing pay structures, implementing
compensation system, and controlling its implementation and administration. Issues arise from
the employees and dissatisfaction is imminent if this function is not given its due care and
attention. It cannot be neglected and the controversies behind its implementation and
administration should not be ignored.
The heart pumps blood and compensation denotes the lifeblood of the employees in terms of
satisfying and fulfilling many of their basic needs. Compensation in the form of money is a primary
motivator and a ticket to survival. This is the reason why management is careful not to allow any
issue on compensation for it may spark discontentment and unexpected employee turnover.
There are three basic types of compensation: base pay, variable pay and benefits. Organizations
provide their employees with a compensation package in order to achieve these three-told
objectives: to retain high performance employees and reduce employee turnover; to achieve
high productivity and efficiency by providing fair compensation among employees
commensurate with their positions; and to satisfy pay requirements in accordance with the
law.
Compensation can be classified into direct and indirect compensation. The four policies that
affect compensation systems are the following: internal alignment, external competitiveness,
employee contribution, and management of the pay system.
The establishment of fair compensation systems needs the following components to make them
more credible and satisfying to employees. They are the following: job analysis, job description,
job evaluation, pay structures, salary surveys, and policies and regulations.
Economists have developed theories that explain the different factors that affect wages. These
theories are the following: subsistence theory, just price theory, wage fund theory, residual
claimant theory, standard of living theory, and bargaining theory.
The terms salary and wage are often used interchangeably. However, this chapter differentiates
the two terms based on the following: the period on when they are paid, the basis of payment,
and their recipients.
Compensation administration can be discussed further by understanding the concepts which
have provided a prodder view of compensation administration as a key function in Human
Resources. They are the following: economic concept, psychological concept, sociological
concept, political concept, equity concept, and communications concept.
Lastly, this chapter deals with the contemporary theories developed by labor economists to
understand the transactions in the labor market. These theories are the following: labor markets,
labor supply, the labor market worldwide, human capital theory, and labor demand.
NATURE OF COMPENSATION
The world compensation has various connotations for different types of employees. For some,
compensation means the whole package of basic salary and benefits that the company provides.
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The majority, however, equates compensation with their contribution to the organization
(Milkovich, Newman, & Gerhart, 2013). When we say “contribution to the organization,” there
are many considerations on how to monetize contribution to the organization in the form of
actual salary. Whatever tools are used by organizations to pay employee based on their
contributions, issues and controversies arise in relation to the payment of salaries.
A high salary may make an employee satisfied for a while, but upon learning of a higher pay given
to another person, which he/she perceives as having the same level of performance, it may spark
discontentment and unmotivated employees which may eventually affect his/her performance.
This is a chain reaction. A below-average performance level can affect overall organizational
performance. A slight decrease in employee performance may significantly contribute to
organizational performance (Rayos, 2015).
At this point, let us first define the term compensation. Compensation is defined as the means
of giving monetary value equivalent to any work performed by an employee. It is also referred to
as all financial rewards and nonfinancial rewards which an employee may receive out of a work
rendered for the employer (Milkovich, Newman, & Gerhart, 2013).
BASIC TYPES OF COMPENSATION
There are three types of compensation: base pay, variable pay, and benefits.
Base Pay. It is the basic pay given to the employee for the actual work rendered usually in the
form of salary or wage. It is the pay that was negotiated and agreed upon by the employee and
the employer during the hiring process.
Base pay is expressed in the form of salary or wage which many people use interchangeably. The
term salary refers to a fixed amount of pay which is given usually twice a month, while the tem
wage is used to mean an hourly or daily based pay for any work rendered for a particular day
(Surbhi, 2015).
It is determined by the level of skills required, educational background, work experience, job
grade, and position of an employee. It is also negotiated during collective bargaining agreements,
developed by using market rate analysis and job evaluation which will be discussed later.
Variable pay. It is the pay linked to actual accomplishments in performance such as bonuses or
incentives based on a target sales quota or target productivity.
Incentives can be paid on individual, group, or team basis. In a much wider scope, incentives can
be provided for all employees regardless of rank (Armstrong, 2015).
There are various reasons for giving incentives. Once reason may be a large reduction in expenses
or an increase of sales volume. For some companies, a revenue growth that exceeds projection
is tantamount to an organization-wide incentive. Another reason may also be because of high
customer satisfaction and an increased percentage of loyal customers (Milkovich, Newman, &
Gerhart, 2013).
Benefits. These are indirect rewards which may either be government-mandated or voluntarily
given by the employer. Examples are: health insurance and vacation and sick leaves.
Benefits help employees to further cope with the demands of the job and their personal life.
Some companies make their benefits attractive to entice job seekers who would like to work for
companies that will take care of them for a long time. Some companies would even extend the
benefits to the employees’ dependents, such as hospitalization and insurance benefits.
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Large companies that are profitable and with large capitalization provide more that what is
mandated by law since they can afford to do so. Whereas small-sized companies can only provide
what the government dictates.
OBJECTIVES OF COMPENSATION
Organizations provide their employees with a compensation package to achieve these three-fold
objectives:
1. To retain high performance employees and reduce employee turnover;
2. To achieve high productivity and efficiency by providing fair compensation among
employees commensurate to their position; and
3. To satisfy pay requirements in accordance with the law.
One of the objectives of compensation is to retain and attract high-performing employees to
work in the organization. A good compensation package can easily attract high caliber job seekers
while it can also help in retaining employees who would not anymore think of leaving the
organization and work for another company. It reduces turnover and encourages loyalty among
employees. This works to the advantage of the organization because it lessens the cost of
recruiting and training new employees. In some cases, loyalty among employees instills stability
and builds a good image for the organization. There is no exodus of unsatisfied employees and
they are just happy and contented to work in the organization until retirement.
Another objective is to maintain high productivity and efficiency in the organization. Employees
should feel that they are treated justly according to their contribution to the organization
(Leventhal, 1980, as cited in Armstrong, 2015). When they feel they are paid fairly, they become
more productive on the job. It also conforms to what is called the “felt fair principle” wherein
employees believe that the pay system is fair if they feel that it is fair (Jaques, 1961, as cited in
Armstrong, 2015). They should not receive what they feel is less than what they deserve in
comparison to others.
There is low productivity when there are low morale and dissatisfaction in the organization. If
employees feel they do not get paid well, they will feel unappreciated and may lead to
discontentment. They will likely lose the drive to work harder and push themselves to improve
their craft.
Part of this objective is to reward deserving employees who are working hard to achieve the goals
of the organization. Employees who are exerting extra efforts should be recognized and
rewarded justly and fairly.
The last objective is to pay employees in accordance with the law. Companies have to abide by
the implementing rules and regulations on salaries, wages, and benefits that they should provide
to their employees. For example, the minimum wage is P512 in the National Capital Region
(DOLE, 2022).
Small Scale industries usually pay what the law provide and this is acceptable for as long as
companies do not pay below the minimum.
CLASSIFICATION OF COMPENSATION
Compensation can be classified into direct and indirect compensation. The level of motivation
that either direct and indirect compensation can provide depends on how they are perceived by
the employees.
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Direct Compensation refers to an actual monetary value that entitles an employee. It can be in
the form of a salary or wage. It can also be in the form of variable pay, such as bonuses, incentives,
commissions, and other performance-based pay. Money is usually attached to direct
compensation.
Indirect Compensation refers to nonmonetary aspects of compensation, such as benefits
packages that include hospitalization and life insurance plans, sick and vacation leaves, car plans,
and educational grants among others. It is usually referred to as the “add-on” or the extra
component of base pay (Armstrong, 2015).
POLICIES AFFECTING COMPENSATION
Milkovich et al. (2013) identified four policies that affect compensation systems: internal
alignment, external competitiveness, employee contribution, and management of the pay
system.
Internal Alignment. One of the challenges of managers is to make the employees happy with
their pay. They should see to it that there is internal alignment for employees having related or
similar tasks and those who have unrelated or dissimilar jobs. If managers are able to align pay
with the contributions of employees in achieving organizational objectives, then there is lesser
discontentment in the organization.
Most of the time, employees tend to make comparisons when it comes to their pay and others
doing similar tasks. For example, how different is the salary of a department secretary who serves
the whole department and an executive assistant who works for just one executive such as a
director? What is the difference in the salary of two supervisors working in two separate
departments such as sales and production? How should the difference in salaries between a
controller and a chief accountant be explained?
All these issues should be addressed by managers because any complaint or discontentment
from a single employee may cause a bigger problem which will be harder to handle. A pay issue
may spark an employee turnover which will be detrimental to the organization. Unmotivated
employees lead to inefficiency and low productivity of employees.
External Competitiveness. Another policy is ensuring competitiveness by aligning pay with
competitors. This can attract more applicants because the salaries are competitive, so to speak.
Some companies pay more than what their competitors give especially on basic pay to retain
employees and to ensure that their salaries are not far behind the company’s competitors. This
prevents them from leaving and transferring to a competitor.
Companies in the same industry compete not only on the products or services they offer. They
also compete on their ability to retain high-performing employees. One of the ways to do this is
to take care of them by providing competitive compensation packages.
However, providing competitive compensation packages should also be cost-effective. Being
competitive in terms of salaries may be costly. Managers should consider also the capacity of the
organization to compete vis-à-vis their competitors. Managers should be able to calculate the
risk of being competitive or using other means to set up the salary structure of the organization.
The question always is, can the organization have the capacity to stay competitive in terms of
salary provisions?
Employee Contribution. Another policy is to look at is the employee contribution. A major
dilemma among managers is to consider employee contribution to performance as a factor of
pay. Should all sales representatives be paid at minimum salary while incentives are based on the
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achievement of individual sales target? Or should their basic pay be based on their performance
while incentives are team-based?
The meaning of employee contribution is relative and each organization attaches a different
combination of pay. Some companies have a minimum basic salary but have high variable pay.
Others put more emphasis on basic pay but minimum on variable pay. Some companies are
strictly performance-based. Therefore, they put a high premium on employee contribution.
Management of the Pay System. Managers in the organization should be capable of putting a
system to the giving of compensation. Employees should be worthy of the pay that they receive.
There should be fairness in providing compensation for everyone in the organization. No one
should be discriminated and each employee should be justly paid.
Managers should also consider the timeliness of pay. Compensation policies include the payment
schedule and the manner by which pays are distributed.
COMPONENTS OF A COMPENSATION SYSTEM
The establishment of fair compensation systems needs key components to make them more
credible to employees. These components help in putting value to different positions which
eventually becomes the basis for determining the specific compensation package. The
components are the following: job analysis, job description, job evaluation, pay structures, salary
surveys, and policies and regulations.
Salary
Surveys
Job
Evaluation
Job
Analysis
Job
Description
Pay
Structures
Policies
and
Regulations
Job Analysis. It is defined as the process of determining all the information specific to a particular
job. The different tasks or activities, such as drafting, drawing, writing, teaching, and encoding,
are obtained. There is also additional information that is necessary to determine the right
compensation for a particular position such as how tasks are performed, the time they are
performed, and the reasons why they are done.
Job analysis can also provide the required behavior to perform the tasks and the performance
standards needed to evaluate job performance. It also determines the knowledge required such
as accounting procedures and the work conditions relevant to the job such as work schedules
and physical setup. It also provides the tools and equipment necessary to perform the job and
the personal characteristics required such as educational background, training, and work
experience (Dessler, 2015). Job analysis is necessary for the development of job descriptions
which are essential in determining pay rates.
Job Description. It is referred to as the written summary of all the duties and responsibilities of
a particular job position. It also includes the job specification which describes the educational
background, experience, skills, and personal traits that are needed to perform a particular job.
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As previously mentioned, job analysis is done to write job descriptions for all jobs in the
organization. Essentially, these job descriptions are used to determine pay levels, starting pay,
and other forms of compensation. Job descriptions are usually given to employees on the first
day of work. They guide the employees on the tasks that they should accomplish.
Job Evaluation. While job analysis provides all the information for each job, job evaluation is the
process of determining the worth of a job (Dessler, 2015). The worth or value of the job in the
organization forms a big part in determining pay rates, specifically basic pay. It also organizes jobs
into a hierarchy as pay levels are developed.
Pay Structures. Many organizations standardize their pay and use grades or levels. Pay structures
help in determining entry pay and incremental increases during performance evaluation or
promotion. They minimize complaints on the corresponding amount of increases because they
are structured and systematically arranged per grade or level.
Salary Surveys. Some organizations participate in salary surveys and purchase market data on
prevailing rates for different positions in the industry where they belong. These help in
determining appropriate rates and at the same time remaining competitive among competitors.
Policies and Regulations. Each organization has its policies in administering and implementing
its payment system. These depend on many factors including the organization’s capacity to
provide compensation and the standards set by law. They also indicate the kind of support that
the top management has given in the implementation of compensation packages.
THEORIES ON WAGES
Over the years, economists have developed theories that are designed to explain the factors that
affect wages. These theories were developed since the giving of wages to workers is a means to
sustain the workers’ survival. Wage in the form of money as a means to pay for basic necessities.
The wage theories are the following: subsistence theory, just price theory, wage fund theory,
residual theory, claimant theory, standard of living theory, and bargaining theory.
Subsistence Theory
This theory is the most popular economic theory on wages. For this
reason, so many viewpoints and articles were written on this theory and
this became the basis for the minimum wage concept. It is also based
on the theory of population by Thomas Malthus. According to the
subsistence theory, an increase in wages above the minimum or
subsistence level will only lead to an increase in population at a faster
rate. Once the population rises, the labor supply will also increase which
will lower wages (Atchison, Belcher & Thomsen, 2013). If actual wages
fall below the minimum or subsistence level, the population will
decrease which will eventually lead to a lower labor supply and an
increase in wages. This scenario will lead to famine, starvation, and disease (Chand, n.d.).
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The tendency of wages to remain fixed at a subsistence minimum level
that led to its being called the Iron Law of Wages or Brasen Law as
coined by Ferdinand Lassalle, a German economist. According to this
theory, wages cannot fall below the minimum because workers will
not be able to work. Since there are also few slots available for
employment, workers compete with each other. This competition will
drive the wages down the minimum level.
David Ricardo, a British economist, used the terms natural price and
market price of labor to explain the Iron Law Wages. A natural price
of labor is a price that is needed for a laborer to sustain himself/ herself. Whereas the market
price of labor is the price paid for the labor as provided by the worker. This market price is never
constant. He argued that there are other factors that may cause the demand for labor to increase
such as new investments in technology. With each increase in investment, there is a
corresponding requirement for more labor. Therefore, the demand for labor increase leads to an
increase in the price of labor. With the increase, the workers have additional wages which are
more that the subsistence level or an increase in minimum wage. This also means that the
workers are enjoying prosperity out of the increase in wages (The Editors of Encyclopedia
Britannica, n.d.).
Just Price Theory
This theory upholds the equity theory of J. Stacey Adams. This
theory emphasizes that employees would like to maintain
equity between inputs (their contribution to the job) and
outputs (the outcomes that they receive out of the perceived
efforts they have given to the organization) (Miner, 2015).
In this theory, wages are provided based on the status or
position of each employee. Employees with high positions have
higher wages. The hierarchy of positions also follows a hierarchy
of wages. So, members of top management have higher wages
than middle managers; while middle managers have higher
wages than front line managers. The more complex the tasks
are, the higher the wages. In the same way that a bigger responsibility entails a higher position,
thus a higher wage. Positions with lesser responsibility and are in the lower level in the hierarchy
have lower wages.
Wage Fund Theory
Adam Smith developed this theory to mean that workers are
paid based on a fund that is already there in the first place.
This fund is also called the wage fund. Employees or workers
will be paid equally by diving the wage fund over the number
of workers. The lower the number of workers, the higher
wage. For example, if the wage fund is ₱2,000,000.00 and the
number of workers is 100, each worker will receive ₱20,000.00.
But if the number of workers is 200, ten each worker will receive
₱10,000.00.
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Classical economist John Stuart Mill supported Adam Smith’s
theory on wage fund. According to Mill, this theory considers the
available wage fund and the number of workers to determine the
employees’ wag level. The wage fund may come from
accumulated capital or wealth that will be used as payment of
wages.
There are various criticisms raised in this theory. It states that
wages have already increased prior to the employment of workers.
On the contrary, critics say that the amount used for paying wages
will not increase unless there are already workers employed for
doing the job. Also, there are significant variations of wages paid
to workers in terms of place, time, and organization. This theory
also states that units of labor are homogeneous. Critics, however,
believe that units of labor are not homogeneous. There are differences in knowledge, skills, education,
attitudes, and the like among workers (Shaile, n.d.)
Residual Claimant Theory
William Stanley Jevons was the first to state it in 1862, but Francis
Walker was able to make a more profound analysis after 20 years.
According to this theory, wages are residual claims after rent,
interest, and profits are deducted from the total product. It
suggests that residual claims will only increase if productivity will
increase, given that there is no additional investment or capital
infused for workers to get more residuals. Wages are called
residuals because the three other factors of production, such as
land, capital, and entrepreneur, are paid first (Chand, n.d.).
On the other criticisms of this theory is that the portion provided
to landlords, entrepreneurs, and capitalists is fixed; workers are the
residual claimants. This is not possible because the entrepreneur is supposedly the residual
claimant but the income he/she gets is not fixed. Another loophole of this theory is that the
influence of unions is not considered (Shaile, n.d.).
Standard of Living Theory
This theory is a better version of subsistence theory in that, wage is determined by the standard
of living of the workers. A standard of living is defined as the level or quality of life that a particular
worker enjoys in a particular location or area. It includes the basic necessities of life, education,
and recreation which he/she has become accustomed with. If a worker is paid high wages, he/she
will become used to it so that he/she will eventually try to maintain this same standard of living
or ever surpass it (Shaile, n.d.).
One of the criticisms of this theory is that there is no such thing as a fixed permanent standard
of living. It may be steady for a considerable period but may not last for a long time. Wages and
salaries may change or may remain constant and the standard of living of the workers may always
depend on the amount of salaries and wages they receive. There is a truth that wages determine
the standard of living of employees and vice versa (Shaile, n.d.).
Bargaining Theory
John Davidson developed this theory to highlight the bargaining power of workers in negotiating
their wages. This is especially true for labor unions that negotiate their wages on the bargaining
table. Wages are high if the workers are stronger than the employer. If the latter is stronger than
the workers, the wages tend to be low.
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The rise of labor organizations had been instrumental in this theory. However, critics found that
laborers can bargain for their own wages even without labor unions (Chand, n.d.).
DIFFERENCE BETWEEN WAGE AND SALARY
The terms wage and salary are often used interchangeably to mean monetary compensation.
However, the difference shown below provide how these terms can be used more correctly.
Paid semi-monthly or on a fixed Based on the number of hours
period such as every 15th and 30th of worked
multiplied
by
the
the month.
employee’s hourly rate
Does not change each month or for Received either daily, weekly, or
a long time.
earlier than the semimonthly
payment of salaries.
S
A
L
A
R
Y
May change only if there is a Usually follow the no work, no pay
directive for a salary increase or rule.
promotion, or etc.
Usually paid on the basis of work
May be considered as a total hours rendered; no paid vacation or
compensation package which also sick leaves to be credited
includes benefits.
(Surbhi, 2015)
Determined thru market pay rates,
industry average, compensation
analysis among competitors.
W
A
G
E
Reference:
Cynthia A. Zaratee, DBA, C.A.Z (2021). Compensation Administration (First Edition). Rex Book
Store.
Prepared by:
ROBERT II I. GEONSON, MPA
Part time Instructor
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