COMPENSATION MANAGEMENT
CHAPTER 1 – The Pay Model
What is Compensation?
Compensation refers to all forms of financial returns and tangible services and
benefits employees receive as part of an employment relationship.
Different Perspectives
Society
 Some people see pay (and benefits) as a measure of justice.
 Example: pay inequalities between men and women.
 Job losses (or gains) in a country is partly a function of labor costs (and
productivity).
Stockholders
 Some stockholders say using stock to pay employees creates a sense of
ownership.
 Others argue it dilutes stockholder wealth.
 Stockholders have a particular interest in executive pay.
 Linking executive pay to company performance increases
stockholders' returns.
***When executive pay is excessive relative to company performance, profits are diverted
away to the executives.
(over paying executives when they could have used it to pay for something else)
Managers
 Compensation is a major expense that must be managed.
 It is also a major determinant of employee attitudes and behaviours.
(employee recognition awards, etc.)
Employees
 Pay is usually a major source of financial security.
 Employees may see compensation as:
 a return in an exchange,
 an entitlement for being an employee of the company,
 an incentive to take/stay in a job and invest in performing well, or
 as a reward for having done so.
Total rewards includes:
-total compensation
-relational returns
Total Rewards
 Total compensation:
 pay received directly as cash payments, such as base pay, merit pay, costof living adjustments, and incentives; and
 pay received indirectly as benefits, such as vacation, pensions, and health
insurance.
 Relational returns
 Psychological returns, such as Recognition and status, employment
security, learning opportunities, challenging work.
Cash Compensation:
Base Pay, Merit/COLA & Incentives
 BASE PAY: Cash that an employer pays in return for the work performed, based
on the skill or education an employee possesses
 MERIT INCREASES are increments to base pay based on performance.
 A COST OF LIVING ADJUSTMENT (COLA) is made to base pay on the basis of changes
in costs of living.
 INCENTIVES (OR BONUSES) are paid in a lump sum rather than becoming a part of
base pay, based on performance. Can be long or short term. (always taxable)
*** one-time payment for meeting previously established performance objectives.
Benefits
 Health Insurance
 Health insurance (medical/dental/vision), life and disability insurance
 Pension
 Retirement and savings programs.
 Allowances
 often grow out of short supply
 Example: car allowance, isolation pay, housing and transportation allowances in China,
isolation pay, jury duty, flex work arrangements, bereavement pay, etc.
Relational Returns
Nonfinancial returns that substantially impact employee behavior, such as
employment security and learning and developmental opportunities.
A network of returns: Created by different forms of pay; useful if bonuses,
development opportunities, and promotions all work together.
The Pay Model
Three basic building blocks:
 The compensation objectives.
 The policies that form the
foundation of the
compensation system.
 The techniques that make up
the compensation system.
Compensation Objectives
Pay objectives guide the design of the pay system and are standards for
judging success.
 EFFICIENCY: improving performance, increasing quality, and controlling
costs.
 FAIRNESS: both the process and outcomes of pay decisions should be
fair.
 COMPLIANCE: conforming to federal, provincial and territorial laws and
regulations. (paying people min wage,
Four Strategic Policies: (1) Internal
Alignment
 Refers to comparisons among jobs or skill levels INSIDE a single
organization.
 Pertains to the pay rates both for employees doing equal work and for
those doing dissimilar work.
 Pay relationships affect the compensation objectives of efficiency,
fairness and compliance.
Four Strategic Policies : (2) External
Competitiveness
 Refers to pay comparisons with competitors external to the organization.
 Pay is ‘market driven’.
 Objectives:
 To ensure that pay is sufficient to attract and retain employees.
 To control labor costs to ensure competitive pricing of products/
services.
Four Strategic Policies: (3) Employee
Contributions
 Refers to how employees are rewarded.
 Understanding the basis for judging performance, helps
perceive pay as fair.
Four Strategic Policies: (4) Management
 Making sure that the right people get the right pay for achieving the
right objectives in the right way.
Pay Techniques
 Techniques tie the four basic policies to the pay objectives.
 Techniques refer to the tools and mechanisms that are used to achieve
the strategic objectives.
 Many variations of pay techniques exist. (paying more for high
performers)
Summary
 Compensation refers to all forms of financial returns and tangible services
and benefits that employees receive as part of an employment relationship.
 There are different perspectives on compensation: society, stockholders
(exec pay will take money away),managers and employees.
 The two major components of total rewards are total compensation and
relational returns. Total compensation is composed of cash compensation
(base pay and incentives) and benefits. Relational returns include
psychological aspects of work such as recognition and status, challenging
work, and learning opportunities.
 The strategic objectives of compensation are efficiency, fairness and
compliance.
 The four strategic policies in the pay model are internal alignment,
external competitiveness, employee contributions, and management.
Chapter 2
Strategy: The Totality of Decisions
Learning
Outcomes
 Explain why managers should tailor their pay systems to support
the organization’s strategy.
 Identify the four steps to develop a total compensation strategy.
 Describe the three tests used to determine whether a pay strategy
is a source of competitive advantage.
 Contrast the “best fit” perspective on compensation with the “best
practices” perspective.
Strategy & Strategic Choices
 Strategy: the fundamental business directions that an organization has
made in order to achieve its strategic objectives.
 A strategic perspective focuses on those compensation decisions that
help the organization gain and sustain competitive advantage.
*** Taking a strategic perspective requires a focus on compensation
decisions that helps the organization gain and sustain
COMPETITIVE ADVANTAGE. (branding like Kleenex, where people
recognize and use the brand name to refer to the actual product; “get me a Kleenex”)
*** The underlying premise of the support business strategy,The greater the
alignment, or fit, between the organizational strategy
and the compensation system, the more effective the organization.
 Different industries may have different pay strategies, but there can be:
 different strategies within the same industry, e.g. Google, Microsoft,
and SAS;
 different strategies within the same company, e.g. SK Holdings.
Support Business Strategy
 Pay systems should align with the organization's business strategy
 A supporting compensation strategy for an INNOVATOR, places more
emphasis on incentives encouraging innovations. (new to market, appeal
to early innovators)
 Compensation in a COST CUTTER STRATEGY (dollar store, walmart,
etc) encourages productivity increases.
 The CUSTOMER-FOCUSED STRATEGY uses customer satisfaction
incentives in the compensation strategy.
 When business strategies change, pay systems should also change
Support HR Strategy
 Pay systems should align with the organization's overall HR strategy and
systems which include hiring, training and development.
 Compensation is key to attracting, retaining, and motivating employees
with the abilities necessary to execute the business strategy.
Recruit, retain, attract
*** KNOW THE STEPS IN ORDER (Key Steps in Formulating a Total Compensation Strategy)**
Step 1
Assess Total Compensation
Implications
 Business strategy and competitive dynamics – understand the
business.
 HR strategy – pay as a supporting player or catalyst for change(encourage
people to perform)?
 Culture/values – pay system mirror image and reputation..
 Social and political context – affects compensation choices. Social justice,
legal regulatory, demographics, cultural difference, global context.
 Employee preferences – wide-ranging, choice is good, up to a certain
point.
 Union preferences – adapt pay strategies to union-management
relationship.
***When you are assess total compensation implication, you want a pay
system that reflects the value of that guides employers and underlines its
treatment of employees
Step 2
Map a Total Compensation Strategy
 Map a total compensation strategy using the five elements of the
pay model.
-onjectives
-internal alignment
-ext competitiveness
***This means that we are dealing with setting objectives, specify policies on
alignment, competitiveness, contributions, and management.
 Decisions in the pay model work in concert and the totality of
decisions form the compensation strategy.
Example: Whole Foods
OBJECTIVES: increase shareholder value, satisfy and delight customers,
and seek employees who will help the company make money.
INTERNAL ALIGNMENT: store is organized into self-managed teams,
executive salaries capped at 19X average full-time employee pay, and
all full-time employees qualify for stock options.
EXTERNAL COMPETITIVENESS: offers a unique total compensation
package
compared to competitors.
EMPLOYEE CONTRIBUTIONS: uses a shared fate technique and monthly
performance affects team pay.
MANAGEMENT: uses a “no-secrets” management technique making
salaries known to all and a “you decide” technique allowing employees
to chosoe their health insurance.
Steps 3 and 4
Implement and Reassess
 Step 3 involves implementing the strategy through the design and
execution of the compensation system.
 Step 4 recognizes that the strategy must change to fit changing
conditions, and involves periodic reassessment. Periodic
reassessment is needed to continuously learn, adapt, and
improve.
Competitive Advantage: ***Three Tests
 IS IT ALIGNED?
 Is the compensation strategy aligned with the business
strategy, economic and sociopolitical conditions, and the
overall HR system?
 DOES IT DIFFERENTIATE?
 Is the compensation strategy different and difficult to imitate?
(difficult to copy)
***The pay strategy that adds value and is difficult to imitate by other employer is a source of
competitive advantage.
 DOES IT ADD VALUE?
 Does the compensation strategy add value by providing a
return on investment?
“Best Fit” versus “Best Practices”
 “Best fit” approach suggests that a company is more likely to
achieve competitive advantage if pay practices are aligned with
business and overall HR strategies; reflects the company’s
strategies and values.
***Design the pay plan, better the fit, better the advantage.
 “Best practices” approach suggests that there exists a set of best-
pay practices, which can be applied universally across all situations,
results in better performance with almost any business strategy.
Guidance from the Evidence
 Internal alignment: Both small and large internal pay differences
can be a best practice.
 External competitiveness: Paying higher than the average paid by
competitors can affect results.
 Employee contributions: Performance-based pay can affect results.
 Managing compensation: All dimensions of the pay strategy need
to be considered.
 Compensation strategy: Embedding compensation strategy within
the broader HR strategy affects results.
Need to identify what practices pay off best under what conditions.
Virtuous and Vicious Circles
Performance-based pay works best when there is shared success.
Shared success improves employee attitudes, behaviors, and
performance when coupled with other “high performance” practices.
Summary
 To improve organizational effectiveness, managers should align the
compensation strategy to the organization’s strategy.
 The steps to develop a total compensation strategy are: 1-assess total
compensation implications, 2-map out a total compensation strategy,
3-implement the strategy and 4-reassess and realign the strategy to ensure
achievement of the objectives.
 The tests used to determine competitive advantage are: Does it align?
Does it differentiate? And does it add value?
 The “best fit” perspective on compensation suggests that compensation
be aligned with the specific business strategy. The “best practices”
perspective suggests there is one set of best pay practices that can be
universally applied across situations and strategies.
Chapter 3:
Defining Internal Alignment
Learning Outcomes
 Define what is meant by internal alignment and pay structure.
 Describe the three factors that determine how internal pay structures
are designed.
 Describe the factors that shape internal structure.
 Explain the two strategic choices involved in designing internal pay
structures.
 Explain three theoretical approaches to determining which pay
structure is best for an organization.
 Describe three consequences of an internally aligned pay structure.
Internal Alignment
 refers to the ***PAY relationships among different jobs/skills/competencies
within a single organization → job structure. Often referred to as internal
equity.***INTERNAL EQUITY = INTERNAL ALIGNMENT
 Structure needs to:
 Supports organization strategy-***plans to achieve the internal goals and objectives
 Supports work flow
***  Work flow is the process by which goods and services are delivered
to the customer.
 Motivates behavior
 “line-of-sight” – relationship between each job and the organization’s objectives.
***-the ability of the employee to see the link between and individual employee’s work and the
achievement of organizational objectives.
Internal Pay Structure
*** Refers to the array of pay rates for different work or skills within a
single organization. ***
*** An internal pay structure can be defined by:
 the number of levels,
 the pay differentials between the levels, and
 the criteria or bases used to determine those levels and differentials.
Differentials
 The pay differences among levels are differentials.
 Higher pay is usually due to work:
 requiring more skill/knowledge,
 performed in unpleasant work conditions, or
 work that adds more value to the company.
 To motivate people to strive for promotion to higher-paying levels
Criteria
***CONTENT refers to work
performed in a job and how it gets
done. A structure based on content
ranks jobs based on skills
required, complexity of tasks,
problem solving, and/or
responsibility.
***VALUE refers to the worth of the
work, its relative contribution to the
organization’s objectives.
A structure based on value
focused on the relative
contribution of the skills, tasks,
and responsibilities of a job to the
organization’s goals.
Job- and Person-Based Structures
*** A job-based structure relies on the work content – tasks, behaviours,
responsibilities.
*** A person-based structure shifts the focus to the employee.
KSAOs knowledge skills abilities and other characteristics.
 The skills, knowledge, or competencies the employee possesses and
if they are used in the job.
What Shapes Internal Structure?
EXTERNAL FACTORS
• Economic Pressures
(supply and demand)
• Government Policies,
Laws and Regulations (benefits, no
discrimination, min. wage, etc)
• Stakeholders (***are union,
stockholder and even political groups,
have a stake in establishing internal
pay structure.)
• Cultures and Customs
(norms, etc.)
ORGANIZATIONAL FACTORS
• Strategy (pay structures)
• Technology (influence design)
• Human Capital (knowledge skills,
eligibility, people, individual)
• HR Policy
• Employee Acceptance (judging for
fairness)
• Cost Implications
(differentials)
Internal Labour Markets
Refer to the rules and procedures that:
 determine the pay for the different
jobs within a single organization, and
 allocate employees among those different
jobs.
Exhibit 3.5
Illustration of an
Internal Labour
Market
By contrast, pay for non-entry jobs (those staffed internally via transfer and promotions,
such as systems engineer, lead engineer, adviser engineer, and consultant engineer in the
example shown in Exhibit 3.5) is connected to external market forces, but the connection
is less direct. External factors are dominant influences on pay for entry jobs, but the
differences for non-entry jobs tend to reflect the organization’s internal factors.
***pay for non-entry job is buffered from
external forces and more heavily enforced by internal
factors.
Strategic Choices in Designing Internal Structures
Tailored
Loosely Coupled
 Adapted by organizations with a
 Adapted by organizations that
low-cost, customer-focused
strategy.
 Has well-defined jobs with
detailed steps or tasks.
 Has well-defined pay structure
 Examples: McDonald’s, Walmart
require constant innovation.
 Jobs are flexible, adaptable and
changing
 Pay structures are more loosely
linked to the organization to provide
flexibility.
 Example: 3M
Strategic Choices in Designing Internal Structures
Egalitarian (finals)
Hierarchical (finals)
 Fewer levels and smaller differentials.
 Have multiple levels
 Equal treatment can mean
 Have detailed job description
knowledgeable employees feel
underpaid, who may quit or change
their behaviours.
 Results in higher performance when
collaboration is required.
 Results in higher performance
when work flow depends on
individual effort.
Equity Theory: Fairness
 People compare the ratio of their
own outcomes to inputs with that of others.
*** Employees judge fairness by
comparing:
 to jobs similar to their own,
 their job to others at
the same employer, or
 their pay against external pay
levels. (FINALS)
The equity theory either supports
egalitarian or hierarchical
Tournament Theory
 Relationship between motivation and performance.
 Example: players perform better where prize differentials are sizeable.
 Works best in situations where individual performance matters most.
Individual performance is dependent on their desire to advance in the organization.
FINALS ***According to tournament theory, the greater the pay differential between and employee’s
present salary and his/her bosses’ salary the harder the employee will work.
*** So that means pay differential do affect pay performance.
Institutional Theory -using the practices of other firms and copies what they do.
 Copy others and conform
 Organizations use “best practices”, and are simply copied
 What aligns with the strategy of one organization may not align with that of another.
 It may not be possible to have “competitive advantage” by simply
imitating practices.
***-a pay strategy that is a source of competitive advantage is one that adds value, and is
difficult for employers to imitate.
FINALS – Institutional Theory predicts that very few firms are first movers instead they copy innovative
practices after innovators have learned how to make the practices work.
Consequences of an Internally-Aligned Pay Structure
 EFFICIENCY
 Aligned structures lead to better
performance.
 FAIRNESS
 Fair or BIG differentials motivate.
 Small differentials facilitate cooperation
and commitment.
 COMPLIANCE
 Comply with regulations of the country
or province labour laws under which we
operate.
Potential Outcomes of an
Internally-Aligned Pay Structure:
• Undertake addtl. training
• Increase experience
• Reduce turnover(less quiting)
• Facilitate career progression
• Facilitate performance
• Reduce pay-related grievances (transparency
& fairness)
• Reduce pay-related work stoppages (strike and
lockouts)
Summary
*** Internal alignment refers to the pay relationships between jobs, skills, and
competencies within a single organization.
 The factors that define internal pay structures are the number of levels, the pay
differentials among the levels, and the criteria used to determine these levels and
differentials.
 External and organizational factors shape internal pay structures.
 The strategic choices involved in designing internal pay structures are how closely to
link pay structure to organization design and workflow, and how to distribute pay
throughout the levels in the structure.
 Theoretical approaches include equity theory, tournament theory, and the
institutional model.
 An internally aligned pay structure can help an organization achieve efficiency,
fairness, and legal compliance.
!!!END OF DAY FREEBIES!!!
T/F: Total compensation includes psychological aspects of work such as recognition and status,
challenging work, and learning opportunities. FALSE (relational returns)
T/F: Incentives may be long-term or short-term. TRUE
T/F Internal Alignment is the first strategic policy - TRUE