Building a Market-Based Pay Structure From Scratch

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Building a Market-Based Pay Structure
From Scratch
http://www.shrm.org/templatestools/toolkits/pages/buildingamarket5/6/2013 basedpaystructurefromscratch.aspx
Scope—This article—primarily for the benefit of HR professionals who are not compensation
specialists—discusses all the steps involved in developing and implementing a market-based
pay structure. It refers to but does not include a detailed discussion of job evaluation or of other
internally focused methods of setting base pay. It also does not include executive
compensation.
Overview
Many organizations ask their human resource professionals to create a base pay structure from
scratch or to revise the existing structure to meet their changing needs. For HR professionals
whose areas of expertise lie outside the compensation arena, such a project can seem
challenging at best. See, Introduction to the HR Discipline of Compensation.
The compensation system development process, however, does not have to be an overwhelming
and dreaded goal. Building a market-based pay structure from scratch encompasses the following
steps:
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Gathering the background information needed for project success.
Determining your sources of external market data and getting the data ready.
Conducting the market data analysis.
Developing the pay structures.
Calculating the costs of the pay structures.
Implementing and evaluating the new pay structures.
This article walks through each of these major steps to help the novice successfully develop a
complete pay structure from scratch. Those seasoned in compensation will find the article helpful
in keeping their compensation skills current in today’s volatile compensation markets.
Business Case
One of the most basic functions of business management is to establish a compensation scheme
that is competitive and equitable and that promotes employee engagement and high
performance. See, Maximize Return on Compensation by Avoiding 7 Common Mistakes.
HR’s Role
HR professionals are key in this process. HR professionals assist managers in determining the
functions the organization needs performed, the best organizational structure, the market
clearing price for such job functions, and ways to communicate the compensation scheme so
that it is perceived as equitable and so that it encourages high engagement and high performance
by employees. HR professionals must do this in an environment where the legal landscape is
constantly changing under several federal laws. See, Compensation Practices Becoming More
Formal, Rigorous.
Step 1: Gathering Background Information
Building anything of value requires a reason or business philosophy and strategy. To ensure
success of the project and complete support from the top down, the project needs a plan that
explains why the system is being built, what is to be built, how all the pieces fit together and
what the expected end result is. To build anything from scratch requires an architect to create a
plan as well as a champion to guide and drive the process. That champion serves as the catalyst
to align decision-makers and resources. That way, what is being built successfully aligns with the
organization’s business philosophy, culture, vision and mission, values, resources and strategic
objectives. Similarly, building a pay structure from scratch requires the architect to articulate the
compensation philosophy, clarify concepts that define the fundamental beliefs about the
structure, and design and develop the strategy. The process also requires a champion to align
decision-makers, obtain buy-in from the top of the organization and execute the plan. See, What
is a compensation philosophy?
Human resource practitioners are in the best position to serve in both the architect and champion
roles to accomplish these tasks. The first step in the process of building a pay structure is
articulating the organization’s compensation philosophy and strategy. See, Salary Structures:
Creating Competitive and Equitable Pay Levels.
Defining the compensation philosophy
A well-designed compensation philosophy supports the organization’s strategic plan and
initiatives, business goals, competitive outlook, operating objectives, and compensation and total
reward strategies. See, Keeping Comp on Track: Some Practical Tips.
As such, most compensation philosophies define the following basic tenets:
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To identify what the organization’s pay programs and total reward strategies are.
To identify how the pay programs and strategies support the organization’s business
strategy, competitive outlook, operating objectives and human capital needs.
To attract people to join the organization.
To motivate employees to perform at the best of their competencies, abilities and skill
sets.
To retain key talent and reward high-performing employees.
To define the competitive market position of the organization in relation to base pay,
incentive compensation and benefits opportunities.
To define how the organization plans to pay and reward competitively, based on business
conditions, competition and ability to pay.
A strong compensation philosophy is typically tied to an organization’s mission, core business,
operating strategies and competitive outlook. For example, a high-tech organization, with a core
business strategy to attract and retain the top professional and managerial talent in the industry
to outdistance competing organizations, might adopt a pay philosophy and strategy of leading the
market with its total cash compensation package or of paying higher than other organizations in
the industry. See, Effectively Managing Base Pay: Strategies for Success.
In another example, a warehouse, distribution and retail organization that has low employee
turnover and exists in a demographically contained community with a large labor pool might
adopt a pay philosophy and strategy of offering a compensation and total rewards package that is
valued less than that of a similar organization located 50 miles away in a highly competitive
community with labor shortages and high employee-demand issues. In this scenario, this
organization adopted a philosophy of matching supply and demand conditions for its own
community and set the policy to control cost.
An effective compensation philosophy should pass the following quality test:
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Is the overall program equitable? See, Managing Pay Equity.
Is the overall program defensible and perceived by employees as fair?
Is the overall program fiscally sensitive? See, Employers Assessing Salary Programs
for Affordability, Competitiveness.
Are the programs included in the compensation philosophy and policy legally
compliant? See, Conduct a Pay Equity Study to Mitigate Litigation Risks.
Can the organization effectively communicate the philosophy, policy and overall
programs to employees?
Are the programs the organization offers fair, competitive and in line with the its
compensation philosophy and policies?
To effectively exist and thrive in today’s competitive marketplace, many organizations realize
that a one-size-fits-all strategy regarding compensation philosophy does not work. Different
philosophies may be developed for different employee segments, such as “hot jobs,” information
technology, “hard to fill,” administrative and operations. See, Philosophizing Compensation.
Management team buy-in
By virtue of its position in the organization, HR can best serve as the architect of and champion
for articulating the organization’s compensation philosophy and strategy. To serve effectively
in those roles, HR needs to develop a knowledge and understanding of the following:
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The marketplace for labor.
The compensation and benefits survey tools necessary to scan the competitive
marketplace.
The jobs in the organization.
How supply, demand and labor market issues affect the organization.
The operational and legal ramifications surrounding the compensation and total reward
programs the organization is considering or currently offering.
Although HR is clearly in the lead in developing an organization’s compensation philosophy and
policy, success lies in close collaboration with the leadership team to obtain valuable input,
direction and concurrence.
Some important questions to ask the leadership team in developing an organization’s
compensation philosophy follow:
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Does the organization wish to lead, lag or meet the market in terms of compensation and
total rewards? How does this decision vary by position type? See, What are the
advantages or disadvantages of a lead, match or lag compensation strategy?
Is the organization currently leading, lagging or meeting the market? Why?
Where is the organization positioned in terms of market competitiveness?
What is the organization’s mix of base pay, variable and incentive pay, working
conditions and benefits offerings?
How are pay and total rewards distributed? See, What are total rewards strategies?
Can you give me some idea on how to develop a total rewards strategy?
Do employees value the organization’s programs, including pay, health care benefits,
retirement and savings benefits, vacation and paid time off, incentives, and profit
sharing? See, Beyond Payroll: Rewarding Employees in Today’s Economy.
What are the strengths and weaknesses of the organization’s current compensation and
total rewards programs?
Is the organization able to attract, hire and retain the human resources it needs to be
competitive and operationally effective? See, Reward Strategies Should Target Key
Talent.
Can the organization afford or effectively execute its current or proposed pay programs?
Does the organization have any potential constraints in executing a unified and consistent
compensation philosophy, such as legal, union and non-union issues, internal and
external labor markets, or special contracts?
Is the organization having trouble hiring employees? If so, in what jobs or geographic
areas?
How long do employees stay with the organization?
What is the turnover rate at the organization?
Why do employees leave the organization? Where are they going?
What are the organization’s career development and promotion policies and strategies?
See, Employee Promotion Policies Can Attract and Retain Talent.
What is the organization’s labor mix?
Who are the organization’s main competitors?
How will the organization align pay and rewards with individual, team and organizational
business initiatives and performance expectations? See, Align Pay with Business
Priorities to Reap Rewards.
By obtaining valuable input from the leadership team and by adopting a collaborative process to
answer important strategy questions, human resources effectively creates the environment
necessary to align and obtain concurrence and buy-in on a compensation philosophy from key
decision-makers. This process does not happen overnight. Rather, one or two discussions of two
to four hours each with management team members will generate the necessary, diverging
viewpoints that best represent consensus on how to link the compensation philosophy and policy
to the organization’s mission, core business, operating strategies and competitive outlook
necessary to be successful.
Other information needed
Other items HR professionals need to gather at project start include the following (approximate
time required will vary based on the size of the organization and other complexities like
locations, reporting structures and level of management layers).
Item Needed
Current job descriptions
Current compensation
“program:” pros and cons
Salary surveys
Its Importance
Job descriptions provide the
essential information for
comparing an organization’s
positions to external survey
positions.
Expected Time Frame
If managers have updated job
descriptions within the last
one to two years, expect one
week to gather.
If managers have not updated
their job descriptions in
several years or if no
descriptions exist, update the
documents first to ensure an
accurate market comparison.
This step can take up to six
weeks to fully complete
discussions with managers
and, in some cases, with
incumbents.
Examining the organization’s Expect one to two weeks,
formal and informal
depending on the depth of
compensation history reveals information available and
what has “worked” in the past familiarity of the project lead
and should be maintained in with the compensation
the new system, and what
“program.”
should be avoided.
Salary surveys provide the
Expect two to three weeks to
external market data necessary research, order and receive, if
to create the pay structures.
the surveys are ready for
delivery. If current-year
surveys are not published, you
may have to use the previous
year’s data with suitable aging
(the aging concept will be
explained later in this toolkit).
Employee census
Work locations
The cost effects of the
proposed system are
calculated using current
employ pay data.
Expect a few hours to pull the
information from the human
resource information system
(HRIS)/payroll system and to
format it into a user-friendly
layout. Depending on the
quality of the HRIS system
report writer, this process may
take much longer.
Organizations with several
Expect a few hours of survey
work locations must consider analysis to make decisions
the impact of geography on
regarding geography’s role in
compensation when
determining pay rates.
determining pay structures.
Step 2: Selecting Sources of External Market Data and Preparing the Data
A quick Internet search will provide the HR professional with a wealth of compensation surveys.
Without formal compensation training, such findings can be overwhelming. How do you know
which surveys are reputable? Which ones are up-to-date? Which ones provide the best value for
the cost? With great focus undoubtedly on the pay structure development process, HR must
make the right decisions regarding salary surveys prior to the start of the market analysis process.
See:
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Obtaining and Using Relevant Salary Survey Data
Using MSAs to Benchmark Compensation
Managing a Salary Survey Project (PDF)
What data sources should I use?
Finding one data source that meets all of an organization’s needs is rare. Using multiple data
sources is critical in allowing for cross-validation and filling in information gaps. HR has several
options when contemplating salary data sources:
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Purchase a salary survey from a survey organization such as a consulting company.
Commission a customized salary survey through a consulting company.
Purchase a salary survey from a trade organization or association.
Use wage data from the Bureau of Labor Statistics (BLS).
Commission a custom survey. See, SHRM Compensation Data Center.
Beware of free surveys. Many individuals new to compensation, especially those without a
budget to purchase salary surveys, will explore websites that offer free pay data. Such data vary
in their reliability. As such, HR professionals should not rely on them for building pay structures.
Many organizations have experienced the fallout from such survey data—everything from
employee visits to the HR department showing that they should be paid more because “it says so
on the Internet” to union organizing drives premised on these Internet numbers.
The issue with such free data, with the exception of BLS data, is that their origins are unknown.
Many of the surveys lack a survey participant list. Moreover, why would an organization provide
its data for free when reputable survey organizations may charge thousands of dollars?
Organizations and consulting companies. Several reputable, long-standing organizations
specialize in producing salary surveys. Typically, the global compensation consulting firms are
also major players in the survey reporting business. When purchasing these surveys, keep in
mind that prices will often be considerably lower for survey participants than for nonparticipants.
Also, some consulting organizations sell their survey reports only to participants. See, How can I
locate sources for salary survey data for all industries and occupations?
Several outstanding but lesser-known organizations also produce quality survey reports.
Searching the Internet with keywords such as the relevant industry or geographic region will turn
up many of these groups.
Trade and professional organizations. Trade and professional organizations and their
publications are another credible source of salary data. They generally offer surveys to members
for free or reduced prices but also sell them to nonmembers at reasonable rates. Sometimes these
organizations do not openly advertise their surveys, but a quick call can help identify options. Be
aware of the potential for bias in these studies, however, inasmuch as these organizations exist
primarily to serve their members.
BLS wage data. Another option, the BLS offers data cuts by occupation, industry and
geographic area. The data are free, so caveat emptor: The information may be a bit dated. The
most relevant results come from using data that are no more than one year old, but if there is no
budget for surveys, BLS data are better than guessing at something so important. You can
progress the data by the market wage increase rate to bring the information approximately up-todate.
Custom survey. If data are not available for a specific position, industry or region, use a custom
survey. The best method is to engage an independent third party to collect and summarize the
data. The third party can assure participants that the data will be kept confidential, which should
elicit more and better information from them. Using a third party will also ensure compliance
with the Department of Justice antitrust guidelines, minimizing your organization’s legal risk.
See, Can I contact other local organizations in my area to get a gauge on merit projections
or other compensation and benefits data? and The Antitrust Implications of Compensation
Benchmarking: Todd v. Exxon.
Organizations like the flexibility custom surveys offer in terms of fine-tuning the data gathering
to very specific needs. However, custom surveys can take anywhere from two to four months
from conception to completion, so the time and cost factors often outweigh the benefit of more
precise data.
Linking the surveys to the compensation philosophy
Most robust surveys will allow for multiple cuts based on revenue category, industry and
geography. The next step is to determine which cuts to use. Those decisions should tie back to
the organization and its compensation philosophy and yield data that most closely match.
Geographic. Often, the geographic cuts used—national, regional or local—parallel an
organization’s recruiting strategy. That is, organizations typically recruit nonexempt employees
locally, so relying on local market data for these positions makes sense. On the other hand,
organizations are likely to recruit nationally for executive positions. National data may be more
appropriate for those jobs, except in a very low-cost labor area (e.g., rural areas or southeast
United States) or a very high-cost labor area (e.g., San Francisco and New York). In the case of
the latter, in which market rates tend to deviate significantly from the national, using cityspecific or possibly regional data may be more effective.
See:
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Geographic Differences in Pay Create Challenges for Employers
Geographic Pay Differentials: Practices in Managing Pay Between Locations
Geographic Pay Differential Practices
Beyond MSAs: Determining How U.S. Pay Varies by Location
National survey reports often provide either geographic data breakdowns or factors for adjusting
the national data for local areas. Some survey providers also report wage differentials for use in
factoring national data to local market needs. Keep in mind that SHRM offers its members a
robust online feature that allows members to select the type of survey they seek[SK1] .
SHRM will then send an e-mail listing survey organizations that provide that type of survey.
Industry. Next, consider whether to use industry-specific or all-industry data, again referring
back to the compensation philosophy. If the relevant industry is very competitive and employees
often move among competitors, focus on industry-specific data, which may tend to be higher
than all-industry data. In some organizations, particular positions may call for industry-specific
data, such as IT positions in a high-tech company. For positions in other departments in the same
organization—e.g., finance, accounting and human resources—all-industry data cuts may serve
the purpose because qualifications are not industry-specific. See, How can I locate sources for
salary survey data for all industries and occupations?
Revenue category. Most employers tend to use data from organizations of a similar revenue size
across all levels of positions. For a more precise assessment, however, some organizations focus
on a select subset of similarly sized employers. This method is most easily done via a custom
survey but can also be accomplished by purchasing data cuts for the targeted group of companies
from a consulting organization. To ensure confidentiality, the data cut is never made at a level
that would allow identification of individual employers’ pay data.
In selecting a group of organizations, look beyond the specific industry and identify companies
from which you hire or to which you lose employees. Some employers fine-tune their data even
more by selecting multiple groups of companies on the basis of their similarly sized functional
groups—for example, IT and sales.
Ensuring quality data in your analysis
HR professionals should consider the following features when determining the quality of a
survey.
Cost. All quality surveys will cost something, but participants to a survey may enjoy a
significantly reduced purchase rate. HR professionals must budget for an annual expenditure on
and investment in salary surveys.
Participants. Surveys should have an easily accessible list of participating organizations, so the
consumer can determine whether the survey group is relevant from a recruitment and retention
perspective. Ideally, the survey will demonstrate a low level of “participant churn” and have
enough participants to allow reporting of market rates. Typically, surveys will not report market
rates unless at least five data points are available to calculate percentile information. For some
metropolitan areas, surveys are periodically unable to report market rates. By and large,
however, the survey should have enough participation to provide market rates at the national,
metropolitan and various revenue levels.
Currency. Most organizations specializing in salary surveys conduct them annually to capture
changes in the market. Some trade and professional organizations, however, may survey their
members only every other year or every third year. Be sure that a survey more than a year old
provides enough value and accurately reflects the market before including it in the analysis.
Applying statistical terms to the compensation philosophy
Most surveys report a variety of data points for use in market analyses. Surveys often provide the
average market rate, also known as the “mean.” The 50th percentile, also known as the
“median,” is the most commonly provided percentile statistic. The survey may also provide the
10th, 25th, 75th and 90th percentiles. These percentiles should, at the very least, be available for
base compensation and total cash compensation, which is base + variable pay (bonus or
incentive).
Some surveys may also show “targeted” total cash compensation versus “actual” total cash
compensation. For example, a finance manager’s target variable pay may be 15 percent of base
pay, but he or she actually received an incentive payout equal to 10 percent of base pay. In
addition, some surveys report statistics around stock options and restricted stock.
To determine the appropriate percentile to use when reviewing market data, consider the
compensation philosophy.
Matching the market. To target the 50th percentile means that an organization wants to pay in
the middle of all organizations that have a similar position. In other words, 50 percent of the
organizations should be paying less than that market rate, and 50 percent should be paying more
than the market rate. “Matching the market” is the formal name for this approach.
Market leader. If an organization chooses to focus on the 75th percentile and take a “market
leader” position, it will pay higher than 75 percent of other organizations with similar positions.
Organizations competing for employees with specialized skill sets in a tight labor market or
organizations that want to be a high payer in the market typically select a market leader position.
Organizations with less robust variable compensation or benefits programs may also select a
market leader base pay position to end up with an overall 50th percentile total compensation
program.
Market lag. If an organization chooses to focus on the 25th percentile and take a “market lag”
position, it will pay higher than only 25 percent of other organizations with similar positions.
Organizations with strong variable compensation or benefits programs, or those encountering
financial difficulties, may opt for a market lag position.
Lead-lag. As an additional variation, some organizations may choose to lead the base pay
market for the beginning of the fiscal year and then lag at the end of that year. “Lead-lag” is the
formal name for this approach to base pay management.
Organizations can lead, lag or match the market at various levels of market position by using a
fixed percentile position or a fixed percentage above or below a point. For instance, an
organization can build its position at 10 percent above the 50th percentile by increasing the
survey rates by 10 percent. Spreadsheet programs afford the user robust data analysis capabilities
and rapid “what if” scenario modeling.
Why and how to age survey data
Salary surveys capture salary data at a specific point in time in the past. However, the market
continues to move because of pay increases, market adjustments, promotions and employee job
transfers. As such, it is necessary to “age” or “trend” the data to a common point in time—for
example, today’s date, the date the pay plan will go live, beginning of new fiscal year—using a
factor that reflects market movements.
HR practitioners should note the effective date of salary survey data to age the data to a common
point in time. Look for a clear statement about the effective date for the survey data in the first
few pages. Note that this may be different than the publication date that appears on the front of
the survey. Although data can be aged for several years, using data more than two years old is
unwise, as older data points often lose market reliability. Aging becomes all the more important
when using multiple surveys with multiple effective dates.
This market movement factor can be determined a number of ways. Associations such as SHRM
and WorldatWork that report on trends in performance-based pay (i.e., merit increases) can
provide a recommended aging rate. Several of the major survey organizations also conduct
annual merit increase surveys and provide their own estimates of the appropriate aging factor.
See, My company can’t afford to purchase new salary and wage survey data each year. Is
there any way that we can use last year’s salary data?
Some organizations select one aging percentage and use it across all jobs and surveys. Others
may choose to age data by job, job level or job family to reflect differences in the market or “hot
jobs.”
Aging survey data is not as complex as it sounds, as the following four-step process
demonstrates:
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Determine the date for the new pay structures. The data in a survey have an effective
date of January 1, 2013. You need to know what the projected rate would be on July 1,
2008, for implementation of the new pay ranges.
Determine the wage movement percentage. Your research shows that wages are
moving, on average, 4 percent per year.
Determine the aging factor. There are six months between January 1 and July 1: 4.0
percent movement x (6 months/12 months in a year) = 2.0 percent.
Apply the aging factor. If the survey reports that the 50th percentile for a given job on
January 1, 2008, is $15.00, the projected rate on July 1, 2008, is $15.30. (Two percent of
$15.00 is $.30.) Use $15.30 to develop your organization’s pay scales on July 1, 2008.
Step 3: Conducting the Market Data Analysis
After obtaining and preparing the data, begin the market analysis.
Selecting benchmark jobs
The first step in market data analysis is to determine the benchmark jobs, or positions that will be
externally market priced. It is sound practice for an organization to benchmark between 50 and
65 percent of its jobs when using market pricing. Benchmark positions should aim to include at
least 70 percent of the employee population.
A benchmark job is one that has a scope of work and responsibilities common to other
organizations or industries. Typically, benchmark jobs can be determined by comparing an
internal job description to a survey job summary or capsule. See, How to Develop a Job
Description and Writing a Job Description.
Jobs with similar roles usually exist across the organization. For example, many different
departments have administrative assistants. Though the job descriptions may differ slightly, that
group of positions most likely equates to one benchmark job. Examples of benchmark jobs might
include accountant, chief financial officer, registered nurse, fundraiser and underwriter.
Survey descriptions are high level and capture only the major job functions, not every detail and
nuance of a job. Many surveys include a “degree of match” indicator, allowing participants to
indicate whether their job is bigger than, equal to or smaller than the survey job. If relying on a
single survey, use caution if more than 25 percent of the survey participants indicate their job is
either smaller or bigger than the survey job. You may need some data adjustment (also called
factoring or leveling) to account for this scope difference.
Additional tips for identifying benchmark positions include the following:
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Always compare job descriptions—never titles alone—when deciding whether a survey
job is a good match to an internal job. Titles vary widely from organization to
organization in terms of scope size and responsibility.
When a benchmark job matches at least 80 percent of a survey job summary or capsule,
consider it a good benchmark.
Select benchmark positions that represent a wide spectrum of the organization’s
functions, departments and levels such as type of work or job family and level of work
being performed (e.g., manager versus individual contributor, junior level versus senior
level).
Review the benchmark position list two or three times before finalizing your list;
benchmarking can be more of an art than a science.
Benchmarking positions against the market
Benchmarking positions against the market is not an easy task. However, by keeping the
following points in mind, the process can be effective, efficient and accurate, and yield an
effective base pay system for the organization.
Review for outliers. After pulling the various market data points, review the salary data for
outliers (extreme data points on either end), and remove as appropriate:
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If the data show extreme highs or lows from one year to the next or if one data point
seems high or low, check to see if the number of organizations or number of incumbents
changed from a prior year’s report.
Rejecting a data point is appropriate if it does not appear valid, but do not automatically
exclude data because they are the lowest or highest—especially when using multiple
surveys.
Adjust as necessary. Use three or more surveys to lessen variability in data from one year to the
next. Adjust data as needed, including the following common data adjustments:
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Adjust for geography when benchmarking positions with a local recruiting market against
data collected nationally.
Adjust for premiums and discounts when benchmarking internal jobs against survey jobs
of a higher or lower scope. Adjustments to benchmarks reflect factors such as scope size,
scope of responsibility, market demands and niche skills. Premium and discount
adjustments should not exceed +/– 20 percent to still be considered a solid match. For
future reference, always carefully document any adjustments or changes to a job match.
Create a market composite for each benchmark position. Combine data points from several
surveys either by simple average, employee-weighted or organization-weighted data to develop
composite market data. Most surveys report 25th, 50th and 75th percentile data points for base
salary, bonus targets, actual bonus payouts and total cash compensation. When using surveys, be
aware that the 25th and 75th percentile data points have less reliability and can fluctuate more
year to year.
Averaging the individual 50th percentile data points from each survey creates the market
composite 50th percentile value. Sometimes, however, an organization values the data in a
specific survey more than in others. As such, that survey’s data can be double or triple weighted
in the calculation to emphasize its importance. In addition, be careful of weighting survey
sources equally, especially if one survey has a larger sample size. Use judgment in reviewing the
data to determine the best approach. There is no right answer, but as long as you are consistent,
the results will be internally accurate.
Review current pay rates against market data. Review each benchmark’s current employee
average pay rates against the target market data. Pay particular attention to those positions with a
20 percent difference above or below the market. Be sure that the matches accurately reflect the
duties in the benchmark position, and make changes as needed.
The composite market data points not only provide the tools necessary to create the pay
structures but also allow comparison between the market and the organization’s compensation
philosophy. Reviewing the market data can confirm that the organization has selected an
appropriate compensation philosophy for its talent management needs, strategic plan goals and
fiscal realities. Reviewing with senior management the high-level composite market data against
the compensation philosophy also affords the opportunity to obtain further buy-in and any
necessary modification to the compensation philosophy.
Step 4: Developing the Pay Structures
Use the composite market data to develop the actual pay structure by constructing job grades,
building a market pay line and calculating the pay ranges.
Constructing job grades
A job grade or job level is simply a group of different but internally equivalent jobs. Grades
enable flexibility and internal equity in an organization by providing a framework in which
equivalent jobs are treated equally for pay purposes. Grades also establish a promotional ladder
for employees. See, Executive Benchmarks, Career Bands, Career Levels, Functions and
Disciplines (PDF) and Matching Jobs with Pay.
For complex roles and larger organizations, formal job evaluation is needed to identify which
jobs are internally equivalent. The process may take some time to complete, but it will assist in
creating a defensible and transparent salary system. In new or recently restructured
organizations, job evaluation is particularly helpful in clarifying the role, responsibility and
reporting relationship of each job. See, Job Evaluation and Market Pricing.
A complete description of how to do job evaluation is outside the scope of this paper. In brief,
formal job evaluation is a process for analyzing a job based on a number of criteria such as
knowledge, experience, decision-making authority, autonomy, supervisory responsibility,
creativity, physical demands, job environment, job scope and organizational relationship. Many
samples of job evaluation questionnaires are available on the Internet or through consulting
companies. See, Performing Job Evaluations.
Formal job evaluation systems usually provide results in numeric points, which enables
spreading these points into job grade categories. Dividing lines between job evaluation points is
challenging and hence must be based on a consistent logic driven by both the main driver of the
job evaluation points and business strategy. Some trial and error may be required to arrive at the
right structure with the correct number of grades and job grouping.
A simpler method of developing job grades is to do whole-job slotting, which delivers
approximate assessments of internal value. In this method, factors such as reporting relationship,
job scope and current pay relationships determine grade placement.
In many organizations, the number of job grades matches the number of pay grades, and those
terms have been used interchangeably herein. Having more job grades than pay grades is
possible, however, by combining a few job grades into the same pay grade. This is usually done
in organizations where the culture supports career path promotions such as a technical career
path. When combining multiple job grades into one pay grade, the range minimum is based on
the junior-most job grade, and the range maximum is based on the senior-most job grade in that
pay grade. This method enables employees and managers to be aware of the potential
progression possible from the starting role to the ending role in a particular career path. (Range
minimum and maximum are explained below.)
Building a market pay line
A market pay line is built using the composite market data points. It allows an organization to
translate the market data into usable information.
Building a market pay line starts with plotting the matched jobs and their dollar amounts on a
graph. The grades or benchmark jobs at each level determine the ordering of the jobs on the X
axis. You can use freehand to connect the data points as shown in Figure 1 or use a regression
analysis tool to create the market line. A number of programs, including MS Excel, build the
regression analysis line (Figure 2). Simply put, regression helps smooth the data and have a fixed
rate of variation between different points, especially when there are multiple benchmark jobs and
some variation among the data. The linear line shown in Figure 2 is the smoothed pay line for the
base salary.
Figures 1 and 2 show base salary, total cash compensation and, as an example, total
compensation at the 50th percentile (50P) level. As previously covered, the appropriate
percentile to use depends on the organization’s target market philosophy.
Calculating pay ranges
A pay range exists whenever an organization must pay different amounts to employees in the
same job grade. Ranges provide flexibility to managers to recognize factors such as experience
and performance. Ranges also permit the recognition of learning curves and performance
variation of employees in their roles. Typically, organizations only calculate base pay ranges
because base pay reflects the guaranteed cash payments and the basic value of the work. See,
Salary Range Structure Practices.
Pay ranges are calculated for each job grade and are simply a spread plus and minus of the
target/market pay point, also known as the range midpoint. Range maximums set the ceiling for a
particular pay grade. Range minimums set the floor. Typically, for junior-level jobs the range
spreads are small or perhaps even nonexistent when flat rates are used. On the other hand, range
spreads are often wide for management roles to reflect the performance and learning curve
variation.
See:

How to Establish Salary Ranges



Designing A Pay Structure (PDF)
Salary Structures: Creating Competitive and Equitable Pay
Employers Pursue Global Grade Structures, Despite Challenges
The midpoint corresponds to where the pay line crosses each grade (Figures 1 and 2). For
example, in Figure 1 for grade B the base pay line crosses at $35,000, and hence, that will
be the midpoint for the range at grade B. Judgments about how the ranges support career
growth, performance rewards and promotions determine range spread. Ranges tend to
widen as you go higher in the organization. Organizations can have ranges with a spread of
25 percent at lower grades to 75 percent for senior roles. In fact, an hourly job has a range
of zero because it has a fixed pay rate for the role irrespective of performance, seniority
and so forth. Wider ranges at senior roles reflect the opportunity for individual
discretionary performance, longer learning curves for the position and longer lengths of
stay of incumbents in the same position.
The following are examples of two ways to calculate a range minimum and maximum:


Calculate 20 percent above and below the midpoint. In Figure 1, grade A has a
midpoint of $20,000. The minimum and maximum are $16,000 and $24,000. In this
example, the range spread is 50 percent [($24,000 - $16,000) / $16,000 = 50 percent].
An alternative way to calculate range spread at a fixed percentage: minimum =
midpoint / [100 percent + (1/2 the percentage range spread)]. Calculate the
maximum as minimum + (percentage range spread x minimum). Continuing the 50
percent range spread example above, calculate the minimum as [$20,000 / (1 + .25)],
or $16,000. The maximum is calculated as [$16,000 + (.50 x $16,000)], or $24,000.
To ensure accuracy, the key is to choose one of these methods and use it consistently.
On occasion, some organizations use the actual market positions of 25th percentile and
75th percentile as the minimum and maximum points for the ranges. This is a possibility if
the approach is based on the organization’s desired market position. Keep in mind,
however, that the 25th and 75th percentiles are subject to greater fluctuations in surveys
from year to year. An organization may also end up with very tight range spreads (e.g., 20
percent) or very wide range spreads (e.g., 80 percent) due to variation in the market data.
Ranges between grades tend to overlap. The extent of overlap can be measured as follows,
continuing the example from above:

If there are two grades, A and B, and B is higher than A, then overlap equals 100 x
[(maximum of grade A - minimum of grade B) / (maximum of grade A - minimum
of grade A)].
Although there is no ideal amount of overlap, too little overlap can lead to high cost during
promotions. Too high of an overlap will lead to low interest in promotions because the
amount of promotional increase will be too low. Figure 3 shows an example of a pay
structure.
Broadbanding is another approach to setting the pay range, which is outside the scope of this
paper. Generally, however, broadbands consolidate three to five traditional ranges into one single
band. Bands will typically have a minimum and a maximum but no midpoint. Range spreads in a
broadbanding system will usually be 100 percent or more. Organizations use bands to create
flexibility within the organization and to break down barriers to promotion and career
development. See, Broadbanding.
Compensation is partly art and partly science. Because internal job evaluation or internal slotting
of jobs determines job grades, these reflect the internal value, whereas the pay ranges reflect the
market or external value. Inherently, some instances of misalignment will occur between the two.
On occasion, jobs may be re-slotted. This situation occurs when the position has a greater
strategic importance to the organization than the external market reflects. In other cases, the
position may have less value than the external market affords it. Use such re-slottings of
benchmark positions sparingly and with caution to avoid undermining the foundation of the job
evaluation system. The goal is to minimize misalignments as much as possible to ensure the
compensation system meets the organization’s needs for strategic success.
Step 5: Calculating the Costs of the Pay Structures
After creating the new pay grades and ranges, the next project step is to consider the financial
impact of those ranges. One of several approaches provides HR and management with the
necessary financial impact information:



Bring-to-minimum calculations.
Compa ratio analysis.
Adjustments for compression and equity.
Bring-to-minimum
The simplest but often most essential calculation is the bring-to-minimum adjustment. In this
scenario, the financial model compares each employee’s current pay to his or her new pay range
minimum. Employees with pay rates below the minimum receive an adjustment to the minimum
of the pay range. These pay rates are also known as green circle rates. Employees with pay rates
above the minimum receive no adjustment.
For example, continuing our earlier scenario, employee X and employee Y are both in pay grade
A. Employee X earns $15,000 a year. As the minimum is $16,000, employee X would receive a
$1,000-a-year pay increase. Employee Y, on the other hand, earns $22,000. As such, employee Y
would receive no bring-to-minimum adjustment. Totaling the annualized bring-to-minimum
adjustments for all employees provides the total annualized bring-to-minimum cost impact of the
new pay system. This figure divided by the total current payroll allows management to see the
cost impact from a percentage point of view. For example, if an organization’s total payroll is
$1,000,000, and total bring-to-minimum adjustments are $20,000, the total bring-to-minimum
cost of the program is 2 percent of current payroll.
Compa ratios
Comparisons of current employee pay and the new system midpoints determine compa ratios.
The formula for compa ratio is current employee pay divided by current range midpoint.
Continuing the example from above, employee X’s compa ratio before any pay adjustments is 75
percent, or .75 ($15,000 / $20,000). Employee Y’s compa ratio is 110 percent, or 1.1 ($22,000 /
$20,000). Compa ratios are useful for identifying at a glance which employees’ pay rates are
below the minimum (green circled) and above the maximum (red circled), and which employees
fall above or below the midpoint. If most employees’ pay rates fall above the midpoint, the new
system risks quick obsolescence. Ideally, the majority of employee pay rates should have room
to grow in the pay ranges.
Compression and equity
Organizations may want to consider adjustments that address undesired compression, such as
closeness in pay rates, between employees. Organizations may adjust pay rates to reflect length
of service, experience or performance. In these situations, employees’ pay rates may be increased
a certain percentage above the range minimum for each year of service or higher level of
performance. Employees with pay rates higher than the recommended adjusted rate would
receive no increase; employees with pay rates lower than the recommended adjusted rate would
receive an adjustment. For example, organizations that want to recognize years of service might
increase each employee’s pay 3 percent for each year of service in the position, up to 10 years.
Pay rates for new employees are set at the minimum of the range. Employees with one year in
the position would be paid 3 percent above the range minimum. Employees with 10 years in the
position would be paid 30 percent above the range minimum.
Although an organization should ideally avoid pay rate compression, doing so is not always
fiscally possible. As such, an organization may have to forgo the compression adjustments and
look only to bring-to-minimum changes. Or an organization may focus its limited dollars on
adjustments for “hot jobs” in year one and changes for other positions in year two of the system.
Alternatively, timing any structure-related pay adjustments for after annual merit increases
allows the organization to reduce the total program costs. The merit increases fund part or all of
the market adjustments.
Step 6: Implementation and Evaluation
Policy development
The organization’s salary structure policy will ultimately drive communication and training. See,
Compensation Policy.
The new compensation policy should include the following details:




How often the salary structures will be updated.
The effective date of the structures.
Roles, responsibilities and procedures for updating salary structures, including approval
authority, surveys used and frequency of participation, and desired peer comparison list.
Which positions will have access to the salary structures, how broad or limited will
general access to the system be, and whether the system will be open or closed to
employees.
To avoid misunderstandings, thoroughly vetting these issues with stakeholders at the beginning
of the project is critical. At project conclusion, document the approved policy during the new
salary structure rollout.
Communication
Depending on organization policy, HR may be the only one with access to the structures, or all
managers and employees may have access. Organizations may operate anywhere along a
communications continuum by deciding to entirely restrict employee access to salary ranges, by
allowing employees to view their own range or by permitting employees to examine their own
range and the next highest range. Managers typically have access to all salary ranges or the
salary ranges relevant to their team members. However, some organizations may decide that
salary range information is too sensitive and, as a result, restrict it entirely.
Regardless of the target group, understanding the goals of the communication process is
important. These goals generally fall into one or more of the following categories:



To ensure understanding.
To change perceptions of equity and competitiveness and to garner buy-in.
To motivate behavior such as pay for performance, pay for skills and the like.
Tailor each communication based on the target audience and the communication goals. For
example, the goal in communicating the new salary structures to the executive team may be to
change a perception that a salary structure will bring unwanted bureaucracy or to get buy-in on
the list of surveyed peer organizations or selected salary surveys moving forward.
Communication to managers who will administer pay using the new structures might simply be
to ensure understanding of effective dates, how to access the structures and how to effectively
use the structures when hiring new or promoting current employees. Communication to
employees who will be paid with the new structure must demonstrate the fairness, equity,
competitiveness and link to business strategy.
See:




Pay Packages: They Just Don’t Understand
Compensation Strategy Shouldn’t Be a Big Secret
Communication Pays Off
Do employees in your organization understand how pay decisions are made?
Training
The organization’s policy regarding access to salary ranges and responsibility for administering
pay in the organization drives the training process. Managers expected to effectively administer
the pay of their team members need training on compensation philosophy, salary survey sources,
how salary ranges are constructed, and how to use the structures when determining appropriate
pay for new and existing employees.
To help managers effectively set expectations for employees regarding their position in a pay
range over time, explaining the pay/performance continuum is helpful. Under this approach, top
performers will reach the maximum of the pay range much faster than average-performing coworkers. Employees who are steady, average performers may never exceed the range midpoint,
as their performance matches the market pay rate for someone fully competent in the position.
Pay rates for employees with unsatisfactory performance, should they not be exited from the
organization, should never progress very far above the range minimum. Figure 4 shows an
example of this approach.
If employees can view their own salary range and other salary ranges, they should receive
training on understanding the organization’s compensation philosophy, salary survey sources and
how salary ranges are constructed.
Pitfalls to avoid
A comprehensive salary structure policy will go a long way in helping the organization avoid
many common pitfalls if it clearly states decision-making authority, roles and responsibilities
regarding pay. Two common pitfalls of compensation systems are the following:


Salary structures do not reflect the organization’s compensation philosophy. If midpoints
are to reflect the theoretical external-market average competitive rate, make sure they do.
Do not let falling compa ratios due to budget restrictions rationalize lower midpoints.
Managers must be able to rely on the midpoint to set reasonable hire rates, recommend
pay increases and justify the salary range to employees.
Salary structures provide no accountability for managers to administer pay. Managers are
in the best place to assess performance and equity of team members. Arm the
management team members with the tools, information, training and coaching they need,
and they will manage pay effectively for the organization.
Evaluation
Like any other program, evaluation is critical to determining the effectiveness of the
compensation program. Using metrics such as employee and manager feedback, voluntary
employee exit surveys and the cost of compensation in relation to company profitability, the HR
professional can assess the compensation program. See, Compensation Programs’ ROI
Highlighted by Study.
Global Issues
Increasingly, employees operate in a global competitive environment. Compensation plans must
take this into account.
See:




Global Executive Pay: Asia Erodes West’s Ability to Attract Talent
Global Rise in Salary Increase Budgets Projected in 2012
Employers Pursue Global Grade Structures, Despite Challenges
Exec Salaries Stagnant Across Europe, but Bonuses Drive Up Pay
Update of Legal Issues
Legal issues are discussed throughout this article. However, listed below are some legal issues
that have arisen, or that have become more salient, since the article was originally published in
2008:

Clawing Back Compensation





Ledbetter Act Adds Lengthy To-Do List for HR
Social Security Benefits to Increase 3.6% for 2012; Higher Cap on Taxable
Earnings
Returning Service Members Must Be Given Reasonable Opportunity to Rebuild
Commission Income
Social Workers Not Covered by FLSA’s Learned Professionals Exemption
A Port in a Storm: Does Your Company Have a ‘Safe Harbor’ Policy?
Update of Trends in Compensation
This article was originally published in 2008 in the middle of what has come to be known as the
Great Recession. Although officially over, the Great Recession continues in the minds and
experiences of many persons—especially the unemployed—as this article is being updated in
early 2013. Some economists predict or fear a “double-dip recession.” This protracted period of
economic downturn has had a profound impact on compensation schemes in terms of changes to
the law and enforcement as described above, but also in nonlegal aspects of compensation
schemes. Many employees today are just glad to have a job, and the competitiveness of
compensation plans may be less important than in periods of robust economic growth. At the
same time, some employees are quite dissatisfied with their current compensation plans and are
looking for opportunities to seek better compensation and benefits plans once the economy turns
around.
See:











America’s New Post-Recession Employment Arithmetic (PDF)
Please Don’t Go: Retention After the Recession
Economic Recovery Brings Workforce Challenges and Opportunities (PDF)
Businesses Face an Engagement Crisis
Post-Recession Challenge: Getting Creative with Compensation
Employers Plan Lean Pay Increases, Engaging Top Performers
Market Pricing Practices Survey: Preferred Data and Tools
Forecast: Tech Positions to See Highest 2012 Pay Gains
Unpaid Interns Sue ‘Black Swan’ Production Company for Wage and Hour
Violations
For 2012, Modest Salary Increases with Regional Variations
Generation X Fails to Match Their Parents’ Living Standards
Tools and Templates
Agencies and organizations


Bureau of Labor Statistics (BLS)
WorldatWork
Information tools

Department of Justice Antitrust Primer
References
Greene, R. J. (2007, August). Benchmarking may be common practice, but is it sound practice?
Workspan.
Grigson, D., Delaney, J., & Jones, R. (2004, October). Market pricing 101—The science and the
art. Workspan.
Hay Group, The. (1996). People, performance & pay: Dynamic compensation for changing
organizations. New York, NY: Free Press.
Risher, H. (2003, March). Making managers responsible for managing pay. Workspan.
Rubino, J. (1992). Communicating compensation programs: An approach to providing
information to employees. Scottsdale, AZ: American Compensation Association.
Schuster, J. R., & Zingheim, P. K. (1992). The new pay: Linking employee and organizational
performance. San Francisco, CA: Josey-Bass.
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