Chapter 6: Compensation Strategy

Overview: This chapter examines compensation in the broad context of an organization's goals as a tool to help it meet those goals.

Corresponding courses

03 New Economy Total Rewards

INTRODUCTION

On March 28, 2007 the electronic retailer Circuit City announced that it would lay off around 3,400 of their store staff. The reason for this was poor financial performance of the company. This action plus some other moves were intended to cut operating costs by around $110 million in 2008 and even more in the following years.1 This kind of announcement is hardly surprising in this day and age. Organizations regularly lay off employees whenever there is a financial downturn in their fortunes. It is a sure sign of the changing nature of the employment relationship within the U.S. Laying off workers is a first response because the major cost factor for almost all organizations is their labor costs representing upward of 75% of total costs. When seen as a realignment of corporate strategy, layoffs can have a positive effect on the company's stock price. This realignment of corporate strategy in turn affects the Human Resources strategies which in turn affects the Compensation strategies and tactics. In this case it will obviously affect the store operations and marketing strategies of the company as well.

But in this case the layoff itself was not the big news; it was how it was implemented. The layoff was described as a "wage management initiative." The Sales Associates to be laid off were to be those who "were paid well above the market-based salary range for their role." They were to be replaced by new Sales Associates who will be paid at the market rate or below. The replaced Sales Associates, who did receive a severance package, can re-apply for their jobs back after 10 weeks and be paid at the market rate.2 This seems to imply that Circuit City is making a major change in its compensation strategy from paying considerably over market for employees who either have seniority or who are good performers to one of paying no more than the market rate. This latter would be considered paying under the market for Sales Associates as a whole. The alternative explanation is that the strategy has not been followed in the past and this move is to properly implement what was initially intended. What is not described in these articles is whether the pay of these Sales Associates was entirely base pay or whether there was a variable pay component and how that was handled.

This example illustrates the intertwining of levels of corporate strategy in an organization and how corporate strategy can influence and/or determine compensation strategy and vice-versa. It also shows that organizations can develop different compensation strategies and that these can help or hinder strategies at higher levels. This action by Circuit City is different than is typical so is probably not going to be seen as a best practice by others. The original big box company was liquidated and is no longer operating as of May 2016.

Goals, Strategy and Tactics

Determining where an organization is going and how it is going to get there involves a specification of goals, strategies, and tactics. These fall along a continuum, illustrated in Figure 6-1, with each one directly affecting the other. Goals require strategies to achieve them and strategies in turn need tactics that set them into effect, specifying the activities that occur and lead to performance. The dotted lines running back in the opposite direction show the reciprocal relationship of these three dimensions where performance affects operational plans, which influence strategies, which influence goals.

Figure 6-1. Strategy Sequence

Goals. Goals consist of desired future states. They are catalysts for present and future activity, and provide guidelines for performance. In order to be goals and not just hopes they need to have some sort of specificity in terms of time, value, and a specific state or condition. For many organizations the goals are found in the mission statement and declare what the organization exits to do and achieve. The goals can be a very simple statement or a complex mission statement.

In the case of Wal-Mart, its mission statement can be summed up in the slogan:

"Always low prices. Always"

In contrast, Costco's founders state:

"We remain committed to our Code of Ethics every day:
to obey the law;
take care of our members;
take care of our employees;
respect our suppliers;
and reward you our shareholders."3

These are very different mission statements from two companies in the same industry

Strategies. The first step in making goals operational is strategy formulation. The organization scans the environment to develop courses of action by discerning the threats and opportunities available to it. The purpose of this comparison is to determine the distinctive competence of the organization, which is what it can do well, and thus will define the competitive advantage it has in the marketplace.

A strategic plan not only guides the organization in allocating available resources, but also sets forth steps for seeking out new opportunities. The organization is looking outward toward the environment as well as inward. Strategic plans specify why and how the development of a unique niche in the environment would be advantageous to the organization. Strategic planning can be aided by many of the new decision making techniques, but it remains a judgmental process in which the entrepreneurial capacity of the organization is tapped.

Wal-Mart's strategies are all designed around bringing low prices to the consumer. It has developed a very efficient and effective system of distribution; it is very aggressive with its suppliers and of course it was one of the first to develop the large warehouse stores. In the area of Human Resources and compensation it has a below market pay level strategy , offers below market benefits plans and makes major use of part time workers. In contrast, Costco stocks a limited number of items, sells them in large quantities, relies on this high volume to buy from suppliers at low prices, provides buyers with a great deal of discretion, has customers buy memberships that tie them to the company, aims for a more upscale customer, does not advertise and last but not least for our purposes, pays the highest wages and benefits in the industry. Clearly these two companies have very different strategic stances.

Tactics. Tactics define exactly how organizational activities can be marshaled to achieve the strategic plan. They are geared toward keeping the organization running on an even keel over a specified time period, usually of short duration. To the organization as a whole, functional plans are tactical; however, to the function there are goals and strategies as well as tactics within the functional area.

It seems logical to say that strategic planning occurs at the top of the organization and tactical planning at middle and lower levels. Although in general this is accurate, it is also somewhat misleading. All managers operate in an environment, control resources, and have a discretionary area of behavior. Thus all managers are in a position to do some strategic planning. There is no doubt, however, that the impact of such planning is greater at the top of the organization.

This book is mainly about the tactics that are used in the field of Compensation Administration. The focus is on how these tactics operate and how they support particular compensation strategies.

THE CHANGING ENVIRONMENT

As the environment changes so must organizations change the way they operate: their strategies must evolve. Organizations are faced with numerous environmental challenges and changes, mainly in the two areas of economy and information technology.

Economy

The 1980s spelled the end of the Old Economy. After World War II the United States developed a dynamic national economy. To a degree this spread to Europe and in the East at least to Japan. This economy was built on manufacturing a vast array of consumer products. Slowly this economy moved more toward services in the U.S. and manufacturing moved more and more overseas. Then began a much more dramatic transformation, that of Globalization. This term has been the term used to describe the change that has taken place in the economy. Its roots are in the rise of capitalism, falling trade barriers and a decline in government control in countries throughout the world. This foreign competition and a national recession forced U.S. organizations to make drastic changes in order to compete. Today markets (product, capital and labor) are all more dynamic and open throughout the world. Country after country is moving toward having a developed economy. The concept in International Economics of comparative advantage is proving more applicable every day.4

Technology

There is much more information available today and it can be accessed rapidly. The world is more transparent, making both threats and opportunities for organizations come from multiple sources and places. Time has been compressed so that change is more rapid and decision making must take into account many more variables.

Although it took longer than many thought it would, the internet and its supporting technology have revolutionized the way most people in the world live. The advent of the Internet and its ability to interconnect people and organizations has expanded the amount and quality of information as well as its timeliness.

Organizational Response

Until the 1980's most successful organizations were large and bureaucratic. Being large was important to obtain economies of scale. This created highly structured organizations with well-defined jobs and functions that required constant coordination. These changes required much more flexibility and adaptability within the organization and they began to change. Middle management positions were eliminated in corporate downsizing; this process called for the reduction in the number of employees in each organization's work force in order to reduce or eliminate inefficiencies or duplication of efforts.

The single largest difference between the old organizations and the new organizations, for our purposes, is their definition of the workplace. Old organizations are traditional and stress internal job structure. They systemize the workplace and compensation programs. Old organizations rely heavily on job analysis and job evaluation when setting pay. (See Chapter 10.) They create highly differentiated wage structures, in which only management enjoys perquisites and stock options.

In contrast, new organizations are less structured. They do not set pay based upon the internal labor market (what other employees in the company earn). Instead, the new organizations base pay on what competitors (the external labor market) pay. At the same time, pay among employees is less differentiated. Often, every employee from the mailroom to the Board Room gets to participate in stock option plans. These new organizations are typically small and lean and have become the basis of a New Economy, and with it new pay policies.

The Employment Contract

Until recently the informal contract between employees and their employer could be called one of loyalty. This is a paternalistic type of relationship. The employer provides job security, increasing pay and in the end some form of retirement.5 Organizations have stopped guaranteeing employees life-long careers. There are many layoffs and these differ from the past. Those who are laid off often do not get rehired when times get better for the organization because with the changes in the economy many people find themselves with outdated skills. Organizations find the skills they now need in the labor market rather than creating them internally.

Employees are jumping ship rather than staying with companies where they have little chance of being promoted. Employees negotiate for their pay individually, and union influence has declined. For the employee the labor market is more important. They keep better track of what is happening in the market and move to where their skills are needed. In addition, they are responsible for developing the new skills needed to be successful in today's market. For both employee and employer the internal labor market has become less important while the external labor market is more important.

Outsourcing and Offshoring

To some degree organizations have always outsourced work. There have always been some functions that weren't worth hiring their own staff to do. But since the mid-80's this trend has increased dramatically. More and more functions that are not considered to contribute greatly to the primary goals of the organization are being farmed out to other organizations, both at home and abroad. As these outsourced jobs have moved up the skill ladder there has been an increasing concern about this trend and its effect on the U.S. labor market.6

When it comes to manufacturing, the better term is offshoring. Manufacturing has progressively moved from the U.S. to other countries, notably in Asia. The U.S. has become a consumer society of products produced in other countries. The demand for labor in the U.S. is becoming more bifurcated all the time since the service economy requires more of both low and high level skills. There is a great debate in the U.S. on immigration policy. At its heart is how we are going to obtain the necessary labor force since we do not seem to be able to produce sufficient workers at these two extremes.

COMPENSATION STRATEGIES

This new economy and its organizational response have been followed up in compensation administration with new and different ways of doing things. These changes have made some tactics outdated and brought others, or new ones, to the fore. In this section we will look at some of the new strategies and the tactics that support them.

Compensation Goals

All compensation elements exist to achieve some purpose. From the organizational standpoint compensation needs to focus on three goals: (1)attracting and retaining employees, (2)motivating and engaging employees and (3)keeping labor costs in line.

Attracting and Retaining Employees. Having employees who are capable of contributing to the successful operation of the organization, while always important, has taken on even more importance. It is undoubtedly true that higher wage rates will bring in more job applicants and help retain current employees. But this is not enough; it must be the right employees. Not all people in the work force will have the skills and attitudes needed in your organization. In this era, retaining the wrong employees is costly monetarily, as well as stifling to the accomplishment of organizational goals. It is necessary to design the compensation program to attract the types of employees who will successfully contribute the most.

Equity plays a part in attracting and retaining employees, particularly retaining them. As discussed in Chapter 4, Equity Theory states that employees make comparisons of their pay as against others. They are not necessarily attempting to maximize their pay but they feel that their worth to the organization should be matched by their pay relative to others. When they perceive inequity there are a number of actions employees take that can be deleterious to the organization up to and including quitting their job. The compensation components of base pay and benefits are the major ways in which employment goals are met.

Motivating and Engaging Employees. Organizational performance is of increasing importance in today's economy at all levels, from the total organization through organizational units, down to each employee. This focus on performance increases the need to motivate employees to do their best, and to keep the performance goals of higher levels of the organization in mind. As seen in Chapter 4 high levels of performance are a matter of motivating employees. This may be the hardest task of compensation. Traditional performance plans, usually identified as merit based pay plans, have not been very successful in relating pay to performance.

What is happening today is not so much the development of new types of plans, but the extension of plans used at the highest levels down to the lowest levels of the organizations. It should be noted that these plans relate pay to performance in a way that brings large rewards when performance is high, but low or no rewards when performance targets are not met. From the employee's standpoint pay is being placed at risk; an uncomfortable situation for many employees. The variable pay component of compensation is the major way in which this goal of motivating and engaging through compensation is achieved.

Labor Costs

This goal has to do with the competitiveness of the organization. This competitiveness is in two regards to two markets. The first is the product market of the organization. Labor costs must be kept to a level that allows the organization to sell its product or service in competition with other organizations producing the same or similar products or services. Thus the product market sets the upper limit for the organization's wage level. The second market is the labor market. The organization must pay enough to attract and retain employees capable of producing the products or services of the organization. In this way the labor market sets the lower level at which the organization may set its wage level.7

As already stressed in this book, labor costs are the major cost item for almost all organizations. Payroll costs are the largest part of labor costs but not nearly all of them. The cost of payroll is a function of the number of employees and their base pay. It also may include costs of overtime and variable pay. Keeping the cost of payroll down is a function of keeping the number of employees down, a strategy that American organizations have been engaging in for a long period of time. The other part of keeping payroll costs down is reducing the cost of base pay. Both of these tactics were a part of the move made by Circuit City described in the beginning of this chapter. Paying lower wage rates is a strategic decision to keep the wage level of the organization low vis-à-vis the market. We will shortly discuss the advantages of this strategy but it certainly can make the goal of attracting and retaining employees difficult.

Increasing the role of variable pay can have a good effect on payroll costs as it makes a portion of payroll cost a variable expense of the organization rather than a fixed cost. Overtime would seem a negative thing for payroll costs and it is, but it may not be so bad for total labor costs since there are other labor costs, particularly benefits, which are a function of the number of employees, not how much they work.

This brings us to the other major part of labor costs, which are employee benefits. The cost of benefits has been rising dramatically for quite a number of years now. In fact, the changes have been so great that they have had a depressing effect on increases in base pay. Later in this chapter and in Chapters 20 and 21 we will examine strategies to keep these costs under control.

Labor cost and wage rates are two very different things. Earlier in this chapter we noted that Wal-Mart pays very low wages and Costco very high wages. But are Wal-Mart's labor costs therefore lower than Costco's? The answer is no, Costco's are lower than Wal-Mart's. Costco has much lower turnover costs than does Wal-Mart. Turnover runs about 17% at Costco versus 44% at Sam's Club, Wal-Mart's warehouse store. Given the costs of turnover to an organization Wal-Mart's labor costs are 2.5 times greater than Costco's. Further, the productivity of Costco workers is greater than Wal-Mart's illustrated by the fact that Wal-Mart earned lower profits per employee than did Costco [$11,039 vs. $13, 647].8

COMPENSATION COMPONENTS STRATEGIES

In chapter 1 we described the major components of compensation to be:

  1. The pay level
  2. Base pay
  3. Variable pay
  4. Benefits

These four components make up the majority of this book. Each one should implement strategies and tactics to ensure the compensation program of the organization achieves its goals. In this section the strategies of each of these components will be covered.

The pay level is the average compensation paid to employees. This has two implications. The first is external: how does the organization compare with other organizations? This question is a strategic one of how the organization wishes to position itself in the marketplace. The second implication is internal. The average compensation is a reflection of the total compensation bill of the organization. Labor is one of the claimants on organizational resources. The size of the compensation bill is a reflection of how funds are allocated within the organization.

The decision on compensation levels (how much will the organization pay?) may be the most important compensation decision the organization makes. A potential employee's acceptance usually turns on this decision, and a large segment of the employer's costs are determined by it.

Compensation decisions are typically micro (individual) or macro (total organization) focused. In practice, most unsophisticated organizations make the decision on compensation level (how much to pay) and compensation structure (relationships to competitors) at the same time. More administratively advanced organizations realize that individual decisions within a proper administrative structure are more consistent, fair, and cost-effective over time.

The compensation level decision may be considered the most important one for individuals. In terms of both employee attraction and cost considerations, it is considered by most managers as a primary consideration. Also, it seems essential to recognize that compensation level decisions can never be completely separated from job-mix, hiring standards, personnel decisions, and internal labor markets/relationships. For these reasons, compensation level decisions are typically the focus of a manager's attention. For the organization, one individual's compensation decision typically goes unnoticed at the end of the year, while structure decisions (and the level of those structures) are what show up on the income statement.

The Pay Level

The term pay level simply means the average base salary paid to workers at some level of analysis (e.g. the job, the department, the employing organization, an industry, or the economy). The importance of the pay level decision to organizations rests on its influence in getting and keeping the desired quantity and quality of employees. If the pay level is too low, the applicant pool may dry up and recruitment efforts may meet with little success. Equally serious, some employees (often the best ones) may leave. At the extreme, the organization may experience difficulties with state and federal regulatory bodies administering minimum wage laws and prevailing wage laws. Also, if no union is present, the organization may be confronted with concerted organizing drives. For existing unions there can be pressing wage demands. It is less apparent, but equally real, that a low pay level may attract only less efficient workers, with the result that labor costs per unit of output rise.

If, on the other hand, the pay level is too high, equally undesirable results are likely: the competitive position of the organization may suffer. Turnover rates may drop below a desirable minimum, leading toward inflexibility or stagnation. Also, if wage and salary levels are too high during periods of wage controls by federal authorities, trouble may be forthcoming from these officials. Frequently, wage and benefit level decisions are hidden in the type and structure of benefit, fringe, and retirement plans.

Changes in pay levels have the most drastic effects on total payroll. Of course, other compensation decisions have payroll effects, but usually not nearly as great. Substantial sums of money can be involved, and for this reason alone an organization must pay close attention to pay levels (both competitively and internally).

Nor are employees and their representatives any less concerned with the organization's pay level. It is here that the absolute amount of the salary rate is determined. Also, it is here that unions exert their major effect, and here that member loyalty is built or lost.

Finally, consumers and the general public have a major interest in pay level decisions. For the consumer wages are a major element in prices and for the general public wages and salaries represent the major portion of national income. Also, too frequent or too drastic changes in wage levels affect the health of our economy.

The available information on what other employers pay comes only as a result of searching. This search takes the form of salary surveys conducted or purchased) by the organization as will be covered in chapter 8. These surveys invariably show a range of salaries paid for the same job by different employers. This range tends to be narrow for the semi-skilled occupations and wider for the skilled occupations. One reason for this is the difficulty of job comparisons. Another is difference in employee quality, although neither of these differences is as wide as compensation differences. The major reason for finding out what others are paying for jobs is to decide how to position your organization in relation to others in the labor market.

High-Wage Employers. High-pay organizations tend to share a number of characteristics: larger size, higher profits, a lower ratio of labor costs to total cost, few industry competitors, and unionization. Larger organizations tend to pay higher base salaries and benefits for a number of reasons. One is that they can usually afford to and therefore are more willing to. Large organizations tend to have financial surplus, which they can use to their best advantage. They are often willing to pay more to attract a pool of competent applicants. There also may be a perceived obligation to counter lower job satisfaction. Finally, those large organizations that are not unionized are continuing targets of union organizers.

A lower ratio of labor costs to other costs may mean that high base salaries are a less significant cost item. As a consequence, organizations with such a ratio can pay high base salaries in the hopes of forestalling labor problems and devote their attention to high-cost items.

Few industry competitors may mean that the organization faces an inelastic demand for its product or service. This allows them to pass on cost pressures as price increases without reducing sales. Also, especially under union conditions, the few competitors may tend to pay equal compensation rates to "take labor out of competition."9

Unions utilize a standard rate policy. They try to equalize wages in the same product market. Unions don't necessarily do this for business purposes and the goals that drive a profit-oriented business. Often union policies are based upon equity considerations as well as practical ones.

Note that all of these reasons, except for size, suggest that high-pay employers tend to group by industry (product market). Thus there is a salary hierarchy among companies that is related at least partially to the industry to which the companies belong.

The high-pay employer may be part of a national organization whose major compensation decisions are made at the corporate level. For example, New York headquartered corporations often appear to pay higher than local competitors. Also, unionized employers may have a uniform compensation scale, dictated by the labor agreement, in all company establishments regardless of their physical location.

Quite naturally, high-pay employers hope to gain several advantages from their high-pay position: higher worker quality as a result of higher hiring standards, ability to insist on higher performance standards, lower turnover, time savings for management because compensation changes do not have to be considered as frequently, insurance against unionization, fewer labor disputes in unionized companies, and company prestige. It is conceivable that the last of these may bear as much, or more weight than the more obvious economic advantages.

Low-Pay Employers. Low-pay employers tend to be relatively small, to occupy competitive product markets, to have low profit margins, and to be nonunion. They have low-paying ability because of the constraints of their product market. Most of their compensation decisions may be explained by this low ability to pay.

Low-pay employers may gauge their position by comparing themselves with the largest and most visible employers. Using salary surveys, they usually pay attention to rates for specific jobs for which there is an active outside market. The starting rate for new production workers may be particularly significant. The jobs on which attention is focused obviously varies by industry.

The minimum feasible compensation is one that will obtain just enough employees to maintain desired employee levels for some period, typically six months. Often organizations pay above this minimum, hoping to obtain employees of higher quality; lower their turnover rates; and lower their recruitment, hiring, and training costs.

Maket Rate Employers. Probably the most common compensation level strategy followed by organizations is to pay the market. These organizations wish to treat their employees fairly and yet not to raise their costs significantly more than their competitors. In short, these organizations are trying to average out the advantages and disadvantages of the high- and low-paying strategies by staying in between. This strategy should enable the organization to recruit and retain an adequate but not outstanding work force. In a tight labor market, they are likely to be affected more like the low-paying organization and need to engage in concerted recruitment activities to obtain new employees. At the same time, internal adjustments must be made to retain current employees. Unfortunately, this adjustment is made after some of the best employees have already left.

The types of organizations that choose to pay the market rate are harder to identify than high- and low-paying organizations. Many organizations with the characteristics of high-paying organizations will choose to pay the market rate instead since this strategy will still supply them with an adequate work force and save them money. In contrast, high-paying organizations are more likely to be those in which it is clear to management that human effort can make a difference in organizational success. Low-paying organizations may wish to pay market rates but often are unable to do so.

To pay the market rate an organization must collect compensation data and determine from that data exactly what the market rate is. This strategy can be characterized as being reactive to the market, so the organization needs to keep in constant touch with other organizations to find out what changes are occurring in employee pay. This strategy also requires that the organization carefully identify where to obtain wage information to ensure that it is getting the best picture of the labor market.

Employing organizations differ in employment-expansion plans, non-salary/wage characteristics of jobs, quit rates, and recruitment and training efforts. This variety insures that compensation levels will always differ from company to company.

Labor Markets and Wage Level Strategies. Labor markets fluctuate in terms of the number of employees and employee hours needed. These swings in labor demand affect employer compensation decisions and compensation differentials among companies. High-pay employers are less affected by these swings because their compensation is high enough above the area level so that they are little affected by short-run changes. They try to limit compensation level changes to once a year and tend to set prices by a percentage markup over average unit costs of production.

Low-pay organizations adjust to changes in labor demand by deciding how far they can lag behind high-paying organizations. During an economic upswing, high-pay employers will be increasing wages, salaries, benefits, and employment. Low-pay employers, to hold down turnover and to increase employment, will have to raise compensation proportionally more than high-paying firms. The compensation gap between high-paying and low-paying firms thereby narrows during an upswing.

During a downswing, high-pay firms stop hiring and may lay off employees. Low-pay firms find that they have more and better applicants and less turnover. This means they can lag further behind the compensation leaders and that the inter-company differential widens.

Although these swings in labor demand compress and expand the differential, it never disappears. The reason is that although some labor markets are tight in upswings, most are quite loose (there is more unemployment than job vacancies) most of the time.

Fluctuations in demand also change hiring standards. When an employer's pool of applicants begins to dry up, the employer may raise compensation or lower hiring standards. Pressure to lower hiring standards is felt first by low-pay firms. During a downswing, hiring standards are raised. It is usually easier, quicker and perhaps less costly to change hiring standards than to change wages. As a result employers may prefer changing hiring standards in the short run to changing wages.

Swings in labor demand have their greatest effects on the less-preferred members of the labor force. Tight labor markets increase the hiring of these groups. Loose labor markets discourage it. Organizations paying market rates can expect to have to react to most of these changes like the low-paying organizations but not to the same degree.

An employer's compensation level is typically, in the final analysis, a matter of policy. Organizations take positions in labor markets and try to maintain them, at the market, or so much above or below it. Most of the time companies pay more than they would need to in order to meet their employment objectives, and in doing so retain quality hiring standards. Preferred groups are hired first, less-preferred groups next. Many firms can quickly expand employment at present compensation levels by merely announcing openings. In this way, employees can flow from lower-wage to higher-wage employers and sectors with no change in differentials.

Internal Labor Markets. So far we have been describing the process of determining or adjusting the (average) wage level of an organization. But most companies have many different jobs, each with its own pay rate. Some kinds of employees are hired from an outside market, typically for jobs at the bottom and top of the skill ladder and for standard clerical jobs. But some employers have only a limited number of entry points. Their jobs are specific to the industry or company and are filled from within. These jobs have no outside market, and their wage rates are determined by administrative decision or collective bargaining. It is useful to describe employers as having either open or closed internal labor markets. Employers with open markets (construction companies, for example) fill most jobs from the outside. Employers with closed markets fill most jobs from within. Open markets are strongly influenced by all the forces in the environment that bear on the organization. Closed markets, in the final analysis, like closed bureaucracies, can determine wages administratively by manipulating both demand and supply. Open and closed internal labor markets constitute not a dichotomy, but a continuum. In the past, most organizations tended toward having closed internal labor markets, because they are advantageous to both employers and employees. More recently with the demands of the new economy, increasingly more organizations have moved toward the open end of the labor market continuum.

A closed internal labor market does not mean that the organization does not have to have a pay level policy. Entry-level jobs are exceedingly important to this type of organization and they must be competitive in the labor markets from which they recruit their organizational entrants. Failure to be competitive at this point will lead to sub-standard hires, and this deficiency will stay with the organization for many years as these employees move within the organization. Closed internal market organizations pay close attention to compensation survey trends both to recruit through their entry points and to retain current employees who are moving upward in the organizational hierarchy.

Compensation levels can be too low and they can be too high. The floor is determined by what labor-market competitors are paying to attract people to their jobs. Thus employers with relatively open internal labor markets need to closely match the hiring rates of relevant labor-market competitors for almost all jobs. Employers with relatively closed internal labor markets, however, need mostly be concerned with the hiring rates of jobs they fill from the outside.

Ceilings on compensation levels are another matter. Employers in the same product market (industry) must not exceed the labor cost per unit (wage costs divided by productivity) of competitors if they wish to remain competitive. But such information is not available. Average compensation rates for jobs and organizations are, but not productivity levels. One suggestion is to use the average compensation of product-market competitors using similar technology.10 Employers with relatively open internal labor markets could use this figure as a ceiling and adjust, if necessary, by changing their job mix (substituting lower-paid jobs for higher-paid jobs) or recruiting in lower-wage markets. Employers using global surveys (exchanging payroll data with frequency distributions of jobs) may be using the job-mix approach. Employers with relatively closed internal labor markets could meet the average compensation of product-market competitors by setting rates for entry jobs at the external-market level and controlling the rates of internally filled jobs to compensate.

Of course, the importance of the product market as a ceiling depends on competition in the product market. In highly competitive industries, organizations follow the practice of low-pay employers discussed earlier. In less competitive industries, the high-pay employer will always serve as a useful reference point. Product-market competitors could also seek competitive advantage through increased productivity of employees. Although compensation levels alone are not expected to achieve increased productivity, they may attract better candidates and encourage them to stay.

Employee Groups. As indicated, a wage level strategy may be utilized for an organization, or for any subpart thereof, such as groups of employees. An organization may have a number of compensation level strategies for different organizational units, locations, or employee groups. The importance of the organizational unit or group of employees may call for a pay level strategy higher than that of other parts of the organization. The characteristics of particular labor markets or competitors may call for a selective compensation level strategy in parts of the organization. Loose labor markets, where there is a constant supply of adequate employees, encourages a low-paying strategy for those employee groups. All these conditions can apply in a single organization, making it useful to have a number of policies rather than a single one. A major concern in employing different compensation level strategies within an organization is to ensure that the differences do not create discrimination in compensation rates within the organization. Establishing low-paying strategies only for employee groups that are predominantly minority or female can lead to charges of discrimination. (See Chapter 27.)

Further, organizations may also distinguish employee groups by their importance to the mission of the organization. Those that are more central tend to have a higher wage level than those who are seen as peripheral. Thus a civil engineering company would very likely pay its civil engineers better or at least as well as the few electrical engineers in the company despite a labor market that says that electrical engineers are paid higher.

Base Pay

As already noted, all employees are not paid the same pay rate. This creates, either consciously or unconsciously, a hierarchy or structure of salaries in the organization. This salary structure needs to be administered by the organization. A well-defined and administered salary structure will help to achieve all of the compensation goals discussed earlier. There are a number of strategic choices that help the organization coordinate its compensation program within the broader strategy of the organization.

Determinants of Wage Structures. Adam Smith explains occupational salary differentials in terms of (1) hardship, (2) difficulty of learning the job, (3) stability of employment, (4) responsibility of the job, and (5) chance for success or failure in the work. This is a theory of wage structure.11 Smith's standards of worth are equally useful in explaining the complexity of salary structure decisions.

Smith goes on to describe two different concepts of value:

  1. Market Value. The market value of an item is the price it brings in a market where demand and supply are equal.
  2. Use Value. Use value is the value an individual buyer or seller anticipates through use of the item. Use value obviously varies among individuals and over time.

These two concepts of worth and the concept of internal labor markets combine to explain important differences among employers in their salary structure decisions. Organizations with relatively open internal labor markets make use of market value in regard to their employees. They also make use of salary surveys in salary structure decisions. Conversely, organizations with relatively closed internal labor markets emphasize employee use value. Their analysis of job worth relies more heavily on perceptions of organization members toward the relative value of jobs.

These two approaches bring up the first strategic consideration for salary structures; the relative value of external data in pay setting versus internal data. External data comes from salary surveys and represents the labor market. Using this data makes competitiveness the main criteria for what the job is worth. This approach is called market pricing. [See the appendix to chapter 11.] When internal data is used the focus is on the value of the job to the organization. In this approach a job structure is built by analyzing and evaluating all jobs into a hierarchy as described in chapters 10 and 11. A salary structure is built by first grouping jobs according to their relative value and then pricing benchmark jobs within each grouping to develop the salary structure. This is the more traditional approach and is described in chapter 12.

There are some other salary structure determinants that are important. Training requirements of jobs in terms of length, difficulty, and whether the training is provided by society, employers, or individuals constitute a primary factor in human-capital analysis and thus job worth. The interaction of ability requirements with training requirements can yield different job values depending on the scarcity of the ability required and the number of people who try to make it in the occupation and fail.

Further, employee tastes and preferences are another factor. People differ in the occupations they like and dislike. In similar manner, occupations have non-monetary advantages and disadvantages of many kinds. Worker expectations of future earnings also strongly influence occupational choice and thus labor supplies. Unfortunately, labor-market information is far from perfect, and responses to labor-market shortages are likely to be more prompt than responses to oversupplies.

Industry specific unions (as opposed to trade unions) have also been shown by economic analysis to affect wage structures. Industrial unions, with their heavy proportions of semiskilled members, are more likely to favor absolute increases. Although large organizations where employees are represented by industrial unions may have a highly differentiated wage structure, they pay less attention to percentage differentials than they would in the presence of craft unions.

Another economic determinant is discrimination. Although pay differentials based on sex or race are unlawful, they still exist. The extent to which such differences are based on productivity differences or represent discrimination is very much a salary structure issue.

What to Pay for. All of these determinants revolve around the job as the basis for pay and that is still the case in a majority of cases. But the relative weight of the job versus the other options- the person or performance- is changing. Many organizations are moving toward paying employees for their competence. This book looks at this alternative in Chapter 15. Paying for competence is more in line with an organic style of organization where human capital is seen as the competitive advantage that the organization has or is trying to develop. These organizations rely on the skills and training of their employees and the constant improvement of these skills to meet tomorrow's demands. 12

We will describe the rise of performance as a criterion for salaries in the next section on variable pay. But clearly performance is becoming a more important variable in pay, even in base pay.

How Structured a Structure? Traditional organizations have salary structures that are highly organized. In these organizations there is a set of pay grades with a salary range for each grade. All jobs are classified into one of these grades usually on the basis of a job evaluation plan. Employees move up in the salary range by whatever criteria are chosen by the organization but results show seniority to be the major criterion. Upward movement is done through promotion from one grade to another. This type of system keeps a high degree of control over base salary costs in the organization but is expensive to operate. Its focus is on internal equity which serves the goal of attraction and retention, but its rigidity makes the organization's competitiveness come under question when the labor market is in upheaval. This type of structure is more fully described in Chapters 12 and 13.

As organizations have been changing, this type of structure has proven to be inefficient and costly. Gradually there have been changes to the degree of structure and in the way the structure is determined. One change has already been discussed, that of market pricing. Here the focus is clearly on the competitiveness of the organization by focusing on external equity rather than internal equity. Market pricing simplifies the administration of the structure. It ignores, or at least downplays, the development of the internal value of the job to the organization, and in its place uses the market value of the job. The details of market pricing are discussed in an appendix to chapter 11 and also in chapter 12.

Most traditional salary structures have a relatively large number of pay grades. The ranges of these grades ordinarily overlap. A technique that reduces this complexity is Broadbanding. This technique reduces the pressure to promote employees to increase their pay, and keeps promotions in line with their real contributions. Broadbanding rearranges the structure to have just a few bands that are very broad rather than having a large number of grades and ranges. Theoretically, salary progression can occur anywhere within this broad range for the employee. In practice, however, it is more common that salaries for particular jobs are concentrated within a portion of the band. Critics are quick to point out that these restrictions end up like the traditional wage grades and ranges and that controlling costs within these bands becomes more difficult.

Determining categories of jobs or employees for each band differs from organization to organization. In fact, whether to have one salary structure or many for the organization is a question that needs to be answered for each organization. More and more the groupings are by occupational areas rather than some form of classification of job level. Many organizations now define "work" in terms of three, four, or five job families: leadership, professional, technical, and individual contributor, for instance. Levels within families are defined, as are tasks and competencies, as the reason for the positions existence. Base salary is defined by a "level" within a competency job family description. Wage/salary progressions are of less interest and variable merit increases are not used. Pay increases are tied to the well being/ability of the organization to pay. In this way competency becomes a major player in setting salaries. [see chapter 15.].13

Pay Differentials. A more recent issue in salary structures is the distance from the top to the bottom of the structure and the shape of the structure. Pay inequality in the United Sates has been widening for some time. Spectacular examples include the case of executives where during the past 30 years, the average real annual compensation of the top 100 C.E.O.'s went from $1.3 million -- 39 times the pay of an average worker -- to $37.5 million, more than 1,000 times the pay of ordinary workers. The differential between top paid workers and lower paid workers is much less than this but is in the range of 30-40% since the 1980's. These changes reflect both a change in organizations and in the labor market.

The change at the top of the organization reflects an increase in the perceived importance of the executive role in an era where performance and competition dominate the economic world. Much more about this will be discussed in chapter 19 but it is clear that this differential is seen by those outside the organization, and more often their stockholders, as out of control.

This pay differential issue extends beyond the comparison of the very top and bottom. There are fewer and fewer of what have been considered "middle class" jobs. The result is that organizations and society in general find that there are low paid and high paid workers needed but not as many in the middle. This has begun to create a core group of more or less permanent employees who are well paid and have good benefits in the organization and a second group of peripheral employees who are under an entirely different employment relationship that is temporary, part time, poorly paid and with no benefits.

Variable Pay

Unlike base pay, not all employees receive variable pay although the usage is increasing all the time. Variable pay traditionally was reserved for sales personnel, some production workers and top management. With an increased focus on performance organizations have been expanding the concept of variable pay to more employee groups. It needs to be emphasized that variable pay is not the same as performance-based pay. Most organizations claim that they pay for performance for all or most of their employees often referring to annual base salary increases. But those are usually plans that are a part of the base pay of the employee. The feature of variable pay that is different is that it is clearly based upon a performance measure or output standard and varies over time with the level of these measures. As such, variable pay is usually an add-on to the base pay plan and not the basis for the whole cash compensation of the employee.

Variable pay has been shown to have considerable positive motivational power14, but it clearly works better in good times than in bad. Total cash compensation can go down when the performance measures of variable pay decline. This is not an attractive situation for any employee and particularly those who are risk averse. In incorporating variable pay into a compensation program there are a number of strategic decisions that need to be taken into account.

Program Inclusion.The first strategic decision is who will be included in the variable pay program. This decision can go as far back as the recruitment and selection of employees. Organizations that have extensive variable pay plans are going to be attractive to a different type of individual than will ones that do not emphasize variable pay. As pointed out above, risk aversive people will not find variable pay attractive and be motivated by it. Further, within the organization there are parts of the organization that are attractive for the use of variable pay both because there are clear performance standards that can ensure a well-run program and also because these parts of the organization are central to maintaining the organization's competitive position.

Integration of Base Pay and Variable Pay. Organizations set a wage level at which they wish to pay their employees. This sets a top limit on the amount that cash compensation is to be. Base pay and variable pay need to fit within this limit. Then the question becomes how much each is to take up of the total. Seen this way variable pay is taking a bite out of base pay. Whatever the wage level the organization wishes to pay, the base pay for employees will be lower than the overall wage level of the organization.

Some organizations, however, view variable pay as an add-on. In this case the wage level is related to base pay, not total cash compensation. Variable pay is added onto this amount. The rationale for this is that variable pay is just that, variable. So in good times this amount will increase when the organization can afford to pay it and will decrease when times are bad. This position is taken mostly when variable pay is based upon organizational measures while the former position is more typical of when variable pay is more individually oriented.

Level of Performance Measure. This leads directly into the next decision, maybe the most important- the organizational level upon which the variable pay will be based. At one end is the individual employee's performance. The advantage to this level, as will be discussed more fully later, is that the line of sight is clear: the employee sees clearly the relationship between what he/she has accomplished and the reward, thus maximizing the probability of the reward being motivating. The disadvantage is that what the individual is doing well may not be related to the strategic goals of the organization. At the other end of the spectrum variable pay is based upon organization success in achieving its goals. This creates a focus on the overall strategy of the organization but the individual employee often does not see the connection to what he/she does or accomplishes.

Benefits

Benefits are very different from cash compensation. They are not one program but many, all with different ways of managing them and different laws that apply to them. Developing a consistent program is extremely difficult. Further, for administrative and legal reasons all employees are generally eligible for benefits in the same amount. This is a very egalitarian part of compensation administration. On the other hand employees differ in the degree to which various benefits appeal to them or that they see the benefit even applying to them.

In benefits administration the organization is caught between two of the compensation goals- cost control and attracting and retaining employees. The cost of benefit has been rising so rapidly that organizations find that they are having to reduce benefit levels or eliminate them and/or cut back on increases in base pay. In recent years this has led to low yearly increases in average pay for employees even when the economy and organizations have been doing well. These increases have not been keeping up with inflation even though inflation rates have been low.

Benefits have another catch-22. On one hand employees get very upset when there are changes to their benefits that either cost them money or reduce their coverage, and this negatively affects their attitudes toward work and the organization and can in turn, affect their performance. On the other hand, some employees do not really understand their benefit package or do not care whether they have the benefits or not. These dilemmas in the field of benefits lead to the consideration of strategic decisions in two interrelated areas: cost control and employee involvement.

Cost Control. It has become imperative for organizations to control benefit costs. Each year benefits take a bigger share of total compensation costs, mainly because of medical plans but also with retirement plans. There are a great many different things an organization can do to try and limit the increasing costs. These center around:

  • Changing or reducing benefits. This may involve working with suppliers to install new types of plans, reducing the current coverage or totally eliminating a benefit.
  • Cost sharing. For the most part it has been the employer who has provided the benefit for the employee. The advantage was that the employee did not have to pay taxes on these benefits and the organization wrote them off as a business expense. More and more employees are being asked to contribute a part of their wages to pay for some part of the benefit costs.
  • Reducing administrative costs. This may include simplifying the programs, combining benefits, or outsourcing problem.

These alternatives are considered more completely in chapter 20.

Employee Involvement. In the past the big problem with benefits was that the employee did not understand what he/she was receiving and had no voice in the program. This has been changing. Organizations are developing benefit plans that can be adapted to the particular employee, within limits, and which bring the employee into the planning process. This aids both in the attraction and retention of employees but also in cost control to some degree. Cloud based benefit plan solutions have made much of this possible, although these plans do require a massive communication program to make sure each employee understands his/her options for benefits.

SOME OBSERVATIONS

Competitiveness. Organizations often cite "paying competitively" as their primary compensation goal. New Economy organizations do not appear to be as concerned over matching average salary rates as their traditional counterparts. Instead, New Economy organizations compete with incentives and variable pay (gainsharing plans, profit sharing, stock option plans that extend down into the lower ranks, etc.).

Motivation. Many organizations utilize compensation as a means to shape individual and group behaviors. While the Old Economy counterparts stress the merit of the individual's achievement and reward for both merit and individual production, the New Economy organization is far more likely to reward the total organization and the team responsible for an achievement (rather than a few select key individuals).

Interestingly, New Economy organizations utilizing team based pay practices do not tend to use formal performance appraisals. (Performance appraisals appear to alienate both the bottom 20% of a work population and the top 20%, leading to a similar exodus from each group.)

While Old Economy organizations stress the merit of individual achievement, New Economy organizations are more likely to reward team effort.

Administrative Effectiveness. Oftentimes, pay plans are utilized because they are administratively simple and inexpensive. Administering base salaries is much less complicated than benefits or incentives. The pay plans used by New Economy organizations often appear unsophisticated compared to the complex pay schemes of Old Economy organization competitors. Simple, straightforward pay plans are the rule.

Cost Control.

Compensation plans can also be designed to ensure cost control. For example, sales compensation that is only paid when profit or sales are achieved.

New Economy organizations appear to pay less due to:

  • lower salary levels
  • higher retirement and health benefits
  • much higher equity compensation

Internal Equity. In Old Economy organizations, fairness in pay has been a traditional value. Job evaluation plans oftentimes exist solely because of this objective. New Economy organizations are far more heavily influenced by the competitive marketplace, and oftentimes pay little attention to this objective.

Cost/Benefit Efficiency. Governments can affect compensation practices with tax laws, making certain types of compensation less expensive than others. For example, U.S. rules relating to stock options and Employee Stock Options (ESOPs). Lower salary levels, higher benefits, and use of stock options translate into more cost effective use of compensation dollars in New Economy organizations. Cash conserving approaches are a reflection of many New Economy organizations' working environments.

Tax Considerations. Clearly, the use of stock options and benefits require an understanding and appreciation of tax codes, but rarely does one hear of this objective as being the driving force for the use of any particular compensation plan in New Economy firms. This is a change from previous decades within the U.S. and Canada, where Old Economy organizations often found their compensation designs dictated by tax accountants.

Capital Accumulation. A primary goal of several compensation elements is the creation of assets and estates for managers or employees (allowing employees to believe they are owners). Capital accumulation has traditionally been only for management. This has changed. New Economy organizations utilize both technology and stock options or equivalents. Starbucks, Cisco, Microsoft, and Apple, followed by such stalwarts as Bank of America, have expanded the participation in these plans to the mailroom.

Many workers were willing to trade higher salaries at more secure and stable companies in exchange for stock options in New Economy organizations. Due to the fact that stock option programs required the employee to stay with the company for a set number of years before vesting (receiving full ownership of the stocks), these programs increased loyalty.

Employee stock option plans created millionaires. In recent years, however, companies that offer employees equity have turned to restricted stock plans that provide ownership rights with less upside risk than stock options.

Social Concern. Some compensation elements exist simply because owners, management, and boards utilize social concerns in their decision making regarding compensation elements. For example, long-term disability plans. New Economy organizations often appear to have a concern for their human resources not shared by their Old Economy counterparts. This is reflected in turnover statistics and compensation plans pointed toward future (not present) compensation. Because of the Internet, organizations can communicate information that otherwise might not be known. This allows New Economy organizations to communicate both their plans and objectives more often and at less expense than is done by Old Economy firms.

Government Compliance. Pay plans are often designed for no other purpose than to meet government compliance issues. This is not as much of a concern in the 2000s as it was in the late 1970s and 1980s. New Economy organizations are too busy in a fight for survival brought about by foreign competition and technology changes to spend enormous time and effort on government compliance. Few believe, however, that the labor laws, equal and minimum pay laws, retirement plan laws and reporting, and other rules and regulations will disappear. All countries shape compensation plans in some manner.

Matching Goals. The compensation plans used often depends on the way in which an organization prioritizes these discussed objectives. Oftentimes two or more objectives can be in conflict, making them difficult to be achieved by a single compensation plan. Because no two organizations have exactly the same goals, there is a diverse use of compensation elements.

Footnotes

1 "Circuit City Cuts Wages to Juice Profits" Business Week Online 3/29/2007, p.2.

2 "Short Circuited: Cutting Jobs as Corporate Strategy" Knowledge@Wharton, April 4, 2007. http://knowledge.wharton.upenn.edu/

3 Costco Wholesale Annual report, 2005, p.5.

4 Carbaugh, R.J., International Economics, Cincinnati, OH. South-Western Pub., 2006.

5 Lawler, E.E., Rewarding Excellence: Pay Strategies for the New Economy, San Francisco, Jossey-Bass,2000.

6 Friedman, T.L. The Earth is Flat: A Brief History of the Twenty-first Century, New York, Farrar, Strauss and Giroux, 2005.

7 Gerhart, B., & Milkovich, G., "Organizational differences in Managerial Compensation and financial Performance," Academy of Management Journal, vol. 33 1990, pp. 663-691.

8 Ghorpade, J., "Wal-Mart's Real cost of Labor" San Diego Union-Tribune, July, 7, 2004.

9 Thomsen, D.J. "Compensation Trends Affect Retention," Personnel Journal, Vol. 59 #1 January 1980.

10 Mahoney, T., "Compensating for Work," in Personnel Management, ed. K. M. Rowland and G. R. Ferris Boston: Allyn & Bacon, 1982, pp. 227-61.

11 See the discussion of Adam Smith's ideas in Chapter 3.

12 Grossman, R., "IBM's HR Takes a Risk," HR Magazine, April 2007, pp.55-59.

13 Thomsen, D. "ERI's competency Compensation Construct" ERI Update, Economic Research Institute, Richland, WA. July, 2007.

14 Zingheim, P. & Schuster, R., High Performance Pay, Scottsdale, AZ. World at Work, 2007

Internet Based Benefits & Compensation Administration

Thomas J. Atchison
David W. Belcher
David J. Thomsen

ERI Economic Research Institute

Copyright © 2000 - 2013

Library of Congress Cataloging-in-Publication Data

HF5549.5.C67B45 1987 658.3'2 86-25494 ISBN 0-13-154790-9

Previously published under the title of Wage and Salary Administration.

The framework for this text was originally copyrighted in 1987, 1974, 1962, and 1955 by Prentice-Hall, Inc. All rights were acquired by ERI in 2000 via reverted rights from the Belcher Scholarship Foundation and Thomas Atchison.

All rights reserved. No part of this text may be reproduced for sale, in any form or by any means, without permission in writing from ERI Economic Research Institute. Students may download and print chapters, graphs, and case studies from this text via an Internet browser for their personal use.

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