Compensation is the total cash and non-cash payments that an employer give to an employee in

exchange for the work they do for his/her business. Compensation is more than an employee's
regular paid wages. It also includes many other types of wages and benefits.

Key Strategic Issues in Compensation:

 Determining compensation relative to market.
 Balance between fixed and variable compensation.
 Deciding whether or not to utilize team-based versus individual pay.
 Creating appropriate mix of financial and non-financial compensation.
 Developing a cost-effective compensation program resulting in high performance.

Determining compensation relative to market:

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. 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:
1. Gathering the background information needed for project success.
2. Determining the sources of external market data and getting the data ready.
3. Conducting the market data analysis.
4. Developing the pay structures.
5. Calculating the costs of the pay structures.
6. Implementing and evaluating the new pay structures.

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.
Step 2: Selecting Sources of External Market Data and Preparing the Data
A quick Internet search will provide HR professionals with a wealth of compensation surveys.
Without formal compensation training, such findings can be overwhelming. How do one 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 before the start of the market analysis process.
Step 3: Conducting the Market Data Analysis
After obtaining and preparing the data, HR can 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
percent 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 with a survey job summary or capsule.
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. An organization can also, review for outliers,
create a market composite for each benchmark position, and review current pay rates as market
data.
Step 4: Developing the Pay Structures
HR can 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.
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.
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. HR professionals can use freehand to connect the data points or use a regression analysis
tool, such as MS Excel, to create the market line. 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 exists among the data.
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 calculate only base pay ranges
because base pay reflects the guaranteed cash payments and the basic value of the work.
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.
 Comparative ratio analysis.
 Adjustments for compression and equity.
 Bring-to-minimum.
Step 6: Implementation and Evaluation
Policy development
The organization's salary structure policy ultimately drives communication and training. 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 general
access to the system will be, and whether the system will be open or closed to employees.
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.

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 reach the maximum of the pay range much faster than average-performing co-
workers. Employees who are steady, average performers may never exceed the range midpoint
because 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.

Balance between fixed and variable compensation:

Fixed pay is the fixed amount of salary that an employee gets at the end of the month whereas
Variable pay is the incentive paid to the employee, monetary or non-monetary, based on their
performance for the month.
The ratio of fixed to the variable component, as a norm, varies based on the role the employee
plays. As a rule, the employees engaged in the sales activities usually have a larger variable than
the employees in the execution role. In India, for the employees engaged in sales activities, the
ratio of fixed to variable can be as much as 60:40, while in the countries like the US it could be
as much as 30:70.
The primary goal of the firm is to maximize its value. The optimal balance between fixed and
variable pay is an important consideration for the firm. There is likely an optimal balance
between the fixed and variable components of compensation. The optimal balance should occur
where the EVA (Economic Value Added) of the firm is maximized, while holding other factors
(e.g., financial leverage) constant.
The change in the variable pay component results both in gains and losses; gains result in higher
future cash flows and profitability due to better financial performance, which increase the EVA
of the firm; losses result in lower future cash flows and profitability due to higher compensation
costs, difficulty in retaining people in certain tough marketing areas, difficulty in attracting
people in certain low-paying sales jobs, difficulty in recruiting fresher and trainees, increased
dissatisfaction with variable compensation packages by certain employees and higher turnover
costs, which ultimately decrease the EVA of the firm. The overall impact of variable pay on the
firm’s value can be depicted.
When the variable pay ratio (i.e., variable pay vs. total pay) is increased, th EVA of the firm first
increases, then likely peaks and eventually declines. The reason for this relationship is that
initially when the variable pay component is still relatively small, the marginal increase in the
EVA of the firm due to the gains from variable compensation offsets the marginal decrease in the
firm’s value due to the losses.
At a certain point, the marginal increase in the EVA of the firm equals the marginal decrease,
and the EVA of the firm reaches the peak. Beyond this point, however, the marginal decrease
offsets the marginal increase, and the EVA falls. Due to the potential losses associated with
variable pay schemes, it is likely that an optimal point of fixed pay and variable pay is reached
where a specific compensation mix is adding the most value to the firm, thereby resulting in
higher EVA.
The variable payout ratio is defined as the variable pay divided by the total pay. In the
illustration the specific variable pay ratio that gives the highest EVA of the firm is considered as
the optimum variable payout ratio. In general, the cost of capital is a decreasing function of the
variable pay ratio, as a higher variable pay ratio will likely decrease the operating leverage of the
firm, decrease the information risk premium, reduce the market risk or beta of the firm, decrease
the seasonality, cyclicality and volatility of operating income and hence, ultimately reduce the
cost of capital.

Deciding whether or not to utilize team-based versus individual pay:

Incentives are a great way to keep workforce motivated, but knowing what kind of incentive
program to implement can make a big difference in terms of results. For many companies,
everything boils down to individual versus team-based incentives. What are each option’s
strengths and weaknesses and which one is a better fit for your company? A better understanding
of both types of incentive programs should help one choose the right option.
Individual Incentives
Individual incentives, as the name suggests, are designed to reward individual employees based
on how well they perform according to established metrics. The main intent of this kind of
incentive program is to encourage top performers to keep on doing great while also encouraging
other employees to follow the former’s example and earn their own bonuses.
Some pros and cons of individual incentives are given below,
Pros:
An individual performance program has its own advantages.
 It drives performance and rewards top performers for their results.
 It draws a clear line between people who produce and those who don’t.
 It provides the best line-of-sight for sales compensation plans.
 It creates a culture with a strong emphasis on sales.
Cons:
But focusing too much on the individual can cause some problems.
 It can create an “everyone for themselves” mentality within the company.
 When a team sales approach is needed, an individual plan can undermine that effort.
 It can create fiefdoms.
 It can result in crediting issues among sales reps.
 Sometimes results in arguments over sales territories.

Team-Based Incentives
Instead of having a few top-performing individuals receive rewards, a team-based incentive
program focuses more on rewarding the team as a whole. If a team finishes a big project sooner
than expected or if they go well above their quota within a given time, all members of the team
get rewarded for their collective effort.
Some pros and cons of team-based incentives are given below,
Pros:
Team-based approaches have a few different advantages.
 Creates an environment that supports a team-based approach to selling.
 Helps to focus employees on the needs of their customers, rather than their individual
paychecks.
 Sales reps sometimes clash over who should take credit for a sale. Using a team-based
approach resolves many issues of who should get the credit for which sale.
Cons:
Of course, any approach also has its disadvantages.
 It equally rewards employees who do not work as hard as others on the same level as top
performers.
 It can undermine the idea of pay-for-performance.
 If not handled properly, it can drive top performers from the company.
 Management is not able to diagnose as quickly what factors most affect performance.
As we can see both these methods have plus and minuses. The key to finding the best one for
one’s company is to look closely how the company defines each employees value.