Developing an effective and efficient compensation system

Would you work 40 or more hour for an organization for no pay and no benefit? The answer would be no, because when the employees work, they are expect to receive some form of compensation from their employer. Developing an effective and efficient compensation system is an important part of the human resource management process. An effective and appropriate compensation system can help attract and retain competent and talented individuals who can help the organization accomplish its mission and goals. In additional, an organization’s compensation system has been shown to have an impact on its strategic performance. (et al. Stephen P. Robbins 2003 Page326)

Manager must develop compensation system that reflects the changing nature of work and the workplace in order to keep people motivated. Organizational compensation can included many different types or reward and benefit, such as base wages and salaries, wage and salary add-ons, incentive payments, and other benefit and services. There are several factors that influence the manager to determine who receive the amount of their wages in an hour or a year for different employees. These can included the kind of job performed, the kind of business the organization is in, whether the organization is labour or capital intensive, management pay philosophy, the organization level of profitability, organization geographical location and employee tenure and performance (see figure 2.1). ( Stephen P. Robbins 2003 Page327)

Figure 2.1 Factors that influence compensation and benefit packages

2.1 Factors influence compensation and benefit

The rate of pay in the organization. Different jobs require different kinds and levels of skills, and these skills have varying levels of value to the organization. The higher the skill level, the higher the pay.

Kind of business the organization is in. Private sector jobs typically provide higher rates of pay than public sector or not for profit jobs, especially for managerial and professional positions.

Whether the business is labour or capital intensive. As business become more capital intensive, fewer workers are need to do the organization’s work, but these employees need higher level of knowledge and skills. And highly skilled employees usually demanded higher rates of pay.

Management philosophy. Some organization will pay above the market rate to attract the best employee, but for some organization will using the principle; we don’t pay any more than they absolutely have to.

Geographical. The higher the cost living in the area will cause the organization to pay much in order they can afford for their living expenses in the place they live.

Profitability of the organization. The more profit the organization earns will cause the organization to pay much for their employees. For some organization may be provide higher pay levels or some type of profit sharing system.

Size of organization. The hourly pay of workers at companies with more than 500 employees tends to be greater than the hourly pay of workers at smaller companies.

Employee’s tenure and performance at their job. Organization reward employees who achieve high level of performance by increasing their pay through a merit or pay performance system. ( Stephen P. Robbins 2003 Page328)

2.2 Total reward and compensation

There are now many organization are spent much of fund on their employees reward, it is critical for top management and HR executives to match total rewards systems and practices with what the organization is trying to accomplish. What their decision make must achieve the objective such as legal compliance, costs effectiveness for their organization, internal or external and equity for employees. They must balance their costs at a level that rewards employees sufficiently for their knowledge, skills, abilities, and performance accomplishment. There are three primary groups for the total reward as show below figure 2.2 (et al. Robert L. 2008 Page360 )

Total Reward


Base Plan



Variable Pay



Stock options


Health/Medical insurance

Life/disability insurance

Paid time off

Retirement/pension plans

Educational assistance

Work life support

Performance and Talent Management


Performance reviews

Goal setting

Talent Management


HR development

Career planning

Succession planning

Figure 2.2 Total Reward Components

2.3 Types of Reward

One of the distinctions not formally a part of Figure 2.2 is that rewards can be both intrinsic and extrinsic. Intrinsic rewards may include praise for completing a project or meeting performance objectives. Other psychological and social form of compensation also reflects intrinsic type of rewards. For intrinsic rewards example, interesting work, responsibility, recognition, achievement, task variety, task significance, and job feedback. Extrinsic rewards are tangible and take both financial and nonfinancial forms. For the nonfinancial reward is referring to career rewards and social rewards. Career reward included the job security, career growth and self development. While social rewards included the status symbols which are title, office and preferred schedule. One tangible component of a compensation program is direct compensation, whereby the employer exchanges financial reward for work done and performance result achieved (Show at figure 2.3). Base pay and variable pay are the most common forms of direct compensation. Indirect compensation commonly consists of employee benefits. (et al. Robert L. 2008 Page361)

Figure 2.3 Classes of organization reward (Packianathan Chelladurai 2006)

Base Pay is the basic compensation that an employee receives which is wage or a salary. There are many organization use two base pay categories, hourly and salaried. Employee paid hourly receives wages, which are payments directly calculated on the amount of time worked. In contrast, people paid salaries receive consistent payment each period regardless of the number of hours worked. Being paid a salary has typically carried higher status for employees than has being paid wage. However, overtime may have to be paid to certain salaried employees as defined by federal and state laws. Another type of direct pay is variable pay. Variable pay is compensation linked directly to individual, team or organization performance. The most common types of variable pay for most employees are bonuses and incentive program payments. Executive often receive longer term rewards such as stock option. (et al. Robert L. 2008 Page361)

Benefit is an indirect reward, for instance, health insurance, vacation pay, or a retirement pension given to an employee or a group of employees for organizational membership, regardless of performance. There is a wide variety of employee benefits, such as paid time off, insurances, pension plan, company car, and more (Show at figure 2.4). A benefit plan is designed to address a specific need and is often provided not in the form cash. For some company will use the flexible benefit schemes enable employers to allow staff to select the benefits that suit them. Flexible benefits schemes can include a wide range of options for staff to select from, including tax efficient benefits such as childcare vouchers and mobile phones or salary sacrifice pensions contributions. ( 2010)For real cases example, Honda factory in Swindon, staff can access benefit s to help them make their money go further. The main offering in the company’s ‘What if….’ Schemes are a pension plan, which has the option of additional voluntary contributions, childcare vouchers and a cycle to work scheme. However there are advantage and disadvantage for giving the flexible benefits to their employees (Show at Figure 2.5). ( 2010)

Private Health care

Private dental and eye care

Discounted insurance

Career breaks


House purchase/ moving expenses

Subsidized meals


Financial support for lifelong learning

Extra vacation days

Sport/Entertainment Vouchers

Pension plans



Figure 2.4 Type of indirect pay or Employee benefit

Figure 2.5 Advantage and Disadvantage of flexible benefits



-Employees select benefits to match their individual needs

-Benefits target the needs of a diverse workforce

-Maximize the psychological value of benefits because paying only for most desired benefits

-Poor selection creates unwanted costs

-Additional administrative costs arise

-Encourages the cost of popular benefits to be marked up

2.4 Reward techniques

There are three types of reward techniques which is job analysis, job evaluation and appraisal. The reward technique is referring to comparisons between jobs or skill levels inside the organization. The process involves comparing jobs and employees skills and competencies in term of their relative contribution to the organization goals. Bratton and gold (2007), stress that reward should not be job but person based, such that the position of employees within the pay structure is determined less by the formal job description and more by the skill and performance they bring to that job. Thus, job analysis and job evaluation are techniques associated with old pay structure developed to meet the needs of bureaucratic Fordist-type organization. (Bratton and Gold 2007 Page 380)

Bratton and Gold (2007) define the job analysis as “the systematic process of colleting and evaluating information about task, responsibilities and the context of a specific job”. The job analysis information informs the manager about the nature of a specific job, in particular the major tasks undertaken by the incumbent, the outcomes that are expected, and the job’s relationship to other jobs in the organization hierarchy and job holder characteristics. Job analysis is the prerequisite for preparing job description and for job evaluation. There are five methods to gathering the job analysis data (Show at figure 2.6). (Bratton and gold 2007 Page 381-382)


Document research


Employee report



Figure 2.6 Methods of collecting job analysis data

“A systematic process designed to determine the relative worth of jobs within a single work organization” define by Bratton and Gold (2007). Job evaluation is a generic label for a variety of processes used to establish pay structure inside an organization. The goal is to achieve internal equity by determining a hierarchy of jobs that is based on the relative contribution of each job to the organization. This hierarchy is then used to allocate rates of pay to jobs regardless of the incumbent. The important of job evaluation to managers has increased because of equal pay legislation, which requires, either implicitly or explicitly, that gender neutral job evaluation schemes be adopted and used to determine and compare the value of jobs within the organization. There are four processes for the job evaluation which is gather the data, select compensable factors, evaluate the job, and assign pay to the job. (Bratton and Gold 2007 Page 383)

Performance appraisal is the process of evaluation individuals in term of their job performance. The performance appraisal technique is to make employee known to the organization controllers and to assist in the process of managerial control. This is the tool that used by the line manager rather than the other. The manager use it to get together to engage in a dialogue about individual performance, development and the support required from the manager. Performance appraisals usually review past behaviour and so provide an opportunity to reflect on past performance ( 2010). Organization is using this as a technique to create the reward to their employees.

2.5 Reward Responsibilities

HR department and operating manager have to work together in order they can administer the organization reward expenditure. There is an illustrated show the division for reward responsibility in figure 2.7. HR department are always guiding the development and administration of an organizational reward system and conduct job evaluation and wage surveys. Besides that, they are also responsibility for developing the base pay programs and create the salary structure or policies for their organization. While for the operating manager is which to evaluate the performance of the employees and consider their performance when deciding the reward increases within the policies and guidelines established by the HR department or upper management. (et al. Robert L. 2008 Page 364)

HR Department

Operating Manager

-Develops and administers the reward system

-Evaluate jobs and analysis pay surveys

-Develops wage or salary structures and policies

-Identify job descriptions and reward concerns

-Recommended pay rates and increases according to HR guidelines

-Evaluate employee performance for reward purposes

Figure 2.7 Typical of HR responsibility: Reward

2.6 Reward Theory

The use of variable pay has grown in popularity over the past decade with 67% of companies offering some form of variable compensation to employees below the executive level. Although there is used by many companies, however there is limited evidence about what factors influence the use of broad based variable pay. Some of the rhetoric in professional literature assumes that performance based incentives improve organization performance, but the scholarly literature is less affirmative. There are three kinds of theory that can use by the organization which is principal-agent theory, positivist theory, and contingency theory.

In principal agent models, performance sensitive pay provides a solution to the problem of aligning the interests of managers with those of owners of the corporations they manage. In the past decade, the practice of compensating managers below senior executive ranks with stock options and other forms of long term incentives has risen dramatically. On its face, principal agent theory provides the rational for doing this. Performance sensitive pay aligns the interest of all levels of employees with the interests of shareholders. However, principal agent theory also predicts a negative correlation between the riskiness of firm level performance and use of performance contingent pay. (Janet H. Marler, 2002)

A major assumption in agency theory is that the employee’s actions cannot be observed or are costly to observe. This may be true under certain circumstances: non programmable jobs, rapid growth, and disbursed ownership. But where monitoring and observing actions of employees is possible, monitoring as in providing supervisors, may be less costly and therefore preferable to more risk prone variable compensation. But In the case of especially skilled positions that are not as programmable or where productivity is not easily evaluated, observation of behaviour is not reliable indicator of performance. For example, R&D jobs compared to general management positions may not be as easily monitored. (Janet H. Marler, 2002)

Strategic contingency theory holds that firm performance is based upon the alignment of an organization’s compensation systems and business strategies. The basic premise of this research is that certain combinations of compensation policies better support the firm’s strategic business objectives. One particular strategy that has gained currency in the nineties is the risk sharing formula characterized by below market base pay offset with a premium of higher variable pay such as stock option. If sales volumes vary significantly, the bottom line is less affected because compensation costs vary as well. (Janet H. Marler, 2002)

2.7 Compensation fairness and equity

Most people in organizations work in order to gain rewards for their efforts. They wish to get the equity pay from their employer whether base pay or variable pay. The equity is referring to the fairness between what a person does and what the person receives. Individual judge equity in compensation by comparing their input against the effort and performance of others and against the outcomes. There are 60% employee are believed that they are underpaid but less than 20% were actually underpaid.

There are external equity and internal equity in the organization. External equity is referring to the employee’s perception of the conditions and rewards of their employment, compared with those of the employees of other firms. If an employer does not provide compensation that employees view as equitable in relation to the compensation provided to other employees performing similar jobs in other organization, that employer is likely to experience higher turnover compare to other organization. Some of the organization will more likely to attract individual with less knowledge and fewer skills and abilities by not being competitive, but this have cause them in low overall organization performance. (et al. Robert L. 2008 Page 365)

Internal equity is referring to the employee’s perception of their responsibilities, reward, and work conditions as compared with those of other employees in similar positions in the same organization. There is two key issue relate to internal equity which is procedural justice and distributive justice. Procedural justice is the perceived fairness of the process and procedures used to make decision about employees, including their pay. What the process of determining the base pay for employees must be perceived as fair. Distributive justice is the perceived fairness in the distribution of outcomes. For example, if a hardworking employees whose performance very good but receive the same pay as an employee who with attendance problem and mediocre performance, then inequity may be perceived. For the real case happen in US, Google to offer gay staff extra pay to allow for tax inequality with straight couples. Google will make up the difference in additional pay for US employees on average 650pound a year. ( 2010)

For some organization they will try to use pay secrecy. They will keep the information of their employee payment so that nobody can know how much the other employee receive and compare with it. By this, the organization can avoid from the employee arguing about the inequity pay. Besides that, some organization has the policies that prohibit employees from discussing their pay with other employees, and violations of these policies can lead to disciplinary action.

2.8 Market competitiveness and Compensation strategy

The market competitiveness of compensation has a significant impact on how equitably employees view compensation. Employers are always concern about the competitive compensation providing to their employees no matter globally, domestically, or locally. There are some organizations establish specific policies about where they wish to be positioned in the labour market. These policies use a quartile strategy, as illustrated in figure 2.8. The strategy can be divided to three which are Meet the market strategy, lag the market strategy and lead the market strategy. (et al. Robert L. 2008 Page 366)

‘Meet the market’ strategy is the strategy that most common use by the organization which position them into second quartile. In this strategy, they are in the middle of market and they can identify the pay data from other employer survey. By this level, the employer can balance the cost pressures and beside that, they can also attract or retain the employee by providing the mid level compensation.

‘Lag the market’ strategy is the first quartile which paying below the market levels. There are several reasons for the organization to use this strategy which is when the employer is experiencing a shortage of fund; it may be unable to pay more. Or when the market is abundance of workers, particular the lower skills, the organization can use this strategy to hire the workers as to save costs.

‘Lead the market’ strategy is the third quartile which uses an aggressive approach to lead the market. This strategy generally enables a company to attract and retain sufficient workers with the required capabilities and to be more selective when hiring. Organization is always looking for the ways to increase their profit because there is a higher cost to use this strategy.

Third Quartile: Above Market Strategy (Maximum)

(Employer positions pay scales so that 25% of other firms pay above and 75% pay below)

Second Quartile: Middle Market Strategy (Median)

(Employer positions pay scales so that 50% of other firms pay above and 50% pay below)

First Quartile: Below Market Strategy (Minimum)

(Employer positions pay scales so that 75% of other firms pay above and 25% pay below)

Figure 2.8 Compensation Quartile Strategies

2.9 Theories of Motivation

Rewarding and motivating employees is one of the most important and one of the most challenging activities that manager perform. Motivation is the willingness to exert high level of effort to reach organization goals, conditioned by the effort’s ability to satisfy some individual need. The effort element is a measure of intensity or drive. A motivated person tries hard. But high levels of effort are unlikely to lead to favourable job performance unless the effort is channelled in a direction that benefits the organization. Therefore we must consider the quality of the effort as well as its intensity. A need refers to some internal state that makes certain outcomes appear attractive. An unsatisfied need creates tension that stimulates drivers within an individual. So motivating high levels of employee performance is an important organizational consideration. There are three kinds of theories for motivation which is Maslow’s hierarchy of need theory, McGregor’s theory X and theory Y, and Herzberg’s motivation hygiene theory. (Stephen P. Robbins and Mary Coulter 2003 page 424)

2.9.1 Maslow’s Hierarchy of Need Theory

The best known theory of motivation is probably Abraham Maslow’s hierarchy of needs theory. He has defined the five needs of every person. The five needs included physiological needs, safety needs, social needs, esteem needs, and self actualization needs. Maslow argued that each level in the hierarchy must be substantially satisfied before the next is activated and that once a need is substantially satisfied it no longer motivates behaviour. If want to motivate someone, the first things need to be understand is to know the level of need of the person in the hierarchy. The managers who understand with this will help them to change for their organization. Maslow separated the five needs into higher and lower levels which show in figure 2.9. (Stephen P. Robbins and Mary Coulter 2003 page 425-426)





Self-Actualization Figure 2.9 Maslow’s Hierarchy Needs

2.9.2 McGregor’s Theory X and Theory Y

Douglas McGregor is best known for his formulation of two sets of assumption about human nature: Theory X and Theory Y. Theory X present an essentially negative view of people, mean the employee have little ambition, dislike work, want to avoid responsibility, and need to be closely controlled to work effectively. Theory Y is offers a positive view which the employee can exercise self direction, accept and actually seek out responsibility, and consider work to be a natural activity. McGregor has grouped Maslow’s hierarchy into lower order (theory X) needs and higher order (theory Y) needs. McGregor theory Y has now affects the way companies conduct performance reviews, and shapes the idea of pay for performance. (Stephen P. Robbins and Mary Coulter 2003 page 426-427)

2.9.3 Herzberg’s Motivation Hygiene Theory

Frederick Herzberg’s motivation hygiene theory proposes that intrinsic factors are related to job satisfaction and motivation, whereas extrinsic factors are associated with job dissatisfaction. His findings have had a considerable theoretical, as well as practical, influence on attitudes toward administration. He has asked the people for detailed descriptions of situations in which they felt exceptionally good or bad about their jobs. He concluded from his analysis of the finding that the replies people gave when they felt good about their job were significantly different from the replies they gave when they felt badly. Certain characteristic were consistently related to job satisfaction and others to job dissatisfaction (figure show at 2.10). Those factors associated with job satisfaction were intrinsic and included things such as achievement, recognition, and responsibility. When people felt good about their work, they tended to attribute these characteristics to themselves. On the other hand, when they were dissatisfied, they tended to cite extrinsic factors such as company policy and administration, supervision, interpersonal relationships, and working conditions. (Stephen P. Robbins and Mary Coulter 2003 page 427-428)

Figure 2.10 Herzberg’s Motivation Hygiene Theory