MOI UNIVERSITY

MBA 820: MANAGING HUMAN RESOURCES

4.0 MANAGING COMPENSATION AND SECURITY

If the abilities of employees have been developed to the point where they meet the job
requirement, it is now appropriate that they be rewarded for their contribution to the
organization. This topic discusses the strategies for rewarding and compensating employees in
organizations. It will cover the following main areas:

4.1 Determining compensation

4.2 Variable compensation and incentives
4.3 Employee benefits

4.1 DETERMINING COMPENSATION

At the end of this topic you should be able:

• Define compensation and explain its importance
• Discuss the factors that determine salary determination
• Discuss the importance of equity in the design of salary structures and pay levels
• Discuss the strategic choices in compensation
• Define and explain the importance of job evaluation

4.1.1 Definition and importance of compensation:

Reward management or compensation, describes the HRM function of paying people for
what they have done and can do for the organization and for themselves by contributing
effectively to the achievement of organizational objectives.

Armstrong (1999) defines it as the process of developing and implementing strategies,

policies and systems which help the organization to achieve its objectives by obtaining
and keeping the people it needs and by increasing their motivation and commitment.

It short it means:
- Rewarding people according to their actual and potential contribution to the
company
- Recognizing that people have their own needs and goals, which must be matched
with the rewards and incentives.

Activity:
Rewards are concerned with both financial and non-financial rewards.
List some intrinsic and extrinsic non-financial rewards that employees expect in
exchange for their commitment, loyalty and performance

Hint: Intrinsic are related to job content while extrinsic are related to job context

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The intrinsic and extrinsic motivational importance of rewards is explained by Herzberg’s two
factor theory of motivation
Importance of reward function

• Wages and salaries constitute one of the greatest cost in organizations

• It is the sole means of economic survival for the employee
• One of the most influential factors determining ones status in society.
• Communicates to employees the important link between rewards and performance

Aims of reward management

 Attract capable employees to the organization

 Motivate employees to give superior performance
 Retain employee services over an extended period of time.

4.1.2 Factors influencing pay determination

1. Supply and demand for employee skills

Following the law of demand and supply an increase in the supply of labour for a particular job
will decrease compensation, while an increase in demand will increase compensation e.g.
doctors, engineers and lawyers are highly paid due to the high demand and low supply of their
services.

2. Labour Unions

Labour unions promote and protect the economic interests of their members. Labour unions use
strikes, go-slow etc to press for higher wages depending on the states of markets for their
employers products e.g. bankers unions will ask for wages when profits are high.

3. Ability to pay

If firms feel they are making less profit they will be reluctant to increase wages but if it is highly
successful it may choose to pay above the market rate to attract high caliber employees.

4. Productivity

Government sometimes can use computed productivity gains in the economy as guideline me to
settle wage disputes between management and unions. However, this method can present
problems as;
(a) There is no precise and accurate measure of productivity acceptable to all
(b) The computations are general averages over a long period of time and not yearly.

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 (c) The productivity gains are not achieved by all industries alike and at the same
time and rate.

5. Cost of living

Cost of living adjustment of wages is useful as a stopgap service in times of inflation when
labour to keep up with rise in prices but it has measurement problems in ascertaining cost of
living increases.

6. Government

The government influences wages and salary levels through minimum wage laws, budget
limitations on ministries and parastatals standard working hours per week for all firms,

Pay levels and pay structures

Organizations reward systems are guided by two types of policies based on the pay levels and
pay structures.

Pay Level: This refers to the total pay structure of an organization relative to that of other
organizations in the labour market. It can also be described as where a company’s pay structure
lies in relation to what other comparable companies pay for similar jobs.

Pay level is a reflection of an organization’s external consistency. External consistency or equity

refers to the degree to which an organization’s wages are competitive with those of competitors.
Salary surveys are normally used to determine pay levels.

Based on prevailing pay levels, an organizations makes a strategic decision to be a market

leader, match the market or lag (i.e. follow the market)

Activity: Why would an organization choose one pay level over another?

Pay Structure: This refers to an organization’s internal pay scale or grades for single jobs or a
group of jobs. This is achieved once the processes of job analysis and job evaluation are done.
Pay structures are designed to achieve internal consistency or equity. Internal consistency means
rewarding people in such a way there is a feeling of fairness and justice by differentiating
between high and low performance.

4.1.3 Equity and rewards

Employees must perceive that the compensation offered is fair and equitable.

Equity: is concerned with felt justice according to natural law or right.

Perception of equity is determined by;
• Ratio of compensation to one’s effort, education, training, experience,
endurance of adverse working conditions etc.

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 • Comparison of this ratio relative to those of others in same position.

In the workplace, employees compare themselves with their peers in terms of their
contribution to the organization and in relation to what they get from the organization.
They compare their ratio of inputs and outcomes with that of another person. (The
theory of equity was advanced by Stacy Adams in 1968 to explain motivation)

Inputs: refer to the contributions made by an individual e.g. effort – both physical and
mental, time, education, training, experience, loyalty, useful contacts age, gender etc..
Outcome: refers to what is received in return for effort e.g. salary, fringe benefits, travel
allowances, medical insurance cover, status symbols, autonomy, recognition, friendly
environment etc.

Examples of ratios of outcomes to inputs

(i) Outcomes of ‘A’ = Outcomes of ‘B Satisfaction

Inputs of ‘A’ Inputs of ‘B’ = (Equity)

(ii) Outcomes of ‘A’ < Outcomes of ‘B’ = Underpayment

Inputs of ‘A’ Inputs of ‘B’ (Inequity)

(iii) Outcomes of ‘A’ > Outcomes of ‘B’ = Overpayment

Inputs of ‘A’ Outcomes of ‘B’ (Inequity)

Reactions of ‘A’

 In situation (ii), ‘A’ will act on outcomes to restore equity i.e. where there is perception
of underpayment by stealing from the organization, taking kickbacks, undermining ‘B’,
joining trade unions or reducing effort.

 In (iii) ‘A’ will attempt to restore balance by decreasing or increasing effort, e.g. working
longer hours, producing quality work, being loyal and committed to organization etc, or
by rationalizing or justifying the higher outcomes on the basis of experience, educational
levels etc. (resorting to subjective distortion of ‘A’s or ‘B’s inputs).
 In situation (i), there is perception of equity, hence no problems.

note

• Equity is taken seriously by employees and management decisions and actions

must be seen to be fair.
• The striving to restore the outcome/input ratio to equity is used as the explanation
of work motivation.

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 • Workers prefer equitable payment to over-payment. Research has shown workers
on a piece rate system who felt overpaid reduced their productivity to restore
equity.
• Equity exists/or is perceived when a person perceives that ratio of outcomes to
input is in equilibrium, with respect to self and in relation to others, thus:
• Output = input = others

The consequences of dissatisfaction with compensation.

Dissatisfaction leads to efforts to reestablish equilibrium: This may take any of the following
ways:
• Corruption – stealing from organization
• Undermining those who are perceived to be unfairly better paid/rewarded
• Absenteeism (running private business)
• Promoting labour organizations/unions
• Quitting/leaving the organization
• Putting in less effort to work hence decreasing output.

To cope with possible feelings of inequity most organizations keep their salaries secret especially
of the executives and others not covered by union contracts.

Employees often underestimate the pay of executives and over estimate the pay of peers and
those below. Going public with salaries can cause lower performance and morale and strained
relationships between superiors and subordinates - unless of course the organization is able to
evaluate performance levels in an objective manner.

4.1.4 Strategic choices in compensation

Objectives
• State the strategic choices available to a firm in the area of rewards
• Explain how rewards can be used to achieve corporate strategy

Designing and implementing an effective compensation programme is a critical HR activity. The

creative use of compensation plans can maximize HR productivity and contribute significantly to
organizational performance. How best to pay people is a continous preoccupation of
management.

What are these strategic choices?

• Importance of external equity – management must decide how much to pay their
employees in respect to competitors. Should it lead, match or lag. This decision will form
the basis on which the rest of the compensation system is built.
• Link between compensation plan and organizations overall strategic plan – the plan
should reward desired behaviour that will lead to the overall organizations goals.

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 Rewarding managers for meeting short-term goals at the expense of long-term goals
indicates a reward system that is inconsistent with the overall strategy
• Merit pay raises or across the board raises – choosing to pay for performance comes with
the challenge of setting performance standards while choosing to pay across the board
presents the challenge of how to motivate and retain highly productive workers.
• Level of pay secrecy – should pay be an affair between an individual and the firm or
public? Secrecy is sometimes adopted to allow management freedom to make pay
decisions and keep pay dissatisfaction lower. Research has shown support for secrecy
• Importance of internal equity – basing pay structure on a job evaluation means taking a
strong stance on internal equity. Basing pay on the person on the job and not the job leads
to inequity.
• Mix of intrinsic rewards – this is important especially where monetary rewards are not
available or are restricted by legislation etc.

A successful compensation plan should be supported by organizational structures, designs and

management processes. Two major strategic initiatives that are commonly adopted by firms are
growth and downsizing. Each strategy would view pay differently.

Growth strategy – focuses on employee performance. Firms pay attention to external

competitiveness and equity. Total pay packages are oriented towards incentives driven by
recruitment needs.
Downsizing- firms following a downsizing strategy are concerned about overall costs, hence
non-monetary rewards would be used instead of monetary rewards. Firms would focus more on
internal issues for survival.

How can the problem of equity be solved?

4.1.5 Job evaluation

Equity is an important concept in compensation. Determination of basic compensation rates

requires a consistent and systematic procedure. The process for establishing basic pay is termed
as “job evaluation.”

Job evaluation is the process of measuring the inputs of employees i.e. skill, effort, experience,
education etc. required for minimum performance and to translate such measures into specific
monetary returns. (It is a systematic and orderly process of determining the worth of a job in
relation to others)

Objectives of job evaluation

• To determine the correct rate of pay.

• Obtain internal and external consistency in wages and salaries.
• Create satisfaction of pay between employer and employee.

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Prerequisites to job evaluation
• Clear and accurate job descriptions and specifications – must be available to provide data
on what to measure.
• Deciding which groups of employees and jobs to evaluate.
• Selling the idea of systematic evaluation to all participants.

Process of Job Evaluation

- Deciding who will do the evaluation
- Training the persons (usually a committee
- Selecting key jobs to represent a range of levels and functions.
- Analyzing jobs – descriptions and specifications
- Agreeing on importance of the elements and comparing with other jobs to
produce a ranking order.
- Noting levels of payment nationally and locally, then deciding on number of job
grades and the rate of payment for each grade.
- Agreeing structure, implementing and reviewing its application periodically.

The labour union representatives usually participate in job evaluations, which may be done by a
committee comprising management representatives and workers representatives. There are 4
main systems of job evaluation, which can be used;

Ranking systems:
- Simple, cheap and well known
- Judges the job as a whole based on a simple job description or title alone.
- Compares one job with another in order of importance e.g. responsibility
complexity or jobholders education or decisions making roles.

This method is popular with small firms or government departments.

Job Classification/Job Grading:

In the ranking system, there is no measure of values. In job grading a scale of values is
created with which jobs and their job descriptions can be compared.

Point system:
This system involves a more detailed quantitative and analytical approach to the
measurement of job worth. The factors usually considered are;
• Skill, experience, education, initiative and integrity
• Effort – physical, mental or visual
• Responsibility, material and people
• Job conditions – hazards etc

Factor comparison:
Similar to ranking but more complicated and expensive. Requires experts e.g.
consultants.

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Advantages of job evaluation

• It provides a systematic procedure for describing and placing a value on a job

• Job description can be employed in recruitment and selection
• People are paid for work performed and satisfaction derived leads to high morale
and cooperation
• Unions are involved in determining pay thus reducing disputes
• It is objective
• Produces logical pay structures
• Perceived to be fair as they are based on facts.

Disadvantages:

• Costly to install and maintain (the more complex types) – e.g. consultants fees
and management time and new pay structures.
• Not a universal panacea (solution). It is sensitive especially where trade unions
are involved – can create more problems that it can solve.
• Evaluations are usually a product of subjective judgments – not as objective
as wished.
• Evaluation schemes deteriorate as organization changes and as evaluators
become more skilled at manipulating the system. Sometimes unjustified
upgrading occurs and the pay structure is no longer equitable.

Job evaluation is concerned with establishing rational links between money and work.
- It is the cornerstone of salary administration.
- The establishment of equitable and competitive base pay will assist in attracting
personnel to the organization.

However, to motivate employees to continue working, the organization can vary compensation
depending on specified behaviour.

4.2 VARIABLE COMPENSATION:

At the end of this topic you should be able to:
• Explain the aims of variable pay
• Describe the types of incentive pay
• Explain the challenges associated with incentive pay

4.2.1 Aims of incentive pay

Variable compensation or reward is applied by organizations to achieve the objective of
motivating and retaining the personnel, while equitable base pay will assist an organization in
attracting personnel. Hence, rewards are used by organizations to achieve two objectives.

• To attract high caliber HR

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 • To motivate and retain HR

The objective of attracting is achieved by offering equitable and competitive basic pay and the
second is achieved by offering varying compensation, which is dependent upon specified
behaviour. Variable compensation links financial and non-financial rewards to individual or
group performance

Objectives of variable compensation.

• Motivate employees
• Increase the commitment of employees to the organization by encouraging them to
identify with its mission and values.
• Help to change the organization culture to one which is performance and results oriented
• Discriminate consistently and equitably on the distribution of rewards to employees
according to their contribution.
• Deliver a positive message about the performance expectations of the company
• Emphasize individual performance or teamwork as appropriate.
• Improve the recruitment and retention of high quality staff.

Disadvantages of Variable compensation

• It is difficult to measure individual performance objectively and subjectivity may lead to

unfair assessments.
• It can encourage people to focus only on those tasks that will earn them rewards quickly
and less concerned about quality and long term issues.
• People end up working for money only.
• Financial rewards may work for some and not others. (Expectancy theory)
• It can lead to pay rising faster than performance if the control systems are not strong
enough.

Rules for successful variable compensation

• Individuals need to be clear about the targets and standards of performance required.
• It should be possible for individuals to track their performance against those targets and
standards.
• They must be in a position to influence their performance by changing their behaviour or
decisions.
• They should be clear about the rewards they will receive for achieving the required end
results.
• The rewards should be meaningful enough to make the efforts required worthwhile.

Factors to consider before introducing variable pay.

• Organization culture – no universal basis for adoption of variable pay schemes. They
have to be matched with the culture and core values of the organization.

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 • Business strategy – variable pay must be linked with the business strategy of the
organization
• Qualitative and quantitative measures – these must be balanced.
• Flexibility – according to profits levels etc
• Avoid short term thinking/objectives – set both short term and long term goals

4.2.2 Schemes for administering variable pay for individual employees can fall under;

Merit Rating/Seniority Progression

Progress through the wage rates can be controlled by the organization by specifying that it
should be based on merit, seniority or both.
The advantages of a merit scheme are:
- Directly linked to performance and salary progression.
- Recognizes increasing competence gained through experience and
- Provides individualized progression rates.

Disadvantages:
- Dependent on the quality of appraisal which can be arbitrary, subjective or
inconsistent – especially when the appraisers are poorly trained.
- Can demotivate average employees who are still important to the organization.
- Create extra payroll costs
- Merit pay is a permanent increase in salary yet quality of future performance
might not justify it
- Being an increase on base salary it can increase unsustainable payroll costs.
- Merit pay may not discriminate properly between performers and non-performers.

Incentive plans for operatives

These are payments made to non-managerial employees in cases where performances above a
level taken as standard for job evaluation receives a reward – usually in the form of cash.
They are measured in number of items produced – output or time taken to do a certain amount of
work.

Incentive plans have disadvantages:

• Opposed by labour unions, as they desire solidarity and uniform compensation among
member on the same job.
• The rate buster i.e. the employee who produces in excess of the standard and ahead of
his colleagues is usually pressured to conform to the group or ostracized and isolated.
Theoretically, management should pay the rate buster more but it prefers not to have a
rate buster at all as he is a disruptive influence. Usually he would be transferred to
smooth relations.

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Example
An organization abandoned an incentive pay plan that rewarded a minority of the entire group.
Allocations were based on supervisor’s monthly appraisals and these were attached by both
employees and labour union as subjective. The effects of dropping the plan were:
• Poductivity dropped by 20%
• Turnover rate of top producers doubled
• Level of job satisfaction reduced
• Poorer producers liked their jobs better
• Supervisors turned to reprimands and threats of lay offs to raise productivity.

Activity: Why were the above reactions experienced?

Conclusions
• Mistakes are made when an excessively loose or tight standard is created. E.g. if
workers make 50% of regular earnings when only 20 –30% was intended or less.
• Inconsistencies in accuracy of standards e.g. easy and tough jobs;
• Jobs with small profit margins attract tighter rates.
• In departments where there is group cohesiveness there is more cheating on rates
• Strategic, isolated or dangerous jobs have looser rates.
• Few operatives make bonuses above the average level except rate busters.

NB: In most incentive schemes, the restriction of output sometimes happens because of the
power of social need to conform rather than monetary, although it works in structured and well
planned systems.

Incentive plans for managers

Executives have many incentive pay schemes designed in relation to income tax regulations.

(a) Cash bonuses based on profits

(b) Cash bonuses based on individual performance evaluation
(c) Offer of company stock at current prices

The above plans are geared towards stimulating more effective managerial behaviour for the
long-run benefit of the organization (market penetration, risk-taking, smooth administration etc).
Others are use of company cars, club membership etc.

Suggestion systems.

Rewarding suggestions which reduce workload, save time and costs etc is a method
organizations use to stimulate creative thinking among employees.

Problems:
- Resentment from supervisors

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 - Jealousy from fellow employees.
Group variable compensation
Groups can also be rewarded for their extra effort e.g.
- Group piece rate as in assembly lines
- Production sharing plans – which share in productivity gains.
- Profit sharing plans – normally involves all employees
- Employee stock ownership.

4.4 EMPLOYEE OR FRINGE BENEFITS

At the end of this topic you should be able to:
• Examine the importance of employee benefits and their purposes
• Discuss the factors that influence employee benefits

Employee benefits also known as fringe benefits are indirect forms of remuneration given in
addition to basic pay. They include paid time away form work such as coffee breaks, annual
leave, sick leave or maternity leave; life and health insurance; retirement income and employee
services such as transport, cafeterias, housing, day care etc.

4.3.1 Importance of employee benefits

 Motivate employees and increase their commitment to the organization

 Provide for actual or perceived needs of employees such as security; housing, company
cars etc
 Demonstrate that the company cares for the needs of employees
 Provide a tax efficient method of remuneration that reduces the tax burden on employees
Types

• Payment for annual leave, holidays, weekends, sick leave.

• Payment for hazards such as old age, death or injury
• Employee services e.g. housing, food, recreation, loans and medical services.
• Legal requirements e.g. social security and compensation for accidents insurance etc.

4.3.2 Factors that influence employee benefits

External influences

1) Government policies and regulations- these include wage controls on how much to pay
employees at maximum and minimum levels. If the government sets a maximum then
employers use benefits to compensate for the shortfall. Tax policies especially on
incomes can be prohibitive for high income earners hence employers would choose to
give a lower pay and give the rest through benefits.
( could this be why executives have very many benefits?)

2) Unions – they negotiate for benefits for their members through the collective bargaining
process. This normally includes: health, transport or housing.

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 3) Economic conditions- employers facing competitive pressure use benefits to either
reduce costs or attract and retain productive employees.

Internal influences

4) Organizational strategies and objectives- A large well-established employer in a

mature growth industry may offer generous benefits while a smaller, emerging firm in a
young industry may want to avoid or reduce fixed costs associated with benefits. The
strategy and objectives of an organization influences the type and amount of benefits
5) Employee preferences and demographics- it is difficult to know what employees prefer
if given a choice. Gender, race, age and class influence the type of benefits given. For
example high income employees prefer non-cash benefits while low income prefer cash.

Activities
• Using theories of motivation such as Maslow’s or Herzberg’s, in what ways can
employers use benefits to meet employees’ needs?
• Refer to an organization (s) you are familiar with and
- describe the types of benefits provided and
- the rationale for choosing those types of benefits
-end-

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