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Human Resource Management

Dr. Karim Kobeissi

Islamic University of Lebanon - 2014

Chapter 9: Direct Financial Compensation
Compensation: An Overview
Compensation is the total of all rewards provided to employees
in return for their services. The overall purposes of providing
compensation are to attract, retain, and motivate employees.
The three major types of compensation:
Direct financial compensation: Wages, salaries, bonuses, and
Indirect financial compensation (benefits): All other financial
rewards, such as health care insurance.
Nonfinancial compensation: Satisfaction from job itself or from
psychological and/or physical environment in which employee

The Components of Total Compensation Program
External Environment
Internal Environment
Indirect (Benefits)
Legally Required Benefits
Social Security
Unemployment Compensation
Workers Compensation

Discretionary Benefits
Payment for Time Not Worked
Health Care
Life Insurance
Retirement Plans
Disability Protection
Employee Stock Option Plans
Employee Services
Premium Pay

Voluntary Benefits
The Job
Meaningful and
Satisfying Job
Recognition for
Feeling of
Possibility of
Opportunity for
Growth and
Enjoy Doing the Job
Job Environment
Sound Policies
Capable Managers
Competent Employees
Congenial Coworkers
Appropriate Status
Working Conditions

Workplace Flexibility
Compressed Workweek
Job Sharing
Part-time Work
Financial Nonfinancial
Equi t y Theor y
Equity theory states that a persons motivation is in
proportion to the perceived fairness of the rewards he or
she receives for the amount of effort he or she exerts, and
that this is also compared with what others receive.
According to the theory, individuals are motivated to
reduce any perceived inequity and will strive to make the
ratios of outcomes to inputs equal. As such, equity is a
very important factor in compensation.

Eq u i t y i n F i n a n c i a l Co mp e n s a t i o n
Financial equity is the perception that there is fair pay for
employees. Firms and individuals view fairness from several
perspectives. Ideally, compensation will be fair to all parties
concerned and employees will perceive it as such. However,
this is a very vague goal.
External equity exists when a firms employees receive pay
comparable to workers who perform similar jobs in other
firms. Compensation surveys help organizations determine
the extent to which external equity is present.

E q u i t y i n F i n a n c i a l C o m p e n s a t i o n ( c o n )
Internal equity exists when employees receive pay
according to the relative value of their jobs within a
single organization.

Employee equity exists when individuals performing
similar jobs for the same firm receive pay according to
factors unique to the employee, such as performance
level or seniority.

Team equity is achieved when teams are rewarded
based on their productivity. However, achieving equity
may be a problem because not all team members
contribute equally to the outcomes.

Primary Determinants of Direct Financial Compensation
Compensation theory alone has never been able to
provide a completely satisfactory answer as to what
an individuals job is worth. Therefore, organizations
typically use a number of factors including the
organization, the labor market, the job, and the
employee to determine any given individuals financial

Primary Determinants of Direct Financial Compensation
Compensation Policies
Organizational Level
Ability to Pay
Labor Market
Compensation Surveys
Cost of Living
Labor Unions
Job Performance
Organization Membership
Political Influence

Direct Financial
Job Analysis
Job Descriptions
Job Evaluation
Organization as a Determinant of Direct Financial Compensation
Managers tend to view financial
compensation as both an expense and
an asset. It is an expense in the sense
that it reflects the cost of labor.
However, financial compensation is
clearly an asset when it helps recruit
good people and encourages them to
put forth their best efforts and to remain
in their jobs.

Compens at i on Pol i c i es
A compensation policy provides general
guidelines for making compensation decisions.
An organization often establishes compensation
policies that determine whether it will be a pay
leader, a pay follower, or strive for an average
position in the labor market (market rate).

Compensation Policies (con)
Pay leaders: Pay higher wages and salaries
to attract high-quality, productive employees
and thus achieve lower per-unit labor costs
Market rate, or going rate: Pay what most
employers pay for same job
Pay followers: Pay below market rate
because of firms poor financial condition or
belief that it does not require highly capable
Organizational Level
The organizational level in which compensation
decisions are made can also have an impact on
pay. Upper management often makes these
decisions to ensure consistency (evenness).
However, organizations are increasingly pushing
these decisions to lower levels in an effort to
retain top performers.

Ability to Pay
An organizations assessment
of its ability to pay is also an
important factor in
determining pay levels.
Financially successful firms
tend to provide higher-than-
average compensation.

Labor Market as Determinant of Direct Financial
Potential employees located within the geographic area from
which employees are recruited consist the labor market.
Labor markets for some jobs extend far beyond the location of
a firms operations. An aerospace firm in St. Louis, for example,
may be concerned about the labor market for engineers in Fort
Worth or Orlando, where competitors are located.
As global economics increasingly sets the cost of labor, the
global labor market grows in importance as a determinant of
financial compensation for individuals.

Compensation Surveys
A compensation survey is a
means of obtaining data regarding
what other firms are paying for
specific jobs or job classes within a
given labor market.
Virtually all compensation
professionals use compensation
surveys that are purchased,
outsourced to a consulting firm, or
conducted by the organization

Expediency (convenience)
Although standard compensation surveys
are generally useful, managers in highly
technical and specialized areas
occasionally need to use nontraditional
means to determine what constitutes
competitive compensation for scarce talent
and niche positions.
They need real-time information and must
rely on recruiters and hiring managers on
the front lines to let them know what is
happening in the job market.
Cost of Living
The logic for using cost of living as a
pay determinant is both simple and
sound: When prices rise over time and
pay does not, real pay is actually
A pay increase must be roughly
equivalent to the increased cost of
living (inflation rate) if a person is to
maintain his or her previous level of
real wages.

L a b o r U n i o n s
The National Labor Relations Act established
legislative support for the right of employees to
organize and engage in collective bargaining to
determine compensation. The areas of mandatory
collective bargaining between management and
unions are defined as wages, hours, and other terms
and conditions of employment.
Cost-of-living allowance has been disappearing.

The Economy
The economy affects
financial compensation
For example, a
depressed economy
generally increases the
labor supply, and this
serves to lower the
market rate. A booming
economy, on the other
hand, results in greater
competition for workers
and drives up the price of

Compensation Legislation
Federal and state laws can also affect the amount
of compensation a person receives ( minimum
wages, regulations for overtime pay, and
standards for child labor, etc).

Job as Determinant of Direct Financial Compensation
Job itself is a determinant factor, especially
in firms that have internal pay equity as
primary consideration.
Organizations pay for value they attach to
Other job-related factors, such as
working conditions
Job Analysis and Job Descriptions
BEFORE an organization can determine the relative
value of its jobs, it must first define their content.
This is done through job analysis. The primary by-
product of job analysis is the job description.

J o b Ev a l u a t i o n
Job evaluation is a process that determines the value of one job
in relation to another and to the company.
The primary purpose of job evaluation is to eliminate internal pay
The four traditional job evaluation methods are:
- Ranking
- Classification
- Factor comparison
- Point methods
Another option is to purchase a proprietary method such as the
Hay guide chart-profile.

Ranking Method
The ranking method is
the simplest method
Raters examine
description of each job
being evaluated and
arrange the jobs in
order according to their
value to the company.

Cl as s i f i c at i on Met hod
The classification method
involves defining a number of
classes or grades to describe
group of jobs.
Compare job description with
class description
Class description that most
closely agrees with job
description determines job

Factor Comparison Method
The factor comparison method assumes
that there are five universal job factors: -
- Mental requirements,
- Skills,
- Physical requirements,
- Responsibilities
- Working conditions.
The evaluator makes decisions on these
factors independently. An evaluation
committee creates a monetary scale,
containing each of the five universal
factors, and ranks jobs according to their
assessed value for each factor.

Point Method
In the point method, raters
assign numerical values to
specific job factors, such
as knowledge required,
and the sum of these
values provides a
quantitative assessment of
a jobs relative worth.

Hay Guide Chart-Profile Method
The Hay guide chart-profile method is a version of
the point method used by approximately 8,000 public-
and private-sector organizations worldwide to evaluate
clerical, trade, technical, professional, managerial, and
executive-level jobs.
It uses the factors of know-how, problem solving,
accountability, and other job-related elements.

Job Pricing
Job pricing results in placing a dollar value
on a job. It takes place after a job has been
evaluated and the relative value of each job
in the organization has been determined.
Firms often use pay grades and pay ranges
in the job-pricing process.

Scatter Diagram of Evaluated Jobs Illustrating Wage Curve, Pay
Grades, and Pay Ranges
100 200 300 400 500
Average Pay per Hour (Current Rates or Market Rates)
Evaluated Points
1 2 3 4 5 Pay Grades
Pay Ranges for
Pay Grades
0- 99 1 $12.00 $13.30 $ 14.60
100-199 2 13.30 14.60 15.90
200-299 3 14.60 15.90 17.20
300-399 4 15.90 17.20 18.50
400-500 5 17.20 18.50 19.80
Evaluated Points Pay Grade Minimum Midpoint Maximum
Pay Ranges
Minimum and maximum pay rate with
enough variance between to allow for
significant pay difference
Generally preferred over single pay
Need to develop a method to advance
individuals through the range

Pay Gr ades
A pay grade is the grouping of similar jobs to simplify pricing
jobs. For example, it is much more convenient for organizations
to price 15 pay grades than 200 separate jobs.
Similar to a universitys practice of grouping grades
Grades of 90100 are an A
Grades of 8089 are a B, etc.
Plotting jobs on a scatter diagram (disperse diagram)
Wage Curve
A wage curve is the fitting of
plotted points to create a smooth
progression between pay grades.
The line drawn minimizes the
distance between all dots and the
line. Although the line of best fit
may be straight or curved, a
straight line is often the result
when the point system is used.

Si n g l e Ra t e Sy s t e ms
Pay ranges are not appropriate for some workplace
conditions, such as assembly-line operations. For
instance, when all jobs within a unit are routine, with
little opportunity for employees to vary their
productivity, a single-rate system may be more
When single rates are used, everyone in the same job
receives the same base pay, regardless of

Adjusting Pay Rates
Good management practice is to correct pay inequities for
underpaid employees as rapidly as possible.
Overpaid jobs present a different problem. Promotion is a
possibility if the employee is qualified for a higher-rated
job and a job opening is available. Another possibility is to
freeze the rate until across-the-board pay increases bring
the job into line.
Bad idea to cut pay

Employee as Determinant of Direct Financial Compensation
In addition to the organization, the labor market, and the job itself,
factors related to the employee are also essential in
determining an individuals compensation. These factors

- Job performance (Performance-Based Pay)
- Skills
- Competencies
- Seniority
- Experience
- Potential
- Political influence
- Luck

Performance-Based Pay
The goal of performance-based pay is to
link pay and performance. It recognizes
that some workers are just better than
other workers at performing the same

Merit pay
Variable pay
Spot bonuses
M e r i t P a y
Merit pay is a pay increase added to employees base pay based on
their level of performance.
It has historically been merely a cost-of-living increase in disguise.
The recession of 2008-2010 may have created a compensation
revolution with regard to merit pay. Pay increases where everyone is
treated essentially the same, with only small differences between the
best performers and mediocre ones, are a thing of the past. Although
many companies continue with traditional merit pay plans, some
companies are starting to quietly freeze or cut pay for some so as to
be able to reward others.

Variable Pay (Bonuses)
Companies are increasingly placing a higher
percentage of their compensation budget in
variable pay as they embrace the concept of pay
for performance. The most common type of
variable pay for performance is the bonus, a
one-time annual financial award based on
productivity that is not added to base pay.
Use of bonuses is a winwin situation.
Spot Bonuses
Spot bonuses are relatively small monetary gifts
provided to employees for outstanding work or effort
during a reasonably short period of time.
If an employees performance has been exceptional,
the employer may reward the worker with a one-time
bonus ranging from $100 or $500 to perhaps as
much as $5,000.
According to a World at Work Survey, 45 percent of
companies use spot bonuses.

Piecework is an incentive pay plan in which employees are
paid for each unit they produce.
For example, if a worker is paid $8 a unit and produces 10 units
a day, the worker earns $80.
Sometimes a guaranteed base is included in a piece-rate plan,
meaning that a worker would receive this base amount no
matter what the output. Piecework is especially prevalent in the
production/operations area.

Skill-Based Pay
Skill-based pay is a system that compensates employees for
their job-related skills and knowledge, rather than the present
The system assumes that employees who know more are more
valuable to the firm and, therefore, they deserve a reward for
their efforts to acquire new skills.
This presents some challenges for management because the
firm must provide adequate training opportunities or else the
system can become de-motivating.
Co mp e t e n c y - Ba s e d Pa y
Competency-based pay is a compensation plan that
rewards employees for the capabilities they attain. It is a
type of skill-based pay plan for professional and managerial
employees. Today, there are many alternatives from which
to choosecore, organizational, behavioral, and technical
This approach requires that considerable time be spent
determining the specific competencies needed for the
different jobs. Blocks of competencies are then priced.

Other Determinants of Pay
Seniority: Length of time an employee has been
with the company
Experience: Has a significant impact on
Potential: Used to attract prospective talent
Political influence: May affect pay and
promotion decisions
Luck: Being in the right place at the right time

Salary Compression: Why Is the New Guy Making What
I Am Making?
Salary compression occurs when less experienced
employees are paid as much as or more than long-
time employees due to a gradual increase in starting
salaries and limited salary adjustment for long-term
As workers discover inequities in their pay, anger and
lower productivity may follow.

T e a m- Ba s e d Pa y
Changing a firms compensation structure from an
individual-based system to one that involves team-based
pay can improve efficiency, productivity, and profitability.
Team incentives have both advantages and
On the positive side, firms find it easier to develop
performance standards for groups than for individuals.
A potential disadvantage for team incentives is that
exemplary performers may feel unrecognized and under-
Company-Wide Pay
In sports, you do not judge the team based on one player, but
on its overall winloss record.
In business, company-wide pay plans based on the firms:
- Profit sharing
- Gain sharing
- Scanlon plan
Offer a possible alternative to the incentive plans previously

Profit Sharing
Profit sharing is a compensation plan that results in
the distribution of a predetermined percentage of the
firms profits to employees.
Normally, most full-time employees are included in a
companys profit-sharing plan after a specified waiting

Gain sharing
Gain sharing plans are designed to link
employees to the firms productivity and to
provide an incentive payment based on
improved company performance.
The goal of gain sharing is improving efficiency,
reducing costs, and improving profitability.
Gain sharing helps align employees with the
organizations strategy.

Sc anl on Pl an
The Scanlon plan provides a financial
reward to employees for savings in labor
costs resulting from their suggestions.
If the company is able to reduce payroll costs
through increased operating efficiency, it
shares the savings with its employees.

Pr o f e s s i o n a l Co mp e n s a t i o n
Professional employees perform work requiring advanced
knowledge in a field, normally acquired through an extended
course of specialized instruction.
Their pay, initially, is for the knowledge they bring to the
organization. Gradually, however, some of this knowledge
becomes obsolete.
Maturity curves are used to reflect the relationship between
professional compensation and years of experience. These
curves are used primarily to establish rates of pay for scientists
and engineers involved in technical work.

Sales Representative Compensation
The straight salary approach is one
extreme in sales compensation. In this
method, salespersons receive a fixed salary
regardless of their sales levels.
At the other extreme is straight
commission, in which the salespersons
pay is entirely determined as a percentage
of sales. If the salesperson working on
straight commission makes no sales, this
salesperson receives no pay.
Between these extremes are endless
varieties of part-salary, part-commission

Contingent Worker Compensation
Contingent workers are employed
through an employment agency or on an
on-call basis and often earn less than
traditional, permanent employees.
Flexibility and lower costs for the
employer are key reasons for the
increased use of contingent workers.
In most cases, contingents earn less pay
and are far less likely to receive health or
retirement benefits than their permanent

Ex e c u t i v e Co mp e n s a t i o n
The pay gap between the most affluent executives and the
average worker has become enormous. It is difficult for workers
who make $12 to $18 an hour to appreciate why these
executives are making such outrageous salaries.
On the other hand, the skills possessed by executives largely
determine whether a firm will survive or fail. Thus, a companys
program for compensating executives is a critical factor in
attracting and retaining the best available talent.
Organizations typically tie salary growth for executives to
market rates and overall corporate performance, including the
firms market value.

Types of Executive Compensation
The basic elements of executive compensation:
Base salary
Bonuses and performance-based pay
Stock option plans
Perquisites (perks)
Bas e Sal ar y
Although it may not represent the largest portion of the
executives compensation package, the base salary
provided is obviously important.
It is a factor in determining the executives standard of
living and may also determine the amount of bonuses
and certain benefits.
U.S. tax law does not allow companies to deduct more
than $1 million of executives salary.

Bonuses and Performance-Based Pay
As shareholders become increasingly
disappointed with high levels of executive
compensation for insignificant
accomplishments, performance-based pay
is gaining in popularity.
This shift reflects a belief that cash bonuses,
based only on achieving meaningful
performance goals, can provide real
incentives to senior level employees.

Stock Option Plans
Stock option plans give executives the
option to buy a specified amount of stock in
the future at or below the current market
The stock option is a long-term incentive
designed to integrate the interests of
management (executives) with those of the
Per qui s i t es
Perquisites (or perks) are any special benefits
provided by a firm to a small group of key executives
and designed to give the executives something
Perks might include a company car, limousine service,
and use of company plane or yacht.
In 2007, the Securities and Exchange Commission
lowered the threshold for disclosure of executive perks
from $50,000 to $10,000.
Golden Parachute Contract
A golden parachute contract protects
executives in the event that another
company acquires their firm or the
executive is forced to leave the firm.
Golden parachute contracts and
severance (separation) agreements
are negotiated prior to executives
being hired.
Executive Severance Pay
Excessive severance
has slowed considerably,
and executives are
walking away with much
less severance pay.
Clawback Contract Provision
The contract terms allows company to
recover compensation if subsequent review
indicates that payments were not calculated
accurately or performance goals were not
70% of country's 100 largest companies
have implemented clawback provisions.