EMPLOYEE COMPENSATION

In exchange for job performance and commitment, an employer offers rewards to employees. Adequate rewards and compensations potentially attract a quality work force, maintain the satisfaction of existing employees, keep quality employees from leaving, and motivate them in the workplace. A proper design of reward and compensation systems requires careful review of the labor market, thorough analysis of jobs, and a systematic study of pay structures.

There are a number of ways of classifying rewards. A commonly discussed dichotomy is intrinsic versus extrinsic rewards. Intrinsic rewards are satisfactions one gets from the job itself, such as a feeling of achievement, responsibility, or autonomy. Extrinsic rewards include monetary compensation, promotion, and tangible benefits.

Compensation frequently refers to extrinsic, monetary rewards that employees receive in exchange for their work. Usually, compensation is composed of the base wage or salary, any incentives or bonuses, and other benefits. Base wage or salary is the hourly, weekly, or monthly pay that employees receive. Incentives or bonuses are rewards offered in addition to the base wage when employees achieve a high level of performance. Benefits are rewards offered for being a member of the company and can include paid vacation, health and life insurance, and retirement pension.

A company's compensation system must include policies, procedures, and rules that provide clear and unambiguous determination and administration of employee compensation. Otherwise, there can be confusion, diminished employee satisfaction, and potentially costly litigation.

DETERMINANTS OF COMPENSATION

Fair and adequate compensation is critical to motivating employees attracting high-potential employees, and retaining competent employees. Compensation has to be fair and equitable among all workers in the same company (internal equity). Internal equity can be achieved when pay is proportionate to the individual employee's qualifications and contributions to a company. On the other hand, compensation also has to be fair and equitable in comparison to the external market (external equity). If a company pays its employees below the market rate, it may lose competent employees. In determining adequate pay for employees, a manager must consider the three major factors: the labor market, the nature and scope of the job, and characteristics of the individual employee.

Potential employees are recruited from a certain geographic area—the labor market. The actual boundary of a labor market varies depending on the type of job, company, and industry. For example, an opening for a systems analyst at IBM may attract candidates from across the country, whereas a secretarial position at an elementary school may attract candidates only from the immediate local area of the school.

Pay for a job even within the same labor market may vary widely because of many factors, such as the industry, type of job, cost of living, and location of the job. Compensation managers must be aware of these differences. To help compensation managers understand the market rate of labor, a compensation survey is conducted. A compensation survey obtains data regarding what other firms pay for specific jobs or job classes in a given geographic market. Large companies periodically conduct compensation surveys and review their compensation system to assure external equity. There are professional organizations that conduct compensation surveys and provide their analysis to smaller companies for a fee.

Several factors are generally considered in evaluating the market rate of a job. They include the cost of living of the area, union contracts, and broader economic conditions. Urban or metropolitan areas generally have a higher cost of living than rural areas. Usually, in calculating the real pay, a cost-of-living allowance (COLA) is added to the base wage or salary. Cost-of-living indexes are published periodically in major business journals. During an economically depressed period, the labor supply usually exceeds the demand in the labor market, resulting in lower labor rates.

The characteristics of an individual employee are also important in determining compensation. An individual's job qualifications, abilities and skills, prior experiences, and even willingness to work in hardship conditions are determining factors. Within the reasonable range of a market rate, companies offer additional compensation to attract and retain competent employees.

In principle, compensation must be designed around the job, not the person. Person-based pay frequently

results in discriminatory practices, which violates Title VII of the Civil Rights Act, and job-based compensation is the employer's most powerful defense in court. For job-based compensation, management must conduct a systematic job analysis, identifying and describing what is happening on the job. Each job must be carefully examined to list the necessary tasks and actions, identify skills and abilities required, and establish desirable behaviors for successful completion of the job.

With complete and comprehensive data about all the jobs, job analysts must conduct systematic comparisons of them and determine their relative worth. Numerous techniques have been developed for the analysis of relative worth, including the simple point method, job classification method, job ranking method, and the factor comparison method.

Information resulting from the comprehensive job analysis will be used for establishing pay or wage grades. Assume that twenty-five jobs range from 10 to 50 points in their job scores based on the job point method. All twenty-five of these jobs are reviewed carefully for their relative worth and plotted on Figure 1. The x-axis represents job points and the ordinate (y-axis) represents relative worth or wage rates. Once a manager can identify fair and realistic wages of two or more jobs, desirably top and bottom ones, then all the rest can be prorated along the wage curve in the diagram.

In order to simplify the administration of a wage structure, similar jobs in the approximate cluster are grouped together into a class or grade for pay purpose. Figure 2 shows how twenty-five jobs are grouped into five pay grades. Employees move up in their pay within each grade, typically by seniority. Once a person hits the top pay in the grade, he or she can only increase the pay by moving to a higher grade. Under certain unusual circumstances, it is possible for an outstanding performer in a lower grade to be paid more than a person at the bottom of the next-highest level.

INNOVATIONS IN COMPENSATION SYSTEMS

As the market becomes more dynamic and competitive, companies are trying harder to improve performance. Since companies cannot afford to continually increase wages by a certain percentage, they are introducing many innovative compensation plans tied to performance. Several of these plans are discussed in this section.

Incentive Compensation Plan

Incentive compensation pays proportionately to employee performance. Incentives are typically given in addition to the base wage; they can be paid on the basis of individual, group, or plant-wide performance. While individual incentive plans encourage competition among employees, group or plant-wide incentive plans encourage cooperation and direct the efforts of all employees toward achieving overall company performance.

Skill-Based or Knowledge-Based Compensation

Skill-based pay is a system that pays employees based on the skills they possess or master, not for the job they hold. Some managers believe that mastery of certain sets of skills leads to higher productivity and therefore want their employees to master a series of skill sets. As employees gain one skill and then another, their wage rate goes up until they have mastered all the skills. Similar to skill-based pay is knowledge-based pay. While skill-based pay evolved in the manufacturing sector, pay-for-knowledge developed in the service sector (Henderson, 1997). For example, public school teachers with a bachelor's degree receive the lowest rate of pay, those with a master's degree receive a higher rate, and those with a doctorate receive the highest.

Team-Based Compensation

As many companies introduce team-based management practices such as self-managed work teams, they begin to offer team-based pay. Recognizing the importance of close cooperation and mutual development in a work group, companies want to encourage employees to work as a team by offering pay based on the overall effectiveness of the team.

Performance-Based Compensation

In the traditional sense, pay is considered entitlement that employees

deserve in exchange for showing up at work and doing well enough to avoid being fired. While base pay is given to employees regardless of performance, incentives and bonuses are extra rewards given in appreciation of their extra efforts. Pay-for-performance is a new movement away from this entitlement concept (Milkovich and Newman, 2005). A pay-for-performance plan increases even the base pay—so-called merit increases—to reflect how highly employees are rated on a performance evaluation. Other incentives and bonuses are calculated based on this new merit pay, resulting in substantially more total dollars for highly ranked employee performance. Frequently, employees also receive an end-of-year lump sum bonus that does not build into base pay.

EXECUTIVE COMPENSATION

Recently, people have been concerned with the excessively high level of executive compensation. According to Business Week's annual executive pay survey, in 1997 Sanford Weill, CEO of Travelers Group, collected $7.5 million in salary and bonuses plus $223.2 million for long-term compensation, totaling $230.7 million. In the same year, Roberto Goizueta, CEO of Coca-Cola, earned a total of $111.8 million, including annual salary, bonuses, and long-term compensation. Compensation for the twenty highest-paid executives ranged from $28.4 million to $230 million.

Frequently, executive compensation becomes controversial. Are these compensations excessive? What justifies such a large compensation for executives? Justification of such a large sum of compensation is linked to the company's performance. In fact, a significant portion of executive compensation results from exercising stock options, which were quite valuable in the recent bull market. Yet ordinary working-class Americans are outraged by the shocking contrast in pay raises: annual executive pay at large companies rose 54 percent in 1996, whereas the pay raises of most working-class people were in the 3 percent to 5 percent range during the same period.

An executive compensation package is typically composed of (1) base salary, (2) annual incentives or bonuses, (3) long-term incentives (e.g., stock options), (4) executive benefits (e.g., health insurance, life insurance, and pension plans), and (5) executive perquisites. Considering the high turnover rate of competent executives, offering a competitive salary is crucial in attracting the top candidates.

Frequently, annual bonuses play a more important role than base salary in executive compensations. They are primarily designed to motivate better performance. In order to underscore the importance of financial performance, usually measured by the company's stock price, top executives are offered stock options. Sometimes, exercising stock options yields more cash benefits to executives than do annual salaries.

In addition to monetary compensation, executives enjoy many different types of perquisites, commonly called perks. Such executive perks include the luxurious office with lush carpets, the executive dining room, special parking, use of a company airplane, company-paid membership in high-class country clubs and associations, and executive travel arrangements. Many companies even offer executives tax-free personal perks, including such things as free access to company property, free legal counseling, free home repairs and improvements, and expenses for vacation homes or boats.

Another perk that became popular recently is the socalled golden parachute—a protection plan for executives in the event that they are forced out of the organization. Such severance frequently results from a merger or hostile takeover of the company. The golden parachute provides either a significant one-time sum to the departing executive or a guaranteed executive position in the newly merged company.