Compensation 101 – The Essentials

Certainly there are differences of opinion among human resources professionals about what is “essential” in a pay program, and certainly trends come and go, but common sense and decades of experience and observation will lead most practitioners (well, those without a lot of money invested in an alternative product they are trying to sell you)  to conclude that there are three components that are essential to an effective compensation management system:

  • an internal equity, or “job evaluation” process
  • a tie to the market through the use of competitive data
  • pay for individuals tied to the performance of their job duties

It is fair to also address up front some of the misunderstandings and misconceptions related to pay:

  • Using surveys only tackles part of the issue.  Market data does no good for jobs that don’t appear in surveys, or for jobs that are different than the surveys.  Market data is only as good as the people who conduct and complete the surveys, and frankly, a lot of it has little to no actual value.  Many of the survey products on the market today that are touted as end-all solutions aren’t surveys at all, but computer models of what pay “should” be.
  • Giving “across-the-board” increases (e.g., everyone gets 3%) is a bad idea, and it isn’t fair.  Even if it was fair that everyone get the same increase, it presupposes that everyone was paid the right way before the increase.  These types of increases lock employees into the position that they were hired, does not reflect the reality of the labor market and do not fairly reward performance.
  • Step increases, and seniority-based pay programs, are fundamentally unfair.  First, they don’t reflect reality — people do not grow at the same rate, and some never grow. Second, seniority doesn’t guarantee higher levels of performance, it only gives you more time to show how you perform.  While there are aspects of seniority that provide value to employers, they pale compared to actual observed performance on the job. What these types of programs actually do is to make pay management easier — not better.
  • An organization should never have to pay more to a new employee than a good performer who is already in the organization — this isn’t “just something that is always going to happen” — its a prime characteristic of poorly managed pay.
  • The right way to deal with a job with two different sets of responsibilities is NOT to average the market rates for the two different jobs.  Here’s a hard fact about how the labor market works; you have to pay for a skill set 365 days a year, even if you only use it 10 days a year.
  • Adjusting pay to reflect the “cost of living” is both costly and ineffective.  While it may seem “fair,” since the beginning of recorded statistics, the cost of labor has always lagged the cost of living.  Why?  It’s very simple — organizations just can’t raise prices every time the BLS puts out its monthly guesstimate of the cost of new housing and appliances.
  • Managing pay the right way is not complicated or expensive, and neither is managing performance.  It just requires actual management.

It should come as little surprise that many if not most pay programs fall victim to one or more of the characteristics listed above.  If those are misconceptions, that what is the optimal solution, and why?

The first essential step, before looking at program design, is establishing a compensation philosophy.  A philosophy is a statement, similar to a mission statement, that clearly sets the position of the organization — how it is going to determine what to pay, what market it intends to compete with, and what position it plans to take to that market.  A well written compensation philosophy, which should be “Board-approved” can serve as a test for every proposed compensation program.

With a philosophy established, the pro-active organization will do the following:

  • use a job evaluation process to create internal equity, ensuring that jobs of similar value to the organization have similar pay opportunities;
  • use relevant and appropriate labor market data to establish pay ranges for each of the pay grades developed using job evaluation; and
  • ensure that each employee in a job is paid in the appropriate part of the pay range for their performance.

Internal Equity

Simply put, “internal equity” is achieved when an organization pays its employees based on their ability to contribute to the success of the organization.  Internal equity is achieved when the pay opportunities for individuals in jobs are linked to the importance of the job internally, rather than how the outside world values a job.

Internal equity is typically achieved through the use of a process called job evaluation. While there are different methods, what they all share is the idea that various characteristics of jobs can be assessed in an objective way — the sum of the various characteristics becomes the overall value.  This is the part the critics may say is “too expensive,” or “too complex,” both of which are simply false.  Most of these critics sell salary survey software.  The truth is that an internally administered job evaluation program will solve some of the biggest problems an organization faces when it comes to pay, such as:

  • How do we determine how to pay jobs that don’t appear in surveys?  Well, you may not know how others value the job, but you will know how YOU do.
  • What do we do with jobs with added levels of responsibility, or which have unusual combinations of duties?  You can’t just add an arbitrary percent to a market rate (frankly, because any attempt to do this is completely arbitrary).  You also shouldn’t fall into “averaging” trap mentioned above, because it doesn’t work.
  • How do we know how to pay an RN vs. an accountant, or an IT Technician vs. an MA? When you try to just hold them up against each other, you really can’t decide, but if you break the job into its elements or characteristics, its actually very simple.  Again, simply put, jobs can have the same overall value for different reasons.

While it does take a little time and effort at the start, once a job evaluation program is in place, it is easy to determine how to pay for new jobs, or what to do if a job is changed.

External Competitiveness

For all its effectiveness, job evaluation does not put the final price tag on a job.  For that, and to ensure an organization is competitive, it is necessary to link the internal values to the external market.  With the plethora of data out there, organizations need to identify which sources of data will give them the information they need.  Surveys should be from reputable publishers with no stake in the data, that is, nothing from recruiters, unions or educational institutions.  Don’t use salary.com or similar “modeling” systems, or use internet “surveys” that rely on self-reported data from participants.

Key things to consider when looking at market data sources include:

  • Is the data for a geographic area relevant for the organization?  Pay for a job where employees are typically hired locally should be set based on local data whenever possible.
  • Will the data capture all the relevant competition from the industries in which employees can work.  While some jobs are “industry-specific,” people in accounting, HR, IT and many other functions can work anywhere.  Only looking at your own industry ignores all the other opportunities a current or prospective employee has.
  • Are the right types of employers (by size or scope) being considered?  The amount any organization can pay is limited by its resources.  The complexity of jobs is also tied to the size of the organization.  The job of a “controller” at a small organization with no other accounting staff is completely different than a controller at a Fortune 500 company with a department of hundreds.

It is better to only have a few good sources than a large number of sources of dubious validity.  What is necessary is to have enough data on enough jobs to effectively tie the internal structure to the outside market.

Individual Pay Decisions

People want to be paid what they are worth.  Actually, they want to be paid based on what they feel they are worth, which is often something entirely different from reality. However, most performance appraisal processes are ineffective at measuring an individual employee’s actual contribution, and many are used simply to generate some sort of percentage increase.  The reality is that what an employee made last year is completely irrelevant to what he or she is worth this year – and that is the mistake far too many employers make.

It is so simple and so common sense, but I guess it needs to be stated.  We hire employees to do a job, and we should pay them based on how well they do it.  Take the job description, figure out how much of it they employee can do the way you want it done, tie that to a part of the pay range, and pay the employee whatever that is.  It doesn’t matter what the percentage increase is.  The organization has identified the price tag for that employee, and it is the same price tag as the labor market puts.  Other employers won’t care how much of a percentage increase it is — they just want to know what the cost will be.

– – – – – – – –

It sounds like a lot.  It isn’t.  Like most anything else, setting something up right in the first place makes subsequent decisions much easier.  In an existing organization, the process is exactly the same — it just takes more time to implement.  For more information, or for a copy of Merces’ guide to our approach to compensation program design, contact Ed Ura at 248-507-4670 or ebura@mercesconsulting.com

 

About Edmund B. Ura

Edmund B. Ura, MAIR, JD, works with governing boards, executives and human resources staff to develop methodologies for ensuring fair and equitable compensation programs that support achievement of organizations' missions. Contact Ed at ebura@mercesconsulting.com.
This entry was posted in Compensation, Competitive Data, Performance Management. Bookmark the permalink.

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