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chapter 11. Compensation: Methods and Policies. Adequate. Equitable. Incentive-providing. A Compensation system should be: (* focus of this chapter). Cost-effective*. Acceptable to the employee*. Secure*. Balanced*.

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Compensation: Methods and Policies

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Compensation: Methods and Policies





A Compensation system should be:

(* focus of this chapter)


Acceptable to the employee*




To the individual employee, the most important compensation decision is how much he or she will earn.

determination of individual pay
Determination of Individual Pay

Three questions need to be addressed:

  • How should one employee be paid relative to another when they both hold the same job in the organization?
  • Should we pay all employees doing the same work at the same level the same?
  • If not, on what basis should we make the distinction?
pay differentials are based on
Pay differentials are based on:
  • Individual differences in experience, skills, and performance
  • Expectations that seniority, higher performance (or both) deserve higher pay
reasons for choosing to pay employees at different rates for the same job 1 of 3
Reasons for choosing to pay employees at different rates for the same job: (1 of 3)
  • Pay differentials allow firms to recognize that different employees performing the same job make substantially different contributions to meeting organizational goals
  • Differentials allow employers to communicate a changed emphasis on important job roles, skills, knowledge, etc.
reasons for choosing to pay employees at different rates for the same job 2 of 3
Reasons for choosing to pay employees at different rates for the same job: (2 of 3)
  • Differentials provide organizations with an important tool for emphasizing norms of enterprise without having employees change jobs (i.e., promotion)
  • Pay differentials allow firms to recognize market changes between jobs in the same grade without requiring a major overhaul of the whole compensation system
reasons for choosing to pay employees at different rates for the same job 3 of 3
Reasons for choosing to pay employees at different rates for the same job: (3 of 3)
  • Without differentials,
    • the pay system violates the internal equity norms of most employees,
    • reducing satisfaction with pay, and
    • making attraction and retention of employees more difficult
methods of payment
Methods of Payment

Flat Rates

Payment for Time Worked

Variable Pay: Incentive Compensation

payment for time worked
Payment for Time Worked
  • General, across-the-board increase for all employees
  • Merit increases paid to some employees
    • based on some indicator of job performance
  • Cost-of-living adjustment (COLA)
    • based on the consumer price index (CPI)
  • Seniority
variable pay
Variable Pay
  • Percentage of an employee’s paycheck is put at risk
  • If business goals are not met, the pay rate will not rise above the lower base salary
  • Annual raises are not guaranteed
  • Helps manage labor costs
  • Does not guarantee equitable treatment of employees
variable pay key design factors

Acceptance by


Support by






Variable Pay: Key Design Factors
types of variable pay
Types of Variable Pay

Individual Incentives

Group Incentives

Organization Incentives

individual variable pay
Individual Variable Pay
  • Merit incentives
  • Individual incentives
    • piecework
    • production bonuses
    • commissions
merit pay problems
Merit Pay Problems
  • Employees fail to make the connection between pay and performance
  • The secrecy of the reward is perceived by other employees as inequity
  • The size of the merit award has little effect on performance
individual incentives
Individual Incentives
  • Possible only in situations where performance can be specified in terms of output
    • e.g., sales dollars generated
    • e.g., number of items completed
  • Employees must work independently of each other so that individual incentives can be applied equitably
conditions for effective individual incentive plans
Conditions for Effective Individual Incentive Plans
  • The task is liked
  • The task is not boring
  • The supervisor reinforces and supports the system
  • The plan is acceptable to employees and managers
  • The incentive is financially sufficient to induce increased output
  • Quality of work is not especially important
  • Most delays in work are under the employees’ control
reasons to use team incentives
Reasons to Use Team Incentives
  • When it is difficult to measure individual output
  • When cooperation is needed to complete a task or project
  • When management feels this is a more appropriate measure on which to base incentives
organization wide incentives
Organization-wide Incentives
  • Usually based on one of two performance concepts:
    • A sharing of profits generated by all employees altogether
    • A sharing of money saved as a result of employees’ efforts to reduce costs
approaches to organization wide incentives





Profit Sharing

Approaches to Organization-wide Incentives
suggestion systems essential elements
Suggestion Systems: Essential Elements
  • Management commitment
  • Clear goals
  • Designated administrator
  • Structured award system
  • Regular publicity
  • Immediate response to each suggestion
gainsharing plans
Gainsharing Plans
  • Employees earn bonuses tied to unit-wide performance as measured by a predetermined, gainsharing formula
  • Commonly used gainsharing plans:
    • Lincoln Electric Plan
    • Scanlon Plan
    • Rucker Plan
    • ImproShare
key elements in designing a gainsharing plan
Key Elements in Designing a Gainsharing Plan
  • Strength of reinforcement
  • Productivity standards
  • Sharing the gains
  • Scope of the formula
  • Perceived fairness of the formula
  • Production variability
newer approaches to gainsharing
Newer Approaches to Gainsharing

Business Plan Gainsharing


Spot Gainsharing

typical profit sharing plans
Typical Profit Sharing Plans
  • Cash or current distribution plans provide full payment to participants soon after profits have been determined
  • Deferred plans credit a portion of current profits to employees’ accounts with cash payments made at the time of retirement, disability, severance, or death
  • A combination of both incorporates aspects of current and deferred options
  • Employee stock ownership plan (ESOP) – employees receive stock in the company
  • ESOPs are tax qualified
    • i.e., in return for meeting certain rules designed to protect the interests of plan participants, ESOP sponsors receive various tax benefits
  • ESOPs are defined contribution plans
    • the employers makes yearly contributions that accumulate to produce a benefit that is not defined in advance
people based pay


Based Pay



Feedback Pay


Based Pay

People-Based Pay
executive pay
Executive Pay

More likely to be based on comparative performance:

  • Compensation committees link CEO’s pay to returns to shareholders
  • Variable performance-based pay is emphasized over guarantees
  • CEOs are encouraged to invest in company stock
  • Performance yardsticks are linked to actual key productivity indices, to the competition, or to both
  • CEOs are held responsible for the cost of capital
issues in compensation administration
Issues in Compensation Administration

Pay Secrecy or Openness

Pay Security

Pay Compression

pay security plans



Benefits (SUB)


Annual Wage


Severance Pay

Cost of Living



Pay Security Plans
solutions to the problem of pay compression 1 of 2
Solutions to the Problem of Pay Compression (1 of 2)
  • Reexamining how many entry-level people are needed
  • Reassessing recruitment itself
  • Focusing on the job evaluation process, emphasizing performance instead of salary-grade assignment
  • Basing all salaries on longevity
solutions to the problem of pay compression 2 of 2
Solutions to the Problem of Pay Compression (2 of 2)
  • Giving first-line supervisors and other managers the authority to recommend equity adjustments for incumbents who have been unfairly victimized by pay compression
  • Limiting the hiring of new employees seeking excessive salaries
  • There is a growing realization that traditional pay systems do not effectively link pay to performance
  • The trend is toward a total compensation approach made up of base pay, variable pay, and benefits
  • Flexibility is an essential ingredient in any compensation plan and can be built using a variable pay approach