Reading: Lesson 4 - Compensation Planning

12.4.A - Compensation Planning

1. COMPENSATION PLANS

1. One of the important reasons people work is to earn money. But money is just one benefit that employees receive for their labor. Other benefits include such things as paid vacations, company-sponsored insurance, health and wellness programs, on-site day care, and employee assistance programs. The pay and other benefits employees receive in exchange for their labor are called compensation. The method used to determine the pay component can be an important factor in attracting employees to the company, motivating them to give their best efforts, and retaining good employees. Therefore, the compensation system must pay employees fairly, in a way that encourages them to work effectively for the company while using the company’s resources efficiently. Many factors affect the amount of pay an employee receives. These include the skill required for the job, the work conditions, the amount of education and experience the person has, the supply and demand for that type of work, and economic conditions.
   
2. A wage is pay based on an hourly rate or the completion of a specified amount of work. Salary is a fixed amount of pay made on a regular schedule, usually weekly, semiweekly, or monthly. Salaries are most often paid to executives, supervisors, professionals, and others who do not work on a fixed schedule of hours each day or week. Companies develop compensation plans to specify how employees will be paid. A compensation plan is a system of policies and procedures for calculating the wages and salaries in an organization. Because businesses vary a great deal in terms of the type of work completed and the qualifications of their employees, different methods are used to determine how employees are paid. Under some plans, employees with the same qualifications and experience are paid the same no matter what tasks they perform or whether one is more productive than another. Other systems determine pay levels by the type of work, the amount produced, or the quality of the work. Commonly used compensation plans are based on time, performance, or a combination.
   
3. The most common payment method is a time plan, which pays a certain amount for a specified period of time worked. Wages are typically a time-based plan. For example, an employee might earn $14.50 per hour. A salary is also based on time worked. For example, a company may pay an employee a salary of $3,800 per month, whereas another company may set an employee’s salary at $51,000 per year. In either case, the employee receives a regular paycheck, often on a semiweekly or monthly basis, with the payment based on the time worked and the wage or salary rate established for that person or job. Time plans are easy to administer because pay is based directly on the amount of time worked. However, time plans do not financially reward employees who provide extra effort or do outstanding work. Changes in the total compensation paid by the business can be made by scheduling employees for fewer or more hours and by adjusting wage and salary rates. Employees are neither rewarded nor penalized with compensation based on their efforts. The only way to earn more money is to work additional time periods if available. If the hours of work are reduced through no fault of the employee, compensation is reduced as well.
   
4. Two types of plans pay employees for the amount of work they produce. A commission plan pays employees a percentage of the volume of sales for which they are responsible. For example, a salesperson may earn a commission of 5 percent of new total sales. If the salesperson makes sales worth $25,000 during one week, he or she would earn $1,250 that week. The commission system provides an incentive to employees because their efforts directly determine their pay. Also, the business can control the relationship between compensation and costs because pay relates directly to the amount of sales. A negative result of the commission plan is that it encourages the salesperson to concentrate on activities that lead to the largest commissions. A salesperson may try to sell products a customer doesn’t need, may concentrate on larger sales opportunities while ignoring smaller but important opportunities, and may not attend to other responsibilities, such as training, that detract from selling time. A similar type of performance pay system is the piece-rate plan. The piece-rate plan pays the employee a fixed rate for each unit produced. An individual employee’s pay is based solely on the amount of work the employee produces. For example, if an employee earns 30 cents for each unit and produces 500 units in a day, the employee earns $150 for the day.
   
5. Although piece-rate plans were first used in factories to encourage employees to increase production, companies also pay other types of employees on the basis of units of work completed. They may pay billing clerks based on the number of invoices processed, data-entry personnel according to the number of lines of copy entered, order pickers based on the number of items they pull from inventory to fill orders, and market researchers based on the number of phone interviews they complete. Well-designed pay plans based on productivity usually result in increased performance, at least in the short run. However, performance plans can make it difficult for new employees to earn a reasonable amount because they are inexperienced and cannot work as efficiently as experienced workers. Performance plans may inadvertently encourage experienced employees to find shortcuts to increase their production, resulting in quality or safety problems. Performance plans are a bit more difficult to control than other compensation plans. It is difficult to predict the quantity of work that one employee or a group of employees can actually complete when their goal is to increase the amount of pay they will earn. Production may increase to a much higher level than expected, resulting in more products than can be sold. Too much production leads to time periods when workers will be idle, without work. But if a company tries to limit the level of production or cut the piece rate to hold down costs, employees will be upset. Some companies are developing innovative ways to compensate performance on specific, short-term projects that motivate employees while not adding greatly to the organization’s costs. The reward is often in the form of a product or service the employee values rather than a direct wage or salary payment. Under one such plan, managers reward employees who have performed well or have accomplished a specific, challenging goal. When an individual or a work team achieves the established goal, the manager provides rewards such as event tickets, gift certificates, or some other reward that is meaningful to the employees in recognition of their efforts.
   
6. To get the advantages of various types of pay systems, some companies use combination plans. A combination plan is a pay plan that provides each employee a base wage or salary and adds incentive pay based on performance. Such a plan assures the employee a specified amount of money but allows the person to earn an additional amount based on work results. It is particularly effective for jobs that require a number of activities that do not directly result in increased production or sales. Some companies provide the incentive based on the performance of a work team or group, rather than on the individual’s performance, in order to encourage cooperation and group effort. A variation of the combination plan is the use of bonuses. A bonus is money paid at the end of a specific period of time (often 3, 6, or 12 months) for performance that exceeds the expected standard for that period. Bonuses relate employee rewards to achievement of important department or company goals or to the overall organizational performance for the time period. If the work unit or company does well, employees share in the financial success. The bonus system is used to encourage employees to focus on long-term performance rather than on day-to-day efforts only. It also encourages them to consider the overall success of the business and how their individual job and the work of their department contribute to that success. To receive a bonus, each person in the department and organization must do well.
   

2. FACTORS AFFECTING PAY LEVELS

1. Determining the compensation plan and the total amount of wages and salaries to be paid is an important business decision. In addition to the type of pay plan, companies consider other factors when determining wages and salaries. For example, employees who bring more skills to the position may be more valuable to the company and therefore receive greater pay than other employees in the same job role. Also, some jobs may be more important to the company than others, justifying greater pay. The company may pay more for greater experience or more years worked for the company. The supply and demand for that type of labor, current economic conditions, and the prevailing wage rates in the community and the industry also affect the rate of pay. Companies may choose to provide a range of employee benefits as an alternative to high wages. Finally, federal and state labor laws affect employee pay.
   
2. Human resources departments are usually charged with developing and maintaining a company’s compensation system. Because employee compensation is often one of the largest expenses of a company, it is important that the total compensation paid is consistent with the revenue earned by the business. If compensation costs are too high, the company will be unable to earn a profit. On the other hand, if wages and salaries are too low, the company will be unable to attract employees with the skills required to perform the company’s work. In either case, the company will be at a competitive disadvantage. Usually human resources departments of large companies employ economists and other specialists to develop pay plans and to determine the total amount of money that should be spent on employee compensation, including benefits. Smaller companies usually attempt to compare the wages and salaries they offer to those offered by competitors to avoid losing valuable employees to other companies as a result of low wages. Compensation plans are reviewed frequently to determine whether they are accomplishing the goals for which they were established, to make sure that they are fair to various categories of employees, and to evaluate the total amount of compensation in relation to the company’s financial performance. Changing a total compensation plan or even parts of the plan is a very difficult task but must be done periodically. Before changing the plan, human resources needs the approval of executives and should involve employee groups in reviewing proposed changes and determining the effects of the changes on employees. The actual changes, the reasons for the changes, and the effects of the changes on compensation should be carefully explained to employees. Employees should be given time to adjust to the changes, especially if the changes may result in a lower level of pay or fluctuations in the amount the employee earns from pay period to pay period.
   
3. Employers must be sure that compensation plans meet all federal and state laws. Laws rarely identify the amount that must be paid to any employee. One exception is minimum wage laws. However, many laws mandate that employers not discriminate in the way compensation is determined.
   
4. A minimum wage law specifies that it is illegal for employers to pay less than a specified wage rate to any employee. Minimum wage laws have been developed as both social and economic policies in many countries. They suggest that workers should not be exploited by employers and that the country wants its citizens to receive at least a minimum level of financial resources for their work. Most businesses and jobs are covered by minimum wage laws, but there are some exceptions. The United States first established a federal minimum wage in the 1930s. At that time, the minimum hourly rate was set at $.25. It has been increased periodically, usually after significant political debate. In 2009, the federal minimum wage rate was raised to $7.25. Most states have established minimum wage rates that apply to businesses in those states not covered by the federal minimum wage. Five states do not have their own minimum wage. Most states have established a higher minimum wage than the federal level. Ten states link their minimum wage rates to a consumer price index, resulting in small increases in most years. The Figure below shows the minimum wage for states and various U.S. territories. 
   

   
   

5. Employers must also follow laws establishing fair levels of compensation. One category of compensation law deals with equal compensation. Under these laws, employers must pay equal wages to workers who perform jobs that require substantially equal skill, effort, and responsibility and are performed under similar working conditions within the same business. It is legal to have compensation differences based on seniority, merit, or the quantity or quality of production. It is always illegal to use compensation plans that result in unfair differences in compensation levels based on race, ethnicity, religion, gender, national origin, age, marital status, or disability. 
   

6. Businesses are influenced by their competitors when establishing pay rates. Prospective employees will often consider several businesses when deciding on a job and will be attracted to those that offer the best combination of compensation, benefits, working conditions, and opportunities for advancement. Therefore, businesses must offer compensation that is competitive with other businesses offering similar jobs. Some employers have shown that by offering higher wages and benefits, they can attract employees who are more productive and loyal. If compensation levels are much higher than those of competitors, it may be difficult for a company to maintain profitability.
   

7. As businesses respond to more international competition, it is no longer possible to compare compensation levels only with those of competitors in the same state or country. U.S. businesses do compete with companies in countries that have much lower wage rates. As a result, some companies have relocated operations to those lower-wage countries. For example, a recent comparison of wage rates of several countries by the U.S. Bureau of Labor Statistics reported the average hourly wage for U.S. manufacturing employees was $35.53. The average rate was $47.38 in Germany, $18.91 in Korea, $6.48 in Mexico, and $1.74 in China. There are also differences in the productivity of and training costs for workers from various countries. Some companies that moved operations to other countries expecting great savings in labor costs have found that other costs, such as shipping and tariffs, are higher than expected.