Mention Compensation to most HR Generalists and the usual reaction is either an inadvertent shudder or a blank stare. Compensation may be the least understood specialty within the Human Resources function. My goal in this article is to try to demystify some of Compensation practices and to provide a framework for establishing a Compensation structure for a company that does not currently have one or would like to revise an existing one.
Why do companies engage in these activities? What is so important about making sure employees are paid appropriately or are placed within the proper grade within their salary structure? One reason is retention. Having some type of evaluation method for your jobs, either internal or external, will help you provide answers when your employees come to you and state that they are not being paid fairly. Another factor is a need to attract good applicants. It is difficult to bring in qualified candidates if your wages do not accurately reflect the market.
A final reason would be financial. If you base your compensation decisions primarily on the external market, having an analysis run against the labor market on an annual basis could help the company address overall labor costs. Suppose the company has a philosophy that it will pay at the 50th percentile of the market, but discovers that they are, in fact paying at the 75th percentile. In that case, the company might reduce their merit increase budget or take other steps to insure that their costs are in line with their overall philosophy.
A Compensation Philosophy
The initial step should be to establish an overall Compensation philosophy, which sounds difficult but is really pretty simple. Start by deciding what is of greater importance, comparing your jobs against other jobs internally or against other jobs in the market. When trying to decide whether to compare your jobs against the internal or external markets, you should consider several factors including your company's business strategy, the competition for labor, and the need for jobs of equal worth to the company to be paid a similar wage.
If you are going to be comparing your jobs internally, you will need to find choose a method to rank the jobs in terms of importance. There are various ways to do this, either by looking at the entire job and determining its importance within the company or by breaking a job into smaller components and applying some point value to each. This is commonly referred to as a point factor approach and can include components such as level of responsibility, independent judgment, or impact of decisions. For many years, point factor plans were the accepted standard for determining the amount a position should be paid but grew out of favor as increased competition in labor markets forced companies to examine what their competitors were paying their employees.
Comparing your company's positions against the external market, called market pricing, is a much more prevalent practice than comparing jobs solely internally. When a company begins to use market pricing, one of the first questions they should ask is where do I want to pay relative to the other companies? Most companies will target the 50th percentile, or market median, of the labor market. This means that half the companies will pay more for that particular job and half will pay less. This is not a reflection on the company that it only wants average performers or average pay; rather it is a statement that, on the aggregate, the company wants to pay a wage that is competitive with the market.
A company may choose to vary from the 50th percentile for a number of reasons. A company could target pay below the 50th percentile if they have an aggressive benefits plan or if they have an incentive plan that pays out above average bonuses. A company could pay above the 50th percentile if they are having trouble attracting candidates due to increased competition or problems within their industry. A company could also decide to have targeted pay above the 50th percentile for a particular job or function. A good example of this occurred in the late 1990s with IT employees where, by a combination of a tight labor market and an increased demand, the Compensation for IT employees skyrocketed so fast no survey could keep up with it.
Finding the Appropriate Market
Once a company determines how they would like to pay their employees compared to the market, they then need to determine what the appropriate market is for each job. The three most common bases for choosing one are location, industry and size of firm.
Different jobs draw from different labor markets and the compensation data used to price them should reflect the appropriate market. For a senior or middle level manager, a company is more likely to recruit nationally to draw from a wider pool of candidates, so using national data would be more appropriate. When recruiting for most professional or non-exempt jobs, the labor market is usually the local region, so using the data for the metropolitan area would be most accurate. If a job is specific to a particular industry (for example a reporter or a pilot), then using data for that industry is appropriate. A company might use the size of firm as the basis for pricing when performing a market analysis on executive or management level positions. After all, one would expect the salary of a CFO of a global manufacturer to be much higher than a CFO for a small single location manufacturer, even if they happen to be in the same geographic area and a similar industry.
One thing to keep in mind is that it is often good practice to keep both the internal and external markets in mind when trying to determine an appropriate pay for a job. Compensation sometimes is as much an art as a science and balancing the pressures from both the labor market and the value a company places on a job can be tricky. The best way to balance these competing influences is to have the Compensation person meet with their HR Partner, address the issues and try to craft a solution that best meets the company's objectives.
Adjusting the Data
Once you have determined where you want to pay your employees and which data to use, then you have to age the data to a specific date. One of the negatives of a market pricing strategy is that it will always be reactive, that is, you are taking data effective from some time in the past. Also, the effective dates of the data are rarely the same, so you will need to age the data to a common date so that all the data is representative for the same period of time.
To do this, you will need to choose an aging factor. This will be the annual rate you expect wages will have risen during the period of time since the survey was complete. Most companies use a figure between 2 to 4% for an aging factor. After that, you pick a common date for all of the data to be effective. January 1st or July 1st are the most frequent dates chosen. Once you have established this data, you apply the aging factor to bridge the gap between the effective date of the survey and the common date you have established. An example:
Let's say you have chosen a 3% aging factor. You have market data for a CFO position showing a salary of $100,000; the effective date of this market data is July 1 and the common date you have chosen is January 1. Since there is a 6 month gap you would apply 50% to the 3% to come up with an aging factor of 1.5% which you would then apply to the market data. This raises the salary of the CFO to $101,500 on January 1.
The Salary Structure
Once you have all of the data aged appropriately, the final step would be to place them in some kind of salary structure. There are many different options a company could choose: traditional salary ranges or broadbands are common ways to structure the jobs within your company.
Traditional salary ranges have a defined minimum, midpoint (middle) and maximum and usually overlap slightly. Jobs of a similar level of scope, market rate and responsibility are placed within the same grade. The grades allow for a clearly defined career progression from Engineer I to Engineer II, for example. Companies that have fairly well defined jobs and clear career paths could find traditional structures an excellent way to differentiate between positions and reinforce a pay for performance philosophy.
Broadbands are similar to the traditional salary range but have a much wider range. Where a traditional range might have a difference of 30-50% between its minimum and its maximum, a broadband could have a difference of 100% or greater between its lowest and highest values. This type of structure offers greater managerial flexibility but does not provide as clear a career progression. Often, several steps within a career path are located within one broadband. An example of a broadband might be a company where all nonexempt employees are placed in one band; all professional exempt employees within another band; all management within a different band; and all executives within a separate band.
While there is no right way or wrong way to building a salary structure, it is a necessary step that almost all companies should take in order to help them achieve their business objectives.
