Compensation Fundamentals: System Design Elements
Author: Joseph J. Martocchio, Professor Emeritus, University of Illinois at Urbana-Champaign
Employee compensation encompasses the rewards employees receive for performing their jobs, to adjust for cost-of-living increases, for their seniority, job performance over time, or acquiring new competencies, skills or knowledge sets.
HR professionals collaborate with high-level managers to determine the optimal compensation plans that will facilitate recruitment, employee job performance and retention - all within budgetary limits. Then, HR relies on its expertise to create and oversee the implementation of compensation programs.
A comprehensive compensation system can be broken down into its component parts. These parts include the building blocks and system design elements.
This guide discusses the system design elements of an employee compensation system. It should be reviewed together with the other parts of the Compensation Fundamentals series:
Compensation System Design Elements
A successful compensation system promotes three important goals:
- Internal Consistency (job structures);
- Market Competitiveness (pay level and pay mix); and
- Recognizing Employee Contributions (pay structures).
Before an organization establishes pay rates for jobs, it is necessary to understand how jobs differ in the required levels of knowledge, skills and abilities. The goal of internal consistency is to define the relative value of each job within an organization based on differences in levels of knowledge, skills and abilities. Relevant comparisons start with grouping jobs that possess the same knowledge, skills and abilities into job structures.
Job structures are sets of jobs that are similar in important ways - for example, by functional area (such as accounting) or by job type (such as managerial jobs) because the jobs placed within each structure share a common set of knowledge, skills and abilities. Ultimately, HR chooses many job structures, and they rely on the numbers of functional areas or job types to guide their employee compensation choices.
HR professionals rely on two practices to build effective job structures:
Job analysis is a descriptive procedure that identifies and defines job content. Job content describes job duties and tasks as well as other pertinent factors such as the knowledge, skills, and abilities needed to perform the job adequately. Traditional job analysis methods entail observation of demonstrable behavior or job incumbents' completion of extensive surveys that measure job content. Job analysis methods must be reliable and valid. Reliable job analysis methods produce consistent results under similar conditions. Having two or more individuals conduct job analysis demonstrates a reliable method when these individuals independently produce consistent results. Valid job-analysis methods ensure that the content of the job is accurate; that is, the job analysis shows the actual work performed. Accuracy is based on the judgment of multiple job analysts (supervisors and managers) using different job analysis methods.
The Occupational Information Network (O*NET) serves as an alternate source of descriptive job information. O*NET is a database that provides job content information containing hundreds of standardized and occupation-specific descriptors on nearly 1,000 occupations encompassing the US economy. The database is constantly updated based on input by a wide range of workers in each occupation and is used by employers to help create job descriptions.
The O*NET Content Model shown below lists the six categories of job and worker information. Job information (also, job content, as described earlier) contains the components that relate to the actual work activities of a job. Work activities is an example of activities that are common across a very large number of occupations. Employees undertake work activities in almost all job families and industries. For example, worker output refers to what physical activities are performed, what equipment and vehicles are operated/controlled, and what complex/technical activities are accomplished as job outputs.
Worker information represents characteristics of employees that contribute to successful job performance. For instance, abilities refer to enduring attributes of the individual that influence performance. Cognitive ability, as an illustration, refers to the level of understanding at higher levels of knowledge or skills difficulty.
Traditional job analysis methods and O*NET produce job descriptions. Job descriptions list job information and worker information that distinguish one job from another. HR uses job descriptions to assist in recruitment, hiring, performance appraisal, training and compensation. For compensation, job descriptions provide the input into the job-evaluation process to assist judging the relative worth of jobs based on job content, enabling pay setting.
Job evaluation is a process that establishes pay differentials among jobs within an organization. Job descriptions facilitate quantifying the key similarities and differences between jobs based on the content identified in the job-analysis process. Job content describes job duties and tasks as well as pertinent factors such as the knowledge, skills and abilities needed to perform the job adequately. Compensable factors represent elements of job content (for example, skills) for assessing job value.
Job evaluation underscores the organization's internal value system by creating a hierarchy of internal job worth based on each job's function. Virtually all organizations will assign higher value to managerial roles than the support roles that assist them. For instance, the manager of an organization's benefits department is responsible for overseeing the benefits function from evaluating the benefits program to ensuring that benefits counselors (support roles) are sufficiently trained.
HR can choose from among several job evaluation methods that vary in the level of detail. For instance, the least detailed method is simple ranking. Simple ranking entails ranking jobs in order of value to the organization. Value is typically conveyed in an organization's mission statement. HR relies on titles alone or in conjunction with information contained within job descriptions to inform their rankings. HR professionals typically do not consider specific elements of job descriptions but overall impressions of the job's value to the organization.
The most detailed job evaluation method is the point method. The point method assigns numerical values to compensable factors that define jobs, and these values are added as a gauge of the overall value for the job. The relative worth of jobs is established by the magnitude of the overall numerical value. For a full explanation of the point method, see How to Use the Point Method of Job Evaluation.
Market competitiveness refers to two compensation policies: pay-level policies and pay-mix policies. Compensation surveys and statistical analysis are important tools to help ensure market competitiveness.
Compensation Policies: Pay Level and Pay Mix
Pay-level policies describe the typical pay levels within an organization relative to pay levels for similar jobs in organizations that compete for the same individuals. There are three standard pay level policies: market lead, market lag and market match, as illustrated below.
The market match policy is also the market pay line. The market pay line is derived from the statistical regression analysis.
Organizations choose pay policies based on several considerations. Oftentimes, organizations use more than one policy to ensure the maintenance of a highly qualified and motivated workforce.
- The market lead policy promotes the recruitment and retention of limited essential talent in the labor market. For instance, cybersecurity experts are in high demand but in low supply. The market lead policy differentiates the organization from competitors by compensating employees more highly than most competitors. Leading the market indicates pay levels that place above the market pay line. In general, market lead policies are set to the third quartile.
- The market match policy (also known as the market pay line), shows a consistency with the pay rates for competitors. It applies to jobs that are in ample supply in the labor market and should enable the organization to recruit and retain this segment of the workforce. For example, administrative assistants are in plentiful supply. The market match policy most closely follows the typical market pay rates because organizations pay according to the market pay line. In general, market match policies are set to the second quartile.
- The market lag policy is rarely used; however, it can be an effective choice when the organization offers excellent employee benefits such as generous paid time off, flexible work schedules and a collegial work environment. The market lag policy separates an organization from the competition by compensating employees less than most competitors. Lagging the market indicates that pay levels fall below the market pay line. In general, market lag policies are set to the first quartile.
Quartiles provide information about the dispersion of data points - in this case, annual salaries. There are four quartile positions. Calculating quartiles starts with arranging every data point in the compensation survey and listing them in order of magnitude from the lowest annual salary to the highest annual salary. Then, count the total number of listed salaries and divide by four. For this example, the compensation survey contains 1,000 data points. Dividing 1,000 data points by four yields 250 data points:
- The 250th data point (starting the count from the lowest value) represents the first quartile.
- The 500th data point provides the second quartile.
- The 750th data point yields the third quartile.
- The highest data point denotes the fourth quartile.
The following is an example of how quartiles would be interpreted:
If the 250th data point is $70,000, then 25 percent of the salaries are at or below $70,000 (first quartile). This figure represents the market lag policy. If the 500th data point is $120,000 (second quartile), then 50 percent of the salaries are at or below $120,000. This figure is the market match policy. If the 750th data point equals $150,000 (third quartile), then 75 percent of the annual salaries are at or below $150,000. This figure provides the market lead pay policy. Finally, if the largest data point is $200,000 (fourth quartile), then all (100 percent) the annual salaries are at the $200,000 level or less.
Pay-mix policies refers to the combination of core compensation and employee benefits that makes up the total compensation package. Organizations distinguish between pay mixes based on the choice of pay practices to include and the relative amount of compensation budget allocated to funding each practice. The figure below provides a visual representation of a pay mix policy.
For every $1 spent on total compensation, the organization allocates $0.25 for employee benefits, $0.05 for short-term incentives, $0.55 for base pay, and $0.15 for long-term incentives.
Setting a pay mix could start with employee benefits. Most organizations allocate approximately 25% - 30% of the total compensation budget to fund employee benefits.
HR professionals determine the appropriate pay mix for each job structure rather than a single mix for all jobs within the organization. Jobs within structures (e.g., administrative, accounting) have common job content and worker requirements.
For example, in a software development organization, a greater portion of incentive compensation might be allocated to software authors and engineers than to administrative staff. Software engineers have important skills relating to meeting the organization's mission. Incentives awards through the year may promote innovation initiatives. In contrast, the administrative staff, while important to the organization, may not play as crucial a role in determining the organization's success. Consequently, less total compensation would likely be allocated to incentive funds. Similarly, with some job structures (such as sales) employees may receive much of their compensation as incentives.
Organizations must pay enough to promote recruitment and retention while also managing limited budgetary resources available for employee compensation. Two practices are the foundation of effective market competitive pay systems:
Compensation surveys entail the collection, analysis and summarization of compensation data. Compensation surveys enable HR professionals to obtain a realistic view of competitors' pay level choices. Without having data about competitors' pay practices, an organization's attempt to establish market competitive pay systems is much like taking a shot in the dark. The risk of paying too low undermines recruitment and retention. Paying more than necessary stands to boost recruitment and retention, but also creates an opportunity cost. Excess expenditures could limit other HR initiatives such as investments in training and development.
Organizations choose between conducting surveys or purchasing them from professional associations or consulting firms. Often, HR professionals work with consulting firms that maintain data about compensation and benefits for a wide range of organizations. The surveys can be tailored to meet the organization's needs to understand their competitors' compensation practices. Obtaining compensation survey information from these sources can be costly (although some survey providers may provide discounts to organizations that participate in a survey).
The US Bureau of Labor Statistics (BLS) publishes compensation and benefits surveys based on a wide range of organizations and workers. Among the many variables, these surveys report information according to industry, occupational groupings, union status, organization size, geographic regions, worker demographics and ownership (which refers to whether an organization is private sector or a federal, state or local government). BLS surveys are published frequently and not targeted toward a set of competitors specific to any organization. HR professionals should become familiar with what is available to help identify data that can inform pay and benefits decisions.
Once HR professionals have completed job evaluation and collected or obtained compensation survey data, the next step is to integrate both using statistical analysis techniques. The goal is to set pay rates based on consideration of job evaluation outcomes (organization's valuation of job worth based on job content) and market pay rates for the same or similar jobs.
Regression analysis is the primary statistical analysis technique that enables HR professionals to predict the values of one variable (pay rates) based on another variable (job evaluation points). The results are pay rates that are consistent with typical pay rates for jobs represented in the compensation survey.
Regression analysis works by estimating the best-fitting line between two variables - job evaluation points and market pay rates. The best-fitting line for this application is the market match pay policy line.
Pay levels that correspond to the market pay line are market-competitive pay rates. The following illustration shows the market pay line. Annual salary is measured as the average market value, or the second quartile value identified in the compensation survey.
The outcome of a regression analysis is an equation that facilitates pay setting within the organization:
Ŷ = a + bX, where:
- Y = predicted salary
- X = job evaluation points
- a = the Y intercept (that is, the Y value at which X = 0)
- b = the slope (that is, the value associated with 1 job evaluation point)
The following illustrates regression results based on an analysis of the data:
- Entry-Level Job: $43,000
- = $40,000 + ($15 × 200)
- Mid-Level Job: $51,250
- = $40,000 + ($15 × 750)
- Advanced Level Job: $58,000
- = $40,000 + ($15 × 1,200)
The pay calculations based on regression analysis can be plotted by the following formula: Ŷ = $40,000 + $15X
Recognizing Employee Contributions
Pay structures are the pay rate differences for jobs of unequal worth contained within corresponding job structures and the framework for recognizing difference in employee contributions through seniority, performance, or learning new competencies, skills or knowledge sets. Jobs of unequal worth are dissimilar jobs based on different compensable factors or differences in the degrees of compensable factors:
Pay grades group similar jobs for pay policy application based on job content - knowledge, skills, and abilities. Pay grades represent the horizontal dimension (job content). HR professionals rely on the results of job evaluation to determine which jobs are grouped into pay grades and judgment about which jobs should be treated similarly for pay policy application.
Pay ranges represent the vertical dimension (pay rates) for each pay grade. Pay ranges include midpoint, minimum and maximum pay rates for the jobs contained within the associated pay grade. The midpoint value corresponds to the results of the regression analysis by setting it according to the predicted values (and it is another term for the second quartile). The midpoint value also represents the market match pay level policy. The minimum and maximum pay rates set the boundaries of acceptable pay for the included jobs.
A pay-range spread is the difference between the maximum and minimum pay rates for pay grades. It is expressed as a percentage of the difference between the minimum and maximum rates divided by the minimum rates. Pay range spreads generally are larger for jobs of higher value than for jobs of lesser value (based on job evaluation points). Jobs with larger job evaluation points are more complex, and there is more room for how an employee makes job performance contributions and impact on an organization's success. In addition, the time for advancement to higher-ranking jobs is often longer than it is for more entry-level jobs, which is accommodated by large pay range spreads.
Below is an illustration of pay grades, pay ranges and pay range spreads.
Pay Grades and Pay Ranges
Pay grades are grouping of similar jobs (horizontal) based on worth determined by job evaluation. Pay ranges show the minimum, midpoint, and maximum rates (vertical) for each pay grade.
Exceptions to Pay Range Minimum and Maximum Values
From time to time, pay rates may fall below the minimum rate or exceed the maximum rate. There are a variety of reasons that may result in these occurrences. The main reason pertains to decisions to set pay outside the boundaries.
Green circle rates fall below the range minimum. Following the color scheme of traffic signals, green means go. HR professionals should adjust pay to at least the minimum rate. Green circle rates are usually increased in one step to achieve or exceed the minimum pay rate.
Red circle rates exceed the range maximum. HR professionals may consider freezing pay until updates to the pay ranges (higher minimum and maximum rates) bring the red circle rate within the range. Updates would be made periodically based on the results of new compensation data. Red circle rates pose a greater challenge. Freezing pay exempts employees from performance-based pay increases, which stands to undercut motivation and may be seen by the employee as a penalty. This is particularly likely when the reason for exceeding the maximum has been a history of outstanding performance. Awarding annual bonuses or incentives that are not added to base pay on a fixed basis is an alternative to freezing pay.