Compensation Philosophy: Critical Navigational Device
A clearly articulated compensation philosophy can help an organization develop a value proposition that will fit its context, attract and retain the required capabilities and motivate people to contribute to its success. Extracting an impressive philosophy statement from a text or copying some other organization’s playbook is quick but can lead to a failed compensation system.?
Understanding an organization is a pre-requisite for possessing the knowledge required to formulate policies that fit its context and its management philosophy and strategy. The model below illustrates how realities interact and how they will impact the success of the effort.
Why the organization exists and what it is designed to do are reflected in its vision (what the desired end state is) and its mission (how the end state will be created). The business strategy must serve the vision and mission and be realistic considering the external and internal realities it faces. “Being the best at everything” (a commonly adopted fantasy) is unrealistic and blurs the focus on what the organization is designed to do and what it is capable of. Defining an organization’s comparative advantage allows it to focus on what it can do best.
3M has always focused on being the leader in adhesive technology. This has caused it to invest in both invention and improvement to create adhesive products someone will want to buy and to focus on offerings that will help it meet its business plan. “To open the skies to ordinary people” is the vision statement for Southwest Airlines. To do that the airline had to offer low rates, which meant it had to focus on efficiency and cost management. Singapore Airlines aspires to be “the airline with service competitors admire.”?That aspiration probably rules out competing on price alone (demonstrated by the fact it serves more than peanuts). The next step is to utilize a comparative advantage to produce a competitive advantage.
What the organization wishes to accomplish and how it does it will lead to decisions about how to structure. As globalization has progressed it has created new issues, such as:
1. provide which products or services and to who?,
2. locate operations where?, and
3. organize how?
For example, some multinationals choose to create everything in one place and distribute products to wherever customers are. Others establish operations near customers. Some subdivide the operations into product units, some create geographic units, and some organize around customer bases. If the constituent elements (often termed strategic business units) are separate profit and loss (and even stock ownership) entities, they may be managed differently.
Once these decisions have been made it is necessary to develop one or more human resource management strategies, which determine how the organization staffs, develops its people and measures and rewards performance.?
What Should The Compensation Philosophy(ies) Be?
Some employees will be paid more than others. Most private sector organizations use different rewards for different types of employees. Direct compensation may involve stock options only for senior management, annual incentives for mid-level management, short-term cash incentives for direct sales personnel and/or cash profit-sharing for all employees. In contrast, most organizations aspire to having all employees participate in the same benefits programs, although some provisions may vary across types of employee.?
When designing the direct compensation package, the offerings may vary across occupations. Whether Walmart adopts the same competitive posture (e.g., pay at prevailing market rates) or differentiates (pay store personnel at market rates and IT specialists 15% above market) raises a new set of issues. The economic realities an organization must deal with may preclude paying more than competitors for talent, at least for everyone. A decision might be made to select those occupations that are most central to the mission and critical for its performance for a premium pay policy. This can limit the costs and still enable the organization to get and keep the people it needs the most. Financial professionals might be the key to one organization’s success, while Marketing personnel might be the ones to move the needles in the right direction for another. The assumption that the pay for all employees will be positioned in the same way relative to market may result in a dysfunctional strategy.
Public sector organizations tend to attempt to pay everyone at the levels prevailing in the relevant labor markets. They focus on other public sector organizations when making comparisons, because in some cases jobs (like police officer and fire fighter) only exist in that sector. Most will also consider competitive data from the private sector for jobs that are mobile across sectors. It is rare for public sector entities to differentiate the competitive posture across occupations or to adopt a premium pay posture. Since they answer to a public that supports them through taxation it is much easier to sell the appropriateness of an “at market” posture. When under attack at a public Board meeting the “market made us do it” defense can be effective. It could be easier for a private sector organization to have wide variations in its competitive posture, although investors would have to believe paying more gets better people and/or gets better results.
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Another major decision that must be made when developing a compensation philosophy is how individual pay rates should be administered. Since pay structures are composed of ranges that are generally 30 – 50% wide there is a need for administrative guidelines that determine individual pay rates. Based on sound compensation management principles individual pay rates should reflect:
1. The relative (internal and external) value of each role,
2. The competence of an individual in the role, and
3. The performance of an individual.
Personal characteristics (age, gender, race) should be irrelevant. This principle is widely accepted (or aspired to)?because violating it can create legal liability and damage an employer’s brand.?It is also immoral.
Much of the public sector has historically based individual pay on longevity (what detractors label “pay for aging”). The federal GS system still uses automatic, step rate progression, as do a number of states, cities, counties and other public entities. This approach has been defended based on the assumption that being in a role longer warrants more pay, irrespective of competence or performance. Although it could be argued longer service will lead to greater competence in reality the correlation generally weakens fairly quickly. Nearly one-half of the federal workforce has been taken out of the GS system and placed into “excepted service” systems and a substantial majority of other public sector entities have abandoned the time-based approach. It has been shown that these systems appeal least to the most competent and best performing employees, who more organizations would most like to keep.
Developing direct compensation structures for geographically dispersed workforces must consider differences in prevailing market pay levels. Many organizations have made the mistake of considering the cost of living in different locations rather than the cost of labor, even though within the U.S. the two measures differ dramatically in the short term across locations. It is important to make it clear to employees that pay is based on cost of labor, NOT cost of living. A lack of clarity causes employees to want the higher of the two each year, which is not economically viable in the long run..
When the pandemic broke out and employees were moved out of their central work locations to work remotely the cost of living vs. cost of labor differences created new issues. Silicon Valley firms had employees move to places that had different market realities. Moving from Sunnyvale to northern Nevada results in lower living costs, at least for some major items such as housing. The cost of labor is also significantly lower. Others moved to similarly high-cost areas such as New York, where competitive pay levels are also high. The employer now had to decide whether both employees should retain the same pay rate, which was still competitive in the Bay area. Coping with this question is still confusing policy makers, at least for employees who are expected to remain remote permanently.
If an IT firm that begins to employ people from Bangalore and Singapore, who perform the same work at their counterparts in Silicon Valley it creates new challenges. The differences in what constitutes a competitive value proposition became much more numerous, and in some cases dramatic. DuPont found that attempting to celebrate a landmark achievement by awarding all employees globally with the same number of stock options ran afoul of legal restrictions in many countries, economic obstacles in some and cultural differences in most. Variations in wages and salaries are enormous across the globe and it becomes critical to ensure the compensation philosophy is designed to produce effective attraction, retention and motivation when managing a global workforce.?
Is Having A Compensation Philosophy Really Necessary?
It is possible to operate without a philosophy, but this is questionable practice in complex organizations. Without a philosophy that can act as a navigational device managers will make individual decisions reactively when an issue arises.
How well an organization defines, measures and rewards performance will have a major impact on workforce effectiveness. If employees do not believe they are compensated equitably, competitively and appropriately they will be dissatisfied. Given the turbulence in the labor markets today it is incumbent on management to create a value proposition that gets, keeps, and motivates the people required for success. Making a series of single event decisions without a navigational device will almost certainly result in a poorly functioning compensation system. Given the increasing propensity to use legal challenges to remedy situations perceived as inequitable can increase an employer’s exposure to legal liabilities. In addition, the brand of an employer will be damaged if compensation decisions are viewed as inappropriate.
About the Author:?Robert Greene, PhD, is CEO at Reward $ystems, Inc., a Consulting Principal at Pontifex and a faculty member for DePaul University in their MSHR and MBA programs. Greene?speaks and teaches globally?on human resource management. His consulting practice is focused on helping organizations succeed through people. Greene has written 4 books and hundreds of articles about human resource management throughout his career.