“How to develop a Compensation Model when adopting absolute ranking in Performance Appraisals?

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Though it is fascinating for employees, when we propose an absolute ranking system, compensation management practitioners would like to explore the best possibilities for handling the components, such as bonuses and merit increases. Let us look at one such sample model here.

Let’s define the following variables:

• ( R_x ): Absolute ranking of employee ( x ) (e.g., 1 for top performer, 2 for second, etc.)
• ( R_y ): Absolute ranking of employee ( y ) (used in the summation for all employees)
• ( T ): Total number of employees
• ( B ): Total bonus pool available
• ( M ): Total merit increase pool available
• ( P_x ): Performance score of employee ( x ) (normalized between 0 and 1)
• ( C_x ): Current salary of employee ( x )

Bonus Pay Calculation: The bonus pay for each employee can be calculated based on their absolute ranking and performance score. Higher-ranked employees receive a larger share of the bonus pool.

[\text{Bonus}x = \left( \frac{T - R_x + 1}{\sum{y=1}^{T} (T - R_y + 1)} \right) \times B \times P_x]

Merit Increase Calculation: The merit increase can be calculated similarly, ensuring that higher-ranked employees receive a more significant percentage increase.

[ \text{Merit Increase}x = \left( \frac{T - R_x + 1}{\sum{y=1}^{T} (T - R_y + 1)} \right) \times M \times P_x ]

Total Compensation Adjustment: The total compensation adjustment for each employee, combining both bonus pay and merit increase, can be expressed as:

[ \text{Total Compensation Adjustment}_x = \text{Bonus}_x + \left( \text{Merit Increase}_x \times C_x \right) ]

Let us look at a simple sample calculation to understand these equations.

Let’s assume:

• ( T = 5 ) (5 employees)
• ( B = $50,000 ) (total bonus pool)
• ( M = 0.05 ) (5% merit increase pool)
• Performance scores ( P_x ) are 0.9, 0.8, 0.7, 0.6, and 0.5 for employees ranked 1 to 5, respectively.
• Current salaries ( C_x ) are $100,000 for all employees.

For the top-ranked employee (( R_1 = 1 )):

Bonus Calculation:

[ \text{Bonus}1 = \left( \frac{T - R_1 + 1}{\sum{y=1}^{T} (T - R_y + 1)} \right) \times B \times P_1 ] [ \text{Bonus}1 = \left( \frac{5 - 1 + 1}{\sum{y=1}^{5} (5 - R_y + 1)} \right) \times 50000 \times 0.9 ] [ \text{Bonus}_1 = \left( \frac{5}{15} \right) \times 50000 \times 0.9 ] [ \text{Bonus}_1 = \left( \frac{1}{3} \right) \times 50000 \times 0.9 ] [ \text{Bonus}_1 = 15000 \times 0.9 = 13500 ]

Merit Increase Calculation:

[ \text{Merit Increase}1 = \left( \frac{T - R_1 + 1}{\sum{y=1}^{T} (T - R_y + 1)} \right) \times M \times P_1 \times C_1 ] [ \text{Merit Increase}1 = \left( \frac{5 - 1 + 1}{\sum{y=1}^{5} (5 - R_y + 1)} \right) \times 0.05 \times 0.9 \times 100000 ] [ \text{Merit Increase}_1 = \left( \frac{5}{15} \right) \times 0.05 \times 0.9 \times 100000 ] [ \text{Merit Increase}_1 = \left( \frac{1}{3} \right) \times 0.05 \times 0.9 \times 100000 ] [ \text{Merit Increase}_1 = 0.0167 \times 0.9 \times 100000 = 1500 ]

Total Compensation Adjustment:

[ \text{Total Compensation Adjustment}_1 = \text{Bonus}_1 + \left( \text{Merit Increase}_1 \times C_1 \right) ] [ \text{Total Compensation Adjustment}_1 = 13500 + 1500 = 15000 ]

This approach ensures that compensation adjustments are proportional to the absolute ranking and individual performance, promoting fairness and motivation.

Are you wondering, “How does managing compensation for larger and more complex employee pools and mapping into your HR IT system, such as #SAPSuccessFactors, work?” We can certainly help. Please reach out to us at [email protected].