Focus Areas Managing and Rewarding Performance

Compensation - Cost or Investment?

Apr 1st 2010
By Reena Wahi & Simran Oberoi

Is compensation a cost or investment? This is a dilemma that every Human Resource professional faces
year on year when convincing CEOs and CFOs to approve the years salary and bonus budgets. And this
question is now even more critical as India is seeing a spiral increase in compensation payouts, which
impacts the overall cost arbitrage of Indias competitiveness in the global economy. Compensation
strategies, so far, have been designed within the four walls of the Human Resource office and are not
yet topics of discussion in board rooms, with the exception of the CEOs pay package!
Traditionally, most of the companies in India (including MNCs) view communicating and tracking
compensation from a cost perspective since they use the Cost-to-Company (CTC) approach rather than
the Value-to-Employee approach for all key aspects attraction of talent, reward communication and
monitoring pay competitiveness. There are various reasons for this:

Limited role of HR in strategic decision making: Historically, the Human Resource department was
accustomed to operating within pre-defined budgets that were provided to them by the business and
finance teams. They had limited or no influence on decisions pertaining to the business strategy and its
linkage to people strategy, which subsequently defined the compensation strategy.

Emphasis on external market practice for cash pay components: When organizations monitor employee
remuneration as a cost, they tend to be followers, that is, they track market trends to compare the
competitiveness of base salary or total cash and their requirement is to match the market pay practice.
Such practice tends to negate the effective use of compensation as an effective tool of organizational
strategy. Furthermore, it undercuts the organisations ability to reward employee vis-a-vis its top-line
and bottom-line performance.

Compensation structure design primarily focus on tax effectiveness: In India, allowances form a large
part of compensation structure and one of the primary reason behind this has been the various tax
deductible provisions in the Direct and Corporate Tax structure of India. Every April, the focus has been
to re-design the architecture to accommodate these changes and minimize tax outflow with little
consideration of whether the structure works to drive sustainable performance or not.

High fixed cash components in the pay mix: According to Hay Group PayNet (our comprehensive global
compensation and benefits platform), the total value of allowances adds up to 40% of the Total
Remuneration and matches the Base Salary values almost equally across levels. With this type of
structure it is imperative that organizations tend to view compensation as a cost to be monitored.

The result of viewing and managing compensation solely as a cost is that the organizations develop
strategies that culminate in short term solutions.

In turn, this leads to:

Disengagement rather than higher engagement: Companies that were using compensation as key means
of retaining employees (either through higher salaries or retention bonuses) were forced to reduce
employee cost. Compensation budgets being squeezed or reduced to minimal levels combined with few
other alternatives being built in, led to high levels of disengagement and a drop in motivation. According
to Hay Groups research in 2009, a review of 1,249 leaders from high-profile organizations operating in
the Indian market revealed that over 60% of the leaders were not engaging the employees they led and
were in fact, demotivating them; only 18% were creating and engaging environment that encouraged
high performance.

Operating cost pressures: In terms of monetary cost, employee costs constitute almost 50-80% of the
overall operating cost of the company mainly because the quantum of compensation payouts is
determined by market demand and supply factors of the job, and not by relative job worth and its
contribution. Moreover, the lack of corresponding productivity and performance on the part of the
employee leads to enhanced pressures on overall operating cost.

Pay structure not linked to performance: When the pay structure is more cash-centric especially
focusing on fixed components, it does not drive performance.

With companies now focusing more on rebuilding profitability, reward is more under the microscope
with CEOs asking the following questions:

1. What performance are we getting in return for what we pay?
2. What is the effectiveness of all the costs allocated to reward?
3. What is the ROI?

Hay Groups recent global research paper Changing Face of Reward highlights that reward is now a top
management issue with the CEOs and boards getting closely involved. Therefore, it is time for Human
Resources now to manage compensation as P&L and learn the art of striking a fine balance between
cost containment and investment maximization. This is more relevant in the Indian context where
structural changes in tax laws will require more innovative approaches to attract and retain employees.

So, how does one achieve that balance?

Periodic realignment of reward strategy to ensure its alignment to business strategy: With the dynamic
nature of business these days with business models, strategy and operating models changing frequently,
it is critical for HR to periodically review the alignment of reward to business. This can be effectively
done with the use of a Total Reward Framework that aligns business needs and employee needs.

ROI to be the key metric on HR Scorecards: Along with other HR metrics like attrition, employee
engagement scores, et al, ROI too should now become an important metric on the HR Scorecard and the
effectiveness of all tangible and intangible reward programmes should be tracked periodically.

Pay for relative worth of the job rather than the person: When compensation is treated as a cost,
organizations tend to focus on paying the person rather than for the job size. They prefer to calculate
the feasibility of hiring a person depending on what the employee would cost them, rather than
identifying the overall value that is being invested in the new employee because the job that he/she is
performing is critical. Also organizations tend to create internal equity issues when they use the cost
approach by hiring at different pay levels irrespective of the defined pay range for a job. If they use the
investment approach they would be defining a pay range for a certain role/job and hiring within that.

Performance is the new mantra: Organizations which track employee pay as cost, tend to provide
inflationary or purely market based salary increases. However, if compensation is an investment, then
merit-based increases are vital since they recognize past performance and drive future performance as
well. Variable pay is one of the critical levers for driving performance and engaging employees in
organizational goals. Apart from incentives and bonuses, differentiated reward structures for high
performers and critical roles would help in using limited budgets effectively.

The challenges that lay ahead are developing and delivering reward programs that drive performance
and retaining and motivating talent without affecting the bottom-line.. This may sound like a tall order.
However, organizations who can keep their eye on the ball will reap better returns in terms of long-term
business performance.

Reena Wahi is Managing Consultant and Head of Reward Strategy at Hay Group. Simran Oberoi is Asia
Pacific Chemical Sector Leader at Hay Group.