Indian Institute of Management

Ahmedabad

IIMA/P&IR0198(D)TEC
Technical Note

Human Resource Management (D):

Compensation Management
Compensation decisions are very crucial for the overall health of the organization.
Depending on the nature of business, compensation may account for anything from five to
60 per cent of the cost of the ooperations. While some organizations find difficult to survive
merely because of high wage bills, others find it difficult to retain people because of low
compensation.
Components of Compensation: Compensation is the package of quantifiable rewards an
employee receives for his or her labour. It includes primarily three components:

Base salary
Pay incentives
Indirect compensation

Base Salary: Base salary is the fixed component that an employee receives irrespective of his
performance. It is an important component of employee compensation as it generally acts as
base for deciding other incentives, perks, and privileges.
Base salary could be decided either on the basis of the job an employee performs or on the
basis of knowledge and skill that an employee possesses. Job-based compensation system is
useful when job designs, technological changes, and organizational processes and structure
are relatively stable. For job-based compensation, jobs are evaluated.
When technology and structure and processes of organization are unstable, the demand for
skills and knowledge of employees also changes quickly. Certain existing employee-skills
and knowledge may become redundant. Simultaneously, some other skills and knowledge
may become more important. In such conditions, organizations tend to develop individual
skill-based compensation systems.
A skill-based system may create inequity in the organization. Frequently younger
employees, armed with latest skill and knowledge of the profession from colleges, attract
higher compensation than older colleagues in the organization. This becomes a source of
conflict, stress, and managerial turnover in the organization. Hence, a system with a thrust
on continuous enhancement of skills and knowledge of people has to be carefully developed
and communicated to employees. Organization and employees both generally share the
responsibility for development of people in this system.

Prepared by Professor Sunil Kumar Maheshwari, Indian Institute of Management, Ahmedabad.

2006 by the Indian Institute of Management, Ahmedabad

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Pay Incentives
Incentives are generally linked with employee performance. They could be in form of bonus,
profit-sharing, employee stock options, etc. Though incentives are variable in nature, it is not
uncommon when they assume the nature of fixed component in practice. However,
organizations often announce payments such as ex-gratia payment to its employees more as
a matter of tradition and right of employee than as a profit-sharing measure in true sense.
Incentives are also one of the greatest sources of conflict between union and management.
Organizations such as Premier Auto Limited and Maruti Udyog Limited faced volatile
industrial relations because of high payments through incentive schemes.
While it is easier to assign the criteria for incentives to those whose performance could be
measures objectively; it is not easy to do so for servicing functions of the organization. This
is another source of conflict in organizations. Further, differential earning opportunities in
different departments because of nature of work, technological differences, and
environmental opportunities also create differences. Managers are required to be careful and
sensitive to these sources of conflict while designing incentive schemes. Moreover, such
schemes require frequent review to reassess the success. A yielding management may
achieve short-term production targets at the cost of long-term sustainability of the
organization.
Indirect Compensation
Indirect compensation consists of benefits that are given for different reasons. These benefits
may be health insurance, vacation, leave travel concession, company car, parking space,
housing, club membership, etc.
Position-linked perks have potential to create hierarchy in the minds of people. While
monetary compensation is not visible in the day-to-day functioning of the organization,
perks are visible and convey hierarchy.
In organizations where discipline and maintenance of organizational systems and processes
are important, creating a hierarchical mindset among employees through perks may be
useful for managers. For example, hierarchy is important in the armed forces. Officers in
such organizations create strong hierarchical mindset primarily through status symbols than
through pay differentials.
Compensation helps in attracting and retaining employees in the organization. The design of
a compensation system influences the ability of organizations to achieve their strategic goals.
Choices in the design of compensation system: Important strategic decisions to design
compensation systems are:
Equity: Internal and external
Pay: Fixed and variable
Performance linkage: Performance versus seniority
Criteria: Job and/or individual competencies
Pay differentials: Egalitarian versus elitism
Position in the Industry: Below market versus above market level
Non-monetary rewards
Openness of the policy

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Equity: Organizations need to be concerned about compensation equity between people

with similar competence, position and experience. External equity is critical for lateral hiring
from the market at senior positions. External equity often creates internal inequity. Such
conditions dilutes emotional bond between people and organization. Internal equity is easy
to maintain when organizations prefer internal development of people over lateral hiring for
senior positions. This creates an atmosphere of security and enhances emotional bond
between people and organization.
Fixed versus Variable Pay: Organizations are often seen to prefer variable pay to people to
ensure performance outcome. However, different people have different preferencs. Persons
who are aggressive, confident and ambitious prefer variable pay, provided it enhances the
potential earning substantially. Hence, this policy has substantial implications for the culture
of the organization.
Performance Linkage: Anuual raise in salary could be linked with seniority and
performance. Policy of performance linked substantial component raise creates competitive
environment in the organizations.
Individual based pay: Pay policy where people are paid according to their capabilities
irrespective of their job-role in the orgazation creates an environment characterised by low
cooperation and competitive. It promotes concern for merit, if implemented carefully.
However it is difficult to implement owing to difficulties in accurate assessment of
competencies of people at regular interval.
Pay Differnetials: Organizations where hierarchy needs to be promoted, high pay
differentials are useful. In owner managed organizations it is often seen that few persons at
the top draw substantially higher salary than others.
Pay Policy: Important factors that influence pay policy are:
Paying capacity of the organization: This determines the maximum pay which an
organization can pay to its employees.
Minimum wage rates: This determines the minimum wages which are to be paid
to workers.
Industry wage rates: This influences the retaining ability of employees in the
organization.
Prevailing wage structure in the region: This influences the actual wage level
decisions.

Business strategy: A cost leadership business strategy would demand moderate fixed

pay, and high linkage of incentives with actual performance. The incentives are likely to
be worked out at the individual level. There is likely to be high status related to achieve
better control and coordination in such organizations. The strategy of quality
enhancement and differentiation might favour high fixed component and group awards
for incentives. There are likely to be less status related perks in such organizations.

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Business life cycle: In the high growth rate product stage, organizations are likely to

have full capacity utilization. It would be appropriate for organizations to design pay
structure characterized by high incentive levels and industry leadership. In the declining
stage compensation is more likely to be characterized by low incentives and high fixed
pay.

Organizational structure: A centralized structure would require high status related

perks. Formalized organizations are likely to be characterized by low incentives and

high fixed pay and job-based pay structure.

Performance appraisal system: Management by Objectives based performance appraisal

system is likely to have high linkage with performance. In such conditions, organizations
would prefect closed compensation policy.

Age and size of the organization: Formalization increases with age and size of the
organization, thus the compensation system. Large companies may try to have market
leadership role for compensation.
Environment: Job-based pay system works well when conditions are more stable and
the required technical capability in employees is relative moderate.

Job-based compensation plan: A large number of organizations prefer job-based

compensation plan over person-based compensation

compensation plan, following steps are followed:

plan.

To

design

job-based

Conduct job analysis

Write job description
Determine job specification
Rate worth of all jobs using a predetermined system (job evaluation)
Create job hierarchy
Classify jobs by grade levels
Establish final pay policy
Individual pay assignment

Job Evaluation Hay Guide Chart

Background: It is one of the most widely used single method of job evaluation. It was

conceived in 1950 by the Hay Group. It is based on factor comparison method and places
importance on the job and not on the individual. Variaous factors that determine the worth
of a bob are:

Know-how

Practical procedures, specialized techniques and knowledge within occupational

fields, commercial functions, and professional or scientific discipline
Skills in planning, organizing, executive, controlling, and evaluating
Interpersonal skills

Problem Solving

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The environment in which thinking takes place

The challenge presented by the thinking to be done

Accountability

Freedom to act the degree of personal or procedural control and guidance

Job impact on end result
Magnitude-reflected by the annual revenue or expense associated with the area
in which the job has its primary emphasis.

Evaluation Process

A set of guide charts are prepared after studying the organization. (A set consists
of three charts: accountability, problem solving, and know-how.)
A benchmark sample of position is selected to cover all organization level,
functions, and units where jobs are to be evaluated.
Position descriptions are prepared jointly by job holder and one level higher
authority.
A job evaluation committee is nominated to evaluate the benchmark sample.
Calibration of three charts is done by the committee.
All other positions are then evaluated, depending on the size, complexity, and
culture of the organization.
Benchmark sample is selected to cover all organizational levels, functions, and
units where jobs are to be evaluated.
Chart values increase at the rate of 15 per cent.

Grading
Jobs
Customer service
representatives
Executive secretary
Senior secretary
Secretary
Senior general clerk
Credit and collection
Accounting clerk
General clerk
Legal secretary
Senior word processing
operator
Word processing operator
Purchasing clerk
Payroll clerk
Clerk-typist
File clerk
Mail clerk
Personal clerk
Receptionist
Some Legislation of Wages

Points Grade
300
5
298
290
230
225
220
175
170
165
160
125
120
120
115
95
80
80
60

Pay Range (`)

5,000-7,500

4,000-6,000

3,500-5,500

3,000-4,500

2,500-3,500

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The Payment of Wages Act, 1936

Maximum wage period = 1 month
Mode of payment: cash or cheque (after authorization from people), within 7 days
where less than 1000 employees are employed; otherwise within 10 days
Time limit for payment of dues for discharged employees
Procedure for levying fine
The Minimum Wages Act, 1948
Determines the bare minimum to keep the body and soul together
Implemented by both states and central governments
Cost of living allowance, cash value of concessions
The Payment of Bonus Act, 1965
Minimum 8.33 per cent of wages
Universities and educational institutes excluded from the purview
Bonus is treated as deferred payment as minimum is to be paid in loss conditions as
well.