Chapter 4: Components of Compensation Strategy
The first strategic decision is about the relative proportions of base pay, performance pay,
and indirect pay to include in the compensation mix.
Three other choices follow what method(s) should be used for establishing base pay,
what type(s) of performance pay(if any) should be provided, and which elements of
indirect pay should be included.
Compensation Mix choices:
Base pay job evaluation, market pricing, and pay for knowledge
Performance pays individual performance, group performance, and organization performance
Indirect pay Mandatory benefits, pension plan, health and life insurance, pay for time not
worked, employee services, and other benefits.
Base pay: is the portion of an individuals compensation that is based on time worked not
on the output produced or results achieved.
Base pay accounts for 75 to 80 percent of the compensation for a typical employee,
performance pay about 5 to 10percent, and indirect pay about 15 percent of the total
compensation. However these proportions vary across firms.
Base pay is guaranteed by the employer if a person works for a certain amount of time;
he or she is paid a prespecified amount of money. In some case, this amount is calculated
on a hourly basis, in others daily, in others weekly, or monthly, or annually.
When base pay is calculated on an hourly basis, base pay is known as wage
When base pay is calculated on a weekly, monthly, or annual basis, it is known as a
Why use base pay? Advantages
Base pay is sometimes preferable to out-put pay, even where out-put related pay is
Substitution of output related pay for time based pay is feasible only for jobs in which the
output is : 1) easy to measure, 2) easy to price in terms of its value to the employer, 3) easy to attribute to individual employee, 4) controllable by the individual employee,4)
Out-put pay is possible, but it is not desirable because it causes unwanted consequences.
Jobs that combine some measurable outputs with immeasurable outputs are also not good
candidates for a pay system based only on output, because employees tend to focus on the
measured behaviours and neglect other behaviours.
People prefer certainty in their rewards and thus prefer a large component of base pay in
their compensation package.
Base pay has been portrayed as something to be used simply because no another
alternative is viable, and this is indeed the major motivation to use it.
Base pay can also be used for more positive reasons: 1) flexibility: With time base pay,
the employer is buying time from the employee. With certain limits, this time may be
directed in many ways and redirected as need arises. Base pay doesnt confine employee
attention to only one or two behaviours, as output tends to pay to do. 2) Base pay allows
the employer to recognize and encourage important job behaviours that dont directly
produce output, such as skill development. 3) Base pay can signal the relative importance
of jobs within the organization. Generally, jobs of greater importance to the organization
carry higher pay rates. 4) Base pay demonstrates commitment on the part of the employer
to the employee, creating a greater likelihood of employee commitment to the employer.
5) Depending on the method used to set up a base pay strategy, it can support a particular
managerial strategy. For example, a pay for knowledge base pay strategy supports a high
involvement managerial strategy. 6) Base pay is used for simplicity- it is usually much
simpler to implement and administer than an output related system.
Base Pay Disadvantages
1) Base pay represents more of a fix employer commitment than performance pay,
especially if salaries are used. Base pay is not linked to variability in an employers
ability to pay in the way that performance pay can be.
2) While base pay does contribute to membership behaviour, it does not directly motivate
task behaviour, nor does it signal key task behaviours.
3) Base pay does not relate to organizational success directly to individual success, it does
not contribute to citizenship behaviour.
4) Base pay is not self correcting. In an output related system, employees who do not
perform up to standard tend to voluntarily remove themselves from the organization
because they are unable to earn enough money. But time base pay provides no such
Time base pay and output and performance pay are not mutually exclusive, but can
combine. Performance Pay
Performance pay can be defined as any type of financial reward given only when
certain specified performance results occur. These results may be based on the
performance of individual employees, a group or team of employees, or the entire
Performance pay is sometimes known as performance contingent pay, variable pay,
or at risk pay.
Pay for performance can be classified into three main categories depending on
whether the performance relates to the individual employee, the group or work team
or the entire organization. Individual performance pay plans include piece rates,
commissions, merit and targeted incentives. Group performance pay plans include
productivity gain sharing plans, goal sharing plans, and other type of team based pay.
Organizational performance pay plan includes employee profit sharing plans,
employee stock plans, and other organizational pay plans.
Advantages of performance pay:
1) Properly designed, performance pay plans can signal key employee behaviours and
motivate employees to achieve them
2) Performance pay can reduce the need for other types of mechanism for controlling
employee behaviour. When employees know that their pay is dependent on
performing particular behaviours, they won`t need a supervisor watching them to
make sure they are working
3) Performance pay can raise an employees interest in performance and provide
employees with information about their current performance levels
4) Different types of performance pay can be used to support specific managerial
strategies. For example, individual performance pay can support a high involvement
5) Performance pay plans make more variable and therefore can help link
compensation levels to the firm`s ability to pay. This linkage helps stabilize an
organization`s employment levels,; lessening the need to lay off employees in
difficult times only to rehire them when business improves.
Disadvantage of performance pay:
One general drawback is that employees generally prefer predictable and certain rewards
to unpredictable and uncertain rewards.
Employees will generally resist substitution of performance pay for base pay or indirect
pay. In order to induce employees to accept this substitution, it may be necessary to offer
higher total compensation than otherwise be necessary. Performance pay cause employees to focus only on aspects of behaviour that are being
measured, ignoring other unmeasured but still important behaviours.
Indirect pay was known as the fringe benefits as the extent costs increased they became
known as only benefits
Indirect pay can be anything that costs the employer money, addresses some type of
employee need (thus conferring some type of benefit on the employee and is not included
as part of the base or performance pay.
Indirect pay systems vary in other ways. One key variation is choice: whether employees
can choose what benefits they receive (a flexible benefits system) or whether they cannot
(a fixed benefits system) another variation is responsibility for costs: whether the
employer covers all costs, or whether employees are required to share in costs.
8 Motives to use Indirect Pay:
1) Competitive pressure. If competitors are offering benefits that are important to the people
the firm wants to hire, then an employer may need to offer similar benefits to attract these
employees. For instance, some employees would never dream of working for an
employer who does not provide an adequate pension plan.
2) In order to satisfy the security needs of their members, unions have always bargained
strongly for comprehensive employee benefits, and unionized firms have had to respond
to these pressures. Non unionized firms may match the packages won by unions at other
firms in order to remove one possible incentive for unionization; although they do not
always do so. On average, employees in unionized firms get about 45 percent higher
benefits than comparable non-union Canadian employees
3) Certain types of indirect pay get more favourable income tax treatment than direct pay. In
this case, a firm may use indirect pay to provide a higher total amount of after tax
compensation to employees than it would if the firm had paid out the same number of
dollars in the form of direct pay.
4) Many benefits items- such as dental or medical coverage can be purchased for cheaply
by the employer than the employee, due to certain employees, such as the ones with
serious health problems, might not even b