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Employee Compensation

Employee Compensation


Employees receive compensation from a company in return for work performed. While most people think compensation and pay are the same, the fact is that compensation is much more than just the monetary rewards provided by an employer. According to Milkovitch and Newman in their 2005 book, Compensation, it is all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship. The phrase financial returns refers to an individual's base salary, as well as short- and long-term incentives. Tangible services and

benefits are such things as insurance, paid vacation and sick days, pension plans, and employee discounts.

An organization's compensation practices can have far-reaching effects on its competitive advantage. As compensation expert Richard Henderson notes, To develop a competitive advantage in a global economy, the compensation program of the organization must support totally the strategic plans and actions of the organization. Labor costs greatly affect competitive advantage because they represent a large portion of a company's operating budget. By effectively controlling these costs, a firm can achieve cost leadership. The impact of labor costs on competitive advantage is particularly strong in service and other labor-intensive organizations, where employers spend between 40 and 80 cents of each revenue dollar on such costs. This means that for each dollar of revenue generated, as much as 80 cents may go to employee pay and benefits.


In terms of compensation, employee payment is divided into different subcategories based on what sort of job the employee has and what payment plan the organization follows for that particular job.

Jobs generally have two classifications, exempt and non-exempt, based on the qualities and position of the employment. Management positions, professional jobs, and many other higher-level positions within an organization are exempt, meaning that they are paid by salary instead of wage. Exempt positions are salary positions, where the employee is paid not by the hour but by a certain interval of time, upon which the employee receives a predetermined amount of payment. Most exempt positions receive higher compensation and benefits than non-exempt jobs but do not receive any added payment for overtime; indeed, people in exempt positions are expected to fulfill expectations often requiring more effort and longer hours than non-exempt positions.

Non-exempt jobs are paid with a wage, an hourly amount. Nearly all entry-level positions and unskilled jobs fall in this category, with the employee receiving payment based on a predetermined, hourly wage. This wage, like the salary, is subject to change based on performance reviews. A different wage is usually available for the employee when working overtime, over 40 hours a week, or on holidays. This wage is higher than the normal hourly rate.

Payment systems are also divided according to two different classifications. First, payment can include a base pay, or set amount that the employee will receive. This is the amount that defines the salary or wage; it is set by the organization through the study of many factors, including the market rate and the history of payment for that position. The base pay and the definition of the job are closely connected. The other type of employee compensation is variable pay, or payment based on some type of performance by the employee. Variable pay can take many forms, including incentives and commissions. Most American jobs are a combination of base and variable pay, the ratio changing for different positions, although American jobs tend to have a higher variable pay component than other nations previously did, an organizational decision that is now being adopted globally.


Several important forms of national legislation have had a significant effect on employee compensation over the last hundred years of United States business. State legislation has often added onto national legislation, increasing compensation for wages or creating additional requirements for organizations, but federal law has led the way in changing compensation practices.

The Fair Labor Standards Act of 1938 (FLSA) applied to all commercial jobs and set the foundation of regulation of employee compensation. Among other things, the act established the first national minimum wage, set restrictions against the employment of minors by defining oppressive child labor, and enforced time-and-a-half policies for overtime work (the law stating that, for certain positions, employees must be paid 50 percent more per hour for overtime). Several other acts throughout American history have affected the FLSA. The Portal-to-Portal Act, enacted in the 1940s, defined work time and what sort of work had to be paid. Other amendments defined more specifically what businesses were covered by the FLSA, made coverage a requirement for care facilities, public establishments, and all government positions, and raised the federal minimum wage several times.

Also important to the history of employee compensation is the Equal Pay Act of 1963, which was created in order to prevent discrimination in pay, especially sexual discrimination. This act included several reasons Congress had for enforcing equal payment for the sexes, citing economic gain and living standards. The act also focused on requiring payment systems to be based solely on skills and experience, rather than gender.

The Employee Retirement Income Security Act of 1974 required a minimum pension plan amount for businesses, and established a series of tax laws to govern the use of pension plan payments.

In 2004, the government enacted several changes to the FLSA, called FairPay. FairPay dealt mostly with reclassifying job positions and their definitions. This caused many jobs to be switched between the categories of exempt and non-exempt. Some supervisors who had previously been on wages were required to switch to salaries, losing their overtime benefits. Other employees,

especially in supportive roles of business administration, were moved from wages to exempt status. These changes were made in order to classify jobs more according to their functions and responsibilities than to their titles.

Most recently, the Fair Minimum Wage Act of 2007 again raised the federal wage level, from $5.25 to $7.25 an hour, to better represent state and private wages across the nation. This act will reach completion in 2009.


Since compensation practices heavily influence recruitment, turnover, and employee productivity, it is important that applicants and employees view these practices in a favorable light. In the following section, we discuss how people form perceptions about a firm's compensation system and how these perceptions ultimately affect their behavior.

Equity is an important concern, so individuals responsible for developing a firm's compensation system need to understand how perceptions of equity are formed. Equity theory, formulated by J. Stacy Adams, attempts to provide such an understanding. The theory states that people form equity beliefs based on two factors: inputs and outcomes. Inputs (I) refer to the perceptions that people have concerning what they contribute to the job (e.g., skill and effort). Outcomes (O) refer to the perceptions that people have regarding the returns they get (e.g., pay) for the work they perform. People judge the equity of their pay by comparing their outcome-to-input ratio (O/I) with another person's ratio. This comparison person is referred to as one's referent other. People feel equity when the O/I ratios of the individual and his or her referent other are perceived as being equal. A feeling of inequity occurs when the two ratios are perceived as being unequal. For example, inequity occurs if a person feels that he or she contributes the same input as a referent other, but earns a lower salary.

A person's referent other could be any one of several people. People may compare themselves to others:

  • Doing the same job within the same organization
  • Working in the same organization, but performing different jobs
  • Doing the same job in other organizations

For example, an assistant manager at a Wal-Mart department store might compare her pay to other assistant managers at Wal-Mart, to Wal-Mart employees in other positions (either above or below her in the organizational hierarchy), or to assistant managers at Kmart department stores.

While the mechanism for choosing a referent other is largely unknown, one study found that people do not limit their comparisons to just one person; they have several referent others. Thus, people make several comparisons when they assess the fairness of their pay; perceived fairness is achieved only when all comparisons are viewed as equitable. When employees' O/I ratios are less than that of their referent others, they feel they are being underpaid; when greater, they feel they are being over-paid. According to equity theory, both conditions produce feelings of tension that employees will attempt to reduce in one of the following ways:

  1. Decrease inputs by reducing effort or performance.
  2. Attempt to increase outcomes by seeking a raise in salary.
  3. Distort perceptions of inputs and/or outcomes by convincing themselves that their O/I ratio already is equal to that of their referent other.
  4. Attempt to change the inputs and/or outcomes of their referent other(s). For example, they may try to convince their referent other(s) to increase inputs (e.g., work harder for their pay).
  5. Choose a new referent other whose O/I ratio already is equal to their own.
  6. Escape the situation. This response may be manifested by a variety of behaviors, such as absenteeism, tardiness, excessive work-breaks, or quitting.

While equity theory poses six possible responses to inequity, only two of them typically occur (namely, numbers 1 and 6). Research findings, for example, have linked underpayment to increases in absenteeism and turnover, and to decreases in the amount of effort exerted on the job. These linkages are especially strong among individuals earning low salaries.

Contrary to equity theory's predictions, these responses occur only when employees believe they are underpaid. Overpaid individuals do not respond because they feel little, if any tension, and thus have no need to reduce it. (The research findings on the issue of overpayment find overpayment to be either just as satisfying as equity, or somewhat dissatisfying but not nearly as dissatisfying as underpayment.) When feeling underpaid, why do some people choose to decrease their inputs, while others choose to escape the situation? A study found that reaction to inequity depends on the source of the comparison; people react differently depending on whether they judge equity on the basis of external (referents outside of the organization) or internal (referents employed by the individual's own organization) comparisons. When perceptions of inequity are based on external comparisons, people are more likely to quit their jobs. For instance, a nurse working for Hospital A may move to Hospital B if the latter pays a higher salary. When based on internal comparisons, people are more likely to remain at work, but reduce their inputs (e.g., become less willing to help others with problems, meet deadlines, and/or take initiative).

From the previous discussion, one may conclude that employees will believe their pay is equitable when they perceive that it:

  • Is fair relative to the pay received by coworkers in the same organization (internal consistency).
  • Is fair relative to the pay received by workers in other organizations who hold similar positions (external competitiveness).
  • Fairly reflects their input to the organization (employee contributions).


To achieve internal consistency, a firm's employees must believe that all jobs are paid what they are worth. In other words, they must be confident that company pay rates reflect the overall importance of each person's job to the success of the organization. Because some jobs afford a greater opportunity than others to contribute, those holding such jobs should receive greater pay. For instance, most would agree that nurses should be paid more than orderlies because their work is more important; that is, it contributes more to patient care, which is a primary goal of hospitals.

For pay rates to be internally consistent, an organization first must determine the overall importance or worth of each job. A job's worth typically is assessed through a systematic process known as job evaluation. In general, the evaluation is based on informed judgments regarding such things as the amount of skill and effort required to perform the job, the difficulty of the job, and the amount of responsibility assumed by the jobholder.

Job evaluation judgments must be accurate and fair, given that the pay each employee receives is so heavily influenced by them. Most firms create a committee of individuals, called a job evaluation committee, for the purpose of making the evaluations. Because those serving on the committee represent the organization's various functional areas, collectively they are familiar with all the jobs being evaluated. Such individuals typically include department managers, vice presidents, plant managers, and HR professionals (e.g., employee relations specialists and compensation managers). The committee chair usually is an HR professional or an outside consultant.

Perhaps the two most serious problems with job evaluation ratings are subjectivity and the rapidity with which jobs fundamentally change, both of which can cause inaccurate and unreliable ratings. In order to minimize subjectivity, the rating scales used to evaluate jobs must be clearly defined, and evaluators should be thoroughly trained on how to use them. Moreover, the evaluators should be provided with complete, accurate, and up-to-date job descriptions. The second issue is more difficult to address. Due largely to changes in technology,

Exhibit 1
Compensable Factors Used in the Point-Factor Method of Job Evaluation
Compensable Factor Rating Criteria
Skill/know-how Education
Effort Physical Effort
  Mental Effort
Responsibility Judgement/decision-making
  Internal business contacts
  Consequence of error
  Degree of influence
  Supervisory responsibilities
  Responsibility for independent action
  Responsibility for machinery/equipment
  Fiscal responsibility
  Responsibility for confidential information
Working conditions Risks
  Physical demands
  Personal demands

jobs now change so rapidly and so fundamentally that evaluation results quickly become out of date.

Job evaluation process is analogous to performance appraisal in that evaluators are asked to provide certain ratings on a form. Job evaluation ratings, however, focus on the requirements of the job rather than on the performance of the individual jobholder. Although several methods may be used to evaluate jobs, the most common approach is the point-factor method. Using this method, jobs are evaluated separately on several criteria, called compensable factors. These factors represent the most important determinants of a job's worth. A list of some commonly used factors and the criteria upon which they are judged appear in Exhibit 1.

The development of a point-factor rating scale consists of the following steps:

  1. Select and carefully define the compensable factors that will be used to determine job worth.
  2. Determine the number of levels or degrees for each factor. The only rule for establishing the number of degrees is that some jobs should fall at each level.
  3. Carefully define each degree level. Each adjacent level must be clearly distinguishable.
  4. Weight each compensable factor in terms of its relative importance for determining job worth.
  5. Assign point values to the degrees associated with each compensable factor. Factors assigned greater weights in Step 4 would be allotted a greater number of possible points for each degree level.

When completing the job evaluation ratings, the evaluators use job descriptions to rate each job, one factor at a time until all jobs have been evaluated on all factors. They then calculate a total point value for a job by summing the points earned on each compensable factor.

This approach to job evaluation is difficult and time-consuming. However, most organizations believe that it is well worth the effort. If properly conducted, the overall score for each job should reflect its relative worth to the organization, thus enabling the firm to establish internal consistency.

When job evaluations have been completed, jobs are grouped into pay grades based on the total number of points received. Jobs with the same or similar point values are placed in the same grade. For example, consider jobs that are rated on a scale from 1 to 1,000. All jobs earning up to 100 points could be assigned to pay grade one, jobs earning 101 to 200 to pay grade two, and so forth.

Administrators use pay grades because, without them, firms would need to establish separate pay rates for each job evaluation point score. Once jobs are classified into grades, all jobs within the same grade are treated alike for pay purposes; that is, the same range of pay applies to each job in a grade.

As companies develop pay grade systems, they must decide how many pay grades to establish. Most firms use thirty to fifty pay grades. However, some use as many as one hundred or more, while others use as few as five or six. The practice of limiting the number of pay grades eases the firm's administrative burdens. However, using a limited number of grades creates a situation in which jobs of significantly different worth fall into the same grade and receive the same pay. This outcome could lead to equity problems. For instance, registered nurses may feel under-paid if classified in the same pay grade as nursing aides.


A firm achieves external competitiveness when employees perceive that their pay is fair in relation to what their counterparts in other organizations earn. To become externally competitive, organizations must first learn what other employers are paying and then make a decision regarding just how competitive they want to be. They then establish pay rates consistent with this decision. Following is an examination of how these steps are carried out.

The firm begins by conducting or acquiring a salary survey. This survey provides information on pay rates offered by a firm's competitors for certain benchmark jobs (i.e., jobs that are performed in a similar manner in all companies and can thus serve as a basis for making meaningful comparisons). Some firms gather this information from existing surveys already conducted by others, such as those produced by the Bureau of Labor Statistics. Trade associations also conduct surveys routinely for their members, or companies may hire consulting firms to gather such information. Salary surveys conducted by others should be used when they contain all the information needed by the company in question. When no such surveys exist, companies generally conduct their own.

After the pay practices of other companies have been identified, the organization must determine how competitive it wants to be (or can afford to be). Specifically, it must set a pay policy stipulating how well it will pay its employees relative to the market (i.e., what competitors pay for similar jobs). The determination of a pay policy is a crucial step in the design of a pay system. If pay rates are set too low, the organization is likely to experience recruitment and turnover problems. If set too high, however, the organization is likely to experience budget problems that ultimately may lead to higher prices, pay freezes, and layoffs.

Once market rates for jobs are determined and a pay policy is established, an organization must price each of its jobs. Since market rates identified by a salary survey usually are restricted to benchmark jobs, how do organizations determine these rates for their non-benchmark jobs? Using the data collected on the benchmark jobs, an organization would determine the statistical relationship (i.e., simple linear regression) between job evaluation points and prevailing market rates. This regression line is referred to as the pay policy line. The appropriate pay rates for non-benchmark jobs are set based on this line.


Recently, the payment plans and benefits for the top executives in American business have been questioned. The national attention that the tax and fraud scandals of 20002002 brought to companies also shed light on the profits chief executives were making, especially their bonus and benefit packages, which many felt to be unfairly inflated based on the returns investors were receiving and the compensation of other employees in the companies. Amendments to the Sarbanes-Oxley Act, carried out in 2006, require that executive compensation pertaining directly to investor information must be disclosed in a separate section of financial reports. This led to a wider knowledge of executive payment practices among the public than had previously been seen before, and began a series of critical examinations of companies and their treatment of top management.

These questionable compensation plans applied to many in top management, including chief executive officers, mergers and acquisitions executives, top tax executives, top sales executives, and top diversity executives. According to a Watson Wyatt analysis, people in these positions received a

2007 pay increase of 11.4 percent or more, with merger and acquisition officers receiving the highest average pay increase. Recent legislation pertaining to executive payment includes the Office of Federal Procurement Policy's 2008 compensation cap establishing a maximum yearly salary for contracted companies and certain management positions within them. The maximum amount for government contract management positionswhich combines salaries, benefits, and other extra executive profitsis $612,196.

In response to the continuing criticism, companies are taking a closer look at how they pay executives and how much payment is financially responsible, healthy for their business, and encouraging to their stockholders. According to a 2008 Wall Street Journal article by Phred Dvorak, approximately 15 percent of Fortune 500 companies took a closer look at their payment systems when paying executives the 2007 salary, taking into account such factors as accumulated wealth. This number is nearly double the amount of firms who accounted for such factors in 2006.

As an example, in 2007 Waddell & Reed Financial Inc. decided to halt further contributions to the retirement fund of the CEO Henry Herrmann. Their review of his accumulated wealth showed that, during his thirty-six-year career, he had amassed roughly $70 million in stocks, deferred compensation, bonuses, and other benefits. The company decided he had sufficient funds to retire and stopped the retirement contribution plan. Although companies' reactions are varied, Waddell & Reed may not be alone in their compensation dilemmascompensation tracker Equilar has found the average stock owned by a large-company CEO in 2007 was worth about 56.7 million dollars. While some companies are declaring such stock gains to be prohibitive, others argue that such stock investments give executives incentives to perform well.

Performance Plans for Executives. There are many forms of performance plans for executives, but most involve the company reaching certain goals under the executive's supervision. Often, a third-party compensation committee is created solely to supervise the compensation plans for top executives, and avoid public criticism or unfair payment practices.

Some performance plans divide compensation requirements into two different areas. First, the compensation committee looks at what accomplishments the company intended to make in the past year under the executive's guidance, and how far the company has progressed in reaching those goals. Second, the committee takes into account leadership qualities and judgment decisions made by the executive, a more flexible factor including personal skills and management talent. A ratio can be formed for these two areas, assigning each a percentage of overall importance.

Other plans divide the executive's accomplishments down even further, taking into account vision, team-building, and accountability. Often, such plans are either long-term or short-term. Short-term plans will evaluate recent goals and decisions made by the executive, while long-term analysis extends throughout the past year. Benefits are awarded based on similar plans, which can factor in growth of company stock and evaluation by other board members.

According to revenue laws established in 1993 to help create fair practice in executive compensation, there are limitations to how much overall tax deductions a company can take from the benefits and payment of its five top executives, unless the payment is performance based. The tax deduction limit was $1 million, which was intended to be the cap for executive salaries for commercial companies, all other benefits being limited to stock options. Performance plans have since evolved to include other benefit forms, but the key component remains stock options.

Deferred Compensation. Most executive retirement plans, granted in the form of a salary percentage or stock options, are considered deferred compensation. It is deferred because the money is set aside in some type of savings account or investment for the executive, until such time as it can be accessed. This is different from the retirement package an executive often receives when stepping down.

Deferred compensation can be of two different types, qualified and nonqualified, as pertaining to taxes. Qualified deferred compensations are those which are subject to tax laws, including the million dollar limit deductable for the company granting the compensation. These are the more traditional, common sort of deferred compensation plan. Some companies, however, choose to grant their executives unqualified deferred compensation, which is not subject to the same tax laws and usually results in a larger retirement package for the executive. The company accomplishes unqualified compensation by setting the money aside within the organization, not legally granting it to the executive but retaining it in a separate account. Any money earned by the fund is reinvested, until the executive retires. The deferred compensation, however, is based upon the success of the company, and if the company becomes insolvent, the fundand the retirement packageare at risk.

Legislation is currently being debated in Congress on increasing taxes and restrictions for nonqualified deferred compensation, since it is seen by some as a loophole in the current laws.

Intermediate Sanctions. Intermediate sanctions are used by the IRS to administer excise taxes to individuals who are believed to have improperly or illegally benefited from a commercial company transaction. Although this is a broad definition, it is meant to apply primarily to family

members, organizations, and company executives who receive benefits from their company greater than the IRS considers reasonable. The sanctions can be applied to the individual receiving the benefits and to anyone who has given permission for such benefits, such as other members of the corporate board.

While these sanctions limit the amount of payment and extra benefits executives can be granted, they also function on more subtle levels. Intermediate sanctions are most often applied by the IRS in cases where the individual profits indirectly from the company's actions. For instance, the executive might receive a certain amount of stock as part of a deferred compensation plan, but also receives a second amount of stock from a dummy organization as a gift or bonus. Overall, the executive has profited more from the exchange than the company could have, and is open to intermediate sanctions. Other arrangements can also lead to sanction penalties by the IRS.

Usually, the money from such activities, plus interest, is returned to the company, and the individual is penalized, usually at 25 percent of the excess benefit as decided by the IRS. If the individual does not return the profits to the organization, or pay the penalty fee within the taxable period, the required tax shoots up to 200 percent of the excess benefit received. A tax of 10 percent might also be imposed on any manager or board member who took part in the decision to impart the excess benefit.

Shareholder Voting. There is a current push for legislation requiring some sort of shareholder vote authorizing executive compensation, known as the Say on Pay law. This would require an annual vote by all shareholders in the company on compensation methods and amounts. Although this legislation has not yet been passed by Congress, it has been submitted numerous times in 20072008. Many organizations are against the Say on Pay law, fearing it would turn compensation plans in a lengthy bureaucratic bargaining system.


As stated before, American companies often used a mixture of base and variable pay to determine an employee's compensation. The amount of variable pay is usually larger in American than internationally, where the term compensation most often means extra benefits and remuneration means the wages or salaries received.

Globally, there are several considerations that must be made when creating a compensation (or remuneration) plan for outsourced workers or international plants. A company should understand what counts as a healthy standard of living for the nation they are working with, as well as knowing what forms of benefits are acceptable. Some changes might be needed for incentive plans in different cultures that put a stronger emphasis on different values or company qualities than the United States does in its incentives. Also, tax laws and data security may be different in other countries, leading to necessary changes in compensation plans.

When creating forms of compensation, whether at home or internationally, there are several factors companies should take into consideration. For instance, any changes in employee compensation will affect the value propositions made to potential employees, Skilled employees will naturally be more attracted to companies that offer above-market rates.

SEE ALSO Employee Benefits; Employee Evaluation and Performance Appraisals; Human Resource Management


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Employee Compensation

Employee Compensation

People work in order to earn money, but the structure of compensation is quite diversified. The two broadest categories are salaries and wages. Salaries tend to be paid every other week or monthly; wages are typically calculated by the hour but paid by the week. As a consequence of legislative language, salary-earning employees are sometimes referred to as "exempt" employees and hourly workers as "non-exempt"; in other words the first are exempt from the requirements of Fair Labor Standards Act (discussed below), the latter group are covered. Compensation may also take the form of commissions paid to sales people based entirely on some percent of the goods or services they sell; this type of compensation is often combined with a minimal salary to even out the ups and downs of commission earningsbut people on pure commission who fail to "earn back" their base salary rarely continue in the job long. Piece work, where pay is based on actual performance of some job measured by units produced, is a variant of this approach. People serving as wait-personnel in restaurants are typically compensated by a low wage inadequate to support them: they get the majority of their income from tips. In the so-called New Economy which began emerging in the 1990s, characterized by cutbacks and layoffs of salaried and professional employees, many individuals became self-employed of necessity but, often, continued working in actual "jobs," much as before. The compensation of such people is based on contract revenues, but they receive no fringe benefits and are required to pay their own payroll taxes.

Compensation has a legal status and, once engaged, people can use the courts to enforce the employment agreement. Employee benefits ("fringe benefits") have another status: they are provided at the employer's option and may be withdrawn at will. As such they are not strictly speaking compensation although, in practice, they are viewed as a part of the full compensation "package." The employer's payment of premiums for certain types of fringe benefits, such as health care coverage and insurance policies (disability, life insurance), are not viewed under tax law as part of the employee's taxable income. Others, such as the provision of an automobile or housing, are taxable and therefore fall under the definition of "compensation."


For the non-exempt part of the workforce hours spent on the job are the measure of compensation to be paid. Time spent at work is regulated by the government, and laws govern pay scales over and above the specified work week, typically 40 hours. The vast majority of exempt workers are also required to work a fixed number of hours a weekbut the hours may be flexible under "flextime" rules set by the employer. For exempt employees, pay for "overtime" is not controlled by law in most cases. In other words, the typical administrative/professional/executive employee is expected to work 40 hoursand as many more as the job may require, the extra hours compensated, if at all, by bonuses or time off. In the case of people working for commissions, time spent on the job is only incidentally related to compensation. Normally, of course, such people spend a lot of time workingbut one can imagine the highly charismatic (and lucky) sales person who, in a couple of hours a month, can move a million dollars worth of real estate.


The Fair Labor Standards Act of 1938 (FLSA) is in a sense the basic law controlling employment and compensation issues and, through amendments passed later, the management of benefits packages. FLSA sets minimum wage, overtime pay, equal pay for men and women, controls child labor, and establishes record keeping requirements. On the whole FLSA is aimed at protecting the non-exempt work forcewhich was the overwhelming majority of all workers at the time of the law's passage. Since that time the profile of the workforce has greatly change; amendments to FLSA have in part reflected these changes. As illustrated by state over-rides of FLSA's minimum wage requirements (see below), states also actively regulate compensation and other aspects of the workplace.

The chief amendment of FLSA was passage of the Equal Pay Act of 1963 (EPA). EPA prohibits unequal compensation of men and women in the same workplace doing similar jobs. EPA makes exceptions for seniority, allows the use of merit systems, and recognizes compensation systems based on performance. EPA requirements do not differentiate between exempt and nonexempt employees.

Other legislation related to employment compensation issues includes: 1) the Consumer Credit Protection Act of 1968 which deals with wage garnishments; 2) the Employee Retirement Income Security Act of 1974 (ERISA), which regulates pension programs; 3) the Old Age, Survivors, Disability and Health Insurance Program (OASDHI), which forms the basis for most benefits programs; and 4) legislation implementing unemployment insurance, equal employment, worker's compensation, Social Security, Medicare, and Medicaid programs and laws.


The two major issues related to compensation are the adequacy of the compensation, addressed by minimum wage laws, and pay equitybetween women and men and between racial and ethnic groupsaddressed by EPA and social anti-discrimination statutes.

Minimum Wage

Non-exempt employees, for whom the definition is intrinsically tied to time, are also guaranteed a minimum wage of $5.15 per hour under federal law. Six states (Alabama, Arizona, Louisiana, Mississippi, South Carolina, and Tennessee) have no minimum wage. Fifteen states have higher minimum wage than the U.S. as a whole: Alaska, California, Connecticut, Delaware, Florida, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New Jersey, New York, Oregon, Washington, and Wisconsin. The highest wage is in Oregon, $7.63 an hour; in 2006 Connecticut had a $7.40 per hour minimum wage to be raised to $7.65 in 2007. The rest of the states have the same minimum wage as the national rate. Under the federal rules, a non-exempt worker is entitled to receive the highest minimum wage available in the place where he or she works. Changes in state law are monitored by the U.S. Department of Labor and may be consulted at

Equal Pay for Women and Men

Detailed data comparing income of men and women in the same occupation are not routinely collected so that the pay-equity issues remains somewhat in the dark, but more general data series give an indication of overall patterns. Based on data published by the U.S. Census Bureau, the average income of a man in 1954, but measured in 2004 dollars, was $20,992 a year. The average income of a woman, using the same method of calculation, was $9,358. On average, in 1954 a woman earned 44.6 percent of what a man earned. Women's earnings were 41.1 percent of men's in 1964, thus showing a decline, 42.2 percent in 1974 (still down from 1954), were up to 49.3 percent in 1984 but dropped again to 43 percent in 1994. In 2004, average male income was $42,832, average female income was $24,998. A gap of $17,834 separated men from women, but women were earning an all time high of 58.4 percent of what men earned on average.

In this 50-year period, women's income grew at a faster rate than men's (1.98 percent a year versus men's income at 1.44 percent). Women's participation rate in the work force grew in this period as well: female participation in the workforce increased from 34 percent to 59.2 percent, 1954 to 2004. At the same time, the difference in male-female income averaged around $17,000 a year in this period, strongly suggesting that women had a competitive advantage in the labor market. This is further substantiated by data, published in Social Trends and Indicators USA showing that more men than women (on a percentage basis) are laid off during periods recessions.

In a 2002 survey conducted by the U.S. Bureau of the Census and published in Current Population Survey data showing income differentials between men and women of the same educational attainment are presented. This study showed that income differentials were substantial across the board: 2000 data showed women on average earning 57.5 percent of what men earned. The differentials were the following: for less than 9th grade education, 59.9 percent; for high school graduates, 59.3; for bachelor's degree, 56.0; for masters, 59.7; for professional degrees, 55.9; and for doctoral degrees, 60.3 percent of what men with the same education attainment level earned.

Racial and Ethnic Differences

The U.S. Bureau of the Census data cited above for all men and women also provide a look at racial and ethnic differenceand difference between men and women in those groups. Data cited are for 2004 only because long-term data are not uniformly available. The highest average earnings are achieved by Asians. Asian women have the highest earnings among all women but earn only 61.1 percent of the income of Asian males. Lowest earnings were reported for Hispanics, again for both males and females. Hispanic females earned 66.5 percent of what Hispanic males earned. Whites had the second highest earnings, but white women lagged farthest behind. They had 56.9 percent of white males' earnings. Black women earned 75.5 percent of black males' earnings. For these four racial and ethnic group comparisons, black women were highest in relation to men.


According to a Wells Fargo press release, announcing the latest Wells Fargo/Gallup Small Business Index, "Sixty percent of small business owners see the amount of compensation they can offer an employee as a critical disadvantage when compared to larger companies."

Are small business owners simply grumbling? No. Data for 2001 from the Census Bureau on firm size measured by employment and payroll show that the smaller the firm, the lower the average payroll per employee. Companies with 10,000 or more employees averaged $39,789 per employee, the smallest firms (1-4 employees) averaged $27,299. With the exception of companies with 5-9 employees, which were even lower than the smallest at $26,706, at each step up the size-scale payroll per employee went up.

Small firms dominate the corporate population. Firms with less than 100 employees were 98 percent of all firms employing people, those with 100 or more employees were 2 percent of companies. But the small firms employed 36 percent of people working for companies in 2001 (41 million) and large firms employed 64 percent (74 million). In 2001 companies with fewer than 100 employees had payroll costs of $29,138 per employee, companies with 100 or more employees had costs of $37,265 per employee, for a differential of $8,127 a year.

In the mid-2000s, indeed in earlier periods as well, small business had certain advantages: it was adding while the large companies were shedding jobs. The small business sector also offers a work environment that is attractive to many individuals and this fact can be turn to an advantage when recruitingeven if with lower salaries. These include hands-on involvement in business activity, absence of bureaucracy, flexible and often more varied job assignments, more rapid and rational decision processes, and the ability of a small business to adapt to the special needs of an employee. Some employees also value closer contact with the customer; yet others, especially those with entrepreneurial ambitions, feel that they can learn more about business in a small enterprise than embedded deep in the structure of a large one.

A practical aid for the small business owner offered by the Bureau of Labor Statistics is an extensive and reasonably up-to-date tabulation of wages actually paid per occupation by area. This is the BLS Wages by Area and Occupation Program, accessible on the internet. Close study of what wages actually are paid often shows that prevailing rates are frequently much more modest than generally believed because of local or regional economic conditions.

see also Employee Benefits; Employee Motivation; Employee Reward Systems


"ADP Small Business ServicesEasyPayNet" The CPA Technology Advisor. August 2005.

Brainfood: Workplace RightsGender pay." Management Today. 7 February 2006.

Magee, Monique D. ed. "Are Women Better Able to Weather Economic Storms?" Social Trends and Indicators USA: Work & Leisure. The Gale Group, 2003.

"Small Businesses Face Tough Competition Attracting Top Talent According to Wells Fargo/Gallup Small Business Index." Press Release. Wells Fargo. 3 May 2005.

"Small Business Index." Business Record (Des Moines). 9 May 2005.

U.S. Census Bureau. Current Population Survey. 21 March 2002.

U.S. Census Bureau. "Historical Income TablesPeople." Available from Retrieved on 5 March 2006.

U.S. Department of Labor. "Minimum Wage Laws in the States-January 1, 200" Available from Retrieved on 6 March 2006.

U.S. Department of Labor. Bureau of Labor Statistics. "Wages by Area and Occupation." Available from Retrieved on 6 March 2006.

                                 Hillstrom, Northern Lights

                                  updated by Magee, ECDI

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Employee Compensation


In exchange for job performance and commitment, an employer offers rewards to employees. Adequate rewards and compensations potentially attract a quality work force, maintain the satisfaction of existing employees, keep quality employees from leaving, and motivate them in the workplace. A proper design of reward and compensation systems requires careful review of the labor market, thorough analysis of jobs, and a systematic study of pay structures.

There are a number of ways of classifying rewards. A commonly discussed dichotomy is intrinsic versus extrinsic rewards. Intrinsic rewards are satisfactions one gets from the job itself, such as a feeling of achievement, responsibility, or autonomy. Extrinsic rewards include monetary compensation, promotion, and tangible benefits.

Compensation frequently refers to extrinsic, monetary rewards that employees receive in exchange for their work. Usually, compensation is composed of the base wage or salary, any incentives or bonuses, and other benefits. Base wage or salary is the hourly, weekly, or monthly pay that employees receive. Incentives or bonuses are rewards offered in addition to the base wage when employees achieve a high level of performance. Benefits are rewards offered for being a member of the company and can include paid vacation, health and life insurance, and retirement pension.

A company's compensation system must include policies, procedures, and rules that provide clear and unambiguous determination and administration of employee compensation. Otherwise, there can be confusion, diminished employee satisfaction, and potentially costly litigation.


Fair and adequate compensation is critical to motivating employees attracting high-potential employees, and retaining competent employees. Compensation has to be fair and equitable among all workers in the same company (internal equity). Internal equity can be achieved when pay is proportionate to the individual employee's qualifications and contributions to a company. On the other hand, compensation also has to be fair and equitable in comparison to the external market (external equity). If a company pays its employees below the market rate, it may lose competent employees. In determining adequate pay for employees, a manager must consider the three major factors: the labor market, the nature and scope of the job, and characteristics of the individual employee.

Potential employees are recruited from a certain geographic areathe labor market. The actual boundary of a labor market varies depending on the type of job, company, and industry. For example, an opening for a systems analyst at IBM may attract candidates from across the country, whereas a secretarial position at an elementary school may attract candidates only from the immediate local area of the school.

Pay for a job even within the same labor market may vary widely because of many factors, such as the industry, type of job, cost of living, and location of the job. Compensation managers must be aware of these differences. To help compensation managers understand the market rate of labor, a compensation survey is conducted. A compensation survey obtains data regarding what other firms pay for specific jobs or job classes in a given geographic market. Large companies periodically conduct compensation surveys and review their compensation system to assure external equity. There are professional organizations that conduct compensation surveys and provide their analysis to smaller companies for a fee.

Several factors are generally considered in evaluating the market rate of a job. They include the cost of living of the area, union contracts, and broader economic conditions. Urban or metropolitan areas generally have a higher cost of living than rural areas. Usually, in calculating the real pay, a cost-of-living allowance (COLA) is added to the base wage or salary. Cost-of-living indexes are published periodically in major business journals. During an economically depressed period, the labor supply usually exceeds the demand in the labor market, resulting in lower labor rates.

The characteristics of an individual employee are also important in determining compensation. An individual's job qualifications, abilities and skills, prior experiences, and even willingness to work in hardship conditions are determining factors. Within the reasonable range of a market rate, companies offer additional compensation to attract and retain competent employees.

In principle, compensation must be designed around the job, not the person. Person-based pay frequently

results in discriminatory practices, which violates Title VII of the Civil Rights Act, and job-based compensation is the employer's most powerful defense in court. For job-based compensation, management must conduct a systematic job analysis, identifying and describing what is happening on the job. Each job must be carefully examined to list the necessary tasks and actions, identify skills and abilities required, and establish desirable behaviors for successful completion of the job.

With complete and comprehensive data about all the jobs, job analysts must conduct systematic comparisons of them and determine their relative worth. Numerous techniques have been developed for the analysis of relative worth, including the simple point method, job classification method, job ranking method, and the factor comparison method.

Information resulting from the comprehensive job analysis will be used for establishing pay or wage grades. Assume that twenty-five jobs range from 10 to 50 points in their job scores based on the job point method. All twenty-five of these jobs are reviewed carefully for their relative worth and plotted on Figure 1. The x-axis represents job points and the ordinate (y-axis) represents relative worth or wage rates. Once a manager can identify fair and realistic wages of two or more jobs, desirably top and bottom ones, then all the rest can be prorated along the wage curve in the diagram.

In order to simplify the administration of a wage structure, similar jobs in the approximate cluster are grouped together into a class or grade for pay purpose. Figure 2 shows how twenty-five jobs are grouped into five pay grades. Employees move up in their pay within each grade, typically by seniority. Once a person hits the top pay in the grade, he or she can only increase the pay by moving to a higher grade. Under certain unusual circumstances, it is possible for an outstanding performer in a lower grade to be paid more than a person at the bottom of the next-highest level.


As the market becomes more dynamic and competitive, companies are trying harder to improve performance. Since companies cannot afford to continually increase wages by a certain percentage, they are introducing many innovative compensation plans tied to performance. Several of these plans are discussed in this section.

Incentive Compensation Plan

Incentive compensation pays proportionately to employee performance. Incentives are typically given in addition to the base wage; they can be paid on the basis of individual, group, or plant-wide performance. While individual incentive plans encourage competition among employees, group or plant-wide incentive plans encourage cooperation and direct the efforts of all employees toward achieving overall company performance.

Skill-Based or Knowledge-Based Compensation

Skill-based pay is a system that pays employees based on the skills they possess or master, not for the job they hold. Some managers believe that mastery of certain sets of skills leads to higher productivity and therefore want their employees to master a series of skill sets. As employees gain one skill and then another, their wage rate goes up until they have mastered all the skills. Similar to skill-based pay is knowledge-based pay. While skill-based pay evolved in the manufacturing sector, pay-for-knowledge developed in the service sector (Henderson, 1997). For example, public school teachers with a bachelor's degree receive the lowest rate of pay, those with a master's degree receive a higher rate, and those with a doctorate receive the highest.

Team-Based Compensation

As many companies introduce team-based management practices such as self-managed work teams, they begin to offer team-based pay. Recognizing the importance of close cooperation and mutual development in a work group, companies want to encourage employees to work as a team by offering pay based on the overall effectiveness of the team.

Performance-Based Compensation

In the traditional sense, pay is considered entitlement that employees

deserve in exchange for showing up at work and doing well enough to avoid being fired. While base pay is given to employees regardless of performance, incentives and bonuses are extra rewards given in appreciation of their extra efforts. Pay-for-performance is a new movement away from this entitlement concept (Milkovich and Newman, 2005). A pay-for-performance plan increases even the base payso-called merit increasesto reflect how highly employees are rated on a performance evaluation. Other incentives and bonuses are calculated based on this new merit pay, resulting in substantially more total dollars for highly ranked employee performance. Frequently, employees also receive an end-of-year lump sum bonus that does not build into base pay.


Recently, people have been concerned with the excessively high level of executive compensation. According to Business Week 's annual executive pay survey, in 1997 Sanford Weill, CEO of Travelers Group, collected $7.5 million in salary and bonuses plus $223.2 million for long-term compensation, totaling $230.7 million. In the same year, Roberto Goizueta, CEO of Coca-Cola, earned a total of $111.8 million, including annual salary, bonuses, and long-term compensation. Compensation for the twenty highest-paid executives ranged from $28.4 million to $230 million.

Frequently, executive compensation becomes controversial. Are these compensations excessive? What justifies such a large compensation for executives? Justification of such a large sum of compensation is linked to the company's performance. In fact, a significant portion of executive compensation results from exercising stock options, which were quite valuable in the recent bull market. Yet ordinary working-class Americans are outraged by the shocking contrast in pay raises: annual executive pay at large companies rose 54 percent in 1996, whereas the pay raises of most working-class people were in the 3 percent to 5 percent range during the same period.

An executive compensation package is typically composed of (1) base salary, (2) annual incentives or bonuses, (3) long-term incentives (e.g., stock options), (4) executive benefits (e.g., health insurance, life insurance, and pension plans), and (5) executive perquisites. Considering the high turnover rate of competent executives, offering a competitive salary is crucial in attracting the top candidates.

Frequently, annual bonuses play a more important role than base salary in executive compensations. They are primarily designed to motivate better performance. In order to underscore the importance of financial performance, usually measured by the company's stock price, top executives are offered stock options. Sometimes, exercising stock options yields more cash benefits to executives than do annual salaries.

In addition to monetary compensation, executives enjoy many different types of perquisites, commonly called perks. Such executive perks include the luxurious office with lush carpets, the executive dining room, special parking, use of a company airplane, company-paid membership in high-class country clubs and associations, and executive travel arrangements. Many companies even offer executives tax-free personal perks, including such things as free access to company property, free legal counseling, free home repairs and improvements, and expenses for vacation homes or boats.

Another perk that became popular recently is the socalled golden parachutea protection plan for executives in the event that they are forced out of the organization. Such severance frequently results from a merger or hostile takeover of the company. The golden parachute provides either a significant one-time sum to the departing executive or a guaranteed executive position in the newly merged company.

see also Employee Benefits


Henderson, Richard I. (2006). Compensation Management in a Knowledge-Based World (7th ed.). Upper Saddle River, NJ: Pearson/Prentice Hall.

Henderson, Richard I. (1994). Compensation Management: Rewarding Performance (6th ed.). Englewood Cliffs, NJ: Prentice Hall.

Klein, Andrew L. (1996). "Validity and Reliability for Competency-Based Systems: Reducing Litigation Risks." Compensation and Benefits Review, 28(4): 31-37.

Milkovich, George T., Newman, Jerry M., and Milkovich, Carolyn (1996). Compensation (8th ed.). New York: McGraw -Hill/Irwin.

Pauline, George B. (1997, March/April). "Executive Compensation and Changes in Control: A Search for Fairness." Compensation and Benefits Review 29: 30-40.

Reingold, Jennifer, and Borrus, Amy. (1997, May 12). "Even Executives Are Wincing at Executive Pay." Business Week, 4041.

Reingold, Jennifer, and Melcher, Richard A. (1998, April 21). "Executive Pay." Business Week, 5866.

Lee Wonsick Lee

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