Building Pay Structures that Recognizes Individual Contributions

Chapter # 07

Resource person: Furqan-ul-haq Siddiqui

Reference Books:

Human Resource Management (12th Edition), R. Wayne Mondy, Pearson Education.

Strategic Compensation: A Human Resource Management Approach (6th Edition), Joseph J., Martocchio Joe, Pearson Education.

Constructing a Pay Structure

Developing Pay Structures based on five steps

1. Deciding on how many pay structures to construct

2. Determining a market pay line

3. Defining pay grades

4. Calculating pay ranges

5. Evaluating the results

1. Deciding on how many pay structures to construct

Companies often establish more than one pay structures depending on

a. Market ratesb. Company’s job structure Company’s pay structure includes1. Exempt and non exempt ( wage – salary)2. Pay structures based on job families3. Pay structures based on geography

Exempt jobs: are not subject to overtime Core compensation in terms of salary Are generally supervisory, professional, managerial

or executive jobs Contains wide variety of duties Non exempt jobs Are subject to overtime Core compensation is expressed as hourly pay rates Are generally non supervisory in nature Duties tend to be narrowly defined

Pay structures based on job family Pay structures are defined on the basis of job family,

which show a distinct pattern in the market Distinct job families include:i. Executiveii.Managerialiii. Professionaliv. Technicalv. Clericalvi. Craft Pay structures based on geographya. The pay for similar positions that are within the same

company, but are located in different parts of the country, can be paid differently

b. Local influences, such as cost-of-living, influence pay structures

2. Determining a Market Pay Line Market pay line is representative of typical market

pay rates relative to a company’s job structure Pay levels that correspond with the market pay line

are market-competitive pay rates Pay rates that fall along the market pay line

represent competitive pay rates on the company’s selection of a relevant labor market

These rates promote internal consistency because they increase with the value of jobs—based on job evaluation points

Pay Structure for Clerk Jobs

Job Evaluation Points

$12000

$ 15000

$ 18000

$ 21000

$ 24000

$ 36000

250 points Clerk 1

500 points Clerk 2

750 points Clerk 3 1200 points

Clerk 4

Market Pay line

3. Defining Pay Grades Pay grades group jobs for pay policy application based

on similar compensable factors and value There is no one formula for determining what is

sufficiently similar in terms of content and value to warrant grouping into a pay grade

Job groupings are influenced by other factors a. Management philosophy b. Wider pay grades that include: i. A relatively large number of jobs ii.Minimize hierarchy iii. Minimize social distance between employees

Narrower pay grades tend to promote: i. Hierarchy ii. Social distance Pay grade widths are eithera. Absolute job evaluation point spreads, where pay

grades are based on a set number of job evaluation points

b. As a percentage-based evaluation point spreads, where the point spread increases as the jobs move up the pay structure, in recognition of the broader range of skills that higher pay grades represent

Pay Grade Definitions

$ 15000

$ 12000

$ 18000

$ 21000

$ 24000

$ 36000

Job Evaluation points

200 - 300 301- 650 651-1150 1151 - 2000

Messenger (200)

Mail clerk ( 220)

Clerk 1 (250)

Receptionist (300)

Mail clerk ii (350) Clerk ii (500) Secretary i (650)

Mail clerk iii (675) Clerk iii ( 750) Secretary ii ( 1000)

Mailroom Sup.( 1175) Chief Clerk (1200) Ex. Secretary (1900)

4. Calculating Pay Ranges for Each Pay Grade Pay ranges build upon pay grades Pay grade represent the horizontal dimension of pay structure ( job

evaluation points) Pay ranges represent the vertical dimension (pay rates) Pay ranges include midpoint, minimum, and maximum pay rates The minimum and maximum values denote the acceptable lower

and upper bounds of pay for the jobs within particular pay grade Mid points are established first, followed by minimum and

maximum rates The midpoint pay value is the halfway mark between the range

minimum and maximum Mid points generally match values along the market pay line

representing the competitive market rate determined by the analysis of compensation survey data

Midpoint may reflect market average or median

Example of Pay Grades and Pay Ranges

Setting Pay Range Midpoints

a. If the company adopts a market lead policy, that company’s midpoint will be higher than the market average

b.If the company adopts a market match policy, that company’s midpoint will be similar to the market average

c. If the company adopts a market lag policy, that company’s midpoint will be lower than the market average

Setting Pay Range Minimums and Maximums a. According to the market averagesb. By developing a pay range spread A range spread is the difference between the maximum and minimum pay rates of

a given pay grade It is expressed as a percentage of the difference between minimum and maximum

divided by the minimum Companies generally apply different range spreads across pay grades Most commonly they use progressively range spreads for pay grades that contain

more valuable jobs in terms of companies criteria Smaller range spreads characterize pay grades that contain narrowly defined jobs

that require simple skills with generally low responsibility Following are some of the reasons for applying larger range spreads for

higher level jobs Higher –level jobs afford employees greater promotion opportunities than entry

level jobs Employees tend to remain in higher pay grades longer The specialized skills associated with higher pay grades jobs are considered

valuable

Setting Pay Range Minimums and Maximums

Example: Typical Pay Range

* 20% to 25% -- lower-level service; production and maintenance

* 30% to 40% -- clerical, technical, paraprofessional

* 40% to 50% -- high-level professional, administration, middle management

* 50% and above -- high-level managerial, executive

Calculation of Range Spread1. Identify the midpoint $ 20,000

2. Determine the range spread 40%

3. Calculate the minimum:

Midpoint/ 100% + ( range spread/2) = $20,000/ 100%+ (40%/2)

= $ 16,666.67

4. Calculate the maximum:

Minimum + ( range spread x minimum = $ 16,666.67 + ( 40% x $ 16,666.67)

$23,333.37 Range Spread = 40%

Midpoint = $ 20,000

Minimum = $ 16,666.67

The impact of Alternative Range Spreads on Pay Range

Minimum and maximum values, with midpoint of $ 25000 Range Spread

20% 50% 80% 120%

$ 22,727 $20,000 $ 17,857 $ 15,625

$ 27272 $ 30,000 $ 32,143 $ 34,375

$ 4,545 $ 10,000 $ 14,286 $ 18,750

Minimum:

Midpoint/ 100% + (range spread/ 2)

Maximum:

Minimum + ( range spread x minimum)

Difference between maximum and minimum values

Setting Pay Range Minimums and Maximums

Adjacent pay ranges usually overlap with other pay ranges so that the highest range paid in one range is above the lowest rate of successive pay grade

Overlapping pay ranges allow companies to promote employees to the next level without adding to their pay

Non overlapping pay range require pay increases for job promotion

Overlap is expressed as a percentage

Calculating Pay Range Overlap

A

$ 20000

$ 35000

$ 3,0000

$ 40,000

B

100% x Max. rate for A – min. rate for B/ Max rate for A – min. rate for A

100% x ($ 35,000 – $30,000) / ( $35000 - $ 20000)

The overlap between range A and range B is 33.33%

$ 30,000

$ 40,000

C

D

$ 40000

$ 60,000 100% x ( $ 40000 - $ 40000) / ( $40000 - $ 30000)

The overlap between range C and D is 0%

Pay Compression Pay compression can be defined as pay differentials that

are too small to be considered equitable. The term may apply to differences between

1. the pay of supervisors and subordinates, 2. the pay of experienced and newly hired personnel of the

same job and 3. pay-range midpoints in successive job grades or related

grades across pay structures Two situations result in pay compression:1. The company’s failure to raise pay range minimums

and maximums2. Companies that retain set range maximums over time

limit increase amount

Example: Pay Compression; Not Raising Minimums and Maximums

TAX-IT, a small accounting firm The salary of newly hired CPAs increased 7%

annually over the last five years Minimum and maximum pay levels for entry-level

CPAs, over the last five years, did not increase due to low profits

CPAs hired five years ago make less than recently hired CPAs

Pay CompressionScarcity of qualified candidates for particular jobs When the supply of such candidates falls behind a company’s

demand, wages for newly hired candidates rise reflecting a bidding process among companies for qualified candidates

Can threaten a companies’ competitive advantage when it results in dysfunctional turnover (high performing employees voluntarily terminate their employment)

Pay compression can be minimized by setting maximum pay rates close to the maximum paid by other companies in the labor market for similar jobs

Setting competitive maximum rates enables a company to raise pay rates for high quality employees who may consider employment opportunities with competitors

Maximum rates should not exceed maximum rates offered by competitors for comparable jobs because high maximum represent costs to the company over and above what are needed to be competitive

Green and Red Circle Pay Rates Green Circle Pay Rates Are below-minimum pay range rates Are usually offered because applicants do not meet every

minimum requirement Red circle pay rates: Are above maximum pay range rates Are given to retain highly-valued employees who have

lucrative job offers elsewhere Are allowed for employees who are demoted to a position

that has a pay grade maximum that is lower than the employee’s current salary

May be offered to employees who exhibit exceptional job performance, but a promotion to a higher pay grade is not granted

5. Evaluating the Results To determine if there was any significant difference between

the company’s internal values for jobs and the market’s value for the same jobs

If discrepancies are evident, the company must reconsider the internal values they have placed on the jobs

If the company’s valuation exceeds the market’s valuation, the company must decide whether its higher-than-market pay rates will undermine its attainment of competitive advantage

If the company undervalues a position, it must determine if the discrepancy is limiting its ability to recruit quality employees

Compensation professionals must also consider each employee’s pay level relative to the midpoint of pay grade

The mid point represents a company’s competitive stance relative to market

Compa-Ratio (Comparative ratio):  The ratio of an employee's actual salary (the numerator) to the midpoint of the applicable (the denominator) salary range. To calculate an individual's compa-ratio, divide the actual salary by the midpoint of the assigned salary range.

Compa-Ratio>1 means? Compa-Ratio<1 means? Compa-Ratio=1 means?

Scatter Diagram of Evaluated Jobs Illustrating the Wage Curve, Pay Grades, and Pay Ranges

100 200 300 400 500

17.20

$19.80

18.50

15.90

14.60 14.00 13.30 12.90

12.00

Average Pay per Hour (Current Rates or Market Rates)

Wage Curve

Evaluated Points1 2 3 4 5

Pay Grades

1

2

3

4

5

Pay Ranges for Pay Grades

0- 99 1 $12.00 $13.30 $14.60 100-199 2 13.30 14.60 15.90 200-299 3 14.60 15.90 17.20 300-399 4 15.90 17.20 18.50 400-500 5 17.20 18.50 19.80

Evaluated Points Pay Grade Minimum Midpoint Maximum

Designing Merit Pay Systems Considerations Companies must insure that employees see definite links

between pay and performance, Companies must avoid using ineffective performance

appraisal methods and poor communication regarding the link between pay and performance,

Companies interested in establishing merit pay system must decide:

i. Merit increase amountsii. Timingiii. Type of merit pay increase – permanent or recurring

increases versus non recurring addition to base payiv. Settle on base pay levels relative to base pay of functionally

similar jobs.

i. Merit Increase Amounts1. Should reflect prior job performance levels

2. Should motivate employees to perform their best

3. To be seen as meaningful, the amounts should account for increases in:

a. Inflation

b. Payroll deductions

c. CPI

Designing Merit Pay Systems

Merit Increase Amounts (contd.) Managers must consider three research findings1.Boosting the merit increase amount will not

necessarily improve productivity. Research has shown diminishing marginal returns on

each additional dollar allocated to merit increase In other words, each additional merit increase dollar

was associated with smaller increases in production2. Employees’ perception of just meaningful

difference in merit increase depends on their;a. Cost of livingb. Attitudes toward the jobc. Expectation of rewards from the job

Merit Increase Amounts (contd.)3. For the pay increase to be considered meaningful,

the employee must see the increase as substantive in a relative sense as well in an absolute sense

Equity theory suggest that an employee must regard his or her ratio of merit to performance as similar to the ratio for other comparably performing people in the company

In practical terms, managers should award the largest merit pay increases to employees with best performance and vice versa

The difference between the increases should be approximately equal to differences in performance

Well designed merit pay structures will fail without adequate funding

Designing Merit Pay Systems

Merit Increase Amounts (contd.) Compensation budgets are blueprints that describe the allocation of

monetary resources to fund pay structures i. Are indexed in percentage terms A 10% increase for next year’s budget means that it

will be 10% greater than size of the current year’s budget

ii.The greater the increases, the greater flexibility in developing innovative systems with substantial motivating

ii. Timing Majority of companies allocate merit increases, cost of

living , and other increases annually Companies may take one of the two approachesi. Establish a common review date or period2. Employee’s anniversary date The day on which the employee began to work for the

company Most employees will have different evaluation dates It may not monopolize supervisors time Can be burdensome because reviews must be

conducted regularly through out the year

Designing Merit Pay Systems

Designing Merit Pay Systems

iii. Recurring versus nonrecurring Merit Pay Increases

Companies traditionally awarded merit pay permanently Permanent increases are associated with some undesirable side

effects In terms of cost companies are increasingly concerned with

containing cost as just one initiative to attain and sustain competitive advantage

Nonrecurring increases – lump sum bonuses which lend themselves to cost containment

Lump sum bonuses strengthen the pay-for-performance link Minimize cost because these increases are not permanent Subsequent percentage increases are not based on higher base pay

levels

Designing Merit Pay Systems

iv. Present Level of Base Pay Pay structures specify acceptable pay ranges

within each pay grade Each job’s base pay level should fall within

minimum and maximum rates for its respective pay grade

Managers should be encouraged to offer similar base pay to new employees performing similar jobs unless employees’ qualification and relevant work experience justify pay differences

Rewarding Performance:

The Merit Pay Grid Pay raise amounts are determined by:a. Performance ratingsb. The position of employees' present base pay rates

within pay ranges Employee performance ratingsa. Overall performance ratings guide the pay raise

decisionb.Based on the principle of recognizing higher

performance with greater rewards

Rewarding Performance: The Merit Pay Grid (contd.)

Employees' position within the pay range Indexed by quartile ranking, a measure of dispersion Quartiles allow to describe the distribution data based on four

groupings known as quartiles The lower a person’s pay falls within its designated pay grade – for

example the first quartile versus the third quartile, the higher the percentage pay raise, all else being equal

The higher a person’s pay within its grade, the lower the percentage pay raise, all else being equal

Holding performance rating constant , compensation professionals reduce merit pay increase percentage s as quartile ranks increases to control employees’ progression through their pay ranges

Pay grade minimums and maximums not only reflect corporate criteria about the value of various groups of unlike jobs but also may be dictated by budgeting

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Merit Pay Grid

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Merit Pay Increase Budget (contd.)1. Supervisors and managers determine how many employees fall

within each performance category.o Excellent =10%o Above Average = 20%o Average = 40%o Below Average = 25%o Poor = 5%

2. Determine the percentage of employees whose pay falls into each quartile.

o Q 4 = 20%o Q 3 = 25%o Q 2 = 40%o Q 1 = 15% In other words 20% of employees earn pay that falls in the range from

$55,000 - $ 70,000 ( fourth quartile) 25% employees earn pay that falls from $ 40,000 –$ 55,000 (third quartile) 40% employees earn pay that falls from $30,000 - $ 40,000 (2nd quartile)

3. Combine both sets of information (1, & 2 above) to determine the percentage of employees who fall into each cell. The Sum of these cells totals 100%.

4. Next Compensation professionals calculate the expected number of employees who fall in to each cell. For this example, assume the company employees 350 employees. The number of employees whose performance rating is excellent and whose base pay falls in the 4th quartile equals 7.

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5. Compensation professionals now distribute the budget amount ($500000) to each cell based on the following formula.

Assume Median for each quartile as:• Q 4 $ 65,000 Q 3 $ 50,000• Q2 $ 35,000 Q1 $ 20,000

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ExcellentAbove

AverageAverage Below Average Poor

Q 4

7 x5% x 65000 = $

22,750

14 x 3% x 65000 = $

18200

28 x 1% x 65000 = $18,200

$ 0 $ 0

Q3 $30,625 $43,750, $2 000 $ 0 $ 0

Q 2 $ 44,000 $ 68,000 $ 117,600 $ 24,000 $ 0

Q 1 $ 12,600 $21,000 $ 29 400 $ 10,500 $ 0

6. Compensation professionals check whether the expected merit increase total fits within the budgeted amount. In this example sum of expected increase exceeds the budgeted amount by 23,425 ( 523,425 – 500,000)

When such increase happens adjust the percentages in the cell with following consideration in mind;

Lowering costs Recognizing performance Equity

Traditional Pay Structure vs. Broad banding

Broadbanding (or 'broad grades') is the consolidation of traditional pay structures, consisting of many, narrow pay ranges into a few, wider ranges or bands.

Thus, broadbanding reduces the emphasis on ‘status’ or hierarchy and places more of an emphasis on lateral job movement within the company.

In a broadbanding structure an employee can be more easily rewarded for lateral movement or skills development, whereas in traditional multiple grade salary structures pay progression happens primarily via job promotion.

In this way, broadbanding is a more flexible pay system.

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