Chapter 4
Components of Compensation
Strategy
Copyright © 2021 by Top Hat 4-1
Learning Outcomes
(Slide 1 of 2)
• Describe the role of base pay, performance pay, and
indirect pay in the compensation mix, and discuss the
advantages and disadvantages of each.
• Identify and differentiate between the three main
methods for establishing base pay.
• Define market pricing and discuss its advantages,
disadvantages, and applicability.
4-2
Learning Outcomes
(Slide 2 of 2)
• Define job evaluation and discuss its advantages,
disadvantages, and applicability.
• Define the pay-for-knowledge system and discuss its
advantages, disadvantages, and applicability.
4-3
Compensation Mix Choices
• In designing any compensation strategy, we
must address two key questions:
1. What role (if any) should each of the three
compensation components (base pay,
performance pay, indirect pay) play in the
compensation mix, and how should each
component be structured?
2. What total level of compensation should be
provided?
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FIGURE 4.1
Compensation Mix Choices
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Fundamental Components of the
Compensation Mix
• Base pay accounts for about 75-80% of the
compensation for a typical employee
• Performance pay for 5-10%
• Indirect pay for about 15% of total
compensation
• Some firms can provide 100% of base or
performance pay
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Components of the Compensation
Mix: Base Pay
• Base Pay
– wages
– salary
• Why Use Base Pay?
– easy to measure
– easy to price in terms of its value to the employer
– easy to attribute to individual employees
– controllable by the individual employee
– relatively stable
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Why Use Base Pay?
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Commission pay is used in many auto dealerships.
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Base Pay
• Advantages • Disadvantages
– Flexible – More fixed employer
– Encourage job commitment
behaviours – Does not directly
– Signal relative motivate task behaviour,
importance of jobs nor signal key task
– Demonstrates a behaviours
commitment – Does not directly
– Support a particular contribute to citizenship
managerial strategy behaviour
– Simplistic – Not self-correcting
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Components of the Compensation
Mix: Performance Pay
• Performance Pay
– any type of financial reward provided only when
certain specified performance results occur
– results may be based on the performance of
individual employees, a group or team of
employees, or the entire organization
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Performance Pay Plans
• Individual performance pay plans
– include piece rates, commissions, merit pay, and
targeted incentives
• Group performance pay plans
– include productivity gain-sharing plans, goal-
sharing plans, and other types of team-based pay
• Organizational performance pay plans
– include employee profit-sharing plans, employee
stock plans, and other organizational pay plans
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Performance Pay
• Advantages • Disadvantages
– Signal key behaviour and – Employees prefer
motivate employees predictability
– Can reduce the need for – May require higher
other types of mechanisms compensation
for controlling employee – May cause focus only on
behaviour rewarded behaviours
– Set performance standards – May cause unanticipated
– Support specific managerial consequences
strategies – Usually more complex than
– Make pay more variable base pay
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Assessment Question 4.1
A dentist charges patients based on the dental
procedure or work performed. Which of the
following terms best describes the dentist’s
compensation?
a. salary
b. benefit
c. piece rate
d. wage
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Components of the Compensation
Mix: Indirect Pay
• Indirect Pay:
– any type of employer-provided reward (or
“benefit”) that serves an employee need but is
not part of base or performance pay
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Indirect Pay
• 15% of total compensation in medium to large
private-sector firms
• 17% in manufacturing sector down to 10% in
the accommodation/food industry, where
many employers don’t provide any benefits
beyond the statutory minimum
• Other research put this cost between 10-20%
of the total compensation, depending on the
type of employers surveyed
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Major Categories Of Indirect Pay
1. Benefits mandated by law
(including employer contributions to the Canada/Quebec Pension Plan, Employment
Insurance, and Workers’ Compensation benefits.)
2. Deferred income plans (known as retirement or pension plans).
3. Life insurance; extended medical, dental, and disability insurance;
and other types of health benefits.
4. Pay for time not worked, such as paid holidays and leaves.
5. Employee services (ranging from psychological counselling to food
services).
6. Miscellaneous benefits, which may range from provision of company
cars to purchase discounts on company products or services.
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Indirect Pay Advantages
• Advantages
– Competitive pressure
– Matches unionized firms
– Favourable tax treatment
– Economies of scale in purchasing
– Protect financial security and peace of mind
– Protect employees from adversity
– Can support managerial strategy
– Promote consequences that benefit the organization
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Indirect Pay Disadvantages
• Disadvantages
– Cost can be substantial
– Rigidity
– Difficult to eliminate once provided
– Difficult to develop efficient benefits package
– Admin and communication costly
– Does not motivate task behaviour
– May cause excessive employee stability
– May encourage undesirable behaviour
– Impact of indirect pay on performance still unclear
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Assessment Question 4.2
Which of the following is not a benefit
mandated by law in Canada?
a. Canada/Quebec Pension Plan
b. Employment Insurance
c. Workers’ Compensation benefits
d. Employee services
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Base Pay Methods
• Market pricing
– Determining the average amount of pay other
employers are offering for a given job
• Job evaluation
– Establishing base pay by ranking all jobs in the firm
according to their value to that firm
• Pay-for-knowledge system (PKS)
– According to the total value of the skills and
competencies an employee has acquired
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Market Pricing
Advantages Disadvantages
• Simplicity and cost • “Going rate” not always easy to
• Keeps jobs aligned with identify
market conditions • Different employers define jobs
differently
• Getting definitive market price
for a given job not always
possible
• Does not address internal equity
• Lack of control of compensation
strategy
• May violate pay equity legislation
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Job Evaluation: Advantages
• Centralized control of compensation costs
• Signals importance of different jobs
• Promotes internal equity
• Makes calibration to the market easier
• Encourages development of job descriptions
• Systematic way to determine pay for new jobs
• Availability of packaged plans from consultants
• Fits well with classical and human relations
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Job Evaluation: Disadvantages
• Job descriptions costly to develop and maintain
• May become an adversarial process
• Job evaluations still substantially subjective process
• Compensable factors used in job evaluations are
often abstract and ambiguous
• Can inhibit change, flexibility and skill development
• More costly to develop and maintain than
market pricing
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Base Pay Methods:
Pay for Knowledge
• Competency-based pay
– Based on the characteristics, rather than the
performance, of individual employees; usually
applied to managerial or professional employees
• Skill-based pay
– Based on the specific skills and capabilities of
individual employees, rather than on the specific
tasks they are carrying out; usually applied to
operational-level employees
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Base Pay Methods
Skill-Based Pay (SBP)
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Advantages of Skill-Based Pay (SBP)
• Provides incentive to learn a variety of skills
• Avoids disincentive to movement
• No job descriptions needed
• Broader and provides more intrinsic rewards
• Allows individuals and teams to be more self-
managing
• Supports behaviours needed by high-involvement
firms
• Helps promote change to high-involvement practices
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Disadvantages of Skill-Based Pay (SBP)
• Employees may be • Unions may resist
“overpaid” relative to • May violate pay equity
competitors laws
• Workers “top out” • Relatively high failure
• If not rotated through rate
jobs regularly, then • More complex to
skills atrophy administer
• Increased training costs • Aligning SBP systems to
• Not all employees want the market difficult
to learn multiple jobs
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Issues in Developing a SBP System
• Deciding which employees
groups to include
• Designing the skill blocks
• Linking skill blocks to pay
– High-low method
• Providing learning
opportunities Training and certification are
• Certifying skill essential for successful skill-based
pay systems.
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Competency-Based Pay Systems
• Four main issues:
– Identifying competencies that demonstrably affect
performance
– Devising methods to measure achievement of
each competency
– Compensating each competency
– Providing learning opportunities
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Assessment Question 4.3
Fit Stop’s CEO, a fitness training and equipment
vendor, wants to pay her employees based on
their ability to learn a variety of skills and shift
from one job to another. Which pay plan will be
suitable for Fit Stop?
a. market pricing
b. piece rate
c. commission
d. skill-based pay
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Exercise
Three firms are briefly described below. For each firm, identify the role (if
any) that you believe indirect pay should play in the compensation
system, and give examples of specific benefits to offer. Explain your
choices.
a) A company offers lawn maintenance and yard cleanup services in the
summer and snow removal services in the winter. It employs about 600
people at peak season (in the summer) and has branches in major cities
across the prairies.
b) A retail clothing chain offers personalized service and caters to upscale
customers. It is located in major cities across Canada and employs
approximately 600 sales staff.
c) A computer software firm develops customized software for specialized
applications for individual clients. Located near Ottawa, it employs about
1000 people.