Compensation 102: Compensation as a Cyclical Process

Overview of the Compensation Process or Cycle

In essence, the annual salary planning process is a series of steps that lead to an assessment of a company's overall pay level and the pay level of each job compared to similar or same jobs in the external marketplace. It allows companies to determine how competitive their pay is when compared to the external market (competitors for the same talent). It also allows companies to set a budget for the next year's salary increases and it leads to the formation of salary structures (a range of pay based on job level/grade). It gives compensation professionals and the company's managers a tool to monitor pay decisions throughout the year. The monitoring step is one that is often left out. Many companies plan the year's salaries and then wait for the same process to occur the following year. It is much more effective to have a monitoring process that monitors: 1) salary levels, 2) pay decisions, 3) position to the market, 4) performance appraisals, and 5) the continually refined budget. That way, the following year is simply a continuation process, rather than the beginning of a new one (e.g., inventing the wheel all over again). Next, we will review the steps in the continual process in detail.

Ongoing Compensation Process or Cycle

  • Best Practice — Understanding the Strategy
    The best compensation practice begins with a review and understanding of the organization's strategic goals. Assessing the corporate strategy is a step that is sometimes missed. It makes a big difference in the compensation plans that you develop, because to be effective, the plan must support the correct strategic focus. The next step is to recognize that all rewards need to be considered when designing a compensation plan (salaries, incentives, benefits, work life benefits, and opportunities for growth). In addition, we want to recognize that compensation is not an island that lives on its own — it is part of a larger human resources function and corporate identity. Therefore, compensation is just one component, and it is developed best when in alliance with all other components of human resources. Next, we will discuss the next step in insuring a seamless compensation process: job descriptions and job evaluations.

  • Job Descriptions and Job Evaluations
    After the strategy and reward components are understood, we can focus on the building blocks of the annual salary planning process. Job analysis and job evaluation (describing the job and assessing its value) are critical first steps. Job descriptions tell us what the job incumbent does. They are used to ensure that we properly match our company's positions to those in market salary surveys. They are also used to ensure internal equity and to be a tool for measuring an employee's performance against the responsibilities set out in the job description. Job evaluations should reflect the strategic criteria which the company most values. They can be point-based, market-based, or some combination of the two. Having completed the job descriptions, we can proceed to the following step in the process: the analysis of compensation surveys and development of salary structures.

  • Compensation Surveys, Salary Structures and Regression Analysis
    Competitive market compensation surveys hold a wealth of information, when used correctly; they include not only the salary information for similar jobs in other companies, but also incentive, benefit, and practice information. One of the tools for analyzing the massive amount of data gathered in salary surveys is a type of statistical analysis called regression analysis. Regression analysis is simply a mechanism for finding out the relationship between two or more variables. For example, if you want to find a relationship between three variables such as education level, amount of sales, and job experience for a group of employees within the same job family, the compensation analyst would use regression analysis. In a case of three or more variables, which was just described, the compensation analyst would use multiple regression analysis (step-wise regression, or data mining may also be considered when there are three or more relational variables).

    When applied to the development of salary structures, regression analysis defines the level of median pay relative to a pay grade. The development of a salary structure from salary surveys helps to provide a tool for management to pay within a range of what the outside competitive labor market would pay. By comparing your company's current salary structure to the one that would be competitive, given your analysis of the outside market, you can determine the amount of overall movement necessary to bring your current salary structures up to date. Your salary structures give managers a guide for the amount of money they can pay for a particular job to remain competitive with the market. By comparing individual's pay to the median (middle point) of the salary structure range, one can compute a comparatio. The comparatio gives you an idea of how close to the middle, that person's salary is (95% is a little less than the midpoint, 105% is a little above the midpoint). With the survey data analyzed and the salary structures developed, we can advance to the creation of an annual salary budget.

  • Annual Salary Budget and Performance Appraisal
    The annual salary budget, which is allocated for payment of increases throughout the year, is derived from a combination of management and company strategies including where the overall company salaries fall within their salary ranges. The performance appraisal is another important consideration when determining the amount of salary or salary increase one should be given. Often, compensation professionals design a salary increase/comparatio matrix. This tool can be a guide for managers' decision making. Essentially, the lower comparatio and the higher performance rating yields the highest salary increase, because these high performers are being paid low relative to the external market. One must also consider, though, internal equity (how an employee's pay compares to others in the same level job within the company). The management tools and employee communications becomes a crucial component of the salary planning cycle. Well designed tools and a customized communication plan help employees and managers understand the rationale behind the salary increase budget and can boost employee buy-in, when framed with the company's strategic goals.

  • Human Resource Information System (HRIS)
    The next step in the process is that of updating the company's human resource system to include the new salary structures and budgeted salary increases. Well designed, timely reports or reporting systems help managers better manage their group/department. It also is the crucial component of the monitoring process that will allow the company to stay abreast on their position to the market. HRIS needs to be involved, up front, in the salary planning process so that they can make any necessary adjustments to the system and integrate the salary planning process with other processes and systems they are executing at the end of the year. A major step in the compensation cycle is the next step, that of monitoring the plan.

  • Ongoing Monitoring of the Compensation Plan
    A system of ongoing monitoring of the compensation plan is one of the most critical steps in the compensation process, but it is the most underutilized. Monitoring the internal company salary metrics (salary levels, pay decisions, position to the market, performance appraisals) to the budget and also monitoring the external market should be done year around. Keeping abreast of salary movement and economics in the marketplace, helps to prepare for the following year, but more importantly, allows compensation to play a more strategic role within the company. Compensation can be on the leading edge of knowing when a critical talent is coming to the forefront. They can conduct more frequent market surveys to assure that critical talent is not lost to a competitor that is paying more competitively.

Question: Why would a company want to continually monitor their compensation plan?

Answer: Monitoring is one of the most crucial stages of the compensation analysis process. By monitoring throughout the year, a company saves a monumental amount of time, resources, stress, and money so they don't have to reinvent the wheel every year. Moreover, by monitoring throughout the year, a company is more likely to retain key talent and reinforce their strategic goals with their compensation plan. They also will more likely retain the critical talent they need to complete their strategic goals.

Here's why: Left unattended, the compensation plan grows stale. The plan that was on target when it was created, is no longer hitting the mark a few months later. This is due to the fact that salaries continue to move in the marketplace, yet companies do not typically change their salary levels, their salary structures, or their budgets to account for this notion. As time goes by, companies begin to lose critical talent. After a few of these incidents, the department managers may ask, "What's going on here?" It's simple, when an employee leaves one firm and moves to another, he/she renegotiates his/her salary. At that time, the new company assures him/her that they are paying competitively by aging the salary survey data to determine the new competitive rate. "Aging the data" is a process of calculating the movement of salary survey data based on the expected annual movement divided by the number of months that have past. If the salary targets were set in January and the new employee comes on board in May, the salary needs to move by four months. If the expected annual movement of salaries was at 5%, or .05, then the new company needs to age the survey data by .05/4 or by 1.25%. In effect, the employee has, by changing companies, received a mid-year increase. In an inflationary market, the effect is much more pronounced and to hang on to critical talent, a company needs to assure they are paying competitively throughout the year. (See more in the next section: Compensation in Inflationary and Recessionary Years.)

The above is just one example of why monitoring is so important. Here are a couple of other reasons why ongoing monitoring is essential: 1) employees come and go throughout the year, which means money needs to be reallocated departmentally when this occurs; and 2) performance appraisals mandate that the compensation analyst and departmental managers meet on a monthly basis to decide on pay increases and incentives for job families and individuals.

Recognizing the ongoing role of compensation planning throughout the year is critical to the strategic success of the company.

An ongoing monitoring of the compensation plan could be seen as crucial a step as the company's strategic goals.