Compensation Administration 237
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Compensation administration is a segment of management or human resource management focusing on planning, organizing, and controlling the direct and indirect payments employees receive for the work they perform. Compensation includes direct forms such as base, merit, and incentive pay and indirect forms such as vacation pay, deferred payment, and health insurance. Compensation does not refer, however, to other kinds of employee rewards such as recognition ceremonies and achievement parties. The ultimate objectives of compensation administration are: efficient maintenance of a productive workforce, equitable pay, and compliance with federal, state, and local regulations based on what companies can afford.

The basic concept of compensation administration—compensation management—is rather simple: employees perform tasks for employers and so companies pay employees wages for the jobs they do. Consequently, compensation is an exchange or a transaction, from which both parties—employers and employees—benefit: both parties receive something for giving something. Compensation, however, involves much more than this simple transaction. From the employer's perspective, compensation is an issue of both affordability and employee motivation. Companies must consider what they can reasonably afford to pay their employees and the ramifications of their decisions: will they affect employee turnover and productivity? In addition, some employers and managers believe pay can influence employee work ethic and behavior and hence link compensation to performance. Moreover social, economic, legal, and political forces also exert influence on compensation management, making it a complicated yet important part of managing a business.


Rudimentary pay management has existed for as long as there have been employers and employees. Owners of typically small, preindustrial businesses commonly weighed their ability to pay against employee responsibilities and contributions in order to determine compensation. The rapid development of corporations, multiplication of administrative hierarchies, and specialization of jobs in the 20th century removed owners from the day-to-day evaluation of jobs. Unionization brought a measure of standardization to wage labor, but neither the private sector nor the federal government began to study systematic job evaluation until after World War 1. The federal government spearheaded the development of formal compensation administration with the passage of the Federal Classification Act of 1923, which ranked government jobs and set salary levels accordingly.

Milton L. Rock and Lance A. Berger, authors of The Compensation Handbook, credited human resource professional Edward N. Hay with providing a foundation for 20th-century compensation management. Hay began his work in the late 1930s, when his employer, a bank, asked him to create a system of pay without ethnic, racial, or gender biases. He embarked on the assignment by analyzing jobs—their duties, responsibilities, skills, education levels, etc.—and composing descriptions based on his findings. Hay operated on the theory that "something that can be measured has value while something that can't be measured has none." Accordingly, this pioneer devised guide charts that systematically evaluated and ranked jobs according to several variables: know-how, accountability, working conditions, physical effort, and problem solving. The guide charts that bore his name would become the world's single most widely used job evaluation technique. By 1943, when Hay founded his trendsetting consulting practice, organizations throughout the United States (including the federal government) had acknowledged the need for a consistent salary-administration system that would facilitate job evaluation, ranking, and pricing.

During the period between the world wars, the American Management Association began to compile descriptions of nonunion (especially clerical and blue-collar) jobs. Beginning in the mid-1930s, the federal government's Employment Service enlisted its field offices throughout the country to describe and codify jobs. The first edition of the resulting Dictionary of Occupational Titles (DOT), published in 1939, contained about 17,500 summary definitions presented alphabetically by title. Blocks of jobs were assigned five- or six-digit codes that classified them in one of 550 occupational groups and indicated whether the positions were skilled, semiskilled, or unskilled. This erratically published compendium became the "bible" of the emerging compensation profession. It provided a foundation for systematic pay plans by promoting internal classifications of jobs and later, external comparisons of jobs across industries.

Mobilization of the domestic economy for World War II significantly advanced the compensation discipline, both directly and indirectly. The war's technological advances helped add 3,500 new occupations in the plastics, paper and pulp, and radio manufacturing industries to the economy, and to the second edition of the Dictionary of Occupational Titles. The war era also saw the imposition of governmental wage and price controls and guidelines. During the "freeze," only companies with rational job evaluation plans could justify upward pay and benefit adjustments. This requirement helped coerce some recalcitrant corporations into formulating systematic pay plans. Since the controls on wages were more stringent than those on benefits, labor unions lobbied for increased benefits and employers gladly capitulated. At the time, generous packages of benefits were nontaxable and cost-effective for employers. Now-common benefits such as pension plans, supplementary unemployment , extended vacations, and guaranteed wages were added to the roster of statutory benefits that had included Social Security (federal), workers' compensation, and unemployment compensation. Over the years, aggressive unions negotiated an astonishing array of benefits, the administration of which fell to compensation managers.

Most companies limited their pay analysis efforts internally until after the war. During the 1950s, Hay and other human resource professionals joined the federal government in broader examinations of compensation. The introduction of computers quickly and continuously simplified and advanced the data collection, quantification, and storage processes. The resulting databases have enabled survey analysts to thoroughly study relationships within and among corporations, industries, and geographic regions.

Sunshine laws ratified in the 1970s combined with equal pay for equal work initiatives began to usher in a new era for the compensation profession, as employees demanded explanations of the rationale behind job assignments, remuneration, and opportunities, as well as employers' overall capacity to pay. Over the course of the decade, pay administration evolved into a thoroughly scientific and bureaucratic method, with its own technologies and rationalization methods.

The profession grew so systematized, in fact, that its precepts were considered nearly as inviolate as natural law until the early 1990s. At that time, corporate downsizing, international competition, and new management schemes compelled compensation managers to be more adaptive to the changing needs of employers and employees. These shifts went to the heart of wage and salary administration: job descriptions. As companies asked their employees to use their competencies and skills to contribute to results in several ways, rather than just one easily described way, the compensation administrator's tasks of job description and comparison have grown more difficult and variable. One observer of these changes has characterized compensation managers in this environment as "engineers" who apply established techniques as situationally warranted. The basics of the discipline still apply, but they are adapted to each corporate culture.


A pay program may include the following four components: base pay, wage and salary add-ons, incentive payments, and benefits and services. Base pay refers to the cash that an employer pays for the work performed. This base pay can be further delineated as either a wage or a salary. Wages are hourly rates of pay regulated by the Fair Labor Standards Act of 1938. This federal legislation formed the foundation of minimum wage, overtime pay, child labor, gender equality, and record keeping requirements for U.S. businesses. Employees who are subject to the Fair Labor Standards Act are known in compensation management parlance as "nonexempt." Salaries, which are usually paid to managers and professionals, are annual or monthly calculations of pay that usually have less relation to hours worked. Most (but not all) salaried workers are "exempt" from the Fair Labor Standards Act of 1938.

Wage and salary add-ons include cost-of-living adjustments (or COLAs), overtime, holiday and other premium wages, travel and apparel expenses, and a host of related forms of premiums and reimbursements. Wage and salary add-ons are used to compensate employees for work above and beyond their normal work schedules or to reimburse them for expenses related to their jobs. COLAs are usually across-the-board contractual increases tied to an economic indicator, such as the consumer price index, that reports an increase in the cost of living.

Incentive payments refer to funds employees receive for meeting performance or output goals as well as to seniority and merit pay. Companies provide these forms of compensation to influence employee behavior, improve productivity, and reward employees for their years of service or their strong job performance.

Finally, benefits and services include paid time off, health insurance, deferred income such as pension and profit sharing programs, company cars, fitness club memberships, child care services, and tuition reimbursement. Social Security, workers' compensation, and unemployment compensation are three legally required benefits. Since its initial passage in 1935, the Social Security Act has been amended and expanded to protect workers and their families from losses due to retirement, disability, and/or death. Employers, employees, and the self-employed make contributions to the Social Security fund over the course of their careers. Workers' compensation benefits have evolved from the early 1900s, when rising industrial accident rates prompted state legislatures to action. All 50 states have enacted laws designed to compensate victims, minimize accident-related litigation, reduce on-the-job accidents, and provide treatment and/or rehabilitation where applicable. Unemployment insurance is designed to help workers through the unexpected loss of a job. Employers pay the premiums for unemployment insurance in the form of variable federal and state taxes. Workers who become unemployed and meet preset eligibility requirements receive weekly benefits.

Benefits may also come in the form of protection programs, such as life and health insurance and pensions and retirement plans. Group life insurance is one of the most widely offered benefits because of its cost-effectiveness. Most employers shoulder the premiums for employees (and sometimes retirees), but end coverage at employee termination. Group health insurance has also become an expected component of benefits plans. Employers typically choose between five prevalent systems: community-based, commercial insurance, self-insurance, health maintenance organization, or preferred provider. Each of these systems has advantages and drawbacks, and in an era of skyrocketing medical costs and impending federal and/or state supervision of the health care industry, this aspect of compensation management has become evermore complex.

Pension and retirement plans include defined-benefit plans and defined-contribution plans. As many as 80 percent of pension plan participants are the beneficiaries of defined-benefit plans. In such a program, the employer promises a fixed pension level, either in terms of a dollar amount or a percentage of earnings scaled to seniority. Defined-contribution plans specify the amount an employer will set aside in an investment fund for the benefit of each employee. These plans have grown increasingly popular in the 1980s and 1990s because employers know their costs up front, employees can also contribute, and the funds can accumulate in a tax shelter. Employee stock ownership plans (ESOPs) and 401(k) plans are the most popular defined-contribution plans. 401(k)s allow employers and employees to defer a maximum amount of annual compensation to a tax-sheltered "savings account" that can then be invested on the employees behalf. ESOPs are allocations of company-donated stock that can be used as retirement or incentive funds. Upon retirement, a worker receives cash based on the value of the stock and seniority.


The interaction between 13 factors affects the actual pay rates employees receive, according to Richard I. Henderson, author of Compensation Management in a Knowledge-Based World. While each factor is straightforward when considered in isolation, it becomes far more complicated when considered alongside the other factors. The 13 factors are:

  1. Types and levels of skills and knowledge required.
  2. Type of business.
  3. Union affiliation or no union affiliation.
  4. Capital-intensive or labor-intensive.
  5. Company size.
  6. Management philosophy.
  7. Complete compensation package.
  8. Geographic location.
  9. Labor supply and demand.
  10. Company profitability.
  11. Employment stability. 12. Gender Difference. 13. Length of employment and job performance.


A general model of compensation administration encompasses the creation and management of a pay system based on four basic, interrelated policy decisions: internal consistency, external competitiveness, employee contributions, and administration of the compensation program. Compensation professionals work with these policy decisions according to individual corporations' needs, keeping in mind the ultimate objectives of compensation administration—efficiency, equity, and compliance. Companies develop their individual compensation strategies by placing varying degrees of emphasis on these four policy decisions. This model of compensation administration shows how companies consider most of the 13 factors previously presented that influence pay rates.


Compensation managers seek to achieve internal equity and consistency—rationalizing pay within a single organization from the chief executive officer on down—through the analysis, description, evaluation, and structure of jobs. This policy requires compensation managers to compare jobs or skill levels to determine the contributions employees with different job titles or skill levels make toward accomplishing company goals. Compensation managers, therefore, should consider internal consistency when determining pay rates for employees who do the same work and employees who do different work. The objective of internal consistency is for compensation managers to determine equitable rates of pay by considering the similarities and differences in work content or job skills as well as the different contributions employees with different jobs and skill levels make to a company's goals. The different values companies have for employees with different jobs reflect the perceived importance of the various jobs or skill levels to achieving company goals.

Internal consistency depends on how a company is structured—i.e., its hierarchy. Companies traditionally maintained larger hierarchies with several levels, but the corporate restructuring and reorganizing trend of the 1990s has resulted in flatter corporate structures with just a few levels. The pay structure of a company is its range of pay rates for different jobs and skill levels within the organization. In other words, pay structures reflect corporate structures. For example, a company may have three organizational levels: executive, managerial, and professional. Each of these levels may correspond to different pay rates. Hence, employees may have salaries of $60,000 in the executive level, $45,000 in the management level, and $30,000 in the professional level. The differences in pay among the various levels are called pay differentials, so the differential between executives and managers is $15,000 and the differential between executives and professionals is $30,000.

An emphasis on internal consistency forces employers to allocate pay fairly across a company's levels. Consequently, a company with the pay and corporate structure outlined above would have deemed it fair that executives earn twice as much as professionals, which seems reasonable in that some companies pay their highest-paid employees 10 to 200 times as much as their lowest-paid employees.

The number of levels and the degree of pay differentials are based on three general criteria: the value of a job and a job's responsibilities, the skills and knowledge needed, and job performance and productivity. Employers can use these criteria to modify employee behavior by indicating what kinds of responsibilities, performance, productivity, skills, and knowledge employees need to move into a different level and receive a higher pay rate.

More specifically, six primary but interrelated factors can shape a company's pay structure:

  1. Social Customs: Beginning in the thirteenth century, employees began demanding a "just" wage. This idea evolved into the current notion of a federally mandated minimum wage. Hence, economic forces do not determine wages alone.
  2. Economic Conditions: Demand for labor influences employee wages. Employers pay wages based on the relative contributions employees make to production goals. In addition, supply and demand for knowledge and skills helps determine wages.
  3. Company Factors: Pay structures depend on the kind of technology a company has and on whether a company uses pay as an incentive to motivate employees to improve job performance and to accept more responsibilities.
  4. Job Requirements: Some jobs may require greater skills, knowledge, or experience than others and hence fetch a higher pay rate.
  5. Employee Knowledge and Skills: Likewise, employees bring different levels of skills and knowledge to companies and hence they are qualified to work at different levels of a company hierarchy and receive different rates of pay as a result.
  6. Employee Acceptance: Employees expect fair pay rates and determine if they receive fair wages by comparing their wages with their coworkers' and supervisors' rates of pay. If employees consider their pay rates unfair, they may seek employment elsewhere, put forth little effort in their jobs, or file lawsuits.


Achieving external competitiveness in the area of compensation means balancing the need to keep operating costs (including labor costs) low with the need to attract and retain quality workers. External competitiveness is how a company's rates of pay compare to those of its competitors.

As Jeffrey Pfeffer argued in the Harvard Business Review, the distinction between two compensation-related terms should preface the discussion of pay rates and competitiveness: the distinction between labor rates and labor costs. Labor rates refer to the actual amount of pay employees receive for a given period—e.g., a labor rate of $18.50 per hour. In contrast, labor costs include the total amount paid to employees as well as the level of productivity. Consequently, a company might have high labor rates, but relatively low labor costs if it has high levels of productivity—i.e., if it takes fewer labor hours to complete tasks and if the quality of its products and/or services is greater than the competition's. Therefore, compensation managers should consider the effects pay rates will have on productivity and not consider pay rates alone or confuse pay rates and labor costs.

Compensation managers achieve external competitiveness by comparing wage levels within their industry, examining their companies' resources and goals, and establishing their own pay levels accordingly. In general, companies can set their pay levels to lead, match, or follow competitors' pay practices. Contemporary compensation policies include "variable pay," where pay levels reflect the fluctuation of the firms' success or decline, and positioning as "employer of choice." "Employer of choice" emphasizes the total compensation package, and may include employment security, educational opportunities, and the promise of intellectual challenges or latitude. In practice, some employers use different policies for different units and/or job groups.

Comparative surveys help compensation administrators correlate jobs and salaries across a given industry and/or the entire economy. The U.S. Bureau of Labor Statistics conducts and publishes three types of annual occupational wage surveys as well as the Monthly Labor Review. The BLS's Area Wage Surveys examine occupations common to a broad range of industries in hundreds of standard metropolitan statistical areas, providing a geographical basis for comparison. The agency's industry wage surveys analyze nearly 100 manufacturing and service sector industries individually. The BLS's National Survey of Professional, Administrative, Technical, and Clerical Pay, which has been conducted since 1959, examines specific positions, including accountants, auditors, attorneys, buyers, job analysts, directors of personnel, chemists, engineers, engineering technicians, draftspersons, and clerical posts.

Job surveys have also been developed by professional human resource groups over the decades. The New York-based American Management Association's "Executive Compensation Service" has compiled and published information on compensation and related subjects since 1950. This publication provides a means for measuring a company's compensation packages against those of other companies.

Establishing the pay level balances a company's profit requirements with competition for competent employees. Factors determining pay level include:

  1. Competition in the labor market: the supply and demand for employees with various qualifications.
  2. Product market conditions: the degree of demand for specific products and the level of industry competition.
  3. Organizational characteristics: industry, management philosophy, size, and technology.

Weighing all these considerations, firms can choose to pay more than the industry average, and therefore favor attracting and retaining quality employees, or pay less than their competitors' average hoping to attract and retain employees through noncompensation means such as recognition events, achievement celebrations, and working in a pleasant environment. A competitive pay level—one that balances all considerations—can help contain labor costs, enlarge the pool of qualified applicants, increase quality and experience, reduce voluntary turnover, discourage unionization, and abate pay-related work stoppages. Once a company has determined its pay level relative to its competitors, compensation managers must determine the best compensation package for each occupation.


This policy area involves the weight companies choose to place on employee performance in determining a compensation program. Some companies may choose to pay all employees the same wage, while others decide to reward employees for seniority and productivity. Companies that choose the latter route tend to emphasize incentive and merit aspects of compensation programs. This approach enables companies to give their employees a measure of control over their compensation and ideally thereby influence their performance. This policy assumes that employees are significantly motivated by pay, which studies fail to confirm or refute conclusively. Nevertheless, pay studies suggest that pay is one of several important employee motivators, just not the consummate one. Compensation based on employee contributions generally is distributed on the basis of employee evaluations.

In order to carry out evaluations perceived as being fair by employees, companies must establish performance standards. To do so, companies should maintain a list of updated job descriptions that indicate what aspects of employee performance will be measured for each job. The aspects of employee performance to be measured should be reasonably attainable. Furthermore, employees should participate in establishing standards and they should know the standards at the beginning of the review period.

A performance evaluation may include objective and/or subjective measurements. Objective assessments (such as number of pieces produced per hour, number of words typed per minute) are clearly reliable and fair, although they may be more difficult to establish for some jobs. Subjective measurement are problematic because of the potential for bias and because inaccurate measurement can lead to employee frustration and apathy. Some objective methods of compensation for performance have become very popular incentives in the late 20th century. Perhaps the most common examples are sales commissions and piecework, but creative additions to these staples have been added recently. Gain-sharing programs tie incentives to increased productivity, quality improvements, and or cost savings. Profit sharing links pay to increases in company profits, and employee stock option plans base increased compensation on a company's stock performance. These programs are geared toward making each employee's vested interest in the company clearer and more immediate through his or her paycheck. These concepts also help control labor costs, because employees do not receive the rewards unless the company performs well.


The administrative policy refers to the tasks of compensation managers in designing and implementing a pay program. Taking into consideration the previous three policies, compensation managers must choose the components that they will include in a company's compensation program—that is, which kinds of base pay, wage and salary add-ons, incentives, and benefits they will offer employees with different jobs and skill levels. Administration also involves determining whether the pay program will attract and retain needed employees successfully, whether employees consider the pay program fair, how competitors pay their employees and if competitors are more or less productive.

Compensation also must reinforce the organization's strategic conditions. Intensifying competition in many industries has brought about shifts in overall corporate strategies and changes in compensation. For example, Ford Motor Co. decided to emphasize customer service in the 1990s as part of its marketing strategy. In order to encourage dealerships to shift their focus as well, Ford had to change its incentive program. Whereas incentives had previously been based strictly on sales, they began to relate to more customer-service-oriented goals.

Environmental and regulatory factors have also become very practical considerations of compensation management. The increasing diversity of the workforce, for example, is one significant trend. Compensation managers at E.l. du Pont de Nemours & Co., for example, have promoted child care, flexible work schedules, career breaks, and other progressive benefits in response to the needs of increasing numbers of women in its workforce. Compensation management has been strongly influenced by regulatory pressures. From state and local payroll taxes, to minimum wage legislation, workers' compensation, child labor laws, equal opportunity mandates, and unemployment and social security requirements, pay administrators wrangle with a daunting array of legal pressures. In all likelihood, the litany of regulations will continue to grow. In the early 1990s, for example, outrage over excessive executive pay at publicly owned companies prompted the Securities and Exchange Commission to require that businesses disclose total executive pay and how that compensation relates to performance.

Companies also adopt different approaches to compensation administration responsibilities. Some rely on a centralized approach where the design and administration of compensation programs are performed by a single company department. Others opt for a decentralized approach where multiple company departments have these responsibilities. The drawback to the centralized approach is that a compensation program may suit general corporate needs, but not individual department needs. Creating compensation task forces with members drawn from various departments helps avoid this problem. Likewise, the decentralized approach also can lead to problems. This approach may make it difficult to transfer employees from one department to another and may bring about a lack of internal consistency.

Consequently, compensation administrators frequently adopt general guidelines that all departmental compensation policies must follow, but allow departments to develop their own policies, such as those for incentives, as long as they adhere to the general guidelines. Ultimately, as Mircea Manicatide pointed out in HR Focus, a compensation program must" be flexible enough to reflect the different needs of the individual and the organization; joint investments in ongoing training; the ebb and flow of an employee's contributions without creating expectations of permanence, and each employee's changing needs over time."

SEE ALSO : Employee Benefits ; Performance Appraisal and Standards

[ April Dougal Gasbarre ,

updated by Karl Heil ]


Henderson, Richard 1. Compensation Management in a Knowledge-Based World. Upper Saddle River, NJ: Prentice Hall, 1997.

Manicatide, Mircea, and Virginia Pennell. "Key Developments in Compensation Management." HR Focus 69 (October 1992): 3-4.

Milkovich, George T., and Jerry M. Newman. Compensation. 4th ed. Burr Ridge, IL: Irwin, 1993.

Pfeffer, Jeffery. "Six Dangerous Myths about Pay." Hariard Business Review, May/June 1998, 109.

Rock, Milton L., and Lance A. Berger. The Compensation Handbook: A State-of-the-Art Guide to Compensation Strategy and Design. 3rd ed. New York: McGraw-Hill, 1991.

U.S. Department of Labor. U.S. Employment Service. Dictionary of Occupational Titles. 4th ed. Washington: GPO, 1991.

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