Determinate factors in compensation system development

The compensation and reward management plays a vital role in achieving human resource management objectives. (Hegewisch, 1991), states that “the pay package is one of the most obvious and visible expressions of the employment relationship; it is the main issue in the exchange between employer and employee, expressing the connection between the labour market, the individual’s work and the performance of the employing organization itself”. The significance of an effective compensation mechanism cannot be undermined and is depicted in Figure 1.

The compensation system is one of the most important instruments that organizations can use to attract, retain and motivate competent and committed employees that will in turn lead to better performance of the employees and the organization.

According to (Luis R.Gomez-Mejia et al, 2002, p. 324), “Compensation is the package of quantifiable rewards an employee receives for his or her labor.” Compensation is one of the major important costs for majority of the firms that may be as high as 60 percent of total costs in certain types of manufacturing firms and still higher for in some service organizations. It implies that, the way the compensation is designed can make a difference in gaining or losing a competitive edge. How much is paid and who gets paid are crucial strategic issues for the firm. From the employee’s perspective, paycheck is very important for its purchasing power and it’s indication of power and prestige. To put in brief, compensation affects a person not only economically but also sociologically and psychologically. A firm cannot afford to mishandle compensation issues as they will have negative repercussions on employees and finally on the performance of the firm.

2. Planning and designing compensation packages:

The firms should be extra more cautious while designing compensation systems as they will have far-reaching consequences. Planning and designing compensation packages is a challenge for the firms in general and more the so for firms operating in an international context. (Andries J du Plessis and K. Huntley, 2009) stated that internationalization impose a movement in the direction of standardization of pay, working conditions and management systems in MNCs, including HRM, the influence of local culture, institutional arrangements and labour market practices. The diversity in needs, motivation, expectations, performance of individuals and the environment make the job more challenging for MNCs.

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2.1 Objectives of international compensation policies: (Dowling and Welch, 2004) are of the opinion that when an organization develops international compensation policies, it seeks to satisfy several objectives:

• The policy should be consistent with the overall strategy and structure of the business needs of the MNC

• The policy must work to attract and retain staff where the greatest needs and opportunities are such as incentive for foreign service, tax equalization and reimbursements for costs

• The policy should facilitate the transfer of international employees in the most cost-effective manner for the organisation

• The policy must give due consideration to equity and ease of Administration.

2.2 Factors in determination of international compensation system: The factors to be considered in determining compensation systems for expatriates include the following:

Cost of living

Knowledge of the laws, customs and employment practices of foreign countries

Exchange rate

Effect of inflation on compensation

Housing cost

Family benefits

Children’s education

Relocation allowance

Income tax

Social services

Readjustment to home base

Variations in the methods of payment

Reserves that include contributions to savings, pension schemes etc.

Medical, emergency and security cover

2.3 Components of International Compensation system:

The key components of international compensation system include:

Base salary: base salary denotes the amount of cash compensation

Foreign services inducement: a salary premium as an inducement to accept a foreign assignment

Hardship premium: compensation for any hardship caused by the transfer

Allowances: various forms of allowances, such as: Cost-of-living allowance, Housing allowance, Relocation allowance, Education allowance, Home leave allowance, Hardship allowance, medical allowance

Benefits: In addition to the allowances, multinationals also provide vacations and special leave, annual home leave, airfares for families to return to their home countries, Rest and rehabilitation leave

The management should also follow certain other guidelines for expatriates:

The expatriate should be provided disposable income that is on par with what he or she would receive at home. This necessitates granting allowances to make up the differences in prices for housing, food and other consumer goods.

In addition to this, the expatriates may be provided an attractive ‘add on’ incentive for encouraging him to accept an international assignment. This may be in the form of a percentage increase over his or her home base salary, lumpsum amount after completing the foreign assignment, etc. More lucrative incentives should be provided for the least desirable locations, otherwise there may not be takers for those unattractive assignments.

The benefits that the expatriates receive should outweigh the costs, discomforts, risks etc which they may experience in the process of undertaking a foreign assignment.

3. Theoretical Foundations of Compensation Strategies: Due to increasing competitive pressures, organizations are looking for value addition from employees by encouraging them to increase their effort and performance beyond a minimum acceptable standard or by reducing labour costs to the minimum. In this direction, the employee motivation has been a constant concern for managers. The compensation package designed for the employees should be motivating enough to get the value addition from the employees.

Individuals’ needs and the factors that motivate them have been debated and discussed for a long time. In this context, the work of Maslow, Herzberg, Victor Vroom, Porter and Lawler and Adam made significant contributions.

3.1 Maslow’s theory: Abraham Maslow, in his classic article, “A theory of Human Motivation” (Maslow, 1943) presents a hierarchy in which at least five sets of needs compose the framework. The needs are classified as: physiological, safety, love, esteem and self-actualization. According to this theory ‘as individuals develop they work their way up a hierarchy based on the fulfillment of a series of prioritized needs'(Steers et al, 2004). The first three needs, according to Maslow, represent deficiency needs and the latter two represent growth needs.

The following figure (Figure 2) explains the hierarchy of needs on the scale of strength of needs.

Figure 2

George and Jones (2002) points out several difficulties in Maslow’s Hierarchy framework. First, there is a concern over the content of the hierarchy. It is possible to collapse the hierarchy into two sections/clusters – lower order and higher order. Two, the individual needs are considered as rigid that movement from one level of the hierarchy to another is possible only once a lower need has been fully satisfied (Hollyforde, 2002). It is possible that other needs may become more important to the individual as context variables change.

3.2. Herzberg theory: Frederick Herzberg (b.1923) developed Hygiene-Motivation theory or Two Factor theory (Herzberg, et al 1967) out of an extensive research he undertook with engineers and accountants in the 1950s. He discovered from his survey that the positive things that workers pointed out in their work experience are not the opposite of the negative. In other words, a dirty kitchen will result in ill-health. But, however, a clean kitchen does not guarantee good health. According to Herzberg, ‘the opposite of job satisfaction is not job dissatisfaction but, rather, no job satisfaction; and similarly the opposite of job dissatisfaction is not job satisfaction, but no job dissatisfaction’ (Herzberg, 1968, pg. 56).

From this argument, he developed two distinct set of factors for job satisfaction and performance in organizations. One, Hygiene factors and two, Motivating factors. Employees tend to be dissatisfied when inadequate hygiene factors are present in the organization. In the same way, employees are satisfied when there are adequate motivating factors. He used the “hygiene” to denote preventive measure. They do not produce any growth in worker output (productivity); they act as preventive mechanisms. These factors include: company policy and administration, supervision, interpersonal relationships, working conditions, salary, status and security. Motivators are growth factors. They are: achievement, recognition for achievement, the work itself, responsibility and growth or advancement. According to Herzberg, out of the five growth factors (Motivators) the last three have greater importance for lasting change of attitudes (Herzberg, 1967).

It can be observed that both Maslow’s Hierarchy of Needs and Herzberg’s Two Factor Theory helps to understand various variables that underlie employee motivation. While Maslow categorizes the variables as lower and higher needs, Herzberg categorizes them as hygiene factors and motivation factors respectively.

3.3 Other theories of motivation: A major issue in establishing adequate reward and motivation schemes is derived from concepts such as equity, fairness and comparability and the factors that contribute towards establishing objectives in compensation systems. Vroom’s expectancy theory emphasizes on the link between rewards and behavior (Vroom, 1964). According to this theory motivation is the product of valence, instrumentality and expectancy. Remunerating systems differ depending on how these affect these motivational components.

Adam’s equity theory stresses on equity in pay structure of employees’ compensation. Employees’ perception of how they are being treated by their firm is of utmost importance to them. When employees perceive inequity, it can lead to lower productivity, higher absenteeism and turnover that work against the interests of the organization. Porter and Lawler (Porter and Lawler, 1968) theory is built upon Vroom’s expectancy and Adam’s equity theories of motivation and these theories are termed process theories of motivation as they focus on effort-performance-reward relationship for each individual and thus provide a more dynamic foundation for most reward strategies.

3.4 Motivational issues in the design of compensation systems:

The mechanism should be designed in such a manner that it follows carrot and stick approach i.e providing rewards for better performance and the reward may be based on the achievement of predetermined targets or standards of performance.

The prospect of promotion and future pay increases is an important part of the system as it encourages employees to increase their levels of effort. The promise of high future rewards in return for current efforts and achievements attempts to encourage commitment and loyalty to the organization.

Certain rewards or salary increments may be paid to an employee which are not dependent upon any appraisal of his or her work. For example: Advancement on reaching a certain age or experience level. But such rewards or increments should not be excessive as it may ensure complacency and safe attitudes.

The system should clearly differentiate between performers and non-performers.

The system should have a challenging component that should drive the employees to achieve noteworthy results.

4. Framework for ‘Employment commitment’.

Organizations that want to be effective in a hyper competitive market environment must strive to gain competitive advantage. While tangible assets like technology can give competitive advantage but the intangible assets such as organizational reputation (e.g., “Employer of Choice”) deliver that competitive advantage. This organizational goal, i.e., becoming employer of choice, can only be achieved through a motivated workforce who could influence organizational productivity and organizational productivity influences reputation. Thus, the task of creating a framework where both the employer and employee benefits involve two important factors. One, increasing organizational productivity and two, increasing employee satisfaction. This can be best described in the following diagram (Figure 3).

Figure 3

As mentioned earlier, motivation is a factor that significantly influences productivity. A higher level of motivation can result in higher productivity. Halepota (2005) explains Maslow’s hierarchy of needs as they are related for higher productivity of the individual employees in construction industry. In this article Hassan views Herzberg’s theory to be an extension of Maslow’s hierarchy of needs and expectancy theory. The instilling of satisfaction within workers is a crucial task of management, for it influences confidence. A confident employee is more likely to bring quality output and hence increases productivity. Hence, employee satisfaction and organizational productivity go hand in hand. In most organizations incentive programmes, higher pay are seen as enough motivating factors to influence employee satisfaction. For example, (Locke, et al 2004) argued that by linking goals to monetary incentives, companies can achieve higher productivity from their employees. However, in recent years this assumption has been questioned by people like Alfie Kohn (1993).

5.1. Designing a compensation system:

Payment systems do not operate in insolation. Remuneration strategies both affect and are affected by all aspects of employment relationship. Thus the design of payment systems should not only be integrated with other human resource management policies but should also reflect and disseminate the overall strategic and cultural objectives of the company. Moreover, organizations must be aware that the differences in individual motives will affect how they, either as individuals or on a collective basis, will respond to certain payment systems. For example, employees concerned with recognition and money may react favourably to Performance related pay schemes, whereas those employees motivated by intellectual and vocational challenge may respond more positively to other forms of payment systems (White, 1982).

An effective compensation system helps the firm to achieve its strategic objectives and is appropriate to the firm’s unique characteristics as well as to its environment. According to (Luis R.Gomez-Mejia, et al 2002), the pay operations managers have to consider the following aspects in designing a compensation system:

Internal vs. external equity: Will the compensation plan be considered as fair within the company, or will it be considered as fair relative to what other local and global companies are paying for the same type of labour?

Fixed versus variable pay: Will pay be paid monthly on a fixed basis – through base salaries or it will vary depending on certain criteria such as performance and company profits? The criteria and the rate of variable pay differ across different countries.

Merit vs Seniority: Will compensation be tied to performance of the employees or length of service of employees in the organization?

Job vs Individual pay: Will pay be based on the value of a particular job or will it be based on the skill and knowledge an employee brings to that job?

Uniform vs Differential pay: Will the compensation plan provides for uniformity in the compensation for the employees or will it establish differential plans?

Below-market vs above market compensation: Will employees be compensated at below-market levels, at market levels or at above market levels?

Monetary vs Nonmonetary rewards: Will compensation plan motivates the employees through monetary rewards like pay and stock options, or through non-monetary rewards like interesting work and job security?

5.2. Design of international reward package:

The main method of designing a compensation package is the ‘balance sheet approach’. Reynolds (1986), cited in Dowling and Schuler (1990) defined it as “a system designed to equalize the purchasing power of employees at comparable position levels living overseas and in the home country, and to provide incentives to offset qualitative differences between assignment locations.”

The pay systems vary from one country to another country. These aspects should also be taken care of by MNCs. For example, salary systems in Europe and North America are generally based on the type of work undertaken and skills required, in some cases, some element of merit pay. However in Japan the main determinant of pay levels has traditionally been the age and seniority of the individual employee in addition to a bonus for group or company performance. There are differences in incentive pay schemes such as individual and group bonuses/ commissions, profit sharing and share options, merit and performance related pay across different countries. An organization must also be aware that specific countries require benefits that may not be offered in the home country. For example, in France employers are required by law to provide every employee with 25 days of vacation. Although an American working for an American company in France is not legally entitled to such a vacation, the organization may want to follow this practice to avoid morale problems with expatriates. (Donald L. Caruth, and Gail D. Handlogten , 2002)

Giammalvo, (2005) says: “Regardless of how well intentioned management may be, unless there is a formula in place that is easily understood, readily verified and perceived to be fair and equitable, it is bound to create conflict and hard feeling among team members.” This suggests that HR needs to ensure there are clearly stated terms and conditions of payment discrepancies amongst similar jobs in different countries. The employees must be made aware of why they are being paid their salary so that there is less likelihood of problems occurring in the future amongst staff members. Schmitt & Sadowski (2003) argue against this theory saying that if the international HR manager is not standardizing pay, then the costs of differentiation will be higher, among other problems.

The complex nature of international compensation warrants special attention for organizations operating in a multi-national environment. It is crucial that organizations understand the kind of employees employed by international firms, the elements that comprise an international compensation system, and the special problems involved.