Chapter 07 Building Pay Structures that Recognizes Individual

Chapter # 07 Building Pay Structures that Recognizes Individual Contributions Reference Books: ØHuman Resource Management (12 th Edition), R. Wayne Mondy, Pearson Education. Ø Strategic Compensation: A Human Resource Management Approach (6 th Edition), Joseph J. , Martocchio Joe, Pearson Education. Resource person: Furqan-ul-haq Siddiqui

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 n

1. Deciding on how many pay structures to construct Companies often establish more than one pay structures depending on a. Market rates b. Company’s job structure Ø Company’s pay structure includes 1. Exempt and non exempt ( wage – salary) 2. Pay structures based on job families 3. Pay structures based on geography Ø

Exempt jobs: ü are not subject to overtime ü Core compensation in terms of salary ü Are generally supervisory, professional, managerial or executive jobs ü Contains wide variety of duties Ø Non exempt jobs ü Are subject to overtime ü Core compensation is expressed as hourly pay rates ü Are generally non supervisory in nature ü Duties tend to be narrowly defined Ø

Pay structures based on job family Ø Pay structures are defined on the basis of job family, which show a distinct pattern in the market Ø Distinct job families include: i. Executive ii. Managerial iii. Professional iv. Technical v. Clerical vi. Craft n Pay structures based on geography a. 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 n

2. Determining a Market Pay Line Market pay line is representative of typical market pay rates relative to a company’s job structure Ø Pay levels that correspond with the market pay line are market-competitive pay rates Ø Pay rates that fall along the market pay line represent competitive pay rates on the company’s selection of a relevant labor market Ø These rates promote internal consistency because they increase with the value of jobs—based on job evaluation points Ø

Pay Structure for Clerk Jobs $ 36000 $ 24000 $ 21000 Market Pay line $ 18000 $ 15000 $12000 250 points Clerk 1 500 points Clerk 2 750 points Clerk 3 Job Evaluation Points 1200 points Clerk 4

3. Defining Pay Grades Pay grades group jobs for pay policy application based on similar compensable factors and value Ø There is no one formula for determining what is sufficiently similar in terms of content and value to warrant grouping into a pay grade Ø 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 Ø

Narrower pay grades tend to promote: i. Hierarchy ii. Social distance Ø Pay grade widths are either a. 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 $ 36000 $ 24000 $ 21000 $ 18000 $ 15000 $ 12000 200 - 300 301 - 650 Messenger (200) Mail clerk ii (350) Clerk ii (500) Mail clerk ( 220) Secretary i (650) Clerk 1 (250) Receptionist (300) 651 -1150 1151 - 2000 Mail clerk iii (675) Mailroom Sup. ( 1175 Clerk iii ( 750) Chief Clerk (1200) Secretary ii ( 1000) Ex. Secretary (1900) Job Evaluation points

4. Ø Ø Ø Ø Ø 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. b. Ø Ø Ø ü ü ü According to the market averages 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 n Example: Typical Pay Range * 20% to 25% -- lower-level service; production and maintenance Ø * 30% to 40% -- clerical, technical, paraprofessional Ø * 40% to 50% -- high-level professional, administration, middle management Ø * 50% and above -- high-level managerial, executive Ø

Calculation of Range Spread 1. Identify the midpoint 2. Determine the range spread $ 20, 000 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% $ 22, 727 $20, 000 $ 17, 857 $ 15, 625 Minimum + ( range spread x minimum) $ 27272 $ 30, 000 $ 32, 143 $ 34, 375 Difference between maximum and minimum values $ 4, 545 $ 10, 000 $ 14, 286 $ 18, 750 Minimum: Midpoint/ 100% + (range spread/ 2) 120% Maximum:

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 Ø Overlapping pay ranges allow companies to promote employees to the next level without adding to their pay Ø Non overlapping pay range require pay increases for job promotion Ø Overlap is expressed as a percentage Ø

$ 40, 000 Calculating Pay Range Overlap 100% x Max. rate for A – min. rate for B/ Max rate for A – min. rate for A $ 35000 100% x ($ 35, 000 – $30, 000) / ( $35000 - $ 20000) $ 3, 0000 B $ 20000 $ 60, 000 A 100% x ( $ 40000 - $ 40000) / ( $40000 - $ 30000) The overlap between range C and D is 0% $ 40000 $ 40, 000 $ 30, 000 The overlap between range A and range B is 33. 33% D C

Pay Compression n 1. 2. 3. n 1. 2. Pay compression can be defined as pay differentials that are too small to be considered equitable. The term may apply to differences between the pay of supervisors and subordinates, the pay of experienced and newly hired personnel of the same job and pay-range midpoints in successive job grades or related grades across pay structures Two situations result in pay compression: The company’s failure to raise pay range minimums and maximums 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 Ø The salary of newly hired CPAs increased 7% annually over the last five years Ø Minimum and maximum pay levels for entry-level CPAs, over the last five years, did not increase due to low profits Ø CPAs hired five years ago make less than recently hired CPAs Ø

Pay Compression Scarcity of qualified candidates for particular jobs Ø 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 Ø Can threaten a companies’ competitive advantage when it results in dysfunctional turnover (high performing employees voluntarily terminate their employment) Ø 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 Ø Setting competitive maximum rates enables a company to raise pay rates for high quality employees who may consider employment opportunities with competitors Ø 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 n Ø Ø Ø Ø 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 n Ø Ø Ø 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

n 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. Ø Ø Ø 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 Average Pay per Hour (Current Rates or Market Rates) $19. 80 5 18. 50 4 17. 20 3 ve r u 15. 90 14. 60 14. 00 13. 30 12. 90 12. 00 W 100 1 Evaluated Points 0 - 99 100 -199 200 -299 300 -399 400 -500 C ge Pay Ranges for Pay Grades 2 a 1 200 300 400 500 Evaluated Points 2 3 4 5 Pay Grades Pay Grade 1 2 3 4 5 Minimum $12. 00 13. 30 14. 60 15. 90 17. 20 Midpoint $13. 30 14. 60 15. 90 17. 20 18. 50 Maximum $14. 60 15. 90 17. 20 18. 50 19. 80

Designing Merit Pay Systems Considerations Ø Companies must insure that employees see definite links between pay and performance, Ø Companies must avoid using ineffective performance appraisal methods and poor communication regarding the link between pay and performance, Ø Companies interested in establishing merit pay system must decide: i. Merit increase amounts ii. Timing iii. Type of merit pay increase – permanent or recurring increases versus non recurring addition to base pay iv. Settle on base pay levels relative to base pay of functionally similar jobs. n

Designing Merit Pay Systems i. Merit Increase Amounts 1. Should reflect prior job performance levels Should motivate employees to perform their best To be seen as meaningful, the amounts should account for increases in: Inflation Payroll deductions CPI 2. 3. a. b. c.

Merit Increase Amounts (contd. ) Ø Managers must consider three research findings 1. Boosting the merit increase amount will not necessarily improve productivity. Ø Research has shown diminishing marginal returns on each additional dollar allocated to merit increase Ø In other words, each additional merit increase dollar was associated with smaller increases in production 2. Employees’ perception of just meaningful difference in merit increase depends on their; a. Cost of living b. Attitudes toward the job c. Expectation of rewards from the job n

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 Ø 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 Ø In practical terms, managers should award the largest merit pay increases to employees with best performance and vice versa Ø The difference between the increases should be approximately equal to differences in performance Ø Well designed merit pay structures will fail without adequate funding n

Designing Merit Pay Systems Merit Increase Amounts (contd. ) n Compensation budgets Ø are blueprints that describe the allocation of monetary resources to fund pay structures i. Are indexed in percentage terms Ø 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 n

Designing Merit Pay Systems Timing n Majority of companies allocate merit increases, cost of living , and other increases annually n Companies may take one of the two approaches i. Establish a common review date or period 2. Employee’s anniversary date Ø The day on which the employee began to work for the company Ø Most employees will have different evaluation dates Ø It may not monopolize supervisors time Ø Can be burdensome because reviews must be conducted regularly through out the year ii.

Designing Merit Pay Systems iii. Ø Ø Ø Ø 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 structures specify acceptable pay ranges within each pay grade Ø Each job’s base pay level should fall within minimum and maximum rates for its respective pay grade Ø 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 Ø

Rewarding Performance: The Merit Pay Grid Pay raise amounts are determined by: a. Performance ratings b. The position of employees' present base pay rates within pay ranges n Employee performance ratings a. Overall performance ratings guide the pay raise decision b. Based on the principle of recognizing higher performance with greater rewards Ø

Rewarding Performance: The Merit Pay Grid (contd. ) n Employees' position within the pay range Ø 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 Ø Ø Ø

Merit Pay Grid 38

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Merit Pay Increase Budget (contd. ) 1. Supervisors and managers determine how many employees fall within each performance category. o o o Excellent =10% Above Average = 20% Average = 40% Below Average = 25% Poor = 5% 2. Determine the percentage of employees whose pay falls into each quartile. Q 4 = 20% Q 3 = 25% Q 2 = 40% 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 (2 nd quartile) o o Ø Ø Ø

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 4 th quartile equals 7. 41

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 • Q 2 $ 35, 000 Q 1 $ 20, 000 42

Excellent Above Average Below Average Poor Q 4 7 x 5% x 65000 = $ 22, 750 14 x 3% x 65000 = $ 18200 28 x 1% x 65000 = $18, 200 $0 $0 Q 3 $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. Ø 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; ü ü ü Lowering costs Recognizing performance Equity

Traditional Pay Structure vs. Broad banding

n Ø Ø Ø 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. 46