Compensation Planning

This resource focuses on the development of a compensation plan that matches the strategy of your company. Topics to be covered are a) getting compensation and value aligned, b) factors in compensation, and c) performance reviews.

Getting Compensation and Value Aligned

Before starting down the road of compensation planning and performance reviews, the company should understand the value expectation of the position to the company.  The challenge here is going from market cost to internal value. Most companies today consider the market cost of a person or position. For example, we say the market compensation cost for a receptionist is $33,000 in our town.  But the other side of the question is what is the value of a receptionist to the company? In answering this question the company quickly runs into a measurement problem. How is the value of any employee measured? Some thoughts:

1. It is not the employee that is measured; it is the role they are fulfilling in the company.  Therefore the receptionist is a role; a machinist is a role.
2. Each role should have a value matrix.  The value matrix is about the contribution to the operation of the firm’s profitability.  
1. A machinist produces a certain level of product which in turn has a gross profit margin.  A certain gross profit is required to achieve overall company profitability. Therefore, gross profit targets can be assigned to each position creating a value to that position.
2. Receptionists and other administrative roles tend to be more difficult to value, because they are not directly revenue producing.  The solution is to determine the available funds for administration. These are then allocated to the administrative positions. The allocation is done using factors such as essential needs and alternative approaches.  In the aggregate, the administrative function must stay in line with the funds generated by the company’s revenue side.
3. Yes, officers get the same kind of position valuation.
3. As part of this value assignment process, the position job descriptions become refined.  With this refinement, the performance expectations for the position can be incorporated into the performance review, below.
4. Now that the position is valued, the compensation for the position can be set based upon this value.  One would expect a range in compensation based upon high or low performance.

Now that the values are set, the overall compensation of the company should be compared with the budget. Before compensation adjustments are made the current level should be in line with values. Most budgets have been done based upon prior year expenses.  If these have not been aligned to value, then the compensation budget may not relate to value. Please note that compensation can be both above and below value.  

What should be done with compensation that is meaningfully outside of the value to the company?  

1. Consider whether there are particular circumstances.  In particular is the value transient or is it permanent?  If it is permanent, the adjustment should happen. If it is transient, then a bonus may be more appropriate.
2. Too often positions that have compensation below value are combined with content individuals that hold no change is needed.  We would challenge this thinking. A highly productive individual should be paid for that productivity, even if they do not “argue for the pay.”  Why? Such an attitude is about building the company for the long-term. Treating people right in all situations is a true application of justice.  
3. How are adjustments made?  Usually in increments over a relatively short period of time, say 2 to 4 years.  Why not immediately? Positions should be about the long-term. The goal is not to see dramatic value adjustments from year to year.  Therefore alignment made over time reinforces that respect for long-term thinking. Note this applies both to adjustments up and down.

By now everyone is wondering where the market compensation fits in to this picture.  The market compensation determines whether the value the position creates in the company can support the quality of person.  In short it is possible that the market may be both above and below the company’s value. What does this mean?

1. If the market compensation rate is above the company’s value for the position, the company will find it difficult to staff the position.  This raises the question of whether the position is needed.
1. For example, the position value of a receptionist is $20,000 in the company based upon the allocation of available administrative costs.  But the market compensation is $30,000. Continuing to employ a receptionist will be difficult. If the company pays the market compensation, it is eroding profits by $10,000.  
1. As a result the company should consider other alternatives to having a receptionist.  
2. What if a person is willing to work below market?  As noted below, money compensation is not the only aspect to compensation.  Therefore, companies regularly find that offsets to cash compensation can be flex-time, training, and environment allowing the individual to accept below market cash compensation.

What is Compensation?

We have been discussing compensation as compared to the value of a position.  Many companies do not have a good grasp of their compensation for an employee.  As a result the comparison to value is poor and the employee does not understand his full compensation.  Let’s consider the components of compensation:

1. Salary and wages: generally this is viewed as compensation, but as will be seen there is much more.  Too often salary or wages are the only discussion point in answering the question of how much do you make?
2. Bonus and profit sharing: In addition to the salary and wages, targeted bonus and profit sharing are part of the compensation.
3. Employer taxes: The federal and state employment taxes, such as FICA, are both shared with the employer and are direct burdens on the employer.  Note included here are programs such as unemployment insurance. Therefore, compensation discussions should include these burdens.  The governments argue that these taxes are there to benefit the employees. Whether the employee values them or not is secondary to the fact that they are part of the compensation cost of the position.
4. Vacation and holidays: Productivity is part of the value of the position.  Therefore, vacation is part of the compensation and should be reflected.  There are differing views on how to show this value.
5. Paid time off such as sick time, free days, birthdays are all treated similarly to vacation and holidays.  
6. Benefits, such as health and life insurance, training, transportation subsidies
7. Retirement programs: The contributions for define benefit plans, profit sharing, and 401k plans are all compensation.

It is recommended that the company have a compensation form that shows all of these items for the employee.  It can seriously change the view of what the company incurs for the position and makes the value discussion more relevant.

Determining Annual Compensation Adjustment

Now that the values of positions are understood and the components of compensation have been aggregated, it is time to consider the compensation adjust for the year.  Note here that this is a company wide adjustment target. Too often compensation adjustments are done only at the individual level. It is the company that we are managing. Therefore the company’s performance dictates the available funds for all compensation.  This process is as follows:

1. The budget is the starting place. Using a mid year compensation review allows for an evaluation of how the budget is shaping up for the year. 
2. The actual compensation is compared to the budget, factoring the above sensitivity.  
1. If the actual is less, then upward adjustment is possible.
2. If the actual is more, then downward adjustment is needed.
3. The amount of the adjustment should factor in the long-term thinking noted above.
4. This results in the over compensation adjustment pool.
3. The individual compensation adjustments can now be made based upon the performance reviews, below.  The aggregate of individual adjustments cannot exceed the compensation adjustment pool.
1. Too often compensation adjustments are made on a one-off basis without overall consideration on the impact on the company.
2. This process minimizes this risk.
4. Cost of living increases. Most companies feel that cost of living increases are the minimum.  However, as noted above, cost of living increases has to be balanced by the company realizing similar increases in its pricing and profits.  .
1. Cost of living changes, generally called inflation, comes from The Consumer Price Index and it compiles a Cost of Living Adjustment (COLA) for the coming year based on the prior year experience.
1. Let’s assume for the previous year that cost of living increased by 2.3%.
2. However, rather than giving all employees a 2.3% raise, we suggest that this amount be used to evaluate the compensation adjustment pool.  
1. If the pool is below CPI that raises an important management issue since the company is not keeping up with inflation for its employee costs.
2. If the pool is above CPI this is good, but is a warning that management may be too generous.  We have seen companies that consistently did increases above CPI only to find that they costed themselves out of the market relative to the company’s capacity to make profits.
2. The distribution of the compensation adjustment pool to individuals based on value, promotions, and performances can be balanced against CPI for the position.
5. For example, if the total of employees’ salaries and other compensation is $400,000 actual for the first 6 months, showing a total of $800,000 for the year.
1. Budget compensation for 2008 is $860,000.
1. Budgeted revenue is on target and the year looks good.
2. Position values have been reviewed with no notable problems
2. The compensation adjustment pool is $60,000
1. This is a 7.5% compensation increase.
3. The amount available for salaries would be the $60,000 less the increase in other costs, such as healthcare insurance, etc.
1. For this example we will assume that these are $10,000.
2. Therefore the pool available for salaries is $50,000.
4. Comparing this to CPI we see
1. At 2.3% CPI, the total increase would be $18,400.
2. The question now is why the available amount is greater than CPI.  Some reasons are:
1. Staff were budgeted but not hired.
2. Existing staff have gotten more productive, (i.e. are working harder.)
3. The budget was too high.
4. Other benefit plans have been cut, such as training.
3. Note that the above reasons could support the above CPI compensation adjustment pool.
5. Now the individual increases, and perhaps decreases are undertaken based upon the performance reviews.
1. But the total adjustments cannot exceed the compensation adjustment pool.

Performance Reviews

While optimal interaction includes regular feedback to employees, it is vital that performance reviews occur at least once per year. As noted above, we recommend that both reviews and compensation adjustments occur mid-year when most business cycles allow adequate time for reflection.

Likewise, since bonuses should be based in part on prior year company performance, we recommend that they are determined and distributed in either the first quarter or mid-year as part of the Compensation Review period. Removing this from the December rush allows adequate planning time as well as tying bonuses to the performance reviews. It also separates the bonus from the annual holiday “thank you gift.”

How should performance reviews be done?

There are many books and papers written on this topic.  We share here some quick observations:

1. There should be a standard form.  The form should have ratings for
1. Key aspects of the position such as skills
2. Attitude towards the company
3. Attitude towards others

1. 360 Reviews: These reviews are typically utilized to provide perspective from a supervisor, a co-worker, yourself, and a subordinate. While the information received might be helpful and informative, the Giersch Group discourages the use of these for the following reasons:
1. Anonymity: Since names are not used, this encourages a closed culture of throwing stones without responsibility. We encourage all performance input and information to be discussed, but between individuals where further explanation can be obtained and thus encouraging an open culture between team members.
2. Equality of Input: Since these reviews are anonymous, all input is weighted on an equal level. However, managers typically have a broader view and their input should be weighted on a different level.

1. Contribution to business
2. Areas for development: Each person should be challenged to grow and increase their effectiveness.
3. Forms should be signed off by the supervisor, reviewed with the employee, signed by the employee and filed in the employee’s personnel file.

Based upon the ratings of the performance review, there is a recommended compensation adjustment.  This should be reviewed by senior management to be sure that the amounts are consistent with the position and performance ratings across the company.  Once the amounts are settled, then the aggregate is compared to the compensation adjustment pool.  Refinements are made to balance recommendations against available funds.

Longevity of Employment

Compensation plans are vital to encouraging staff to become a part of the company. Many HR consultants contend that this generation will switch jobs many times in their lifetime and that long-term employment with one company is a trend of the baby boomers. However, we advocate that a working environment in which an employee participates as a builder of the company, along with good compensation planning, will motivate an employee to continue over the long-term. While monetary compensation is often satisfying to an employee, it is rarely enough to motivate for the long-term. Employees typically desire to be part of something larger in which they can invest their lives.

Articles for Further Reading

1. “Give Til It Doesn’t Hurt” is an article by Jack and Susie Welch which discusses the distribution of bonuses. http://www.businessweek.com/magazine/content/08_06/b4070092840947.htm?chan=magazine+channel_opinion
2. “Paychecks aren’t Everything” addresses the issue of non-compensation as part of the overall plan for employee satisfaction. http://www.inc.com/resources/recruiting/articles/20080201/malter.html
3. “Putting an End to End-of-Year Reviews” discusses the merits of evaluating on a continual or at least quarterly basis rather than one time at year-end. http://www.inc.com/magazine/20071201/putting-an-end-to-end-of-year-reviews.html

For more information, please visit the Giersch Group at www.gierschgroup.com or contact us at prosper@gierschgroup.com.