Compensation Philosophy Introduction

Compensation philosophy refers to the approach that a company takes to determining compensation. Total compensation is a mix of pay and benefits, and the structure that the pay takes as well. The compensation philosophy should be aligned with the company’s overall strategy. For example, Wal-Mart pays at low rates in order to help it compete on a low cost basis – a lower cost of doing business is conducive to that approach. Costco takes a different approach, believing that paying above market for its employees will deliver higher workplace engagement, and a more experienced, efficient workforce. The gains in efficiency and engagement will offset the higher cost per worker, is the general thinking there. So the compensation philosophy can be different between two firms in the same industry, but the philosophy has to be aligned with the rest of the business, including the key business objectives.

Different Compensation Philosophies

There are three basic compensation philosophies – lead, lag or follow the competition. The sort of base philosophy is to follow the competition, which means to set compensation policies in line with the market (SHRM.org, 2015). Under this approach, the competition basically sets the bar for compensation for the different roles, and your company follows what they are doing. This is also known as a match strategy.

The lead strategy is when the company takes the lead, setting compensation. Other companies follow you. As the compensation leader, typically the company will focus on having higher compensation rates, paying more than competitors. This is often done to attract better candidates, and in many cases there are sound operational reasons for this. Companies with the best talent are often the best performing companies – having your pick of great applicants can be a source of competitive advantage for a company.

The lag strategy is to pay below the market for jobs. There are two ways that this works. First, the company can offer far superior things in other areas – the work environment,...

This is something seen in tech startups, where there are cash flow issues but people are willing to take less because there is more opportunity or the work is more intrinsically rewarding. The lag strategy is also used by companies that utilize a lot of low-grade labor. Unskilled labor often comes with high turnover, and higher error rates, so companies that have to choice but to leverage the unskilled labor pool typically want to pay as little as possible, in order for each worker to have a net positive contribution to the company.
Recommendation

I normally recommend that companies take the lead approach to compensation, but because compensation philosophy needs to be aligned with strategic objectives and the rest of the operational strategy it is important that even a leading strategy takes these factors into account. The reason I recommend a lead strategy is that I believe companies should take a lead strategy in all their endeavors. The most successful companies are the ones that strive to be the best, to dominate their industries. I do not advise any company to be happy with anything other than the #1 position in their market, because any other position in inherently less stable in the long run. The reality is that in order to be the best on the market, a company needs to have better, smarter people than its competitors. To attract the best people, a company typically needs to offer better compensation. The reality is that top companies often offer talented people opportunity, and on average employees prefer to make more money, all other factors being equal.

Sturman and McCabe (2006) note that the lagging strategy typically does not pay off. It offers poor utility because a company that attracts weaker workers will continually struggle in the marketplace. The best workers from that company will be picked off by competitors – they have higher turnover intention. Their study showed that total utility is higher for the lead strategy at all levels,…