Human Resources and Compensation Philosophy

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, the opportunity or challenge, and upward mobility are all areas that can be emphasized to make up for lagging in total compensation. 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, and highest for the 5-10% levels, at which point the company might hit the point of diminishing returns where it is overpaying for people beyond their ability to produce better than their counterparts at other companies. The match strategy does not underperform in terms of utility, but nor does a company put itself in a position to derive competitive advantage. The lead strategy is the only one from which HR can derive competitive advantage for a company, because the lead strategy genuinely does attract the best people. Over time, this impact should be compounded, because the company will end up with a better employer brand than competitor as well, baking in some of those productivity gains by attracting better people on reputation alone.
Pay Policy Lines
It is generally recommended that for specialized roles a company should lead the market, or at least match. For the areas where a firm derives its greatest competitive advantage, leading is best, and for other more functional, transactional areas matching works. It is not recommended to lag the market, simply for the fact that you are ruling out getting the most talent, and there are going to be negative impacts on the employer brand. If large numbers of unskilled laborers are required, the match and lag strategies might be the same (i.e. minimum wage) and that is okay, unless the company genuinely feels that leading will be able to help the company have better productivity or retention rates than the competition. For some low-end job categories, that might not actually be possible.
Pay Discrimination
Surveys are a means by which pay discrimination can be identified. Pay discrimination is a fairly complex issue, and identifying it cannot simply be done through self-reporting. A company needs to examine how pay is dispersed throughout its organization, and only by doing that can it effectively determine if pay discrimination is. Surveys are capable of gathering data that is not only accurate but statistically valid, so that HR can use this data to determine if pay discrimination exists. Anecdotal evidence is insufficient – the discrimination must exist as a verifiable pattern for HR to address it at a systemic level.
That said, surveys can also be useful in identifying where discrimination exists within the organization as well. If there is a particular manager or department that is guilty of discrimination, that data could be buried in an organization that is good overall. So the ability to gather data via a survey can also allow the human resources department to identify trends or patterns that might help it to identify discrimination in specific parts of the company. In essence, surveys are valuable because they allow for the gathering of a lot of data, and with relative anonymity to tackle sensitive issues like pay discrimination.
There is not much research about this – the literature surrounding pay discrimination has gone beyond how to use surveys to identify discrimination. The literature focuses on sources of discrimination, and its prevalence and its impacts. It is actually understood that surveys are one of the means by which information is gathered – nobody has produced a study recently to describe the fact that surveys gather information. That’s just something you know.
Conclusions
The choice of compensation philosophy definitely depends on the circumstances of the employer, because compensation philosophy must be aligned with the overall strategy, and the strategic objectives. A philosophy that is misaligned will create inefficiency somewhere. One example would be having grossly overqualified people in some roles, wasting their talents, or underqualified people in roles delivering poor performance. For example if McDonalds hired MBAs to run their restaurants at $100K to start, they’d get those people, but those people’s skills would doubtless be squandered in that environment.
So in general, wherever a firm extracts its competitive advantage is where it needs to plug the most amount of money. Wherever it extracts limited advantage, it can afford to match the market. But the evidence shows that there is almost never benefit to lagging the market – even for minimum wage jobs you’d want that to be a situation where the company is matching the market.


References

Bowman, Jeremy. “Why Wal-Mart will never pay employees as much as Costco” Motley Fool [Web]. 2016. Retrieved December 5, 2017 from https://www.fool.com/investing/2016/1

SHMR.org “Planning and design: Compensation philosophy: What are the advantages or disadvantages of lead, match or lag compensation strategy. SHRM.org 2015. Retrieved December 5, 2017 from https://www.shrm.org/resourcesandtools/tools-and-samples/hr-qa/pages/cms_024253.aspx

Sturman, Michael & McCabe, David. “Choosing whether to lead, lag or match the market” Scholarly Commons 2006. Web. Retrieved December 5, 2017 from http://scholarship.sha.cornell.edu/cgi/viewcontent.cgi?article=1338&context=articles