No business could survive without the most important component - the people. Being fairly compensated, appreciated, and able to earn a living wage is crucial to maintaining engaged and loyal employees.
Since payroll costs typically make up the largest portion of any company’s costs, it is vitally important to remain cognizant of labor costs in an attempt to keep costs low and profits high.
Where do you even begin when trying to balance business needs and employee needs? Well, a great starting point is creating a well-defined compensation philosophy.
Table of Contents: Types of Compensation Philosophies
What is a compensation philosophy?
The idea of a compensation philosophy is to be able to “set it and forget it.” A good compensation philosophy provides transparency so that everyone in the company is on the same page.
A compensation philosophy should detail the “why” behind the company’s position on compensation, and create a clear strategy to provide consistency across the organization.
Just like a mission, vision, and values statement sets a tone and direction for a company, the leadership team must evaluate the company’s position on compensation and what the company can afford.
Important questions to ask when establishing a compensation philosophy:
Does the company want to pay more than the rest of the market?
Does the company want to pay less in base salary, but then make up for it with benefits?
These two questions will help you formulate the basis for how much you are actually going to pay your team. Once you answer these questions, you can start to play around with the different types of compensation philosophies to find the best one for you and your company.
Review of Compensation Philosophy Basics
Market value is seen as the set salary point for a particular role at current market conditions. A company could decide to meet the market value (paying at the 50th percentile), to lead the market (pay above the 50th percentile), or lag the market (pay below the 50th percentile).
Obviously if a company wants to lag the market, they must compensate in some other way to attract talent. If a company leads the market in base salary, but doesn’t offer competitive benefits, the total compensation might be below market average. There are so many factors to consider when creating a compensation philosophy.
Traditionally, there are two basic compensation philosophies - entitlement and performance based. An entitlement compensation philosophy means that each year an employee is with the company, they should receive an increase in pay, regardless of performance.
A performance based compensation philosophy means that an employee’s salary increase should be tied to their performance and ability to hit goals. People Operations leaders know that creating an effective and useful compensation philosophy actually is much more complex and nuanced than just these two types.
Here are 5 different types of compensation philosophies
So, you may be asking yourself, “How do I create a compensation philosophy?” Once you get an understanding of the basics, answer some questions about how you want to pay your team, you can look into some of the different types of compensation philosophies below.
Below you will find examples of compensation philosophies - these will be a good start in creating a compensation philosophy. Then you can get creative, mix and match philosophies, and create the right philosophy for you and your company.
Market Plus:
This philosophy is when a company decides to meet or lead the market on all base salaries and then to award additional compensation to departments based on added value to the organization. In situations like this, the organization must evaluate how specific departments or roles are adding value to the organization to ensure that all business units are being rewarded fairly and appropriately.
Pro: Can attract and retain experienced and high achieving employees
Con: Possibility for inequity across teams, and not recognizing high performing individuals
Pay for Performance:
This philosophy typically has a broad range of direct compensation, and employees are paid based on their individual and company performance. At first glance, this may appear to be the best way to handle compensation, however, with this model you must make sure to evaluate performance equally and fairly. This requires to have clearly outlined job scorecards and metrics to ensure that all employees have equal opportunity to be paid fairly. This bonus system can create a lot of pressure on the executive team to make sure that the company performs well enough for people to get their bonus.
Pro: Promotes high performing people and rewards them for their hard work
Con: Can create competition between employees and lead to lower collaboration
Mission-Based:
Businesses with this model may lag the market in base salary, meaning cash compensation is low. In order to attract and retain employees, companies with this model must create and engage a strong organizational culture and mission. You might see this in non-profit organizations or organizations supporting a particular cause. They attract talent because they are part of something bigger. In a for-profit company, this type of philosophy would usually include higher company equity in exchange for lower base salary.
Pro: Attracts people who are likely very invested and aligned with the core values and mission of the company
Con: Can be hard to attract top talent
Egalitarian:
Pay in this model is competitive and set at a market value. On top of that, all group rewards and bonuses are distributed equally and tied directly to business success. An example of this is a company profit sharing program that benefits all employees equally once the conditions of a payout are met. This type of compensation philosophy is best when you want to foster group cohesiveness. Win as a team, lose as a team.
Pro: Creates a culture of collaboration and “win as a team” mentality
Con: Can over-reward low performers, and under-reward high performers
Unstructured:
Perhaps one of the most common models exhibited by new companies, in this model every employee is offered a different deal, as needed, to promote retention and performance. This model can work out in the beginning to get your first employees in the door, but should be avoided. This model can bring rise to inequality, bias, and disgruntled employees. Often it can come down to who is the best at negotiating. Not having a structure on how much to pay for a particular role can make it extremely difficult to forecast and plan business finances. This could also lead you down a path to potential lawsuits for pay inequality. Does this model sound like your business?
Pro: Easiest, most flexible in trying to attract talent and create individualized offers
Con: Bias, potentially discriminatory, hard to create budgets
An example of a compensation philosophy that combines the options above is a company that is Pay for Performance with base salary and Egalitarian in benefits. For example, an employee’s annual salary increase can be based on their performance metrics and hitting targets, while everyone in the company receives the same benefits and ability to earn a bonus through a company profit sharing program.
With so many factors to consider when creating a compensation philosophy, it can help to have experts guide you through it. If you think your company could benefit from a compensation philosophy, reach out to Talent to Team today to get professional and expert help. Talent to Team can also help your organization complete market research, create salary benchmarks, pay ranges, and job levels to take your compensation to the next level.