NEW SYLLABUS

COMPENSATION MANAGEMENT SURESH MUKE

TM

A Book Of

COMPENSATION MANAGEMENT For

M.P.M. (Semester - III) As Per Pune University's Revised Syllabus Effective from June 2014

Suresh Muke B.Com., DBM, MBA

N2113

COMPENSATION MANAGEMENT First Edition : July 2014 © : Author

ISBN 978-93-5164-054-7

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Preface The last decade of the twentieth century and the beginning of the 21st century has witnessed enormous changes in social, political and economical systems throughout the world. The advantages of advanced electronic technology at the end of year 2000 provided a strong impetus for rapid growth in the profitability and value of many Indian businesses, employment and employee compensation. With these changes many experts in HR brought about changes in compensation concepts and technologies which were widely used in the pay systems. Job analysis, job descriptions and job evaluation were considered as bureaucratic, old fashioned and obsolete. New concepts and terms such as competence based pay, person-based pay, 360 degree review, performance assessment and coaching, became major additions to the HR compensation vocabulary. Today, Human Resource Management has become a key function for organisations as retention of talent and a motivated work force enable organisations to sustain themselves in the competitive environment. The Compensation Management function has a very crucial role in this regards as, the Information Technology and service sector is booming and dominating the manufacturing industry sector, where retaining talent is a challenge for HR professionals. So an effective Compensation Management System is a strategic need of an organisation. The word 'Compensation' refers to the HR strategic management programme of wages and salaries. It consists of all forms of monetary and non monetary rewards given to the employees. Compensation Management is being taught for the MPM course of Pune University and is based on the latest syllabus of the University of Pune, giving an elaborate in-depth look at the topics prescribed. The book introduces the concepts of compensation and its management and its relevance to the decision of fixing wages which are linked with the labour market, incentives, computation of CPI, wage components, wage surveys etc. It also covers statutory and monetary and non-monetary employee benefits and also elaborates the legal and taxation part of compensation management. Designing and administering a compensation system that rewards employees fairly while stimulating them to provide goods and services that satisfy customer demands and allow organisations to operate with profit would be the focus of today's business. I am sure that this book will be of immense use to the students from the view point of their examination. In spite of sincere efforts, printing errors might have crept in the book at some places. I hope that I will be excused for the same. I am very grateful for the contribution of my colleagues and students from IMCC who encouraged and supported me in the endeavour. I would also like to acknowledge the support of my wife and daughters who stood by me patiently during the writing of the book. Finally, I am very grateful to Shri. Dineshbhai Furia, Shri. Jigneshbhai Furia, my publishers, for providing me with this opportunity and the entire staff of Nirali Prakashan for their research and support. I shall consider my labour amply rewarded if this book is appreciated by those for whom it is meant.

Pune

Suresh Muke

Syllabus … 1. Introduction to Compensation Management

(7 + 2)

Objectives of Compensation, Formulation, Theories of Wage determination, Types of Wages, Compensation decisions, Compensation Bench Marking, Types of Executive Compensations. 2. Labour Market

(7 + 2)

Macro Economics of Labour Markets, Neoclassical Micro Economic and Labour Markets Supply and Demand different types of Labour Market in India, Impact of Labour demand and Supply on Compensation Fixation. 3. Wage Policies

(7 + 2)

National Wage Policy: Objectives, Concepts. Company Wage Policy: Wage Determination, Pay Grades, Economic Principles. External Equity: Wave Surveys, Wage Components. 4. Pay Structures

(7 + 2)

Different Pay Structures, Pay Roll Management, Deductions, Issues involving pay increases, Cost to Company (CTC) Computation Dearness Allowance: Computation of CPI - Exercise, Wage Incentives Concept; Different kinds of Wage Incentives plans and their Application, Pay for Performance, Competency based pay. 5. Employee Benefits

(7 + 2)

Types of Employee benefits, Statutory Employee Benefits in India, Tax obligation on Employee Benefits.

Contents …

1. Introduction to Compensation Management

1.1 – 1.22

2. Labour Market

2.1 – 2.18

3. Wage Policies

3.1 – 3.26

4. Pay Structures

4.1 – 4.40

5. Employee Benefits

5.1 – 5.12

Chapter

1…

Introduction to Compensation Management Contents … 1.1 1.2 1.3 1.4 1.5

Introduction to Compensation Management Meaning of Compensation Objectives of Compensation Components of Compensation Designing Compensation 1.5.1 Steps in Designing a Compensation Plan 1.5.2 Criteria for Effective Compensation 1.5.3 Principles of Compensation Formulation 1.6 Theories of Wage Determination 1.6.1 Classical Theories 1.6.2 Marxian Surplus - value Theory 1.6.3 Purchasing - power Theory 1.6.4 Human - capital Theory 1.7 Types of Wages 1.8 Compensation Decisions 1.8.1 Types of Compensation Decisions 1.8.2 Factors Affecting Compensation Decisions 1.8.3 Compensation Decisions and Business Strategy 1.9 Compensation Benchmarking 1.10 Types of Executive Compensation • Points to Remember • Questions for Discussion • Project Questions • Case Study

Objectives …
To understand the Meaning, Objectives and Formulation of Compensation
To be able to discuss the concept of Wages and Salaries
To learn how decisions about Compensation is being taken in the Organisation
To be aware of the types of Wage
To study Organisational Strategy and Compensation 1.1

Compensation Management

Introduction to Compensation Management

1.1 Introduction to Compensation Management “If you pick the right people and give them the opportunity to spread their wings - and put compensation and rewards as a carrier behind it - you almost don’t have to manage them.” — Jack Welch In general the term compensation refers to the payment a person receives for the work he does. From the employer’s perspective, the money that they pay to the employees in return for the work that they do is something that they need to plan for in an elaborate and systematic manner. Unless the employer and the employee are in broad agreement, the net result is dissatisfaction from the employee’s perspective and friction in the relationship. When an organisation employs people; it has to keep in mind that the chosen person is an investment for the organisation and has to make sure that the employee sticks to the company for a longer period of time. This is because these employees are likely to be a part in the firm’s success and hence it is the organisation’s motto to protect this investment. The employer has to pay the employee what they are worth else the employee may leave and choose to work elsewhere. It is very important for the firm to carefully chart out its compensation policy.

1.2 Meaning of Compensation Compensation is the outcomes (rewards) employees receive in exchange for their work, or Pay is an exchange between the individual or group and the employer. Compensation is the total amount of the monetary and non-monetary pay provided to an employee by an employer in return for work performed as required. Compensation is the remuneration received by an employee in return for his/her contribution to the organisation. It is an organised practice that involves balancing the workemployee relation by providing monetary and non-monetary benefits to employees. Compensation is an integral part of the human resource management which helps in motivating the employees and improving organisational effectiveness. A great deal about the firm’s value and culture can be understood from the compensation package. Employees are more likely to look at what a company pays rather than what it says. In many respects, people behave as they are rewarded. Insofar as this is true, a compensation scheme communicates to the employees what the firm's expectations are of them.

1.3 Objectives of Compensation The objectives of the compensation function are to create a system of rewards that is equitable to the employer and employees alike. The desired outcome is: • •

An employee who is attracted to the work Motivated to do a good job for the employer 1.2

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Introduction to Compensation Management

Some of the objectives we can classify are: 1. Attract Highly Competent Personnel: Compensation needs to be set in a way that it would attract highly qualified applicants. High wages attracts many aspiring candidates from the job market. 2. Retain Employees: Employees may quit when they are given a compensation package which is not competitive enough. 3. Maintain Equity: Equity should be maintained when compared to a similar job within the organisation. 4. Incentive for Change in Behaviour: The pay should be sufficient enough to influence the employee’s behaviour positively. 5. Wage Cost Budget: The compensation system should help the organisation to control the cost within the budget. 6. Legal Compliant: The system should comply with the legal provisions which are applicable and amended from time to time. 7. Easy to Understand and Implement: The system should be easy to understand for all the employees.

1.4 Components of Compensation In today's business environment organisations pay their employees several benefits-both financial as well as non-financial. Typical remuneration of the employee comprises wages and salary, incentives, fringe benefits, perquisites and non-monetary benefits. 1. Wages and Salary: Wages represent hourly rate of pay, and salary refers to the monthly rate of pay, irrespective of the hours put in by an employee. Wages and salaries are subject to annual increments. They differ from employee to employee, and depend upon the nature of job, seniority, and merit. 2. Incentives: Also called as 'additional pay with output', incentives are paid in addition to wages and salaries. Incentives depend upon productivity, sales, profit or cost reduction efforts. Incentives can be paid for a group or for individuals. 3. Fringe Benefits: Fringe benefits include employee benefits such as provident fund, gratuity, medical care, hospitalisation, accident relief, health and group insurance, canteen, uniform, recreation etc. 4. Perquisites: Normally these are provided to executives and may include a company car, club membership, paid holidays, furnished house, and stock option. The main intention of providing these perquisites is to retain employees. 5. Non-monetary benefits: These include challenging assignments, acknowledging merits and achievements, career growth opportunities, better working conditions, flexitime etc. 1.3

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Introduction to Compensation Management

1.5 Designing Compensation Since employees are the ones who actually run the company; they are key to its success. The basic objective of any organisation is to maximise its profits and employees are one of the important means to achieve that objective. In order to attract the best talent and retain it; companies need to design their compensation plan carefully. A competitive compensation plan will act as a base to gain best employees and keep them dedicated to the company.

1.5.1 Steps in Designing a Compensation Plan The basic essential part of the compensation plan is that it should be easily understandable, workable and acceptable to employees. The remuneration scheme normally has two components: • •

base rate scope by which base rate can be increased.

The manager responsible for devising the compensation plan, follows the steps indicated below: Job Description

Job Evaluation

Job Hierarchy

Job Survey

Pricing Jobs

Fig. 1.1: Compensation Plan

1. Job Description: It is very important for designing the pay system. This helps managers to identify important job characteristics such as skills, experience, working environment etc. 1.4

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Introduction to Compensation Management

2. Job Evaluation: There are various techniques available for evaluating the job. Each job is analysed and defined in terms of worth that an organisation is likely to consider. 3. Job Hierarchy (Levels): When all the compensation factors are assigned, the points scored would help to establish the hierarchy of the job’s worth. 4. Pay Surveys: In order to establish the final wage, prevailing wages in the industry and labour market need to be ascertained by conducting pay surveys. 5. Pricing Jobs: In this process the job evaluation is matched with the labour market, thereby establishing pay levels for each job and grouping the different pay levels into pay grades.

1.5.2 Criteria for Effective Compensation According to Patson there are seven criteria for an effective compensation system: Adequate Acceptable to the employee Equitable

A Compensation System should be

Balanced

Incentiveproviding

Secure

Cost-effective

Fig. 1.2: Criteria for Effective Compensation

1. Adequate: It meets the Compensation wages prescribed under the minimum wages act. 2. Equitable: Each person should be paid fairly, in line with his or her effort. 3. Balanced: Pay, benefits and other rewards should provide a reasonable total reward package. 4. Cost-effective: Pay should not be excessive, keeping in mind the organisation’s funds. 5. Secure: The package should keep the employee satisfied and make him feel secure by covering their basic needs. 6. Incentive: It should motivate effective and productive work. 7. Acceptable to Employee: The employee should understand the pay system and see that it is reasonable for both the parties. 1.5

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Introduction to Compensation Management

1.5.3 Principles of Compensation Formulation Formulating a proper compensation package is crucial to a company’s success. Compensation is mostly in the form of cash but it could also be in the form of appreciation consequently resulting into promotions. Though an employee is ready to join at lower wages (which is quite common in countries like India); it is the moral duty of an employer to pay fair wages - at par with the industry standards and also considering employee’s performance. While designing and implementing a compensation package one should ideally consider factors such as: balance in the supply and demand for level of wages, wages justifiable according to the level of work, equal pay for equal work, objective methods of measuring the work, sufficiency of wages (internally as well as externally and comparison of jobs across same type of industries (in relation to their fairness, complexity of task and skill requirements). To begin with, a sample compensation plan could be installed having minimum and non-overlapping grades. With such a compensation system in place, employee’s performance will improve, if he knows that these conditions have been taken into consideration. Need – Based Minimum Wages It is important to note that the wages should be equal to or more than the “Need – Based Minimum Wages.” It means that the minimum wages should be arrived at considering the basic human needs of the industrial worker. It is calculated considering the below factors as base: • • • •

The standard working class family is assumed to be of three members, disregarding the earnings of other family members Clothing requirement is considered at par with the per capital consumption The housing rent is considered at the minimum rent charged by the government in the subsidised Industrial Housing Scheme Fuel, lighting and other miscellaneous items of expenditure should constitute 20% of the total minimum wages

Compensation Issues The objective to pay fair and equitable wages may apparently look easy but quite complex to achieve. It is one of the main difficulties faced by any organisation. Belcher D.W. in his “Wages and Salary Administration” has classified compensation issues into the following categories which are discussed below: 1. Wages and Salary Levels: The wages and salary levels are dependent on three major factors which are: wage rates in the community and in similar industries; influence of the workers’ union on the wage rates and corporate philosophy on the 1.6

Compensation Management

Introduction to Compensation Management

wages. The corporate management has to work out the details of the wage scale and refine the wage system considering: the cost of living, productivity, prevailing wage rates, ability to pay and attraction and retention of employees. 2. Wages and Salary Structure: The wage structure of an organisation is according to the hierarchical order of employees i.e. employees at the top get highest wages and it gets reduced as we go down in the hierarchy. The complexity of skills required and the responsibility is established for each level and pay structure is decided accordingly. This is known as job evaluation. Various qualitative and quantitative methods are used for evaluating the jobs such as: (1) Ranking method (2) Job Classification method (3) Point Rating method and (4) Factors Comparison method. 3. Individual Wages Determination: The compensation needs to be equal for similar type of jobs. Hence it is important to establish individual wage rates and increments solely based on the nature of the job and the work performance. If there are no disparities in this, the union may not object to it. Company Philosophy: The corporate philosophy, values and the style and attitude of the management plays an important role in deciding company’s policy for wages and compensation package.

1.6 Theories of Wage Determination With the changing economic environment, theories of wage determination have changed over the period of time. Contemporary wage theory has replaced the old theory with the emergence of modern organisations such as corporations. The theories have also been influenced by the speculations on what share the labour force contributes to the gross domestic product.

1.6.1 Classical Theories The classical theory of wage determination was proposed by Adam Smith. According to him the wages are determined by the law of demand and supply. So the labour and employer work for their own interest. The labours are attracted towards the market where the employment opportunity is higher. Although Adam Smith has not given any specific analysis for the demand and supply of labour and nor did he provide a specific theoretical pattern, he has provided some elements which are central to the employment theory. According to him the quality of worker’s skills is one of the most important determinants of economic growth. He said that the workers should get increased compensation in order to acquire new and improved skills. In a developing country the wage level should be higher than the basic survival level of earnings. •

Subsistence Theory: This theory is based on and focuses only on the supply part and neglects the demand part. According to this theory the basic determinant of 1.7

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Introduction to Compensation Management

subsistence wage is supply of workers. The wages given to the workers should be enough to allow them to live and support their families. Ricardo wrote that the “natural price” of labour was simply the price necessary to enable the labourers to subsist and to perpetuate the race. Ricardo’s statement was consistent with the Malthusian theory of population, which held that population adjusts to the means of supporting it. The theorists argue that labour rate would not vary for long. If wages rise, then the number of labours would increase which will bring the wage rates down and when the wage rate falls below subsistence, then the number of workers would decrease and it will bring down the wage rates. •

Wages-Fund Theory: This theory lays emphasis on the demand side. According to this theory labour demand could increase only when the fund available for the payment of wages increases. Ricardo stated that an increase in capital would result in an increase in the demand for labour. The fund available for providing wages should be divided by the number of workers in order to determine the average wage rate. This fund could vary over a period of time but for a given moment it is fixed. In order to increase the average wage, workers should try to increase the accumulation of capital so that excessive funds are available for distribution of wages. Furthermore, the proponents of the wages-fund doctrine had been unable to prove the existence of any kind of fund that maintained a predetermined relationship with capital, and they also failed to identify what portion of the labour forces contribution to a product was actually paid out in wages. Indeed, the total amount paid in wages depends upon a number of factors, including the bargaining power of labourers.

1.6.2 Marxian Surplus-Value Theory The surplus-value theory was given by Karl Marx. In Marx’s opinion, it was not the pressure of population that drove wages to the subsistence level but rather the existence of large numbers of unemployed workers. According to Marx in a capitalistic market, labour is treated only as resource for production. Marx considered that the owner of capital could force the worker to spend more time on the job than was necessary for earning this subsistence income, and the excess product-or surplus value-thus created would be claimed by the owner. This argument was eventually disproved, and the labour theory of value and the subsistence theory of wages were also found to be invalid. Without them, the surplusvalue theory collapsed. •

Residual-Claimant Theory: In Smith’s residual–claimant theory of wages, rent would be deducted first before profits i.e. after all other factors of production have received compensation for their contribution to the process, the amount of capital left over 1.8

Compensation Management

•

Introduction to Compensation Management

will go to the remaining factor. In 1875, Walker formulated residual theory of wages in which the shares of the landlord, capital owner and entrepreneur were determined independently and subtracted, thus leaving the remainder for labour in the form of wages. It should be noted, that any of the factors of production may be selected as the residual claimant; assuming that independent determinations may be made for the shares of the other factors. However, it is doubtful, that such a theory has value as a tool for explanation of wages distribution. Bargaining Theory: In Smith’s bargaining theory of wages, hours and working conditions are determined by the relative bargaining strength of the parties to the agreement. He found that employers had greater bargaining strength than employees and were in a better position to unify their opposition to employee demands and were also able to withstand the loss of income for a longer period than the employees. This idea was further developed to a considerable extent by John Davidson, who proposed in The Bargain Theory of Wages (1898) that the determination of wages is an extremely complicated process involving numerous influences that interact with each other to establish the relative bargaining strength of the parties. This theory argues that no one factor or single combination of factors determines wages and that no one rate of pay is perfect for calculation and that there are multiple ranges of rates, any of which may exist simultaneously. The upper limit of the range represents the rate beyond which the employer refuses to hire certain workers which is influenced by many factors, including the productivity of the workers, the competitive situation, the size of the investment and the employer’s estimate of future business conditions. The lower limit of the range defines the rate below which the workers will not offer their services to the employer. This rate includes minimum wage legislation, the workers’ standard of living, their appraisal of the employment situation and their knowledge of rates paid to others. Neither the upper nor the lower limit is fixed and either may be changed depending on the relative bargaining power of employees and employer. This theory is very attractive to labour organisations as compared to the subsistence and wages-fund theories since it provides a very logical reason for the existence of unions i.e. the bargaining strength of a union is much greater than that of individuals. However it should also be noted that historically labourers were capable of improving their situations without the help of labour organisations which indicates that factors other than the relative bargaining strength of the parties must have been at work. Bargaining theory can explain wage rates in short-run situations (such as the existence of certain wage differentials); however it has failed in the long run to explain changes observed in the average level of wages. 1.9

Compensation Management

Introduction to Compensation Management

Marginal-productivity Theory Smith had observed that a relationship existed between wage rates and the productivity of labour. German economist Johann Heinrich von Thünen had worked out a marginalproductivity type of analysis for wages in 1826. Marginal productivity theory if applied to wages holds that employers will tend to hire workers of a particular type until the contribution that the last (marginal) worker makes to the total value of the product is equal to the extra cost incurred by the hiring of one more worker. The wage rate is established in the market through the demand and supply for the type of labour required for the job. Competitive market forces assure that the workers will receive a wage equal to the marginal product. Under the law of diminishing marginal productivity, the contribution of each additional worker is less than that of his predecessor, but since all workers of a particular type are assumed to be alike i.e. are deemed interchangeable; anyone could be considered as the marginal worker. Therefore, all workers receive the same wage and therefore, by hiring to the margin, the employer maximises his profits. Employers will keep hiring as long as each additional worker contributes more than his wages. However, beyond the margin, hiring additional workers would cost more than their contribution and this would lead to losses. Some critics feel that due to unrealistic assumptions, marginal-productivity theory makes it unviable and it could be only used in contribution to understanding long term trends in wages.

1.6.3 Purchasing-power Theory The purchasing-power theory of wages mentions the relationship between wages and employment and the business cycle. It is not a theory of wage determination as such but is rather a theory of the influence spending has (through consumption and investment) on economic activity. One of the assumptions of the theory is that changes in wages will have a significant effect on consumption since wages make up such a large percentage of the national income and hence it is therefore assumed that a decline in wages will reduce consumption and that this in turn will reduce demand for goods and services, causing the demand for labour to fall. The actual outcome would depend upon several factors, particularly those that involve prices (or other cost-of-living considerations). If wages fall more rapidly than prices, labour’s real wages will be drastically reduced, consumption will fall, and unemployment will rise— unless total spending is maintained by increased investment, usually in the form of government spending. Entrepreneurs may look upon the lower wage costs (as they relate to prices) as an encouraging sign toward greater profits, in which case they may increase their investments and employ more people at the lower rates, thus maintaining or even increasing 1.10

Mr. SURESH MUKE

ABOUT THE AUTHOR

Mr. Suresh Muke has done his graduation in Commerce from Pune University. He has also completed his Diploma in Business Management and Masters in Business Administration from IMDR, Pune. He has worked with Tata Motors for the last 38 years in various key positions. Mr. Muke is a trainer and guest faculty for MPM, DBM and MBA courses in many Management Institutes. During guest lectures, he has covered topics like Total Quality Management, Strategic Management, Performance Management System, Balance Score Card, Competency Mapping, and Challenges to HR etc.

ABOUT THE BOOK

This book on Compensation Management covers the following topics: • Introduction to Compensation Management • Labour Market • Wage Policies • Pay Structures • Employee Benefit

SALIENT FEATURES OF THE BOOK • Widely recommended Text Book for MPM : Semester-III • According to the latest syllabus of University of Pune. • This book is written in simple and lucid English, so that the contents are easy to understand. • It focuses on clarity of the fundamental concepts and explains them according to the need of students. • Each chapter ends with related questions for discussion, points to remember, case study, activities and previous Pune University questions, which help students recapitulate all that has been covered in the chapter. • The explanation of each topic is supported by figures, graphics, charts and tables. Each topic and sub topic is further illustrated with examples. ISBN 935164054-X

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