Employee Compensation

AuthorLawrence Kleiman, G. Taylor

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Employees receive compensation from a company in return for work performed. While most people think compensation and pay are the same, the fact is that compensation is much more than just the monetary rewards provided by an employer. According to Milkovitch and Newman in Compensation, it is "all forms of financial returns and tangible services and benefits employees receive as part of an employment relationship" The phrase "financial returns" refers to an individual's base salary, as well as short- and long-term incentives. "Tangible services and benefits" are such things as insurance, paid vacation and sick days, pension plans, and employee discounts.

An organization's compensation practices can have far-reaching effects on its competitive advantage. As compensation expert Richard Henderson notes, "To develop a competitive advantage in a global economy, the compensation program of the organization must support totally the strategic plans and actions of the organization." Labor costs greatly affect competitive advantage because they represent a large portion of a company's operating budget. By effectively controlling these costs, a firm can achieve cost leadership. The impact of labor costs on competitive advantage is particularly strong in service and other labor-intensive organizations, where employers spend between 40 and 80 cents of each revenue dollar on such costs. This means that for each dollar of revenue generated, as much as 80 cents may go to employee pay and benefits.

Compensation costs have risen sharply in recent years, primarily because of escalating benefit costs. Employers now spend more than $1 trillion on employee benefits. In 2003 the Society for Human Resource Management reported that benefit costs averaged 39 percent of total payroll in 2001, up from 37.5 percent in 2000. This means that, on average, employers provide about $18,000 in benefits to each employee annually. The biggest cost increases have been in health benefits, which have been rising at an average of 12 percent annually for the past several years.

An organization must contain these spiraling costs if it is to get a proper return on its human resource investment, and thus gain a competitive advantage. When compensation-related costs escalate, the organization must find a way to offset them. In the past, companies passed along these increases in costs to the customer in the form of higher prices. However, most U.S. companies now find it very difficult to raise prices. Thus, to remain competitive in light of fierce domestic and foreign competition, unfavorable exchange rates, and cheaper foreign labor costs, it is imperative that companies find ways to control labor costs. Unless this can be done, organizations may be forced to implement such adverse actions as pay freezes, outsourcing/offshoring, and/or massive layoffs.

A host of laws such as the Equal Pay Act, Fair Labor Standards Act, and the Employment Retirement Income Security Act, regulate corporate compensation practices. Some pertain to pay issues such as discrimination, minimum wages, and overtime pay; others pertain to benefits, such as pensions, unemployment compensation, and compensation for work-related injuries. Organizations must understand and fully follow these laws in order to avoid costly lawsuits and/or government fines.

Pay and benefits are extremely important to both new applicants and existing employees. The compensation received from work is a major reason that most people seek employment. Compensation not only provides a means of sustenance and allows people to satisfy their materialistic and recreational needs, it also serves their ego or self-esteem needs. Consequently, if a firm's compensation system is viewed as inadequate, top applicants may reject that company's employment offers, and current employees may choose to leave the organization. With the aging of the U.S. workforce and the impending retirement of the "baby boomers," employers must be more concerned than ever before about retaining skilled, productive workers. Moreover, disgruntled employees choosing to remain with the organization may begin to behave unproductively (e.g., become less motivated, helpful, or cooperative).


Because compensation practices heavily influence recruitment, turnover, and employee productivity, it is important that applicants and employees view these practices in a favorable light. In the following section, we discuss how people form perceptions

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about a firm's compensation system and how these perceptions ultimately affect their behavior.

One would expect that an individual's satisfaction with his or her compensation would simply be a function of the amount of compensation received: the higher the compensation rate, the greater the satisfaction. However, in reality things are not that simple. In fact, the amount of pay is less important than its perceived fairness or equity. To put this finding in perspective, consider the behavior of many professional athletes when negotiating a new contract. The average NBA salary in 2003 was $4.9 million; the average baseball salary was $2.4 million; the average NFL salary was $1.3 million. Yet, ball players continue to ask for more money. In many instances, these demands stem from neither need nor greed. Rather, the demand for greater salaries often stems from perceptions of inequity. For instance, despite a $15 million salary, a player...

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