Building a Market-Based Pay Structure From Scratch

Overview

Management in many companies ask their human resource practitioners at some point in their careers to create a base pay structure from scratch or revise the existing structure to meet their changing needs. For those whose areas of expertise lie outside the compensation arena, such a project can seem challenging at best. See, Introduction to the HR Discipline of Compensation. The compensation system development process, however, does not have to be an overwhelming and dreaded goal. Rather, building a market-based pay structure from scratch encompasses several major steps:

• Gathering the background information needed for project success.
• Determining your sources of external market data and getting the data ready.
• Conducting the market data analysis.
• Developing the pay structures.
• Calculating the costs of the pay structures.
• Implementing and evaluating the new pay structures.

This comprehensive treatment walks through each of these major steps to help the novice successfully develop a complete pay structure from scratch. Those seasoned in compensation will find the paper helpful in keeping their compensation skills current in today’s volatile compensation markets.

Step 1: Gathering Background Information

Building anything of value requires a reason or business philosophy and strategy. To ensure success of the project and complete support from the top down, the project needs a plan that explains why the system is being built, what is to be built, how all the pieces fit together and what the expected end result is.  To build anything from scratch requires an architect to create a plan as well as a champion to guide and drive the process. That champion serves as the catalyst to align decision makers and resources. That way, what is being built successfully aligns with the organization’s business philosophy, culture, vision, mission, values, resources and strategic objectives. Similarly, building a pay structure from scratch requires the architect to articulate the compensation philosophy, clarify concepts that define the fundamental beliefs about the structure, and design and develop the strategy; and a champion to align decision makers, obtain buy-in from the top of the organization and execute the plan. To accomplish this, human resource practitioners are clearly in the best position to serve in both the architect and champion roles. Therefore, the first step in the process of building a pay structure is articulating the organization’s compensation philosophy and strategy.

Defining the compensation philosophy

A well-designed compensation philosophy supports the organization’s strategic plan and initiatives, business goals, competitive outlook, operating objectives, and compensation and total reward strategies. See,Keeping Comp on Track: Some Practical Tips. As such, most compensation philosophies define the following basic tenets:

• To identify what the organization’s pay programs and total reward strategies are.
• To identify how the pay programs and strategies support the organization’s business strategy, competitive outlook, operating objectives and human capital needs.
• To attract people to join the organization.
• To motivate employees to perform at the best of their competencies, abilities and skill sets.
• To retain key talent and reward high performing employees.
• To define the competitive market position of the organization in relation to base pay, variable compensation and benefits opportunities.
• To define how the organization plans to pay and reward competitively, based on business conditions, competition and ability to pay.

Typically there are links between a strong compensation philosophy and an organization’s mission, core business, operating strategies and competitive outlook. See, Effectively Managing Base Pay. For example, a high-tech organization, with core business strategy to attract and retain the top professional and managerial talent in the industry to outdistance competing organizations, might adopt a pay philosophy and strategy of leading the market with its total cash compensation package, or paying higher than other organizations in the industry.

In another example, a warehouse, distribution and retail organization that has low employee turnover and exists in a demographically contained community with a large labor pool might adopt a pay philosophy and strategy of offering a compensation and total rewards package that is valued less than a similar organization located 50 miles away in a highly competitive community with labor shortages and high employee demand issues. In this scenario, this organization adopted a philosophy of matching supply and demand conditions for its own community and set the policy to control cost.

An effective compensation philosophy should pass the following quality test:

• Is the overall program equitable?
• Is the overall program defensible and perceived by employees as fair?
• Is the overall program fiscally sensitive?
• Are programs included in the compensation philosophy and policy legally compliant?
• Can the organization effectively communicate the philosophy, policy and overall programs to employees?
• Are the programs the organization offers fair, competitive and in line with the its compensation philosophy and policies?

To effectively exist and thrive in today’s competitive marketplace, many organizations realize that a one-size-fits-all strategy regarding compensation philosophy does not work. Different philosophies may be developed for different employee segments, such as “hot jobs,” information technology, “hard-to-fill,” administrative and operations. See, Philosophizing Compensation.

Management team buy-in

By virtue of its position in the organization, HR can best serve as the architect of and champion for articulating the organization’s compensation philosophy and strategy. To serve effectively in those roles, HR needs to develop a knowledge and understanding of the following:

• The marketplace for labor.
• Which compensation and benefit survey tools are necessary to scan the competitive marketplace.
• The jobs in the organization.
• How supply, demand and labor market issues affect the organization.
• The operational and legal ramifications surrounding the compensation and total reward programs the organization is considering or currently offering.

While HR is clearly in the lead in developing an organization’s compensation philosophy and policy, success lies in close collaboration with the leadership team to obtain valuable input, direction and concurrence.

Some important questions to ask the leadership team in developing an organization’s compensation philosophy include the following:

• Does the organization wish to lead, lag or meet the market in terms of compensation and total rewards? How does this vary by position type?
• Is the organization currently leading, lagging or meeting the market? Why?
• Where is the organization positioned in terms of market competitiveness?
• What is the organization’s mix of base pay, variable and incentive pay, working conditions and benefit offerings?
• How are pay and total rewards distributed?
• Do employees value the organization’s programs, including but not limited to pay, health care benefits, retirement and savings benefits, vacation and paid time off, incentives and profit sharing?
• What are the strengths and weaknesses of the organization’s current compensation and total rewards programs?
• Is the organization able to attract, hire and retain the human resources it needs to be competitive and operationally effective?
• Can the organization afford or effectively execute its current or proposed pay programs?
• Does the organization have any potential constraints in executing a unified and consistent compensation philosophy, such as legal, union and non-union issues, internal and external labor markets, or special contracts?
• Is the organization having trouble hiring employees? If so, in what jobs or geographic areas?
• How long do employees stay with the organization?
• What is the turnover rate at the organization?
• Why do employees leave the organization? Where are they going?
• What are the organization’s career development and promotion policies and strategies?
• What is the organization’s labor mix?
• Who are the organization’s main competitors?
• How will the organization align pay and rewards with individual, team and organizational business initiatives and performance expectations?

By obtaining valuable input from the leadership team and by adopting a collaborative process to answer important strategy questions, human resources effectively creates the environment necessary to align and obtain concurrence and buy-in on a compensation philosophy from key decision makers. This does not happen overnight. Rather, one or two discussions of two to four hours each with key management team members will generate the necessary, diverging viewpoints that best represent consensus on how to link the compensation philosophy and policy to the organization’s mission, core business, operating strategies and competitive outlook necessary to be successful.

Other information needed

Other items HR professionals need to gather at project start include the following (approximate time required will vary based on the size of the organization and other complexities like locations, reporting structures and level of management layers).

Step 2: Selecting Sources of External Market Data and Preparing the Data

A quick Internet search will provide the HR professional with a wealth of compensation surveys. Without formal compensation training, such findings can be overwhelming. How do you know which surveys are reputable? Which ones are up to date? Which ones provide the best value for the cost? With great focus undoubtedly on the pay structure development process, HR must make the right decisions regarding salary surveys prior to the start of the market analysis process. See, Selecting and Using Compensation Surveys: Critical Issues for Today’s HR Professionals.

What data sources should I use?

It is rare to find one data source that meets all of an organization’s needs. Using multiple data sources is critical because it allows for cross validation and filling in information gaps. There are several options when contemplating salary data sources.

• Purchase a salary survey from a survey organization such as a consulting company.
• Commission a customized salary survey through a consulting company.
• Purchase a salary survey from a trade organization or association.
• Use the Bureau of Labor Statistics’ wage data.
• Commission a custom survey.

See, Compensation Data Center.

Beware of free surveys. Many individuals new to compensation, especially those without a budget to purchase salary surveys, will explore web sites that offer free pay data. Such data vary in their reliability. As such, HR professionals should not rely on them for building pay structures. Many organizations have experienced the fallout from such survey data—everything from employee visits to the HR department showing that they should be paid more because “it says so on the Internet” to union organizing drives premised on these Internet numbers.

The issue with such free data, with the exception of BLS data, is that their origins are unknown. Many of the surveys lack a survey participant list. Moreover, why would an organization provide its data for free when reputable survey organizations may charge thousands?

Organizations and consulting companies. There are several reputable, long-standing organizations that specialize in producing salary surveys. Typically, the global compensation consulting firms are also major players in the survey report business. See, How can I locate sources for salary survey data for all industries and occupations? When purchasing these surveys, keep in mind that prices often will be considerably lower for participants than for nonparticipants. Also, some consulting organizations sell their survey reports only to participants.

There are also several outstanding but lesser known organizations that produce quality survey reports. Searching the Internet with key words such as the relevant industry or geographic region will turn up many of these groups.

Trade and professional organizations. Trade and professional organizations and their publications are another credible source of salary data. They generally offer surveys to members for free or reduced prices, but also sell them to nonmembers at reasonable rates. Sometimes these organizations do not openly advertise their surveys, but a quick call can help identify options. Be aware of the potential for bias in these studies, however, inasmuch as these organizations exist primarily to serve their members.

Bureau of Labor Statistics’ wage data. Bureau of Labor Statistics (BLS) wage data is another option. BLS offers data cuts by occupation, industry and geographic area. The data are free, so caveat emptor: the information may be a bit dated. The most relevant results come from using data that are no more than one year old, but if there is no budget for surveys, BLS data are better than guessing at something so important. You can progress the data by the market wage increase rate to bring the information approximately up to date.

Custom survey. If data are not available for a specific position, industry or region, use a custom survey. The best method is to engage an independent third party to collect and summarize the data. The third party can assure participants that the data will be kept confidential, which should elicit more and better information from them. Using a third party also will ensure compliance with the Department of Justice Anti-Trust Guidelines, minimizing your organization’s legal risk. See, Can I contact other local organizations in my area to get a gauge on merit projections or other compensation and benefits data? and The Antitrust Implications Of Compensation Benchmarking: Todd v. Exxon.

Organizations like the flexibility custom surveys offer in terms of fine tuning the data gathering to very specific needs. However, custom surveys can take anywhere from two to four months from conception to completion, so the time and cost factors often outweigh the benefit of more precise data.

Linking the surveys to the compensation philosophy

Most robust surveys will allow for multiple cuts based on revenue category, industry and geography. The next step is to determine which ones to use. Those decisions should tie back to the organization and its compensation philosophy and yield data that most closely match.

Geographic. Often, the geographic cuts used—national, regional or local—parallel an organization’s recruiting strategy. That is, organizations typically recruit nonexempt employees locally, so it makes sense to rely on local market data for these positions. On the other hand, organizations are likely to recruit nationally for executive positions. National data may be more appropriate for those jobs, except in a very low (e.g., rural areas or southeast United States) or a very high-cost of labor area (e.g., San Francisco and New York). In the case of these two cities, in which market rates tend to deviate significantly from the national, using city-specific or possibly regional data may be more effective. See, Geographic Differences in Pay Create Challenges for Employers.

National survey reports often provide either geographic data breakdowns or factors for adjusting the national data for local areas. Some survey providers also report wage differentials for use in factoring national data to local market needs. Keep in mind that SHRM offers a robust feature to its members on its web site that allows members to select the type of survey they seek. SHRM will then send an e-mail listing survey organizations that provide that type of survey.

Industry. Next, consider whether to use industry-specific or all-industry data, again referring back to the compensation philosophy. If the relevant industry is very competitive and employees often move among competitors, focus on industry-specific data, which may tend to be higher than all-industry data. In some organizations, particular positions may call for industry-specific data, such as IT positions in a high-tech company. For positions in other departments in the same company—e.g., finance, accounting and human resources—all-industry data cuts may serve the purpose because qualifications are not industry-specific.

Revenue category. Most companies tend to use data from organizations of a similar revenue size across all levels of positions. For a more precise assessment, however, some organizations focus on a select subset of similarly sized companies. That is most easily done via a custom survey, but also can be accomplished by purchasing data cuts for the targeted group of companies from a consulting organization. To ensure confidentiality, the data cut is never made at a level that would allow identification of individual companies’ pay data.

In selecting a group of companies, look beyond the specific industry and identify companies from which you hire or to which you lose employees. Some companies will fine tune their data even more by selecting multiple groups of companies on the basis of their similarly sized functional groups—e.g., IT, sales, etc.

Ensuring quality data in your analysis

There are several things to consider when determining the quality of a survey.

Cost. All quality surveys will cost something, but participants to a survey may enjoy a significantly reduced purchase rate. HR professionals must budget for an annual expenditure on and investment in salary surveys.

Participants. Surveys should have an easily accessible list of participating organizations so the consumer can determine whether the survey group is relevant from a recruitment and retention perspective. Ideally, the survey will demonstrate a low level of “participant churn” and have enough participants to allow reporting of market rates. Typically, surveys will not report market rates unless there are at least five data points to calculate percentile information. For some metropolitan areas, surveys periodically are unable to report market rates. By and large, however, the survey should have enough participation to provide market rates at the national, metropolitan and various revenue levels.

Currency. Most organizations that specialize in salary surveys conduct them annually to capture changes in the market. Some trade and professional organizations, however, may survey their members only every other year or every third year. Be sure that a survey more than a year old provides enough value and accurately reflects the market before including it in the analysis.

Applying statistical terms to the compensation philosophy

Most surveys report a variety of data points for use in market analyses. Surveys often provide the average market rate, also known as the mean. The 50th percentile, also known as the median, is the most commonly provided percentile statistic. The survey may also provide the 10th, 25th, 75th and 90th percentiles. These percentiles should, at the very least, be available for base compensation and total cash compensation, which is base + variable pay (bonus or incentive).

Some surveys may also show “targeted” total cash compensation versus “actual” total cash compensation. For example, a finance manager’s target variable pay may be 15 percent of base pay, but he or she actually received an incentive payout equal to 10 percent of base pay. In addition, some surveys will report statistics around stock options and restricted stock.

To determine the appropriate percentile to use when reviewing market data, consider the compensation philosophy.

Matching the market. To target the 50th percentile means that an organization wants to pay in the middle of all organizations that have a similar position. In other words, 50 percent of the organizations should be paying less than that market rate and 50 percent should be paying more than the market rate. “Matching the market” is the formal name for this approach.

• Market leader. If an organization chooses to focus on the 75th percentile and take a “market leader” position, it will pay higher than 75 percent of other organizations with similar positions. Organizations competing for employees with specialized skill sets in a tight labor market or organizations that want to be a high payer in the market typically select a market leader position. Organizations with less robust variable compensation and/or benefits programs may also select a market leader base pay position to end up with an overall 50th percentile total compensation program.
• Market lag. If an organization chooses to focus on the 25th percentile and take a “market lag” position, it will pay higher than only 25 percent of other organizations with similar positions. Organizations with strong variable compensation and/or benefits programs, or those encountering financial difficulties, may opt for a market lag position.
• Lead-lag. As an additional variation, some organizations may choose to lead the base pay market for the beginning of the fiscal year and then lag at the end of that year. “Lead-lag” is the formal name for this approach to base pay management.

Organizations can lead, lag or match the market at various levels of market position by using a fixed percentile position or a fixed percentage above/below a point. For instance, an organization can build its position at 10 percent above the 50th percentile by increasing the survey rates by 10 percent. Spreadsheet programs afford the user robust data analysis capabilities and rapid “what if” scenario modeling. See, What are the advantages or disadvantages of a lead, match or lag compensation strategy?

Why and how to age survey data

Salary surveys capture salary data at a specific point in time in the past. However, the market continues to move because of pay increases, market adjustments, promotions and employee job switches. As such, it is necessary to “age” or “trend” the data to a common point in time—e.g., today’s date, the date the pay plan will go live, beginning of new fiscal year—using a factor that reflects market movements.

It is important to note the effective date of salary survey data to age the data to a common point in time. Look for a clear statement about the effective date for the survey data in the first few pages. Note that this may be different from the publication date that appears on the front of the survey. Although data can be aged for several years, it is wise not to use data that are more than two years old, as older data points often lose market reliability. Aging becomes all the more important when using multiple surveys with multiple effective dates.

This market movement factor can be determined a number ways. Associations such as SHRM and World@Work that report on trends in performance-based pay (i.e., merit increases) can provide a recommended aging rate. Several of the major survey organizations also conduct annual merit increase surveys and provide their own estimates of the appropriate aging factor. See, My company can't afford to purchase new salary and wage survey data each year. Is there any way that we can use last year's salary data?

Some organizations select one aging percentage and use it across all jobs and surveys. Others may choose to age data by job, level or job family to reflect differences in the market or “hot jobs.”

Aging survey data is not as complex as it sounds, as the following four-step process demonstrates.

• Determine the date for the new pay structures. The data in a survey have an effective date of January 1, 2008. You need to know what the projected rate would be on July 1, 2008, for implementation of the new pay ranges.
• Determine the wage movement percentage. Your research shows that wages are moving, on average, 4 percent per year.
• Determine the aging factor. There are six months between January 1 and July 1: 4.0% movement x (6 months/12 months in a year) = 2.0%
• Apply the aging factor. If the survey reports that the 50th percentile for a given job on January 1, 2008, is $15.00, the projected rate on July 1, 2008, is $15.30. (Two percent of $15.00 is $.30.) Use $15.30 to develop your organization’s pay scales on July 1, 2008.

Step 3: Conducting the Market Data Analysis

After obtaining and preparing the data, begin the market analysis.

Selecting benchmark jobs

The first step in market data analysis is to determine the benchmark jobs, or positions that will be externally market priced. It is sound practice for an organization to benchmark between 50 and 65 percent of its jobs when using market pricing. Benchmark positions should aim to include at least 70 percent of the employee population.

A benchmark job is one that has a scope of work and responsibilities that is common to other organizations and/or industries. Typically, this can be determined by comparing an internal job description to a survey job summary or capsule. See, Job Descriptions: An Overview. Jobs with similar roles usually exist across the organization. For example, many different departments have administrative assistants. While the job descriptions may differ slightly, that group of positions most likely equate to one benchmark job. Examples of benchmark jobs might include accountant, chief financial officer, registered nurse, fundraiser and underwriter.

Survey descriptions are high level and capture only the major job functions, not every detail and nuance of a job. Many surveys include a “degree of match” indicator, allowing participants to indicate whether their job is bigger than, equal to or smaller than the survey job. If relying on a single survey, use caution if more than 25 percent of the survey participants indicate their job is either smaller or bigger than the survey job. You may need some data adjustment (also called factoring or leveling) to account for this scope difference.

Additional tips for identifying benchmark positions include the following:

• Always compare job descriptions—never titles alone—when deciding whether a survey job is a good match to an internal job. Titles vary widely from organization to organization in terms of scope size and responsibility.
• When a benchmark job matches at least 80% of a survey job summary or capsule, consider it a good benchmark.

• Select benchmark positions that represent a wide spectrum of the organization’s functions, departments and levels: type of work/job family, level of work being performed (e.g., manager vs. individual contributor; junior level vs. senior level).
• Review the benchmark position list two or three times before finalizing your list; benchmarking can be more of an art than a science.

Benchmarking positions against the market

Benchmarking positions against the market is not an easy task. However, by keeping the following points in mind, the process can be effective, efficient and accurate, and yield an effective base pay system for the organization.

Review for outliers. After pulling the various market data points, review the salary data for outliers (extreme data points on either end) and remove as appropriate:

• If the data shows extreme highs or lows from one year to the next, or if one data point seems high or low, check to see if the number of organizations or number of incumbents changed from a prior year’s report.
• It is appropriate to reject a data point if it does not appear valid, but do not automatically exclude data because it is the lowest or highest—especially when using multiple surveys.

Adjust as necessary. Use three or more surveys, to lessen variability in data from one year to the next. Adjust data as needed including the following common data adjustments:

• Adjust for geography when benchmarking positions with a local recruiting market against data collected nationally.
• Adjust for premiums and discounts when benchmarking internal jobs against survey jobs of a higher or lower scope. Adjustments to benchmarks reflect factors including but not limited to scope size, scope of responsibility, market demands and niche skills. Premium and discount adjustments should not exceed +/– 20 percent to still be considered a solid match. For future reference, always carefully document any adjustments or changes to a job match.

Create a market composite for each benchmark position. Combine data points from several surveys either by simple average, employee-weighted or organization-weighted data to develop composite market data. Most surveys report 25th, 50th and 75th percentile data points for base salary, bonus targets, actual bonus payouts and total cash compensation. When using surveys, be aware that the 25th and 75th percentile data points have less reliability and can fluctuate more year to year.

Averaging the individual 50th percentile data points from each survey creates the market composite 50th percentile value. Sometimes, however, an organization values the data in a specific survey more than others. As such, that survey’s data can be double or triple weighted in the calculation to emphasize its importance. In addition, be careful of weighting survey sources equally, especially if one survey has a larger sample size. Use judgment in reviewing the data to determine the best approach. There is no right answer, but as long as you are consistent, the results will be internally accurate.

Review current pay rates against market data. Review each benchmark’s current employee average pay rates against the target market data. Pay particular attention to those positions with a 20 percent difference above or below the market. Be sure that the matches accurately reflect the duties in the benchmark position and make changes as needed.

The composite market data points provide not only the tools necessary to create the pay structures, but also allow comparison between the market and the organization’s compensation philosophy. Reviewing the market data can confirm that the organization has selected an appropriate compensation philosophy for its talent management needs, strategic plan goals and fiscal realities. Reviewing with senior management the high-level composite market data against the compensation philosophy also affords the opportunity to obtain further buy-in and any necessary modification to the compensation philosophy.

Step 4: Developing the Pay Structures

Use the composite market data to develop the actual pay structure by constructing job grades, building a market pay line and calculating the pay ranges.

Constructing job grades

A job grade or job level is simply a group of different jobs that are internally equivalent. Grades enable flexibility and internal equity in an organization by providing a framework in which equivalent jobs are treated equally for pay purposes. Grades also establish a promotional ladder for employees.

For complex roles and larger organizations, formal job evaluation is needed to identify which jobs are internally equivalent. See, Job Evaluation and Market Pricing. The process may take some time to complete, but it will assist in creating a defensible and transparent salary system. In new or recently restructured organizations, job evaluation is particularly helpful in clarifying the role, responsibility and reporting relationship of each job.

A complete description of how to do job evaluation is outside the scope of this paper. See, Introduction to Job Evaluation. In brief, formal job evaluation is a process for analyzing a job based on a number of criteria such as knowledge, experience, decision-making authority, autonomy, supervisory responsibility, creativity, physical demands, job environment, job scope and organizational relationship. Many samples of job evaluation questionnaires are available on the Internet or through consulting companies.

Formal job evaluation systems usually provide results in numeric points, and this enables spreading these points into job grade categories. Dividing lines between job evaluation points leads to issues and hence must be based on a consistent logic driven by both the main driver of the job evaluation points and business strategy. Some trial and error may be required to arrive at the right structure with the correct number of grades and job grouping.

A simpler method of developing job grades is to do whole-job slotting, which delivers approximate assessments of internal value. In this method, factors such as reporting relationship, job scope and current pay relationships determine grade placement.

In many organizations, the number of job grades matches the number of pay grades, and those terms have been used interchangeably herein. It is possible to have more job grades than pay grades, however, by combining a few job grades into the same pay grade. This is usually done in companies where the culture supports career path promotions such as a technical career path. When combining multiple job grades into one pay grade, the range minimum is based on the junior most job grade and the range maximum is based on the senior most job grade in that pay grade. This enables employees and managers to be aware of the potential progression that is possible from the starting role to the ending role in a particular career path. (Range minimum and maximum are explained below.)

Building a market pay line

A market pay line is built using the composite market data points. It enables an organization to translate the market data into usable information.

Building a market pay line starts with plotting the matched jobs and their dollar amounts on a graph. The grades or benchmark jobs at each level determine the ordering of the jobs on the X axis. You can use freehand to connect the data points as shown in Figure 1 or use a regression analysis tool to create the market line. A number of programs, including MS Excel, build the regression analysis line (Figure 2). Simply put, regression helps smooth the data and have a fixed rate of variation between different points, especially when there are multiple benchmark jobs and there is some variation among the data. The linear line shown in Figure 2 is the smoothed pay line for the base salary.

Figure es 1 and 2 show base salary, total cash compensation and, as an example, total compensation at the 50th percentile (50P) level. As previously covered, the appropriate percentile to use depends on the organization’s target market philosophy.

Calculating pay ranges

A pay range exists whenever an organization must pay different amounts to employees in the same job grade. Ranges provide flexibility to managers to recognize factors such as experience and performance. Ranges permit the recognition of learning curves and performance variation of employees in their roles. Typically, companies only calculate base pay ranges because base pay reflects the guaranteed cash payments and the basic value of the work.

Pay ranges are calculated for each job grade and are simply a spread plus and minus of the target/market pay point, also known as the range mid-point. Range maximums set the ceiling for a particular pay grade. Range minimums set the floor. Typically, for junior level jobs the range spreads are small or perhaps even nonexistent when flat rates are used. On the other hand, range spreads are often wide for management roles to reflect the performance and learning curve variation.

The midpoint corresponds to where the pay line crosses each grade (Figures 1 and 2). For example, in Figure 1 for grade B the base pay line crosses at 35,000, and hence, that will be the midpoint for the range at grade B. Judgments about how the ranges support career growth, performance rewards and promotions determine range spread. Ranges tend to widen as you go higher in the organization. Organizations can have ranges with a spread of 25 percent at lower grades to 75 percent for senior roles. In fact, an hourly job has a range of zero since there is a fixed pay rate for the role irrespective of performance, seniority etc. Wider ranges at senior roles reflect the opportunity for individual discretionary performance, longer learning curves for the position and longer lengths of stay of incumbents in the same position.

The following are examples of two ways to calculate a range minimum and maximum:

• Calculate 20 percent above and below the midpoint. In Figure 1, grade A has a midpoint of $20,000. The minimum and maximum are $16,000 and $24,000. In this example, the range spread is 50 percent [($24,000 - $16,000) / $16,000 = 50%].
• An alternative way to calculate range spread at a fixed percentage: minimum = midpoint/{100% + (1/2 the percentage range spread)}. Calculate the maximum as minimum + (percentage range spread X minimum). Continuing the 50 percent range spread example above, calculate the minimum as [$20,000/(1+.25)], or $16,000. The maximum is calculated as [$16,000 + (.50 x $16,000)], or $24,000.

To ensure accuracy, the key is to choose one of these methods and use it consistently.

On occasion, some organizations use the actual market position of 25th percentile and 75th percentile as the minimum and maximum points for the ranges. This is a possibility if the approach is based on the organization’s desired market position. Keep in mind, however, that the 25th and 75th percentiles are subject to greater fluctuations in surveys from year to year. An organization may also end up with very tight range spreads (e.g., 20%) or very wide range spreads (e.g., 80%) due to variation in the market data.

Ranges between grades tend to overlap. The extent of overlap can be measured as follows, continuing the example from above:

• If there are two grades, A and B, and B is higher than A, then overlap equals 100 X {(Maximum of Grade A - Minimum of Grade B) / (Maximum of Grade A - Minimum of Grade A)}

Although there is no ideal amount of overlap, too little overlap can lead to high cost during promotions. Too high overlap will lead to low interest in promotions, since the amount of promotional increase will be too low. Figure 3 shows an example of a pay structure.

Broadbanding is another approach to setting the pay range, which is outside the scope of this paper. See, Broadbanding. Generally, however, broadbands consolidate three to five traditional ranges into one single band. Bands will typically have a minimum and a maximum but no midpoint. Range spreads in a broadbanding system typically will be 100% or more. Organizations use bands to create flexibility within the organization and break down barriers to promotion and career development.

Compensation is partly art and partly science. Because internal job evaluation or internal slotting of jobs determines job grades, these reflect the internal value, while the pay ranges reflect the market or external value. Inherently, there will be some instances of misalignment between the two. On occasion, jobs may be re-slotted. This occurs when the position has a greater strategic importance to the organization that the external market reflects. In other cases, the position may have less value than the external market affords it. Use such re-slottings of benchmark positions sparingly and with caution to avoid undermining the foundation of the job evaluation system. The goal is to minimize misalignments as much as possible to ensure the compensation system meets the organization’s needs for strategic success.

Step 5: Calculating the Costs of the Pay Structures

After creating the new pay grades and ranges, the next project step is to consider the financial impact of those ranges. One of several approaches provides HR and management with the necessary financial impact information:

• Bring-to-minimum calculations.
• Compa ratio analysis.
• Adjustments for compression and equity.

Bring-to-minimum

The simplest but often most essential calculation is the bring-to-minimum adjustment. In this scenario, the financial model compares each employee’s current pay and his or her new pay range minimum. Employees with pay rates below the minimum receive an adjustment to the minimum of the pay range. These pay rates are also known as green circle rates. Employees with pay rates above the minimum receive no adjustment.

For example, continuing our example from above, employee X and employee Y are both in pay grade A. Employee X earns $15,000 a year. As the minimum is $16,000, he would receive a $1,000 a year pay increase. Employee Y, on the other hand, earns $22,000. As such, she would receive no bring-to-minimum adjustment. Totaling the annualized bring-to-minimum adjustments for all employees provides the total annualized bring-to-minimum cost impact of the new pay system. This figure divided by the total current payroll allows management to see the cost impact from a percentage point of view. For example, if an organization’s total payroll is $1,000,000, and total bring-to-minimum adjustments are $20,000, the total bring-to-minimum cost of the program is 2 percent of current payroll.

Compa ratios

Comparisons of current employee pay and the new system midpoints determine compa ratios. The formula for compa ratio is current employee pay/current range midpoint. Continuing the example from above, employee X’s compa ratio before any pay adjustments is 75%, or .75 ($15,000/$20,000). Employee Y’s compa ratio is 110%, or 1.1 ($22,000/$20,000). Compa ratios are useful for identifying at a glance which employees’ pay rates are below the minimum (green circled) and above the maximum (red circled), and which employees fall above or below the midpoint. If most employees’ pay rates fall above the midpoint, the new system risks quick obsolescence. Ideally, the majority of employee pay rates should have room to grow in the pay ranges.

Compression and equity

Organizations may want to consider adjustments that address undesired compression, such as closeness in pay rates, between employees. Organizations may adjust pay rates to reflect length of service, experience or performance. In these situations, employees’ pay rates may be increased a certain percentage above the range minimum for each year of service or higher level of performance. Employees with pay rates higher than the recommended adjusted rate would receive no increase; employees with pay rates lower than the recommended adjusted rate would receive an adjustment. For example, organizations that want to recognize years of service might increase each employee’s pay 3 percent for each year of service in the position, up to 10 years. Pay rates for new employees are set at the minimum of the range. Employees with one year in the position would be paid 3 percent above the range minimum. Employees with 10 years in the position would be paid 30 percent above the range minimum.

While ideally an organization should avoid pay rate compression, fiscally this is not always possible. As such, an organization may have to forgo the compression adjustments and look only to bring-to-minimum changes. Or, an organization may focus its limited dollars on adjustments for “hot jobs” in year one and changes for other positions in year two of the system. Alternatively, timing any structure-related pay adjustments for after annual merit increases allows the organization to reduce the total program costs. The merit increases fund part or all of the market adjustments.

Step 6: Implementation and Evaluation

Policy development

The organization’s salary structure policy ultimately will drive communication and training. See, Compensation Policy. The following issues should be included in the new compensation policy:

• How often the salary structures will be updated.
• The effective date of the structures.
• Roles, responsibilities and procedures for updating salary structures, including approval authority, surveys used and frequency of participation, and desired peer comparison list.
• Which positions will have access to the salary structures, how broad or limited is general access to the system, and whether the system is open or closed to employees.

To avoid misunderstandings, it is critical to thoroughly vet these issues with stakeholders at the beginning of the project. At project conclusion, document the approved policy during new salary structure roll out.

Communication

Depending on organization policy, HR may be the only one with access to the structures, or all managers and employees may have access. Organizations may operate anywhere along a communications continuum by deciding to restrict employee access to salary ranges entirely, allowing employees to view their own range, or permitting employees to examine their own range and the next highest range. Managers typically have access to all salary ranges or the salary ranges relevant to their team members. However, some organizations may decide that salary range information is too sensitive and, as a result, restrict it entirely.

Regardless of the target group, it is important to understand the goals of the communication process. These goals typically fall into one or more of the following categories:

• To ensure understanding.
• To change perceptions of equity and competitiveness and to get buy-in.
• To motivate behavior such as pay for performance, pay for skills, etc.

Tailor each communication based on the target audience and the communication goals. For example, the goal in communicating the new salary structures to the executive team may be to change a perception that a salary structure will bring unwanted bureaucracy or to get buy-in on the list of surveyed peer organizations or selected salary surveys moving forward. Communication to managers who will administer pay using the new structures might simply be to ensure understanding of effective dates, how to access the structures and how to effectively use the structures when hiring new or promoting current employees. See, Pay Packages: They Just Don't Understand. Communication to employees who will be paid with the new structure must demonstrate the fairness, equity, competitiveness and link to business strategy. See, Compensation Strategy Shouldn't be a Big Secret; Communication Pays Off and Do employees in your organization understand how pay decisions are made?

Training

The organization’s policy regarding access to salary ranges and responsibility for administering pay in the organization drives the training process. Managers expected to effectively administer the pay of their team members need training on compensation philosophy, salary survey sources, how salary ranges are constructed and how to use the structures when determining appropriate pay for new and existing employees.

To help managers effectively set expectations for employees regarding their position in a pay range over time, explaining the pay/performance continuum is helpful. Under this approach, top performers will reach the maximum of the pay range much faster than average performing co-workers. Employees who are steady average performers may never exceed the range midpoint, as their performance matches the market pay rate for someone fully competent in the position. Pay rates for employees with unsatisfactory performance, should they not be exited from the organization, should never progress very far above the range minimum. Figure 4 shows an example of this approach.

If employees can view their own and other salary ranges, they should receive training on understanding the organization’s compensation philosophy, salary survey sources and how salary ranges are constructed.

Pitfalls to avoid

A comprehensive salary structure policy will go a long way in helping the organization avoid many common pitfalls since the policy clearly states decision-making authority, roles and responsibilities regarding pay. Two common pitfalls of compensation systems are the following:

• Salary structures don’t reflect the organization’s compensation philosophy. If midpoints are to reflect the theoretical external market average competitive rate, make sure they do. Do not let falling compa ratios due to budget restrictions rationalize lower midpoints. Managers must be able to rely on the midpoint in order to set reasonable hire rates, recommend pay increases and justify the salary range to employees.
• Salary structures provide no accountability for managers to administer pay. Managers are in the best place to assess performance and equity of team members. Arm the management team with the tools, information, training and coaching they need, and they will manage pay effectively for the organization.

Evaluation

Like any other program, evaluation is critical to determining the effectiveness of the compensation program. See, Compensation Programs' ROI Highlighted by Study. Using metrics such as employee and manager feedback, hiring issues concerning salaries, voluntary employee exit surveys and the cost of compensation in relation to company profitability, the HR professional can assess the compensation program.

Pulling it All Together – Final Thoughts on Compensation System Development

Building a pay structure from scratch is not an easy undertaking. There are many steps to do, many stakeholders to involve and much to research. Compensation system development is not only science but also art. Those new to the compensation system development process should not feel overwhelmed. By following the steps and decision-making points outlined in this article and by conducting research for data on reliable and authoritative web sites, the HR practitioner can create simple, easy to understand, yet sophisticated and fiscally sensitive pay structures that will serve the organization’s strategic needs now and in the future. There are few such rewarding opportunities to dramatically affect the organization’s strategy and the employee’s careers.

References:

Greene, R. J. (2008, August). Benchmarking may be common practice, but is it sound practice. Workspan.

Grigson, D., Delaney, J., & Jones, R. (2004, October). Market pricing 101 – the science and the art. Workspan.

Risher, H. (2003, March). Making managers responsible for managing pay. Workspan.

Rubino, J. (1992). Communicating compensation programs: An approach to providing information to employees. Scottsdale, AZ: American Compensation Association.

Schuster, J R., & Zingheim, P. K. (1992). The new pay: Linking employee and organizational performance. San Francisco: Josey-Bass.

The Hay Group. (1996). People, performance & pay: Dynamic compensation for changing organizations. New York: Free Press.