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CHAPTER 8
Building Pay Structures That Recognize Employee Contributions
Learning Objectives
8-1. Explain the concept of pay structures and the five steps necessary to construct
pay structures.
8-2. Discuss the components of merit pay systems.
8-3. Summarize the features of sales compensation plan design.
8-4. Describe the essentials of person-focused pay program design.
8-5. Summarize pay structure variations.
Outline
I. Constructing a Pay Structure
II. Designing Merit Pay Systems
III. Designing Sales Incentive Compensation Plans
IV. Designing Person-focused Programs
V. Pay Structure Variations
VI. Key Terms
VII. Discussion Questions and Suggested Answers
VIII. End of Chapter Case; Instructor Notes, and Questions and Suggested Student Responses
IX. Crunch the Numbers! Questions and Suggested Student Responses
XI. Additional Cases from the MyManagementLab Website; Instructor Notes, and Questions
and Suggested Student Responses
Lecture Outline
I. Constructing a Pay Structure
A. Overview
1. Based on five steps
a. Deciding on how many pay structures to construct
b. Determining a market pay line
c. Defining pay grades
d. Calculating pay ranges for each pay grade
e. Evaluating the results
B. Step 1: Deciding on the Number of Pay Structures
1. Usually more than one depending on market rates and company’s job structure
2. Exempt and nonexempt pay structures
a. Categories reflect a distinction in the Fair Labor Standards Act (FLSA)
b. Exempt jobs are not subject to overtime provisions of the act and are
expressed as an annual salary.
c. Nonexempt jobs are subject to overtime provisions and compensation is
expressed as an hourly pay rate
3. Pay structures based on job family
a. Pay structures are defined on the basis of job family which show a distinct
pattern in the market
b. Distinct job families include:
i. Executive
ii. Managerial
iii. Professional
iv Technical
v. Clerical
vi. Craft
4. Pay structures based on geography
a. The pay for similar positions that are within the same company, but are
located in different parts of the country, can be paid differently
b. Local influences, like cost-of-living, influence pay structures
C. Step 2: Determining a Market Pay Line
1. Market pay line is representative of typical market pay rates relative to a
company’s job structure
2. Pay levels that correspond with the market pay line are market-competitive pay
rates
D. Step 3: Defining Pay Grades
1. Pay grades group jobs for pay policy application based on similar compensable
factors and value
2. Job groupings are influenced by other factors such as management philosophy
4. Wider pay grades minimize hierarchy and social distance between employees
5. Narrower pay grades tend to promote hierarchy and social distance
6. Companies may choose to vary the “absolute” point spread by increasing the
point spread as they move of up the pay structure, in recognition of the broader
range of skills that higher pay grades represent
E. Step 4: Calculating Pay Ranges for Each Pay Grade
1. Pay ranges build upon pay grades
a. Pay ranges represent the vertical dimension (pay rates) and are designated
with the following pay rates
i. Minimum - the lower bound of pay within a pay grade
ii. Midpoint - generally represents the competitive market average or median
iii. Maximum - the upper bound of pay with a pay grade
2. Setting pay range midpoints
a. According to competitive pay policy
b. If the company adopts a market lead policy, that company’s midpoint will be
higher than the market average
c. If the company adopts a market match policy, that company’s midpoint will be
similar to the market average
e. If the company adopts a market lag policy, that company’s midpoint will be
lower than the market average
3. Setting pay range minimums and maximums
a. According to the market averages
b. By developing a range spread
i. The difference between the minimum and maximum pay rates of a given
pay grade
ii. Progressively higher range spreads for pay grades that contain more
valuable jobs in terms of a company’s criteria
iii. Smaller range spreads characterize pay grades that contain narrowly
defined jobs that require simple skills with relatively low responsibility
c. Higher-level jobs afford employees greater promotion opportunities than entry
level jobs
d. Adjacent pay ranges usually overlap with other pay ranges so that the highest
rate paid to one is greater than the lowest rate of the successive pay grade
4. Pay compression
a. Occurs whenever a company’s pay spread between new hires or less qualified
employees and more qualified job incumbents is small
b. Occurs when
i. Companies fail to raise pay range minimums and maximums
ii. Scarcity of qualified candidates for particular jobs
c. Can threaten a companies’ competitive advantage when it results in
dysfunctional turnover (high performing employees voluntarily terminate their
employment)
5. Green circle pay rates
a. Are below-minimum pay range rates
b. Are usually offered because applicants do not meet every minimum
requirement in the job description
6. Red circle pay rates
a. Are above maximum pay range rates
b. For exemplary performers, may offer lump sum bonus not added to regular
pay
F. Step 5: Evaluate the Results
1. To determine if there was any significant difference between the company’s
internal values for jobs and the market’s value for the same jobs
a. If the company’s valuation exceeds the market’s valuation, the company must
decide whether its higher-than-market pay rates will undermine its attainment
of competitive advantage
b. If the company undervalues a position, it must determine if the discrepancy is
limiting its ability to recruit quality employees
2. Compa-ratios
a. Index the relative competitiveness of internal pay rates, based on pay range
midpoints
b. Are calculated by dividing the employee’s pay rate by the pay range midpoint
c. A ratio of one means that the employee’s pay rate equals the pay range
midpoint
d. A ratio of less than one means the employee’s pay rate falls below the
competitive pay rate for the job
II. Designing Merit Pay Systems
A. An effective merit pay program that recognizes employee contributions requires
avoiding such pitfalls as ineffective performance appraisal methods and poor
communication regarding the link between pay and performance
B. Merit Increase Amounts
1. Should reflect prior job performance levels and motivate employees to perform
their best
2. Considerations in setting amount:
a. There are diminishing marginal returns on each additional dollar allocated to
merit increases
b. Employees’ perceptions of just-meaningful differences in merit increases
depend on their cost of living, their attitudes toward the job, and their
expectations of rewards from the job
c. Equity theory suggests that an employee must regard his or her own ratio of
merit increase pay to performance as similar to the ratio for other comparably
performing people
g. Compensation budgets are blueprints that describe the allocation of monetary
resources to fund pay structures
C. Timing
1. Most increases given on an annual basis
2. Two main approaches
a. Common review date/period which is best suited for smaller companies
b. Employee’s anniversary which can be burdensome as reviews must be
conducted regularly throughout the year
D. Recurring versus Nonrecurring Merit Pay Increases
1. Recurring increases are permanently added to base pay
2. Nonrecurring increases contain costs and are given as one-time lump sum bonuses
E. Present Level of Base Pay
1. Pay structures specify acceptable pay ranges for jobs within each pay grade
2. Should be within federal guidelines of several equal employment opportunity
laws
F. Rewarding Performance: The Merit Pay Grid
1. Amounts are determined by two main factors
a. Performance ratings
b. The position of employees’ present base pay rates within pay ranges
2. Employee performance ratings
a. Overall performance ratings guide the pay raise decision
b. Based on the principle of recognizing higher performance with greater
rewards
3. Employees’ position within the pay range
a. Salaries and hourly wages are indexed by quartile ranking
b. Holding performance ratings constant, merit pay increase percentages are
reduced as quartile ranks increase, to control employees’ progression through
the pay ranges
G. Merit Pay Increase Budgets
1. Budgets limit the merit pay increase percentages in each cell
2. Expressed as a percentage of the sum of employees’ current base pay
3. Varies according to performance level and position in the pay range
4. Steps to ensuring that merit pay increases do not exceed the limit
a. Supervisors and managers determine how many employees fall within each
performance category
b. Determine the percentage of employees whose pay falls into each quartile
c. Combine both sets of information to determine the percentage of employees
who fall into each cell
d. Calculate the expected number of employees in each cell to provide an
estimate of the employees’ performance distribution
e. Use this formula: (Expected number of each cell) X (Desired pay increase for
cell %) X (Current median pay level for quartile)
f. Ensure the total amount is within budget
III. Designing Sales Incentive Compensation Plans
A. Purposes of Sales Incentive Compensation Plans
1. Help businesses meet their objectives by aligning the financial self-interest of
sales professionals with the company’s marketing objectives
2. Particular sales objectives include:
a. Improve sales productivity
b. Improve sales coverage of current customers
c. Grow sales overall
B. Alternative Sales Compensation Plans
1. Choosing the appropriate plan depends on the company’s competitive strategy
2. Five main alternatives
a. Salary-only
b. Salary-plus-bonus
c. Salary-plus-commission
d. Commission-plus-draw
e. Commission-only
3. Salary-Only Plans
a. Sales professionals receive fixed base compensation which does not vary with
level of units sold, increase in market share, or any other indicator of sales
performance
b. Relatively risk-free compensation for employees
c. Burdensome to employers because they must compensate regardless of their
achievement levels
d. Appropriate where
i. Sales are of high-priced products and services, or technical products with
long lead times for sales
ii. Sales professionals are primarily responsible for generating demand
whereas other employees actually close the sales
iii. It is impossible to follow sales results for each sales professional since
sales are accomplished through team efforts
iv. Sales professionals are involved in training or other activities when they
are not directly involved in making sales
4. Salary-plus-bonus plans
a. Offer set base pay with an incentive bonus
b. Give one-time bonuses, usually tied to meeting specific, exceptional goals
5. Salary-plus-commission plans
a. A commission is a form of incentive compensation based upon a percentage of
the selling price of the product or service
b. These plans spread the risk of selling between the company and the sales
professional
6. Commission-plus-draw plans
a. Award sales professionals with subsistence pay (draw) to cover basic living
expenses and also incentives to excel
b. The draws are just advances on the commissions the sales professional will
earn in the future
c. Two types of draws
i. Recoverable draws act as company loans to employees that are carried
forward indefinitely until the employee sells enough to repay
ii. Non-recoverable draws act as salary because employees are not obligated
to repay the loans if they do not sell enough
7. Commission-only plans
a. Sales professionals derive their entire income through commissions and
therefore shoulder all the risk
b. Straight commissions award sales professionals with a fixed percentage of the
sales revenue
d. Graduated commissions award sales professionals with an increased
percentage of the sales price as the volume increases
e. Multiple-tiered commissions
i. Award sales professionals with higher percentages of the sales made in a
given period
ii. Earned if the sales level exceeds a predetermined level
f. Commission plans not always best tactic
i. Can cause competitive behaviors between employees
iii. Can undermine employees’ intrinsic motivation to sell
May lose their genuine interest for the challenge and enjoyment that
selling brings
May “go through the motions” of selling and disregard quality and
customer satisfaction
C. Sales Compensation Plans and Competitive Strategy
1. Sales plans with salary components are most appropriate for differentiation
strategies because sales professionals can turn attention to addressing client needs
2. Commission-oriented sales compensation plans are best suited for lowest cost
strategies because compensation expenditures vary with sales revenue
D. Determining Fixed Pay and the Compensation Mix
1. Depends mainly on three factors:
a. Influence of the sales professional on the buying decision
b. Competitive pay standards within the industry
c. Amount of non-sales activities required
2. Influence of the sales professional on the buying decision
a. The more influence sales professionals have on the “buying decisions”, the
more the compensation mix will feature incentive pay
b. In some industries, it is the sales professional’s technical expertise, more than
sales skills that influences the “buying decision”
3. Competitive pay standards within the industry
a. The compensation mix must be competitive with market standards to attract
and retain quality sales professionals
4. Amount of non-sales activities required
a. The more non-sales duties sales professionals are required to perform the
more their compensation packages should include a fixed pay component
IV. Designing Person-focused Programs
A. Overview
1. Person-focused programs refer to both knowledge and skills
2. Reward employees for acquisition of job-related knowledge and/or skills
3. A fundamental issue is whether investments in training provide measurable
pay-offs to companies
B. Establishing Skill Blocks
1. Skill or knowledge “blocks” are sets of skills necessary to perform a specific job,
or group of jobs
2. The number of blocks varies according to the variety of jobs within a company
generally from two to several
4. Development should be based on three considerations:
a. Job descriptions should be developed
b. Individual jobs should be organized into job families or groups
c. Skills should be grouped into blocks
C. Transition Matters
1. Concerns moving from job-based pay exclusively to including person-focused
knowledge plans
2. Skills assessment
a. Centers on who should assess:
i. Whether employees possess skills at levels that justify a pay raise
ii. On what basis assessments should be made
iii. When assessments should be conducted
b. Input should come from peers, self-assessment, and experts (e.g. supervisors)
c. Must identify performance measures
d. Performance should be assessed frequently to during transition phases
4. Aligning pay with the knowledge structure
a. One of most difficult tasks in moving toward a person-focused system
b. If an employee’s actual earnings is more than the person-focused system
indicates as being appropriate, managers must develop a reasonable course of
action for that employee to acquire the skills or knowledge
c. If employees are underpaid (over qualified), the company must provide pay
adjustments quickly
5. Access to training
a. Person-focused systems make training necessary rather than optional for
employees motivated towards self-improvement
b. Employees must have equal access to training
i. To meet the intended aim of person-focused programs
ii. To reward employees for enhancing their skills
iii. To address legal imperatives
c. Restricting access to training can lead to violation of
i. Title VII, Civil Rights Act of 1964
ii. Age Discrimination in Employment Act of 1967
d. Employees must be formally informed of the options and rewards
D. Training and Certification
1. Successful person-focused programs depend on a company’s ability to develop
and implement systematic training programs
2. Companies typically increase the amount of classroom and on-the-job training
3. Should be based on accurate job descriptions
E. In-house or Outsourcing Training
1. Training can be in-house or outsourced depending on:
a. Expertise: The availability of in-house expertise
b. Timeliness: Training will be outsourced if there is not enough time to develop
and deliver it in-house
c. Size of the employee population to be trained: Large numbers make in-house
more cost effective
d. Sensitivity or proprietary nature of the subject matter: The more sensitive the
subject matter, the more likely the training will be in-house
2. Certification and recertification
a. Certification ensures that employees possess minimal levels of skills
proficiency
b. Recertification involves retraining or retesting employees to ensure employees
have retained minimal skills proficiency
V. Pay Structure Variations
A. Broadbanding
1. The broadbanding concept and its’s advantages
i. Consolidates existing pay grades and ranges into fewer, wider pay grades and
broader pay ranges
ii. Represents the organizational trend toward flatter, less hierarchical corporate
structures that emphasize teamwork over individual contributions alone
iii. Can reduce management layers and promote quicker decision-making cycles
iv. Shifts responsibility to supervisors and managers for administering each
employee’s compensation within the confines of the broadbands
2. Limitations of broadbanding
a. Changes how compensation dollars are allocated, but not how much
b. Broadbanding can increase compensation expenses, because managers have
greater latitude in assigning pay to their employees
c. Necessitates a trade-off between the flexibility to reward employees for their
unique contributions and a perception among employees that fewer
promotional opportunities are available
d. Makes employees and employers rethink the idea of promotions as a positive
step through the job hierarchy
B. Two-Tiered Pay Structures
1. The two-tier pay system concept and its advantages
a. Reward newly hired employees less than established employees
b. On temporary basis, employees have opportunity to progress from lower
entry-level pay rates to higher rates enjoyed by more senior employees
b. Permanent two-tier systems reinforce the pay-rate distinction by retaining
separate pay scales
c. Lower-paying scales apply to newly hired employees, whereas current
employees enjoy higher-paying scales
d. Maximum rates to which newly hired employees can progress are always
lower than more senior employees’ pay scales
e. Most prevalent in unionized companies
2. Limitations of two-tier pay structures
a. The lower pay scale for new hires may restrict a company’s ability to recruit
and retain quality employees
b. Lower tier employees may resent pay differential and not extend themselves
beyond their job descriptions
c. Can cause lower employee morale
d. Can lead to excessive turnover
End of Chapter
VI. Key Terms
Pay structures: Assign different pay rates for jobs of unequal worth and provide the framework
for recognizing differences in individual employee contribution
Pay grades: Group jobs for pay policy application
Pay ranges: Represent the vertical dimension (pay rates) and includes midpoint, minimum, and
maximum pay rates
Midpoint pay value: The halfway mark between the range minimum and maximum rates
Range spread: The difference between the maximum and minimum pay rates of a given pay
grade
Pay compression: Occurs whenever a company’s pay spread between newly hired or less
qualified employees, and more qualified job incumbents is small
Green circle rates: Below-minimum pay range rates
Red circle rates: When companies pay certain employees greater than maximum rates for their
pay ranges
Compa-ratios: Index the relative competitiveness of internal pay rates based on pay range
midpoints
Equity theory: Suggests that an employee must regard his or her own ratio of merit increase
pay to performance as similar to the ratio for other comparably performing people in the
company
Compensation budgets: Blueprints that describe the allocation of monetary resources to fund
pay structures
Common review date: All employees’ performances are evaluated on the same date Common
review period: All employees’ performances are evaluated on the same date or during the same
period
Employee’s anniversary date: The day on which the employee began to work for the company
Nonrecurring merit increases: Lump sum bonuses
Merit pay increase budget: Is expressed as a percentage of the sum of employees’ current base
pay
Salary-only plans: Sales professionals receive fixed base compensation, which does not vary
with the level of units sold, increase in market share, or any other indicator of sales performance
Salary-plus-bonus plans: Offer a set salary coupled with a bonus
Commission: A form of incentive compensation based on a percentage of the selling price of a
product or service
Salary-plus-commission plans: Spread the risk of selling between the company and the sales
professional
Commission-plus-draw plans: Award sales professionals with subsistence pay or draws
Draw: Subsistence pay component awarded as an advance, which is charged against
commissions that sales professionals are expected to earn
Recoverable draws: Act as company loans to employees that are carried forward indefinitely
until employees sell enough to repay their draws
Nonrecoverable draws: Act as salary because employees are not obligated to repay the loans if
they do not sell enough
Commission-only plans: Salespeople derive their entire income from commissions
Straight commission: Is based on a fixed percentage of the sales price of the product or service
Graduated commissions: Increase percentage pay rates for progressively higher sales volume
Multiple-tiered commissions: Similar to graduated commissions except employees earn a
higher rate of commission for all sales made in a given period if the sales level exceeds a
predetermined level
Skill (knowledge) blocks: Sets of skills (knowledge) necessary to perform a specific job or
group of similar jobs
Certification: Ensures that employees possess at least a minimally acceptable level of skill
proficiency upon completion of a training unit
Recertification: Employees periodically must demonstrate mastery of all the jobs they have
learned or risk losing their pay rates
Broadbanding: Consolidates existing pay grades and ranges into fewer, wider pay grades and
broader pay ranges
Two-tier pay structures: Reward newly hired employees less than established employees.
