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E. Budget Controls: Top Down
Top-down budgeting begins with an estimate from top management of
the pay increase budget for the entire organization. Once the total budget is
determined, it is then allocated to each manager, who plans how to distribute it
among subordinates.
There are many approaches to top-down budgeting. A typical one,
planned pay-level rise, is simply the percentage increase in average pay for
the unit that is planned to occur.
oSeveral factors influence the decision on how much to increase the
average pay level for the next period.
How much the average level was increased this period
Ability to pay
Competitive market pressures
Turnover effects
Cost of living
Current Year’s Rise
This is the percentage change in the average wage in the past year.
average pay at year end average pay at year beginning
Percent pay-level rise = 100 × average pay at year beginning
-
Ability to Pay
Any decision to increase the average pay level is in part a function of the
organization’s financial circumstances.
Financially healthy employers may wish to maintain their competitive
positions in the labor market or share financial success through bonuses and
profit sharing.
Conversely, financially troubled employers may not be able to maintain
competitive market positions.
oThe conventional response has been to reduce employment. By analyzing
pay and staffing at each level, potential cost savings can be discovered.
oOther options are to reduce the rate of increase in average pay by
controlling adjustments in base pay and/or variable pay. Raising
employees’ copays and deductibles for benefits is another.
oOften as a last resort, firms decrease base wages (as well as variable pay).
oOther alternatives also exist. For example, the employers can reduce costs
by reducing the different sources of contract employees.
Competitive Market Pressures
Managers determine an organization’s competitive position in relation to
its competitors. A distribution of market rates for benchmark jobs is collected
and analyzed into a single average wage for each benchmark.
oThis “average market wage” becomes the “going market rate,” and this
market rate changes each year in response to a variety of factors in the
external market.
Turnover Effects
Sometimes referred to as “churn” or “slippage,” the turnover effect
recognizes the fact that when people leave (through layoffs, quitting, retiring),
they typically are replaced by employees who earn a lower wage.
Turnover effect can be calculated as annual turnover multiplied by the
planned average increase.
The turnover effect will reduce benefit costs linked to base pay, such as
pensions.
Cost of Living
Although there is little research to support cost of living increases,
employees undoubtedly compare their pay increases to changes in their living
costs. Unions consistently argue that increasing living costs justify increasing
pay.
It is important to distinguish among three related concepts:
oCost of living—expenditure patterns of individuals for goods and services.
It is more difficult to measure because employees’ expenditures depend on
many things: marital status, number of dependents and ages, personal
preferences, location, and so on.
oChanges in prices in the product and service markets—measured by
several government indexes, one of which is the consumer price index.
oChanges in wages in labor markets—as Exhibit 18.7 shows, changes in
wages in labor markets are measured through pay surveys. These changes
are incorporated into the system through market adjustments in the budget
and updates of the policy line and range structure.
oThe three concepts are interrelated.
Wages in the labor market are part of the cost of producing goods
and services, and changes in wages create pressures on prices.
Changes in the prices of goods and services create the need for
increased wages in order to maintain the same lifestyle.
oMany people refer to the CPI as a “cost-of-living” index, and many
employers choose, as a matter of pay policy or in response to union
pressures, to tie wages to it. However, the CPI does not necessarily reflect
an individual employee’s cost of living.
Instead, it measures changes in prices over time.
oChanges in the CPI indicate only whether prices have increased more or
less rapidly in an area since the base period.
oIf employers decide to use the CPI rather than labor market salary surveys
to determine the merit budget, they basically are paying for inflation rather
than performance or market changes.
oThe CPI is of public interest because changes in it trigger changes in labor
contracts, social security payments, federal and military pensions, and
food stamp eligibility.
oTying budgets or payments to the CPI is called indexing.
Rolling It All Together
Let us assume that the managers take into account all these factors—
current year’s rise, ability to pay, market adjustments, turnover effects,
changes in the cost of living, and geographic differentials—and decide that
the planned rise in average salary for the next period is 6.3 percent.
oThis means that the organization has set a target of 6.3 percent as the
increase in average salary that will occur in the next budget period.
oIt does not mean that everyone’s increase will be 6.3 percent.
oIt means that at the end of the budget year, the average salary calculated to
include all employees will be 6.3 percent higher than it is now.
Distributing the Budget to Subunits
oA variety of methods exist for determining what percentage of the salary
budget each manager should receive.
Some use a uniform percentage, in which each manager gets an
equal percentage of the budget based on the salaries of each subunit’s
employees.
Others vary the percentage allocated to each manager based on
pay-related issues—such as turnover or performance—that have been
identified in that subunit.
oOnce salary budgets are allocated to each subunit manager, they become a
constraint: a limited fund of money that each manager has to allocate to
subordinates.
Typically, merit increase guidelines are used to help managers
make these allocation decisions.
Merit increase grids help ensure that different managers grant
consistent increases to employees with similar performance ratings and
in the same position in their ranges. Additionally, grids help control
costs.
To limit the number of employees placed in high performance
categories (and thus the number of employees receiving the largest
merit increases), some companies used forced distribution approaches.
F. Budget Controls: Bottom Up
In contrast to top-down budgeting, where managers are told what their
salary budget will be, bottom-up budgeting begins with managers’ pay
increase recommendations for the upcoming plan year. Exhibit 18.8 shows the
process involved.
1. Instruct managers in compensation policies and techniques—train
managers in the concepts of a sound pay-for-performance policy, and in
standard company compensation techniques such as the use of
pay-increase guidelines and budgeting techniques. Communicate market
data and the salary ranges.
2. Distribute forecasting instructions and worksheets—furnish managers
with the forms and instructions necessary to preplan increases. Most firms
offer managers computer software to support these analyses and to enter
information and perform what-if analyses.
Adjustments for each individual are fed into the summary merit budget,
promotion budget, equity adjustment budget, and so on, on a summary screen.
The type of information available to each supervisor to guide him or her
in making recommendations might include performance rating history, past
raises, training background, and stock allocations are all included.
Guidelines for increases based on merit, promotion, and equity
adjustments are provided, and all the worksheets are linked so that the
manager can model pay adjustments for employees and see the budgetary
effects of those adjustments immediately.
Some argue that providing such detailed data and recommendations to
operating managers makes the process biased.
3. Provide consultation to managers—offer advice and salary information
services to managers upon request.
4. Check data and compile reports—audit the increases forecasted to ensure
that they do not exceed the pay guidelines and are consistent with
appropriate ranges. Then use the data to feed back the outcomes of pay
forecasts and budgets.
5. Analyze forecasts—examine each manager’s forecast, and recommend
changes based on noted inequities among different managers.
6. Review and revise forecasts and budgets with management—consult with
managers regarding the analysis and any recommended changes. Obtain
top-management approval of forecasts.
7. Conduct feedback with management—present statistical summaries of the
forecasting data by department, and establish unit goals.
8. Monitor budgeted versus actual increases—control the forecasted
increases versus the actual increases by tracking and reporting periodic
status to management.
The result of the forecasting cycle is a budget for the upcoming plan
year for each organization’s unit as well as estimated pay treatment for each
employee.
oThe budget does not lock in the manager to the exact pay change
recommended for each employee. Rather, it represents a plan, and
deviations due to unforeseen changes such as performance improvements
and unanticipated promotions are common.
oThe approach places responsibility for pay management on the managers
by requiring them to plan the pay treatment for each of their employees.
The compensation manager takes on the role of advisor to operating
management’s use of the system.
G. Embedded (Design) Controls
Controls on managers’ pay decisions come from two different aspects of
the compensation process:
oControls that are inherent in the design of the techniques
oThe formal budgeting process
Many other techniques include:
oJob analysis and evaluation
oSkill- and competency-based plans
oPolicy lines
oRange minimums and maximums
oBroad bands
oPerformance evaluation
oGain sharing
oSalary-increase guidelines
Controls are built into these techniques to direct them toward the pay
system objectives.
Range Maximums and Minimums
Ranges set the maximum and minimum dollars to be paid for specific
work.
The maximum is an important cost control.
oIdeally, it represents the highest value the organization places on the
output of the work.
oWith job-based structures, skills and knowledge possessed by employees
may be more valuable in another job, but the range maximum represents
all that the work produced in a particular job is worth to the organization.
oSpecific jobs may have a maximum rate (a cap) but individuals may not.
They can earn beyond the job’s maximum through promotions,
profit sharing, and so on.
oIf employees are paid above the range maximum, these rates are called red
circle rates.
Most employers “freeze” red circle rates until the ranges are
shifted upward by market update adjustments so that the rate is back
within the range again.
An organization also has the option to combine a salary freeze
with the use of merit bonuses, which unlike merit increases, do not
become part of base salary.
If red circle rates become common throughout an organization,
then the design of the ranges and the evaluation of the jobs should be
reexamined.
Green circle rates refer to instances where employees are paid
below the minimum.
Range minimums are the minimum value placed on work.
oOften rates below the minimum are often used for trainees.
oPay below minimum may also occur if outstanding employees receive a
number of rapid promotions and pay increases have not kept up.
Broad Bands
oBroad bands are intended to offer managers greater flexibility compared to
a grade-range design.
Usually broad bands are accompanied by external market
“reference rates” and “shadow ranges” that guide managers’ decisions.
oBands may be more about career management than pay decisions.
Rather, the control is in the salary budgets given to managers.
The manager has flexibility in pay decisions, as long as the total pay
comes in under the budget.
Promotions and External versus Internal Hires
Promotion-based pay increases are often substantial, meaning that cost
control efforts must monitor both rates of promotion and the salary increase
that is given with promotions.
oSome organizations limit the number of promotions permitted within a
time period and some also limit the number of grades/levels that an
employee can advance as well as the size of the promotion salary increase.
Another, more strategic issue concerns the degree to which positions are
filled from the inside via promotion versus the use of outside hires.
oOutside hires often command a pay premium and, to the degree that their
higher pay is known to other employees, internal equity pressures may, in
some cases, result in higher pay for current employees as a means to
preserve current norms regarding relative pay.
Compa-Ratios
Range midpoints reflect the pay policy line of the employer in
relationship to external competition. To assess how managers actually pay
employees in relation to the midpoint, an index called a compa-ratio is often
calculated:
average rate actual paid
Compa-ratio = range midpoint
A compa-ratio of less than 1 means that, on average, employees in a
range are paid below the midpoint. That is, managers are paying less than the
intended policy. There may be several valid reasons for such a situation:
oThe majority of employees may be new or recent hires.
oThe majority of employees may be poor performers.
oPromotion may be so rapid that few employees stay in the job long enough
to get into the high end of the range.
A compa-ratio greater than 1 means that, on average, the rates exceed
the intended policy. The reasons for this are the reverse of those mentioned
above:
oA majority of workers with high seniority
oA majority of workers with high performance
oLow turnover
oFew new hires
oLow promotion rates
Compa-ratios may be calculated for individual employees, for each
range, for organization units, or for functions.
Other examples of controls designed into the pay techniques include the
mutual sign-offs on job descriptions required of supervisors and subordinates.
Another is slotting new jobs into the pay structure via job evaluation,
which helps ensure that jobs are compared on the same factors.
Similarly, an organization-wide performance management system is
intended to ensure that all employees are evaluated on similar factors.
Variable Pay
The essence of variable pay is that it must be re-earned each period, in
contrast to conventional merit pay increases or across-the-board increases that
increase the base on which the following year’s increase is calculated.
Increases added into base pay have compounding effects on costs, and
these costs are significant.
The greater the ratios of contingent to core workers and variable to base
pay, the greater the variable component of labor costs and the greater the
options available to managers to control these costs.
Although variability in pay and employment may be an advantage for
managing labor costs, it may be less appealing from the standpoint of
managing effective treatment of employees. The inherent financial insecurity
built into variable plans may adversely affect employees’ financial well-being,
especially for lower-paid workers.
Analyzing Costs
Costing out wage proposals is commonly done prior to recommending
pay increases, especially for collective bargaining.
Commercial compensation software is available to analyze almost every
aspect of compensation information.
oSoftware can easily compare past estimates to what actually occurred.
oIt can simulate alternate wage proposals and compare their potential
effects.
oIt can also help evaluate salary survey data and simulate the cost impact of
incentive and gain-sharing options.
III. Managing Revenues
Although the cost of compensation is most easily measured, do not forget that
compensation is also central to driving future revenues.
Some companies are beginning to analyze the value added of pay decisions and
how that influences revenues.
oThis analysis requires a shift in how compensation is viewed. Compensation
becomes an investment as well as an expense. Decisions are based on analysis of
the return on this investment.
Exhibit 18.9 illustrated the approach to assessing value gained in different ways,
which directly or indirectly influence revenues.
The practice of analyzing the returns from compensation decisions is in its early
stages. The promise is that it will direct thinking beyond treating compensation as
only an expense to considering the returns gained as well.
A. Using Compensation to Retain (And Recruit) Top Employees
A substantial share of employees, especially high performers, leave their
jobs because of being “pulled” by opportunities elsewhere.
Employers would do well to keep compensation current and competitive
because other organizations will eventually find these “passive job seekers”.
