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CHAPTER EIGHT
DESIGNING PAY LEVELS, MIX, AND PAY
STRUCTURES
Overview
This chapter focuses on the major decisions and techniques involved in determining an
organization’s external competitiveness policy—establishing pay levels and pay mix forms
and designing pay structures. Most organizations survey other employers’ pay practices to
determine the rates competitors pay. Based on the survey results, an employer considers
how it wishes to position its total compensation in the market: lead, match, or lag its
competitors. This policy decision may differ for different business units and even for
different job groups within a single organization. An organization’s competitive position
policy is translated into practice by setting pay-policy lines which serve as reference points
around which pay grades and ranges or bands are designed.
There are seven major decisions involved in setting externally competitive pay and designing
the corresponding pay structures. They include:
Specifying the employer’s competitive pay policy
Defining the purpose of the survey
Selecting relevant market competitors
Designing the survey
Interpreting survey results and constructing the market line
Constructing a pay policy line that reflects the external pay policy
Balancing competitiveness with internal alignment through the use of ranges, flat rates,
and/or bands
The chapter concludes with a discussion on the issues associated with combining the internal
structure (job evaluation results) with external market rates. Internal alignment and external
competitiveness merge together in a pay structure which has two aspects:
Pay-policy line
Pay ranges
The pay-policy line translates an organization’s external competitive policy into practice. Use of
pay grades and ranges or bands offers flexibility to deal with pressures from both external and
internal pressures on pay decisions. The process of balancing internal and external pressures is a
matter of judgment. De-emphasizing internal alignment may lead to unfair treatment among
employees and inconsistency with the fundamental culture of an organization. On the other
hand, neglecting external competitive pay practices will affect the ability to attract and hire
applicants who match an organization’s needs. External pay relationships also impact labor
costs and hence the ability to compete in the product/service market.
Learning Objectives
Identify and discuss the seven major decisions in setting externally competitive pay and
designing the corresponding pay structures.
Interpret the pay-policy line, including choice of measure, updating, and relating the
pay-policy line to the market line.
Discuss developing grades and ranges, including establishing range midpoints,
minimums and maximums, and any overlap.
Understand the need for adjusting the pay structure.
Lecture Outline: Overview of Major Topics
I. Major Decisions
II. Specify Competitive Pay Policy
III. The Purpose of a Survey
IV. Select Relevant Market Competitors
V. Design the Survey
VI. Interpret Survey Results and Construct a Market Line
VII. From Policy to Practice: The Pay-Policy Line
VIII. From Policy to Practice: Grades and Ranges
IX. From Policy to Practice: Broad Banding
X. Balancing Internal and External Pressures: Adjusting the Pay Structure
XI. Market Pricing
XII. Review
XIII. Your Turn: Google’s Evolving Pay Strategy
IX. Still Your Turn: Word-of-Mouse: Dot-Com Comparisons
Lecture Outline: Summary of Key Chapter Points
I. Major Decisions
The major decisions in setting externally competitive pay and designing the
corresponding pay structures are shown in Exhibit 8.1:
oSpecify the employer’s competitive pay policy
oDefine the purpose of the survey
oSelect relevant market competitors
oDesign the survey
oInterpret survey results and construct the market line
oConstruct a pay policy line that reflects the external pay policy
oBalance competitiveness with internal alignment through the use of ranges, flat
rates, and/or bands
II. Specify Competitive Pay Policy
Chapter 7 covered the first decision, determining the external competitive pay
policy.
Translating any external pay policy into practice requires information on the
external market. Surveys provide the data for translating that policy into pay levels,
pay mix, and structures.
Definition: A survey is the systematic process of collecting and making judgments
about the compensation paid by other employers.
III. The Purpose of a Survey
An employer conducts or participates in a survey for a number of reasons:
oTo adjust the pay level in response to changing rates paid by competitors
oTo set the mix of pay forms relative to that paid by competitors
oTo establish or price a pay structure
oTo analyze pay-related problems
oTo estimate the labor costs of product/service market competitors
A. Adjust Pay Level—How Much to Pay?
Most organizations make adjustments to employees’ pay on a regular
basis.
Such adjustments can be based on:
oThe overall movement of pay rates caused by the competition for people in
the market
oPerformance
oAbility to pay
oTerms specified in a contract
B. Adjust Pay Mix—What Forms?
Adjustments to the different forms of pay competitors use (base, bonus,
stock, benefits) and the relative importance they place on each form occur less
frequently than adjustments to overall pay level.
It is not clear why changes to the pay mix occur less frequently than
changes in the pay level.
oPerhaps the high costs of redesigning a different mix create a barrier.
oPerhaps inertia prevails.
oMore likely, insufficient attention has been devoted to mix decisions.
The mix organizations use may have been based on external
pressures such as health-care costs, stock values, government
regulations, union demands, and what others did.
Some pay forms may affect employee behavior more than others. Good
information on total compensation, the mix of pay competitors use, and costs
of various pay forms is increasingly important.
C. Adjust Pay Structure?
Many employers use market surveys to validate their own job evaluation
results.
The job structure that results from internal job evaluation may not match
competitors’ pay structures in the external market. Reconciling these two pay
structures is a major issue.
Rather than integrating an internal and external structure, some
employers go straight to market surveys to establish their internal structures.
Such “market pricing” mimics competitors’ pay structures. Accurate
information and informed judgment are vital for making all these decisions.
D. Study Special Situations
Information from specialized surveys can shed light on specific
pay-related problems.
A special study may focus on a targeted group such as patent attorneys,
retail sales managers, secretaries, or software engineers. Unusual increases in
an employer’s turnover in specific jobs may require focused market surveys to
find out if market changes are occurring.
E. Estimate Competitors’ Labor Costs
Survey data are used as part of employers’ broader efforts to gather
“competitive intelligence.”
To better understand how competitors achieve their market share and
price their products/services, companies seek to examine (i.e., benchmark)
practices costs, and so forth against competitors, including in the area of
compensation.
One source of publicly available labor cost data is the Employment Cost
Index (ECI), one of four types of salary surveys published regularly by the
Department of Labor. The index allows a firm to compare changes in its
average costs to an all-industry or specific-industry average.
oHowever, this comparison may have limited value because industry
averages may not reflect relevant competitors.
IV. Select Relevant Market Competitors
To make decisions about pay level, mix, and structures, a relevant labor market
must be defined that includes employers who compete in one or more of the following
areas:
oThe same occupations or skills
oEmployees within the same geographic area
oThe same products and services
Exhibit 8.3 shows how qualifications interact with geography to define the scope
of relevant labor markets.
oAs the importance and complexity of the qualifications increase, the geographic
limits also increase. Competition tends to be national or international for
managerial and professional skills but local or regional for clerical and production
skills.
oHowever, these generalizations do not always hold true:
In areas with high concentrations of scientists, engineers, and managers,
the primary market comparison may be regional, with national data used only
secondarily.
Some larger firms ignore local market conditions. Instead, they
emphasize internal alignment across geographic areas to facilitate the use of
virtual teams.
Some writers argue that if the skills are tied to a particular industry—as
underwriters, actuaries, and claims representatives are to insurance, for example—it
makes sense to define the market on an industry basis, and some research agrees.
If accounting, sales, or clerical skills are not limited to one particular
industry, then industry considerations are less important.
From the perspective of cost control and ability to pay, including competitors in
the product/service market is crucial. However, this becomes a problem when the
major competitors are based in countries with far lower pay rates, such as China or
Mexico.
While the quantity of data available for international comparisons is improving,
using the data to adjust pay still requires a lot of judgment. Even with good
international survey data, judgment is still required.
A. Fuzzy Markets
New organizations and jobs fuse together diverse knowledge and
experience, so “relevant” markets appear more like “fuzzy” markets.
Organizations with unique jobs and structures face the double bind of
finding it hard to get comparable market at the same time they are placing
more emphasis on external market data.
V. Design the Survey
Consulting firms offer a wide choice of ongoing surveys covering almost every
job family and industry group imaginable.
Designing a survey requires answering the following questions:
oWho should be involved in the survey design?
oHow many employers should be included?
oWhich jobs should be included?
oWhat information should be collected?
A. Who Should Be Involved?
In most organizations, the responsibility for managing the survey lies
with the compensation manager.
Outside consulting firms are typically used as third-party protection from
possible “price-fixing” lawsuits.
oLawsuits have been filed alleging that the direct exchange of survey data
violates Section 1 of the Sherman Act, which outlaws conspiracies in
restraint of trade.
oSurvey participants may be guilty of price fixing if the overall effect of the
information exchange is to interfere with competitive prices and artificially
hold down wages.
oIdentifying participants’ data by company name is considered price fixing.
B. How Many Employers?
There are no firm rules on how many employers to include in a survey.
oLarge firms with a lead policy may exchange data with only a few (6 to 10)
top-paying competitors. A small organization in an area dominated by two
or three employers may decide to survey only smaller competitors.
oNational surveys conducted by consulting firms often include more than
100 employers. Clients of these consultants often stipulate special analyses
that report pay rates by selected industry groups, geographic region, and/or
pay levels.
Publicly Available Data
oIn the United States, the Bureau of Labor Statistics (BLS) is the major
source of publicly available compensation (cash, bonus, and benefits but
not stock ownership) data. The BLS publishes extensive information on
various occupations in different geographic areas.
oWhile some private sector firms may track the rate of change in BLS data
as a cross-check on other surveys, the data are often not specific enough to
be used alone.
oTailoring analysis to specific industry segments, select companies, and
specific job content is not feasible.
“Word of Mouse”
oBefore computers, individual employees had a hard time comparing their
salaries to others’; gathering information haphazardly, via word of mouth.
oThe ease of access computers provide means managers must be able to
explain salary variations among employees.
oUnfortunately, the quality of much salary data on the Web is highly
suspect. Few sites (except the BLB) offer any information on how they
collected their data. There are some good exceptions, Salary.com.
Many Surveys (But Few That Are Validated)
oOpinions about the value of consultant surveys are rampant; research is
not.
oThe fact that companies typically use three or more surveys (for all job
types) suggests that different surveys do, in fact, imply different pay levels.
Many firms select one survey as their primary source and use others to
cross-check or “validate” the results.
oSome employers routinely combine the results of several surveys and
weight each survey in this composite according to somebody’s judgment of
the quality of the data reported.
oNo systematic study of the effects of differences in market definition,
participating firms, types of data collected, quality of data, analysis
performed, and/or results is available.
oFor staffing decisions, employment test designers report the test’s
performance against a set of standards (reliability, validity, etc.).
oJob evaluation’s reliability and validity (or lack of) has been much studied
and debated. For market surveys and analysis, similar indices and
standards do not exist.
C. Which Jobs to Include?
There are several approaches to selecting jobs for inclusion.
Benchmark-Job Approach
oBenchmark jobs have stable job content, are common across different
employers, and include sizable numbers of employees.
oIf the purpose of the survey is to price the entire structure, then benchmark
jobs can be selected to include the entire structure. In Exhibit 8.7, the more
heavily shaded jobs in the structures are benchmark jobs.
oThe degree of match between the survey’s benchmark jobs and each
company’s benchmark jobs is assessed by various means. One approach is
benchmark conversion/survey leveling. As another example, the Hay
Group has installed the same job evaluation plan in many companies that
participate in its surveys. Other surveys simply ask participants to check
the degree of match.
Low-High Approach
oIf an organization is using skill-competency-based structures or generic job
descriptions, it may not have benchmark jobs to match with jobs at
competitors who use a traditional job-based approach.
oMarket data must be converted to fit the skill or competency structure. The
simplest way to do this is to identify the lowest- and highest-paid
benchmark jobs for the relevant skills in the relevant market and to use the
wages for these jobs as anchors for the skill-based structures.
oWork at various levels within the structure can then be slotted between the
anchors.
Benchmark Conversion/Survey Leveling
oIn cases where the content (e.g., job description) of an organization’s jobs
does not sufficiently match that of jobs in the salary survey, an effort can
be made to quantify the difference via benchmark conversion.
oIf an organization uses job evaluation, then its job evaluation system can be
applied to the survey jobs. The magnitude of difference between job
evaluation points for internal jobs and survey jobs provides an estimate of
their relative value and thus guidance for adjusting the market data.
D. What Information to Collect?
Three basic types of data typically are requested:
oInformation about the organization
oInformation about the total compensation system
oSpecific pay data on each incumbent in the jobs under study
Exhibit 8.9 lists the basic data elements and the logic for including them.
No survey includes all the data. Rather, the data collected depend on the
purpose of the survey, and the jobs and skills included.
Organization Data
oThis information reflects the similarities and differences among
organizations in the survey. Surveys of executive and upper-level positions
include financial and reporting relationships data, since compensation for
these jobs is more directly related to the organization’s financial
performance.
oThe competitors’ data have not been used to compare competitors’
productivity (revenues to compensation) or labor costs.
oBut this is changing. Metrics of organization performance such as turnover
and revenues are being collected.
oOther outcomes such as earnings per share, market share, customer
satisfaction, employee pay satisfaction, and recruiting yield ratios are not
included. Financial data are gathered from other, often publicly available
sources (e.g., Google Financial, Thompson Financial). Examples include
metrics on organization success (revenues, net income, customer
satisfaction), turnover (voluntary quit rates), and recruiting (yield ratios).
Total Compensation Data
oInformation on all types of pay forms is required to assess the total pay
package and competitors’ practices.
oThree alternatives—base pay, total cash (base, profit sharing, bonuses), and
total compensation (total cash plus benefits and perquisites)—are the most
commonly used measures of compensation. Exhibit 8.10 draws the
distinction between these three alternatives and highlights the usefulness
and limitations of each.
oExhibit 8.11 shows some results of conducting a pay survey that includes
these three measures on a sample of engineers:
Base pay: This is the amount of cash the competitors decided
each job and incumbent is worth. A company might use this
information for its initial observations of how “good” the data appear to
fit a range of jobs.
Total cash: This is base plus bonus. Total cash measures reveal
competitors’ use of performance-based cash payments.
Total compensation: This includes total cash plus stock options
and benefits. Total compensation reflects the total overall value of the
employee (performance, experience, skills, etc.) plus the value of the
work itself.
VI. Interpret Survey Results and Construct a Market Line
The greatest challenge of total compensation surveys is to understand how to
evaluate the information.
After the survey data are all collected, the next step is to analyze the results and
use statistics to construct a market pay line.
A. Verify Data
A common first step is to check the accuracy of the job matches, and
then check for anomalies, age of data, and the nature of the organizations.
Accuracy of Match (and Improving the Match)
oIf a company job is similar but not identical, some companies use the
benchmark conversion/survey leveling approach; that is, they multiply the
survey data by some factor that the analyst judges to be the difference
between the company job and the survey job.
Anomalies
oPerusal of salary data gives an analyst a sense of the quality of the data and
helps identify any areas for additional consideration.
oAnomalies may include:
Does any one company dominate?
Do all employers show similar patterns?
Outliers?
oThe best way to answer questions on anomalies is to do an analysis of them
alone.
B. Statistical Analysis
While the statistics necessary to analyze survey data, including
regression, are covered in basic statistics classes, a number of websites are
probably more fun.
A useful first step in the analysis is to look at a frequency distribution of
the pay rates.
Frequency Distribution
oThis helps visualize information and may highlight anomalies.
oShapes of frequency distribution can vary. Unusual shapes indicate may
reflect problems with job matches, widely dispersed pay rates, or
employers with widely divergent pay policies.
Central Tendency
oA measure of central tendency reduces a large amount of data into a
single number. Exhibit 8.14 defines commonly used measures.
oThe distinction between “mean” and “weighted mean” is important.
If only company averages are reported in the survey, a mean may
be calculated by adding each company’s base wage and dividing by the
number of companies.
Weighted mean is calculated by adding the base wages for all 585
engineers in the survey and then dividing by 585. A weighted mean
gives equal weight to each individual employee’s wage.
Variation
oThe distribution of rates around a measure of central tendency is called
variation. Variation tells us how the rates are spread out in the market.
oStandard deviation is probably the most common statistical measure of
variation, although its use in salary surveys is rare.
oQuartiles and percentiles are more common measures in salary survey
analysis.
C. Update the Survey Data
Because they reflect decisions of employers, employees, unions, and
government agencies, wages paid by competitors are constantly changing.
Additionally, competitors adjust their wages at different times.
A survey that requires three months to collect and analyze is probably
outdated before it is available. The pay data are usually updated (a process
often called aging or trending) to forecast the competitive rates for the future
date when the pay decisions will be implemented.
The amount to update is based on several factors, including historical
trends in the labor market, prospects for the economy in which the employer
operates, and the manager’s judgment, among others.
Some recommend using the Consumer Price Index (CPI). It is not
advisable to do so because the CPI measures the rate of change in prices for
goods and services in the product market, not wage changes in labor market.
Exhibit 8.15 illustrates updating.
