3 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
CHAPTER THREE
DEFINING INTERNAL ALIGNMENT
Overview
Chapter Three is the first of four chapters in Part Two, Internal Alignment: Determining the
Structure. The Bureau of Labor Statistics (BLS) shows large differences in pay as a function of
position / job. The average annual pay for a licensed practical nurse working at a hospital is
$43,550 and registered nurse is $72,070. Physicians and surgeons median annual pay for
primary care is $251,578 and $425,509 for specialties. Why does position matter so much when
it comes to pay? Why don’t hospitals pay all types of “jobs” the same? Can a registered nurse
get promoted to a physician? What about at law firms, can an associate become a partner? If so,
what is the payoff?
This chapter discusses internal alignment and how it affects employees, managers, and
employers. Internal alignment refers to the pay relationships among jobs/skills/competencies
within a single organization. An internal pay structure—the array of pay rates for different jobs
within an organization—is defined by (1) number of levels of work; (2) the pay differentials
between the levels; and (3) the criteria used to determine the levels and differentials. Pay
Learning Objectives
• Define internal alignment and pay structure and discuss how they support the
organization’s objectives.
• Discuss how internal pay structures vary among organizations.
Chapter Three: Defining Internal Alignment 3 – 2
Lecture Outline: Overview of Major Topics
I. Jobs and Compensation
II. Compensation Strategy: Internal Alignment
A. Supports Organization Strategy
B. Supports Work Flow
C. Motivates Behavior
III. Structures Vary Among Organizations
A. Number of Levels
B. Differentials
C. Criteria: Content and Value
IV. What Shapes Internal Structures?
A. Economic Pressures
B. Government Policies, Laws, and Regulations
C. External Stakeholders
D. Cultures and Customs
V. Strategic Choices in Designing Internal Structures
A. Tailored versus Loosely Coupled
B. Hierarchical versus Egalitarian and Layered versus Delayered Structures
VI. Guidance from the Evidence
A. Equity Theory: Fairness
B. Tournament Theory (and Pay Dispersion): Motivation and Performance
3 – 3 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
Lecture Outline: Summary of Key Chapter Points
I. Jobs and Compensation
• This chapter throws some light on the fact that organizations design their pay structures
around jobs and job levels and that, in many organizations, an employee’s pay depends
on both the nature of the job and the job level (and thus promotion rate).
II. Compensation Strategy: Internal Alignment
• Setting objectives is the first issue in a strategic approach to pay.
• The second issue, internal alignment, addresses pay relationships inside the
organization.
Definition: Internal alignment, often called internal equity, refers to the pay relationships
among different jobs/skills/competencies within a single organization.
• Exhibit 3.1 shows a structure for engineering work at a division of Lockheed Martin,
the world’s largest defense contractor.
Definition: Pay structure refers to the array of pay rates for different work or skills within
a single organization. The number of levels, the differentials in pay between the levels, and
the criteria used to determine those differences describe the structure.
A. Supports Organization Strategy
• An organization’s strategy needs to support important aspects that go into
maintaining its competitive advantage.
B. Supports Work Flow
• Work flow refers to the process by which goods and services are delivered to the
customer.
• The pay structure ought to support the efficient flow of work and the organizational
design. The text uses the example of Merrill Lynch redesigning the flow of work
(and the pay structure) to better reflect its clients’ needs, and increase its profits.
Chapter Three: Defining Internal Alignment 3 – 4
C. Motivates Behavior
• Internal pay structures are part of the network of returns: pay increases for
promotions, more challenging work, and greater responsibility as employees move
up in the structure.
III. Structures Vary Among Organizations
• An internal pay structure can be defined by:
1. The number of levels of work,
A. Number of Levels
• One feature of any pay structure is its hierarchical nature: the number of levels and
reporting relationships.
• Some are more hierarchical, with multiple levels; others are compressed, with few
levels.
B. Differentials
• The pay differences among levels are referred to as differentials.
• If we assume that an organization has a compensation budget of a set amount to
distribute among its employees, there are a number of ways it can do so:
o It can divide the budget by the number of employees to give everyone the same
amount.
• One intention of differentials is to motivate people to strive for promotion to a
higher-paying level.
o As Exhibit 3.3 shows, the same basic structure, in terms of percent differentials,
3 – 5 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
Copyright © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
can be paired with different pay level policies.
o Although a lead engineer is paid more in the structure on the right, the percent
differential between the lead engineer and systems engineer is the same in both
(28%)
C. Criteria: Content and Value
• The most common bases for determining internal structures are:
o Content—refers to the work performed in a job and how it gets done (tasks,
behaviors, knowledge required, etc.).
▪ A structure based on content typically ranks jobs based on skills required,
complexity of tasks, problem solving, and/or responsibility.
o Value—refers to the worth of the work: its relative contribution to the
organization objectives.
Use Value and Exchange Value
o Use value reflects the value of goods or services an employee produces in a job.
▪ Similar job content in two different companies may be valued differently
based on how it contributes to organization objectives.
Job- and Person-Based Structures
o A job-based structure relies on the work content—tasks, behaviors, and
responsibilities.
o A person-based structure shifts the focus to the employee—the skills,
Chapter Three: Defining Internal Alignment 3 – 6
performed as the criterion.
▪ GE Healthcare (Exhibit 3.2) uses the individual employees’
competencies/knowledge required at each level of work.
IV. What Shapes Internal Structures?
• Exhibit 3.4 categorizes the major factors that shape internal structures as external and
organization factors, even though they connect and interact.
A. Economic Pressures
• Adam Smith was an early advocate of letting economic market forces influence
pay structures.
o He was the first to ascribe both an exchange value and a use value to human
resources.
• Karl Marx said that employers unfairly pocketed the surplus value created by
the difference between use and exchange value.
• A countering theory put forth in the last half of the 19th century, marginal
productivity, says that employers do pay use value.
o Unless an employee can produce a value equal to the value received in
wages, it will not be worthwhile to hire that worker.
• In addition to supply and demand for labor, supply and demand for products and
services also affect internal pay structures.
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organizations and flexible employees.
B. Government Policies, Laws, and Regulations
• In the United States, equal employment legislation forbids pay systems that
discriminate on the basis of gender, race, religion, or national origin.
• The Equal Pay Act and the Civil Rights Act require “equal pay for equal work,”
• Much pay-related legislation attempts to regulate economic forces to achieve
social welfare objectives.
• But legislation also aims at differentials.
o A contemporary U.S. example is the “living wage.” A number of U.S. cities
require minimum hourly wage rates well above what federal law requires.
• The anticipated outcome of such legislation is a flatter, more compressed
structure of wage rates in society.
C. External Stakeholders
• Unions, stockholders, and political groups have a stake in how internal pay
structures are determined.
• Most unions seek smaller pay differences among jobs and seniority-based
promotions as a way to promote solidarity among members.
D. Cultures and Customs
• Culture is defined as, “the mental programming for processing information that
people share in common.” Shared mind-sets may judge what size pay
differential is fair.
o Plato declared societies strongest when the richest earned a maximum of
four times the lowest pay.
o Aristotle favored a five-times limit.
Chapter Three: Defining Internal Alignment 3 – 8
o President Roosevelt proposed a maximum wage: a 100% tax on all income
above 10 times the minimum wage.
• Historians note that in the 14th-century western Europe, the Christian church
endorsed a “just wage” doctrine, which supported the existing class structure.
o The doctrine was an effort to end the economic and social chaos resulting
• Even today, cultural factors play a role in shaping pay structures.
o Many traditional Japanese employers place heavy emphasis on experience in
E. Organization Strategy
• The belief is that pay structures that are not aligned with the organization
strategy may become obstacles to the organization’s success.
F. Organization Human Capital
• Human capital—education, experience, knowledge, abilities, and skills required
to perform the work—is a major influence on internal structures.
• The greater the value added by the skills and experience, the more pay those
skills will command.
G. Organization Work Design
• Technology used in producing goods and services influences the organizational
design, the work to be performed, and the skills/knowledge required to perform
the work.
• The design of organizations is undergoing profound changes.
▪ They might either be a supplier or a temporary work supplier. Or, they
may be working under a temporary contract for a limited amount of time
or on a limited project.
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▪ These employees may be supplied by outsourcing specialists. Pay for
these employees is based on the internal structure of their home
employer rather than of the workplace at which they are currently
located.
H. Overall HR Policies
• The organization’s other human resource policies also influence internal pay
structures.
• Most organizations tie money to promotions to induce employees to apply for
higher-level positions.
o If an organization has more levels, it can offer more promotions, but there
I. Internal Labor Markets: Combining External and Organization Factors
• Internal labor markets refer to rules and procedures that
1. Determine the pay for the different jobs within a single organization and
2. Allocate employees among the different jobs.
• External factors are dominant influences on pay for entry jobs, but the
differences for nonentry jobs tend to reflect internal factors.
J. Employee Acceptance: A Key Factor
• Employees judge the fairness of their pay through comparisons with the
compensation paid to others for work related in some fashion to their own.
Chapter Three: Defining Internal Alignment 3 – 10
▪ Researchers report that employees’ perceptions of procedural fairness
▪ This research also suggests that pay procedures are more likely to be
perceived as fair:
2. If employees participated in the process,
4. If the data used are accurate.
▪ Applied to internal structures, procedural justice addresses how design
and administration decisions are made and whether procedures are
applied in a consistent manner.
o Distributive justice—the results of the procedures, i.e., the pay structure
itself.
K. Pay Structures Change
• Pay structures change in response to external factors such as skill shortages.
• Pay structures established for organizational and economic reasons at an earlier
time may be maintained for cultural or political reasons. It may take another
economic jolt to overcome the resistance to change the pay structure.
• This “change-and-congeal” process does not yet support the continuous changes
occurring in today’s economy.
• New norms for employee acceptance will probably need to include recognition
that people must get used to constant change, even in internal pay structures.
o Pay for airport security screeners relative to other airport jobs illustrates the
change-and-congeal process.
V. Strategic Choices in Designing Internal Structures
• Aligned pay structures support the way the work gets done, fit the organization’s
business strategy, and are fair to employees.
• Greater internal alignment—fit—is more likely to lead to success. Misaligned
3 – 11 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
Copyright © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
structures become obstacles. They may still motivate employee behavior, but it may be
undesirable behavior.
• Two strategic choices are involved in internally aligning pay structures:
1. How to specifically tailor the organization design and work flow to make the
structure?
2. How to distribute pay throughout the levels in the structure?
A. Tailored versus Loosely Coupled
• A low-cost, customer-focused business strategy may be supported by a closely
tailored structure.
o Jobs are well defined with detailed tasks or steps to follow. Their pay
• A business strategy that requires constant product innovation and short product-
design-to-market cycle times many be supported by a loosely coupled structure.
o Such businesses may have a turbulent and unpredictable competitive
environment. No steps at all are laid out.
B. Hierarchical versus Egalitarian and Layered versus Delayered Structures
• Exhibit 3.6 clarifies the differences between hierarchical and egalitarian pay
structures.
• Egalitarian structures have fewer levels and/or smaller differentials between
adjacent levels and between the highest- and lowest-paid workers.
• Structures can also be said to vary from layered to delayered.
o In Exhibit 3.7, the layered structure has eight different levels, with relatively
small between-level differentials in comparison to the delayered structure,
which has three levels.