Components of an effective compensation system? How is an underpaid employee likely to
Compensation is the reward an employee receives in exchange for performing the organisational
tasks. Compensation is Direct and Indirect.
Direct compensations are Wages, Salaries, Bonuses or Commission.
Indirect Compensation is Paid Leave, Insurance, Medical Benefits, Housing Allowance,
etc that are not a part of the direct compensation.
Components of effective compensation system:
Organisations have to have effective compensation policy to:
Acquire qualified personnel:
Compensation should be on par, if not better than prevailing industry rates in order to attract
Retain present employees:
Employees quit if compensation levels are not competitive.
Compensation should ensure internal equity, i.e. compensation should be related to relative
worth of jobs. External equity should be maintained by paying wages similar to those paid to
persons performing similar tasks in other companies. Internal equity should be maintained by
paying the employees with similar responsibilities, qualifications and experience similar salaries.
Reward desired behavior:
Compensation should reinforce desired behavior through increments and rewards and act as an
incentive for the behavior to occur again. Similarly withholding increments for poor performance
will ensure that the employee puts in more efforts.
For example: Many organisations appreciate the employee effort though Thank you cards for the
effort they have put in for the month. This invokes a sense of healthy competition among
employees and a positive work spirit. Also the methods of “Star of the month” which rate the
productivity and efficiency enable measuring the employee efficiency.
A rational compensation plan helps attract and retain employees at a reasonable cost. Without
proper structure the organisation may overpay or underpay the employees.
A compensation policy is effective if salaries and perquisites are:
Adequate: In line with what is paid in similar companies in the same geographical area.
Balanced: A reasonable combination of direct and indirect benefits
Cost effective: What the organisation can afford to pay.
Equitable: Commensurate with the effort put in and the ability used.
Incentive: Sufficient incentives are needed to motivate the employees to work effectively.
Secure: Sufficient to satisfy the employee’s basic need and make him feel secure
Factors affecting Compensation:
Supply and Demand:
The availability of people and the demand determine the “Going-Wage-Rate”. When the demand
is high and the availability low, salaries are high. When the availability exceeds the demand,
salaries are low.
Ability to pay:
If a company is doing well and has the ability to pay, the tendency is to raise the compensation
level. However if a company is highly successful, there is little need to pay far more than the
competitive rates to obtain good personnel. The company may choose to pay above competitive
rate to attract the best availability in the industry.
Cost of living:
The cost of living index does not determine the base compensation. It indicates what the rate of
increase in salary should be to keep up with the inflation so that employees’ real wages do not
Indirect benefits are employer provided rewards and services other than wages and salaries.
These benefits are provided for various reasons:
1. Keep wages and salaries low and hence obtain tax benefits
2. Make the salary package competitive to recruit and retain talent.
3. Act as motivators
4. Ensure long – term employment as some benefits are linked to time spent in an
Some other indirect benefits that companies offer are:
Insurance: employees are insured by the company for accident, disability/death.
Medical benefits: medical benefits are provided to the employees by the company through
Retirement benefits: retirement benefits like provident fund, gratuity, pension are provided for
retiring employees who have served for a long term.
Paid leave: Employees are given certain special leave like casual leave, privileged leave, medical
leave during which they receive their salary and full benefits. Certain number of days in a year
only is allotted for such benefits. Reimbursement for travel is also allotted in certain companies.
Other benefits: Benefits like assistance for housing, children education, marriage loans at low
interest are also provided. Other perks’ like telephone reimbursement etc are also some of the
benefits that certain organisation avails to the employees.