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Bases for Traditional Pay System & Modern Pay System and Establishing Pay Plans
By Dr. G C Mohanta, BE, MSc (Engg.), MBA, PhD (Mgt.), Professor, Al-Qurmoshi
Institute of Business Management, Hyderabad, India
Bases for Traditional Pay System:
The traditional pay system is based on:
➢ Cost of living and labour market
➢ Base wage or salary
➢ Evenly distributed between employees
➢ Correlated with seniority
➢ Individual performance
Bases for Modern Pay System:
The modern pay system is based on:
➢ Variable pay
➢ Based on business performance
➢ Differentiated
➢ Based on individual performance
➢ Based on team and organisational performance
➢ Used as a means of communicating values
Traditional Pay System
Traditional Pay Systems sets pay levels in a narrow band with regular annual increases. There
may be 3 to 4 percent pay increase annually. Increases are meant for promotions, merit, cost of
living, etc. There is less distinction between merit increases and cost of living increases.
Because of the low levels (3 to 4 percent) of salary budget funding, most merit raises are
perceived as little more than cost of living increases. This "base pay" system is one that most
people are familiar with. Often, it includes a set salary or wage, a set schedule for merit
increases, and a set benefits package.
Modern Pay System
Modern Pay System pays greater emphasis on variable pay, rather than an automatic increase
each year. In other words, the base wage is seen as what the job is worth on the open market
(determined by surveys, supply and demand, specialty, etc.), while merit pay is a reward for the
results by employee each year. With this system, an employee can get a raise either by increasing
his job's value or by performing well.
Some companies are using a three-way system to determine annual increases: Did the employee
accomplish his goals? Did the company reach its targets? Did the employee act in accordance
with the established competencies for his job?
Some companies are creating broader bands in their salary structures. In the past, large
companies had many complicated salary levels in each department, which made it difficult for
employees to move to different jobs because they would have to take a pay cut. For example, by
creating 5 large bands, rather than 25 narrow bands, employees can seek more opportunities in
other areas of the company without penalty.
Additionally there are bonuses, team based incentive/gain sharing, profit sharing, quality awards,
stock purchase options, etc. in Modern Pay System.
Establishing Pay Plans
Objectives of Compensation Management:
The basic objective of compensation management can be briefly termed as meeting the needs of
both employees and the organization. Since both these needs emerge from different sources,
often, there is a conflict between the two. This conflict can be understood by agency theory
which explains relationship between employees and employers. The theory suggests that
employers and employees are two main stakeholders in a business unit, the former assuming the
role of principals and the latter assuming the role of agents. The compensation paid to employees
is agency consideration.
Each party to agency tries to fix this consideration in its own favour. The employers want to pay
as little as possible to keep their costs low. Employees want to get as high as possible. The
compensation management tries to strike a balance between these two with following specific
objectives:
Attracting and Retaining Personnel:
From organization’s point of view, the compensation management aims at attracting and
retaining right personnel in the organization. In the Indian corporate scene, there is no dearth of
personnel at operative levels but the problems come at the managerial and technical levels
particularly for growing companies. Not only they require persons who are well qualified but
they are also retained in the organization. In the present day context, managerial turnover is a big
problem particularly in high knowledge based organizations.
Motivating Personnel:
Compensation management aims at motivating personnel for higher productivity. Monetary
compensation has its own limitations in motivating people for superior performance. Alfie Kohn
has gone to the extent of arguing that corporate incentive plans not only fail to work as intended
but also undermine the objectives they intend to achieve. He argues that this is due to inadequate
psychological assumptions on which reward systems are based. His conclusions are as follows:
• Rewards punish people - their use confirms that someone else is in control of the
employee.
• Rewards rupture relationships - they create competition where teamwork and
collaboration are desired.
• Rewards ignore reasons - they relieve managers from the urgent need to explore why an
employee is effective or ineffective.
• Rewards discourage risk taking - employees tend to do exactly what is required to earn
the reward, and not any more.
• Rewards undermine interest - they distract both manager and the employee from
consideration of intrinsic motivation.
Notwithstanding these arguments, compensation management can be designed to motivate
people through monetary compensation to some extent.
Optimizing Cost of Compensation:
Compensation management aims at optimizing cost of compensation by establishing some kind
of linkage with performance and compensation. It is not necessary that higher level of wages and
salaries will bring higher performance automatically but depends on the kind of linkage that is
established between performance and wages and salaries. Compensation management tries to
attempt at this.
Consistency in Compensation:
Compensation management tries to achieve consistency - both internal and external - in
compensating employees. Internal consistency involves payment on the basis of criticality of
jobs and employees' performance on jobs. Thus, higher compensation is attached to higher-level
jobs. Similarly, higher compensation is attached to higher performers in the same job.
Level of jobs within an organization is determined by job evaluation. External consistency
involves similar compensation for a job in all organizations. Though there are many factors
involved in the determination of wage and salary structure for a job in an organization which
may result into some kind of disparity in the compensation of a particular job as compared to
other organizations, compensation management tries to reduce this disparity.
Compensation Management Process:
In order to achieve the objectives of compensation management, it should proceed as a process.
This process has various sequential steps as shown:
- Organization’s strategy
- Compensation policy
- Analysis of contingent factors
- Design and implementation of compensation plan
- Evaluation and review
Organization’s Strategy:
Organization’s overall strategy though not a step of compensation management, is the starting
point in the total human resource management process including compensation management.
Companies operating in different types of market/product having varying level of maturity, adopt
different strategies and matching compensation strategy and blend of different compensation
methods. Thus, it can be seen that organizations follow different strategies in different market
situations and align their compensation strategy and contents with these strategies.
In a growing market, an organization can expand its business through internal expansion or
takeover and merger of other organizations in the same line of business or a combination of both.
In such a growing market, the inputs, particularly human resources, do not grow in the same
proportion as the business expands. Therefore, in order to make the growth strategy successful,
the organization has to pay high cash to attract talents. For example, information technology is a
fast growing business presently and we find maximum merger and higher managerial
compensation in this industry.
In mature market, the organization does not grow through additional investment but stabilizes
and the growth comes through making the present investment more effective, known as learning
curve growth. In such a situation, average cash and moderate incentives may work. The benefits
which have been standardized have to be maintained.
In the declining market, the organization has to harvest profit through cash generation and cost
cutting and if this cannot be sustained over the long run, the possible retrenchment of business to
invest somewhere else. In such a case, compensation strategy involves cost control with below
average cash and incentive payments.
Cascio has observed that in viewing the compensation from strategic point of view, the
companies do the following:
- They recognize remuneration as a pivotal control and incentive mechanism that can be used
flexibly by the management to attain business objectives.
- They make the pay system an integral part of strategy formulation.
- They integrate pay considerations into strategic decision making processes, such as those that
involve planning and control.
- They view the company's performance as the ultimate criterion of the success of the strategic
pay decisions and operational remuneration programmes.
Management Strategy
This relates to the basic existence of any organization its objectives and goals i.e. vision and
mission of the enterprise, for which human resources are hired, and the organization pays to its
employees to keep them motivated for accomplishing those set objectives in a cost effective
manner.
Business Strategy – This defines the direction in which organization is going in relation to its
environment in order to achieve its objectives.
Compensation Philosophy consists of a set of beliefs which underpin the reward/ compensation
strategy of the organization and govern the reward policies that determine how reward processes
operate.
Compensation Strategy defines the intentions of the organization on reward policies, processes
and practices required to ensure that it has the skilled, competent and well-motivated workforce
it needs to achieve its business goals. A strategic perspective on compensation takes the position
that how employees are compensated can be a source of sustainable competitive advantage.
Compensation strategies can affect many facts of the business. Such as:
 Improved employee morale and retention
 Increased employee engagement and productivity
 Strengthened governance and compliance with company vision and mission
HR Strategy is aligning the goals of HR to the goals or strategy of the organisation; recruitment,
retention and termination are a small part of it. In developing HR strategy two critical questions
must be addressed.
What kinds of people do we need to manage and run our business to meet our strategic
business objectives?
What people programs and initiatives must be designed and implemented to attract,
develop and retain staff to compete effectively?
In order to answer these questions four key dimensions of an organization must be addressed.
These are:
Culture: the beliefs, values, norms and management style of the organization
Organization: the structure, job roles and reporting lines of the organization
People: the skill levels, staff potential and management capability
Human resources systems: the people focused mechanisms which deliver the strategy -
employee selection, communications, training, rewards, career development, etc.
Compensation Policy:
Compensation policy is derived from organizational strategy and its policy on overall
human resource management. In order to make compensation management to work
effectively, the organization should clearly specify its compensation policy, which must
include the basis for determining base compensation, incentives and benefits and various
types of perquisites to various levels of employees. The policy should be linked with the
organizational philosophy on human resources and strategy.
Besides, many external factors which impinge on, the policy must also be taken care of
Job Analysis and Evaluation. Job analysis provides basis for defining job description and
job specification with the former dealing with various characteristics and responsibilities
involved in a job and the latter dealing with qualities and skills required in job performer.
Job analysis also provides base for job evaluation which determines the relative worth of
various jobs in the organization. The relative worth of various jobs determines the
compensation package attached with each job.
Analysis of Contingent Factors:
Compensation plan is always formulated in the light of various factors, both external and
internal, which affect the operation of human resource management system. Various
external factors are: conditions of human resource market, cost of living, level of
economic development, social factors, pressure of trade unions and various labour laws
dealing with compensation management. Various internal factors are: organization’s
ability to pay and employees' related factors such as work performance, seniority, skills,
etc. These factors may be analyzed through wage/salary survey.
Design and Implementation of Compensation Plan:
The organization may be able to design its compensation plan incorporating base
compensation with provision of wage/salary increase over the period of time, various
incentive plans, benefits and perquisites. Sometimes, these are determined by external
party, for example, pay commissions for Government employees as well as for public
sector enterprises. After designing the compensation plan, it is implemented.
Implementation of compensation plan requires its communication to employees and
putting this into practice.
Evaluation and Review:
A compensation plan is not a rigid and fixed one but is dynamic since it is affected by a
variety of factors which are dynamic. Therefore, compensation management should have
a provision for evaluating and reviewing the compensation plan. After implementation of
the plan, it will generate results either in terms of intervening variables like employee
satisfaction and morale or in terms of end result variable like increase of productivity.
However, this latter variable is more important. The evaluation of compensation plan
must be done in this light. If it does not work as intended, there should be review of the
plan necessitating a fresh look.

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Bases for traditional pay system & modern pay system and establishing pay plans

  • 1. Bases for Traditional Pay System & Modern Pay System and Establishing Pay Plans By Dr. G C Mohanta, BE, MSc (Engg.), MBA, PhD (Mgt.), Professor, Al-Qurmoshi Institute of Business Management, Hyderabad, India Bases for Traditional Pay System: The traditional pay system is based on: ➢ Cost of living and labour market ➢ Base wage or salary ➢ Evenly distributed between employees ➢ Correlated with seniority ➢ Individual performance Bases for Modern Pay System: The modern pay system is based on: ➢ Variable pay ➢ Based on business performance ➢ Differentiated ➢ Based on individual performance ➢ Based on team and organisational performance ➢ Used as a means of communicating values Traditional Pay System Traditional Pay Systems sets pay levels in a narrow band with regular annual increases. There may be 3 to 4 percent pay increase annually. Increases are meant for promotions, merit, cost of living, etc. There is less distinction between merit increases and cost of living increases. Because of the low levels (3 to 4 percent) of salary budget funding, most merit raises are perceived as little more than cost of living increases. This "base pay" system is one that most people are familiar with. Often, it includes a set salary or wage, a set schedule for merit increases, and a set benefits package. Modern Pay System Modern Pay System pays greater emphasis on variable pay, rather than an automatic increase each year. In other words, the base wage is seen as what the job is worth on the open market (determined by surveys, supply and demand, specialty, etc.), while merit pay is a reward for the results by employee each year. With this system, an employee can get a raise either by increasing his job's value or by performing well.
  • 2. Some companies are using a three-way system to determine annual increases: Did the employee accomplish his goals? Did the company reach its targets? Did the employee act in accordance with the established competencies for his job? Some companies are creating broader bands in their salary structures. In the past, large companies had many complicated salary levels in each department, which made it difficult for employees to move to different jobs because they would have to take a pay cut. For example, by creating 5 large bands, rather than 25 narrow bands, employees can seek more opportunities in other areas of the company without penalty. Additionally there are bonuses, team based incentive/gain sharing, profit sharing, quality awards, stock purchase options, etc. in Modern Pay System. Establishing Pay Plans Objectives of Compensation Management: The basic objective of compensation management can be briefly termed as meeting the needs of both employees and the organization. Since both these needs emerge from different sources, often, there is a conflict between the two. This conflict can be understood by agency theory which explains relationship between employees and employers. The theory suggests that employers and employees are two main stakeholders in a business unit, the former assuming the role of principals and the latter assuming the role of agents. The compensation paid to employees is agency consideration. Each party to agency tries to fix this consideration in its own favour. The employers want to pay as little as possible to keep their costs low. Employees want to get as high as possible. The compensation management tries to strike a balance between these two with following specific objectives: Attracting and Retaining Personnel: From organization’s point of view, the compensation management aims at attracting and retaining right personnel in the organization. In the Indian corporate scene, there is no dearth of personnel at operative levels but the problems come at the managerial and technical levels particularly for growing companies. Not only they require persons who are well qualified but they are also retained in the organization. In the present day context, managerial turnover is a big problem particularly in high knowledge based organizations. Motivating Personnel: Compensation management aims at motivating personnel for higher productivity. Monetary compensation has its own limitations in motivating people for superior performance. Alfie Kohn has gone to the extent of arguing that corporate incentive plans not only fail to work as intended but also undermine the objectives they intend to achieve. He argues that this is due to inadequate psychological assumptions on which reward systems are based. His conclusions are as follows:
  • 3. • Rewards punish people - their use confirms that someone else is in control of the employee. • Rewards rupture relationships - they create competition where teamwork and collaboration are desired. • Rewards ignore reasons - they relieve managers from the urgent need to explore why an employee is effective or ineffective. • Rewards discourage risk taking - employees tend to do exactly what is required to earn the reward, and not any more. • Rewards undermine interest - they distract both manager and the employee from consideration of intrinsic motivation. Notwithstanding these arguments, compensation management can be designed to motivate people through monetary compensation to some extent. Optimizing Cost of Compensation: Compensation management aims at optimizing cost of compensation by establishing some kind of linkage with performance and compensation. It is not necessary that higher level of wages and salaries will bring higher performance automatically but depends on the kind of linkage that is established between performance and wages and salaries. Compensation management tries to attempt at this. Consistency in Compensation: Compensation management tries to achieve consistency - both internal and external - in compensating employees. Internal consistency involves payment on the basis of criticality of jobs and employees' performance on jobs. Thus, higher compensation is attached to higher-level jobs. Similarly, higher compensation is attached to higher performers in the same job. Level of jobs within an organization is determined by job evaluation. External consistency involves similar compensation for a job in all organizations. Though there are many factors involved in the determination of wage and salary structure for a job in an organization which may result into some kind of disparity in the compensation of a particular job as compared to other organizations, compensation management tries to reduce this disparity. Compensation Management Process: In order to achieve the objectives of compensation management, it should proceed as a process. This process has various sequential steps as shown: - Organization’s strategy - Compensation policy - Analysis of contingent factors - Design and implementation of compensation plan - Evaluation and review Organization’s Strategy:
  • 4. Organization’s overall strategy though not a step of compensation management, is the starting point in the total human resource management process including compensation management. Companies operating in different types of market/product having varying level of maturity, adopt different strategies and matching compensation strategy and blend of different compensation methods. Thus, it can be seen that organizations follow different strategies in different market situations and align their compensation strategy and contents with these strategies. In a growing market, an organization can expand its business through internal expansion or takeover and merger of other organizations in the same line of business or a combination of both. In such a growing market, the inputs, particularly human resources, do not grow in the same proportion as the business expands. Therefore, in order to make the growth strategy successful, the organization has to pay high cash to attract talents. For example, information technology is a fast growing business presently and we find maximum merger and higher managerial compensation in this industry. In mature market, the organization does not grow through additional investment but stabilizes and the growth comes through making the present investment more effective, known as learning curve growth. In such a situation, average cash and moderate incentives may work. The benefits which have been standardized have to be maintained. In the declining market, the organization has to harvest profit through cash generation and cost cutting and if this cannot be sustained over the long run, the possible retrenchment of business to invest somewhere else. In such a case, compensation strategy involves cost control with below average cash and incentive payments. Cascio has observed that in viewing the compensation from strategic point of view, the companies do the following: - They recognize remuneration as a pivotal control and incentive mechanism that can be used flexibly by the management to attain business objectives. - They make the pay system an integral part of strategy formulation. - They integrate pay considerations into strategic decision making processes, such as those that involve planning and control. - They view the company's performance as the ultimate criterion of the success of the strategic pay decisions and operational remuneration programmes. Management Strategy This relates to the basic existence of any organization its objectives and goals i.e. vision and mission of the enterprise, for which human resources are hired, and the organization pays to its employees to keep them motivated for accomplishing those set objectives in a cost effective manner. Business Strategy – This defines the direction in which organization is going in relation to its environment in order to achieve its objectives.
  • 5. Compensation Philosophy consists of a set of beliefs which underpin the reward/ compensation strategy of the organization and govern the reward policies that determine how reward processes operate. Compensation Strategy defines the intentions of the organization on reward policies, processes and practices required to ensure that it has the skilled, competent and well-motivated workforce it needs to achieve its business goals. A strategic perspective on compensation takes the position that how employees are compensated can be a source of sustainable competitive advantage. Compensation strategies can affect many facts of the business. Such as:  Improved employee morale and retention  Increased employee engagement and productivity  Strengthened governance and compliance with company vision and mission HR Strategy is aligning the goals of HR to the goals or strategy of the organisation; recruitment, retention and termination are a small part of it. In developing HR strategy two critical questions must be addressed. What kinds of people do we need to manage and run our business to meet our strategic business objectives? What people programs and initiatives must be designed and implemented to attract, develop and retain staff to compete effectively? In order to answer these questions four key dimensions of an organization must be addressed. These are: Culture: the beliefs, values, norms and management style of the organization Organization: the structure, job roles and reporting lines of the organization People: the skill levels, staff potential and management capability Human resources systems: the people focused mechanisms which deliver the strategy - employee selection, communications, training, rewards, career development, etc. Compensation Policy: Compensation policy is derived from organizational strategy and its policy on overall human resource management. In order to make compensation management to work effectively, the organization should clearly specify its compensation policy, which must include the basis for determining base compensation, incentives and benefits and various types of perquisites to various levels of employees. The policy should be linked with the organizational philosophy on human resources and strategy. Besides, many external factors which impinge on, the policy must also be taken care of Job Analysis and Evaluation. Job analysis provides basis for defining job description and job specification with the former dealing with various characteristics and responsibilities involved in a job and the latter dealing with qualities and skills required in job performer. Job analysis also provides base for job evaluation which determines the relative worth of
  • 6. various jobs in the organization. The relative worth of various jobs determines the compensation package attached with each job. Analysis of Contingent Factors: Compensation plan is always formulated in the light of various factors, both external and internal, which affect the operation of human resource management system. Various external factors are: conditions of human resource market, cost of living, level of economic development, social factors, pressure of trade unions and various labour laws dealing with compensation management. Various internal factors are: organization’s ability to pay and employees' related factors such as work performance, seniority, skills, etc. These factors may be analyzed through wage/salary survey. Design and Implementation of Compensation Plan: The organization may be able to design its compensation plan incorporating base compensation with provision of wage/salary increase over the period of time, various incentive plans, benefits and perquisites. Sometimes, these are determined by external party, for example, pay commissions for Government employees as well as for public sector enterprises. After designing the compensation plan, it is implemented. Implementation of compensation plan requires its communication to employees and putting this into practice. Evaluation and Review: A compensation plan is not a rigid and fixed one but is dynamic since it is affected by a variety of factors which are dynamic. Therefore, compensation management should have a provision for evaluating and reviewing the compensation plan. After implementation of the plan, it will generate results either in terms of intervening variables like employee satisfaction and morale or in terms of end result variable like increase of productivity. However, this latter variable is more important. The evaluation of compensation plan must be done in this light. If it does not work as intended, there should be review of the plan necessitating a fresh look.