Compensation Management

Theories of Compensation and Role of Compensation

Employee compensation or remuneration is the payment an employee receives in return for his or her contribution to the organisation. Compensation occupies an important place in the life of an employee. His or her standard of living, status in the society, motivation, loyalty, and productivity depends upon the compensation he or she receives. For the employer too, employee compensation is significant because of its contribution to the cost of production.

Besides, many battles (in the form of strikes and lock-outs) are fought between the employer and the employees on issues relating to wages or bonus. For HRM too, employee compensation is a major function. The HR specialist has a difficult task of fixing wages and wage differentials acceptable to employees and their leaders. A typical compensation of an employee comprises of financial as well as non-financial compensation.

Theories of Compensation

' Theories of Compensation '

Economic Theories

Economic theories of compensation provide guidance in formulation of wage policies. All economic theories are founded on assumptions about the relationships between the owners of land, labour and capital which are known as the factors of production. Economic theories of wages can be broadly classified as follows – Macro theories and Micro theories.

Macro Theories

Macro theories are essentially macro in nature because each attempts, in some way, to describe or account for the broad economic influences of society that affect the level of compensation of workers. Various macro theories are as follows –

(i) Subsistence Theory – David Ricardo developed the subsistence theory of wage. It is also known as the Iron Law of Wages or the Brazen law of Wages. This theory states that – “The labourers are paid to enable them to subsist and perpetuate the race without increase or diminution”. The theory was based on the assumption that if the workers were paid more than subsistence wage, their numbers would increase as they would procreate more; resulting in spurt in supply of labour and this would bring-down the rate of wages. If the wages fall below the subsistence level, the number of workers would decrease – as many would die of hunger, malnutrition, disease, cold, etc., and many would not marry, when that happened the wage rates would go-up.

(ii) Wage Fund Theory – Adam Smith developed this theory. His basic assumption was that wages are paid out of a predetermined fund of wealth which lay surplus with wealthy persons – as a result of organisation savings. This fund could be utilised for employing labourers for work. If the fund was large, wages would be high; if it was small, wages would be reduced to the subsistence level. The demand for labour and the wages that could be paid by them were determined by the size of the fund. Francis A. Walker attacked the wage fund theory. He argued that wages were paid out of the product of labour and not from some previously accumulated capital. It is production that furnishes true measure of wages. This theory is further explained by John Stuart Mill. According to him, wages depend upon two quantities –

  • Wage fund or the circulating capital set aside for the purchase of services of labourers; and
  • The number of labourers seeking employment.

(iii) Supply and Demand Theory – This theory in economics relates to the laws of supply and demand. In essence this assumes that employers pay enough to recruit and retain employees, but avoid paying too much since that adds unnecessarily to labour costs and may make a business uncompetitive in the marketplace.

Supply and demand theory, however, is based on the premises that ‘other things are equal’ and that a ‘perfect market’ for labour exists. In the real world, of course, other things are never equal and there is no such thing as a universally perfect market, i.e., one in which everyone knows what the going rate is, there is free movement of labour within the market and there are no monopolistic or other forces interfering with the normal processes of supply and demand. The existence of internal markets means that individual firms exercise a good deal of discretion about how much they pay and how much attention they give to external market pressures.

(iv) Residual Claimant Theory – The residual claimant theory is a version of wage fund theory. It has been advanced by the American economist Francis A. Walker. He hypothesized that the wage fund was derived not from previous year’s operations, but simply from residue of the total revenues after deducting all other legitimate expenses of business operations, such as, rent, taxes, interest, and profits. According to this theory, after all other factors of production have received compensation for their contribution to the process, the amount of capital left over will go to the remaining factor. Following this through to its logical conclusion, if the “other expenses” consumed all of the revenue, labour, being the “residual claimant”, would receive no wages and presumably would not be entitled to them.

(v) National Income Theory – In the 1930s, John Maynard Keynes developed the national income theory. It is also known as Full Employment Wage Theory. This theory states that full employment is a function of national income. National income in turn, is equal to the total of consumption plus private or public investment. If the national income falls below a level that commands full employment, it is the responsibility of the Federal Government to manipulate any or all of the three variables to increase national income and return to full employment.

(vi) Neo-Keynesian Distribution Theory – It is a modified version of the national income theory. It explains how full employment conditions can be achieved without conflicting with general living standards or with stable prices. It also recognises the fact that entrepreneurial decisions can determine the general level of wages in the short-run. Money wage rates, within limits, are determined by bargaining between the capitalist and the employee. This theory acknowledges that economic forces alone do not determine the wage level.

(vii) Consumption/Purchasing Power Theory – The wage theories got closely associated with the employment practices. It concerns the relation between wages and employment and the business cycle. According to this theory, wage increases are desirable because they raise labour income, thereby stimulating consumption. Since wage earners spend a very large proportion of their incomes, it is held that higher wages will result in a rise in consumer spending and thus act to sustain or to stimulate the economy.

(viii) Investment Theory – This theory proposed that labour markets vary in the scope of ‘worker investment’ required for their particular industry. Generally, the wider the labour market is, the higher the wages are. The individual worker’s ‘investments’ consist of the education, training, and experience that the worker has invested in a lifetime of work. Individual workers vary in their desire to maximise income, just as employing organisations vary in their worker investment requirements.

Micro Theories

Following theories have been termed “micro” because they treat the wage structure within a given industry or even a given company, directly involving the bargain and the exchange between employer and employee. Various micro theories are as follows –

(i) Human Capital Theory – Concepts of human capital are significant to reward managers since the focus is switched from viewing pay and benefits as costs to be minimised to one in which the organisation is seen to invest in the employee. Hence, it is in the interests of both employee and employer to increase skill levels and to retain these in the business. In an analysis based on the 1998 Workplace Employee Relations Survey, Forth and Millward find some evidence that pay increases are larger when there is evidence of ‘some form of up-skilling’ of the workforce. However, the evidence is not clear-cut. Human capital theory as stated by Ehrenberg and Smith – “Conceptualises workers as embodying a set of skills which can be ‘rented-out to employers. The knowledge and skills a workder has – which come from education and training, worker has including the training that experience brings – generate a certain stock of productive capital.”

For an employee, the returns on human capital investment are a higher level of earnings, greater job satisfaction and, at one time, if less so now, the belief that security of employment is assured. For the employer the return on investment in human capital is improved performance, productivity, flexibility, and the capacity to innovate resulting from an enlarged skill base and increasing levels of competence.

(ii) Bargaining Theory – According to this theory, wages are determined by the relative bargaining power of workers or trade unions and of employers. When a trade union is invoived, basic wages, fringe benefits, job differentials, and individual differences tend to be determined by the relative strength of the organisation and the trade union. The bargaining theory of wages holds that wages, hours, and working conditions are determined by the relative bargaining strength of the parties to the agreement. Smith hinted at such a theory when he noted that employers had greater bargaining strength than employees. Employers were in a better possible to unify their opposition to employee demands, and employers were also able to withstand the loss of income for a longer period than could the employees. This idea was developed to a considerable extent by

John Davidson, who proposed in The Bargain Theory of Wages that the determination of wages is an extremely complicated process involving numerous influences that interact to establish he relative bargaining strength of the parties. This theory is applicable whether wages are being set by collective agreement or otherwise, i.e., individually.

(iii) Marginal Productivity Theory – The theory has been propounded by economists like Philips Henry and J.B. Clark. According to this theory, wages are based upon an entrepreneur’s estimate of the value that will probably be produced by the last or marginal worker. In other words, it assumes that wages depend upon the demand for, and supply of, labour. Consequently, workers are paid what they are economically worth. The result is that the employer has a larger share in profit as has not to pay to the non-marginal workers. As long as each additional worker contributes more to the total value than the cost in wages, it pays the employer to continue hiring; where this becomes uneconomic, the employer may resort to superior technology.

(iv) Productive Efficiency Theory – This is an offshoot, or refinement, of the marginal productivity theory in that each worker is provided the opportunity to increase his or her wages by increasing his or her productive efficiency. This theory provides the basis for an array of monetary motivational tools, such as, incentives systeins, bonuses, and profit-sharing plans. Many economists feel that because of its realistic application, the productivity theory is the most constructive of recent wage theories.

Behavioural theories

Behavioural theories revolve around the concept that organisations offer better compensation to deter undesirable behaviour by making a job too good to lose. Prominent behavioural theories are explained below –

(1) Employee’s Acceptance of a Wage Level – This type of thinking takes into consideration the factors, which may induce an employee to stay on with a company. The size and prestige of the company, the Behavioural Theories of the union, the wages, and benefits that the employee all have power receives in proportion to the contribution made by him their impact. Thus, compensation is viewed as more than providing for livelihood and includes other inducements to accept or continue employment.

(2) Internal Wage Structure – Social norms, traditions, customs prevalent in the organisation and psychological pressures on the management, the prestige attached to certain jobs in terms of social status, the need to maintain internal consistency in wages at the higher levels, the ratio of the maximum and minimum wage differentials, and the norms of span of control, and demand for specialised labour, all affect the internal wage structure of an organisation. Thus, this. theory implies that compensation is an internal structural issue of the organisation which is influenced by market and social factors. means of.

(3) Wage and Motivators – Money often is looked upon as means of fulfilling the most basic needs of man. Food, clothing, shelter, transportation, insurance, pension plans, education, and other physical maintenance and security factors are made available through the purchasing power provided by monetary income. Thus, performance-based rewards such as merit increases, bonuses, commissions, stock options, etc., are required to motivate employees.

(4) Tournament Theory – This model was developed by Lazear and Rosen and it focuses on an organisation’s hierarchy as an incentive instrument. This model compares life in an organisation to a sporting match, for example, a golf tournament. Each round in the tournament represents a competition for a position at a higher job level. All contestants are ranked based on their performance. The winner(s) will go on to the next round. The advantage of tournaments to an employer is that it is often easier to observe relative performance than absolute performance.

Additionally, it may be in the interests of the organisation to structure pay so that uie winner makes very large sums as a way of spurring on those lower in the hierarchy as well as giving the CEO himself the incentive to perform well. The ultimate carrot and reward in tournament theory is the possibility of becoming the Chief Executive Officer (CEO). Thus, tournament theory provides one possible explanation for the high cơmpensation of employees and more generally, compensation differential within organisations. It helps and distinguishing poor from good employees. limit costly labour organisations to turnover

Role of Compensation

(1) Helps in Attracting Talent – The compensation packages that businesses offer to employees play an important role in the company’s ability to attract top talent as job candidates. Top- performing employees greatly impact the competitiveness and productivity of a business. The specific components of an attractive compensation package vary per employee. A high base salary may attract a top job candidate that is young and single, while a job candidate with a family may consider a flexible work schedule extremely important. Therefore, recruiters should research a job candidate’s current or prior salary and benefits to get an idea of what is important to the candidate. 

(2) Acts as Source of Organisational Effectiveness – Organisational effectiveness be obtained only from high-performing employees. High-performing employees can make other resources perform highly. Remuneration is a proven and established means of stimulating employees to perform exceedingly well. 

(3) Serves as Medium between Organisation and Employees – Remuneration has the capacity to perform the role of a medium as it brings organisation and its employees together. Therefore, successful management of remuneration is important to both organisation and its employees.

(4) Helps in Retaining Employees – Retaining productive employees is critical to running a successful business. Retaining employees saves companies money in training costs and helps to maintain an efficient and knowledgeable workforce. Health insurance and retirement packages are benefits that many employees desire from their employers. Companies that offer these benefits have a much better chance of retaining workers than businesses that fail to offer benefit packages. Other ways to retain employees is through regular promotions, which not only provides an employee with a higher base salary, but also the ability to take on more responsibility in the workplace.

(5) Motivates Employees for Better Performance – Remuneration is a dynamic instrument. It not only creates opportunities for fulfilment of motivational needs, but also enhances the intensity of motivation. This means, employee motivation doubles every time he/she is suitably rewarded. Enhanced motivation leads to higher performance, which in turn leads to higher rewards.

(6) Helps to Differentiate between Good and Poor Performers – General performance profile of a typical organisation consists of a marginal percentage of high performers and low performers, and majority of average performers. Performance of average employees can be enhanced through suitably rewarding high performers and depriving reward from low-performing employees. This remuneration distinction not only helps to manage different performers differently, but also facilitates average performers to become high performers.

(7) Stimulates Employee Involvement – Employee involvement, participation and empowerment studies sufficiently establish that performance excellence can come from employees who are totally involved with organisation. This involvement can be obtained only by creating opportunities for employees to involve themselves in organisational management. Remuneration is one potential source that can be effectively tapped for creating these avenues of involvement.

(8) Strengthens Organisational Competitiveness – Organisational competitiveness comes from sheer performance capacity of organisations. This capacity can be sharply evident when organisations encounter situations of crisis. Therefore, any organisation that intends to strengthen its competitiveness must first focus on implementing a suitable remuneration system.

(9) Maintains Organisational Harmony – Remuneration that is managed well can be a great source of organisational harmony, which is a prerequisite for great employee and organisational performance.

About the author

Sarvesh Arora

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