Compensation management

COMPENSATION MANAGEMENT

INTRODUCTION TO COMPENSATION

Importance of Pay

Pay represents by far the most important and contentious element in the employment relationship, and is of equal interest to the employer, employee and government -

• to the employer because it represents a significant part of his costs, is increasingly important to his employees' performance and to competitiveness, and affects his ability to recruit and retain a labour force of quality;

• to the employee because it is fundamental to his standard of living and is a measure of the value of his services or performance; • to the government because it affects aspects of macro-economic stability such as employment, inflation, purchasing power and socio-economic development in general.

While the basic wage or pay is the main component of compensation, fringe benefits and cash and non-cash benefits influence the level of wages or pay because the employer is concerned more about labour costs than wage rates per se. The tendency now is towards an increasing mix of fringe benefits, which therefore have an important impact on pay levels. In industrialized countries, and sometimes in countries with high personal tax rates, the non-pay element of executive compensation has substantially increased in recent years. Objectives of Pay

Pay determination may have one or more objectives, which may often be in conflict with each other. The objectives can be classified under four broad headings.

The first is equity, which may take several forms. They include income distribution through narrowing of inequalities, increasing the wages of the lowest paid employees, protecting real wages (purchasing power), the concept of equal pay for work of equal value. Even pay differentials based on differences in skills or contribution are all related to the concept of equity.

A second objective is efficiency, which is often closely related to equity because the two concepts are not antithetic. Efficiency objectives are reflected in attempts to link a part of wages to productivity or profit, group or individual performance, acquisition and application of skills and so on. Arrangements to achieve efficiency may be seen also as

being equitable (if they fairly reward performance) or inequitable (if the reward is viewed as unfair).

A third objective is macro-economic stability through high employment levels and low inflation, for instance. An inordinately high minimum wage would have an adverse impact on levels of employment, though at what level this consequence would occur is a matter of much debate. Though pay and pay policies are only one of the factors which impinge on macro-economic stability, they do contribute to (or impede) balanced and sustainable economic development.

A fourth objective is the efficient allocation of labour in the labour market. This implies that employees would move to wherever they receive a net gain; such movement may be from one geographical location to another, or from one job to another (within or outside an enterprise). Such movement is caused by the provision or availability of financial incentives. For example, workers may move from a labour surplus or low wage area to a high wage area. They may acquire new skills to benefit from the higher wages paid for skills. When an employer's wages are below market rates employee turnover increases. When it is above market rates the employer attracts job applicants. When employees move from declining to growing industries, an efficient allocation of labour due to structural changes takes place.

The need for a Compensation Strategy-For any / all of the following reasons:

1 To attract and retain the best in the industry

2 To have compensation strategy aligned to each business to better serve independent business needs

3 Should attract lateral hires

4 Need for greater flexibility in taking compensation decisions 5 Need to align employee career movement

6 Adding value through personnel costs

GOALS OF A COMPENSATION STRATEGY

1 Capable applicants are attracted towards the Organization and it helps acquire qualified competent personnel

2 To retain current employees so that they do not quit

 If compensation levels are not competitive, it will result in higher turnover

3 Motivate employees to perform better 4 Encourage value – added performance

5 Control costs

 Through a rational compensation system, employees can be obtained and retained at a reasonable cost

6 Promoting continuous development through competence – related and skill – based pay schemes, effective performance management

7 Promoting teamwork through team pay

8 Promoting flexibility by replacing hierarchical and rigid pay structures

9 Providing value for money by evaluating the costs as well as benefits of reward management practices

10 Facilitating easy understanding by all, including employees, operating managers and HR personnel

11 Providing value for money by evaluating the costs as well as benefits of reward management practices

12 Easy administration

CHARACTERSTICS OF A SOUND COMPENSATION STRATEGY

1 Be congruent with and support corporate values, beliefs, philosophy and culture

2 Emanate from business strategy and business plans (medium and long – term)

3 Fit the desired management style

4 Provide the competitive edge required; be based on an industry benchmarking study

5 Be based on an Organization’s ability to pay 6 Be adaptable to changing business conditions 7 Ensures Equity – both internally and externally

8 Complies with the legal regulations as imposed by the government

9 Is effectively communicated

10 Careful selection of performance measures, determination of performance awards and distribution mechanisms

11 Union participation and involvement in designing the policy to facilitate comprehension and acceptance

12 Provisions for modifications and periodically reviewed

A COMPENSATION STRUCTURE COMMUNICATES

1 Organization Philosophy / Culture 2 Career Progression

3 Benefits to Employees 4 Individual v/s Team Focus

5 Performance Recognition giving the message to align Total COMPENSATION with Business Situation, Needs & Goals

6 Generate Flexibility / Variability of Costs

7 Focus on Effectiveness of Total Compensation Policy

FACTORS INFLUENCING COMPENSATION POLICY

Philosophy Organization Mission, Vision, Goals & Values –

Inclination towards People Development, Attraction & Retention of Talent

Parity Inter / Intra Level Relativity, Compa Ratio Positioning Assess Competitiveness – Current & Targeted

Percentile Positioning Paying Ability Budget Considerations

FACTORS AFFECTING COMPENSATION POLICY EXTERNAL FACTORS

1. Parity: External equity (prevalent pay structures in industry / geographic location)

2. Demand and supply: of labour and market condition 3. Geographic location: cost of living and inflation

ORGANIZATION - RELATED

1. Philosophy: mission, vision, goals & values – inclination towards people development, attraction & retention of talent, goodwill & organization culture

2. Parity: internal equity (relevant differentiating factors performance, seniority, skills, responsibilities, interpersonal abilities, individual vs. Team vs. Organization roles)

3. Paying ability: budget considerations / financial

implications / limits of ability to pay; business performance

4. Legalities: compliance of statutory and government requirements

5. Trade unions: influence in collective bargaining

6. Fringe benefits: statutory (overtime payment, canteen subsidy, employee provident fund, gratuity) & non-statutory (conveyance allowance, LTA, loans, insurance)

INDIVIDUAL RELATED

1. Job – related: job requirements and internal consistency 2. Competition: availability of special competent personnel

3. Flexibility: due to varied levels of competencies and skills of managers

4. Responsibilities: individual productivity and performance / contribution to output

5. Individual assessment: qualifications and relevant experience

WHAT IS A COMPENSATION SYSTEM

Allocation, conversion, and transfer of a portion of the income of an organization to its employees for their monetary & in-kind claims on goods & services

A Monetary claims are wages or salaries paid to an employee in the form of money / or a form that is easily and quickly transferable to money at the discretion of the employee

1. Wages & salaries in the form of money could be 2 types: present payments (earned & acquired at present time) & deferred payments (earned but not acquired until some future time)

2. Coins / paper money / cheques, credit cards

3. Stock option plans / pension plans / post retirement income adjustments

B In-kind claims are claims on goods & services made available & paid for either totally or in some percentage by the employer

 in lieu of money provide an equivalent value for what has been offered & received

 little or no immediate monetary gain

 organizations purchase the usually desired goods & services to take advantage of –

1. Economies of scale available through group purchasing 2. The benefits available through tax laws & regulations 3. Government laws requiring certain services

NON-COMPENSATION SYSTEM

Situation – related rewards, related to the physical & psychological well – being of each employee, these rewards satisfy the emotional & intellectual demands

- Impact on the intellectual, emotional & physical well-being of the employee

8 DIMENSIONS OF COMPENSATION SYSTEM - PAY FOR WORK & PERFORMANCE

- money provided in short – term (weekly / monthly / annual bonuses & awards)

- permits employees to pay for goods & services desired

- depends on: job requirements; outputs that meet or exceed quantity, quality & timeliness standards;

innovations leading to improved productivity; dependability; loyalty

- includes: base pay, premiums & differentials, short – term bonuses, merit pay, travel expenses, clothing reimbursement etc

- PAY FOR TIME NOT WORKED

- days off with pay for holidays, longer paid vacations, election official, witness in court, paternity leave, maternity leave, time off to vote, personal leave, relocation payments, lunch & rest periods etc

- although they increase labour costs, but they enhance quality – of – work – life opportunities for most employees

- LOSS-OF-JOB INCOME CONTINUATION

- job security is a prime consideration

- loss of job could be due to any of the following: * accident

* sickness

* personal performance

* interpersonal dynamics problems * firm’s decline / end

- unemployment insurance, supplemental unemployment benefits (subs), severance pay, job contract etc help unemployed workers subsist until new employment opportunities arise

- DISABILITY INCOME CONTINUATION

- health or accident disability can lead to non – performance of normal assignments

- family expenses persist

- social security, workers’ compensation, sick leave, travel accident insurance, accidental death and dismemberment, short &

long-term disability plans are provided - DEFERRED INCOME

- providing income after retirement

- includes social security, pension plans, profit sharing (long term), stock option plans

- funds invested in these draw tax-free interest thus employees can defer tax obligations

- SPOUSE (FAMILY) INCOME CONTINUATION

- Providing dependents with income when an employee dies or is unable to work due to total and permanent disability

- life insurance plans, social security, pension plans, workers’ compensation

- HEALTH, ACCIDENT AND LIABILITY PROTECTION

- Income continuation & payment for the expenses incurred for overcoming the illness / disability

- wide variety of insurance plans available

dependents)

- major medical, dental & vision care. hearing aid, post-retirement medical plans, prescription drugs, visiting nurse

- liability – related insurance: group legal, group automobile, group umbrella liability, employee liability

- INCOME EQUIVALENT PAYMENTS

- Perks or perquisites

- tax free: charitable contributions, giving of gift, employee

assistance programs, counseling, child adoption, child / elderly

care, subsidized food service, discounts on merchandise, fitness programs, parking, commuting assistance (transportation to &

from work), fly first class, professional memberships, professional journals, special relocation & moving allowances, pay for spouse

on business trips, home entertainment allowance, domestic staff

allowance, mobile phone, use of assistant for personal services - Tax favoured: medical expense reimbursement, chauffeur – driven car, company plane / yacht, company provided facilities, personal use of credit cards, vacation accommodation, special loan arrangements, club membership, concierge services

DIMENSIONS OF NON-COMPENSATION SYSTEM

• Enhance dignity and satisfaction from work performed - Least expensive & most powerful rewards

- Employee recognition leads to self - worth & pride

- Employees should feel that they are needed & their efforts are being appreciated

• Enhance physiological health, intellectual growth, and emotional maturity

- Provide a safe working environment: provision of safe equipment, risk free environment, minimization of noxious fumes, avoidance of extreme heat, cold & humidity conditions, elimination of contact with radiation & other disease–related materials, reduced noise levels, clean workstation,

- stress & technological advancements – affect emotional well-being of the individual: providing a stable & secure lifestyle, training & development opportunities to overcome health-related problems

• Promote constructive social relationships with coworkers

- an inexpensive & valuable reward is a work environment where trust, fellowship & loyalty emanate from the top levels of management, percolating to the grassroots

- comradeship of workplace associates

- opportunity to develop productivity – promoting social relationships

- moving towards team – based operations

• Design jobs that require attention and effort - restructuring job tasks to make it challenging - sense of accomplishment from work

- job rotation to increase flexibility - turning supervisors to mentors

- making jobs more interesting & less repetitive

Organizations increase quality & productivity; reduce employee turnover, absenteeism, tardiness, waste of physical resources, theft & malicious damage

• Allocate sufficient resources to perform work assignments

- all necessary human, technical and physical resources should be made available to support & aid the employee in accomplishing

the assignment

- the organization must enable employees to gain the required skills & knowledge necessary to perform the assignment

- organization should do everything possible to assist the employee in completing the assigned work successfully

• Grant sufficient control over job to meet personal demands

− employee participation in decision-making process

− casual dress day

− scheduling work activities

− flexible work schedules: compressed workweeks, flextime programs, work from home choice

− job sharing (2 part-time employees share 1 full-time job)

• Offer supportive leadership & management

− employee faith & trust in management

− skill & interest in coaching & counseling of employees

− praise for a job well done

− constructive feedback leading to improvement in job performance

− sufficiently flexible leadership with policies, rules, regulations so that an employee can meet job responsibilities without infringing on rights & opportunities of other employees

TRADITIONAL COMPONENTS OF A COMPENSATION PROGRAM Fixed cash compensation

- largest component of the total compensation & rewards package

output / performance

- base wages & salaries – depends on the internal value (determined by job evaluation) & external value (through market pay surveys) of employee

- after-tax paycheck

- determines lifestyle of the employees

- leisure activities restricted / defined by the paycheck - most critical part of the four components

Wage & salary add-ons

- monetary remuneration

- paid over & above the salary

- includes payments for working overtime, shift differentials, premium pay for working on holidays / weekends - least critical of the four components

Incentive payments

- pay- for - output system

- performance pay – linked to both the company & the individual

- difficult to measure in the service industry which employs 70% of the workforce of the total employed people

- in several professions, it is difficult to measure output & pay incentives

Employee benefits & services

- hidden payroll or fringe benefits

- indirect financial & non-financial payments

- supplementary compensation totally dependent on organizational philosophy

- includes benefits provided by an employer to his employees & his family (in some cases)

- benefits for employment security; health protection; old age & retirement; personnel identification, participation &

stimulation

- two types: mandatory employee benefits: voluntary benefits

MANDATORY EMPLOYEE BENEFITS

• Employer is compelled to provide for certain benefits by the operation of the law

• Paid holidays – factories act, 1948 a weekly paid holiday

• Paid vacations – one day for every 20 days worked

(one month notice or one month’s pay) – paid @ 15 days wage for every completed year of service with a maximum of 45 days wage in a year

• Lay-off compensation - industrial disputes act, 1947 (@ 50% of the total of the basic wage & da for the period of their lay-off) – paid upto 45 days in a year

• Workmen’s compensation – workmen’s compensation act, 1923 – payment to meet the contingency of invalidity & death of a worker due to employment injury or occupational disease

• Health benefits – employee state insurance act, 1948 – sickness benefit, maternity benefit, disablement benefit, dependent’s benefit, medical benefit

• Canteen facility – factories act, 1948 – canteen in factories employing more than 250 workers

• Provident fund – contributions by employer & employee are 8.5% of basic salary – benefit payable on retirement, voluntary separation or death

• Employee pension scheme – introduced in 1995 –employer contribution is directed to pension + 1.66% of employee wages contributed by central govt.

• Entitled to pension @ 1 / 70th of salary for each year of service

• Gratuity – after 5 years of continuous service – 15 days’ salary per year of service upto a ceiling of INR

3,50,000/-• Companies with more than 10 employees

• Given in case of separation, superannuation, death or disablement

• No contribution of employees towards this benefit

• PSU scheme – public sector scheme

• Various pension schemes with accrual rates varying from 1/100 to 1/60

• Both employer & employee contribute

• Membership is mandatory for all those in PSUs

• Leave encashment scheme – claim encashment of unutilized leave at the termination of service

• Not-taxable in the hands of the retired employee

• Payable to dependents in case of death of employee VOLUNTARY EMPLOYEE BENEFITS

• Its is entirely the choice of the employer to provide these benefits to the employees

• Shift premium – for IInd & IIIrd shifts for the odd hours

• Company housing accommodation – some companies even pay for the utility bills (electricity / water & society charges)

• Group mediclaim / personal accident insurance – adequate coverage for the hospitalization expenses incurred due to illness, disease or injury sustained in accident / pregnancy (for female) for employee & immediate family dependents

• Educational facilities – sponsor higher education of employees & family members

• For certifications / trainings / memberships etc

• co-operative credit societies – for fostering self-help than going to money lenders

• Legal aid – provide legal assistance & aid through company lawyers or others as & when required

• Recreational facilities – gyms, clubs, internet café, one film per week shows etc

• Regular meetings & gatherings – of employees with their families to express talent, creativity & relieve of work stress

• Loans – at subsidized rates of interests for housing deposits, vehicle purchase, marriage, illness or death of a close family member

• Personal health care – extensive health check-up periodically

• cellular phones / laptop – on basis of business requirement

• Corporate credit card – to take care of official expenses arising out of business trips

• Gifts – on various occasions like birthday, anniversary, festivals – to strengthen bond between employer & employee

COMPENSATION STRUCTURE – VARIOUS PERSPECTIVES

SALARY TRENDS

AVERAGE SALARY INCREASE IN TOTAL COST TO COMPANY (TCC) FOR THE YEAR 2006 ACROSS ASIA PACIFIC –

4.5% 5.5% 8.0% 8.0% 3.5% 4.0% 14.0% 4.5% 3.0% 6.5% 7.0%

Australia China Hong Kong India Japan Korea

1 Average salary hike in 2006 for India at 14%, making it the highest in Asia Pacific

2 Employees in management staff cadre received average salary hike of 16% in 2006

VARIABLE PAY TREND

1 Employee expectations are on the rise

2 Senior/ Top Management received the highest percentage of variable pay in their compensation in the range of 17% to 30% 3 Variable Pay increasing in year 2006 -

 Banking Sector from 13% to 24%  IT from 13% to 18%

 Manufacturing from 10% to 16%  FMCG from 14% to 18%

PERCEIVED BENEFITS

1 International Educational Advancement Program & Tuition Reimbursement

2 Signing Bonus

3 Investment company makes on Employee & Training imparted (National/ International)

4 OPPORTUNITIES OF LEARNING – Early responsibility in career, freedom at work and innovate

5 JOB PROFILE – Work Content, Challenging Assignments

6 CAREER PROSPECTS & GROWTH OPPORTUNITIES – “Growing our own timber”

7 FUTURE PLANS OF COMPANY – Growing organization

8 TREATMENT OF PEOPLE – Strong values of trust, caring, fairness and respect within organization, healthy relationship at work.

NEW COMPENSATION APPROACHES Changing environmental pressures

Three changes having impact on organization structure & management systems:

 Product markets have become global

 increased competition in domestic & foreign markets  Rapidly changing technology

 greater need to employ technically & professionally skilled workers

 keep their knowledge – base & competencies current  Fast – changing demographic composition of Workforce

* higher age group of employees, more women employees, rising level of formal education

Organization’s response

 Major changes in organization structure & management systems  new model: flat, flexible, team-based, participative,

 changes in the job from being specialized & stable multidimensional

 horizontal growth of employees

 new approaches to compensation & rewards

FOUR NEW APPROACFHES TO COMPENSATION SKILL-BASED PAY

 Employees are paid according to their number of skills

- skills are grouped in ‘skill-blocks’ – as an employee acquires each block, his pay goes up

- skill block includes different types of skills:

**breadth skills which focus on all related jobs in an integrated production process

**depth skills which aim to increase specialization in a particular area

**vertical skills which are generally possessed by managers & professionals

 Advantages to organizations

 a workforce is created that can perform multiple tasks  organization gets flexibility to rotate employees & take

care of organization menaces like absenteeism, overtime, turnover, work-flow interruptions due to production bottlenecks and variations in product demand

 better problem solving capability

 improved productivity & quality of services/ products  stronger employee commitment

 employees become familiar with the operations & tend to recognize the value their own contributions

 Advantages to the employees

 acquire more self-control over their own earnings  develop greater capacity for self-management

 experience more varied and enriched task assignments  these contribute to job satisfaction to a great extent

BROADBANDING

 Delayering of pay structure

- a typical pay structure consists of grades & ranges

- a grade is a grouping of jobs falling within a certain range of evaluation points

- attached to grades are pay ranges – minimum to maximum spread

* successively higher grades will have higher minimum & higher maximum pay rates

- pay structure typically consists of a tall hierarchy of narrowly defined grades, each with a relatively limited pay range

* such structures create in employees a strong motivation to strive towards upward mobility as a means to obtain higher compensation rewards

 Broadbanding is defined as

- Consolidation of existing pay grades into a small number of wide bands

- results in broad minimum-maximum pay spread for each band

- compared to conventional pay structures, broadband structures have fewer bands & broader pay ranges

- best – suited to the needs of flexible, flatter & performance-oriented organizations of today

- Allow flexibility in moving employees between jobs within a band without formal job titles & pay grade changes

- Flat structures place increased emphasis on lateral career moves & skill development that can be rewarded through broadbanding

- Greater scope for pay growth through within- band-pay increases than through promotions to a higher band

Example1 of how broad banding works  Band I - Executives, entry-level staff

 Band II - Sr. Executives, supervisors, coordinators  Band III - Assistant managers

 Band IV - Managers, business managers

 Band V - General managers, national managers  Band VI – CTO, CFO, CMO

 Band VII - President & CEO

Example2 of how broad banding works

 In a HR consultancy firm there are 3 bands across the organization with a wide pay range in the same band:

- Entry level: requires good quantitative skills, knowledge of basic MSOffice, ability to analyze & ability to learn fast

- Proficiency level: skills in project management, problem-solving, resource management, thorough subject knowledge - Mastery level: a leadership position requiring visionary skills & ability to give direction to the organization

To move up the ladder, the employee needs to add value that would clearly separate his accountability & key performance indicator

*here advancement means adding newer competencies

 Defined as

- financially measurable reward paid to an individual based on his overall performance

- a powerful tool that enhances employee productivity & performance

TEAM REWARDS

- These are awarded to teams or groups based on their collective performance in achieving the assigned targets

- periodically targets are monitored to encourage improved productivity & reward

- provide each member an opportunity to receive a bonus on the output of the team a whole

- most appropriate when jobs are inter-related

- generally payouts are determined by team rankings (based on criteria like ratings by internal & external customers, achievement of quarterly team objectives & the management input recognizing special circumstances)

- within same team also, all members do not receive same payout – it is subject to peer evaluation

- major problem in this is designing a model team-based pay system

Steps for setting up team rewards

- Appraising teams

- to evaluate the performance of team against kras / preset targets

- communicate the results to ensure transparency

- measure the performance of the team (actuals vs. Targets) every month

- rewarding teams

- Make the minimum level of performance the benchmark of team reward

- make team performance mandatory for individual rewards - distribute the team reward in proportion to the basic pay of the grade to which each team member belongs

- build a geometric rate of progression of the award for each successive target

- link the individual award to the basic pay of the grade to which the individual belongs

VARIABLE PERFORMANCE LINKED PAY (VPLP)

 The corporate buzzword today

 Becoming a more common method for rewarding employees while linking their performance more closely to the employer’s

financial success

 Some companies are allowing all levels of employees to participate in these programs

 Variable pay is an innovative way to bring wages and salaries in line with companies’ market performance

 A simple concept that’s based on rewarding employees for increased sales or efficiency

 rewarding employees who increase productivity or efficiency provides incentive for other employees who want to share in the bounty

 rather than rewarding every employee with a pay raise or bonus, variable pay rewards the individual worker, or a team of workers, for extraordinary efforts

 Indian companies increasingly adopting VPLP  more than 85% organizations having VPLP

Objectives / Benefits of VPLP

A powerful tool to enhance employee productivity & thus impact bottomline

 align rewards to business goals

 build a high-performing organizational culture

 links overall compensation strategy with the organization’s business strategy

 helps differentiate between a mediocre & a star employee  a very effective motivational technique

 helps team members understand their job expectations better

 a valuable retention tool

 helps upgrade skills of team members by inducing a competitive environment

Types of Plans

 Individual – Based Pay

 Individual-based plans are the most widely used

 Of the individual-based plans commonly used, merit pay is by far the most popular

- its use is almost universal

- merit pay consists of an increase in base pay, normally given once a year

- supervisors’ ratings of employee performance are typically used to determine the amount of merit pay granted

- once a merit pay increase is given to an employee, it remains a part of that employee’s base salary for the rest of his or her tenure with the firm

 Team – based pay

 Normally reward all team members equally based on group outcomes

 these outcomes may be measured objectively or subjectively

 the criteria for defining a desirable outcome may be broad or narrow

 as is less commonly done in individual-based programs, payments to team members may be made in the form of a cash bonus or in the form of non-cash awards such as trips, time off, or luxury items

 Plant – wide / company – based pay

 Plant-wide or company-wide pay-for-performance plans reward all workers in a plant or business unit on the basis of the

performance of the entire plant or business unit  profit and stock prices are generally not meaningful

performance measures for a plant or unit because they are the result of the entire corporation’s performance

 most corporations have multiple plants or units, a factor that makes it difficult to attribute financial gains or losses to any single segment of the business

- therefore, the performance indicator most frequently used to

distribute rewards at the plant level is plant or business unit efficiency, which is normally measured in terms of labor or material cost savings compared to an earlier period or another plant or business unit

 They are the broadest type of variable-pay incentive programs  Reward employees on the basis of the entire corporation’s

performance

 the most widely used program of this kind is profit sharing. Profit sharing is a company-wide pay-for-performance plan that uses a formula to allocate a portion of declared profits to

employees

 typically, profit distributions under a profit-sharing plan are used to fund employee retirement plans

Features of VPLP

 Can be in cash or kind

 generally offered in terms of extra perks as soft housing loans, company cars, junkets abroad, mediclaim policies  If overall company performance is poor, SBU / team

 Largely, it does not exceed 30% of an executive’ s annual pay

Minuses of VPLP

 Recalculations in the case to reward nonexempt (hourly) employees

 VPLP requires employers to include certain types of variable compensation, such as bonuses, in employees’ regular hourly wage rates

 as a result, companies that pay variable compensation to nonexempt employees must often recalculate employees’ regular hourly pay rates by factoring in the variable pay  the recalculation then affects the overtime pay

calculations

 employers who are designing variable compensation

programs that include nonexempt employees must be sure to review their programs.

 failure to do so could cost significantly more in penalties and payment of back wages

Unspoken assumptions

Several underlying assumptions are behind the variable-pay concept, which derive from the very nature of the society that we live in and are not necessarily accurate:

- money motivates people to work harder

- increased motivation will increase performance - fair measurement of work performance is possible

Money as a motivator

• there is no doubt that money can be a powerful motivator • however, it isn’t always

Performance measurement

 motivation is clearly linked to performance

 however, in many cases motivation is not the problem

- the performance problem may be due to lack of skills, poor organization, bad strategy etc

- measuring performance is difficult and the most significant practical problem in VPLP

- even harder to manage is the problem of perception: even where there are real, perhaps obvious, performance differences, the employee who doesn’t perform well is more likely to attribute

his or her low output to favoritism rather than performance Implementation

• Failure of this motivational technique due to • inadequate planning

• poor implementation

• poor communication of details of the scheme across the organization

• undefined evaluation method

• individual objectives are not quantified for variable pay calculation

Effective implementation by

-well – defined individuals & group targets

-effective communication of the scheme to the employees -commitment from the top

-effective performance-evaluation mechanism

* simple, measurable performance criteria that is understood by all

-timely payouts

Employers need to do a better job of mapping individual employee performance and linking it with compensation

Conclusion

To create and implement an efficient variable-pay plan, an employer must make a commitment to define employee expectations in

behavioral and measurable terms

- This means making goals achievable, profitable, and practical for both the company and its workers

- the key to the success of variable compensation is to have something you can measure and understand—something that is linked to creating economic value for the company

- instead of continually ratcheting up base pay, manufacturing and service companies are adopting and expanding the use of incentive compensation programs, at all levels, to reward outstanding achievement without increasing fixed costs

EVA (Economic Value Added)

• It is a performance metric that calculates the creation of shareholder value

• Eva is the calculation of what profits remain after the costs of a company's capital - both debt and equity – are deducted from operating profit

• True profit should account for the cost of capital

• Steps to calculate EVA:

 Calculate net operating profit after tax (NOPAT)  Calculate total invested capital (TC)

 Determine a cost of capital (WACC)  Calculate EVA = NOPAT – WACC% * (TC)

• It is a financial performance method to calculate the true economic profit of a company

• Used for: setting organizational goals, performance

management, determining bonuses, communication with shareholders & investors, motivation of managers, capital budgeting, corporate valuation, analyzing equity securities (the non-debt securities of a corporation representing an ownership interest)

• Links employee performance with profits

• It is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise

• An estimate of true economic profit

• Amount by which earnings exceed or fall short of the required minimum rate of return that shareholders could get by investing in other securities of comparable risk

• Calculated by combining 3 factors: net operating profit after taxes, capital & cost of capital

• Continuous improvement in EVA brings continuous increase in shareholder’s wealth since a sustained increase in EVA brings increase in market value of the company

• Incorporates 2 principles of finance into management decision – making

• Primary objective of any company is to maximize the wealth of its shareholders

• The value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital

• NIIT, TCS & Godrej have implemented EVA in India

• Across the world, Seimens, Sony, Whirlpool, Johnson & Johnson, Cadbury, Bausch & Lomb have implemented EVA

• New concept for productivity enhancement, investor’s confidence & employee motivation

Steps for implementing

EVA-• Measuring of EVA – concept defined & explaining throughout the company

• Managing through training programmes – oriented to educate the managers how they would earn in direct proportion to the wealth that the company would make

• Motivation of employee benefits / rewards through performance linked remuneration scheme

• Preparing mindset of employees in the long-run, to understand the impact of EVA on their personal remuneration

INCENTIVE PLANS: Five Types: Merit Pay Gainsharing ProfitSharing Stock Options ESOPs

Merit Pay: An incentive plan implemented on an institutional wide

basis to give all employees an equal opportunity for consideration, regardless of funding source. The merit increase program is implemented when funds are designated for that purpose by the institution's administration, dependent upon the availability of funds and other constraints. .

Advantages

• Allows the employer to differentiate pay given to high performers.

• Allows a differentiation between individual and company performance.

• Allows the employer to satisfactorily reward an employee for accomplishing a task that might not be repeated (such as implementation of new systems).

Gainsharing: A technique that compensates workers based on

improvements in the company's productivity.

How does Gainsharing work?

A Company shares productivity gains with the workforce. Workers voluntarily participate in management to accept responsibility for major reforms. This type of pay is based on factors directly under a worker’s control (i.e., productivity or costs). Gains are measured and distributions are made frequently through a predetermined formula. Because this pay is only implemented when gains are achieved, gainsharing plans do not adversely affect company costs.

What are the 'Gains' that are measured?

• Increases in production with equal or less effort. • Equal levels of production with less effort.

What are examples of Gainsharing formulas?

• Calculate gain in hours: The actual hours worked minus the expected hours (for the given level of output) equals the gain in hours.

Advantages

• Helps companies achieve sustained increases in productivity.

• Employees become more involved the productivity gains made by the

Disadvantages

• Adherence to the FLSA requires employers to recalculate each worker's "regular rate" of pay. To overcome this limitation, employers

employer.

• Employees can share in the benefits

of employee sponsored

improvements.

• Enhances commitment to

organizational goals.

• Leads to improvements in other measures of company performance, including: teamwork, product quality, lower rates of absenteeism, defects, and "downtime."

may restrict this type of

compensation to exempt

employees.

• The formulas and program may be difficult to understand.

• Requires a shift to a more team oriented management style.

When does Gainsharing work best?

Works best when company performance levels can be easily quantified. Employee involvement significantly enhances the effectiveness of incentive pay. When used simultaneously, productivity gains from combining these techniques can exceed gains achieved separately.

What is the best way to implement Gainsharing?

Meet with executives to develop a clear understanding of Gainsharing. Develop various formulas and models to be used in predicting future gains and the costs associated with sharing those gains. Prepare rules, presentation materials, and dissemination of policy. Retrain

supervisors and administrators. Teams of employees are selected by peers to develop cost-saving measures. Through their personal

knowledge about their jobs, employees are able to reduce waste and increase efficiency.

Profit Sharing: An incentive based compensation program to award

employees a percentage of the company's profits.

How does Profit sharing work? The company contributes a portion

of its pre-tax profits to a pool that will be distributed among eligible employees. The amount distributed to each employee may be weighted by the employee's base salary so that employees with higher base salaries receive a slightly higher amount of the shared pool of profits. Generally this is done on an annual basis.

Advantages

• Brings groups of employees to work together toward a common goal (the success/benefit of the company).

• Helps employees focus on profitability.

• The costs of implementing the plan rise and fall with the company's revenues.

• Enhances commitment to

Disadvantages

• The pay for each employee moves up or down together (no individual differences for merit or performance).

• Focuses only on the goal of profitability (which may be at the expense of quality).

• For smaller companies, these plans may result in drastic swings in earnings for employees which the

organizational goals. employees may find difficult to manage their personal finances.

• Adherence to the FLSA requires employers to recalculate each worker's "regular rate" of pay. To overcome this limitation, employers may restrict this type of

compensation to exempt

employees.

When does Profit sharing work best? When company earnings are

relatively stable (or steadily increasing).

What is the best way to implement Profit sharing? Meet with

executives to develop a clear understanding of profit sharing. Develop various formulas and models to be used in predicting future gains and the costs associated with sharing those gains. Prepare rules.

Stock Options: The ‘right’ to purchase stock at a given price at some

time in the future. Stock Options come in two types:

1. Incentive stock options (ISOs) in which the employee is able

to defer taxation until the shares bought with the option are sold. The company does not receive a tax deduction for this type of option.

2. Nonqualified stock options (NSOs) in which the employee

must pay infome tax on the 'spread' between the value of the stock and the amount paid for the option. The company may receive a tax deduction on the 'spread'.

How do Stock options work? An option is created that specifies that

the owner of the option may 'exercise' the 'right' to purchase a company’s stock at a certain price (the 'grant' price) by a certain (expiration) date in the future. Usually the price of the option (the 'grant' price) is set to the market price of the stock at the time the option was sold. If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.

They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters.

o Allows a company to share ownership with the employees.

o Used to align the interests of the employees with those of the company.

o In a down market, because they quickly become valueless

o Dilution of

ownership

o Overstatement of

operating income

Nonqualified Stock Options

Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates

Advantages

o Aligns executive

and shareholder interests.

o Company receives tax deduction. o No charge to earnings. Disadvantages o Dilutes EPS o Executive investment is required o May incent

short-term stock-price

manipulation

Restricted Stock

Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income

Advantages

o Aligns executive

and shareholder interests.

o No executive

investment required. o If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings.

Disadvantages

o Immediate dilution of EPS for total shares granted.

o Fair-market value

charged to earnings over restriction period.

Performance shares/units

Grants contingent shares of stock or a fixed cash value at beginning of performance period; executive earns a portion of grant as performance goals are hit

Advantages

o Aligns executives

and shareholders if stock is used. o Performance oriented. o No executive investment required. o Company receives

tax deduction at payout.

Disadvantages

o Charge to earnings,

marked to market.

o Difficulty in setting performance targets.

When do Stock options work best?

-Appropriate for small companies where future growth is expected. -For publicly owned companies who want to offer some degree of company ownership to employees.

What are important considerations when implementing Stock Options?

-How much stock a company be willing to sell. -Who will receive the options.

-How many options are available to be sold in the future.

-Is this a permanent part of the benefit plan or just an incentive.

ESOPs

Employee Stock Ownership Plan (ESOP): An ESOP is a defined contribution employee benefit plan that allows employees to become owners of stock in the company they work for. It is an equity based deferred compensation plan. Several features make ESOPs unique as compared to other employee benefit plans. First, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer. Second, an ESOP is unique among qualified employee benefit plans in its ability to borrow money. As a result, "leveraged ESOPs" may be used as a technique of corporate finance.

ESOPs

• An opportunity to buy stock at a set price some time in future for a stated period

• Stock option is the right or privilege to buy stock under an offer valid for a stated period

• A form of variable pay compensation package

Objectives of ESOPs

• Instrument for attracting critical skills / highly valued or scarce skills

• Inculcates employee feeling of ownership and commitment

• Creates additional wealth for employees

• Supplement retirement / social security benefits

• For employee retention particularly for groups apprehended of high turnover

• Helps introduce a performance management system without incurring full cash out flow / lessening possible individual differences in the immediate cash bonus

• Enforces corporate governance

Infosys, Wipro, Maruti Udyog Limited, GE, Godrej, P & G, Zee Network, Castrol etc have introduced ESOPs

Features of ESOPs

• It is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer

• A company has to create a trust fund for employees and funds it by contributions of stock, cash or buy stock or cash to pay back the ESOP’s loan and to buy back stock in order to set-up a ESOP system

• Shares held by ESOP trust are distributed to the employees through an employee option scheme

• Return on an ESOP portfolio is linked to company performance since investment is through employer’s securities

• All employees except part-time directors are eligible to ESOPs of the company

• The terms, price & offer of ESOPs is done by compensation committee of the board of directors

• Options granted to employee are not transferable to any other person

• ESOP trust provides a warehouse for sponsoring company’s shares which can be sold or transferred to employees in future

• Reservation up to 5% can be made by the issuer of the company for employees of his company or promoters of the company

3 stages:

• Grant of option (enable employee to purchase a certain number of shares of the company stock at a determined price, usually within a specified period of time)

• Vesting (employee gets right to apply for the shares)

• Exercise of option (on payment of exercise price, employee is conferred the shares of the company)

• There is a minimum period of one year between grant of options and vesting of options & company shall have the freedom to specify lock in period

• Typically, lock-in period of 3-5 years with the provision that if employee separates from the service of the company (except in the case of death / medical incapacity), the shares would be forfeited & reverted to the trust

• Shares are not physically transferred to employees at this stage

• Once the shares are transferred in favour of the employee, only then the latter may decide to sell them in the market (this sale will attract capital gains tax)

• During the lock-in period, the shares registered in the name of the employee would be kept in the custody of the trust

Types of ESOPs • One-off, uniform

• An offer plan where the company may decide to include non-performers, trainees, short-service staff, temps

• A one-time allotment for an equal number of shares, options or warrants to all at the market value

• SEBI guidelines allow allotment of options below the market price for shares, subject to the differential being accounted in the books of the company

• One-off, differential / discretionary

• Also a one-off scheme where company may differentiate allotments by grades, seniority or market value of special skills

• Factors like achievements, potential, loyalty, hard work & contribution to corporate performance if considered, then the discretionary element will go up considerably

• Ongoing schemes

• Use a combination of uniform, differential & discretionary allotments dynamically.

• May be warrants, shares or options that can be issued as “sign-on” bonus on confirmation / promotion /

superannuating / recognition of outstanding contribution

• Given to some or all individuals

• Have a vesting schedule

• Are structured to enable flexibility

• Proxy: stock appreciation rights / phantom shares

• Notional units apportioned to employees

• Are productivity / contribution – linked incentive programmes rather than stock option plans

• An employee is allotted notional units / shares of the company based on certain criteria at a set price

• Employee is required to exercise his option within a given period (say 2 years) – when the share price is high & will be eligible to draw the differential or the whole in cash on deduction of tax

• Provision is made to enable employees to decline the shares & opt for the cash differential between the cost of exercise & the market price

• It would have the effect of a stock appreciation right / phantom share

Some definitions

• Phantom stock – a bonus that rewards employees based on the value of the company’s stock & the dividend performance of the stock

• Discount stock option – stock option with an exercise price which is less than the fair market value on the sale of the grant

• Indexed stock option – the exercise price is equal to the fair

market value at grant, but the price adjusts upward or downward depending on an index (in relation to the market / industry / peer group performance / any other measure)

• Performance accelerated stock option – has a fair market value exercise price & a service – based vesting schedule (longer than traditional options which are generally for 10 years), but which becomes exercisable at an earlier date in case specified

performance goals are achieved

• Performance contingent stock – has a fair market value price, which becomes exercisable only when performance goals are achieved. It lapses in case the set goals are not achieved

• Purchased stock option – down payment required to be made (% of the market price) before the option may be exercised

• Reload/restoration stock option – stock option automatically

granted upon the exercise of a previously granted stock option to the extent that the optionee uses shares rather than cash to pay the purchase price of the original option (the exercise price of the reload option is the fair market value on the date of the grant & reload option expires on the same date as the original option

• Variable - priced stock option – with an exercise price that fluctuates upward or downward in relation to stock price performance (yo-yo stock option or indexed stock option)

Premium stock option – exercise price greater than the fair market value on the date of the grant

How does ESOP work?

The ESOP operates through a trust, setup by the company that accepts tax deductible contributions from the company to purchase company stock.

 The contributions made by the company are distributed to

individual employee accounts within the trust.

 The amount of stock each individual receives may vary according

to pre-established formulas based on salary, service, or position.

 The employees may ‘cash out’ after vesting in the program or

when they leave the company. The amount they may cash out may depend on the vesting requirements.

 When an ESOP employee who has at least ten years of

participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25% of the

value. This option continues until age sixty, at which time the employee has a one-time option to diversify up to 50% of his/her account. This requirement is applicable to ESOP shares allocated to employee's accounts after December 31, 1986.

 Employees receive the vested portion of their accounts at either

termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.

Advantages

• Capital Appreciation. Companies

sell some or all of their equity to employees and by doing so convert corporate and personal taxes into tax-free capital appreciation. This allows the owner to sell 100% of his or her company, get money out tax-free and still maintain control of the company.

• Incentive Based Retirement.

Provides a cost-effective plan to motivate employees. After all, who works harder, owners or employees?

• Tax Advantages. Enables tax

advantaged purchasing of stock of a retiring company owner. With this purpose, a company owner may sell their shares to the ESOP and incur no taxable gain on the sale. A company owner can sell all or some of the company to the employees cost free. Owners who sell 30% or more of their company to an ESOP are allowed to "roll-over" the proceeds into other securities and defer taxation on the gain.

• Company reduces it's tax liability. A company can reduce its

corporate income taxes and increase its cash flow and net worth by simply issuing treasury stock or newly issued stock to its ESOP.

Disadvantages

• Dilution. If the ESOP is used to

finance the company’s growth, the cash flow benefits must be weighed against the rate of dilution.

• Fiduciary Liability. The plan

committee members who

administer the plan are deemed to be fiduciaries, and can be held liable if they knowingly participate in improper transactions.

• Liquidity. If the value of the stock

appreciates substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock, upon employees’ retirement.

• Stock Performance. If the value of

the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan. In an extreme case, if the company fails, the employees will lose their benefits to the extent that the ESOP is not diversified in other investments

What is the best way to implement ESOP?

1. Determine how you want to use the ESOP. Will it be used as an employee benefit plan? Or, as an incentive program?

2. Conduct a feasibility study to determine the value of the company’s stock and impact of the contributions that must be made to the trust.

3. An ESOP requires different accounting procedures and a different method of allocating stocks and other investments among the employees than other types of plans. For this reason the plan should be designed by an ESOP specialist in order to avoid IRS difficulties.

What are the alternatives to ESOP?

1. Employee stock options.

Profit Sharing. An ESOP differs from a profit sharing plan in that an ESOP is required to invest primarily in employer securities, while a profit sharing plan is usually prohibited from investing primarily in employer securities.

LAWS & REGULATIONS RELATED TO COMPENSATION PAYMENT OF WAGES ACT, 1936

An Act to regulate the payment of wages to certain classes of employed persons

MINIMUM WAGES ACT, 1948

An Act to provide for fixing minimum rates of wages in certain employments

EQUAL REMUNERATION ACT, 1976

An Act to provide for the payment of equal remuneration to men and women workers and for the prevention of discrimination, on the ground of sex, against women in the matter of employment and for matters connected therewith or incidental thereto.

PAYMENT OF BONUS ACT, 1965

Act to provide for the payment of bonus to persons employed in certain establishments on the basis of profits or on the basis of production or productivity and for matters connected therewith.

EMPLOYEES' STATE INSURANCE ACT, 1948

An Act to provide for certain benefits to employees in case of sickness, maternity and employment injury and to make provision for certain other matters in relation thereto

1952

An Act to provide for the institution of provident funds 2*[3*[, family pension fund and deposit-linked insurance fund]] for employees in factories and other establishments

THE PAYMENT OF GRATUITY ACT, 1972

An Act to provide for a Scheme for the payment of gratuity to employees engaged in factories, mines, oilfields, plantations, ports, railway companies, shops or other establishments and for matters connected therewith or incidental thereto

THE WORKMEN'S COMPENSATION ACT, 1923

An Act to provide for the payment by certain classes of employers to their workmen of compensation for injury by accident

PROBLEMS & ISSUES

Whether extrinsic rewards such as performance-related pay actually motivate employees to better performance is a matter of controversy. It has been claimed that monetary rewards usually have a limited time-span in regard to their motivating effect. Therefore extrinsic rewards such as performance pay, even if they can exert a continuing impact on performance, should

• be consistent with overall management objectives, so that performance pay may not be consistent with, for example, a purely cost reduction strategy &

• only be used to reinforce a motivational system in which intrinsic (non monetary) rewards exist, such as reorganization of work processes, training, employee involvement/consultation in decision-making, two-way communication, opportunities to contribute ideas, career development plans and goal setting. Some of the reasons for the failure of performance-related pay and some of the problems and issues facing employers flow from a variety of circumstances such as the following:

i. Inadequate criteria to measure performance, or criteria which are not easily understood, communicated and accepted. Performance pay should therefore be negotiated.

ii. Inappropriate performance appraisal systems in that the

objectives of the appraisal system (e.g. where it is intended to identify training needs or suitability for promotion) do not match the objectives of the reward system.

iv. The reward system is not designed to meet the objectives sought to be achieved. There could be a variety of objectives e.g. to satisfy distributive justice, attract and retain capable staff, match particular levels of pay in the labour market, change

organizational culture (e.g. towards greater customer satisfaction) or to reinforce it.

v. The absence of a right mix of extrinsic and intrinsic rewards. vi. The lack of an appropriate quantum of pay which should be

subject to performance criteria. This occurs when the amount which depends on performance is too small, or it is too large and therefore the amount placed at risk (when performance is poor) is not acceptable to employees.

vii. The absence of periodic evaluation of the scheme.

viii. Non-recognition of the fact that performance, especially profit, is sometimes (even often) dependent on factors outside the control of employees e.g. management decisions, exchange rates,

recessions.

There are many arguments in favour of performance-related pay which are theoretically attractive. However, it is not easy to find evidence which unequivocally supports or disproves these views, because of the scarcity of empirical evidence or because the introduction of the

scheme has been faulty. Governments can sometimes facilitate the introduction of performance-based pay. In Britain for instance, the Finance Act of 1987 introduced tax relief for approved schemes to encourage their adoption and proliferation.

Two benefits at the macro level have been claimed for performance pay. The first relates to employment. If increases in basic pay are transferred to a profit-related scheme (e.g. 10% of basic pay), the employer may be more inclined to hire new employees as his wage cost is less than otherwise. If the percentage of profit to be shared remains fixed, additions to the workforce do not cost the employer more in terms of the profit-related pay. On the other hand, new

recruitment would reduce the quantum existing employees will receive unless profits increase, and consequently dissatisfaction among

employees could set in.

The second argument is that if basic pay is reduced as a percentage of total earnings, increased earnings will not result in inflationary

tendencies as such increases are the result of increased profits/productivity.

• where performance/profits increase, higher pay is an incentive to employees

• where profits reduce, the reduction in the performance-related pay can cushion employees against redundancies

• employee identification with the success of the business is enhanced

• variations in pay lead to employees becoming more familiar with the fortunes (or misfortunes) of the business. This would depend on the information-sharing practices of the management.

Several criticisms of a general nature (apart from those directed at particular types of schemes) have been made against performance-related pay. Among them are the following:

i. where the performance earnings fall employees are less inclined to accept reductions in their guaranteed pay

ii. positive employment effects could be negated due to opposition from employees to recruitment as it would dilute their earnings iii. since performance/profits depend on a variety of factors beyond

the control of employees, it is not possible to link pay to the performance of employees. If it is linked to the overall

performance of the enterprise, then management decisions should logically be subject to scrutiny by employees.

iv. it is difficult to determine whether the amounts paid out under schemes are more than matched by performance gains.

Even though the evidence is not always clear whether profit-sharing, for instance, raises productivity levels, the positive link between profit-sharing and productivity is clearer in enterprises with employee

participation arrangements. Where the extra payments replace a fixed wage component and is not an additional component of pay, there is a greater likelihood that the extra pay is matched by performance

increases. In the case of group incentives payments are never proportionate to individual performance, as poor performers ("free riders") benefit from the efforts of others.

Unit II :

CLASSICAL SOCIAL WAGE THEORIES A. Subsistence Theory

 Propounded by David Ricardo, 1817  Also known as the "Iron Law of Wages“