Best Practices in Compensation

The core principle to apply when it comes to compensation is fairness. Accordingly, there are two best practices that should be the guiding principles in setting salary levels within an organisation:

  1. Internal Equity. This principle states that employees that do the same type of job, with the same level of skill and experience, should earn comparable amounts. This is to ensure fairness within the organisation. If the person sitting next to you is performing a job of equal value, you'd consider it unfair if he/she earned more than you.

  2. External Competitiveness. This principle states that salaries offered should be competitive in regards to the salaries offered by comparable companies in the same geographic area, for similar job scopes and levels of experience. If a company in the building next door is employing people who do jobs of equal value, but pay 20% more, then you're not going to feel that your present employer is being fair.

There are a few important corollaries that derive from these two simple principles:

  1. Corollary #1: when making a salary offer to a new hire, that person's salary at his/her previous job should not determine what offer you should make. You have to make the offer based on the internal equity and external competitiveness principles. If that leads to an offer that is substantially higher or substantially lower than what the candidate earned in his/her previous job, then so be it.

  2. Corollary #2: when making salary offers to expat candidates, there should be no "expat salary". What they earned in their home country is not necessarily comparable to what offer should be made to them in the new country they are moving to. The internal equity and external competitiveness principles make no mention of nationality. It would be demoralising for a local candidate, doing the same job as an expat, to earn less just because of what passport he holds. It is, however, acceptable (and recommended) to offer expats relocation expenses and assistance, since they are moving from another country.

  3. Corollary #3: the offer you make to a candidate should be fair, but firm. You need to have properly calibrated it using the internal equity and external competitiveness principles. If the candidate tries to bargain you higher, you need to be reluctant to do so. This is because you need to set salaries based on fair consideration of the two core fairness principles, not according to how skilled a particular candidate is at bargaining. This principle will also help you make better hiring decisions, because there are broadly two things that candidates look for in a new job: hygiene factors, and motivators (cf. two factor theory). Candidates who bargain over hygiene factors are at higher risk of being the less competent candidates, because they could be the kind of person who stagnates in any job hence their best chance of getting hygiene factor increases is when they switch jobs. For such candidates, their career history/CV follows the "join for the money, leave for the money" principle. The more competent candidates however earn their increases on the job through good performance, and they tend to focus on motivators when choosing their next job. They are less often on the job market too - you will notice longer job tenures on their CV.

  4. Corollary #4: at the yearly salary review, the two principles need to be examined again: internal equity, and external competitiveness. To examine external competitiveness, you need to look at recent salary surveys for the given country/area. You may find that salaries have risen by a small or large amount, or even in rare cases actually fallen. It's a job market: levels will rise and fall with the market supply and demand, and you need to stay in line with market levels. If market salary levels have risen substantially, then you will need to increase salaries by the corresponding amount so as to retain your staff.

  5. Corollary #5: you shouldn't bargain salaries with employees, because otherwise the employees with the best bargaining skills end up with the highest salaries, which would be unfair to the others. Remuneration levels should be set using the two core fairness principles, which require no bargaining.

  6. Corollary #6: during your regular reviews of the external competitiveness principle, you may find that certain employees are being under-paid. In such cases, you need to immediately increase them, even though they haven't explicitly asked for an increase.

As part of the external competitiveness analysis, it is important to get hold of high-quality salary surveys. Certain surveys (e.g. surveys where users self-report salary levels) may be biased. In major economies, high-quality salary surveys are generally readily available. However, in smaller or less developed economies, it may be hard to get hold of quality data.

In regards to external competitiveness, you may also want to decide that your company will pay above the average. A good place to be, in regards to average salary levels, is in the third quartile of salary surveys: i.e. in the quartile just above the average of comparable companies. Fully satisfactory employees should earn up to the top of the third quartile, whilst the exceptional employees should be in the top quartile, or even above it, when it comes to key individuals who are integral to the success of the company.

In regards to internal equity, the challenge becomes properly evaluating the level of skill and performance of each person. Therefore, it is important that you have implemented a fair and structured employee appraisal system.