Is a Compensation Plan Necessary?

One of the most common comments we hear from our small and medium sized clients is, "We don't need a compensation plan, we are a small employer and pay on an individual-to-individual basis."

Actually, money by its very nature requires even the smallest employer to implement a compensation system and to live by it on a continuing basis. For example, in most small business settings, there are managers, clerical support, technical experts, front line employees and, possibly, other support staff. A business with one (1) location typically may employ five (5) to thirty (30) employees, including managers, and those with multiple locations a proportionate number. And, many leaders of these organizations typically tell us it is not worth conducting employee evaluations on such a small number of employees because they "know" their employees' performance and effectiveness and so they don't need to establish a formalized pay plan.

And this is probably true, particularly within a one (1) site operation. Most owners do not need formal records or formal policies outside of job descriptions and employee handbooks. But compensation is a different matter. Recordkeeping is always a part of paying employees, so much that every dollar of payroll is recorded. With this recordkeeping already in progress, it is not difficult to ask this question: "Does each employee's pay have a logical relationship to every other employee's pay, as well as to such outside factors as what other employer's are paying, inflation, etc.?"

After all, this is what a pay system is. It is nothing more or less than establishing a relationship between the different amounts employees are paid and justifying that relationship. There is no one way these relationships have to be established, but there is a general approach most small businesses can utilize in developing a system to meet their basic needs.

Why is a compensation system worthwhile? Why is it worth making the effort to systematically relate employees' pay rates? The answer is the same for small as it is for large businesses. Establishing pay rates that are realistically tied to outside factors such as what competitors or organizations competing for talent are paying and the continuing effects of inflation, will help owners hire good people and retain them. Establishing rates that are realistically related to what other employees within the organization are being paid will ensure internal equity and subsequently help avoid dissatisfaction. Finally, every employer must introduce an element of pay-for-performance so that their pay system will become a part of the employee's effort to motivate more and better work.

The concept of pay-for-performance; however, should be clarified: It is commonly held by psychologists that pay increases do not motivate more and better work if increases are routine. An "annual merit increase," for example, is not a true merit increase if an employee can, in fact, do an average job during the year and still get his or her annual raise. In fact, this type of pay progression will eventually demotivate more senior employees, because no matter the effort, the same increase is provided. A true pay-for-performance system is only effective when an employee has performed unusually well and because of his or her unusual or exceptional performance, receives a raise that otherwise would not have been granted.

In designing and implementing a compensation plan for the small business, the key to success is to ensure that the plan is simple, easily understood and appreciated by employees and easily administered by owners and management. It also must reflect external equities (competitiveness), internal equities (position worth and pay-for-performance) and organizational affordability (budget considerations). The basic steps in establishing such plan include:

1. Confirm the positions to be covered by the plan and describe each position in some detail SESCO recommends the criteria-based job description, which includes a built-in performance appraisal format. This tool has been very successful and widely used within the contracting services industries.

2. Determine how much each position (not the person) is worth to the organization. We at SESCO call this the organization's "right price" for each position; a blending of the market, current pay realities and affordability.

3. Establish labor grades and pay ranges incorporating operational realities.

4. Reduce the pay plan to writing to include implementation guidelines and administrative procedures (how will the plan be maintained from year-to-year and other policies such as the process for reviews and increases).

5. Thoroughly educate leaders to include pay philosophy, compensation realities, their role in managing the organization's largest single controllable cost and other important financial, business and human resource realities. Subsequently communicate the new plan to all employees.

6. In addition to the compensation plan, support the overall compensation package by providing all employees a custom employee benefit statement describing the value of all benefits provided, thereby communicating their total compensation package.

Compensation is at the heart of the employer-employee relationship. It is the employer's largest single controllable cost and it meets the employee's basic "survival" needs. Compensation can also be an employee relations issue and demotivator if not properly implemented and can be a performance motivator if properly managed.

SESCO Management Consultants is available to assist with your human resource issues, including the development of compensation plans. You may contact us by phone at 423-764-4127 or by email at sesco@sescomgt.com .