Items Description of Module

Subject Name Human Resource Management

Paper Name Performance and Compensation Management
Module Title Foundation of Compensation Management
Module Id Module No. – 22
Pre- Requisites Basic understanding of Compensation management
Objectives To develop effective understanding about the foundation of compensation
management
Keywords Theories of Compensation management, Economic theory

QUADRANT-I

1. Module 23: Foundation Of Compensation Management

2. Learning Outcomes
3. Introduction
4. Theories compensation management
5. Summary

1. Module 22: Foundation of Compensation Management

2. Learning Outcomes:
By the end of this module, students will be able to
 Understand the concept of compensation management
 Identify different theories of compensation
3. Introduction
An individual’s basic needs viz. food, clothing, education, housing; medical care and transportation
are met through what he receives as compensation from his workplace. This compensation is affected
and also affects a lot many things. It is affected by economy of a specific geographical area, the
psychology of the management and trade unions, the expectations of the society, the industry trends,
the technological state etc. At the same time compensation also affects the very existence and growth
of the origin, the status and psychology of the employee, the well-being of the society, the growth of
the society, and finally the growth of the economy at large. All these aspects have been framed in the
form of theories that govern the compensation management in any organization.
4. Theories of Compensation:
4.1. Economic Theories: The dictionary meaning of compensation is simply reward or
reimbursement or return. In economic terms it means exchange between employer and
employees for the tasks performed by the latter. The employer has the liberty to pay
reward/compensation to its employees in financial as well as non-financial form in any
proportion as mutually arranged between the employer & the employee. In a narrow sense
 compensation is the amount paid by employer to the employee for the services rendered by him
for production of goods and services. Thus the economic aspect of compensation is actually most
important for which theories have been propounded by various thinkers. We will discuss about
them in the following section

Compensation

Economic Theory Behaviour Theory

Employee acceptance of a
Labour market Theory compensation level
Subsistence Theory Internal compensation structure
Surplus value Theory Wages and motivation
Residual claimant theory Tournament theory
Marginal productivity Theory
Bargaining Theory

Figure 22.1: Economic & Behavioral Theories related to compensation.

a) Labour Market Theory suggests that compensation, like any other price is determined by the
forces of demand & supply. The employer has to understand his requirement related to number
and type of employees at a particular compensation level. The employer will continue engaging a
specific type of employees till the compensation is equal to the marginal productivity. Employees
on the other hand will be available for employment till some another recruiter has something
better to offer to him, or till he is able to justify his contentment levels in the same job.
 Source: https://whistlinginthewind.org/2012/08/19/labour-market-in-the-real-world/
b. Subsistence Theory or the iron ‘law of wages’ as propounded by David Ricardo postulates that
labour is compensated for the work done by them so that they can survive. The theory also
assumes that if compensation increases beyond this survival level, the employee will enhance his
family by reproducing more as now he would be able to support a larger family. As the number of
individuals to be employed increases, i.e. supply of labour increases, with a specified amount of
employment available, compensation would decline. If compensation fall below survival levels,
employees and their family would die of malnutrition, hunger, etc. resultantly supply of labour
will decrease& compensation level will increase. The theory concludes that in the long run
compensation tends to minimum.
c. Wage Fund Theory as proposed by Adam Smith proposes that compensation is paid out of a
fund that is created to house the surplus wealth with employer or the capitalist which is a result of
his retained earnings. This surplus wealth is used to engage employees to perform different tasks.
In case of large funds, compensation will be high as more funds would be available for
disbursement and if funds are less then compensation just enough for survival would be paid.

Source: https://www.slideshare.net/manumelwin/wage-fund-theory-wage-theories-compensation-
management-manu-melwin-joy
d. Surplus Value Theory (Karl Marx): Labour is treated as a commodity that is purchased on
payment of a price. Although while determining the price of any product labour cost is
significantly considered, but the labour is paid very less as compared to the time spent by them in
manufacturing of a product. The surplus thus goes to surplus fund.
e. Residual Claimant Theory Francis A. Walker in his residual claimant theory identifies four
factors of production. These factors are land, labour, capital and entrepreneurship. The amount of
residual value after payment to all factors except labour is called compensation. This also implies
that all factors of production are important except labour. That is why labour is the residual
claimant.
f. Marginal Productivity Theory Philips Henry Wicksteed (UK) and John Clark (USA) in their
theory of marginal productivity state that compensation is the estimate made by the entrepreneur
about the value created by the marginal employee. Therefore, this theory also suggests that
compensation depends on demand and supply of the workforce.
g. Bargaining Theory John Davidson proposed that compensation is totally dependent on the
bargaining power of employees, trade unions and employer. If the trade union is stronger than the
employer compensation will tend to be higher and if employer is powerful and well established,
the compensation will be low. Hence compensation depends on the bargaining capacities of the
parties involved.
Limitations of Economic Theories
The limitation with these economic theories is that they assume labour market to be perfectly
competitive and employees are absolutely free to move in & out the markets. This practically
seems to be almost impossible. Economic Theories are based on the most primitive format of
compensation and its management. Here it is assumed that an individual is well aware about all
his self interests being fulfilled. These theories are criticized on the following grounds:
a) The economic theories of compensation management are away from reality as they assume
free entry and exit of employees which is practically impossible.
b) Economic theories assume completely competitive labour market where uniform
compensation is practiced which again is a myth. Huge variances exist in compensation
across regions, industry and even at individual employee levels.

4.2. Behavioral Theory of Compensation: Compensation is something that is largely influenced by

& largely influences human behavior. For the organization, the contribution of the employee is
important for the attainment of its goals and objective in support of its vision and mission. For an
employee, compensation affects his motivation, commitment and performance. These intangible,
immeasurable aspects pose a threat to the economic theories. These human traits significantly
impact the employer as well as employee’s perception towards compensation.
Behavioral theories conceptualize compensation as a tool to create and imbibe emotions in a
employee suggesting him that the job is too good to be lost. The major behavioral theories put
forward by various experts can be summarized as follows:
a. Acceptance of compensation: The general image and name of the organization and
amount of compensation are two significant deciding factors that govern the employee’s
intention to work in that organization. Although the compensation is directly proportional
to the contribution made by the employee towards organizational goals. So,
compensation apart from just providing livelihood is the major reason of
continuance/discontinuance from the organization. Organizations have to actually make
sure that the employees are contended in terms of all financial as well as non-financial
rewards.

Low Search for

Satisfaction alternatives

Expectation
Increased
of high
aspiration
rewards

High
satisfaction

This is a vicious circle. As soon as the satisfaction level of employee lowers, he searches
for new alternatives with high rewards. As per the general human tendency, for a short
span of time individual is satisfied but gradually his aspirations touch new heights & gain
his satisfaction level lowers. Hence compensation level acceptance is very important to
sustain the employee.
Internal Compensation structure of an organization is dependent on multiple factors,
many of which are not economic in nature. These include psychology of the
management, social recognition associated with the job, social norms & customs
prevalent in that particular society/locality, the intention of maintaining consistency in
compensations, the span of control and the requirement of specialized labour. This theory
 thus tries to emphasize that compensation is internally created and managed concept that
affects a whole lot of other factors.
b. Tournament Theory: This theory as developed by Lazer and Rosen in 1981 emphasises
on the hierarchy of the organization. The theory assumes life of the organization as a
sports match for eg., a golf tournament. Each round in the tournament denotes a struggle
for a higher job level. All participants are ranked on the basis of their performance. The
winners will proceed to the next round. For the employer judging becomes relatively
easy by making a comparison in performances. The four main features of the tournament
theory are:
 Compensation slots are well defined in advance.
 Promotions are awarded to employees not because they are good, but because they
performed better than the others.
 The level of effort of an employee is normally directly proportional to the benefit he
assumes to gain.
 The participants are known in advance and no outsiders are allowed to be a part of
the tournament.
The reward that is received is not only direct compensation increase but also includes
prospective rewards of being a part of the tournament in future. The tournament theory
thus, helps an organization to limit the labour turnover and distinguishes good performers
from the poor ones.
c. Wage and Motivators: Compensation as a layman can understand is the amount of
money an individual earns from his job. Compensation is thus an instrument to fulfil
one’s needs. But, actually every individual has some expectations/ aspirations from his
life. These aspirations motivate him to enhance his compensation and hence his earnings.
This behavioral aspect of one’s personality needs increments, bonuses, commissions, etc
to motivate him.
d. Inter and Intra Industry Compensation Differentials
Compensation differentials are a common feature. Employees with similar skill sets and
efficiency levels (which is a myth) if hired in a perfect market would receive identical
compensation in equilibrium. But what actually exists is imperfect competition. So
compensation differentials largely exist on account of inter and intra industry differences.
Compensation within the industry is varied just as across industries. The reasons for
compensation differentials within the industry may be due to: -
 Nature of industry
  Technology
 Competencies & skill sets
 Sector
 Competition strategy
 Business Environment
 Quality of work force
 Nature of Industry:- The nature of industry is an important characteristic to decide the
compensation. By nature of industry we mean the business processes, technology deployed,
skill-set required and most importantly the customer requirements. Again for a manufacturing
firm the skills & competencies required will differ from that of a service firm and so the
Compensation plans will also be different.
 Technology:- Some industries are highly technical and automated in their business processes
while others are not so organization with high levels of automation although need less
number of employees, but they have to be well qualified trained, skilled & creative and so are
compensated high.
 Competencies & Skill Sets:-Competencies are developed gradually as per the job
requirements. Sometimes new skills have to be brought in the organization at a high premium
and at other times internally premium and at other times internally a skill set may be
developed. So again varied competencies & skills demand different compensation plans to be
implemented. For example an operator in an IT firm will most likely be an engineer and so
his compensation will be handsome whereas in a call center he will be a school pass out,
hence compensation differential.
 Sector:- Industry could be functioning in an organized sector or an unorganized one. In the
organized sector like that of candle making or utensil making orders are erratic, technology is
poor, margins are low & compensation are low on the other hand in organized sector like that
of television making where technology is latest, capital base & infrastructure is excellent,
compensation will definitely be good. Thus, sector is also responsible for compensation
differentials. Organizations implement differentiation strategy and maintain higher
compensation levels or an average. Others like textiles, spare parts etc. who employ large
chunks of seasonal & temporary employees, enforce lower compensation levels.
Source: https://en.wikipedia.org/wiki/File:Energy_by_major_sectors_of_the_economy.gif

 Business Environment:- Business environment turbulence brings in a lot of

compensation differentials across organizations. Compensation decisions are highly
influenced by local turbulences hence creating disparities.
 Quality of Work Force:- While discussing quality of work force in today’s times
we will talk about two aspects. One is the academic & technical qualifications which
is desired to enter the work force and acquire a descent compensation, Secondly the
skills or qualities desired to sustain in that particular work. So differentials must in
terms of both the aspects. A well-qualified individual may enter the workforce at a
particular compensation and may stay for long at the same level whereas , a little low
qualification but with huge learning & grasping power may be able to climb the
ladder of compensation plan fast.
e. Designing Compensation Structure: Designing compensation is the most difficult and
crucial part of compensation structure decision making. The steps involved in designing a
compensation structure are as follows:
a) Determination of Worth of Jobs to Organization: After establishing a
compensation philosophy which determines external compensation relativity, based
on job evaluation, relative worth of each job is identified and compensation levels are
fixed for each job based on the requirements of that job. A detailed compensation
structure is set up in which remuneration is organized by detailing different grades
and minimum and maximum compensation rates for each of those grades.
Employees should be paid according to the relative worth of a job. In other words,
jobs which are of higher value are paid more as compared to the jobs which are of
lower value. Internal compensation relativity is determined through job evaluation.
Different methods of job evaluation can be used to determine the relative worth of
job to the organization.
 Positions should be placed in a structure and level; according to the following
criteria:
 Interpersonal skills
 Problem solving ability
 Accountability
 Managerial Capabilities
 Qualifications (academic & professionally)
 Exposure in the specific industry

Executive

Officer

Sr. Associate

Associate

Clerk

b) Determination of Worth of Jobs in the Marketplace: The next step is the

determination of compensation rates of competitors. While fixing the compensation
levels in the organization, a lot of things need to be considered like compensation
surveys, internet data, competitor benchmarking and labour market trends. The
compensation survey is conducted using jobs which are similar across different
organizations. These are called benchmark positions. For e.g. engineers, electricians,
accountants, etc. the organization has to decide its compensation philosophy within
the entire spectrum of compensation rates. Organizations who want to hire best talent
would have to compensate levels found through the compensation surveys. Whereas,
if the organization is interested in average people then a more middle of the road
compensation philosophy might be adopted. Organizations design different
compensation structures on the basis of its philosophy and policy. For e.g. some
organizations have a broader compensation structures as compared to other
 organizations. While determining the compensation structure, an organization should
take into consideration the total cost of structural implementation.
Compensation surveys are conducted every year to estimate the amount by which
other organizations will increase their range or compensation rates. For e.g. people
who possess technical skills are often paid at a higher rate because demand for these
people is more than their supply.

6. Summary
The theoretical aspect of compensation management suggests the major theories working around
compensation and its management. Compensation is the most crucial feature of organized
working culture and so numerous economists, sociologists and industrial psychologists have
worked tremendously on the development and structuring of the same. The dictionary meaning
of compensation is simply reward or reimbursement or return. In economic terms it means
exchange between employer and employees for the tasks performed by the latter. The employer
has the liberty to pay reward/compensation to its employees in financial as well as non-financial
form in any proportion as mutually arranged between the employer & the employee. In a narrow
sense compensation is the amount paid by employer to the employee for the services rendered by
him for production of goods and services. Thus the economic aspect of compensation is actually
most important for which various economic theories have been developed. Compensation is
something that is largely influenced by human behavior. For the organization, the contribution of
the employee is important for the attainment of its goals and objective in support of its vision and
mission. For an employee, compensation affects his motivation, commitment and performance.
These intangible, immeasurable aspects pose a threat to the economic theories. These human
traits significantly impact the employer as well as employee’s perception towards compensation.
Behavioral theories conceptualize compensation as a tool to create and imbibe emotions in an
employee suggesting him that the job is too good to be lost. Both type of compensation theories
had their own advantages and dis advantages. So it actually depends on the situation that which
theory of compensation management would be applicable where. So a judicious adoption has to
be executed by the management of the organization before selection of any compensation theory.