Labor costs are among a company’s biggest expenses, totaling 40-60% of an organization’s operating budget, according to professional services firm Deloitte. But employee compensation isn’t just an expensive line item on your spreadsheet; it’s also a key way to attract and retain the employees you need to move your business forward.
“You’re a company with a strategic plan, and you have goals and expectations,” said Elliot Dinkin, President and CEO of consulting and actuarial firm Cowden Associates. “The only way to implement and do all [that] is with the right people.”
Finding and retaining the right people, however, requires coming up with a compensation philosophy and plan that addresses your company’s business strategy, and uses the right compensation metrics to ensure your policies are on track. Here’s how to build a pay plan that supports your organization’s strategic goals — and meets the needs of both your company and your employees.
Compensation Philosophies and Policies
A company’s compensation philosophy establishes the basis for its pay policies and drives its decisions about everything from base pay to executive compensation. It ensures that a company’s pay practices are equitable and uphold the organization’s needs.
The Society for Human Resource Management (SHRM) recommends that Human Resources in conjunction with the executive leadership team work collaboratively to develop a compensation philosophy. Together, they should consider everything from the company’s budget to its strategic goals and the market rate for the kinds of employees they want to hire and retain.
Compensation philosophies vary widely and should speak to who you are as a business, advised Dinkin. “It’s got to parallel who you are...[your] mission and vision and strategic plan,” he said. One company may focus more on incentive plans, rewarding workers for goals met, than base pay, according to professional services firm KPMG. For another, work-life balance initiatives could be vital to its compensation practices.
Metrics to Measure
With the groundwork laid, you can then develop the pay practices that will bring your compensation philosophy to life. Compensation plans can cover specifics such as:
- Pay Structures: Spells out how companies will compensate workers in different roles.
- Variable Compensation: The amount workers might earn above their base salary based on their performance.
- Performance Ratings: Measures workers’ accomplishments and can be used to determine salary increases or other incentives.
Compensation metrics help companies monitor whether their pay policies and benchmarks are on track. Here are six metrics that a company should measure in any compensation analysis.
1. Total Cost of Workforce
The total cost of the workforce tallies up all the money you spend on staffing and related expenditures. While labor is a huge cost for most businesses, many leaders aren’t aware of how much they’re spending on their workforce. Generally Accepted Accounting Principles, or GAAP accounting, doesn’t require the analysis, so it’s a metric that many companies don’t track, said Jeff Higgins, founder and CEO of HCMI, a workforce analytics software and services firm.
But it matters. “You can’t manage well what you can’t measure well,” Higgins stressed. The calculation should include pay and benefits. Some leaders also add in the operating costs to run the Human Resources department, he said. HCMI’s website recommended including the cost to outsource tasks to gig workers and other types of contractors, consultants, and contingent, temporary workforce members, too.
2. Market-Ratio
Any compensation plan should evaluate market data to determine the market rate for a company’s target employees. Data points can come from internal market studies, sites like Glassdoor.com or the US Bureau of Labor Statistics (BLS), and information from recruiters and new hires. The market-ratio is the current pay divided by the market equivalent, Dinkin said. It is used to gauge how competitive a certain position is compared to the market.
So, say you hire a manager for $50,000 and the market rate is $55,000. In this instance, the market-ratio would be $50,000/$55,000, or 0.91.
“It doesn’t mean that my wage structure has to mirror the market 100% because I could never chase that; it moves too quickly,” said Dinkin. “But I need to have an idea of what the market is, so I know what my competition is doing.”
3. Pay Range
The pay, or salary, range sets the boundaries for a particular position — its starting point and the outer limit. Within the pay range is the midpoint of the salary range, which is the average of the minimum and the maximum pay for a position and typically considered a job’s market rate. Understanding the pay range, including the midpoint, will guide you as you set salaries for new hires, or consider pay raises for existing employees.
[“We] have to have a blueprint, a guidepost to tell [us] how to operate,” Dinkin said. “Otherwise, [we’re] just doing it willy-nilly and that’s not going to work.”
4. Compa-Ratio
Also called the comparison ratio, the compa-ratio considers how much an employee is making and where their compensation falls compared to the midpoint of a salary or, often, the average market rate. Mathematically, the calculation would be the employee’s compensation divided by what the employer is comparing the salary to and would look like: Salary/the midpoint of the salary, for example.
“That’s important for a company to understand, because if [we’re] trying to attract and retain top talent, and [are] nowhere near where [we] need to be…[we’ve] got a problem,” Dinkin said.
Another way to consider pay is by looking at the salary range penetration. It compares an employee’s salary within their position’s total pay range.
That calculation would look like this: Salary minus pay range minimum, then that figure divided by the difference between minimum and maximum numbers in the range. Finally, multiply it by 100 to get the percentage.
So, for somebody making $50,000 within a pay range that stretches from $45,000 to $55,000, the salary range penetration calculation would go like this: ($50,000-$45,000)/($55,000-$45,000) x 100 = 50%.
With it, you can understand where the worker’s compensation falls within the pay boundaries of their position — and if they’re toward the bottom, in the middle, or at the top.
5. Target Percentile
The target percentile is the amount you’re willing to pay to bring on the workers that your business requires. Workers in the 50th percentile are typically making about the middle of what’s offered in the market — less than 50% of people in the same role and more than the remainder with the same job. The US Bureau of Labor Statistics offers examples for the 10th, 25th, 50th, 75th, and 90th percentile.
As you consider your company’s hiring needs, the target percentile is important. When a company’s strategic goals require hiring top talent, such as highly educated engineers to develop a new product for instance, they can’t simply offer market rate to bring them on board; the best and brightest will expect to make more than your average employee in that role. So that company’s target percentile to attract the right hires might be the 75th percentile, Dinkin said. In other words, 75% of employees in that role will make less than what that company plans to offer.
Determining the target percentile can require some complicated math. But calculators like this one at Calculator Soup can help as you consider what you’re currently paying your own employees in the role and where the new, highly talented hire might fit in. In the case of the engineering position, if you have six people in the role and two are making $100,000, two are making $120,000, one is making $130,000, and one is making $150,000, the 75th percentile would be $127,500, according to the calculator.
“It doesn’t mean that every single job in my company has to be at the 75th percentile, but if [bringing in top talent is the goal], then I have to really put my business plan to work that way,” said Dinkin.
6. Internal Equity
Internal equity is the metric used to measure what people in the same role are paid compared to employees in similar positions across an entire company. HR professionals should use this information to ensure pay equity — offering equal pay for equal work — and eliminate the historic practice of paying some individuals less based on their gender, race, or other protected class. Calculating internal equity allows employers to uncover and resolve discriminatory pay practices and demonstrate that their pay practices are fair.
“My pay practices cannot discriminate against a protected class,” Dinkin said. “So, I, as an employer, better be able to say, if ever challenged, that I can defend my pay practices.”
Calculating internal equity requires audits, an HR-led process that should happen every few years, wrote consultant Amii Barnard-Bahn in an article in the Harvard Business Review. Especially for larger-sized organizations, she recommended hiring auditors to analyze the data, identify any issues, and work on remediation. This is called a pay equity audit, or PEA, and there are companies and consultancies that specialize in this.
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As you dive into compensation metrics, it’s important to remember that employee salaries shouldn’t be your sole focus as you search for ways to boost workforce engagement and retention. Especially now, as the COVID-19 pandemic continues, company culture — the shared values and activities that bind a company’s employees together — is key, said John Millen, Managing Partner of the Millen Group, an independent employee benefits firm. People are no longer basing employment decisions on simply who will pay top dollar. They want to land where they feel valued. Said Millen: “Salary is important, but it’s not the most important thing.”
