- The four primary direct forms of compensation are salary, hourly, commission and bonuses.
- Beyond direct compensation, there is indirect compensation, such as benefits and equity-based programs, which is just as important a part of your plan.
- The right way to launch a compensation program has a lot to do with doing your research first and then not skipping or missing any critical steps.
- This article is for small business owners and employee supervisors who want to learn more about what a compensation program consists of and how to implement it successfully.
What is a compensation plan?
A compensation plan, also referred to as a "total compensation plan," encompasses all of the compensatory components of a company's strategy – employees' wages, salaries, benefits and total terms of payment. Employee compensation plans also include raise schedules, all fringe benefits, and any union perks or employer-provided vendor discounts.
A strategically designed compensation philosophy that is kept current, relevant and in accordance with employment laws, supports several important components of your business:
- Strategic plans
- Budgeting and business goals
- Industry-competitive challenges
- Operating needs
- Total reward strategies that support retention of the company's top talent
The Society for Human Resource Management (SHRM) further outlines the purpose and value of maintaining a dynamic and strategic compensation program:
- It describes how your organization's pay and compensation philosophies support your business strategy, competitiveness within the industry, operating objectives and staff needs.
- It helps attract qualified candidates to join your organization.
- It serves as a strong motivator for employees to perform at high levels and exceed goals.
- It helps keep your business competitive in the marketplace in terms of base pay, incentives, total compensation and benefits opportunities.
Key takeaway: A compensation program constitutes a company's total method of renumeration, including payment, benefits and any other form of compensation for services rendered.
Why do companies need a compensation plan?
Companies need a thoughtful compensation program to remain competitive within their industry and to attract and retain top talent. Employers who just go with whatever they feel they should pay their employees will slowly lose the talent game they are playing with their competitors. Additionally, managing a workforce without a predetermined budget is insanity in action. Compensation programs allow for consistent and predictable budgeting and planning.
According to PayScale's 2020 Compensation Best Practices report, companies are having a tougher time than ever finding (and keeping) enough skilled talent to fill all of their needs. To attract and retain the top workers they desire, more organizations are focusing on building "an employer brand, which includes a more strategic approach to compensation and career pathing as well as better benefits and more varied and incentivizing ways to reward performance."
Key takeaway: Every company needs a compensation plan to organize and strategize how they will attract and retain top talent, as well as to budget in a wise and predictable manner.
What is direct and indirect compensation?
The most foundational of compensation components are either "direct" forms such as salary, hourly pay, commission, or bonus monies, or "indirect" forms, which are benefits of various kinds.
The 4 types of direct compensation
Although you can use any of the four types to compensate employees for their work, employers typically choose one and stick with it. The exception is bonus pay, which is meant to be an addition to regular pay based on employee or company performance.
The most traditional form of salary is a monetary amount scheduled over a one-year period. How often salaried employees are paid is another part of the compensation strategy, but businesses typically pay their employees every two weeks.
Salary is the most common method of direct compensation for exempt employees. An exempt employee is not eligible for overtime pay. They receive a base salary for the work they perform rather than an hourly rate, so employers pay exempt employees for the job they do instead of the number of hours they work.
Nonexempt employees are typically paid an hourly rate, eligible for overtime pay and guaranteed at least minimum wage. When an employee works over 40 hours in a workweek, their employer must pay them overtime.
Hourly rate of pay is typically a predetermined dollar amount per hour of work. Typically, nonexempt employees are paid an hourly rate rather than a salary. They employees generally keep a timecard or clock in and out to begin and end their work shift. During times of slow or reduced work, or a change in a company's budget, nonexempt employees may not work as many hours as they did in previous weeks. Thus, there is no guarantee of a routine number of hours worked per pay period. [Read related article: Salary vs. Hourly: What's Better for Your Business?]
When compensation is based on volume, production or a predefined level of performance, this is a commission. Other expressions of this type of renumeration are "piecework" and "piecemeal."
Most commonly, there are two methods utilized and referred to as paid commission. One calculus is based on volume of services performed or products made. The second form is structured around sales volume. An example of a worker with this type of compensation is a real estate broker: They sell a house and will be compensated off of that sale. It doesn't matter how long or what work activities it took to sell the house, only that the house was sold.
Bonuses are used to motivate employees or increase their overall performance. This is a variable method of compensation that is commonly associated with sales professionals, who tend to be salaried or exempt personnel. For example, if a sales professional exceeds her quarterly target by a certain dollar amount, based on a predetermined matrix, she receives a commensurate bonus.
Bonuses can also be paid for company performance, as well as when difficult-to-fill positions are filled with employees with unique or highly sought-after skills or experience.
Types of indirect compensation
Indirect compensation can be any fringe benefit that employers offer. Most commonly, it refers to the various types of insurance offered by employers, including medical, dental, life, short- and long-term disability, and vision. Employee retirement programs, like 401(k) plans, are another common form of indirect compensation. [Looking for an employee retirement plan for your business? Check out our recommendations for the best retirement programs.]
Equity-based programs are another compensation offering, though these aren't typically offered within the small business realm. Equity-based compensation is generally some sort of share or stock in the company.
These are some other examples of indirect compensation:
- Disability income protection
- Vacation days or paid time off (PTO)
- Paid holidays
- Flexible working hours or scheduling
- Other forms of retirement benefits
- Opportunities for advancement
- Student loan assistance
- Educational benefits
- Assistance with child care expenses
- Relocation benefits
- Company car
- Company equipment (laptops, mobile phones, etc.)
PayScale's 2020 survey reveals the most common ways companies reward their top talent and their employees overall:
Key takeaway: The four types of direct compensation – salary, hourly pay, commission and bonus pay – are provided in return for completed work. Indirect compensation, on the other hand, can include PTO, healthcare and retirement benefits, flexible work schedules, and so on.
How to develop and implement a compensation plan
Think of the challenge of developing a compensation strategy less in terms of a "right way and wrong way" and more in terms of what's right for your team. Here are some suggestions to guide you along the way.
- Create an outline. Set an objective for your program and certain targets. We also suggest that you begin with job descriptions for each position on the team and set a generalized budget for your personnel.
- Appoint a compensation manager. This position, which is usually filled by someone in human resources, aligns the program and researches what each position pays within the industry, how job classifications will be determined, and how direct compensation will be selected.
- Create a compensation philosophy. Determine how competitive you are going to be within your industry's job market. Are you going to lead the market in direct compensation, or offer modest pay with great benefits?
- Rank jobs and place them within a matrix. Outline what, if any, tiers of pay should exist in pay structures for executives and sales employees, for example. You also should determine potential tiers within each job classification.
- Develop grades for seniority within each job classification. It is important to develop opportunities for career advancement. Create levels 1-3 or senior- and entry-level roles that may impact the compensation matrix but will offer advancement for employees.
- Settle on salaries and hourly rates of pay. Once you have your outline for your compensation platform, assign rates of pay and a salary range for each position and job classification. This is when you fine-tune your organizational budget.
- Complete necessary policies. A number of policies related to payroll, fringe benefits and other pay-related matters be impacted by a compensation plan. For example, companies often have policies for paid holidays, healthcare benefits, payroll administration, and company-issued pay advances that need to factor into or at least align with the company's compensation policy. [Read related article: Employee Handbooks for Startups]
- Get approval or buy-in from your company's other leaders. Once everything is in place, ensure that all of your company's leadership remains on board and in full support of what you'll soon launch.
- Develop a communication plan. All your employees should learn about the compensation program at the same time. Use several methods of communication to share the plan (e.g., email, group gatherings, social media, flyers in common areas, etc.). Issue this messaging in multiple languages if not all your employees speak English as a first language. You should expect a lot of questions. The complexities of total compensation are not easily understood by everyone – and it is essential that every employee understands their compensation package.
- Monitor so you can adjust or evolve as needed. Be prepared to make modifications to your compensation. Over time, adjustments will be necessary for you to remain legally compliant and competitive.
Ensuring equity, fairness, legality and competitiveness
Part of developing a compensation plan is ensuring it's fair for all your employees. This does not only pertain to gender, culture, race, ethnicity and so on, although that is part of it. We are also talking about skill sets and experience that new team members bring to your company.
SHRM outlines a quality test that your compensation plan should pass before you unveil it to your company. The test addresses the following questions:
- Are the programs in the compensation philosophy and policy legally compliant? Be mindful of both state laws (which include PTO or vacation regulations in some cases) and federal laws (such as the Affordable Care Act).
- Is the overall program equitable (i.e., fair to all employees)?
- Is the overall program defensible and perceived by employees as fair? In this case, perception is reality.
- Is the overall program fiscally sensitive? That is, can you maintain the benefit offerings even if profits dip for a quarter or two?
- Can your organization effectively communicate the philosophy, policy and overall program to employees?
- Are the programs fair, competitive, and in line with your overall compensation philosophy and policies?
- Is the compensation policy competitive? Will it help your organization attract and retain top talent in your industry?
There are many reasons to adjust or update your compensation program. It may grow out of date for your company, or it may not comply with new employment laws. Retention and recruitment purposes are other motivating factors to keep your compensation plan active and relevant.
Each of these attributes represents a critical value to any compensation program, as it's the foundation of the employer's relationship with each of its employees.
Key takeaway: You need a solid plan for developing and implementing your compensation program. Make certain that you are creating a system that is equitable, fair, legal and competitive – or you'll have a lot of repair work down the road.
Compensation plan examples
Although it is difficult to see other companies' total compensation programs (as many companies hide these details from outsiders), we can share a number of resources that have worked well for others. These are a few of the many compensation planning and design companies that the SHRM lists as resources:
- Culpepper and Associates Inc.
Services offered: Compensation surveys and services
Services offered: Talent management suite
- CompensationCloud Inc.
Services offered: Employee compensation management software
- Flex HR
Services offered: Full-service consulting
- CRG emPerform
Services offered: All-inclusive employee performance management
Key takeaway: There are many resources for templates and tools for compensation plan development. These options can make the task of creating a comprehensive compensation plan more manageable.
Compensation plans are helpful to anchor down a company's plan for attracting and retaining the best team members possible. Be sure to take the time necessary to develop a complete program and communicate the plan effectively to everyone on your team.