Importance and Common Types of Compensation

Updated September 28, 2023

In exchange for services, employees are rewarded with base salaries, incentives, commission, wages and other benefits. Most employers recruit well-qualified employees who are loyal and productive. To attract and retain productive workers, employers provide competitive compensation packages. In this article, we explain what compensation is, the importance of compensation and common types of employee compensation.

What is compensation?

Compensation is the systematic approach of providing monetary values to an employee as a reward for work completed or service provided. The approach adopted by employers helps a business or a company determine the wages and other benefits of employees. Compensation is also adjusted depending on the goals, available resources and the needs of a firm. Besides, compensation is used as a tool by management for numerous purposes aiming to sustain a company. The following are some of the ways employers can use compensation strategies:

Rewarding and encouraging peak performances
Increasing and maintaining morale or satisfaction
Recruiting and retaining qualified employees
Achieving external and internal equity
Modifying practices of employee unions through negotiations
Reducing turnover and encouraging company loyalty

Components of compensation systems

The compensation system becomes fair to both employees and employers when it is based on systematic components. The components are used to determine the value of various positions. Some of the common compensation components used by employers and management include the following:

Job description: The job description defines the functions, responsibilities, requirements, environment, duties, conditions and location, among other aspects of a job position. The description can be developed to define each job position individually or for an entire team. The job description is used to determine the compensation of various functions.
Job evaluation: Evaluation is used to determine the value and worth of jobs with other positions in companies. Evaluation involves a systematic comparison between job positions to determine value to establish rational pay structures. Four main techniques are used in the assessment to determine the worth of the job. The methods include factor comparison, point method, classification and ranking.
Job analysis: Employers study various job positions to determine the responsibilities and activities of each position, necessary qualifications and conditions of performing the job. Job analysis techniques used include questionnaires, observation and interviews.
Salary surveys: This involves the collection of market data and salary information. The information collected includes cost of living indicators, inflation indicators, average salaries and salary budget averages. Firms can use reports from reliable survey companies or conduct their surveys.
Pay structure: Structure is used in standardizing compensations. Pay structures include grades, with every grade having minimum wages and steps of increasing the salaries and raising the grades.
Policies and regulations: There are numerous federal, tax, local employment and province laws that affect compensation. The rules define wages, shape benefit plans and influence the amount of pay for employees.

Types of employee compensations

Besides the basic salaries, employees enjoy a variety of compensations. Here are some of the common types of compensation packages for employees.

Base pay

Base pay involves the minimum wages or salaries that employees receive as payments. Base pay is also referred to as the fixed amounts of money employees get as a reward for their services. The payment rates can be daily, weekly, monthly or annual. Several factors affect base pay rates. The aspects include the following:

Skillset and level of education: The level of education and the skillsets required for a job affect the base pay rate. For example, a profession or a career requiring specialized knowledge and skillset generally offers higher base pay than those provided to manual and other roles where skill sets and knowledge are not a requirement.
Supply and demand in labour markets: Supply and demand for employees in a particular job position impact salaries. For example, if the demand for IT professionals is high, the base salary for the technicians increases.
Location: The cost of living in an area affects the base salary. Employees working in a town where the cost of living is high attract better pay than other employees in areas where inflation of the cost of living is low.
Personal profile of the applicant: The unique characteristics included in the profile of a candidate can impact the base pay. Education level, experience, referrals and key performances are factors that can affect the base salary. Candidates with broad experience and good performance attract higher base pay compared to candidates with poor evaluations.

Commissions

Commission packages are compensations given based on performance. Some employers offering commission packages offer a low base salary with high commissions, while other employers offer commissions without a base salary. The commission motivates employees to improve productivity and perform well because their pay is impacted by performance. Commonly, commission packages are given to employees in sales jobs. The salespeople receive an agreed percentage on the amount they generate, or it can also be flat rates when they meet the targeted sales.

Overtime pay

Employees who exceed the regular working hours are rewarded with overtime compensation. The overtime pay varies as employers have different specifics of calculating overtime compensation rates. However, the rate agreed is multiplied by the hours of overtime. Standard overtime rates are double or one and half times the average pay rates. To calculate your overtime compensation, multiply the normal pay rate by the set overtime rate.

Bonuses

Employee bonus is determined by the performance of employees, the company or the team. The compensation is given to team members or individuals who reach the targeted goals. Bonus pay motivates employees to perform better. There are different types of bonuses that employees get as compensation. Here are some of the types of bonuses:

Performance-based bonuses: These bonuses focus on performances and are given to encourage employees to achieve target goals. The bonus is given over time according to companies' plans; it can be semi-annually or annually.
Spot bonuses: These bonuses are rewards showing immediate acknowledgement for excellent performance and contributions of employees. The bonus is given based on feedback and observation of exceptional efforts. This is a quick method of appreciating well-performing employees without waiting for the year-end bonus.
Sign-on bonuses: These bonuses are useful in attracting applicants to join a firm. The bonus is given after a candidate clinches the job. Employees receive this bonus first payments or shortly after joining the company.
Retention bonuses: This bonus is useful in retaining important employees during transition periods such as acquisitions or mergers. The amount given as a retention bonus varies with the contribution, achievements and position of employees.
Referral bonuses: This is a reward for current employees who successfully refer interested job applicants who qualify and are hired. These bonuses are incentives that encourage employees to find suitable and qualified job candidates.
Project-based bonuses: These are rewards for employees who have completed specific projects under budget, on time and within the performance criteria established. The bonus is based on project metrics and is useful in encouraging team members of projects to meet set deadlines.

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Importance of compensation strategies

Compensation is an essential element of business. Having excellent compensation plans may provide a firm with an edge in competitive industries. Here are some of the importance of having and implementing compensation strategies.

Increase employee motivation

Rewarding employees gives a sense of worth and value. With the feeling of appreciation, you increase the morale of employees and in turn, productivity increases. Besides, with the hope of getting bonuses and other compensation, employees find the motivation to deliver better results.

With job contentment and morale coming from compensation, there is steadiness and improvement in performance. The monetary value invested in the compensation of employees is paid back by the increase in productivity. However, if an employer reduces the salary and fails to pay other compensations, they lower morale, which lowers productivity.

Competitive recruitment edges

Salaries and other compensations are motivating factors for some job applicants. Therefore, a company offering better compensation than its competitors stands a better chance of getting the best employees. Although other factors such as responsibilities, working hours and the work environment are some aspects job applicants consider, some also look for well-paying jobs.

Legal compliance

There are province and government laws that govern various facets of employee pay and working hours. The rules cover the minimum rates and the number of hours employees can work in a week. Beyond the given hours, the employees are entitled to overtime pay. Employers have to comply with the laws to avoid lawsuits or actions by the government.

Employee loyalty

Employees who are contented with the salary and other compensations are likely to stand for a company. One way of showing loyalty is by staying at the company even when the business is not doing well or getting other job offers. Businesses benefit from loyalty and employee retention as they may not have to pay the separation rates and incur other costs when recruiting a replacement for employees who have left their positions.

Increased production

Happy employees can be very productive. Compensation is one way of making employees feel appreciated and part of the project. Furthermore, other rewards like bonuses motivate workers to perform well and efficiently. With good performance and quality services, production increases.