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Compensation Equity: Definition & Importance

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  • 0:02 Compensation Equity Defined
  • 0:53 External & Internal Equity
  • 2:18 Employee Equity
  • 3:42 Importance
  • 5:39 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Employees want to be treated fairly by employers. This is especially true in the area of compensation. In this lesson, you'll learn about the concept of compensation equity, including internal equity, external equity and why compensation equity is important.

Compensation Equity Defined

Kathy owns a custom furniture company. Her company makes custom furniture by hand and sells it through the Internet and a small company-owned retail store. She employs a broad range of employees, from artisans to salespeople to office staff. Her company is going through a growth spurt, and she has recently increased her labor force by about a third. In bringing new employees into the company, Kathy needs to be mindful of pay equity.

Equity is a sense of fundamental fairness. In the context of compensation, financial equity, or compensation equity, is the perception by employees that they are being paid fairly. The perception of being overpaid or underpaid can create a sense of inequity in the workplace - a sense of unfairness. Compensation equity has an external component and an internal component. Let's take a look.

External & Internal Equity

Kathy knows it's important that her employees believe they are being paid a competitive wage. A competitive wage is a sign of external pay equity. External equity is the perception that an employee is being paid the same as others working in a similar job at other companies.

Kathy also knows it's important for her employees to believe that everyone inside the company is being paid fairly. This sense of internal fairness is often referred to as pay equity. Pay equity means that employees believe that their pay is basically equal to the value of their work. It also means that employees that have equivalent responsibilities with about the same degree of knowledge, skills, experience, productivity and seniority are paid about the same. It's important to note that the focus is on equivalent responsibilities and qualifications, not identical.

A different job title does not necessarily make responsibilities different. For example, let's say that Kathy creates two positions. One position is called 'first assistant manager' and the second position is called 'second assistant manager.' The qualifications and responsibilities are exactly the same, but Kathy decides to pay the first assistant manager 20% more than the second assistant manager based on the title alone. This is an example of pay inequity because the responsibilities and qualifications are equivalent.

Employee Equity

Kathy does have to balance pay equity with employee equity in determining compensation. Employee equity exists when employees are paid in a manner consistent with their unique characteristics, such as level of productivity, knowledge, skills and seniority, compared to other employees.

Pay equity and employee equity are not mutually exclusive and can be logically reconciled. You will find that an internally equitable compensation system compensates similarly situated employees the same. Employees with the same experience, knowledge and skills with equivalent responsibilities are paid about the same, but may be paid differently than employees with different experience, knowledge and skill in jobs that are not equivalent. Let's look at an example.

Kathy employs cabinetmakers to build custom wood furniture. She pays all apprentice-level cabinetmakers the same base pay with an annual raise for each year of service. She pays journeyman level cabinetmakers a higher wage, which is adjusted for each year of service. Finally, she pays master-level cabinetmakers the highest base pay with additional pay for each year of service. She may also provide performance bonuses for all cabinetmakers regardless of rank. In this situation, both pay equity and employee equity are achieved because similarly situated employees within the company are compensated the same.

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