Compensation Management: Theories & Challenges

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  • 0:02 What Is Compensation…
  • 1:14 Compensation…
  • 3:32 Compensation…
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Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

Compensation management is the art of using different pay and benefits to recruit and keep the best talent within an industry. In this lesson, we'll learn about some theories and strategies of compensation management.

What Is Compensation Management?

Compensation is the set of valuable things that is given to employees in exchange for their labor. Usually compensation is money, which is given to employees as an hourly wage or salary. However, in addition to pay, some organizations offer benefits, stock options, bonuses, profit sharing, commissions, allowances, and other rewards.

It is very common for labor to be the largest expense for an organization. As such, systems are put in place that attempt to ensure that no money is being wasted and that the money that is spent secures the highest levels of productivity from the best employees possible. These systems are called compensation management.

The ideal compensation management system pays employees well enough to be motivated to do their best and want to stay with an organization. New talent will be drawn to the company based at least in part on the fact that employees at the firm are compensated fairly. Those who are not performing at high levels will receive less pay than their productive counterparts and will eventually leave the organization to make room for more-talented individuals.

Compensation Management Theories

There are three main theories that are used by human resource professionals when developing compensation management plans:

  1. Behavior Reinforcement Theory
  2. Equity Theory
  3. Agency Theory

Behavior reinforcement theory is similar to that of operant conditioning. If a person is rewarded for a particular behavior, he or she is more likely to perform those actions again. You can probably think about a time when you did something that made your parents or teacher happy, and you were rewarded in some way. The positive reaction motivated you to do the same actions again because you would anticipate getting the same or a similar reward.

Equity theory suggests that employees' actions will be changed based on their perception of how they are paid in comparison to their coworkers. For example, if you and Billy work the same number of hours and have the same type of job and a similar level of work experience, you would expect to be paid fairly and about the same salary. However, if you discovered that Billy was paid more than you are, then your productivity will probably decrease so that you are only working up to the level that is fair based on your new perception of your compensation.

Agency theory attempts to use pay in order to get the different interests of people involved with the company to become one in the same. There are many categories of people within a company and each has their own set of priorities:

  • Employees wish to have a safe workplace, to be paid fairly based on their level of effort, and maybe even share in company profits if the company is successful. After all, the company could not make profits without employees.
  • Management seeks to increase the productivity of employees and to be paid fairly based on their level of expertise within the organization.
  • Stockholders want the company to maximize profits by reducing costs (including labor expenses) while increasing the value and reputation of the company.

As you can see, the priorities of each group can be in direct conflict. The agency theory of compensation management can make it a priority to maximize productivity, performance, and the reputation of the company so that employees, management, and stockholders all ultimately have the same goals.

Compensation Management Challenges

Here is a short list of common challenges that face compensation managers today:

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