Building a Market-Based Pay Structure

from Scratch
January 12, 2018

Scope—This article, primarily for the benefit of HR professionals who are not compensation
specialists, discusses the steps involved in developing and implementing a market-based pay
structure. It refers to but does not include a detailed discussion of job evaluation or of other
internally focused methods of setting base pay. It also does not include executive compensation
practices.

Overview

Many organizations ask their human resource professionals to create a base pay
structure from scratch or to revise the existing structure to meet their changing needs.
For HR professionals whose areas of expertise lie outside the compensation arena,
such a project can seem challenging at best. See Introduction to the HR Discipline of
Compensation.

The compensation system development process, however, does not have to be an

overwhelming and dreaded goal. Building a market-based pay structure from scratch
encompasses the following steps:

 Gathering the background information needed for project success.

 Determining the sources of external market data and getting the data ready.
 Conducting the market data analysis.
 Developing the pay structures.
 Calculating the costs of the pay structures.
 Implementing and evaluating the new pay structures.

This article walks through each of these major steps to help novices successfully
develop a complete pay structure from scratch. Those seasoned in compensation will
find the article helpful in keeping their compensation skills current in today's volatile
compensation markets.

Business Case

One of the most basic functions of business management is to establish a

compensation scheme that is competitive and equitable and that promotes employee
engagement and high performance. Competitive compensation practices are essential
to employee recruitment and retention efforts. See Maximize Return on Compensation
by Avoiding 7 Common Mistakes.

HR's Role

HR professionals are key in this process. HR professionals assist managers in

determining the functions the organization needs performed, the best organizational
structure, the market clearing price for such job functions, and ways to communicate the
compensation scheme so that employees perceive it as equitable and so that it
encourages their high engagement and high performance. HR professionals must
accomplish this responsibility in an environment where the legal landscape is constantly
changing under several federal laws. See Compensation Practices Becoming More
Formal, Rigorous.

Step 1: Gathering Background Information

Building anything of value requires a reason or business philosophy and strategy. To

ensure success of the project and complete support from the top down, the project
needs a plan that explains why the system is being built, what is to be built, how all the
pieces fit together and what the expected end result is. To build anything from scratch
requires an architect to create a plan as well as a champion to guide and drive the
process. That champion serves as the catalyst to align decision-makers and resources.
That way, what is being built successfully aligns with the organization's business
philosophy, culture, vision and mission, values, resources, and strategic objectives.
Similarly, building a pay structure from scratch requires the architect to articulate the
compensation philosophy, clarify concepts that define the fundamental beliefs about the
structure, and design and develop the strategy. The process also requires a champion
to align decision-makers, obtain buy-in from the top of the organization and execute the
plan. See What is a compensation philosophy?

Human resource practitioners are in the best position to serve in both the architect and
champion roles to accomplish these tasks. The first step in the process of building a pay
structure is articulating the organization's compensation philosophy and strategy.

Defining the compensation philosophy

A well-designed compensation philosophy supports the organization's strategic plan and

initiatives, business goals, competitive outlook, operating objectives, and compensation
and total reward strategies. See Keeping Comp on Track: Some Practical Tips.

As such, most compensation philosophies define the following basic tenets:

 To identify the organization's pay programs and total reward strategies.

  To identify how the pay programs and strategies support the organization's
business strategy, competitive outlook, operating objectives and human capital
needs.
 To attract people to join the organization.
 To motivate employees to perform at the best of their competencies, abilities and
skill sets.
 To retain key talent and reward high-performing employees.
 To define the competitive market position of the organization in relation to base
pay, incentive compensation and benefits opportunities.
 To define how the organization plans to pay and reward competitively, based on
business conditions, competition and ability to pay.

A strong compensation philosophy is typically tied to an organization's mission, core

business, operating strategies and competitive outlook. For example, a high-tech
organization, with a core business strategy to attract and retain the top professional and
managerial talent in the industry to outdistance competing organizations, might adopt a
pay philosophy and strategy of leading the market with its total cash compensation
package or of paying higher than other organizations in the industry. See Big
Companies Are Raising Wages for Lower Earners.

In another example, a warehouse, distribution and retail organization that has low
employee turnover and exists in a demographically contained community with a large
labor pool might adopt a pay philosophy and strategy of offering a compensation and
total rewards package that is valued less than that of a similar organization located 50
miles away in a highly competitive community with labor shortages and high employee-
demand issues. In this scenario, this organization adopted a philosophy of matching
supply and demand conditions for its own community and set the policy to control
cost. See What are the advantages or disadvantages of a lead, match or lag
compensation strategy?
An effective compensation philosophy should pass the following quality test:

 Is the overall program equitable? See Managing Pay Equity.

 Is the overall program defensible and perceived by employees as fair?
 Is the overall program fiscally sensitive?
 Are the programs included in the compensation philosophy and policy legally
compliant? See Conduct a Pay Equity Study to Mitigate Litigation Risks.
 Can the organization effectively communicate the philosophy, policy and overall
programs to employees? See Employees Rarely Understand Their Employer's
Pay Policy.
 Are the programs the organization offers fair, competitive and in line with the
compensation philosophy and policies?
To effectively exist and thrive in today's competitive marketplace, many organizations
realize that a one-size-fits-all strategy regarding compensation philosophy does not
work. Different philosophies may be developed for different employee segments, such
as "hot jobs," information technology, hard to fill, administrative and
operations. See Philosophizing Compensation.

Management team buy-in

By virtue of its position in the organization, HR can best serve as the architect of and
champion for articulating the organization's compensation philosophy and strategy. To
serve effectively in those roles, HR needs to develop a knowledge and understanding of
the following:

 The marketplace for labor.

 The compensation and benefits survey tools necessary to scan the competitive
marketplace.
 The jobs in the organization.
 How supply, demand and labor market issues affect the organization.
 The operational and legal ramifications surrounding the compensation and total
reward programs the organization is considering or currently offering.

See Business Acumen: More Than Just Business Knowledge.

Although HR is clearly in the lead in developing an organization's compensation

philosophy and policy, success lies in close collaboration with the leadership team to
obtain valuable input, direction and concurrence. Important questions to ask the
leadership team in developing an organization's compensation strategy include:

 Where is the organization positioned in terms of market competitiveness?

 Who are the organization's main competitors?
 What is the organization's mix of base pay, variable and incentive pay, working
conditions, and benefits offerings?
 How are pay and total rewards distributed? See What are total rewards
strategies? Can you give me some idea on how to develop a total rewards
strategy?
 Do employees value the organization's programs, including pay, health care
benefits, retirement and savings benefits, vacation and paid time off, incentives,
and profit sharing? See Total Rewards Trends for the Next Five Years.
 What are the strengths and weaknesses of the organization's current
compensation and total rewards programs?
 Is the organization able to attract, hire and retain the human resources it needs
to be competitive and operationally effective?  
 Is the company measuring key retention metrics? How long do employees stay
with the organization? What is the turnover rate? Why do employees leave, and
where are they going?
  Can the organization afford and effectively execute its current or proposed pay
programs?
 Does the organization have any potential constraints in executing a unified and
consistent compensation philosophy, such as legal, union and nonunion issues,
internal and external labor markets, or special contracts? What are the
organization's career development and promotion policies and
strategies? See Promotions See Uptick, but Not Related Pay Increases.
 What is the organization's labor mix?
 How will the organization align pay and rewards with individual, team and
organizational business initiatives and performance expectations? See Variable
Pay Aligns Performance with Rewards.

By obtaining valuable input from the leadership team and by adopting a collaborative
process to answer important strategy questions, HR professionals effectively create the
environment necessary to obtain buy-in on a compensation philosophy and strategy
from key decision-makers. This process does not happen overnight. Rather, to be
successful, HR will need more than one lengthy discussion with management team
members to generate the necessary, diverging viewpoints that best represent
consensus on how to link the compensation philosophy and policy to the organization's
mission, core business, operating strategies and competitive outlook.

Other information needed

HR professionals need to gather additional information at the start of the project. The
approximate time required to compile this information will vary based on the size of the
organization and other complexities like locations, reporting structures and level of
management layers. The needed information includes:

 Current job descriptions. Job descriptions provide the essential information for

comparing an organization's positions with external survey positions. If managers
have updated job descriptions within the last one to two years, expect one week
to gather. If managers have not updated their job descriptions in several years or
if no descriptions exist, the updates should occur first to ensure an accurate
market comparison. This step can take up to six weeks to fully complete
discussions with managers and, in some cases, with incumbents.
 Current compensation "program" pros and cons. Examining the
organization's formal and informal compensation history reveals what has worked
in the past and should be maintained in the new system, and what should be
avoided. Expect one to two weeks, depending on the depth of information
available and familiarity of the project lead with the compensation program.
 Salary surveys. Salary surveys provide the external market data necessary to
create the pay structures. Expect two to three weeks to research, order and
receive, if the surveys are ready for delivery. If current-year surveys are not
published, HR may have to use the previous year's data with suitable aging (the
aging concept is explained later in this toolkit).
  Employee census. The cost effects of the proposed system are calculated using
current employee pay data. Expect a few hours to pull the information from the
human resource information system (HRIS)/payroll system and to format it into a
user-friendly layout. Depending on the quality of the HRIS system report writer,
this process may take much longer.
 Work locations. Organizations with several work locations must consider the
impact of geography on compensation when determining pay structures. Expect
a few hours of survey analysis to make decisions regarding geography's role in
determining pay rates.

Step 2: Selecting Sources of External Market Data and Preparing the Data

A quick Internet search will provide HR professionals with a wealth of compensation

surveys. Without formal compensation training, such findings can be overwhelming.
How do you know which surveys are reputable? Which ones are up-to-date? Which
ones provide the best value for the cost? With great focus undoubtedly on the pay
structure development process, HR must make the right decisions regarding salary
surveys before the start of the market analysis process. See The Art of Setting
Pay and Using MSAs to Benchmark Compensation.

What data sources should I use?

Finding one data source that meets all of an organization's needs is rare. Using multiple
data sources is critical in allowing for cross-validation and filling in information gaps. HR
has several options when contemplating salary data sources:

 Purchase a salary survey from a survey organization such as a consulting

company.
 Commission a customized salary survey through a consulting company.
 Purchase a salary survey from a trade organization or association.
 Use wage data from the Bureau of Labor Statistics (BLS).
 Commission a custom survey. See SHRM Compensation Data Center.

Beware of free surveys. Many individuals new to compensation, especially those

without a budget to purchase salary surveys, explore websites that offer free pay data.
However, such data vary in their reliability. As such, HR professionals should not rely on
them for building pay structures. Many organizations have experienced the fallout from
such survey data—everything from employees visiting the HR department showing that
they should be paid more because "it says so on the Internet" to union organizing drives
premised on these Internet numbers.

The issue with such free data, with the exception of BLS data, is that their origins are
unknown. Many of the surveys lack a survey participant list. Moreover, why would an
organization provide its data for free when reputable survey organizations may charge
thousands of dollars?

Organizations and consulting companies. Several reputable, long-standing

organizations specialize in producing salary surveys. Typically, the global compensation
consulting firms are also major players in the survey reporting business. When
purchasing these surveys, HR should keep in mind that prices are often considerably
lower for survey participants than for nonparticipants. Also, some consulting
organizations sell their survey reports only to participants. See How can I locate sources
for salary survey data for all industries and occupations?

Several outstanding but lesser-known organizations also produce quality survey reports.
Searching the Internet with keywords for the relevant industry or geographic region will
turn up many of these groups.

Trade and professional organizations. Trade and professional organizations and their

publications are other credible sources of salary data. They generally offer surveys to
members for free or reduced prices but also sell them to nonmembers at reasonable
rates. Sometimes these organizations do not openly advertise their surveys, but a quick
call can help identify options. HR should be aware of the potential for bias in these
studies, however, inasmuch as these organizations exist primarily to serve their
members.

BLS wage data. Another option, the BLS offers data cuts by occupation, industry and
geographic area. The data are free, so caveat emptor: The information may be a bit
dated. The most relevant results come from using data that are no more than one year
old, but if there is no budget for surveys, BLS data are better than guessing at
something so important. HR can progress the data by the market wage increase rate to
bring the information approximately up-to-date.

Custom survey. If data are not available for a specific position, industry or region,
using a custom survey is an option. The best method is to engage an independent third
party to collect and summarize the data. The third party can assure participants that the
data will be kept confidential, which should elicit more and better information from them.
Using a third party will also ensure compliance with the U.S. Department of Justice
antitrust guidelines, minimizing the organization's legal risk. See Can I contact other
local organizations in my area to get a gauge on merit projections or other
compensation and benefits data? and Avoiding Anti-Trust Violations.

Organizations like the flexibility custom surveys offer in terms of fine-tuning the data
gathering to very specific needs. However, custom surveys can take anywhere from two
to four months from conception to completion, so the time and cost factors often
outweigh the benefit of more precise data.

Linking the surveys to the compensation philosophy

Most robust surveys allow for multiple cuts based on revenue category, industry and
geography. The next step is to determine which cuts to use. Those decisions should tie
back to the organization and its compensation philosophy and yield data that most
closely match. Cuts include:

 Geographic. Often, the geographic cuts used—national, regional or local—

parallel an organization's recruiting strategy. That is, organizations typically
recruit nonexempt employees locally, so relying on local market data for these
positions makes sense. On the other hand, organizations are likely to recruit
nationally for executive positions. National data may be more appropriate for
those jobs, except in a very low-cost labor area (e.g., rural areas or southeast
United States) or a very high-cost labor area (e.g., San Francisco and New
York). In the case of the latter, in which market rates tend to deviate significantly
from the national, using city-specific or possibly regional data may be more
effective.

National survey reports often provide either geographic data breakdowns or factors for
adjusting the national data for local areas. Some survey providers also report wage
differentials for use in factoring national data to local market needs.

 Industry. Next, HR professionals should consider whether to use industry-

specific or all-industry data, again referring back to the compensation philosophy.
If the relevant industry is very competitive and employees often move among
competitors, the focus can be on industry-specific data, which may tend to be
higher than all-industry data. In some organizations, particular positions may call
for industry-specific data, such as IT positions in a high-tech company. For
positions in other departments in the same organization (e.g., finance,
accounting and human resources), all-industry data cuts may serve the purpose
because qualifications are not industry-specific. See How can I locate sources for
salary survey data for all industries and occupations?
 Revenue category. Most employers tend to use data from organizations of a
similar revenue size across all levels of positions. For a more precise
assessment, however, some organizations focus on a select subset of similarly
sized employers. This method is most easily done via a custom survey but can
also be accomplished by purchasing data cuts for the targeted group of
companies from a consulting organization. To ensure confidentiality, the data cut
is never made at a level that would allow identification of individual employers'
pay data.
In selecting a group of organizations, HR should look beyond the specific industry and
identify companies from which the employer hires or to which it loses employees. Some
employers fine-tune their data even more by selecting multiple groups of companies on
the basis of their similarly sized functional groups—for example, IT and sales.

Ensuring quality data in the analysis

HR professionals should consider the following features when determining the quality of
a survey:

 Cost. All quality surveys cost something, but participants in a survey may enjoy a
significantly reduced purchase rate. HR professionals must budget for an annual
expenditure on an investment in salary surveys.
 Participants. Surveys should have an easily accessible list of participating
organizations, so the consumer can determine whether the survey group is
relevant from a recruitment and retention perspective. Ideally, the survey will
demonstrate a low level of "participant churn" and have enough participants to
allow reporting of market rates. Typically, surveys do not report market rates
unless at least five data points are available to calculate percentile information.
For some metropolitan areas with lower participation, surveys are periodically
unable to report market rates. By and large, however, the survey should have
enough participation to provide market rates at the national, metropolitan and
various revenue levels.
 Currency. Most organizations specializing in salary surveys conduct them
annually to capture changes in the market. Some trade and professional
organizations, however, may survey their members only every other year or
every third year. HR should make sure that a survey more than a year old
provides enough value and accurately reflects the market before including it in
the analysis.

Applying statistical terms to the compensation philosophy

Most surveys report a variety of data points for use in market analyses. Surveys often
provide the average market rate, also known as the "mean." The 50th percentile, also
known as the "median," is the most commonly provided percentile statistic. The survey
may also provide the 10th, 25th, 75th and 90th percentiles. These percentiles should, at
the very least, be available for base compensation and total cash compensation, which
is base + variable pay (bonus or incentive).

Some surveys may also show "targeted" total cash compensation versus "actual" total
cash compensation. For example, a finance manager's target variable pay may be 15
percent of base pay, but he or she actually received an incentive payout equal to 10
percent of base pay. In addition, some surveys report statistics for stock options and
restricted stock.
To determine the appropriate percentile to use when reviewing market data, HR should
consider the employer's compensation philosophy:

 Matching the market. To target the 50th percentile means that an organization
wants to pay in the middle of all organizations that have a similar position. In
other words, 50 percent of the organizations should be paying less than that
market rate, and 50 percent should be paying more than the market rate.
"Matching the market" is the formal name for this approach.
 Market leader. If an organization chooses to focus on the 75th percentile and
take a "market leader" position, it will pay higher than 75 percent of other
organizations with similar positions. Organizations competing for employees with
specialized skill sets in a tight labor market or organizations that want to be a
high payer in the market typically select a market leader position. Organizations
with less robust variable compensation or benefits programs may also select a
market leader base pay position to end up with an overall 50th percentile total
compensation program.
 Market lag. If an organization chooses to focus on the 25th percentile and take a
"market lag" position, it will pay higher than only 25 percent of other
organizations with similar positions. Organizations with strong variable
compensation or benefits programs, or those encountering financial difficulties,
may opt for a market lag position.
 Lead-lag. As an additional variation, some organizations may choose to lead the
base pay market for the beginning of the fiscal year and then lag at the end of
that year. "Lead-lag" is the formal name for this approach to base pay
management.

Organizations can lead, lag or match the market at various levels of market position by
using a fixed percentile position or a fixed percentage above or below a point. For
instance, an organization can build its position at 10 percent above the 50th percentile
by increasing the survey rates by 10 percent. Spreadsheet programs afford the user
robust data analysis capabilities and rapid "what if" scenario modeling.

Selecting benchmark jobs

The first step in market data analysis is to determine the benchmark jobs or positions
that will be externally market priced. It is sound practice for an organization to
benchmark between 50 percent and 65 percent of its jobs when using market pricing.
Benchmark positions should aim to include at least 70 percent of the employee
population.

A benchmark job is one that has a scope of work and responsibilities common to other
organizations or industries. Typically, benchmark jobs can be determined by comparing
an internal job description with a survey job summary or capsule.
Jobs with similar roles usually exist across the organization. For example, many
different departments have administrative assistants. Though the job descriptions may
differ slightly, that group of positions most likely equates to one benchmark job.
Examples of benchmark jobs might include accountant, chief financial officer, registered
nurse, fundraiser and underwriter.

Survey descriptions are high level and capture only the major job functions, not every
detail and nuance of a job. Many surveys include a "degree of match" indicator, allowing
participants to indicate whether their job is bigger than, equal to or smaller than the
survey job. If relying on a single survey, HR should use caution if more than 25 percent
of the survey participants indicate their job is either smaller or bigger than the survey
job. Data adjustment (also called factoring or leveling) may be needed to account for
this scope difference.

Additional tips for identifying benchmark positions include the following:

 Always compare job descriptions—never titles alone—when deciding whether a

survey job is a good match to an internal job. Titles vary widely from organization
to organization in terms of scope size and responsibility.
 When a benchmark job matches at least 80 percent of a survey job summary or
capsule, consider it a good benchmark.
 Select benchmark positions that represent a wide spectrum of the organization's
functions, departments and levels such as type of work or job family and level of
work being performed (e.g., manager versus individual contributor, junior level
versus senior level).
 Review the benchmark position list two or three times before finalizing the list;
benchmarking can be more of an art than a science.

Benchmarking positions against the market

Benchmarking positions against the market is not an easy task. However, by keeping
the following points in mind, the process can be effective, efficient and accurate, and
yield an effective base pay system for the organization.

 Review for outliers. After pulling the various market data points, review the
salary data for outliers (extreme data points on either end), and remove as
appropriate. If the data show extreme highs or lows from one year to the next or
if one data point seems high or low, check to see if the number of organizations
or number of incumbents changed from a prior year's report. Rejecting a data
point is appropriate if it does not appear valid, but do not automatically exclude
data because they are the lowest or highest—especially when using multiple
surveys.
  Adjust as necessary. Use three or more surveys to lessen variability in data
from one year to the next. Adjust data as needed, including the following
common data adjustments:

 Adjust for geography when benchmarking positions with a local recruiting market
against data collected nationally.
 Adjust for premiums and discounts when benchmarking internal jobs against
survey jobs of a higher or lower scope. Adjustments to benchmarks reflect
factors such as scope size, scope of responsibility, market demands and niche
skills. Premium and discount adjustments should not exceed +/-20 percent to still
be considered a solid match. For future reference, always carefully document
any adjustments or changes to a job match.

 Create a market composite for each benchmark position. Combine data

points from several surveys either by simple average, employee-weighted or
organization-weighted data to develop composite market data. Most surveys
report 25th, 50th and 75th percentile data points for base salary, bonus targets,
actual bonus payouts and total cash compensation. When using surveys, be
aware that the 25th and 75th percentile data points have less reliability and can
fluctuate more year to year.

Averaging the individual 50th percentile data points from each survey creates the
market composite 50th percentile value. Sometimes, however, an organization values
the data in a specific survey more than in others. As such, that survey's data can be
double or triple weighted in the calculation to emphasize its importance. In addition, HR
should be careful of weighting survey sources equally, especially if one survey has a
larger sample size. HR professionals should use judgment in reviewing the data to
determine the best approach. There is no right answer, but with consistency, the results
will be internally accurate.

 Review current pay rates against market data. Review each benchmark's

current employee average pay rates against the target market data. Pay
particular attention to those positions with a 20 percent difference above or below
the market. Be sure that the matches accurately reflect the duties in the
benchmark position, and make changes as needed.

The composite market data points not only provide the tools necessary to create the
pay structures but also allow comparison between the market and the organization's
compensation philosophy. Reviewing the market data can confirm that the organization
has selected an appropriate compensation philosophy for its talent management needs,
strategic plan goals and fiscal realities. Reviewing with senior management the high-
level composite market data against the compensation philosophy also affords the
opportunity to obtain further buy-in and any necessary modification to the compensation
philosophy.

Step 4: Developing the Pay Structures

HR can use the composite market data to develop the actual pay structure by
constructing job grades, building a market pay line and calculating the pay ranges.

Constructing job grades

A job grade or job level is simply a group of different but internally equivalent jobs.
Grades enable flexibility and internal equity in an organization by providing a framework
in which equivalent jobs are treated equally for pay purposes. Grades also establish a
promotional ladder for employees. See 'Job Leveling' Helps to Grade a Position's Value.

For complex roles and larger organizations, formal job evaluation is needed to identify
which jobs are internally equivalent. The process may take some time to complete, but it
will assist in creating a defensible and transparent salary system. In new or recently
restructured organizations, job evaluation is particularly helpful in clarifying the role,
responsibility and reporting relationship of each job. See Matching Jobs with Pay.

A complete description of how to do job evaluation is outside the scope of this paper. In
brief, formal job evaluation is a process for analyzing a job based on a number of
criteria such as knowledge, experience, decision-making authority, autonomy,
supervisory responsibility, creativity, physical demands, job environment, job scope and
organizational relationship. Many samples of job evaluation questionnaires are available
on the Internet or through consulting companies. See Performing Job Evaluations.

Formal job evaluation systems usually provide results in numeric points, which enables
spreading these points into job grade categories. Dividing lines between job evaluation
points is challenging and hence must be based on a consistent logic driven by both the
main driver of the job evaluation points and business strategy. Arriving at the right
structure with the correct number of grades and job grouping may require trial and error.

A simpler method of developing job grades is to do whole-job slotting, in which jobs are
internally compared against one another. In this method, factors such as reporting
relationship, job scope and current pay relationships determine grade placement.

In many organizations, the number of job grades matches the number of pay grades,
and those terms have been used interchangeably herein. Having more job grades than
pay grades is possible, however, by combining a few job grades into the same pay
grade. This is usually done in organizations in which the culture supports career path
promotions such as a technical career path. When combining multiple job grades into
one pay grade, the range minimum is based on the junior-most job grade, and the range
maximum is based on the senior-most job grade in that pay grade. This method enables
employees and managers to be aware of the potential progression possible from the
starting role to the ending role in a particular career path. (Range minimum and
maximum are explained below.)

Building a market pay line

A market pay line is built using the composite market data points. It allows an
organization to translate the market data into usable information.

Building a market pay line starts with plotting the matched jobs and their dollar amounts
on a graph. The grades or benchmark jobs at each level determine the ordering of the
jobs on the X axis. HR professionals can use freehand to connect the data points or use
a regression analysis tool, such as MS Excel, to create the market line. Simply put,
regression helps smooth the data and have a fixed rate of variation between different
points, especially when there are multiple benchmark jobs and some variation exists
among the data.

Calculating pay ranges

A pay range exists whenever an organization must pay different amounts to employees
in the same job grade. Ranges provide flexibility to managers to recognize factors such
as experience and performance. Ranges also permit the recognition of learning curves
and performance variation of employees in their roles. Typically, organizations calculate
only base pay ranges because base pay reflects the guaranteed cash payments and
the basic value of the work.

Pay ranges are calculated for each job grade and are simply a spread of plus and minus
of the target/market pay point, also known as the range midpoint. Range maximums set
the ceiling for a particular pay grade. Range minimums set the floor. Typically, for junior-
level jobs the range spreads are small or perhaps even nonexistent when flat rates are
used. On the other hand, range spreads are often wide for management roles to reflect
the performance and learning curve variation.

The midpoint corresponds to where the pay line crosses each grade. Judgments about
how the ranges support career growth, performance rewards and promotions determine
range spread. Ranges tend to widen higher in the organization. Organizations can have
ranges with a spread of 25 percent at lower grades to 75 percent for senior roles. Wider
ranges at senior roles reflect the opportunity for individual discretionary performance,
longer learning curves for the position and longer lengths of stay of incumbents in the
same position.
In order to determine a fixed percentage within a range spread, the following
calculations would be made.

Step 1. Calculate the range spread:

(Grade Maximum - Grade Minimum) / Grade Minimum

Grade A has a midpoint of $37,500. The minimum and maximum are $30,000 and
$45,000. In this example, the range spread is 50 percent [$45,000 – $30,000 / $30,000
= 50 percent].

Step 2. Calculate a fixed percentage in the range spread:

For example, find 10% percent above and below the midpoint.

Grade A has a midpoint of $37,500.

$37,500 x .10 = $3,750. 10 percent above the midpoint is $41,250.

$37,500 x .10 = $3,750. 10 percent below the midpoint is $33,750.

On occasion, some organizations use the actual market positions of 25th percentile and
75th percentile as the minimum and maximum points for the ranges. This is a possibility
if the approach is based on the organization's desired market position. However, the
25th and 75th percentiles are subject to greater fluctuations in surveys from year to
year. An organization may also end up with very tight range spreads (e.g., 20 percent)
or very wide range spreads (e.g., 80 percent) due to variation in the market data.

Ranges between grades tend to overlap. The extent of overlap can be measured as
follows, continuing the example from above:

If there are two grades, A and B, and B is higher than A, then overlap equals 100 x
[(maximum of grade A - minimum of grade B) / (maximum of grade A - minimum of
grade A)].

Although there is no ideal amount of overlap, too little overlap can lead to high cost
during promotions. Too high of an overlap will lead to low interest in promotions
because the amount of promotional increase will be too low.

Broadbanding, another approach to setting the pay range, is outside the scope of this
article. Generally, however, broadbands consolidate three to five traditional ranges into
one single band. Bands typically have a minimum and a maximum but no midpoint.
Range spreads in a broadbanding system are usually 100 percent or more.
Organizations use bands to create flexibility within the organization and to break down
barriers to promotion and career development.  
Compensation is partly art and partly science. Because internal job evaluation or
internal slotting of jobs determines job grades, these reflect the internal value, whereas
the pay ranges reflect the market or external value. Inherently, some instances of
misalignment will occur between the two. On occasion, jobs may be reslotted. This
situation occurs when the position has a greater strategic importance to the organization
than the external market reflects. In other cases, the position may have less value than
the external market affords it. HR should use such reslottings of benchmark positions
sparingly and with caution to avoid undermining the foundation of the job evaluation
system. The goal is to minimize misalignments as much as possible to ensure the
compensation system meets the organization's needs for strategic success.

See:

How to Establish Salary Ranges

Salary Structures: Creating Competitive and Equitable Pay

Employers Pursue Global Grade Structures, Despite Challenges

Step 5: Calculating the Costs of the Pay Structures

After creating the new pay grades and ranges, the next project step is to consider the
financial impact of those ranges. One of several approaches provides HR and
management with the necessary financial impact information:

 Bring-to-minimum calculations.
 Compa ratio analysis.
 Adjustments for compression and equity.
 Bring-to-minimum

Bring-to-minimum calculations

The simplest but often most essential calculation is the bring-to-minimum adjustment. In
this scenario, the financial model compares each employee's current pay with his or her
new pay range minimum. Employees with pay rates below the minimum receive an
adjustment to the minimum of the pay range. These pay rates are also known as green
circle rates. Employees with pay rates above the minimum receive no adjustment.

For example, continuing the earlier scenario, employee X and employee Y are both in
pay grade A. Employee X earns $29,000 a year. Given that the minimum is $30,000,
employee X would receive a $1,000 base salary pay increase to bring them to the
minimum in the pay range for their grade, of $30,000.
Employee Y, on the other hand, earns $48,000. As such, employee Y would receive no
bring-to-minimum adjustment because the maximum in the pay range for their grade is
$45,000.

Finding the cost of the total bring to minimum pay adjustments for all employees:

Totaling the annualized bring-to-minimum adjustments for all employees provides the
total annualized bring-to-minimum cost impact of the new pay system. This figure
divided by the total current payroll allows management to see the cost impact from a
percentage point of view. For example, if an organization's total payroll is $1,000,000,
and total bring-to-minimum adjustments are $20,000, the total bring-to-minimum cost of
the program is 2 percent of current payroll.

Compa ratios

Comparisons of current employee pay and the new system midpoints determine compa
ratios. The formula for compa ratio is (current employee pay) / (current range midpoint).

Compa ratios are useful for identifying at a glance which employees' pay rates are
below the minimum (green circled) and above the maximum (red circled), and which
employees fall above or below the midpoint. If most employees' pay rates fall above the
midpoint, the new system risks quick obsolescence. Ideally, the majority of employee
pay rates should have room to grow in the pay ranges. See Compa Ratio Calculation
(Excel).

Compression and equity

Organizations may want to consider adjustments that address undesired compression,

such as closeness in pay rates, between employees. Organizations may adjust pay
rates to reflect length of service, experience or performance. In these situations,
employees' pay rates may be increased a certain percentage above the range minimum
for each year of service or higher level of performance. Employees with pay rates higher
than the recommended adjusted rate would receive no increase; employees with pay
rates lower than the recommended adjusted rate would receive an adjustment. For
example, organizations that want to recognize years of service might increase each
employee's pay 3 percent for each year of service in the position, up to 10 years. Pay
rates for new employees are set at the minimum of the range. Employees with one year
in the position would be paid 3 percent above the range minimum. Employees with 10
years in the position would be paid 30 percent above the range minimum.
Although an organization should ideally avoid pay rate compression, doing so is not
always fiscally possible. As such, an organization may have to forgo the compression
adjustments and look only to bring-to-minimum changes. Or an organization may focus
its limited dollars on adjustments for hot jobs in year one and changes for other
positions in year two of the system. Alternatively, timing any structure-related pay
adjustments for after annual merit increases allows the organization to reduce the total
program costs. The merit increases fund part or all of the market adjustments. 

Step 6: Implementation and Evaluation

Policy development

The organization's salary structure policy ultimately drives communication and

training. The new compensation policy should include the following details:

 How often the salary structures will be updated.

 The effective date of the structures.
 Roles, responsibilities and procedures for updating salary structures, including
approval authority, surveys used and frequency of participation, and desired peer
comparison list.
 Which positions will have access to the salary structures, how broad or limited
general access to the system will be, and whether the system will be open or
closed to employees.

To avoid misunderstandings, thoroughly vetting these issues with stakeholders at the

beginning of the project is critical. At project conclusion, HR should document the
approved policy during the new salary structure rollout.

Communication

Depending on organization policy, HR may be the only one with access to the
structures, or all managers and employees may have access. Organizations may
operate anywhere along a communications continuum by deciding to entirely restrict
employee access to salary ranges, by allowing employees to view their own range or by
permitting employees to examine their own range and the next highest range. Managers
typically have access to all salary ranges or the salary ranges relevant to their team
members. However, some organizations may decide that salary range information is too
sensitive and, as a result, restrict it entirely.

Regardless of the target group, understanding the goals of the communication process
is important. These goals generally fall into one or more of the following categories:

 To ensure understanding.
 To change perceptions of equity and competitiveness and to garner buy-in.
  To motivate behavior such as pay for performance, pay for skills and the like.

Organizations should tailor each communication based on the target audience and the
communication goals. For example, the goal in communicating the new salary
structures to the executive team may be to change a perception that a salary structure
will bring unwanted bureaucracy or to secure buy-in on the list of surveyed peer
organizations or selected salary surveys moving forward. Communication to managers
who will administer pay using the new structures might simply be to ensure
understanding of effective dates, how to access the structures and how to effectively
use the structures when hiring new or promoting current employees. Communication to
employees who will be paid with the new structure must demonstrate fairness, equity
and competitiveness and link to business strategy.

Training

The organization's policy regarding access to salary ranges and responsibility for
administering pay in the organization drives the training process. Managers expected to
effectively administer the pay of their team members need training on compensation
philosophy, salary survey sources, how salary ranges are constructed, and how to use
the structures when determining appropriate pay for new and existing employees.

To help managers effectively set expectations for employees regarding their position in
a pay range over time, explaining the pay/performance continuum is helpful. Under this
approach, top performers reach the maximum of the pay range much faster than
average-performing co-workers. Employees who are steady, average performers may
never exceed the range midpoint because their performance matches the market pay
rate for someone fully competent in the position. Pay rates for employees with
unsatisfactory performance, should they not be exited from the organization, should
never progress very far above the range minimum.

If employees can view their own salary range and other salary ranges, they should
receive training on understanding the organization's compensation philosophy, salary
survey sources and salary range constructions. Employees may not be prohibited from
discussing their own salary with other employees given that this is protected activity
under the National Labor Relations Act. See Can an employer in a nonunion facility
prohibit employees from discussing their salaries?

Pitfalls to avoid

A comprehensive salary structure policy goes a long way in helping the organization
avoid many common pitfalls if it clearly states decision-making authority, roles and
responsibilities regarding pay. Two common pitfalls of compensation systems are the
following:

 Salary structures do not reflect the organization's compensation

philosophy. If midpoints are to reflect the theoretical external-market average
competitive rate, organizations should make sure they do. Falling compa ratios
due to budget restrictions should not rationalize lower midpoints. Managers must
be able to rely on the midpoint to set reasonable hire rates, recommend pay
increases and justify the salary range to employees.
 Salary structures provide no accountability for managers to administer
pay. Managers are in the best place to assess performance and equity of team
members. If the organization arms the management team members with the
tools, information, training and coaching they need, they will manage pay
effectively.

Evaluation

Like any other program, evaluation is critical to determining the effectiveness of the
compensation program. Using metrics such as employee and manager feedback,
voluntary employee exit surveys and the cost of compensation in relation to company
profitability, HR professionals can assess the compensation program. See The
Compensation Scorecard: What Gets Measured Gets Done.

Global Issues

Increasingly, employees operate in a global competitive environment. Organizations

must take this into account when designing compensation plans and make decisions
regarding paying locally or globally or taking a hybrid approach.