Ch. 9: Compensation
Chapter 9 (Ahmad, Boselie and Van der Heijden) deals with compensation and reward systems, the third HPWP. The lecture covers the aims of compensation, different forms and types of compensation, employment contract types, bases for pay, employee benefits, and five theories on when pay is fair (equity theory, i-deals, tournament theory, expectancy theory, agency theory). It ends with the Tinbergen norm, CEO pay ratios in the US and EU, and career tips.
1. Aims of compensation
Compensation serves several aims:
- Attracting the best human assets to the firm;
- Influencing employee attitudes, behaviours and motivation;
- Retaining good and great performers;
- Controlling labour costs;
- Employer branding (pay and benefits signal what kind of employer you are).
2. Financial and non-financial compensation
| Financial | Non-financial |
|---|---|
| Salary, bonuses, 13th month, holiday allowance, etc. | Recognition, training, flowers after 10 years of service, etc. |
The key is balance: financial rewards alone do not create commitment, and recognition alone does not pay the rent.
3. Employment contract types
- Permanent contract: open-ended employment; security for the employee and long-term investment for the employer.
- Temporary contract: employment for a fixed period or project; gives the employer numerical flexibility.
- Full-time contract: a standard full working week.
- Part-time contract: fewer hours than full time (very common in the Netherlands).
- Daily wages / absence of contract: payment per day or per task without a formal employment contract (e.g., platform or gig work such as ride-hailing or meal delivery).
4. Bases for pay: how much should you earn?
- Role-based: the job is described in a job description and pay is determined by job evaluation (the weight of the job, e.g., in a job grading system).
- Skills and knowledge based: pay depends on education and experience.
- Seniority: automatic increase based on years in the company (common in many collective agreements).
- Status/reputation: pay based on market value and fame, for example in football.
5. Forms of compensation
| Form | Description |
|---|---|
| Fixed pay (the standard) | A fixed amount per month |
| Variable pay | An amount per sale or related to performance (bonuses, commissions) |
| Employee benefits (becoming more important) | Vacation days, flexible work hours, laptop, phone |
| Cafeteria plans | Employees can partly choose their own compensation package, e.g., 'buying' and 'selling' vacation days |
Other benefits (with some specific for the US context or for countries with certain systems):
| Category | Examples |
|---|---|
| Insurance | Medical (medical care, dental care, vision care), life and other (life, short-term disability, long-term disability, long-term care) |
| Paid leave and retirement | Holidays, vacations, jury duty leave (in countries with a jury system), funeral leave, sick leave, military leave (in countries with military obligation), personal leave, family leave |
| Career-related benefits | Education assistance, non-production bonus and stock options (which can also be part of variable pay) |
| Health promotion | Employee assistance programmes (e.g., for addiction), wellness programmes, fitness centres, subsidized commuting |
| Family-friendly benefits | Child care assistance, adoption assistance, flexible workplace, employer-provided personal computer |
6. When is payment fair? Five theories
- Equity theory (fairness);
- Idiosyncratic deals (i-deals) (fairness);
- Tournament theory (pay difference between employee and manager);
- Expectancy theory (pay leads to behaviour);
- Agency theory (owner versus manager interests).
6a. Equity theory
Employees compare the ratio of their own outcomes to their inputs with that of others. Inputs: all effort, time, energy, commitment, reliability etc. that I put into my job. Outcomes: all rewards and benefits like pay, bonuses, security, personal growth, etc. that I get from the job.
A situation where employees experience their own outcome/input ratio to match that of others: (my outcomes / my inputs) = (other's outcomes / other's inputs). The comparison is influenced by perception: people often have an unrealistic view of their own task package and performance, so the comparison is often wrong. Openness and transparency about the process is key because it partly replaces perception.
John earns 3,000 euro per month and Emma 3,300 euro. Both build 4 bikes per month. John's ratio: 3,000 / 4 = 750 euro per bike. Emma's ratio: 3,300 / 4 = 825 euro per bike. John perceives inequity (under-reward): same input, 10% less pay (3,300 / 3,000 = 1.1). He may react by lowering his effort, asking for a raise, or leaving. In the second version, John builds 4 normal bikes, while Emma builds 3 normal bikes and 1 cargo bike, which is more complex. If John recognizes that Emma's input is higher, the difference in pay may be perceived as fair. This shows that equity depends on the perceived inputs, and why transparency about what counts as input matters.
6b. Idiosyncratic deals (i-deals)
An i-deal is an individual deal with an employee, for example flexible working times or extra payment. Organizations must maintain rules and procedures but also be flexible: search for balance.
- Too few i-deals and too many rules and procedures: a too rigid organization.
- Too many i-deals and too few rules and procedures: no control (and risk of perceived unfairness).
- Good check: the deal should be explainable and understandable to the rest of the organization. If not, rethink the deal.
6c. Tournament theory: a metaphor for salary spread
Salaries in a hierarchy can be seen as prizes in a tournament:
- Prizes (salaries) are fixed in advance for each level;
- You receive the prize by being better than others, not by being 'good' (relative performance);
- Higher prizes increase effort in job performance (a large pay gap to the next level motivates to compete for promotion);
- There is a limit to the spread: the risk of losing has to be acceptable (too large a gap can demotivate, encourage sabotage or reduce cooperation).
6d. Expectancy theory
Effort leads to performance, performance to reward, and reward to motivation. Questions: does my effort influence my performance? Will my performance be rewarded? Do I value this reward (valence)? Problems in practice: the relationship between effort and reward is often unclear, and the goals of employee and organization are often different (profit versus 'fun' at work). See Chapter 8 for the full theory.
6e. Agency theory
The principal is the owner of the organization; the agent is the management of the organization. There is a risk of different interests, for instance long-term success (principal) versus short-term growth or personal benefits (agent). Compensation can be used to align the interests, for example by tying executive pay to stock performance and financial targets (as a large technology company does). Agency theory can be extended to other stakeholders: society, government and employees.
7. The Tinbergen norm (1:5)
A normative suggestion: the top manager should not earn more than 5 times the salary of the employee at the lowest level of the organization. Example: if the lowest salary is 2,000 euro per month, the maximum top salary is 5 x 2,000 = 10,000 euro per month.
The question it raises: what is a fair and acceptable difference between the CEO's pay and the shop floor worker's salary?
| CEO pay | Worker pay | Ratio | |
|---|---|---|---|
| USA (S&P 500, 2024) | 18.9 million dollars (yearly increase 7%) | Median worker 49,500 dollars (increase 3%) | 18,900,000 / 49,500 = about 381 times |
| EU (top 100 companies, 2023) | Median 4.15 million euro | Average EU worker 37,863 euro | 4,150,000 / 37,863 = about 110 times |
Both ratios are far above the Tinbergen norm of 1:5. From the perspective of equity theory and legitimacy, such gaps can damage perceived fairness and societal acceptance; from tournament and agency theory they are sometimes defended as incentives and as a way to align managers with shareholders.
8. Career tips
Three tips on how to choose your job: development is more important than money (especially early career); select your boss, not the job; search for those things that intrinsically motivate you.
Three tips on how employers select employees: honesty and transparency; fit to the job (Einstein is really smart, but probably a bad HR manager); there is no 'right' answer to any question, but there is a right way of dealing with it.
Key take-aways
- Compensation aims to attract, influence, retain, control costs and support employer branding.
- Balance financial and non-financial rewards; fixed pay, variable pay, benefits and cafeteria plans.
- Pay can be role-based, skills-based, seniority-based or status-based.
- Fairness: equity (outcome/input ratios), i-deals (explainable), tournaments (relative performance, limited spread), expectancy (clear links), agency (align owner and manager).
- Tinbergen norm 1:5 versus actual CEO ratios of about 381 (US) and 110 (EU).
Andere hoofdstukken van Strategic Human Resource Management
- Ch. 1: SHRM in the 21st century
- Ch. 2: SHRM and context (guest lecture)
- Ch. 3: Adding value through people (guest lecture)
- Ch. 4: Human resource metrics and measures
- Ch. 5: Mutual gains?
- Ch. 6: High performance work systems (guest lecture)
- Ch. 7: Selective recruitment and selection
- Ch. 8: Performance management
- Ch. 10: Career development
- Ch. 11: Talent management
- Ch. 12: Employee participation
- Ch. 13: Human resource roles
- Ch. 14: International HRM