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How to develop an effective compensation strategy in 6 steps

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9 min read

A compensation strategy is about so much more than just providing your employees with a fair pay packet that complies with FLSA laws such as minimum wage and overtime pay. In order to stay relevant as an employer in a competitive market, you also need to offer additional benefits such as healthcare, wellness programs, and retirement plans.

The best compensation strategy is one that helps you appeal to the increasing expectations of employees so that you can attract and retain quality talent. It should also help you create a positive company culture based on employee satisfaction that has a direct impact on performance and the bottom line of your business.

But what does this involve exactly?

Read on to find out how to develop a compensation strategy that keeps your employees happy and helps you grow and develop as a successful employer.

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What is a compensation strategy?

So, what is strategic compensation and how do you design a strategy that helps your business grow?

Let’s start by looking at a basic compensation strategy definition.

A compensation strategy forms a part of your overall business strategy game plan. It lays out your small business hiring policies on employee benefits and compensation and aligns them with your business mission, vision, and goals. It’s about deciding where you want to compete, how competitive you need to be, and how you will reward your employees. In other words, what provisions you need to make in order to compensate your employees fairly so that they remain at your company.

Aside from helping you recruit and retain top talent, an effective compensation, and benefits strategy:

  • Drives company culture and employee engagement
  • Sets your position in the market
  • Boosts morale and helps your employees feel valued and appreciated as an important part of the company
  • Incentivized your employees to give their best in terms of performance and productivity
  • Forms an integral part of your employer brand and reputation.

This is why it is so important for you as an HR department or small business manager to design a strategy for pay and workers’ compensation that helps you stand out.

What are the different types of compensation strategies?

Although there are certain requirements in terms of compliance with the Fair Labor Standards Act (FLSA), when it comes to designing an employee compensation strategy, there isn’t a one-size-fits-all solution. Each company is different and the industry standards and expectations you should be aiming for will depend on a range of factors.

For example, some employees are hourly, and some are salaried; some receive bonuses and others work on performance-based commission. The best compensation strategy for you might be completely different from what works well for the business next door.

With that in mind, let’s take a look at three of the most popular types of compensation strategies: salary, commission, and hourly.

Salary compensation

This is the most traditional HR compensation strategy. With salary compensation, you pay your employees a defined amount for a one-year period. You can pay salaries monthly, weekly, or every two weeks.

If you opt for a salary compensation strategy, then your employees receive a base amount per pay period rather than an hourly rate. You would therefore class them as exempt employees. This means, amongst other things, that you are not obliged to pay them overtime if they work more than their contractually defined hours per week (provided you pay them more than $23,660 per year). In other words, you pay them for the work they do rather than the hours they spend doing it.

Of all the compensation strategies, this one works best if your employees work around 40 hours per week, or if their performance is difficult to measure. This is also a good option if your employees work remotely as they have the flexibility to set their own schedules, provided they meet performance expectations.

This is not a good option if your employees regularly work longer hours than anticipated, or for employees who work best with immediate financial incentives, such as sales reps.

Salary plus commission

Another popular employee compensation strategy you might consider is salary plus commission. This is where you pay your employees a lower base rate, which they can then top up with performance-based commissions. This works best if your employees work individually rather than as part of a team. The better they perform and the more targets they hit, the more commission they earn.

A salary plus commission compensation style arguably enables you to offer the best of both worlds. Although your employees won’t get the same level of income security as they would if you paid them a fixed salary, with a commission-based strategy, they have the financial incentive to perform well in order to increase their base salary.

This system works especially well for employees who work in sales, real estate, or any other job with clearly defined performance goals. It is less effective for those employees who aren’t comfortable in competitive environments, or those positions where it is difficult to track individual performance.

Straight hourly compensation

Another effective compensation strategy that you might consider implementing is a straight hourly compensation system. This is best if you hire nonexempt employees who you pay by the hour. You are legally obligated to guarantee at least a minimum wage per hour, but you do not have to guarantee a routine number of hours worked per pay period. You do, however, have to pay overtime if your hourly nonexempt employees work over 40 hours in a given working week. Some states have additional overtime laws, including ones where employees receive time and a half for any hours worked beyond eight in a day.

An hourly compensation strategy works best for entry-level positions or low-paying jobs. They are also a great option if your requirements as an employer tend to fluctuate. For example, if you work in the service industry then your employees can work more hours doing peak seasons, and fewer during quiet periods. You can also adjust schedules according to your budgets.

An hourly strategy can also be appealing if your employees are motivated by flexibility and the possibility of earning overtime when they need it. For example, it could work well for students or people with young children. However, hourly compensation offers less financial security, especially if the hours you offer your employees frequently fluctuate from one week to the next. Hourly employees are also less likely to receive additional benefits such as health insurance or PTO, which might put employees off from joining your company.

How to create a compensation strategy in 6 steps

Now that we’ve looked at what a compensation strategy is and some of the strategies you could implement, let’s look at the steps you need to take in order to design the best compensation strategy for your business.

Make sure the following steps are included in the compensation section of your HR checklist for startups and small business.

Establish budget allocation

The first step is establishing what your compensation budget is, and how it will be allocated. In other words, how much of your budget you will allocate to salaries, and how much you will reserve for benefits and other incentives. This will help you control labor, health care, and other miscellaneous benefit costs.

Be as realistic as possible with your HR and operational budgets. Identify how much you can feasibly spend on any given employee and stick to it. Make sure you factor in all costs, including taxes, payroll costs, existing benefits, compensation, and bonuses. You should also consider any performance or merit increases that you will offer as part of your annual review process.

Review compensation strategy market data

The next step is market research. This means investigating trends in terms of both compensation and benefits. What is salary benchmarking like for each role in your company? Which compensation packages do your competitors offer? This will help you establish what you should be offering in order to remain competitive so that you can attract top talent to your business.

Determine your compensation strategy pay grades

Once you’ve done your research, you need to determine a framework for compensation. This means defining your pay grades based on job positions and duties. For example, lower pay grades might include entry-level roles, pay grade two for technician roles, pay grade three for managers, and pay grade four for executives. This framework will help you define how much you should be paying each level in line with job requirements and experience (skill or competency-based pay). And this is one of the foundations of a competitive compensation strategy.

This is also a good point to conduct a pay equity analysis to make sure you are paying all employees at each level fairly and across the board. In other words, you are offering equal pay for all employees performing the same duties, regardless of gender, race, or any other defining characteristics.

Verify compliance requirements

Although it is generally up to you to define your compensation strategy, there are a number of legal obligations you need to comply with. For example, the Fair Labor Standards Act (FLSA) sets the legal requirements for minimum wage, overtime, equal pay, record-keeping, and child labor. It also defines requirements relating to payment practices, payroll taxes, payslips, and withholding allowances. Make sure you meet all legal requirements when you define your strategic compensation system, and clearly outline all payments and deductions on your payslips.

Check out this post on setting up payroll for small business if you are not sure where to start. You can also download our handy free payslip template to help you stay payroll compliant.

Design your benefits package

Defining your salary grades is one part of your compensation system, but you also need to consider what fringe benefits you will offer your employees. Benefits can be a great incentive that often cements a potential new employee’s decision to join your company or accept an offer from one of your competitors.

The aim here is to be as competitive as possible, whilst sticking to your established budget allocation. This means not overstretching or offering benefits that you won’t, realistically, be able to honor in the long term.

You should also consider which incentives would be more appealing for your workforce demographics. For example, would your typical employee value health insurance, retirement incentives, PTO or tuition reimbursement more? What about flexible work hours, access to on-site services, or subsidized transportation benefits? And how many benefits are you realistically able to offer each pay grade?

Create a performance management system

Once you’ve defined your compensation strategy, you need to implement a system for tracking performance. This will ensure your employees know what they need to do in order to meet their performance objectives. This is especially important if you implement a compensation system based on pay for performance, such as salary plus commission.

The first step is defining what model you will use to assess performance. For example, you can use a pay-for-performance compensation model to encourage your employees to hit their performance goals. This might be in the form of merit pay increases or variable pay programs.

You also need to decide how you will manage each step of the process. This means setting clear goals and designing KPIs to measure the progress of each individual. You also need to decide how often you will conduct your performance appraisals. Will you offer coaching and mentoring?

The best way to manage all this is by using performance management software. The main function of performance management software is to assist the HR department in laying out concrete performance expectations. This information can then later be used to calculate performance-based commissions and rewards.New call-to-action

Compensation strategy example

As we have just seen, you need to consider many factors when you design your compensation strategy. You need to gather and analyze external market data and develop, implement and calculate the costs of your pay structures. All this helps you develop a strategy that is both competitive and equitable. And this will help you promote employee engagement and increase performance. How you do this is up to you.

You might choose to include some or all of the following incentives in your compensation package:

  • Overtime pay
  • Variable salaries based on experience or longevity
  • Employee healthcare
  • Raises and bonuses
  • 401(k) or retirement packages
  • Profit-sharing options
  • Paid time off (sick days, personal days, vacation time, etc.)
  • Learning and development opportunities and/or reimbursement
  • Flexible schedules
  • Employee perks (gym membership, on-site childcare, etc.)

The best compensation strategy for you will depend on the demographics of your workforce and your industry. For example, you could offer a vacation package to motivate younger employees. But you might find that focusing more on retirement benefits works better with older employees. Or, if you work in retail, you could offer product discounts to entry-level employees. But you might find that a company car is more of an incentive for your executive-level employees. Conducting thorough research will help you establish what works best for the particular needs and expectations of your employees.

Tips for creating the best compensation strategy

  • Be as specific as possible. Use SMART goals to define performance targets. This will ensure your employees know what they need to do in order to achieve them.
  • Conduct accurate research and stay up to date with market trends and fluctuations. This includes knowing what your competitors are offering so that you can stay relevant in your market.
  • Make sure you are realistic about the rewards and incentives you offer. Once you set the standard high, it’s very difficult to backtrack if your financial situation changes.
  • Focus on clear and transparent communication. You should never disclose specific financial data relating to salaries. However, you should be open and honest about how you reward performance. This will help motivate all your employees to strive for success.
  • Create a strategy that encourages your employees to grow and develop.
  • Don’t confuse rewards and recognition. Rewards should be of substantial value and offered for specific achievements, such as promotions or annual bonuses. Recognition should be offered whenever an employee exceeds expectations. Think of it as more of a symbolic offering to acknowledge an employee’s hard work.
  • Finally, make sure you are fair. This doesn’t mean that all your compensation packages should be equal. In fact, you will probably implement a number of different strategies for different employees depending on their role and level of seniority. What we mean here is that you should reward good performance fairly across the board, relative to each role. If certain groups feel they’re being rewarded unfairly compared to others, then you risk disengaging your workforce. This is relevant internally or compared to the external market. Make sure your compensation strategy has clearly defined benchmarks and that you meet any expectations that you set.
Cat Symonds is a freelance writer, editor, and translator. Originally from Wales, she studied Spanish and French at the University of Swansea before moving to Barcelona where she lived and worked for 12 years. She has since relocated back to Wales where she continues to build her business, working with clients in Spain and the UK.  Cat is the founder of The Content CAT: Content And Translation, providing content development and translation services to her clients. She specializes in corporate blogs, articles of interest, ghostwriting, and translation (SP/FR/CA into EN), collaborating with a range of companies from a variety of business sectors. She also offers services to a number of NGOs including Oxfam Intermón, UNICEF, and Corporate Excellence - Centre for Reputation Leadership.  For more information or to contact Cat visit her website or send her a message through LinkedIn.

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