There are two different types of compensation: direct and indirect. What is the difference? Direct compensation refers to an employee’s base wage (what they are paid for their services), where indirect compensation is everything else. Examples of indirect compensation maybe daycare, retirement plans, paid time off, etc. This method of compensation is usually used as an incentive.
The components you will need to develop a competitive and fair compensation system include:
- Job Descriptions
- Pay Structures or Pay Grades
- Policies and Regulations
Types of Compensation Plans
Standard Base Pay Program: offers fixed salary ranges for each position type for employees performing the standard duties of their jobs. Most companies set up minimum and maximum levels within those pay ranges to account for variations in experience and skill levels. (Download How to Set up a Pay Grade Scale for more information)
Incentive Compensation: to help motivate employees to perform optimally, more companies are moving toward more of a reward-based compensation style. Some of the features may be:
- Hiring Bonuses: be sure to tie it to a specific time before paying out the bonus, for example ½ after six months and the remainder after 1 year of employment or you can pay out the bonus but stipulate in the contract that if they leave or are terminated for cause before 1 year of employment the bonus will be prorated then paid back, for example if the bonus was $10,000 and the employee leaves after 6 months, they will need to pay $5,000 back.
- Piece Rate Pay: this is paying employees by the amount of work they produce instead of paying for the number of hours worked, employees are paid a set amount of money for every “piece” produced. This plan can be modified by paying a flat hourly rate, topped with a smaller piece rate. For example, an employer pays $10 an hour plus 25 cents for every piece completed. It should be noted that in most states, paying this way does not make you exempt from over time laws, check with your accountant before switching to this pay method.
- Commissions: Employee’s earn a percentage of every sale they close. Salespeople can work on a straight commission basis, receiving pay only from sales or on a salary plus commission incentive plan. You can actually turn this into a company-wide compensation strategy (download Fishbowl Compensation Plan for more details).
- Merit Pay: These plans typically are used in conjunction with annual reviews. Employees are scored on their performance on a sliding scale. Supervisors would rate an employee’s work on a scale of one to five, with five being the best rating possible. Raises then are protracted based on the rating. An employee with a one might not receive any raise, while workers who score a four could receive a 3 percent raise, with the highest raises reserved for those ranking in the top tier of scoring. (see Review Pay Raises).
- Profit-sharing: is a company-wide incentive plan that provides all workers with a piece of the company revenues when the business reaches certain goals during the year. (see Incentive Programs).
- Bonus or Reward Plans: could include a bonus for reaching a deadline or completing a project under budget. Long-term incentives can include longevity pay with bonuses paid after specified years of employment. (see Incentive Programs for more details).
- Deferred Compensation Plans: is an arrangement in which a portion of an employee’s income is paid out at a date after which that income is actually earned. Examples of deferred compensation include pensions, retirement plans, and employee stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee actually receives the income.