Compensation Management: Definition, Objectives, Importance


Compensation is the human resource management function that deals with every type of reward individuals receive in exchange for performing an organizational task.

The consideration for which labor is exchanged is called compensation.

Compensation is what employees receive in exchange for their work. It is a particular kind of price, that is, the price of labor. Like any other price, remuneration is set at the point where the demand curve for labor crosses the supply curve of labor.

What is Compensation and Compensation Management?

Compensation is referred to as money and other benefits received by an employee for providing services to his employer.

Compensation refers to all forms of financial returns: tangible services and benefits employees receive as part an employment relationship, which may be associated with employee’s service to the employer like provident fund, gratuity, insurance scheme and any other payment which the employee receives or benefits he enjoys in lieu of such payment.

According to Dale Yoder, “Compensation is paying people for work”.

“Compensation is what employees receive in exchange for their contribution to the organization”. – Keith Davis

In the words of Edwin B. Flippo, “The function compensation is defining as adequate and equitable remuneration of personnel for their contributions to the organizational objectives”.

Cascio has defined compensation as follows;

“Compensation includes direct cash payments, indirect payments in the form of employee benefits and incentives to motivate employees to strive for higher levels of productivity”

Beach has defined wage and salary administration as follows;

“Wage and salary’ administration refers to the establishment and implementation of sound policies and practices of employee compensation. It includes such areas as job valuation, surveys of wages and salaries, analysis of relevant organizational problems, development, and maintenance of wage structure, establishing rules for administering wages, wage payments, incentives, profit sharing, wage changes and adjustments, supplementary payments, control of compensation costs and other related items.”

Compensation can be in the form of cash or kind. Compensation may be defined as money received in the performance of works, plus the many kinds of benefits and services that organizations provide their employees.

Different Types of Compensation

There are different types of compensation. Schuler identified three major types of compensation, which are mentioned below;

  1. Non-monetary Compensation.
  2. Direct Compensation.
  3. Indirect Compensation.

Non-monetary Compensation

It includes any benefit that an employee receives from an employer or a job that does not involve tangible value. Examples are career development and advancement opportunities, opportunities for recognition, as well as work environment and conditions.

Direct Compensation

Direct Compensation comprises of the salary that is paid to the employees along with the other health benefits.

Money is included under direct compensation. It is an employee’s base wage which can be an annual salary or hourly wage and any performance-based pay that an employee receives.

Direct compensation consisting of pay received in the form of wages, salaries, bonuses, and commissions provided at regular and consistent intervals.

These include the basic salary, house rent allowances, medical benefits, city allowances, conveyance, provident funds, etc. It also includes bonuses, payments for holidays, etc.

Indirect Compensation

Indirect compensation can be thought of as the non­monetary benefits an employee gets from the organization.

It includes everything from legally required public protection programs such as Social Security to health insurance, retirement programs, paid leave, childcare or moving expenses.

While benefits come under indirect compensation and may consist of life, accident, health insurance, the employer’s contribution to retirement, pay for a vacation, employer’s required payment for employee welfare as social security.

Rewards and recognitions, promotions, responsibility, etc., are some factors that induce confidence in the employees and motivate them to perform better. It also instills the faith in them that their good work is being recognized and they can boost their career opportunities if they continue to work harder.

Objectives of Compensation Management

The basic objective of compensation management can be briefly termed as meeting the needs of both employees and the organization.

Employers want to pay as little as possible to keep their costs low. Employees want to get as high as possible.

Objectives of compensation management are;

  1. Acquire qualified personnel.
  2. Retain current employees.
  3. Ensure equity.
  4. Reward desired behavior.
  5. Control costs.
  6. Comply with legal regulations.
  7. Facilitate understanding.
  8. Further administrative efficiency.
  9. Motivating Personnel.
  10. Consistency in Compensation.
  11. To be adequate.

Compensation management tries to strike a balance between these two with specific objectives;

Acquire qualified personnel

Compensation needs to be high enough to attract applicants. Pay levels must respond to the supply and demand of workers in the labor market since employees compare for workers.

Premium wages are sometimes needed to attract applicants working for others.

Retain current employees

Employees may quit when compensation levels are not competitive, resulting in higher turnover.

Employees serve organizations in exchange for a reward. If pay levels are not competitive, some employees quit the firm. To retain these employees’, pay levels must be competitive with that of other employers.

Ensure equity

To retain and motivate employees, employee compensation must be fair. Fairness requires wage and salary administration to be directed to achieving equity.

Compensation management strives for internal and external equity.

Internal equity requires that pay be related to the relative worth of a job so that similar jobs get similar pay.

External equity means paying workers what comparable workers are paid by other firms in the labor market.

Reward desired behavior

Pay should reinforce desired behaviors and act as an incentive for those behaviors to occur in the future. Effective compensation plans reward performance, loyalty, experience, responsibility, and other behaviors.

Good performance, experience, loyalty, new responsibilities, and other behaviors can be rewarded through an effective compensation plan.

Control costs

A rational compensation system helps the organization obtain and retain workers reasonable cost. Without effective compensation management, workers could be overpaid or underpaid.

Comply with legal regulations

A sound wage and salary system considers the legal challenges imposed by the government and ensures employers compliance.

Facilitate understanding


Further administrative efficiency

Wage and salary programs should be designed to be managed efficiently, making optimal use of the HRIS, although this objective should be a secondary consideration with other objectives.

Motivating Personnel

Compensation management aims at motivating personnel for higher productivity.

Monetary compensation has its own limitations in motivating people for superior performance. Besides money people also wants praise, promotion, recognition, acceptance, status, etc. for motivation.

Consistency in Compensation

Compensation management tries to achieve consistency-both internal and external in compensating employees. Internal consistency involves payment on the basis of the criticality of jobs and employees’ performance on jobs.

Thus, higher compensation is attached to higher-level jobs. Similarly, higher compensation is attached to higher performers in the same job.

To be adequate

Compensation must be sufficient so that the needs of the employee are fulfilled substantially.

Pre-requisites for Effective Compensation Management

An effective compensation system should fulfill the following criteria:

  1. Adequate: Minimum governmental, union, and managerial pay level positions must be met by the compensation system.
  2. Equitable: Care should be taken so that each employee is paid fairly, in line with his/her abilities, efforts, education, training, experiences, competencies, and so on.
  3. Balanced: Pay, benefits, and other rewards must provide a reasonable compensation package.
  4. Secure: Employees security needs must be adequately covered by the compensation package.
  5. Cost-Effective: Pay must be neither excessive nor inadequate, considering what the enterprise can afford to pay.
  6. Incentive Providing: The compensation package should be such that it generates motivation for effective and productive work.
  7. Acceptable to all Employees: All employees understand the pay system well and feel it is reasonable for the enterprise and the individual.

Importance of Sound Wage Structure

A sound wage policy is to adopt a job evaluation program in order to establish fair differentials in wages based upon differences in job contents.


  1. The organizations’ ability to pay.
  2. Supply and demand of labor.
  3. Prevailing market rate.
  4. The cost of living.
  5. The living wage.
  6. Psychological and Social Factors.
  7. Skill Levels Available in the Market.

1. The organizations’ ability to pay


Companies that have good sales and, therefore, high profits tend to pay higher those which running at a loss or earning low profits because of a higher cost of production or low sales. In the short run, the economic influence on the ability to pay is practically nil.


2. Supply and demand of labor

If the demand for certain skills is high and supply is low, the result is a rise in the price to be paid to these skills. The other alternative is to pay higher wages if the labor supply is scarce and lower wages when it is excessive.

Similarly, if there is a great demand for labor expertise, wages rise; but if the demand for manpower skill is minimal, the wages will be relatively low.

3. Prevailing market rate




Second, various government law’s and judicial decisions make the adoption of uniform wage rates an attractive proposition.

Third, trade union encourages this practice so that their members can have equal pay, equal work, and geographical differences may be eliminated.

Fourth, a functionally related firm in the same industry requires essentially the same quality of employees, with the same skill and experience. This results in a considerable uniformity in wage and salary rates.

Finally, if the same or about the same general rates of wages are not paid to the employees as are paid by the organizations’ competitors, it will not be able to attract and maintain the sufficient quantity and quality of manpower.

4. Cost of living



5 Living wage



6. Psychological and Social Factors




To satisfy the conditions of equity, fairness, and justice, management should take these factors into consideration.

7. Skill Levels Available in the Market

With the rapid growth of industries business trade, there is a shortage of skilled resources. The technological development, automation has been affecting the skill levels at faster rates.


Challenges or Problems of Compensation Management

Even the most rational methods of determining pay must be tempered by good judgment when challenges arise.

The implications of these demands may cause analysts to make further adjustments to compensation.

  1. Strategic Objectives.
  2. Prevailing Wage Rates.
  3. Union Power.
  4. Government Constraints.
  5. Comparable Worth and Equal Pay.
  6. Compensation Strategies and Adjustments.
  7. International Compensation Challenges.
  8. Productivity and costs.

1. Strategic Objectives

Compensation management is not limited to internal and external equity. It also can be used to further an employer’s strategy. Employee compensation might have been initially anchored by the relative worth of jobs and the prevailing wage rates in the local market.

2. Prevailing Wage Rates

Market forces may cause some jobs to be paid more than their relative worth. Demographic shifts and relative supply and demand relationships affect compensation.

3. Union Power

When unions represent a portion of the workforce, they may be able to obtain wage rates that are out of proportion to the relative worth of the jobs.

Unions may also limit management’s flexibility in administering merit increases since unions often argue for raises that are based on seniority and are applied across the board equally.

4. Government Constraints

Government sets minimum wage, overtime pay, equal pay, child labor, and record-keeping requirements. The minimum-wage and overtime provisions require employers to pay at least a minimum hourly rate regardless of the worth of the job.

5. Comparable Worth and Equal Pay

Beyond “equal pay for equal work” is the idea of “comparable pay for comparable work” called comparable worth. It requires employers to pay equal wages for jobs of comparable values.

Comparable worth is used to eliminate the historical gap between the incomes of men and women.

6. Compensation Strategies and Adjustments

Most organizations have compensation strategies and policies that cause wages and salaries to be adjusted.

A common strategy is to give nonunion workers the same raises that are given to unionized employees; this often is done to prevent further unionization.

7. International Compensation Challenges

The globalization of business affects compensation management.

Compensation analysts must focus not only on equity but on competitiveness too. The growing globalization of business also means a greater movement of employee among countries.

As employees are relocated, compensation specialists are challenged to make adjustments that are fair to the employee and the company while keeping competitiveness in mind.

8. Productivity and costs

Regardless of the company or social policies, employers must make a profit to survive. Without profits, they cannot attract enough investors to remain competitive.

Therefore, a company cannot pay its workers more than the workers give back to the firm through their productivity.

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