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The Compensation Scorecard: What Gets Measured Gets Done
 

By Jim Kochanski and David Insler, Sibson Consulting   7/29/2010
 

Employee compensation, one of the largest expenses in any organization, is also one of the least managed. While transparent data and scorecards have improved the management of other aspects of performance greatly, compensation often goes unevaluated beyond the fundamental measure of incremental costs. The invisible nature of compensation leads to problems. These include failing to differentiate pay for performance, over- and/or underpaying jobs relative to the market, having compensation spending grow faster than revenue and allowing employees to suspect that they are not being paid fairly.

Using a compensation scorecard can greatly increase an organization’s compensation effectiveness. Because it is true that what gets measured gets done, it is critically important to measure and manage compensation. With the right measures, organizations can use what they spend on compensation more effectively to help execute their strategy.

What Is a Compensation Scorecard?

A compensation scorecard collects and displays the results for all the measures that an organization uses to monitor compensation and compare compensation among internal departments or units. It can be used to:

Help organizations detect and prevent compensation problems.

Make compensation decisions and actions more transparent.

Improve the quality of compensation decisions.

The sample compensation scorecard below is a relatively basic example used by Alpha Corp., a hypothetical company that chose to report each department’s average performance rating on a scale of 1 (low) to 5 (high), average merit increase, grade inflation,* compa ratio (actual salary divided by the midpoint of the salary range), and annual incentive and long-term incentive (LTI) correlation with profit growth.

 

Alpha Corp.’s Sample Compensation Scorecard

Department

Average Performance Rating (1–5)

Average Merit Increase
(4% Budget)

Grade Inflation

Compa Ratio

Annual Incentive
(% of Target)

LTI Correlation with Profit Growth

A

3.4

4.3%

-3%

101%

100%

.4

B

3.2

4.4%

0%

98%

102%

.3

C

4.0

4.2%

12%

96%

105%

.4

D

4.1

3.4%

8%

99%

100%

.6

E

3.6

3.6%

17%

88%

110%

.5

F

3.1

3.5%

20%

105%

100%

.4

G

3.2

3.5%

-5%

99%

100%

.5

H

4.2

3.9%

20%

91%

110%

.7


*
Grade inflation is determined by calculating the percentage change in the number of incumbents in each grade.


**
Compa ratio is actual salary divided by the midpoint of the salary range. It is a gauge of the appropriateness of the organization’s salary ranges.


***
The direct correlation between profit growth over a three-year period relative to LTI expense.


Source: Sibson Consulting.

Different organizations should use different measures, units of comparison and other factors, depending on what they want to measure. Compensation scorecards are such powerful tools that they must be designed carefully to reinforce the desired outcomes that are unique to their strategy and situation, as in the hypothetical example below.


Why Alpha Corp. Introduced a Compensation Scorecard

Before Alpha Corp. had a compensation scorecard, there was no visibility among departments concerning compensation. Managers made their decisions in a vacuum, which led to widely different compensation decisions and actions from department to department.

In an effort to improve the quality of its compensation decisions, Alpha Corp. decided to test a relatively basic compensation scorecard (see the example above). The goal was to improve transparency and make managers feel more responsible for how they spent the company’s money.

In the first compensation scorecard, the numbers for the different departments varied substantially. By the next year, however, once the managers realized that their compensation actions were visible to all the managers, the numbers were better aligned. Moreover, the departments’ performance ratings matched performance better, and merit increases were more in line with each department’s performance ratings.

By the second year, the compensation scorecard had become an accepted tool in Alpha Corp. Employee compensation was being measured and managed for the first time.

Most compensation scorecards are issued by HR once a year, usually after the organization’s annual compensation actions have taken place. This is a less prescriptive and heavy-handed approach to pay differentiation than a forced ranking or forced distribution.

 

There are three steps to creating a compensation scorecard: confirm the organization’s compensation strategy, review the key elements within the compensation strategy, and decide what measures to use.

Confirm the Organization’s Compensation Strategy

Written or unwritten, an organization’s compensation strategy needs to be coordinated with its overall business strategy as well as its intended employment value exchange. The employment value exchange is the combination of rewards employees get (intrinsic and extrinsic) and the expectations of performance and engagement that employers set for employees. Senior leadership should review the compensation strategy with guidance from HR.

The six fundamental compensation strategies are:

1. Competitive. Pay is maintained closely at a chosen market point (below, at or above market value).

2. Performance differentiation. Employees are paid for performance, within a broad range of total direct compensation.

3. Egalitarian. Base pay is competitive; group rewards are tied to business success.

4. Mission-based. Cash compensation is low but internal equity is high, and employees have a strong affiliation with the organization’s mission.

5. Cost of compensation. The cost of compensation is kept at or below a certain ratio of revenue.

6. Unstructured. Each employee gets an individual deal, as needed, to promote retention and performance.

Alpha Corp. uses the performance differentiation compensation strategy because it is most consistent with its desired culture and way of achieving results.

Some organizations try to use a blend of strategies, which can create chaos and lead to inequities. For example, it is impossible to pay for performance consistently and adhere rigorously to a market pay point for all jobs and employees. One strategy must take precedence. Other organizations might be rewarding the right behaviors but with the wrong vehicle.

Right Behavior/Right Reward

A common compensation problem is employing the wrong vehicle to reward a specific behavior or driver. For example, if an organization uses above-market salary increases to reward annual performance against goals, compensation can become a drag on profits. Below are some examples of "right" rewards. 

Reward Driver

The Right Reward

Performs job duties.

Base salary increase.

Meets annual goals and objectives.

Salary increases and incentives (team or individual).

Demonstrates specific competencies.

Promotion, development opportunities, special assignments.

Accrues years of tenure/service.

Service awards, vacation, pension and other benefits.

Completes special projects or puts forth extraordinary effort.

Recognition awards and spot bonuses.

 

If an organization has not updated its compensation strategy in recent years, now is a good time to do so. The economy, demographics and the talent market have all changed dramatically in recent years, prompting organizations to alter their business strategies. For example, because of the general talent shortages and the economic growth that existed between 1997 and 2007, many organizations still have a compensation strategy whose primary goal is to attract and retain employees, with less emphasis on pay for performance. Strategies that were appropriate in the past might need to be refined if not revamped.

Review the Key Elements Within the Compensation Strategy

The next step in developing a compensation scorecard is for the organization’s leadership to determine, set or confirm direction on the elements that make up the compensation strategy:

The role of pay is the function and prominence of pay in the overall employee value proposition relative to other elements.

Funding criteria are the factors that will drive compensation funding, including the balance of business results and market factors.

Job valuation is the basis for valuing work and jobs, which defines the relative emphasis of internal versus external factors in the valuation process.

Competitive positioning is the comparison groups/peers and the desired level of compensation delivered relative to the comparison group.

Individuals vs. teams is the extent to which compensation will reward individuals and/or groups.

Mix of pay is the desired mix of fixed and variable compensation elements, including what pay delivery vehicles will be used and the purpose of each.

Governance is the roles, responsibilities and decision rights of key compensation decisions.

Communication and openness is the degree to which the organization openly communicates its compensation strategy, programs and pay opportunities.

Direction on these elements helps determine what to include in a scorecard and what measures to use. For example, in reviewing its competitive positioning and mix of pay, an organization might choose to pay primarily in base pay and compare at the 50th percentile of similar sized organizations, or it could chose to have a significant portion of its pay be variable and target the 75th percentile when outperforming its competitors. Such decisions will affect what is measured and reported in the scorecard.

Decide What Measures to Use

Once the organization has chosen a strategy and decided the direction on strategy elements, it must select a set of measures to use to assess and manage its compensation effectiveness. Some examples are provided below. 

Measures That Might Be Included in a Compensation Scorecard

Average market percentile is the percentage to market for benchmark jobs.

 Compa ratio is the ratio of average salary in a grade relative to midpoint.

Grade inflation is the growth or decline in average salary grade distribution.

Incentive differentiation is the average percent of target paid and the standard deviation.

Market to midpoint is the ratio of benchmark job market data to grade midpoint overall.

Merit differentiation is the average percent increase associated with each level of performance ratings.

Peer pay productivity is the ratio of market positioning of pay to market positioning in revenue or profit.

Percent over range is the percentage of employees over the salary range maximum.

Percent under range is the percentage of employees under the salary range maximum.

Performance distribution is the weighted average of performance ratings and the standard deviation.

Performance to pay relationship is the level of differentiation in pay associated with performance levels.

Promotions are the percentage of people promoted and the average increase.

Relative pay productivity is the ratio of overall pay to overall revenue and profits.

Turnover is the number of terminations in one year divided by the average headcount for the year (beginning-year headcount plus end-of-year headcount divided by two).

Because measures usually are more visible and get more attention than an organization’s compensation strategy, it is important not to send the wrong messages by including inappropriate results in the compensation scorecard just because they are available. To illustrate, it is helpful to look at two of the most common high-level compensation strategies and the measures that would be appropriate for each.

Individual differentiation for performance within a broad market range is probably the most frequently used compensation strategy for broad-based populations. It has the value of staying near the market overall and being flexible for rewarding performance. Of course, the problem is that to reward performance and stay within market, the organization must pay some people less than market in order to pay others more than market. Naturally, managers try to game this strategy and pay everyone at or above market, with the highest performers getting even more. The appropriate measures for this strategy might include a comparison of the level of performance differentiation and pay differentiation and percentage over or under range.

Although it would be very common to add compa ratio or average market percentile, these measures could confuse the actual strategy. If an organization measures compa ratio or market percentile, it is reinforcing a different strategy and different behavior. For example, to keep their employees from looking bad on compa ratio, managers might not differentiate pay adequately for high performers.

Tightly controlling pay around a desired market positioning or maintaining egalitarian pay is another popular compensation strategy. The key measures for this strategy would include compa ratio and market percentile. In this case, an emphasis on measuring compensation expense ratios or performance differentiation would send the wrong message and promote the wrong behavior.

Other Considerations

Most organizations’ discussions about compensation scorecards eventually turn to activity and outcome measures. It is, however, important to be cautious about trying to link outcomes directly to compensation rather than measuring if compensation actions are coordinated with the organization’s compensation strategy.

For example, some organizations once considered talent retention to be an outcome of appropriate compensation. As a result, they had a compensation scorecard measure for retention (or undesirable turnover). Because many factors in addition to compensation affect retention, a number of these organizations found themselves overpaying their employees. Some even created a culture of rewards entitlement by focusing on the retention of all employees. While high pay might handcuff the talent, it does not necessarily reinforce a culture of performance.

Another outcome that some organizations consider is productivity, measured as revenue per employee. Once again, many factors other than pay, such as staffing ratios, have more of an influence on productivity. Just like retention, productivity is an important outcome for an overall scorecard, but it might not be appropriate as a measure of compensation effectiveness.

It is, nevertheless, interesting to note that organizations should consider productivity when selecting their competitive positioning in their compensation strategy. If an organization is the most productive company in its industry, it could have higher pay position than its less-productive competitors.

Conclusion

The compensation scorecard is a powerful way to track and influence the use of compensation in an organization’s compensation strategy. It provides a means to ensure better management of one of the largest expenses in any organization. Rather than measure and report on everything related to compensation, it is important to use scorecard elements that reinforce the organization’s desired compensation strategy.

Jim Kochanski is a senior vice president in the Raleigh office of Sibson Consulting. David Insler is a senior vice president in the Los Angeles office and West Regional Leader.

This article is adapted and reposted with permission from Sibson Consulting,
a division of Segal.

© 2010 by The Segal Group Inc. All rights reserved.

Related SHRM Video:

Compensation Strategy
Focus on HR's host Kathleen Koch speaks to Jim Kochanski and John Rubino about some of the issues today's compensation systems have and advice on how to address them.

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