Introduction to Compensation and Benefit Design: Applying Finance and Accounting Principles to Global Human Resource Management Systems
The Current HR Cost-Classification Structure
Let’s now examine the fundamental elements covered in this book. First, it is important that you understand the terminology commonly used in compensation and benefit analysis. After reviewing this terminology, the discussion turns to these terms within the context of the current accounting framework.2
Compensation and Benefit Elements
The most commonly used terminology related to compensation and benefits within the organizations are as follows:
Base salary: Base or basic or fixed pay describes the “fixed” part of pay. This pay element is mainly paid to employees to come to work (to attract employees). It is also paid to employees to do the assigned work by applying the required skills, knowledge, and abilities using normal effort and demonstrating necessary work behaviors. Basic pay is usually the largest component of the total pay package. In other words, basic pay is the amount of nonincentive wages or salaries paid over a period of time for work performed. It may include additional payments that are not directly related to the work effort.
Compensation professionals use the following methods to determine base pay levels:
- Job-based pay
- Skill- or competency-based pay
- Market-based pay
- A combination of these three
Compensation books adequately explain these methodologies.3 The professional organization WorldatWork4 conducts seminars and develops various publications explaining these methodologies. Some compensation specialists have tried to define precisely the distinctions between the terms base pay and basic pay .
Chuck Czismar, in a blog post5 from January 6, 2010, attempts to create a distinction between the terms base pay and basic pay . He says that base pay refers only to “non-incentive wages and salary paid out over a twelve month period for work performed.” He goes on to define basic pay as “the amount of non-incentive wages or salary paid out over a twelve month period for work performed, but including additional payments not directly related to work effort.” He seems to be referring to additional variable pay allowances and to 13th and 14th month payments, prevalent in various countries.
The term fixed is used to distinguish this pay component from others that are of a variable nature, such as bonuses, incentives, and various contingent payments.
Base compensation has other flows (or changes), as well. Here is a list of the cost flows (changes) that affect the base pay in total:
- Part-time status to full-time status
- Full- time status to part-time status
- Change of status to nonpaid leave
- A temporary allowance (on and off)
- A temporary adder (on and off)
- Exempt employee to nonexempt and vice versa in the United States
- Promotion increase
- Annual performance increment or merit increase
- Salary reductions
- Overtime payments
- Workers’ compensation (on and off)
- Salary differentials (on and off)
- General increases
- Step increases
- Cost-of-living adjustments
All these variables affect the total base pay expenses and therefore the total costs for employees in an organization. To understand the real impact of employee-related expenditures, there is a need to record and analyze all these expense triggers. Also to forecast or budget these expenditures, all these inflows and outflows need to be documented, tracked, and analyzed. But the current accounting systems do not identify these flows separately in any detail. The payroll systems aggregate these pay transactions into a composite gross rate. To the accounting structure, it is not important to keep track of the various employee flows (although some of these flows could be tracked separately by payroll systems but not by accounting systems).6 If the salary is stated in monthly terms, these individual expense transactions are tracked in the aggregate monthly stated salary.
- Incentive compensation: Incentives or bonuses payments are paid to an employee for achieving time-bound goals and objectives. Terms such as incentive targets, objectives ( bonus objectives ), measurements , and ratings are all contextual terms used in most organizations. Incentive compensation refers to contingent payments paid to employees only when certain predetermined financial or individual objectives are met.
- Allowances: Allowances are usually temporary adders to the basic pay. Housing allowance, transportation allowance, and education allowance are common. Allowances are widely used in various countries. Allowances are paid for special situations or conditions.
- Pay adders: Adders to base pay are common in the United States. Overtime pay, callback pay, on-call pay are examples of pay elements and are provided for work that is done beyond normal working hours. These adders are governed by wage and hour laws in most countries.
- Risk benefits: Risk benefits are payments made for medical, disability, and life (actually death) situations. The benefits in this category are provided to employees in lieu of direct cash payments to mitigate the various life risks for employees and their families.
- Retirement benefits: Retirement benefits are common compensation elements that organizations provide to assist employees with their post-employment lives. Retirement benefits can take the form of defined benefit or defined contribution plans.
- Equity compensation: Employee equity programs in the past had been mostly provided to senior executives to motivate them to increase shareholder value. This component of pay has seen sweeping accounting changes over the past ten years or so. There has been a growth of many different structures for these plans; nonqualified stock options, incentive stock options, restricted stock options, stock appreciation rights are a few. Accounting, tax, and legal implications are integral to the design, development, and administration of these programs. More recently, issues surrounding executive compensation excesses, earnings management, insider trading, ownership culture, stock option pricing and expensing, dilution effects, and overhang have all clouded this pay element with a lot of debate and discussion.
- Perquisites: Perquisites are elements of compensation that are normally paid to senior executives. The practice is widespread around the world. Most common are first-class travel, executive jets, country club memberships, executive physicals, and financial planning. Perquisites can be direct cash payments or are compensation payments in the form of expense reimbursements for approved executive benefits.
- Expatriate compensation: Expatriate compensation is made to employees who are sent by companies to live and work abroad. Within this overall category, there can be many sub-categories of payments. Among them are cost-differential payments, housing differential payments, education allowance, tax protection or tax equalization payments, moving expense allowances and foreign-service premiums, and hardship and special area allowances. An expatriate assignment occurs when an employee is transferred to a foreign jurisdiction (different from the headquarters country or the employee’s country of permanent domicile).
The appendix at the end of this chapter describes all the terms and words used in the field of total compensation. This will set the stage for a comprehensive analysis of the finance and accounting implications involved in compensation and benefit plan design.