UNIT II EMPLOYEE COMPENSATION AND LABOUR MARKET

Macroeconomics of Labour markets- Unemployment and its impact on labour market- Neoclassical
microeconomics of labour markets-models, supply and demand-economic model Implications on
employee compensation- economic theories and employee compensation- trade -offs - valuation of
employee compensation.

TABLE OF CONTENTS

2.1 Macroeconomics of Labour markets .....................................................................................2

2.2 Unemployment and its impact on labour market....................................................................3

2.3 Neoclassical microeconomics of labour markets....................................................................5

2.4 Models, supply and demand...................................................................................................7

2.5 Economic model Implications on employee compensation....................................................9

2.6 Economic Theories..................................................................................................................11

2.7 Employee Compensation.........................................................................................................14

2.8 Trade offs..............................................................................................................................19

2.9 Valuation of employee compensation....................................................................................21

2.1 MACROECONOMICS OF LABOUR MARKETS

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According to macroeconomic theory, the fact that wage growth lags productivity growth indicates that
the supply of labor has outpaced demand. When that happens, there is downward pressure on wages,
as workers compete for a scarce number of jobs and employers have their pick of the labor force.
Conversely, if demand outpaces supply, there is upward pressure on wages, as workers have more
bargaining power and are more likely to be able to switch to a higher paying job, while employers
must compete for scarce labor.

Factors That Influence Supply and Demand

Some factors can influence labor supply and demand. For example, an increase in immigration to a
country can grow the labor supply and potentially depress wages, particularly for unskilled jobs.4 An
aging population can deplete the supply of labor and potentially drive up wages.
These factors don’t always have such straightforward consequences, though. A country with an aging
population will see demand for many goods and services decline, while demand for healthcare
increases.
Not every worker who loses their job can simply move into healthcare work, particularly if the jobs in
demand are highly skilled and specialized, such as those for doctors and nurses. For this reason,

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demand can exceed supply in certain sectors, even if supply exceeds demand in the labor market as a
whole.
Factors influencing supply and demand don’t work in isolation, either. If it weren’t for immigration,
the U.S. would be a much older—and potentially less dynamic—society. So while an influx of
unskilled workers might exert downward pressure on wages, it likely offsets declines in demand.
Other factors influencing contemporary labor markets, and the U.S. labor market, in particular, include
the threat of automation as advanced technologies gain the ability to do more complex tasks; the
effects of globalization as enhanced communication and better transport links allow work to be moved
across borders; the price, quality, and availability of education; and a whole array of policies, including
the minimum wage.
2.2 UNEMPLOYMENT AND ITS IMPACT ON LABOUR MARKET
Unemployment is a term referring to individuals who are employable and actively seeking a job but
are unable to find a job. Included in this group are those people in the workforce who are working but
do not have an appropriate job. Usually measured by the unemployment rate, which is dividing the
number of unemployed people by the total number of people in the workforce, unemployment serves
as one of the indicators of a country’s economic status.
1. Economic Impact
 Reduced Consumer Spending: Unemployed individuals typically have lower income, which
leads to reduced consumer spending. This decrease in demand can slow economic growth and
negatively affect businesses, potentially leading to further job losses.
 Lower GDP Growth: High unemployment rates can lead to a decrease in the overall Gross
Domestic Product (GDP) since fewer people are working and producing goods and services.
 Increased Government Expenditures: Governments often increase spending on
unemployment benefits and social programs, which can strain public finances. This might lead
to higher taxes or reduced spending in other areas.
2. Labor Market Dynamics
 Increased Competition for Jobs: High unemployment means more people are competing for
fewer available jobs. This can lead to a “buyers' market” for employers, where they can be
more selective and offer lower wages.
 Skills Mismatch: Prolonged unemployment can lead to a skills mismatch where the skills of
job seekers may not align with the requirements of available jobs, making it harder for them to
find employment.
 Long-term Unemployment: Extended periods of unemployment can erode skills and work
experience, making it even harder for individuals to get back into the workforce. This can lead

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 to structural unemployment, where the unemployed do not have the skills needed for available
jobs.
3. Social Impact
 Mental Health Issues: Unemployment can lead to stress, anxiety, and depression. The loss of
a job can impact an individual's self-esteem and overall well-being.
 Social Unrest: High levels of unemployment can lead to increased social tensions and unrest.
People might become frustrated with economic conditions and government policies, which can
manifest in protests or other forms of social discontent.
4. Labor Market Adjustments
 Wage Pressures: In high unemployment situations, workers may accept lower wages or worse
working conditions to secure a job, which can contribute to wage stagnation or declines.
 Shift in Job Types: Persistent unemployment can lead to shifts in the types of jobs available,
with some industries shrinking while others grow. Workers might need to retrain or reskill to
adapt to these changes.
5. Long-term Effects
 Decreased Lifetime Earnings: Extended unemployment can reduce an individual’s lifetime
earnings potential, as they might miss out on career progression and wage growth
opportunities.
 Economic Inequality: Unemployment can exacerbate economic inequality, as those with
fewer resources or less education are more likely to be affected by job losses and less likely to
recover quickly.

2.3 NEOCLASSICAL MICROECONOMICS

Neoclassical microeconomics provides a framework for understanding labor markets through
the lens of supply and demand, focusing on how wages and employment levels are determined.
Here's a detailed look at the neoclassical perspective on labor markets:
1. Labor Market Equilibrium
 Supply and Demand: In neoclassical economics, the labor market is governed by the forces of
supply and demand. The labor supply curve represents the number of hours workers are willing

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 to work at different wage rates, while the labor demand curve reflects the number of workers
firms are willing to hire at various wage levels.
 Equilibrium Wage: The intersection of the labor supply and demand curves determines the
equilibrium wage rate and the equilibrium level of employment. At this point, the quantity of
labor supplied equals the quantity of labor demanded.
2. Labor Supply
 Individual Decision-Making: Neoclassical theory assumes that individuals make rational
decisions about how much labor to supply based on the trade-off between labor and leisure. As
wages increase, the opportunity cost of not working (i.e., the value of leisure) also increases,
which typically leads to an increase in the quantity of labor supplied.
 Substitution and Income Effects: Higher wages have two effects on labor supply:
o Substitution Effect: Higher wages make work more attractive relative to leisure, so
individuals are likely to work more.
o Income Effect: Higher wages increase income, allowing individuals to afford more
leisure. This might lead some workers to work less if they feel they can maintain their
desired standard of living with fewer hours.
3. Labor Demand
 Marginal Productivity: Firms decide on the amount of labor to hire based on the marginal
productivity of labor, which is the additional output produced by an extra unit of labor.
According to neoclassical theory, firms will hire workers up to the point where the marginal
productivity of labor equals the wage rate.
 Diminishing Marginal Returns: Neoclassical economics posits that as more workers are
hired, the marginal productivity of each additional worker tends to decrease due to diminishing
returns. This principle influences how many workers firms will employ at different wage
levels.
4. Wage Determination
 Market-Wide Factors: Wages are determined by the interaction of labor supply and demand
in the broader market. Factors influencing this interaction include changes in worker
preferences, technological advancements, and shifts in industry demand.
 Human Capital: Neoclassical economics emphasizes the role of human capital (skills,
education, and experience) in wage determination. Higher levels of human capital typically
lead to higher productivity and, consequently, higher wages.
5. Employment and Unemployment

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 Natural Rate of Unemployment: The neoclassical model introduces the concept of the natural
rate of unemployment, which includes frictional and structural unemployment. Frictional
unemployment arises from the time it takes for workers to find new jobs, while structural
unemployment occurs due to mismatches between workers' skills and job requirements.
 Full Employment: In the neoclassical framework, full employment is achieved when the
economy is at the natural rate of unemployment. This is where all resources are efficiently
utilized, and there is no cyclical or demand-deficient unemployment.
6. Policy Implications
 Minimum Wage Laws: Neoclassical economics suggests that minimum wage laws can lead to
unemployment if set above the equilibrium wage rate, as they create a price floor that can result
in a surplus of labor (i.e., more people willing to work than there are jobs available).
 Labor Market Flexibility: The theory advocates for labor market flexibility, including
policies that enhance worker mobility and reduce barriers to job creation. This includes
reducing regulations that may impede hiring and firing, as well as investing in education and
training to improve labor market outcomes.
7. Criticisms and Extensions
 Behavioral Economics: Critics argue that the neoclassical model’s assumptions of rational
decision-making and perfect information may not always hold true in real-world labor markets.
Behavioral economics and other approaches highlight factors such as biases, imperfect
information, and social influences.
 Institutional Factors: The neoclassical model may also underemphasize the role of
institutions, such as labor unions and employment protection legislation, which can
significantly impact labor market dynamics.
Neoclassical microeconomics provides a foundational understanding of labor markets,
emphasizing the role of supply and demand, individual decision-making, and the effects of
wages on employment. However, real-world labor markets are influenced by a range of factors
that extend beyond the traditional neoclassical framework.
2.4 MODELS/THEORIES IN MICROECONOMICS
1. Theory of Consumer Demand
The theory of consumer demand relates goods and services consumption preference to
consumption expenditure. Such a correlation provides a way for consumers, subject to budget
constraints, to achieve a balance between expenses and preferences by optimizing utility.
2. Theory of Production Input Value

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According to the production input value theory, the price of any item or product is determined
by the number of resources spent to create it. Cost may include several of the production
factors (including land, capital, or labor) and taxation. Technology may be regarded as either
circulating capital (e.g., intermediate goods) or fixed capital (e.g., an industrial plant).
3. Production Theory
The production theory in microeconomics explains how businesses decide on the quantity of
raw material to be used and the quantity of items to be produced and sold. It defines a
relationship between the quantity of the commodities and production factors on the one hand,
and the price of the commodities and production factors on the other.
4. Theory of Opportunity Cost
According to the opportunity cost theory, the value of the next best alternative available is the
opportunity cost. It depends entirely on the valuation of the next best option and not on the
number of options.
THE DEMAND AND SUPPLY MODEL OF MICROECONOMICS
The demand and supply model of microeconomics explains the relationship between the
quantity of a good or service that the producers are willing to produce and sell at different
prices and the quantity that consumers are willing to buy at such prices. In a market economy,
price and quantity are considered basic measures to gauge the goods produced and exchanged.
Basic definitions
Demand: In microeconomics, demand is referred to as the quantity of product or service that
the consumers are willing to purchase at a particular price level. The quantity demanded by the
consumers also depends on their ability to pay.
Supply: In microeconomics, supply refers to the amount of product or service that the
producers are willing to provide at a particular price level. Moreover, companies seek to
maximize their profit; hence, they would manufacture and supply a larger quantity of products
if they can be sold at higher prices.
Law of Demand and Supply
In microeconomics, the law of demand states that the quantity of commodities demanded by
consumers varies inversely with prices of the commodities, all other factors being constant.
This implies that if the price of any commodity increases, the demand for that commodity will
decrease.
The law of supply states that an increase in the price of any commodity will lead to an increase
in supply and vice versa, all other factors being constant. The producers attempt to maximize
their profit by increasing the quantity when the price rises.

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The point of intersection of the demand curve and supply curve is called the equilibrium point.
At the equilibrium point, the price and quantity are respectively known as the equilibrium
price (P*) and equilibrium quantity (Q*). Due to a change in any of the economic or
consumer factors, the market shifts away from the equilibrium point. However, the economy
behaves accordingly to bring the market back to the equilibrium point.
Now, assume that the price of a certain commodity falls below P*. In such a case, the demand
for that commodity will surge. The quantity supplied will not be enough to cater to the quantity
demanded, resulting in excess demand or shortage. The producers will realize that they have an
opportunity to sell whatever quantity they have at a higher price and make profits.
Consequently, the price will rise toward the equilibrium. Similarly, if the price of a commodity
increases above P*, there will be a drop in quantity demanded. At the new price, the quantity
supplied is more than the quantity demanded, which results in excess supply or surplus. The
producers will eventually start selling at lower prices, causing an increase in demand, and the
market will move towards the equilibrium point.

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 2.5 ECONOMIC MODEL IMPLICATIONS ON EMPLOYEE COMPENSATION
Employee compensation is influenced by various economic models and theories, which shape
how wages and benefits are determined in the labor market. Here's a detailed exploration of
these implications:
1. Supply and Demand for Labor
The basic principle of supply and demand applies to the labor market:
 Supply of Labor: Represents the quantity of labor that workers are willing and able to provide
at different wage rates. Factors influencing labor supply include population demographics,
education levels, immigration, and social factors like retirement age.
 Demand for Labor: Reflects the quantity of labor that employers are willing to hire at various
wage rates. This is influenced by the productivity of labor, technology, business demand for
goods and services, and profitability considerations.
Implications for Employee Compensation:
 Wage Determination: In a competitive labor market, wages tend to equalize to the value of the
marginal product of labor (VMPL), which is the additional output produced by hiring one more
worker. Employers will typically pay wages that balance their costs with the productivity gains
from hiring additional labor.
 Skill Premiums: Different skills and levels of education command different wages due to
varying demand-supply dynamics. Higher-skilled workers often earn higher wages due to their
higher productivity and relative scarcity.
2. Human Capital Theory
Human capital theory views education, training, and experience as investments that increase a
worker's productivity and earning potential over time.
Implications for Employee Compensation:
 Education and Training: Employers may offer higher wages to employees with relevant
education and skills because they contribute more to productivity and profitability.
 Career Progression: Compensation often increases with experience and tenure as workers
accumulate human capital and become more productive.
3. Efficiency Wage Theory
Efficiency wage theory suggests that paying higher wages can improve worker productivity
and reduce turnover costs for employers.
Implications for Employee Compensation:
 Higher Productivity: Higher wages can motivate employees to work harder, reduce
absenteeism, and enhance job satisfaction, leading to increased productivity.

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 Reduced Turnover: Paying above-market wages can attract and retain talented employees,
reducing recruitment and training costs associated with high turnover.
4. Bargaining Models (e.g., Collective Bargaining)
In unionized settings or where there's collective bargaining, wages and benefits are often
determined through negotiations between employers and employee representatives.
Implications for Employee Compensation:
 Negotiated Wages: Collective bargaining can lead to higher wages and better benefits
compared to non-unionized environments, reflecting the bargaining power of organized labor.
 Union vs. Non-union Effects: Industries or regions with strong unions may have higher
average wages and better benefits due to collective bargaining agreements.
5. Marginal Productivity Theory of Income Distribution
This theory asserts that individuals earn income equal to their marginal productivity in the
factors of production they supply.
Implications for Employee Compensation:
 Wage Disparities: Wage differences across occupations and industries reflect differences in
the productivity of labor and the value of the goods and services produced.
 Inequality: Income inequality can arise from disparities in human capital, skill levels, and
access to opportunities for training and education.
6. Information Asymmetry and Principal-Agent Theory
In contexts where employers have more information than employees, such as regarding job
performance or market conditions, principal-agent theory examines how compensation can
align incentives.
Implications for Employee Compensation:
 Performance-based Pay: Incentive schemes like bonuses or stock options link compensation
to performance metrics, aligning employee incentives with organizational goals.
 Monitoring and Agency Costs: Compensation structures can mitigate agency costs by
motivating employees to act in the best interests of the organization.

2.6 ECONOMIC THEORIES

Three Economists and Their Theories
The three most important economists were Adam Smith, Karl Marx, and John Maynard Keynes
(pronounced canes). Each was a highly original thinker who developed economic theories that
were put into practice and affected the world’s economies for generations.

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Human Resource is the most vital resource for any organization. It is responsible for each and
every decision taken, each and every work done and each and every result. Employees should
be managed properly and motivated by providing best remuneration and compensation as per
the industry standards. The lucrative compensation will also serve the need for attracting and
retaining the best employees.It is the remuneration received by an employee in return for
his/her contribution to the organization. It is an organized practice that involves balancing the
work-employee relation by providing monetary and non-monetary benefits to employees.It is
an integral part of human resource management which helps in motivating the employees and
improving organizational effectiveness.
Types
Compensation provided to employees can direct in the form of monetary benefits and/or
indirect in the form of non-monetary benefits known as perks, time off, etc. It does not include
only salary but it is the sum total of all rewards and allowances provided to the employees in
return for their services. If the compensation offered is effectively managed, it contributes to
high organizational productivity.

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1.Direct
2. Indirect

Compensation decisions are influenced by many factors – labor law compliance, industry
characteristics and the economic environment, among others. Economists have been developing
theories to understand wage determination for centuries.

Economic Theories in Compensation Management

Economists view employment as an exchange of labor services in return for payment of money or
payment in kind. They also view compensation as a function of labor market dynamics, particularly
demand and supply. Wage theories thus aim to explain how wages are determined and how wage
relationships are developed in this context. There are several different wage theories, historical and
modern, that apply to different kinds of wages paid and different problems associated with wage
determination.

Historical Wage Theories

 Subsistence Theory: Also called the Iron Law of Wages, this theory proposes that wages tend
towards a minimum wage necessary to sustain basic need of a worker over the long run. Thus
wages cannot fall below a certain subsistence wage level since workers will be unable to work
at wage levels that do not allow them access to the most basic of necessities. Subsistence
theory also believes that there is an inherent equilibrium, which is achieved whenever there is
an imbalance between labor supply and demand, which will lead to the resetting of the
minimum or subsistence wage. In simpler terms, whenever wages are higher, the number of

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 workers will increase until there is excess, which will force wages to decrease to the
subsistence level.

 Just Price Theory: This theory proposes that wages are set in accordance with established
status distributions in society. Thus the aim is to regulate wage levels in such a way as to allow
individuals to maintain their place in society. Even though this theory was popular in the time
of Aristotle and Plato, one can see its influence even in today’s compensation systems where
maintaining the status of a group of employees drives compensation behaviors (e.g. supervisors
are paid more than the people who report to them).

 Surplus-Value Theory: This theory posits that the value created by a worker in excess of what
he gets paid is the surplus value that is appropriated by the business as profit. Thus, a business
can generate tremendous increases in wealth, productivity and capital resources by maximizing
the surplus value generated by employees.

 Wages Fund Theory: This theory assumes that wages are regulated by how much fixed capital
employers have allocated to a wage-fund against the number of workers available in the labor
market. The basic assumption here is that the wage fund is a fixed and unchanging amount and
so wage rates will fluctuate up or down based on the number of available workers in the
market.

Modern Wage Theories

 Marginal Productivity Theory: This theory proposes that the demand for labor is determined
by the marginal productivity of that labor, and wage rates are determined by the value of the
marginal product of labor. In simpler terms, organizations value the efforts of a worker in terms
of the revenue earned by employing each additional worker. Operating under the assumptions
of this theory, an organization will continue to employ workers until the marginal revenue
product is equal to the wage rate, because it would not be efficient for an organization to pay its
workers more than the revenue generated by the work. Employment and wages are thus
inversely related according to the marginal productivity theory.

 Human Capital Theory: This theory looks at the effects of experience, skills, on-the-job
training and education on the workforce, and the decisions that employers and employees make
regarding investments in human capital. Analysis of wages according to the human capital
theory show that the amount of early schooling a worker receives is directly proportional to the
wage the worker commands. On the other hand, schooling received in later years does not
contribute to a wage differential in any significant manner.

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2.7 EMPLOYEE COMPENSATION

Employee compensation is the combination of wages and benefits you provide each employee in
exchange for their work. While a compensation package can include things like salary, benefits,
commissions and stock options, the right blend of compensation for each employee will depend on
several factors. Offering fair and competitive employee compensation is crucial for attracting and
retaining top talent, so it is important that you understand the various types of compensation
packages available.

5 types of compensation packages to consider

There are five primary compensation packages you can offer employees. You don’t necessarily
need to limit employee compensation to one or another of these options; you can choose a
combination of them. According to Amy Roy, vice president of talent at the employer of record
company Atlas, standard employee compensation packages “are usually made up of cash, equity
and non-cash components (e.g., insurance, other types of benefits and perks).”

The right compensation type for each employee depends on factors such as their job description
and seniority level.

Here are five types of compensation packages to consider:

1. Base pay package

A base pay package is a standard amount of money an employee receives in exchange for working
a set number of hours (typically 40 hours per week). Employees who receive a base pay package
are paid an hourly wage or a salary. Most employees work for base pay, but their role determines
whether they are salaried or hourly.

“An employee working on a project or with defined tasks will usually prefer a base salary
package,” Jeremy Jarry, founder and CEO of stock-option consultancy B3GIN, told us. “Hourly-
type packages are often for entry-level positions or low-paying jobs.”

2. Commission package

A commission package is compensation given based on employee performance. Some commission

packages include a low base-pay salary and high commissions, whereas others offer only
commissions. A commission package incentivizes employees to perform well, since their paycheck
is tied to their performance.

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“Often, these compensation packages are given to individuals working in sales,” Jarry said. “They
will receive a percentage on the turnover they generate or a flat dollar amount if they hit a sales
target.”

3. Equity package

Employers can create equity compensation packages by offering employees a base salary plus
stock options.

“Stock options are a financial instrument that gives its beneficiary the possibility to purchase a
certain number of shares in a company at a fixed price,” Jarry said, adding that types of stock
options include incentive stock options, nonqualified stock options, and restricted stock units.

4. Benefits package

An employee benefits package includes additional perks that workers receive on top of their base
wages. You are legally required to offer a few employee benefits, including family and medical
leave, health insurance (for companies with 50 or more full-time employees), FICA (Social
Security, Medicare and federal insurance contributions), unemployment insurance and workers’
compensation.

Other standard employee benefits include dental and vision insurance, tax-free accounts for
medical expenses (such as health savings accounts, flexible spending accounts or health
reimbursement arrangements), life and disability insurance, paid time off (e.g. holidays, sick leave,
vacation time, parental leave), retirement plans, commuter benefits, gym reimbursement, tuition
assistance, and employee assistance programs (EAPs).

Although these benefits may sound expensive, these options can work for a range of employer
budgets.

“There are lower-cost supplemental benefits (e.g., online fitness programs, financial wellness,
telemedicine, flexible work schedules) that could be included in your compensation package that
could help create a more attractive package,” Roy said.

5. Bonuses

Bonuses are often tied to the performance of the employee, their team or the company as a whole.
Although you can offer bonuses to employees of any level, many employers give bonuses to
employees in leadership roles.

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“For VP through the C suite, there’s generally a higher percentage of a bonus that’s available, and
it often ties to the team’s performance as well as your own and the company’s financials,” said
Tara Furiani, CEO of people consultancy firm Not the HR Lady.

When creating a bonus plan for your business, consider the company’s financials, projections and
goals.

The importance of employee compensation

Although it is important to stay within your budget, offering competitive and desirable employee
compensation often pays off because you can use it to recruit and attract the best employees,
encourage company loyalty, and reduce employee turnover.

It’s also a good idea to review employees’ compensation throughout their tenure with the
company. Rewarding your employees’ hard work with competitive raises and bonuses can boost
employee satisfaction, encourage high performance, and improve your overall company reputation.
It can also help you retain your best workers; you don’t want good employees to leave your
company because they feel undervalued.

“A good compensation package is a part of why an employee will decide to join or stay in a
business,” Jarry said. “Thus, combining a good corporate culture, strategic vision and right
compensation package will be fundamental.”

How to determine compensation

There is a good chance you will offer a variety of compensation packages throughout your
organization to accommodate different job types, seniority levels and expertise. If you are
wondering how to determine the proper compensation for each employee, follow these four steps:

1. Research current market rates.

The first step is to do your research. Search online job boards, view open jobs on competitors’
websites, and read market rate studies to identify what others in your industry are paying for
similar positions. You can also survey current employees with similar roles within your
organization to see their expectations.

When you’re analyzing market rates and determining your compensation management strategy,
Roy said to ask yourself the following questions:

 What are the market and competitors doing?

 How do you want to compete against the market rate?

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 What is expected in your industry (e.g., tech employees may expect different benefits than
hospitality employees)?

 What is your strategy to attract new talent or retain employees, and are you having difficulty
doing so?

 What is your budget?

 What do your employees value most?

2. Establish standard company benefits.

Although some businesses overlook this step, it’s important to establish standard company
benefits. Create a list of the basic offerings that every employee will receive, like overtime pay and
health insurance. Furiani said you can also create a list of standard offerings for each position type
(e.g., entry-level, professional individual contributor, manager, senior manager, director, vice
president, C-level executive).

This list of benefits can help you maintain a fair and equal workplace. Be intentional about what
type of compensation you are offering, and reward similar levels of work the same, regardless of
whether employees ask for it.

For example, “while it may seem counterintuitive, you don’t want your chief marketing officer (a
woman) whom you just hired to not have equity because she didn’t ask for it, when all of her other
C-suite counterparts (men) do,” Furiani said. “This is how you ‘accidentally’ create a biased
workplace and pay inequity.”

3. Create a pay structure.

Establish a pay structure with different grades containing the minimum wage requirements and a
grade range or step increments.

“For specific positions (such as sales), each grade will also have a defined commission program,”
Jarry said. “At a more advanced level, the pay structure should be catering to each business
department and seniority level.”

Make sure to consider your current compensation budget, your financial forecasts, and potential
promotions.

4. Modify compensation as needed.

Your compensation packages need to grow as your business does. If your business becomes highly
profitable, consider adjusting your compensation packages to reward your team with higher wages
and increased benefits.

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You must also continually update your pay structures to account for inflation and evolving industry
expectations. Furiani recommended conducting a pay equity study to ensure you offer appropriate
compensation for existing and new roles.

2.8 TRADE-OFFS

A trade-off refers to a decision where you must give up, or sacrifice, one thing in order to achieve
another. Whenever you cannot have everything at once, a trade-off must be made.

For example, consider choosing what to eat: cooking at home often means cost savings, but it’s
more time-consuming. In contrast, ordering take-out saves time, but costs more money.

Making such choices means weighing the benefits and costs of the various options, inevitably
requiring trade-offs to be confronted and, ultimately, the best alternative to be identified.

Understanding trade-offs is important because every choice comes with an opportunity cost: what
must be given up when you choose one thing over another.

Therefore, it is important to examine everything you’ll have to give up when you choose a
particular option – not just the direct costs but also other less obvious indirect costs incurred by not
being able to have the next-best alternative as a result of your choice.

For example, if you decide to go to university, your direct cost is your tuition. But if your decision
to study means you had to give up a full-time job that you also enjoyed, then, in addition to tuition,
your opportunity cost of studying is also the foregone wages you would have earned and
enjoyment from your job if you had chosen to work instead.

Examples of trade-offs

Many of the decisions we make every day involve trade-offs. Some examples include increasing
physical activity by walking instead of driving, but at the cost of tiring ourselves and taking more
time; choosing to work more hours for extra income, but, therefore, having less leisure time; using
single-use plastics for convenience, but harming the environment; and so on.

Trade-offs are also inevitable when we decide what products to buy, such as choosing a new laptop
from all the models available: we need to make trade-offs between the various models’ screen size
and weight, computing power and price, etc. Trade-offs are found in all sorts of applications,
including personal decisions, but also business, government, and economics, and more.

Trade-Off In Business

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In business, assessing trade-offs is vital for making strategic decisions or allocating scarce
resources. Common strategic trade-offs may include these examples:

 Balancing investment risk versus reward

 Prioritizing projects based on strategic benefit versus monetary cost

 Weighing a job candidate’s level of experience and education versus organizational fit

 Optimizing economic gain versus environmental and social impacts

When making business decisions, it is important not just to consider what benefits you may gain
from a decision but also what you may be potentially missing out on, which may have significant
effects on profitability.

However, evaluating trade-offs between benefits and costs can be tricky, especially when there are
multiple alternatives to choose between and potentially many decision-makers to be involved.
Nonetheless, there are some things you can do to help make better decisions when trade-offs are
involved.

Consequences of avoiding trade-offs: indecision as a decision

Being faced with difficult trade-offs can be overwhelming, prompting us to put off making any
decisions at all for fear of the costs associated with making the wrong choice. However, not
making a decision is itself a decision – often with negative consequences.

When struggling with indecision, we may miss opportunities if there is a specific timeframe during
which a decision must be made. In other instances, indecision leads to stagnation, and no potential
benefits of available options are realized. If you hesitate to invest in professional development or a
new business opportunity because you can’t decide which option is best, you might end up missing
out on the benefits that any of those choices could have provided.

By failing to choose, we allow circumstances to dictate our outcomes rather than taking control of
our future. Often, any well-considered choice is better than no choice at all, as it leads to progress
and allows us to learn and adapt from the results of our decision. Therefore, when struggling with
difficult trade-offs, remember the cost of inaction and set a deadline for making your decision.

Tips for evaluating trade-offs

Here are four tips to help you evaluate strategic trade-offs more effectively, which can help you
make decisions that align with your organization’s best interests and allocate resources more
efficiently:

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1. Ensure that decision-makers are knowledgeable and competent, and include people from
diverse backgrounds whose perspectives could uncover valuable information you would
otherwise be unaware of.

2. Establish explicit limits for how much of a sacrifice you are willing to accept for achieving
your goals; for example what reduction in current revenue is acceptable in return for greater
future profits?

3. Specify explicit criteria and weights representing their relative importance – in effect,
quantifying acceptable trade-offs – to be used in support of decision-making.

4. Use valid and reliable methods, potentially including specialized software such as 1000minds,
to help you assess trade-offs – depending on the application, potentially involving many
decision-makers – and keep track of the implications for your decision.

Following these tips can help you evaluate trade-offs properly more effectively, which is crucial
for making decisions that align with your organization’s best interests and minimize opportunity
costs.

2.9 VALUATION OF EMPLOYEE COMPENSATION

Valuing employee compensation comprehensively involves assessing and quantifying various

forms of remuneration that employees receive. The aim is to get a holistic view of what an
employee is actually earning beyond just their base salary. Here’s a detailed explanation of how to
value employee compensation:

1. Base Salary

The base salary is the fixed amount of money an employee is paid regularly, usually on an annual
basis. This is the most straightforward component of compensation.

 Calculation: Base salary is directly listed in the employment contract or offer letter.

 Example: If an employee’s base salary is $70,000 per year, this amount is directly used in the
compensation calculation.

2. Bonuses and Incentives

Bonuses and incentives are additional forms of compensation that are often tied to individual
performance, company performance, or meeting specific targets.

 Types:

o Performance Bonuses: Paid for achieving specific goals or milestones.

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 o Commission: Common in sales roles; a percentage of sales made.

o Profit-Sharing: Employees receive a share of company profits, typically distributed

annually.

 Calculation: Estimate based on past performance or company policy.

 Example: If an employee typically earns a performance bonus of $10,000 annually, this

amount should be included in the total compensation.

3. Benefits

Benefits are non-wage compensations provided to employees. They can be direct (monetary value)
or indirect (non-monetary value).

 Health Insurance:

o Cost to Employer: Includes premiums, deductibles, and out-of-pocket expenses

covered by the employer.

o Calculation: Determine the annual cost of the health insurance plan provided to the
employee.

o Example: If the company covers $7,000 annually for health insurance, this should be
included in the total compensation.

 Retirement Contributions:

o 401(k) Match: Employers often match a percentage of employee contributions up to a

certain limit.

o Pension Plans: Contributions made to a defined benefit pension plan.

o Calculation: Add the amount contributed by the employer annually.

o Example: If the company contributes $4,000 annually to the employee’s 401(k), this
amount is added to the total compensation.

 Paid Time Off (PTO):

o Vacation Days, Sick Leave, and Personal Days: The monetary value of time off can
be calculated based on the employee’s base salary.

o Calculation: Divide the annual salary by the total number of workdays to get a daily
rate, then multiply by the number of PTO days.

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 o Example: If an employee has 15 PTO days and their daily salary is $200, the value of
PTO is $3,000.

4. Equity Compensation

Equity compensation gives employees an ownership stake in the company, often through stock
options, restricted stock units (RSUs), or employee stock purchase plans (ESPPs).

 Stock Options:

o Value Calculation: The value of stock options depends on the difference between the
exercise price and the current market price of the stock, multiplied by the number of
options.

o Example: If an employee has stock options to buy 1,000 shares at $10 each, and the
current market price is $15, the intrinsic value is $(15 - 10) * 1,000 = $5,000.

 Restricted Stock Units (RSUs):

o Value Calculation: RSUs are valued based on the current market price of the stock.
The value also depends on the vesting schedule.

o Example: If an employee has 100 RSUs with a current stock price of $50, the value of
these RSUs is $5,000.

 Employee Stock Purchase Plans (ESPPs):

o Value Calculation: Employees can buy stock at a discounted price. The value is
calculated based on the discount and the number of shares purchased.

o Example: If the discount is 15% and the stock price is $40, and the employee buys 100
shares, the discount is $600 (100 shares * $40 * 15%).

5. Perks and Additional Compensation

Perks and additional compensation include various non-monetary benefits that have a value but are
not direct payments.

 Company Car:

o Value Calculation: The value includes lease or depreciation costs, maintenance, and
insurance.

o Example: If the company car has an annual cost of $6,000, this should be included in
the total compensation.

 Education and Training:

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 o Value Calculation: Includes the cost of courses, certifications, or tuition
reimbursement provided by the company.

o Example: If the company covers $2,000 annually for education, this amount is added to
the total compensation.

 Childcare Assistance:

o Value Calculation: Includes any subsidies or on-site childcare costs.

o Example: If the company provides $3,000 worth of childcare assistance annually,

include this amount.

 Other Perks:

o Examples: Gym memberships, free meals, and travel allowances. Assign a monetary
value based on cost or typical market rates.

Total Compensation Calculation

To calculate the total compensation:

1. Sum up all components:

o Base Salary

o Bonuses and Incentives

o Benefits

o Equity Compensation (if applicable)

o Perks and Additional Compensation

2. Example Calculation:

o Base Salary: $70,000

o Bonus: $10,000

o Health Insurance: $7,000

o 401(k) Match: $4,000

o RSUs: $5,000

o Company Car: $6,000

o PTO: $3,000

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Total Compensation: 70,000+10,000+7,000+4,000+5,000+6,000+3,000=105,00070,000 + 10,000
+ 7,000 + 4,000 + 5,000 + 6,000 + 3,000 =
105,00070,000+10,000+7,000+4,000+5,000+6,000+3,000=105,000

This comprehensive view helps in understanding the complete value an employee receives and aids
in making decisions about salary negotiations, job offers, and compensation packages.

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