Determining Employee Compensation

Employment is a transaction, plain and simple. The employee is seeking a number of things, these likely include things like: income, retirement income, mental stimulation, insurance, or being part of a team. An employer has something that needs to get done and not enough people to do it. An employment agreement is reached when the individual believes that the company is offering a sufficient mix of benefits in exchange for their time and effort. We know all this, so why be so explicit in stating it here?

Despite having this knowledge, actions commonly inadvertently contradict these basics. 

Employee compensation boils down to benefits in exchange for value delivered. Most employers think they know what they want from employees, and employees have certain benefits (namely, salary) they expect in return. So how is it, that the identification of value, agreement on measuring value, and process of rewarding value is so challenging? Why is there strife over employee compensation, to some degree, at nearly every organization?


Identifying Value

There is strife over employee pay because there is a sense of "fairness" or obligation many people feel toward people on their team. For example, it would feel odd to have someone who is only 3 years out of college given the title of Senior Developer and get paid more than someone with 20 years experience... but what if that young person out-performs the more senior one by an order of magnitude?* The process of identifying and quantifying the value that the organization seeks forces a thorough and considered breakdown of responsibilities and objectives. Importantly, this approach can bring to light the fact that you need to reconsider your basic assumptions and policies, but most fundamentally, you need to reconsider what your compensation structure is incentivizing. 

What about seniority? What about degrees or certifications? These kinds of attributes are much easier to quantify, they lack subjectivity, and given the correlation between them and delivered value, it is really easy to just compensate based on these "safe" metrics. Furthermore, there is an expectation of title and pay consistency between companies**. Put together, it is easy to see why value is frequently misattributed.

As a business owner or operator, your mindset must be defining value as something provided in exchange for the stability or growth of the company. It is true that value is in the eye of the beholder, an asymmetrical exchange of value is not sustainable, and by aligning expectations before hiring and during review cycles, you ensure that there is an agreed upon expectation for exchanged value. If you are paying an employee more than your perception on the value they are delivering, that means you are short-changing something else in your budget (another employee, investment in growth, investment in employee benefits, etc.) If you are paying an employee less than the value they deliver, specifically less than their perception of the value they deliver, they will either decrease their contributions or they will leave.  Neither of these yields sustainability in your employee base, and it is no secret how expensive it is to hire.

Critical to all of this, is your dedication to finding an optimized and sustainable strategy, which necessitates an absolute willingness to be wrong. There is a challenge in identifying the balance between being confident, yet humble, and assertive, yet open to being challenged. You can't waste all of your time wondering if you made a mistake, but it is just as dangerous to get stuck in your ways. The book Predictable Success does an excellent job of discussing this in the context of growing a business.

* Also consider the flip side of this where a linear performance to value equation could suggest that this junior engineer should make an order of magnitude more in salary, which also isn't realistic.)

** I argue that you should strive to hire the type of people that seek this direct "compensation for value" exchange and avoid someone that is too hung up on titles. This is predicated on you delivering on that promise, though. These people tend to be the most curious, energized, and proactive contributors; someone exhilarated by the idea that they aren't bound by traditional structures resulting from obligation-based compensation.

Perception of Value

Perception of value is important and successful, stable employment is predicated on agreement between employee and employer. If the employee's perception of their value is not aligned with yours, then there is a failure in your process somewhere. This doesn't mean you need to knock them down a peg, this means that you need to more clearly communicate your expectations, your definition of value, how the employee will be measured against these, and what their current measurement values are. At the end of that discussion, there should be agreement on those metrics.

Communication Requires a Common Language

In communication, it is the responsibility of the communicator to ensure their message is understood as it was intended; it helps when the recipient makes this easy on you, but it isn't their job. The employer is responsible for communicating their definition of value, their measurement scales and techniques, and what compensation results. The employee is responsible for communicating how much value they believe they deliver and any challenge to the definition or measurement that will be used.

Communication is much easier when there is a common language. In compensation discussions, that common language is the set of agreed-upon quantifiable objectives and the scores the employee received when measured against them. I recommend resources like the Manager Tools podcast for more detail,but it boils down to clearly defined, measurable objectives and regular one-on-ones to stay on track.

Compensation Calculation

Reaching an up-front agreement on the exchange of value avoids the challenging, but common, situation where an employee's annual review states they have "exceeded" ambiguous expectations and there is no framework for setting anyone's expectation for what that means. What happens when the employee thinks that means a 10% raise and you think it means a 5% raise? The most sustainable approach to avoiding this is to take advantage of everything above wherein the conclusion is agreeing upon the value exchange ahead of time, eliminating most, if not all of, the contention. The compensation calculation has two key components, clearly defined salary ranges for clearly defined job levels, and a clearly defined raise equation with clearly defined inputs.

Documented Salary Bands

I see push back on this more often than not, and I get it. There is apprehension in giving this information away, but generally, the reasons are not good. If it is to hide gender/race/other inequality, then that is disappointing and revolting, and I urge you to reconsider. If it is an attempt to prevent people from having the ammunition they need to ask for a raise, then you aren't doing a good job of documenting expectations and goals or you aren't paying enough, neither of which make for a sustainable business. If you document these bands and someone is not where they think they should be, then you can clearly lay out how they can get there, this incentivizes them to be a better employee. Employee growth through self-motivation is extremely valuable long term. 

This approach also reduces the drama because it necessitates agreement on the current exchange of value (salary and output) as well as the desired growth of that exchange (wherein both parties benefit). It also fosters a mindset where people expect that by showing analytical, factual evidence, they can fix things they see as broken, or the culture supports the process by which they discover they were wrong. Commonly, there is compromise on something in between, because rational people in an environment that doesn't punish being wrong usually learn a lot from each other.

Raise Equation

There are a number of considerations that need to be made when determining a raise, but the more of that calculation that is subjective, the more inconsistency you end up with. Inconsistency will either become unsustainable, or it will incentivize behaviors you don't want to incentivize. Over time, those behaviors manifest as culture and retention of your best employees becomes nearly impossible.

The percentage of a raise can be demystified by using something like the following:

Base Percentage ✕ Performance Factor ✕ Company Revenue Target = % Raise

Where the base percentage might be static across the company or might differ by tier, and the performance factor is determined by the employee evaluation (against clearly defined measurable goals), for example:

  • Needs Improvement: Something in the 0.0 to 0.5 range
  • Meets Expectations: 1.0
  • Exceeds Expectations: 1.5

The company revenue target factor allows you to control for how well the company is doing so that you aren't promising an unrealistic raise in a tough year. It would be reasonable to have a fudge factor here too, though I'd recommend capping it (at least on the down side). For example, maybe an 85% maximum negative multiplier so you can effectively drop the raise by 15% of its original value based on "gut feeling." 

To put some numbers to it, if you hit your revenue target as a company, you can have an Engineer 4 (with a base percentage of 10%) who performed extremely well get a 0.10 * 1.5 * 1.0 = 15% raise and someone who performed poorly get 0.10 * 0.1 * 1.0 = 1% raise.

The equation might differ for your company, but if you find the equation doesn't usually work for what you would have done manually before you institute the equation (or what you "want" to happen), you should challenge yourself and be open to the idea that you might have inadvertently been imposing bias.

What DOES Your Compensation Plan Incentivize?

Incentives can be challenging to understand, especially when the implications of many of them play out on a longer timescale. That shouldn't deter you, in fact it should encourage you, to really question what your compensation plan incentivizes. For example, a rule like "we don't give promotions in back-to-back annual evaluations" sounds reasonable, because the vast majority of the time you won't be able to justify doing it. In fact, most of the time it's even a question, it means the person was probably not brought in at the right level. However, that firm stance incentivizes your superstars to put things on cruise control, especially after getting a promotion, because cruise control for them is still an above average performance. 

Everything boils down to incentives. If money, titles, time off, all-expenses-paid vacations, or other perks can be had in exchange for value delivered to the company, then you will get more value from the employees. It's that simple. To aide this process, there are three fundamental responsibilities of the leadership team. 

  1. Clearly communicate what you and the leadership team value so the employees know where to focus their effort.
  2. Clearly communicate what the reward will be. For example, if salary is calculated by that equation, salary bands are documented, and job tier roles/responsibilities are clear, then they'll know that if they deliver X they should get a Y percent raise and, if criteria Z is met, a promotion.
  3. Deliver on it. If you skip this step, trust will be damaged. There are extenuating circumstances, this is where openness and honesty with the affected individual can save an otherwise fraught situation.

This isn't to say all employees will kick it into high gear, but many will. When this happens, not only will you get more value from your employees, you will immediately be able to identify those employees that have drive and passion to achieve something – something that everyone tries to screen for in interviews, but isn't always successful. 

With this strategy you are incentivizing the following:

  • Clear communication of standards, objectives, and feedback surrounding performance
  • Performance matters, if the employee works hard and repeatedly delivers value, they will be rewarded
  • Accountability for successes and failures, if coupled with clear communication this can almost always be a net-positive, at least for the employee

Unintended Consequences

Often the "if it ain't broke, don't fix it" mindset prevails and people can get stuck in some ruts. In fact, everyone ought to be able to identify things they do simply because they have been doing them that way and it is working. It is unrealistic to constantly be optimizing everything. However, it is worth considering the unintended consequences of common compensation strategies that might be incentivizing behavior without realizing it.

There is a strong argument for leveraging aspects for multiple strategies, and there is nothing wrong with that, as long as the raise equation and relevant inputs are measurable and clearly communicated.

  • Seniority Based
    • Pros: You incentivize stability in the workforce. You demonstrate loyalty to your employees.
    • Cons: You incentivize stagnation, initiative, curiosity, and proactivity are not perceived as valuable. You are more likely to experience an aging workforce. It is very easy to get stuck in ruts because the people in charge have bee there the longest and at least a portion of them are only that senior because of time served.
    • Notes: With heavy reliance on this strategy you incentivize people to stay, but not necessarily the ones you would benefit the most from staying. You are incentivizing "career cruise control" rather than your most innovative, curious, proactive, and driven individuals.
  • Promoted to the Level of Incompetence
    • Also known as the Peter Principle, this is one of my favorite concepts and I have seen it play out many times. If a person is good at job X, they must be good at managing groups of people doing job X. Basically, someone is promoted because they are good at their job, and they stop being promoted when they stop being good at their job, they have reached their level of incompetence.
    • Pros: You have been able to identify people who are good at their job, and hopefully set them up to guide or mentor newcomers (although, maybe in an ineffective way).
    • Cons: When taken to the extreme, this means that the most senior people, the ones in charge of critical decisions, are not the right people for those positions.
  • Skill Based
    • This includes adding new skills or having the most diverse set of skills, basically a measure of "who can do the most things relevant to the business?" This is commonly seen in smaller companies and startups where that agility is crucial. However, instead of seeking and rewarding this explicitly, a small company can identify this as valuable for specific roles right now, and then over time the definition of value will change to meet the company needs.
    • Pros: These people can save (or make) a small company. You end up with a handful of people who can put out fires during critical times. Several people end up with excellent and marketable skill sets. You are incentivizing skill growth and loyalty.
    • Cons: Most things aren't done right, they're just done well enough, because there isn't a specialist driving things. You build technical debt. It's easy to get stuck in ruts. You are incentivizing "duct tape" solutions and de-prioritizing long term stability by accepting technical debt.
  • Performance
    • Pros: You incentivize people to drive hard, be curious, and to be proactive. You incentivize people to be able to define their value and the value they seek in return. You incentivize development plans and a heavy focus on personal improvement.
    • Cons: This approach can seem callous and appears to lack loyalty (although I argue that by rewarding performance you are demonstrating loyalty to high performers and by not rewarding performance you are demonstrating a strong lack of loyalty to that group). This approach, if not executed well, can incentivize masking failures or falsely representing success.

Closing Thoughts

A purely performance based solution has challenges as well, if this article lead you to believe I suggested otherwise then I failed to make my point that they key is in the agreed exchange of value, both defining and communicating it. If you take anything from this piece it is that you should take the time to define value for your organization, to concretely identify expectations and measurements against those expectations, and all of this should be openly communicated. Don't get hung up on the equation I used or picking a single strategy for compensating employees; open yourself and your organization up to the discussion and start to ask questions. Seek to disprove your existing assumptions.