Determining employee compensation

Since none of us exist as completely self-sufficient agrarians, we will all accept some form of compensation for the work we do. For most of us, that will come in the form of a check from our employer while some will pursue self-employment. Put simply, compensation represents the price tag for the work a person does.

After looking back on conversations I’ve had over the last several years, it’s clear to me that employees generally misunderstand compensation. I think that’s understandable as few have ever been in a position to set someone’s pay.

I think we have a responsibility to ourselves to build a strong understanding of compensation. I’m convinced that it will help us establish contentment and apply our effort properly towards accomplishing our goals. Be honest, you’d be happy if you knew you were paid exactly right. And you’d love knowing how your compensation was set so you could do something about it.


Not sure you can make it through this whole article? I’ve summarized the critical bits:

  • Business owners hire employees to make profit for them
  • Compensation has nothing to do with a person’s worth
  • Two things determine how much an owner will pay an employee: The market and the company’s financial situation.
  • The market decides how much an employer will have to pay for certain work. It’s the economics of supply and demand.
  • When the number of people who can do certain work goes up, the price employers will pay goes down.
  • If there are fewer people available to do certain work, the employer will have to pay more.
  • If the company cannot afford the market rate, it must offer less to employees. Special circumstances may encourage an employee to accept less than the market rate. Otherwise, the business will live with an unfilled positon until the market rate comes down, or finances improve.
  • A business owner is free to ignore the market and pay whatever they want (more or less). It’s their business and they can do whatever they want with it.

It’s important to note:

You cannot determine how much to compensate a person for a given position without careful evaluation of what the market will bear. Anything else would be guessing.

Market rate for a position can generally be determined by a careful analysis of:

  • How much would I have to pay a replacement to fill a position
  • What would a non-competitor pay one of my employees currently in the position

The whole bale of hay

I hope you’ll stay with me for a detailed discussion of why the bullets above make sense.

Before digging into how one determines compensation, a bit of background is in order.

How compensation works

Let’s confine our discussion for a moment to the relationship between an employer and an employee. At it’s core, compensation represents how much someone values something getting done.

It’s strikingly similar to how much we pay for a gallon of milk or loaf of bread. The difference, and a source of confusion, is that we typically are the ones paying for products, where in the world of employment, we are accepting payment. Those are vastly different modes of operation.

Compensation has nothing to do with a person’s worth. High compensation doesn’t indicate a better/smarter person nor does low compensation indicate that someone is less valuable. It’s simply a factor of market value. A gallon of milk may cost $3/gallon when a gallon of water is $1. One isn’t better or worse than the other. But they do have different prices in the marketplace.

Gasoline went from $0.80 to almost $4.00 within a few years. The gas wasn’t any better or worse, but the market set drastically different prices for it.

Do work, get paid

It’s good to remember that employment is a standing agreement between an employer and the employee. The agreement usually comes about when the employer offers (the term “offer” is important) the employee to pay them X for accomplishing Y. The employee accepts and a cycle of work followed by pay days ensues.

I’ll say it again, it’s an offer. No one is compelled by anything other than their circumstances, to accept. Just as importantly, either one can terminate the agreement at any time. As long as both parties feel that the arrangement is acceptable, the agreement continues.

So why would an employer offer to pay someone to do work (bear with me, the digression will be worth it)?

Why employers hire people

Humans need air, businesses need profit. Without profit a business will die. Many businesses also have other goals, but profit is the one thing you cannot ignore.

To make profit, work must be done and businesses need people to help. To continue making widgets that customers pay $10 for, the Widget Express must find widget makers. As business grows, they have need for more people.

And who is profit for? The business owner! Why does the business owner care to have work done for them? To make them profit. Don’t miss this point: “The job of every employee is to make profit for the owner(s).” If an employee doesn’t bring in profit, they don’t stick around long.

How do employees make profit for the owners?

To answer the question, we need to first understand how the owner made profit before there were employees. History will lead the way.

When Widget Express got started, the owner did all the work. She made the widgets, did the accounting, and took care of customers. Her compensation was the difference between money in and money out. In the first year, she sold 10,000 widgets for $10/each resulting in $100,000 of sales. She spent $40,000 in materials, rent, etc. Her profit (compensation): $60,000.

Who sets the owner’s pay?

Wait a minute! Who decided that she should get $60,000? The market decided. People decided to pay $10 for her widgets. She set her price by figuring out what the market would bear (and yes, that’s the hard part). Without going into too much economics, it’s the balance of supply and demand.

One other quick note…if she could go out and get a job that pays $80,000/year, she should probably shut down the business and take the job (all other things being equal). Again, the market would decide whether the widget making/selling is worth more than a job she could take.

Supply and demand?

If the widgets are really cheap, lots of people will want to buy them. As the price goes up, fewer people will be willing to part with their cash.

There is a sweet spot for everything. The pricing of a widget is remarkably similar to the compensation of an employee. It all comes down to what people will pay.

The Market always decides

When she put them up for sale at $20/each, none sold. At $2/each, she would have no profit (and acually lose money with $40,000 in expenses and only $20,000 in sales), so that wouldn’t work. $10/each turned out to be what the market would bear. She could sell a reasonable number of widgets and still make money.

If you take nothing else away from this article, remember this:

When it comes to distributing money (setting prices), the market ALWAYS decides. Always.

This isn’t communist Russia. Whether we like it or not, we like in the land of Adam Smith’s capitalistic machine. The market decides what our Widget Express owner makes, plain and simple. There may be temporary forces at work (the government is always a good example), but ultimately, the market will force things back into balance. This is a gross simplification of macro and micro economics (both of which are fascinating), but the concept is sound. There is a ton of pricing theory that would muddy our discussion, so let’s just live with $10 as the price.

The first employee

Hang in there, this is about to get good.

For the second year of business, our business owner feels that she could sell 20,000 widgets if she could just spend less time making widgets and more time on marketing. By doing some quick calculations, she determines that selling 20,000 widgets at $10/each will bring in sales of $200,000. She estimates that her costs will jump to $100,000 as she’ll have to buy a new machine and larger office.

Finances determine the boundaries

But wait a second, someone has to make the widgets now. We have a bigger office and new machine, but the boss is out selling. By her estimates, there will be $100,000 that must be split between profit and paying her new employee. She could pay someone $40,000, but that would only leave $60,000 in profit, the same as the year before. That would be silly! She’s taking a risk on a larger office, new machine, and betting that she can bring in the extra sales. There must be a payoff to justify the risk. Otherwise, she could just do the widget making herself and forget about more selling.

So that means that the employee will need to make less than $40,000. To make the risks worth it, she feels that her profits must double. So that means she’s looking for $80,000 in profit, leaving $20,000 to pay an employee. Is that a reasonable salary? Let’s see!

Markets determine the price

Just like we go to the store and see what we might want to buy, choosing the things we feel are a good value and skipping those we don’t need, or feel too expensive…employers do the exact same thing.

Her Widget Express business has a need for someone to make widgets. The market has people who know how to make widgets. She asks around, talking to various recruiters, HR friends, potential employees, and other business owners. She finds that people with the skills she needs generally get paid $25,000.

That’s more than she planned to pay, but it’s not too far out of her range. And it’s still less than her firm ceiling of $40,000. She decides that she’ll move forward with a hire and sets down to choose who it will be.

Two people in particular stand out of all the potential employees because they have experience making widgets and would need almost no training.

And then there’s the X factors

I know I said that compensation is determined by market price and the company’s finances. But there are some X factors that may or may not play into the decision. At the end of the day, people hire other people. It’s not simple math. X factors are those particulars that swing the compensation that an employee generally receives up or down.

The owner of Widget Express really likes Bob, an outgoing guy whose personality meshes well with hers. Unfortunately, Bob’s employment history shows that he’s generally made closer to $30,000 and he really likes his current job. To entice him to join her company, she’s certain that she’ll have to offer $30,000, almost $10,000 more than she wanted to spend.

At the other end of the spectrum is Frank. He makes great widgets, but something felt odd each time she spoke with Frank. Something about his personality just didn’t fit her style. His employment history showed that he generally made a bit less that the market average of $25,000.

So now she has a decision to make. The personality X factor (and there are tons of others) makes a difference. Would she rather pay the least and offer Frank $22,000 and have to live with his odd personality, or offer Bob close to $30,000 knowing that he’ll be a delight to have around?

People hire people! The direction she goes all depends on what kind of business she wants to build. Profit may be more important, so she may choose Frank. Or maybe harmony at the office is critical and she would accept less profit.

Finding what the market will bear

The amount that the “market will bear” is a fancy way of saying, “What’s the most that the market will accept?” This can be a very subjective analysis as it’s somewhat of a dance between potential employee and employer when it comes down to making/accepting offers. Sources for market data include:

  • Recruiters
  • Other business owners/managers
  • Employees at other companies
  • Job postings

Determining the market price for an empty position (or new one) is simpler. You look at what people generally make in their current positions at other companies. Finding the market rate for an existing position requires asking:

  • How much would I have to pay a replacement if the position was empty tomorrow?
  • What could a person is this position make at another company right now?

Answering these questions requires knowing exactly what a job entails.

Clearly define what gets done and level of accountability

A job is made up of the tasks that need to be done, multiplied by the level of accountability. If I’m expected to do simple tasks and have no accountability, I have a really easy job. On the other end of the spectrum, if I’m expected to do simple tasks and will be instantly fired if I make a single mistake (lots of accountability), I have a much more demanding job. The latter will likely pay more than the former.

In most cases, the business owner is more accountable than anyone else in an organization and everyone below them shares lesser degrees of accountability. It comes down to the level of reward or consequence when a job is done properly or incorrectly. If a business owner screws up, they may pay the ultimate price: the business closes and they may be left with significant debt.

High accountability comes with large rewards and/or serious consequences. Low accountability jobs have little or now rewards/consequences.

Manager and team leader are very different

An employee’s responsibility for those who work for them can significantly impact their own level of accountability. In addition for having to do one’s own work, having to handle one or more people doing work for you can make an employee much more valuable. Again, it all depends on the market. Typically, the market will reward those who have other employees reporting to them more than an individual.

If the employee determines the level of reward/consequence for those below them (including hiring/firing), that’s a ton of accountability. We probably refer to that person as a manager. This is as close as one can typically come to the level of accountability an owner has.

On the other hand, a team leader generally has some responsibility for those below them, adding a small amount of personal accountability. He/she doesn’t hire/fire and probably doesn’t have to answer personally for the mistakes or problems of those below. They have somewhat more accountability than an individual employee.

The market typically sets lower compensation for team leaders than true managers as they are more readily available.

What doesn’t determine compensation?

I mentioned earlier that there’s a lot of confusion about compensation. I’ve heard some common misconceptions about how to determine pay for a position. Here are some of the common factors that do not determine what the market will bear:

  • Hard work - There are two reasons that this really has nothing to do with compensation:
    1. Everyone is expected to work hard. People who don’t should be fired. Hard work is not a differentiator.
    2. Profit is what matters to a company. Sweat only produces profit when an employee does the right work. Working really hard on the wrong things doesn’t do anything particularly valueable for the organization. Good judgement and the ability to work hard on the right things ARE important X factors for a position.
  • Job titles - Just as grades mean different things to different people, job titles can vary wildly across companies and industries. A Vice President at one company may be responsible for $10 million in profit where at most banks, the tellers may become VPs. What matters is the work. A job title may help narrow down the comparison as one considers market value. But one cannot ever assume that two different jobs with the same title are the same. It’s comparing apples and oranges.

  • Tenure or years with a company - This can be a sacred cow for many people. I’m a fan of the saying that “sacred cow makes for the best barbeque”. What really matters is the value an employee brings each day. If all other things are equal, being with a company 20 years does not make a person more valuable that a new hire. Most likely, the knowledge that a long-time employee brings is really valuable, but that’s a different issue.

    This is not to say that a company should never value an employee’s long tenure. It can be valuable to potential employees that long time employees are given some special consideration. That’s a very reasonable X factor that may prove important to a company’s success.

  • Earning it / Deserving it - Remember that employment is simply an agreement that the employee will do certain work for a given amount of money. The market gives the employee and employer input on whether the price they agreed to is reasonable. An employee should only expect to get paid more when they do more than what was asked of them if the employer agreed to that beforehand. You and I would both be appalled if our mechanic came to us after an oil change and asked for several thousand dollars. He explains that he replaced our engine and really earned it. Without agreement up front, it does’t work that way.

  • Need - An individual’s situation has no affect on what the market will pay for a job to be done. It can have a significant influence on a business owner who may choose to offer a different compensation amount than the market. But, that’s more of a personal decision.

X Factors

There are a ton of things that may affect compensation. Some are subtle and others may dramatically impact the amount. Generally, the market determines an average compensation range for a particular type of work or job, then employees and employers separately determine which X factors will influence their decisions and the final compensation they feel is appropriate. Here are just a few:

  • Ability to self-direct (requires less oversight)
  • Attitude
  • Amount of experience
  • Benefits (Health insurance/401k)
  • Communication abilities
  • Company health
  • Employee reviews
  • Employer’s distance from home
  • Flexible scheduling
  • Good judgement and intuition about how to be impactful
  • Skills outside the job description
  • Special knowledge / skill
  • Timeliness
  • Travel expectations (time away from the family)
  • Work conditions
  • Work schedule / Vacation

What about kindness and corporate benevolence?

There absolutely are companies that exist for more than just profit. And I think that’s great. They really want to make the world a better place. It’s not helpful to let those other goals color the basic realities of the marketplace. To have an intelligent conversation about compensation, the market rate is the best starting point.

For those organizations who go beyond profit, they may choose to buck the market and make different decisions (paying more than market rate, giving extra consideration to tenure, etc). I see that as an intentional adjustment of what the market sets as the base rate. That doesn’t take anything away from the market rate or it’s value as a conversation starter.

Published April 18, 2010

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