External /Internal Equity

The main purpose of this project is to point out the relationship between external equity in discussing pay versus benefits, and also to investigate the best compensation package (with special focus on external market competitiveness and internal equity) that will be of benefit to recruit and retain productive and motivated staff members. Key words: external equity, compensation, internal equity, motivation CHAPTER ONE 1. 0 LITERATURE REVIEW 1. 1 Equity Theory

Basically, employees make comparison of their job inputs (Effort, experience, education, competence) and outcomes (Salary levels, raises, recognition) relative to those of others.

Individuals tend to make comparison of their outcome-input ratio with the outcome –input ratio of relevant others. A state of equity exist when individuals perceive that their ratio is equal to relevant others, while inequity exist when the ratio are not the same. This led to the theory of social equity been proposed by J.

Stacy Adams (1963) based upon Festinger’s (1957) theory of cognitive dissonance, that has received considerable attention in the organizational behavior literature (Vecchio 1981).

According to Adams (1963), an employee brings to a job certain inputs (such as education, experience, training, and skill), and receives certain outcomes (such as intrinsic and extrinsic rewards). Inequity occurs when an individual perceives that the ratio of his or her outcomes to inputs is not equal to the ratio of some referent other, such as a work peer (Adams 1965).

Individuals can feel inequity exists when they are undercompensated or overcompensated relative to their referent other (Walster, Berscheid, and Walster 1973). When inequity is perceived, individuals may experience “distress”–anger or resentment in the case of under compensation and guilt in the case of over compensation (Austin and Walster 1974).

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Evidence suggests that individuals may base perceptions of equity on a number of comparison others (Ronen, 1986; Hills, 1980; Middlemist & Peterson, 1976). ased on common choices of comparison others, there are at least three distinct types of equity: external equity, internal equity, and employee equity. For the purpose of this project external and internal equity will be addressed. 1. 2 EXTERNAL EQUITY External equity exists when an organization’s pay rates are at least equal to the average rates in the organization’s market or sector. Employers want to ensure that they are able to pay what is necessary to find, keep and motivate an adequate number of qualified employees.

Creating a compensation structure that starts with competitive base pay is critical. Limited evidence suggests that managers at higher organizational levels may use external comparison others more than managers at lower organizational levels (Ronen, 1986; Heneman, Schwab, Standal, & Peterson, 1980). This may occur because greater participation in professional networks at higher levels may make inputs and outputs of external others more salient. One way organizations achieve external equity is through the use of labor market pay surveys (Davis, 1997). . 3 INTERNAL EQUITY Internal equity exists when employees in an organization perceive that they are being rewarded fairly according to the relative value of their jobs within an organization. Another way of stating this is to say that a person’s perception of their responsibilities, rewards and work conditions is seen as fair or equitable when compared with those of other employees in similar positions in the same organization. Factors such as skill level, the effort and the responsibility of the role, as well as working conditions are considered. Although employees use internal as well as external comparison others (Andrews & Henry, 1963; Finn & Lee, 1972), their relative importance is unclear. Finn and Lee (1972) found that employees using internal comparison others were more satisfied with pay than those using external others. However, Hill (1980) found that people tended to use either internal and external referents or neither. One way organizations achieve internal equity is through the use of job evaluation plans. CHAPTER TWO 2. 0 COMPENSATION

According to Tanushree Sanwal (2009), compensation is the remuneration received by an employee in return for his/her contribution to the organization. It is an integral part of human resource management which helps in motivating the employees and improving organizational effectiveness. Adequate compensation also serves the need for attracting and retaining the best employees. It is an organized practice that involves balancing the work-employee relation by providing monetary and non-monetary benefits to employees.

Compensation 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. compensation management philosophy believes in satisfying the various needs of an individual, such as social needs, psychological needs, safety needs, self-actualization needs etc. In absence of compensation it may not be possible to attract suitable people to work for the organization. Compensation helps in running an organization effectively and accomplishing its goals. Modern day organizations need to design the compensation systems aligning with the business goals and strategies.

Three strategic objectives of compensation of particular importance are: (1) attracting and retaining the talent required for a sustainable competitive advantage, (2) focusing the energy of employees on implementing the organization’s particular competitive strategy, and (3) improving productivity 2. 1 THE ROLE OF HR According to schuler and Jackson (2006) human resources is responsible for setting the compensation system in the whole organization, monitor it and do a proper follow up, when the compensation system does not work properly.

HR introduced several procedures to measure the fairness in compensation in the organization. HR introduced job design and job evaluation to compare different jobs across the organization. There are two ways of determining the levels of pay according to Thorpe and Holman (2000). The first is to focus on the labor market and to pay everyone at around the market rate. In this case, there is a comparison with employees in other organizations and it is called “external equity” (Hume, 1995).

The second as its first priority the organizational goals and supports a reward system according to the organizational objectives and considering the job evaluation. In this case, there is a comparison of employees in the same organization and it is called internal equity (Hume, 1995). It is supported that the most dissatisfied employees are those who face internal inequity, namely when senior managers are “generously paid” and the other employees feel the unfairness (Hume, 1995). 2. 2 EXTERNAL EQUITY IN COMPENSATION.

The organization competes with other employers to attract, hire and retain the best employees. It has to offer a competitive salary package to make employees feel satisfied and prevents them from looking for job elsewhere. The external equity is about keeping the personnel expenses budget under control and securing the position of the organization in the pay market. Most organization do not choose to pay more than the competitors, but they want to pay in-line with competitors and they choose the median for most job positions. Most of the times, the market rate is considered to be most efficient approach.

In most competitive markets, there is no other choice but to pay the market rate in order to attract qualified staff and to ensure satisfaction. Furthermore, according to Thorpe & Homan (2000), small organizations with growth potential can attract new employees by promising a greater share of rewards and better career as the company will expand successfully in the future. However, supply and demand differ substantially among market resulting in significant variation in wages across labor markets. Schuler and Jackson (2006) pointed out factors that could contribute to wage differences among markets.

They are geographical location, union status, industry sector, organization size, company prestige, product competition, education and experience level of available work force, licensing or certification requirements called for by the job. A combination of the factors determines the labor market for a particular job. 2. 3 INTERNAL EQUITY IN COMPENSATION. Internal equity in compensation is more important than external equity for many organizations. The unfairness in the compensation inside the organization is more visible.

It is supported that the most dissatisfied employees are those who face internal inequity, namely when senior managers are “generously paid” and the other employees feel the unfairness (Hume, 1995). Internal equity is about proper job design and job evaluation and setting the same compensation principle for the comparable job across the organization. The performance related compensation components are the usual source of the differences in the pay for the comparable job positions as human resources has to co-operate with line managers for a better understanding of the business and also set a better bonus pay.

Schuler and Jackson (2006) pointed out job related factors that could be used to set compensation levels. They are education required, experience required, physical demands, responsibility for equipment/materials, responsibility for safety of others, supervisory/managerial responsibility, working conditions, accident or health hazards, public contact, manual dexterity. CHAPTER THREE 3. 0 PAY EQUITY: Internal and External Considerations. 3. 1 COMPANY VIEW Basically, companies emphasize external equity in setting a compensation structure.

For example, a 1975 Bureau of National Affairs study shows that over 80% of both small and large firm ranked external effectiveness as their most compensation objective. This emphasis on external equity demands the availability of high quality of labor market data. Because labor market tend to be highly variable, difficult to track, difficult to describe, companies are forced to participate in elaborate, costly wage surveys to get the data they need. However, companies are beginning to recognize limitations associated with focusing on external equity as the primary basis for setting compensation objectives.

A 1985 study by the conference board showed that employers are starting to consider internal factors as more important that the external factors in setting wage level. These companies recognize that over emphasizing external equity may detract from important internal equity considerations. 3. 2 EMPLOYEES VIEW Individual view equity differently from the way organization views it. While organizations make comparison with other organization, individuals compare their pay with others within the same establishment. For this reason perception of internal equity can influence an organization compensation objective, much more than external issues.

A study conducted in 1972 by Allan N. Nash adds insight to this issue. The result showed that 80% of employees indicated that they will be angered if they found themselves paid less than others in same establishment In addition to pay, there are many things that influence employee perception of equity. Study shows that workers often rank job security, working conditions, advancement opportunity, management appreciation, relationship with co-workers, and flexibility of working hours or job assignment ahead of pay.

In summary, it appears that employees may look at compensation equity from a different view point than that of their employers. Companies go to great length to establish mechanism for accessing pay practices in other companies, while employees are primarily concerned with pay equity in their own company. 3. 3 EXPERT OPINION The following statement indicates the opinion of some compensation experts. The first two supports external equity, while the last two favors internal equity. •“In most cases it makes sense to focus on external pay comparison as the major as the major criteria to determine compensation levels.

Both internal and external and inequity have serious consequences for the organization. However the consequences of external inequity…are more severe for the organization and they are the ones that deserve primary attention” (Edward E. lawler 1981). •“We feel it is important to underline the sovereignty of external equity influence on wages over internal equity influence. Certainly the power of a wage or salary to attract employee is based solely on external equity considerations. The retention power of a wage or salary is also influenced heavily by external equity considerations.

When external and internal equity considerations are in conflict, we suspect …. that external equity takes precedence” (Mark. J Wallace and Charles f. hay 1983).
• “Most pay comparison research suggests that it is probably more important to have internal equity than external equity. Employee can seemingly grasp of whether they think they are fairly paid by a particular employer through looking at other jobs in that organization than they can by weighing external information”(Thomas h. Patten 1977). “Experience seems to indicate that establishment of compromise rate in case of conflict is probably the solution. Internal consistency is more important than strict external competitiveness” (Milton. A . Rock 1984). CONCLUSION My findings suggest that there is no right or wrong answer in which should be the primary consideration external or internal equity for formulating compensation objectives. According to a study conducted by Government of Canada human resource council, a good compensation strategy includes a balance between internal equity and external competitiveness.

Compensation and benefits affect the productivity and happiness of employees, as well as the ability of your organization to effectively realize its objectives. It is to your advantage to ensure that your employees are creatively compensated and knowledgeable of their benefits. The long term need is to establish both a strategic organization wide pay level policy that specifically addresses a company’s approach to pay relative to marketplace (external equity), and an internal job evaluation methodology for use in assessing the relative value of each job in an organization (internal equity)..

Kent Romanoff et al. In conclusion, HR should consider a two way approach in setting wage levels. External data should be used to establish strategic guidelines for overall company pay policy. In addition, a second job evaluation methodology should be used to determine the value of a company’s job. This establishes internal equity. .