How Does Your Employer Decide Your Salary?

Deciding a person's salary is both an art and a science. It is an art because there can never be a salary that is objectively "correct", but it is also a science because a salary decision should be data-driven and derived based on facts.

A point to note - this post will discuss how base salary or basic salary may be determined, which is typically the number negotiated following a job offer. This is the fixed compensation element that an employee receives on a regular basis, and is the foundation of any compensation package. The base salary is then used to calculate variable pay such as performance bonuses, sales commissions, as well as other incentives. 

Another point to note is that this list will not include legislative requirements (e.g. Progressive Wage Model, Minimum Qualifying Salary for foreigners) as these are beyond an organization's control.

The factors listed below are certainly not exhaustive, but should be fairly representative of what most organizations would take into consideration:

1) Your Organization's Compensation Philosophy

The compensation philosophy is a set of principles on which compensation practices and salary decisions are based. For example, an organization may state that it adheres to "pay-for-performance", where the compensation focus is on performance-based variable pay. An organization may also state its intention to pay market-competitive base salaries, and even define the market percentile at which it would like to pay its employees

The base salary of most employees (excluding selected top management such as the C-suite who are typically remunerated on a person-to-holder basis) is guided by the organization's compensation philosophy, if it has one. However, do note that the philosophy is only a guide - there will always be exception cases due to each employee's unique circumstances.

2) Budget

Affordability is the biggest limiting factor in salary determination - especially for businesses since employee salaries are often a significant part of business costs. 

Having a salary budget makes it seem like there is a hard limit to how high a salary can go. In practice though, there is typically some flexibility in salary decisions as the salary profile of the employee population is always changing due to the different salaries of exiting employees and new joiners. For example, if a highly paid employee leaves and his/her replacement is paid less, the cost savings may, in theory, be used to fund other headcount within the team to achieve cost neutrality.

3) Job Size / Level

The job size is usually determined by how complex or difficult a job in terms of the knowledge and skills required, as well as the impact it has on the organization. There are different job evaluation methods out there in the market such as those developed by HR consultancies Mercer, Korn Ferry Hay, and Willis Towers Watson - all of which attempt to provide an objective way of determining how big a job is. A larger job within the same industry and function typically commands a higher salary. 

4) External Salary Benchmark

The external salary benchmark of a job refers to the chosen salary point that is derived from the aggregate salary data of other organizations. Organizations may use different benchmarks, and this is usually guided by their respective compensation philosophies, if they have one. The benchmarks may be differentiated based on industry, job function, job level, and percentile - there are indeed many ways to define the appropriate benchmark, depending on each organization's unique situation. Salaries are therefore heavily influenced by the chosen benchmark, as this provides a reference for what each organization perceives to be a competitive salary for any given job.

5) Internal Equity

Even if an organization has a clear idea of what a competitive salary is for any given job, it may not pay such a salary simply because existing employees in similar roles may be paid lower. Unless there is good justification for bringing in the new hire at a higher salary point, an organization may not want to upset internal equity and risk disengaging its existing employees by paying a new hire significantly more that the peer group. As such, there will always be a tension between paying competitive salaries to attract new talent, while ensuring existing employees' gap to the market-competitive salary point is minimized.

6) Relevant Experience and Competence

Organizations may assume that someone with more relevant experience will be more competent in a role, all other things being equal - and it is this added competence that organizations may be willing to pay a premium for.  Of course, the correlation between experience and competence may not always be true, but is nevertheless a fair assumption.

7) Position within Applicable Salary Range

Most organizations with developed HR practices will have unique salary ranges that may be differentiated based on rank / job level / job function. Each of these salary ranges have a minimum, mid-point, and maximum - and ideally, each employees should receive a salary that is within the relevant salary range. While in principle an employee can be paid any salary as long as it is within the range, there may be additional policy guidelines that prevent new hires from being hired at a salary that is too high within the range. There are 2 reasons for this: 

i) The employee may be perceived to be "overpaid" for the role he/she is performing relative to the organization's chosen market benchmark, as well as other employees who are in similar roles whose salaries may, on average, be closer to the middle or lower part of the range.

ii) Assuming the salary range maximum and job level remains unchanged, the new hire may hit the salary ceiling within just 1 to 2 salary adjustment cycles if the salary offer is too high within the range. The salary will then remain stagnant, which may lead to the employee becoming disengaged and becoming a flight risk.

Other Factors

You will notice that the 7 factors above have something in common - they all revolve around the job that an organization is hiring for. There is good reason for this, as salaries are a reflection of the perceived value an employee brings to the organization - and this is heavily dependent on each employee's job. 

There are, however, non-job-related factors that some organizations use in salary determination, which may not always be defensible:

1) Last Drawn Salary

This approach of using an external candidate's last drawn salary to determine his/her new salary a logically flawed, since the last drawn salary is paid to a person for performing his/her previous role in a different organization with different pay policies, rather than the job the new organization is hiring for. 

If the last drawn salary is low relative to other employees performing similar roles, then there may be a tendency to depress the offer based on the belief that the candidate should not receive a "windfall". This tendency may exist even if the person is moving into bigger role with more complex responsibilities.

Conversely, if the last drawn salary is high relative to other employees performing similar roles, then there is a tendency to inflate the offer just to get the candidate on board. This tendency may exist even if a person is moving into a smaller role with less complex responsibilities.

Using the last drawn salary to develop a salary offer is problematic in both scenarios. As such, HR will typically use the job-related factors to justify a salary proposal, and only use the last drawn salary as a reference to gauge what might be acceptable to the candidate during the salary negotiation process.

2) Academic Qualifications

While salaries are indeed differentiated by academic qualifications at the fresh graduate level, this is only because of the absence of formal job experience, which necessitates the use of qualifications as a proxy for determining the perceived value a person brings to an organization.

In all other cases, academic qualifications should only used as to differentiate salaries if the qualification enables an employee to take on larger or more complex responsibilities. This is in line with the principle of salaries being a reflection of perceived value. Otherwise, the attainment of a higher qualification, on its own, cannot be used as a defensible argument for salary differentiation.

Conclusion

A fair amount of due diligence goes into each salary decision, and decisions typically become more complex at senior management levels due to the need to consider other remuneration elements which junior employees and middle management may not be eligible for. Regardless of complexity, the salary numbers are never randomly determined - there is always a story behind the numbers.