Theories of Compensation

In order to understand which components of remuneration are more effective, we need to understand the conceptual framework or theories or employee remuneration. Three such theories are reinforcement and expectancy theories, equity theory and agency theory.

Theories-of-Compensation

1. Reinforcement and Expectancy Theories
The reinforcement theory postulates that a behavior which has a rewarding experience is likely to be repeated. The implication for remuneration is that high employee performance followed by a monetary reward will make future employee performance more likely. By the same token, a high performance not followed by a reward will make its recurrence unlikely in future. The theory emphasizes the importance of a person actually experiencing the reward.
Like the reinforcement theory, Vroom’s expectancy theory focuses on the link between rewards and behavior. Motivation, according to the theory, is the product of valence, instrumentality and expectancy. Remuneration systems differ according to their impact on these motivational components. Generally speaking, pay systems differ most in their impact on instrumentality the perceived link between behavior and pay. Valence of pay outcomes remains the same under different pay systems. Expectancy perceptions often have more to do with job design and training than pay systems.

2. Equity Theory
Adam’s equity theory says that an employee who perceives inequity in his or her rewards seeks to restore equity. The theory emphasizes equity in pay structure of employees’ remuneration.
Employee’s perceptions of how they are being treated by their firms are of prime importance to them. The dictum ‘a fair day work for fair day pay a sense of equity felt by employees. When employees perceive inequity, in can result in lower productivity, higher absenteeism or increase in turnover.

3. Agency Theory
The agency theory focuses on the divergent interests and goals of the organization’s stakeholders and the way that employee remuneration can be used to align these interests and goals. Employers and employees are the two stakeholders of a business unit, the former assuming the role of principals and the latter the role of agents. The remuneration payable to employees is the agency cost. It is natural that the employees expect high agency costs while the employers seek to minimize it. The agency theory says that the principle must choose a contracting scheme that helps align the interest of the agents with the principal’s own interests. These contracts can be classified as either behavior-oriented (e.g. merit pay) or outcome oriented (e.g. stock option schemes, profit sharing, and commission).

At the first sight, outcome-oriented contracts seem to be the obvious solution. As profits go up, rewards also increase. Remuneration falls when profits go down.

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