A Business Encyclopedia

Theories of Compensation

Definition: The Compensation is the remuneration given to the employees for the work they do for the organization. In other words, an employee is entitled to both the financial and the nonfinancial benefits in return for his contribution to the organization.

To understand which component of compensation is efficient, we need to go through the theories of compensation. There are three theories of compensation viz. Reinforcement and Expectancy Theory, Equity Theory and Agency theory which are explained below.

Theories of Compensation

theories of compensation

  1. Reinforcement and Expectancy Theory: This theory is based on the assumption that, the reward-earning behavior is likely to be repeated, i.e. an employee would do the same thing again for which he was acknowledged once.

    Similarly, in the case of Expectancy Theory, given by Vroom, the employee is motivated to do a particular thing for which he is sure or is expected that performance will be followed by a definite reward or an outcome.

  2. Equity Theory: According to this theory, there should be equity or the uniformity in the pay structure of an employee’s remuneration. If the employee feels he is not being paid fairly for the amount of work he does in a day will result in lower productivity, increased turnover and high absenteeism. The remuneration system should comply with three types of equity:

    2.1 Internal Equity: The employee perceives the fairness in different pay for different jobs based on the nature of work involved, i.e. he must feel that pay differentials among the jobs are fair.

    2.2 External Equity: The employee should feel the fairness in what they are being paid is in line with what other players in the same industry are paying to their employees for the same kind of job.

    2.3: Individual Equity: The employee perceives the pay differentials among the individuals who are performing the same kind of a job and within the same organization. Usually, an individual with more experience gets high remuneration as compared to the fresher irrespective of the nature of a job.

  3. Agency Theory: This theory states that both the employer and the employee are the stakeholders of the company, and the remuneration paid to the employee is the agency cost. The employee will try to get an increased agency cost whereas the employer will try to minimize it. Hence, the remuneration should be decided in such a way that the interest of both the parties can be aligned.

Thus, these theories posit that the compensation in the form of salary or wages can be decided on the basis of the outcome or the behavior of an employee.

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