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The Different Forms of Compensation

There are two forms of compensation provided to employees; direct and indirect.  Direct forms of compensation have a multitude of types or methods, from salaries to bonuses.  Indirect compensation is primarily the various types of benefits and long term incentives.  This article is an introduction to the terminology of compensation.

One of the forms of compensation is direct remuneration for services rendered by the employee.  The term used for this is wages.  It consists of four different groups of payment from the employer to the employee.  They are salary, hourly, commission and bonus types of wages.

Direct Forms of Compensation

Salary

This type of wage is customarily a set sum of remuneration over a defined period of time.  The most traditional form is a dollar amount over a period of one year.  The frequency of payment is another part of the compensation and is based on industry standards.  Most businesses pay for services twice a month. 

Salaries are the most commonly used tool to pay professional or licensed employees.  In general there is an expectation from the employer of a longer term commitment from the employee for providing a regular uninterrupted compensation stream via a salary.

Hourly

This is a dollar amount per hour of service to the employer, more commonly used to compensate unskilled and skilled laborers in the workforce.  This form of compensation comes with an implied understanding that during times of slow or minimal workloads, the employee may not be used to provide services.  In effect, there is no guarantee of a regular cycle of pay.

Commission

When compensation is based on volume or some form of performance, this is known as commission based remuneration.  Other terms used include piecework or piecemeal.  Many industries used this type of remuneration to get a minimum standard of production in exchange for compensation.  It is used to shift risk from the employer to the employee.  There are two methods to calculate commission.  One is based on volume of services and the other is based on sales.

An example of an industry that uses volume remuneration extensively is the fishing industry.  The men that work on the boats have a risk that the captain will not find fish.  In exchange, the captain may hit upon some nice fishing grounds and bring in a large catch.  Once the fish is offloaded, the processors use commission to compensate the production workers.  These workers are paid by piecemeal, that is, how much final product they can generate from the catch.  Typically their cuts of the meat are weighed and they are compensated based on that measurement for services rendered.

An example of an industry that uses sales based commissions is the auto retail dealerships.  Here the salesman is enticed to get the buyer to purchase the vehicle so that he may receive compensation for his services.  Other commission based industries include, brokers, real estate agents, door to door salesmen, internet website owners and some folks in the cleaning services.

Bonuses

Bonuses are used to increase performance from the employee.  This is a variable type of remuneration and is more commonly found with salaried staff to incentivize them for a particular goal whether time or volume based.  Other reasons used for bonuses are to increase or maintain retention of certain skills or the pool of skill-sets needed in the company.   Sometimes bonuses are paid when a company meets certain financial standards or goals over an extended period of time.

Bonuses are not commonly used with hourly or commission based employees due to the nature of the type of compensation already established.  However, in small businesses it is used as a tool to incentivize these two types of remuneration to meet certain goals.The other form of compensation is indirect in value.  This includes benefits and equity based programs.  In general, these two types of indirect compensation provide value to an employee over a longer period of time. 

For a more detailed and informative analysis and comparison of direct compensation, I have written an article describing these and their respective IRS compliance requirements.  In addition I explain the connection to Exempt and Non-Exempt status and connection with the owner’s profit.  Read:  Four Types of Direct Compensation for a more in-depth understanding of direct compensation.

If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.

Indirect Forms of Compensation

Benefits

This particular group is traditionally thought of in the form of insurances (health, dental, life, disability and vision) and retirement.  Very few small businesses provide benefits to their employees due to the cost involved.  When small businesses begin providing benefits, they customarily start out with retirement because of simplicity and low cost.  As they grow, they add health insurance (mandated by law for employers with 50 or more employees) and continue to expand the benefit package as the number of employees increase and the risk of business performance decreases.  Benefits allow for retention and recruitment.

Other benefits can include transportation, paid time off, vacation time, and customized incentives (lodging, meals, phones, etc.).

Equity Based Programs

Rarely found in the small business world for several reasons.  These types of indirect compensation tie the employee to the company via ownership.  Due to the complexity and the legal issues involved, very few small businesses use this tool.  This is a sophisticated method to retain key employees and is discussed in another article.

Summary

This article introduced the reader to the terms of compensation.  There are two forms of compensation, direct and indirect.  Each form of compensation has types of remuneration (pay).  As a small business owner, you need to understand the basic forms of compensation and the types used to pay employees.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.  If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.

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About David J Hoare (405 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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