human resources. One is determining the levels of pay and benefits within the organization. Most companies are smart enough to understand the value of internal equity, since employees talk to each other, and it is difficult to discriminate internally in terms to pay, by law. Internal equity is practiced most strongly at companies that have strict policies with respect to pay scales. These are typically based on a combination of hierarchy, experience and ability. In some circles, the concept of internal pay equity specifically applies to all levels of the organization, from the CEO on down. A good example of a company that practices strong internal pay equity is Costco. Former CEO Jim Sinegal famously only made $200,000 per year and the new CEO makes less than a million, offering what is at least pay equity for a company in the United States.

Internal pay equity is important because it signals that pay is strictly based on merit throughout the organization. People within the organization are more apt to feel that their pay is commensurate with their contribution to the company. If there is no internal pay equity, that indicates that the company may have problems. Workers might see that others who contribute roughly the same to the company are paid much more, and this can negatively affect motivation. So internal pay equity is something that creates positive motivation and facilitates a stronger team culture as well (Executive Press, 2014).

External pay equity means that the compensation is more focused on setting compensation standards more in line with the market. The competition for workers in such companies is considered perhaps to be across companies, which means that pay must be set in line with other companies in the same industry. This is something you see at high levels — competition for top executives makes their pay more in line with those of other firms than in line with internal standards (Aggarwal & Samwick, 1999).

External pay equity is also reflected at entry levels, often, because entry level workers tend to move between companies frequently, and have skills sets that are largely interchangeable. This makes them price-takers, and firms in a given industry will leverage that to compete with each other on pay. This is reflected, for example, in the number of low-paying service sector jobs — all companies in these sectors pay roughly the same wage in order to balance between cost control and competitiveness as an employer. In either case, there is usually a disconnect between these wages at the bottom and wages further up the management ladder, because as managerial skill sets increase, they become more valuable and transferable internally rather than externally. McDonalds is a good example of a company that practices external wage equity both at the executive levels and entry levels, and there is tremendous disconnect between the wages at each level, a lack of internal equity.

There are several advantages for internal equity in organizations. The first is that it creates a stronger organizational culture, including stronger loyalty to the organization, because it makes all workers feel like an important part of the company whose contribution is fairly valued. Companies can use internal equity to create motivation within the organization, because it creates a direct link between contribution and results for the workers.

This, conversely, is one of the major cons of external equity. External equity programs often function at the expense of internal equity. It is not that internal equity is entirely discarded, but there can be tremendous gaps between pay at different levels. This creates a demotivating scenario where lower level workers do not feel compelled to make additional contributions to the organization because they feel that such contributions will not be rewarded anyway — or even worse that higher-ups will reap the rewards of their additional effort. The benefits of external equity, however, are that when recruiting candidates from the outside, the company is more likely to offer fair value, and therefore is more likely to deliver better personnel, in particular when recruiting from the outside. The downsides are that there is likely to be more turnover and the risk of morale issues is also higher.

If we look at Costco, its internal equity strategy directly supports its strategic direction. The company believes that lower turnover equals higher productivity, allowing it to deliver lower costs. It also believes that superior service results from a higher level of commitment to the organization, again with a positive result, in this case increased customer loyalty. So the company’s policy acts as an important component to its overall market strategy.

The same can be said for McDonalds and its external equity policy. The company emphasizes two things — low costs and high efficiency. This is achieved by hiring great managers to build highly efficient systems, something facilitated by high external equity, but also by keeping labor costs low in other areas of the organization. Again, this is something achieved by pricing low-end labor at market prices, which allows it to keep this labor cost down, even if it means some negative impact on productivity. The company actually has to take steps to reduce that negative productivity impact associated with the high turnover.

References

Aggarwal, R. & Samwick, A. (1999). Executive compensation, strategic competition, and relative performance evaluation: Theory and evidence. The Journal of Finance. Vol. 54 (6) 1999-2043.

Executive Press. (2014). Internal pay equity methodologies. Compensation Standards.com. Retrieved April 13, 2014 from http://www.compensationstandards.com/nonmember/files/IntPay.htm

Martocchio, J.J. (2009). Strategic compensation: A human resource management approach (5th ed.). Upper Saddle River, NJ: Pearson Education.