EFFECT

OF

INTERNAL

AND

EXTERNAL

EQUITY

ON

ORGANISATION COMPENSATION SYSTEM

Introduction
In todays competitive globalized economy, an organizations compensation
strategy and its approach to equity can affect the organizations ability to attract,
retain, and motivate its employees. Essentially, an effective employee
compensation system must balance two factors employee motivation and
labour costs; thus in designing its pay structure, an organisation must consider
both external equity and internal equity. Particularly, great consideration must
be put on internal equity which appears the more important factor in retaining
and motivating employees for organizational effectiveness.
Generally, equity (or fairness), as a central theme in compensation theory and
practice, arises in many different contexts. These include:

The legal and economic issue of equal pay for similar work.
Pay differences caused by external competition or market pressures.
The fairness of individual wage rates for people doing the same job.
Individual employee views of their value relative to their pay.

External versus Internal Equity

External equity refers to comparisons of an organizations pay structure with the
going rate or other competitive pay structures in the market. External pay equity
exists when employees in an organization perceive that they are being rewarded
fairly in relation to those who perform similar jobs in other organizations.
On the other hand, internal equity means ensuring fairness in pay for employees
doing similar jobs. Internal pay equity exists when employees in an organization
perceive that they are being rewarded fairly according to the relative value of
their jobs within an organization. In other words, employees perception of their
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responsibilities, rewards and work conditions is seen as fair or equitable when

compared with those of other employees in similar positions in the same
organization. Factors such as skill level, the effort and the responsibility of the
role, as well as working conditions are considered.
Organizations typically emphasise external equity in the design of their
compensation structures. Here the market pricing analysis is done and
compensation strategies are formulated by assessing the competitors or industry
standards. Organizations set the compensation packages of their employees
aligned with the prevailing compensation packages in the market. At times,
higher compensation packages are offered to attract and retain the best talent.
This focus on external equity enables a company to develop compensation
structures and programs that are competitive with other companies in
appropriate labour markets. Thus, creating a compensation structure that starts
with competitive base pay is important.
However, once this is done, there are several advantages to considering internal
equity. Individual employees view equity differently from the way or how
organizations view it. While organizations tend to compare themselves with
other organizations, individuals, once hired, tend to compare their pay with that
of other people within the organization. A study conducted in 1972 by Allan N.
Nash adds insight to this issue. Participants were asked which of the following
situations would make them the most angry:
1. If they were paid less for similar work than employees were paid in other
organizations.
2. If they were paid less for the same work than employees were paid in their
own organization.
3. If they were paid less for different work than employees were paid in their
own organization.
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Seventy-eight percent of the respondents indicated that they would be the most
angered if they found themselves paid less than others doing the same job in
their own organization.
The internal equity method undertakes the job position in the organizational
hierarchy. The process aims at balancing the compensation provided to a job
profile in comparison to the compensation provided to its senior and junior level
in the hierarchy. The fairness is ensured using job ranking, job classification,
level of management, level of status and factor comparison. Internal pay equity
does not mean that all employees are paid the same; it means that they are paid
fairly in relation to other staff in the same role. Differences in salary may be
based on education, experience, years of service, or responsibility level.
In addition to pay, there are many things that influence an employee's
perception of equity including job security, working conditions, advancement
opportunities, management appreciation, relations with co-workers, and
flexibility of hours or job assignment ahead of pay and these must be well
balanced among different hierarchies of employees as well.
Advantages of maintaining strong internal equity consideration in the
compensation system include
Perception of Fairness
Organizational culture is an important strategic factor to business success. To
develop and maintain a culture of fairness, an organization need to strongly
factor in internal equity. If employees look at others in similar jobs and see
equal pay, they will likely feel like the organization and its leaders are fair and
this positively affect job performance.
In Equity Theory Towards a General Theory of Social Interaction (The
Academic Press, 1976), J. Stacy Adams proposed that an employee
continuously monitors his or her inputs and outputs on the job, and perceives an
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equitable situation when the ratio of his or her inputs and outputs are equal, to
those of other employees. If this ratio is not equal, the employee may feel angry
(as a result of not being paid enough) or guilty (as a result of being paid too
much). Either feeling could result in dissatisfaction or discomfort.
Reduced Exposure to Legal Issues on Discrimination
While the market-based approach may attract the most talented workers, an
emphasis on internal equity offers better protection against discrimination
lawsuits. If a company pays different wages to workers in the same role, it runs
the risk of being sued for wage discrimination. By ensuring internal equity, you
mitigate your risks.
Consistent Performance Standards
When employees are paid on a consistent scale, the organization also have the
opportunity to maintain consistent performance standards. When conducting job
analysis and developing a job description, organizations establish the abilities,
duties and responsibilities required for a position that earns a certain amount of
pay. If one employee clearly falls short of the standards and production of
colleagues, there is tangible and fair justification for a demotion or termination.
By paying fairly, the organization limits the worker's ability to claim unfair
treatment or lack of motivation for poor performance.
Team Cohesiveness
Internal equity is especially important in an organization built on a team
structure. Members of a work team can more easily collaborate when they earn
similar compensation as peers. Equitable compensation protects against a
natural barrier that can impede cohesiveness in a work team.
Conclusion
Agreed, organizations must try to reconcile external and internal equity issues
when setting wage and salary policy. The long-term need is to establish both a
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strategic organization-wide wage-level policy that specifically addresses a

company's approach to pay relative to the marketplace (external equity) and an
internal job evaluation methodology for use in assessing the relative value of
each job in an organization (internal equity). But since employee perceptions of
equity are most affected by comparisons with jobs that are similar to theirs, the
internal ranking provides the best guidance for setting individual wage levels.
While external data could be used to establish strategic guidelines for overall
company pay policy. In addition, a sound job-evaluation methodology should be
used to determine the relative internal value of the company's jobs. This job
evaluation methodology lays the groundwork for establishing internal equity.
This approach provides an objective basis for making critical compensation
decisions and adds increased credibility to an organization's pay practice and
better satisfies employees' equity concerns. Employees perception of inequity
or unfairness expectedly results in low morale and loss of organizational
effectiveness.