What is Compensation?

Compensation is a cash or non-cash payment made in exchange for services rendered. Compensation can include base pay, bonuses, commissions, merit pay, and tip income. It can also include ancillary or deferred payments, such as stock options, vacation pay, pension benefits, free parking, and medical insurance. Compensation levels are based on regional salary surveys; a periodic review of these surveys ensures that an employer sets compensation packages at competitive levels, in order to retain employees. Compensation is also based on performance, so that top-level performers can receive significantly greater pay than mid-range performers.

In a service business, compensation is typically the largest expense incurred by the employer. It is still a significant expense even in businesses that do not require a significant amount of employees.

Types of Compensation

The main types of compensation are as follows:

Base pay. The fixed salary or hourly wage paid to an employee for performing their job duties.
Bonuses. One-time or periodic payments awarded for meeting performance targets, achieving milestones, or as a year-end incentive.
Commissions. Payments based on a percentage of sales or deals closed, commonly used in sales positions.
Profit sharing. A program where employees receive a share of the company’s profits, typically distributed annually.
Stock options and equity. Grants that allow employees to buy company stock at a set price, offering potential future value based on company performance.
Overtime pay. Additional pay for hours worked beyond the standard workweek, as governed by labor laws.
Shift differentials. Extra compensation for working less desirable shifts, such as nights, weekends, or holidays.
Hazard pay. Additional wages for working in dangerous or high-risk environments.
Benefits (non-cash compensation). Includes health insurance, retirement plans, paid leave, education assistance, and other perks that enhance total compensation.
Deferred compensation. Income earned in one period but paid in the future, such as pensions or executive retirement plans.

Compensation Taxes

Compensation is subject to a variety of taxes and withholdings, including Social Security and Medicare. Locally, a municipal government might also impose a head tax, such as $10 per person employed, per month. Technically, a head tax is not a compensation tax, because it does not vary based on the amount of compensation paid out. Instead, a head tax is a fixed amount charged per person employed.

Accounting for Compensation

Compensation is usually charged to expense in the period when the related benefits are incurred - which is to say, in the current period. However, if compensation relates to the production of goods, then the cost of the compensation is instead capitalized into the cost of the resulting inventory. If this inventory is sold, then its cost is charged to the cost of goods sold, along with the cost of the compensation included in it. If the inventory instead remains in stock, then the included compensation cost is also included in this asset, and will remain there until the goods are sold.