Types of Compensation

Everything you need to learn about the types and forms of compensation provided to employees in an organization. Compensation is what employees receive in exchange for the services rendered in an organization.

The term ‘compensation’ refers to all forms of financial returns and tangible benefits that employees receive as part of the employment relationship.

In the era of globalization, where the business environment has become increasingly complex and challenging, structuring an effective compensation package to attract and retain talent is an important function of organizational effectiveness.

Compensation may achieve several purposes assisting in recruitment, job performance, and job satisfaction.

In other words we can say that Compensation is the process of providing adequate, equitable and fair remuneration to the employees.

Some of the types of compensation given to employees are:-

1. Financial Compensation 2. Non-Financial Compensation 3. Primary Compensation 4. Incentive compensation 5. Job Evaluation 6. Wages and Salary Administration 7. Incentives 8. Bonus 9. Fringe Benefits 10. Social Security Measures.

Additionally, there are some types of compensation which are particularly prevalent to the Indian Industries. They are:-

1. Basic Pay 2. Dearness or Cost of Living Allowance 3. Incentive Payments 4. Performance-Based Remuneration 5. Bonus 6. Fringe Benefits and Miscellaneous Cash Allowances.

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Types and Forms of Compensation Provided to Employees in an Organization

Types of Compensation – Classified as Financial and Non-Financial Compensation

Compensation is what employees receive in exchange for the services rendered in an organization. The term ‘compensation’ refers to all forms of financial returns and tangible benefits that employees receive as part of the employment relationship. In the era of globalization, where the business environment has become increasingly complex and challenging, structuring an effective compensation package to attract and retain talent is an important function of organizational effectiveness.

Compensation refers to as a wide range of financial and non-financial rewards given to employees for their services rendered to the organization. It is paid in the form of wages, salaries and employee benefits such as paid vacation, insurance, maternity leave, free traveling facility, retirement benefits, etc.

Compensation can be classified into two categories:

1. Financial Compensation

2. Non-Financial Compensation

Type # 1. Financial Compensation:

Financial compensation is most popular and important compensation that is given in the form of money. It is the most important motivational factor that satisfies employees’ basic needs like food, clothing, etc.

It is further categorized into two parts:

I. Direct Compensation:

Direct compensation means compensating employees by paying them money in the following forms:

a. Wages-Wages means remuneration paid in cash for the work performed by an employee.

b. Bonus- Bonus means extra cash paid to an employee for exceeding his performance or on completion of specified project or target.

Other financial incentives that are directly given to employees in the form of cash.

II. Indirect Compensation (Fringe Benefits):

Dessler refers to indirect compensation as the indirect financial and non- financial payments employees receive for continuing their employment with the company which are an important part of every employee’s compensation. Other terms such as fringe benefits, employee services, supplementary compensation and supplementary pay are used.

Armstrong says indirect compensation or employee benefits are elements of remuneration given in addition to the various forms of cash pay. They also include items that are not strictly remuneration such as annual holidays.

Management uses it ostensibly to facilitate its recruitment effort or influence the potential of employees coming to work for a company, influence their stay or create greater commitment, raise morale, reduce absenteeism in general and improve the strength of the organization by instituting a comprehensive programme in this area.

According to Chhabra, indirect or supplementary compensation involves ‘fringe benefits’ offered through several employee services and benefits such as housing, subsidized food, medical aid, creches and so on. It involves rewards provided by organizations to employees for their membership, attendance or participation in the organization.

Because of the increasing costs of fringe benefits, some people also label them as ‘hidden payroll.’ Benefits currently account for almost 40 per cent of the total compensation costs for each employee. The basic purpose of fringe benefits or supplementary compensation is to attract and maintain efficient human resources within the organization and to motivate them.

Types of Indirect Compensation:

Below are some of the more popular indirect compensations offered by today’s organizations.

a. Social Security:

This is a federally administered insurance system. According to law, both employer and employee must pay into the system, and a certain percentage of the employee’s salary is paid up to a maximum limit. How much is paid by employer and employee is calculated on the average monthly wage (weighted towards the later years). It is provided mainly to give financial security to employees when they retire.

b. Workers’ Compensation:

It is meant to protect employees from loss of income and to cover extra expenses associated with job-related injuries or illness. The laws generally provide for replacement of lost income, medical expenses, rehabilitation of some sort of death benefits to survivors, and lump-sum disability payments.

c. Retirement Plans:

Retirement and pension plans, which provide a source of income to people who have retired, represent money paid for past services. Private plans can be funded entirely by the organization or jointly by the organization and the employee during the time of employment.

One popular form of pension plan is the defined-benefit plan. Under this plan, the employer pledges to provide a benefit determined by a definite formula at the employee’s retirement date. The other major type of retirement plan is the defined contribution plan, which calls for a fixed or known annual contribution instead of a known benefit.

d. Paid Holidays:

These comprise Christmas Day, New Year’s Day, Independence Day, Labour Day, etc. One relatively new concept is the floating holiday, which is observed at the discretion of the employee or the employer.

Another relatively new concept is referred to as personal time-off or personal days. Under this concept, organizations give employees a certain number of days with pay to attend to personal affairs. Normally these days can be taken at the employee’s discretion.

e. Paid Vacations:

Typically, an employee must meet a certain length-of-service requirement before becoming eligible for paid vacation. The time allowed for paid vacations generally depends on the employee’s length of service.

Unlike holiday policies that usually affect everyone in the same manner, vacation policies may differ among categories of employees. Most organizations allow employees to take vacation by the day or week but not in units of less than a day.

f. Other Benefits:

Organizations may offer a wide range of additional benefits, including food services, exercise facilities, health and first-aid services, financial and legal advice, and purchase discounts. The extent and attractiveness of these benefits vary considerably among organizations. For example, purchase discounts would be especially attractive to employees of retail store or an airline.

Type # 2. Non-Financial Compensation:

Non-financial compensation refers to compensating employee not in form of money but in some other forms that stimulate employees’ morale and also improve his performance.

It can be in the following forms:

I. Job security

II. Recognition

III. Participation

IV. Pride in job

V. Delegation of responsibility

VI. Other incentives

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Types of Compensation – Non-Monetary Forms of Compensation: Primary and Incentive Compensation

Good compensation plans, well administered have a salutary effect on the entire enterprise. Employees are happier in their work, co-operation and loyalty are higher, amount of output is up, and quality is better. In the absence of such plans compensation is determined subjectively on the basis of haphazard and arbitrary decisions. This creates several iniquities which are among the most dangerous sources of friction and low morale in an enterprise.

Although there can be both monetary and non-­monetary forms of compensation prevailed in an enterprise, yet it is the former which is the most basic element by which individuals are attracted to an organisation persuaded to remain, and induced to engage in behaviour beneficial to the company.

Let us discuss the administration of monetary compensation in two parts:

1. Primary compensation, and

2. Incentive compensation.

1. Primary Compensation:

The primary monetary compensation is basic pay in the form of wages or salaries. In popular usage a distinction is drawn between these two words. The word ‘wage’ is used to denote payments to hourly-rated production workers and the word salary is used to denote payments to clerical, supervisory and managerial employees. For our purpose, however, this distinction is meaningless because roughly the same problems are involved in the administration of both wage and salary policies.

I. Basis of Time:

The oldest and most common system of paying employees is on the basis of time, i.e., rate per hour, per day, per week, per month or per year. Under this system no consideration is given to the quality or the amount of output. The employer buys the time of the worker, i.e., the worker is guaranteed a definite payment for a specified period of working.

Use of time rates for salaried employees is almost universal. Time basis is more satisfactory when units of output are not distinguishable and measurable and employees have little control over the quality of output or when there is no clear-cut relation between effort and output as on some machine- paced jobs; work delays are frequent and beyond the employee’s control; quality of work is especially important; supervision is good and the supervisors know what constitutes “a fair day’s work”, and competitive conditions and cost control do not require precise advance knowledge of labour costs per unit of output.

The merits of the system are as under:

i. It is simple to understand. Workers can easily calculate their remuneration.

ii. It is liked by trade unions because it does away with differences of payments and assures a guaranteed income for a given period of work.

iii. It helps in maintaining the quality of output because the worker is not tempted to increase his speed to produce sub-standard units to earn more.

iv. It helps in maintaining the machines and equipment in good condition by avoiding damage to them which would otherwise result if the speed of operations is unduly increased by workers in order to increase production.

v. It does not cause employees to overwork them and hence it results in fewer accidents and better employee health.

This can be the only satisfactory system where the units of output are not distinguishable or measurable or there is no clear-cut relationship between the effort and output of a worker, as is true in the case of most of the indirect workers, like office employees and executives.

Following are the demerits of this system:

i. As this system does not distinguish between efficient and inefficient workers, there is no incentive for workers to improve their efficiency.

ii. As all the workers are paid equal remuneration irrespective of their quantity of output, the more efficient among them are tempted either to reduce their speed and efficiency or to leave the organisation.

iii. As this system provides security to the workers, they are tempted to shirk work which would lead to loss to the employer.

iv. In order to make the labourers work without wasting their time, the employer is obliged to appoint personnel for supervision and this increases his cost of production.

II. Real Wages:

Wages can be expressed in two ways: nominal and real. When they are expressed in terms of money paid to the worker they are called nominal wages. But when they are expressed in terms of their purchasing power with reference to some base year they are called real wages.

These wages are arrived at by making adjustment in the nominal wages for the rise or fall in the cost of living index. Thus, if the nominal wage of a worker in 1988 was Rs.400 p.m., and in 1998 it is Rs.900 p.m. but if the living in 1998 has become thrice costly as in 1988, the real wage of the worker in 1998 is Rs.300 only.

There are three requisites of a sound primary compensation structure:

i. It should be internally equitable;

ii. It should be externally competitive; and

iii. It should pay individuals on the basis of their performance.

A description of these requisites now follows:

i. Internal Equity:

Internal equity means that there should be a proper relationship between the wages and salaries of various ‘positions within the enterprise. If, for example, the salary of a foreman, though above the average rate in the community, is lower than that of his subordinates, the foreman is not being paid fairly.

There is inequity in the rates. In other words, the relative wages of an employee are almost as important for him as his absolute wages. Unfair differentials in pay lower his morale and often result in high turnover. However, one important implication of the pursuit of equity in pay is that it loses its incentive and reward properties and becomes merely fair compensation, just one part of the psychological contract.

ii. Externally Competitive:

Once the wages have been made internally equitable, management’s next task is to compare them with those being paid in the community for comparable jobs. The wages and salaries of workers must be in alignment with wages and salaries other organisations are paying at similar levels.

If this external alignment or comparability is lacking the organisation will not be able to retain its capable employees or attract employees from outside. The need to achieve external alignment is highest in times of full employment when due to shortage of labour a new worker can choose among employers and when older employees can go to jobs elsewhere.

To achieve external alignment the management must first know what average rates of its key jobs are prevailing in the community. It can then fix its own wage level at this average level or it may decide a higher or a lower level of wages for itself. In either case the internal relationship among jobs must remain undisturbed.

iii. Individual Pay Determination:

In the final step, management has to decide whether all individuals in jobs of the same level should be paid the same pay or different pay and how this should be determined.

There are four basic approaches to the determination of individual pay:

(a) The single rate approach,

(b) The merit approach,

(c) The automatic approach, and the

(d) Informal approach.

(a) Single Rates Approach:

When employee performance does not vary significantly on the job because everyone is required to work at about the same pace (e.g., in simple office jobs) single rates are frequently paid to employees on jobs. If there are any pay differences in such jobs employees may consider these as favours.

(b) Merit Approach:

If differences in individual performance and output are important to a company then some basis for compensating employees for these differences should be established. Merit rating is a management practice designed to gear the pay of employees to actual differences in work accomplishments. Merit rating systems assume that performance can be observed with reasonable accuracy even when it cannot be objectively measured.

(c) The Automatic Approach:

Under this approach both the amount of the pay increase and the period of review are usually predetermined. In this approach since no consideration is shown to worker’s individual performance or merit he does not have enough incentive to put in greater effort.

(d) The Informal Approach:

Sometimes individual pay decisions are made on an informal basis without formal guides or controls. This is most incorrect because this creates iniquities and confusion among employees regarding what is expected of them. Lack of company-wide standards may also result in pay decisions being influenced by personal favouritism.

The above three requisites are complementary because each reflects different set of factors in the total situation. Internal equity motivates an employee to progress to jobs of higher skills and responsibility. Externally competitive rate prevents him from leaving the organisation.

2. Incentive Compensation:

The fundamental basis for any incentive compensation programme is simple – It should equitably and consistently recognise and compensate employees for superior performance. Otherwise, employees may treat bonuses merely as an entitlement, rightfully expecting their bonuses to be paid simply because they show up to work each day and put in eight hours.

If the bonus programme ultimately treats unequal employees equally, the ability to use the bonus as a motivational tool is severely compromised. Giving ample rewards and recognition to star performers has the benefit of providing a role model for other employees. As a result, standards of performance are elevated and morale is strengthened.

A second premise of a well-crafted incentive compensation programme is that it must direct individual behaviour toward achieving common company goals. To many people, money is a motivator, pure and simple. To others, it is simply a form of recognition for a job well done. Regardless, it can and should be used to induce desired behaviour toward carefully crafted corporate objectives.

A third premise of an effective incentive programme is that it should be designed to affect favourable change within your organisation. People, by nature, are fearful of and resistant to change. Incentive compensation can be used as a “carrot” to induce desired organisational change.

A fourth premise of a thoughtfully designed incentive programme is that it should allow a substantial portion of compensation to be a variable cost. Ideally, the plan should reward results rather than actions. In other words, a manager who consistently works 14-hour days should not necessarily be rewarded for his work ethics.

Only if the employee achieves clearly defined results, such as meeting schedules, should they be rewarded. Therefore, if a portion of an individual’s compensation is tied to their results, the more successful the company. As a result, what was a fixed expense (salary) is broken into an expense with both variable and fixed components.

Naturally, the fixed and variable components of any employee’s compensation will vary depending on the type of employee your company needs. A high variable component will tend to attract risk-takers who will expect a larger reward for the amount of risk they take. Conversely, a compensation plan with a high salary, or fixed component, will tend to attract more conservative employees who value the security and stability of their position.

Every organisation needs a mixture of both of these employees. For example, most companies probably would not want an aggressive risk taker as a controller, conversely, a conservative, security-conscious manager may not be what is needed to maximise profits. Therefore, the overall compensation programme must equitably reward the contributions of both.

Finally, the programme should have some degree of flexibility in order to meet the unique needs of both your company and employees. Clearly, the programme should recognise the contributions of different groups of employees. For example, the efforts of your controller and sales manager may be equally vital to your company’s success, yet the bonus programme should be tailored to reward them based on the unique contributions of their individual positions.

The controller might be rewarded based on average age of accounts receivable and the timeliness and accuracy of job cost reports, whereas the sales manager might be rewarded based on sales, and new business opportunities identified. Additionally, the performance of employees within a given classification may vary as to their relative impact on your company’s success. The programme must be designed so that individuals in similar positions are rewarded commensurate with their contribution.

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Types of Compensation – Related to Workers (Job Evaluation, Wages and Salary Administration, Incentives, Bonus, Fringe Benefits and Social Security Measures

“Worker’s compensation is really a worker’s right, rather than a benefit.” “At the most basic level, we would expect that there is a strong relationship between GDP levels and actual compensation levels in the different markets across the region. In the more wealthy countries, we expect higher compensation levels in the less wealthy countries.”

Compensation is a systematic approach for providing monetary value to employees in exchange for work performed. Compensation may achieve several purposes assisting in recruitment, job performance, and job satisfaction. In other words we can say that Compensation is the process of providing adequate, equitable and fair remuneration to the employees. It includes job evaluation, wage and salary administration, incentives, bonus, fringe benefits, social security measures, etc.

1. Job Evaluation:

It is the process of determining relative worth of jobs:

i. Select suitable job evaluation techniques

ii. Classify jobs into various categories

iii. Determining relative value of jobs in various categories

2. Wages and Salary Administration:

This is the process of developing and operating a suitable wage and salary programmes.

It covers:

i. Conducting wage and salary survey

ii. Determining wage and salary rates based on various factors.

iii. Administering wage and salary programmes

iv. Evaluating its effectiveness

3. Incentives:

It is the process of formulating, administering and reviewing the schemes of financial incentives in addition to regular payment of wages and salary.

It includes:

i. Formulating incentive payment schemes

ii. Helping functional managers

iii. Review them periodically to evaluate effectiveness

4. Bonus:

It includes payment of statutory bonus according to the Payment of Bonus Act, 1965, and its latest amendments.

In India the employees drawing above certain compensation are not covered under the Bonus Act. However, the employer pays them suitable lump sum variable amount depending upon their level in the organisation which is called ex gratia. This is not compulsory on the part of the employer but acts as an incentive to the employee.

5. Fringe Benefits:

These are the various benefits at the fringe of the wage. Management provides these benefits to motivate the employees and to meet their life time contingencies.

These benefits include:

i. Disablement benefit

ii. Housing facilities

iii. Educational facilities to employees and their children

iv. Canteen facilities

v. Recreational facilities

vi. Conveyance facilities

vii. Credit facilities

viii. Legal clinic

ix. Medical, maternity and welfare facilities

x. Company stores

6. Social Security Measures:

Management provides social security to their employees in addition to the fringe benefits.

These measures include:

i. Workmen compensation to those workers (or their dependents) who met with an accident

ii. Maternity benefits to women employees

iii. Sickness benefits and medical benefits

iv. Disablement benefits/allowance

v. Dependent benefits

vi. Retirement benefits like provident fund, pension, gratuity, etc.

A lot of thinking and comparison with competitive organisations goes into fixing the compensation of employees particularly for middle management and above levels by the management. Some organisation pays certain amount annually to key executives which are not a part of the regular pay and allowances. By doing this the incentive acts to deliver enhanced performance but also ensure the loyalty of the key executive to remain with the company.

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Types of Compensation – Prevalent in the Indian Industries: Basic Pay, Dearness Allowance, Incentive Payments, Performance-Based Remuneration, Bonus and a Few Others

The basic types of compensation prevalent particularly in the Indian industries are:

(1) Basic pay,

(2) Dearness or cost of living allowance,

(3) Incentive payments,

(4) Performance-based remuneration,

(5) Bonus,

(6) Fringe benefits and miscellaneous cash allowances.

Type # 1. Basic Pay:

Basic pay universally constitutes the most important component of compensation. However, there are variations in the manner in which basic pay is determined and paid. It may be on daily, weekly or monthly basis. In India, under the Minimum Wages Act, 1948, both the central and state governments have fixed minimum daily rates of wages for a large number of sweated employments.

In the U.S.A., U. K. and France, there has been the practice of fixing hourly rates of wages for several categories of workers. In the organised sectors in India, the practice of prescribing monthly basic rates of wages under wage scales with provision of annual increments is widely prevalent.

Basic wages are significant for workers for a variety of reasons. Generally speaking, most other cash allowances made available to workers, such as dearness allowance, house rent allowance, city compensatory allowance, medical allowance and so on, are linked with the quantum of basic wages. Besides, contributions to social security funds such as provident and pension funds, gratuity and certain cash allowances are often linked to basic wages.

The quantum of basic pay is also taken into account in determining the scales of certain fringe benefits, such as housing accommodation, and travelling and leave travel allowances. Overtime payments for additional hours worked are also usually based on basic pay.

Type # 2. Dearness or Cost of Living Allowance:

Dearness allowance or cost of living allowance, separate and distinct from basic pay, has been an important component of compensation in industrial and governmental employments in India and a number of Asian countries. The basic purpose behind the provision of dearness allowance is to offset the rise in prices of consumption goods and to protect the real wages from being encroached by price rise.

Starting during the Second World War period on a temporary and experimental basis, the system has become a permanent feature of the wage structure in Indian industries and governmental and semi-governmental employments.

In general, the quantum of dearness allowance payable to industrial workers as well as government and semi-government employees is linked with the fluctuations in the Consumer Price Index Numbers for industrial workers worked out by Labour Bureau, Ministry of Labour, and Government of India, which has been engaged in the task since 1946.

The specific schemes for the determination of D.A. have considerably varied from time to time. In its earliest form, flat rates on a graduated basis without any linkage to CPI numbers were prevalent. Subsequently, calculation of D.A. came to be made with reference to rise or fall in the CPI numbers calculated by either the central or state governments.

Initially, the percentage of neutralisation for the rise in prices was higher in low wage brackets tapering off gradually when wages rose. Later, a more or less consistent formula providing for neutralisation for rise in prices on a common percentage basis emerged for government and semi-government employees. However, the industrial establishments have their own separate schemes generally worked out on the basis of negotiations.

In many countries such as the U.S.A. and Australia, there are schemes of automatic revision of basic rates of pay when prices rise above the specified level. Many collective agreements in the U.S.A. contain escalator clauses to avoid frequent bargaining for revision of wage rates.

Type # 3. Incentive Payments:

In a number of industrial undertakings, employees are in receipt of incentive payments. These incentive schemes are generally directly related to the quantum, and in some cases, to the quality of goods produced by individual employees or a group of them. The specific schemes vary from organisation to organisation, and with different sets of employees in the same organisation.

There are schemes, such as the straight piece-rate system, in which the earnings of employees vary in the same proportion as increase in output. In many schemes, incentive payments are lower than the proportion of increase in output. There are also schemes in which incentive payments are higher in proportion to the increase in output. In a number of schemes, incentive payments vary in different proportions at different levels of output. Performance-based remuneration described below may also be considered incentive payment.

Type # 4. Performance-Based Remuneration:

During more recent years, especially after the onset of globalisation and competition, many categories of employees, particularly managerial and supervisory personnel, have been receiving performance- based remuneration.

Such a remuneration is worked out on the basis of the outcome of performance appraisal of individual employees, which takes into account the level of their performance in such areas as extent of improvement in the quantity and quality of products or services, acquisition of skills and capabilities, regularity of attendance, relationship with co-employees, capacity to face challenging situations and extent of commitment to work.

The specific schemes of performance appraisal vary from organisation to organisation and different sets of personnel in the same organisation. Based on performance appraisals, individual employees are allotted specific grades, and are remunerated and given inducements based on their performance. Performance appraisal also constitutes key to decisions in other areas of HRM such as promotion, transfer, demotion and even separation.

Type # 5. Bonus:

Employees in a large number of industrial establishments in India have been in receipt of profit- sharing bonus. Initially, the practice of giving bonus to industrial workers started on an ad hoc basis primarily at the discretion of employers. However, during the course of time, it became a major bone of contention between employers and workmen, often resulting in industrial unrest and work stoppages.

Many disputes on the question of bonus came up for decision by industrial tribunals and even Supreme Court. In view of the mounting and regular unrest over the question, the Payment of Bonus Act was enacted in 1965. The Act specifies in some detail the formula for the calculation of bonus, and prescribes both the minimum and maximum bonus payable to specified categories of workers.

Type # 6. Fringe Benefits and Miscellaneous Cash Allowances:

Apart from wages and salaries, incentive payments, dearness allowance and bonuses, employees are often in receipt of several types of indirect compensation or fringe benefits, both in cash and kind.

These include housing facilities and house rent allowance, city compensatory allowance, leave-travel facilities, medical facilities and allowances, educational facilities and allowances for the children of employees, social security benefits such as sickness benefit, provident fund, gratuity and pension, concessional availability of electricity and food-grains, transport facilities, supply of uniforms and so on.

The nature and scale of fringe benefits vary widely from organisation to organisation. To the employer, they are a part of labour cost. In many organisations, they constitute a substantial portion of labour cost, surpassing even the wage bill.

Many of these fringe benefits are made available to employees voluntarily by the employers; many have been the outcome of collective agreements and many others have been statutorily imposed. Many employers, owning large-scale industrial establishments and also those having their establishments in remote and isolated areas, provide housing accommodation to their employees and have also established well-equipped hospitals and dispensaries.

Gary Dessler and Biju Varkkey have preferred to keep various forms of compensation into two main categories—direct financial payments such as wages, salaries, incentives, commission and bonuses, and indirect financial payments such as employer-paid insurance and leave travel concessions. Joseph J. Martocchio has classified seven types of monetary or core compensation in the context of practices in the U.S.A.

These are as follows – hourly pay, annual salary, cost of living adjustments, seniority pay, merit pay, incentive pay and person-focused pay, pay-for-knowledge and skill-based pay. Practices in regard to forms of compensation or their combinations vary from organisation to organisation depending on a set of internal and external factors.

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