The particle flow approach to calorimetry benefits from highly granular calorimeters and sophisticated software algorithms in order to reconstruct and identify individual particles in complex event topologies. The high spatial granularity, together with analogue energy information, can be further exploited in software compensation. In this approach, the local energy density is used to discriminate electromagnetic and purely hadronic sub-showers within hadron showers in the detector to improve the energy resolution for single particles by correcting for the intrinsic non-compensation of the calorimeter system. This improvement in the single particle energy resolution also results in a better overall jet energy resolution by improving the energy measurement of identified neutral hadrons and improvements in the pattern recognition stage by a more accurate matching of calorimeter energies to tracker measurements. This paper describes the software compensation technique and its implementation in particle flow reconstruction with the Pandora Particle Flow Algorithm (PandoraPFA). The impact of software compensation on the choice of optimal transverse granularity for the analogue hadronic calorimeter option of the International Large Detector (ILD) concept is also discussed.