Published August 1, 1998

Establishing an Incentive Compensation Program for Employees

Why?

The fundamental basis for any incentive compensation program is simple: It should equitably and consistently recognize 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 program 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 program is that it must direct individual behavior 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 behavior toward carefully crafted corporate objectives.

A third premise of an effective incentive program is that it should be designed to affect favorable change within your organization. People, by nature, are fearful of and resistant to change. Incentive compensation can be used as a "carrot" to induce desired organizational change.

A fourth premise of a thoughtfully designed incentive program 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 their 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 the greater the. 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 (i.e., larger bonus opportunity) 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 organization 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 maximize profits. Therefore, the overall compensation program must equitably reward the contributions of both.

Finally, the program should have some degree of flexibility in order to meet the unique needs of both your company and employees. Clearly, the program should recognize 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 program 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 program must be designed so that individuals in similar positions are rewarded commensurate with their contribution.

How?

There is no such thing as "cookie cutter" approach to designing an incentive compensation program. Every company is different in some respect, be it in the market in which it competes, its organizational culture, or its own unique blend of employees. As a result, no two companies' bonus programs should be identical. However, there are several fundamental components that are common to most effective plans. In broad terms, the company's owners must make three critical decisions.

  • How to calculate it?
  • Who is included?
  • How much?

What are some of the objective factors you should consider when determining the answers to the above questions?

  • Quality Issues
  • Formal/informal surveys
  • Type of business
  • Inventory management
  • Sales volume
  • Operating costs and profits
  • Financial performance
  • Safety

The other critical determination that must be made is who in the company will assume more of the risk ... the owner or the employees. Naturally, the more risk one assumes the greater the potential of the ensuing financial reward.