Return on investment. How often is that term spoken of in business?
It's what shareholders expect. It's what CEOs are paid to achieve. Yet, when it comes to compensation, return on pay is seldom referenced--and as a result, rewards programs are not typically held to account for their contribution to share value and growth as other corporate investments are. Well, we live in a business age where that lack of accountability isn't acceptable anymore. So, let's talk about how to improve things.
Investment return in business is driven by some combination of three factors: 1) new or increased revenue streams and sources; 2) improved margins, and; 3) and lowered expenses. Let's use those standards to discuss three ways compensation can be organized to impact ROI in a positive way.
- Pay Incentives from Productivity Profit. There is a sequence a company needs to work through to determine that portion of its profit that is attributable to the contribution of its workforce. That process should include the following:
- Define a capital account. At a minimum, this should be made up of total shareholder contributions plus debt--and any other items owners deem to be related to their investment in the business.
- Account for a capital charge. This is a percentage of the capital account that represents the return shareholders expect to receive before sharing value with employees. It's the cost of capital if you will. Some companies use their borrowing rate for this while others plug in a number that owners agree best fits their investment expectations. Anything from 8 to 20% is common.
- Calculate your productivity profit. This is arrived at by first applying the capital charge to the capital account and arriving at a number. Next, you will subtract that number from the net operating income of the business for the year. The difference is your productivity profit. The capital charge accounts for that part of the company's profit that is attributable to the shareholder's capital at work. The remainder can be credited to the impact of people at work.
- Make sure incentives are paid out of productivity profit. The previous three steps help you define what value creation means in your business. It happens once shareholders have received a pre-determined return on their capital investment. Until that level of performance is reached, value should not be shared with employees. And all incentives should be paid out of productivity profit.
- Tie Metrics to ROI Factors. When you build your annual incentive plan, make sure that the criteria you use supports the above-mentioned drivers of ROI. Bonuses, for example, should only be paid if the performance of employees has contributed to increased or new revenues, better margins or lowered costs. This may require some effort in aligning specific roles and duties with ROI criteria. It will also mean you need to spend time discussing ROI and value creation with employees, so line of sight is reinforced and a unified financial vision is forged. But you can't expect employees--on whom you rely to drive ROI--to be in sync with shareholder expectations if their pay doesn't communicate and support how return on investment in business is derived.
- Make Profits a Center-Piece of Value Sharing. Although that seems like an obvious guideline, you would be surprised how many organizations don't adhere to it. Many a bonus payment has been made in years when a company is not even profitable. Likewise, organizations often introduce new pay plans or compensation changes without any reference to profitability standards or a guiding philosophy about value creation and sharing. Companies need profitability (either immediate or eventual) to be an important focus of their discussions about--and engineering of--incentive plans and other aspects of their total compensation construct. You can't expect employees to be focused on the importance of profitability if their compensation is not tied to it.
If your organization will focus on these three guidelines in the development of a rewards philosophy and the construction of specific rewards strategies, you will find that shareholders and employees will experience greater alignment and compensation will become an enabler of company growth instead of a drain. Your ROI on pay will be measurable and improvable.
If you want to learn how top talent can improve your ROI on pay, sign up today for our upcoming webinar: http://www.vladvisors.com/compensation-knowledge-center/webinars/secrets-to-retaining-top-talent