New Year's Day has come and gone. You've “closed the books” on 2015. It’s time to turn the page, look forward and...(insert your favorite cliché here). So…as you anticipate the coming year, what will be different in your business? What will improve? How will your growth goals be met? Will you bring on new talent, increase results expectations for current producers or raise standards of performance in other ways? If so, what role will your compensation strategy play in that effort? And how will you know whether your pay approach is having the impact you want?
Have I sufficiently exhausted you with those questions? Well, let me give you some relief by providing a head start in answering them. If you want to improve results, increase the performance and engagement of your people and feel better about the investment you are making in compensation in 2016, here are four pay strategy commitments I recommend you make right now.
- Define Value Creation. If a company wants pay to be performance-focused then it has to be able to determine the threshold at which value creation is attributable to the productivity and contributions of its people and not just other capital at work in the business. This is typically done by first identifying a capital “account”—a figure that represents the total investment of shareholders in the business (stock, cash contributions, debt, etc.). Next you establish a capital account “charge”—a percentage that represents the amount of return shareholders expect to receive on their investment before sharing value with others. Multiply that percentage times the capital account. The result represents a profit threshold that should be met before value sharing occurs with other profit contributors in the organization (people). Business leaders run into trouble if they try to share value without first defining where value creation really begins in the enterprise.
- Write a Compensation Philosophy Statement. This is a concept I’ve referred to repeatedly in my posts—and with good reason. A compensation philosophy statement is a kind of pay constitution that should guide all decisions about the creation and management of specific rewards strategies. It defines the performance outcomes you are trying to achieve and what you are willing to “pay for.” At a minimum, a statement should address what the company believes the balance should be between guaranteed and variable compensation and between short and long-term incentives. It should also define with whom value-sharing should occur and under what conditions. Developing an effective compensation philosophy statement is a bit painful but worth the sacrifice and energy. It will allow you to provide a clear picture to your key producers in particular of the belief system that informs the way they are paid and what they need to do to achieve maximum income potential within your organization.
- Build a Total Compensation Structure. Building pay plans within a Total Compensation Structure means rewards strategies are not developed in a vacuum. It starts by mapping out all pay levels and who is eligible for certain kinds of compensation programs within each band--salary ranges, annual bonus potential (as a percent of salary), long-term incentives, general employee benefits, retirement plan, executive benefits, supplemental retirement plans, etc. As new pay plans are considered or existing ones are evaluated, it is done in the context of the overall structure--much like evaluating individual investment holdings within a broader portfolio. After all the mapping has occurred, the pieces are consolidated into a Total Compensation Dashboard where all pay and benefit programs by tier can be reviewed in one place. Organizations who build a Total Compensation Structure that is compatible with their written pay philosophy feel more in control of their rewards investment. There is greater continuity and integrity in the operation of their overall compensation strategy.
- Measure the Return on Your Compensation Investment. Pay represents one of the largest deployments of capital a company consistently makes and yet it is not measured like we expect other investments in the business to be. Compensation should be held accountable for generating a positive return to shareholders, but most organizations don’t know how to go about measuring it. Here is one way (but certainly not the only way) to consider accomplishing that.
- Define a capital account and charge. This refers to the calculation described in #1 above.
- 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. That’s why we call it a productivity profit.
- Determine your productivity profit ratio. This is done by dividing your productivity profit by your total compensation investment (salaries, bonuses, commissions, long-term incentives, benefits, etc.). The resulting number is your Return on Total Rewards Investment (ROTRI). The first time you calculate this ratio you will wonder if it’s good or bad. It’s neither. It just “is.” What’s important is what happens to that ratio over time (see #d).
- Tract your ROTRI. This simply means performing the calculation described in #c every year and paying attention to whether or not it is improving. You will want to “tweek” your compensation investment allocation based on whether or not this ratio is moving in the right direction. Your Total Compensation Structure will help you do that.
These four commitments can help you transform the way you share wealth within your organization while simultaneously simplifying your compensation life. They will change pay from an expense that you feel the need to contain to a growth enabler that both improves shareholder value and magnifies the economic well-being of all stakeholders in your business.
To dive deeper into how to make your compensation strategy more effective, download our Private Company Pay Plan Checklist. It will help you evaluate your current compensation approach and envision the steps you need to take to improve it.