Annual Incentive Plans: The 3 Most Common Mistakes

Many, if not most, organizations have some kind of annual incentive plan. Unfortunately, a majority of them are not happy with it. Often, our phone rings when an organization can't take it anymore and wants help with its plan. When it does, we typically hear one or more of the following complaints:

  • "Our bonus plan has become an entitlement--people just expect it."
  • "Our incentive program isn't structured properly--we're paying out benefits when we aren't even profitable."
  • "Our plan is completely discretionary. I go into the closet at the end of the year and try to determine how much of our profit to share, who should get a payout and how much they should receive. There's got to be a better way."
  • "Our short-term incentive plan has become too complicated. We have too many metrics and people are confused."
  • "Our employees don't understand what they need to do to maximize the payout from their plan--and then they complain about how much they get."



Annual incentive plans should be self-financing.

There's more, but you get the picture. The issues these business leaders articulate are symptomatic of three common mistakes companies make with their annual incentive plans:

1. They are too discretionary. This hurts both the employer and the employee. When plans are solely discretionary, employers are under pressure every time payouts are due to come up with a "fair" way to ferret out bonus payments. They often end up arguing with themselves over what should be done. "Well...we were barely profitable this year and I probably shouldn't be paying anything out. But these key people worked really hard and I don't want them to think I don't appreciate their effort." Employees, on the other hand, wish they knew what they had to do (how they had to perform) to receive their bonus--and what potential payout they could earn.  

Remedy--Annual incentives can have a discretionary component but should be based largely on three results categories: company performance, department performance and individual performance. Each of those areas should be "weighted" based on an employee's ability to impact that element. For example, executive level employees might be weighted 75% company, 0% department and 25% individual performance. On the other hand, a middle manager's allocation might be something like 25/50/25%. And so on.  You can have one plan but allocate payouts based on what each employee is able to impact by using this weighted approach.

2. They are too complicated. This usually stems from the company going overboard on the metrics it incorporates into its plan. In this case, business leaders are trying to micro manage performance and behavior through the incentive plan. If employees aren't clear on how they can impact the results they're expected to achieve to get a payout--or it seems overly complicated--they check out.  The benefit doesn't seem meaningful and achievable to them. 

Remedy--Limit the number of performance metrics you incorporate to two or three. Also, offer a range of benefit that is available. You can do this by developing a performance matrix that has minimums and maximums on each axis.  In the middle is the sweet spot of performance you're looking for (for example, a revenue and a margin target).  As long as you meet the minimum standards for each axis, some level of payout occurs. This approach also allows someone to receive more than 100% of their target payout if superior results are achieved. A third metric, such as profitability, can be introduced that modifies the payout if certain thresholds aren't achieved.

3. They are not "self-financed." Incentve plans are only effective if they are rooted in a value creation and value sharing philosophy. They should only be paid out of value that has been produced and only once it's been created.  Businesses commonly pay out benefits in years when they aren't even profitable. This erodes shareholder value and defeats the purpose of the incentive. Remedy--Spend time organizing your thinking around what you believe about pay in general and value sharing specifically. Before designing any plan, a financial model should define the point at which shareholders think value is being created by employees--not just other capital already at work in the business. We call this productivity profit--the part of net operating income that is attributable to the contributions of people at work in the business. Incentives should always be paid out of productivity profit. When they are, payouts are self-financed--they come out of the value participants helped create. This provides an incentive framework that both shareholders and employees can feel good about.
More could be said about each of these, but hopefully this gives you at least a preview of how an effective annual incentive is engineered. Spending time examining these issues up front will save hours of time and lost profitability in the long run.
Annual incentive plans are an important part of a Total Compensation Structure that frames the financial partnership an organization wants to have with its employees. You want to make sure it's being used as an effective tool to build a more unified financial vision for growing your business.
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