Higher Salaries or More Incentives?

To a large extent, compensation planning is a balancing act. It's not unlike building a diversified investment strategy where different asset classes are blended together to create a "balanced" portfolio. Ultimately, the asset classes chosen should be related to both the investor's investment philosophy and the financial outcomes that person wants to achieve at some point in the future. Organizing and executing a compensation strategy in a business is really no different.

One of the fundamental issues most business leaders grapple with in this regard is finding the right mix between guaranteed and variable compensation. In their hearts, most would likely prefer there be some master formula for how much should go to salaries and how much to incentives. If that same edict could also tell them what percentage of value sharing should reward long-term performance versus short-term, that would really make them happy. Needless to say, it's not quite that simple. However, there are some guiding principles that can help.

First and foremost, a company has to be able to define the kind of performance it needs. This grows out of a vision of what the future company will look like and in what time-frame. It is further determined by how an organization defines its business model and strategy, as well as the roles and expectations attached to them. When most people examine this, they come to the conclusion that there are a combination of performance metrics that have to be met simultaneously for the company's growth goals to be achieved. For example...

  • Sales performance needs to meet increasing expectations year to year.
  • Middle managers need to execute on both short and long-term key performance initiatives that impact margins and profits.
  • Executives need to deliver a satisfactory if not superior return on assets while growing shareholder value for ownership.

These needs argue for a compensation strategy that provides an "adequate" floor of compensation with a heavy emphasis on value-sharing to increase the focus on the performance metrics most critical to the organization. Companies that find themselves so situated usually collect market pay data to see where the salary ranges are for the critical positions in their company. Then they peg themselves at about the 40 to 50th percentile for key roles in the company--those best positioned to impact growth. They develop a philosophy about pay that states they will pay modest salaries but significant upside potential for those who help create value. They further define what value creation means. Then they turn to the short-term versus long-term value sharing issue.

To address the balance between sales, performance and growth incentives, a company must define the role of each for the company. Such definitions might look something like the following:

  • Our sales incentive is designed to maintain top-line revenue growth of "x" percent per year.
  • Our performance incentive is designed to reward the achievement of our annual budget or targeted results, with superior results reflected in increased value sharing.
  • Our growth incentive is designed to reward those who improve shareholder value over an extended period of time (three years or more) and will be paid out of the productivity profit of the company (profit that accounts for a capital "charge" for the return achieved by non-human capital at work in the business).

With the context formed, a company can begin to assess its compensation priorities as they relate to the balance between salaries and incentives. Most companies that follow this thought process conclude that sales incentives need to be isolated from performance and growth incentives in terms of their purpose and role. However, performance (short-term) and growth (long-term incentives) probably play an equal role in creating the sense of partnership the company wants to achieve with its key producers. As a result, many organizations that go through this analysis conclude that 50 to 60 percent of compensation should be in a guaranteed form with the other 40 to 50 percent coming from incentives.

As companies begin thinking in these terms, their focus is usually on making sure they create or stabilize their annual incentive plan, before embarking on the long-term portion. It's just a practical decision to ensure the revenue engine of the company is functioning at a superior level. Over time, they gravitate to dividing the value-sharing portion of pay fairly evenly between long-term and short-term benefits. This keeps employees focused on immediate performance issues but with a view towards building long-term value for the company--and, as a result, for themselves.

How you apply these principles may be different and you may draw different conclusions for your organization. However, by using this thought process you can more easily answer the question posed at the outset--"Which should we have, higher salaries or more incentives?"

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