Making Bonus Plans More Effective

One of the inquiries our firm receives more than almost any other goes something like this: “Can you help us fix our bonus plan?” The question usually stems from the company having tried a number of iterations of a bonus arrangement over the past few years and feeling like it isn’t “working.” Sometimes these plans are largely discretionary, other times they have become a virtual entitlement. And more times than I can count, the company has put itself in the position of paying out value when it isn’t even profitable. Yikes!

With that frame of reference in mind, let me share some steps that should ensure a more effective annual incentive plan arrangement. While each company is different, and you may have metrics and measures that vary according to your circumstances, this planning sequence should help you organize things in a way that protects shareholders while providing a great plan for participants.

Bonus plan design works best if it is approached as follows:

1. Determine the eligible group. You may want to begin with primarily executive or management employees and expand later from there.
2. Next, assign eligible employees to tiers based on salary, roles and responsibilities. The number of tiers will depend on the size of the eligible group, but there are 3-6 for most companies.
3. Determine how profit will be defined for purposes of the new plan.Common measurements include: EBITDA; net operating profit after tax; earnings before taxes; operating income; net free cash flow; etc. Measurements may be expressed as benchmark/budget numbers (e.g., $1 million of EBT) or as a growth in profits approach (e.g., 10% increase in EBT from prior year).
4. Establish a minimum threshold of financial performance (as determined in step 3) that must be met before the funding of any incentives. For example, if using a benchmark/budget approach it might be determined that the first $X of profits will not be subject to the incentive plan. With a growth in profits approach, it might be determined that the first 6% of growth will not apply, but any excess will.
5. Select the percentage of profits to be credited to the Bonus Pool (“Pool”). This might be a straight percentage (simplest) or a tiered percentage (that rewards higher values for better results).
6. Allocate the entire Pool to the different tiers using one of following methods:
   1. Percentage to different tiers (e.g., 40% to senior management, 20% to middle management, 40% to all other employees)
   2. Discretion of board/CEO/shareholder(s)/executives/managers
7. Allocate each tier’s Pool among the plan participants utilizing one of the following methods:
   1. Individual performance score (requires internal job appraisal system convertible to scoring result.) Employee evaluations may impact individual participation in the profit award. That is, the evaluation scoring system can influence the amount of the allocation to be received (e.g., a 100% system).
   2. Discretion of board/CEO/shareholder(s)/executives/managers
8. Calculate each employees bonus as a percentage of his salary based on the results in step 7
9. Adjust the allocation (entire Pool and/or participant) as needed to reflect relative performance/value of each tier and/or the participants.
10. Determine how company would like to express the bonus opportunity to participants. “Your bonus opportunity will range between 20-40% of your salary, depending on the level of profits we attain.” “You will receive approximately y% of all profits in excess of x.”
11. Develop management processes to communicate and reinforce the profit-generating capacity of all employees. During performance reviews, goals should be set that are tied to profitable activities. Conversations between management and employees must reflect an understanding of the importance of achieving profitability goals and of each associate’s contribution to the same.
12. Apply consistent judgment and evaluation standards. A review committee should oversee the process to assure the highest possible commitment to consistency, fairness and diligence.

These steps, of course, have to be modified to fit the specific needs of each organization. In addition, ideally those building the plan will construct a financial model to test the metrics that are developed for the plan and project its potential impact at various levels of performance such as base, target (budget) and superior.

To learn more about the principles and practices addressed here, check out our recent blog entitled "Pay the Company First".