That's a question that is felt at a visceral level by anyone trying to drive growth in a business. Intuitively, most CEOs know they should have a better handle on how much their key producers are being paid and why. They've looked at market pay data and thought strategically about the role each person is playing in the company's growth plans. At the same time, they would be hard pressed to articulate why a given employee group received an increase in compensation this past year and what standards had to be met to merit that improvement.
As this issue is examined in company after company we meet with, we suggest that a "value matrix" be developed that will articulate the standards each compensation plan must meet to be justified. This exercise should be done in conjunction with the development or evaluation of the company's written compensation philosophy statement that articulates what the company believes it should "pay for." We recommend the value matrix incorporate and define the following components. Down the vertical axis, each piece of the compensation package is listed: salary, annual bonus, qualified retirement plan, long-term incentive plan, group benefits, executive benefits, etc. Across the horizontal axis, the following standards should be defined for each plan:
- Purpose--This is a brief statement that should answer the question: "Why do we have this plan; what outcome is it intended to drive?" For example, the purpose statement for a short-term incentive plan might say something like: Enhance current cash payments to executives for achieving top and bottom line annual goals.
- Standard--Here we want to define what measure will be used to define how the plan value will be targeted. For example, the salary standard might be articulated as the 50th percentile of market pay. A standard for a long-term incentive plan might be defined as 20 to 30% of salary. Even if something like Phantom Stock is being used, it should be quantified other than by just the number of shares being distributed. Group benefits would typically be stated in terms of a percentile of market standards, as salary is.
- Investment--This figure is a dollar amount the company anticipates investing in the pay program on either a per employee basis or for the group as a whole (that is to be included) and the period being evaluated. Each form of compensation needs to be calculated and the company commitment quantified. To come up with this figure, the company will need to make assumptions about the level of results it anticipates will be achieved to trigger incentive payments in particular. It may decide to tie the assumed dollar volume to a base, targeted or superior level of business performance.
- ROI--This is a standard that identifies performance thresholds the company needs to be achieving to merit the pay investment that has been allocated. Salary levels, for example, may be tied to an ROA target the business needs to achieve while short-term incentives might be based on a combination of revenue growth and margin (or other key performance indicators).
When a company goes through this kind of analysis, it is forcing itself to think about compensation as an investment that is being allocated rather than merely an expense to be contained. It creates a standard against which it's pay allocation can be measured. If companies want to get serious about growth, their leaders must think about compensation in these terms and understand the extent to which this deployment of capital is contributing to growth. Pay for performance in this context is not just a fancy term for having a bonus plan. It's a strategic approach to the decision making process that impacts what, for most companies, is the largest budget item on their financial statement.