Incentives: Short-Term vs. Long-Term

Most business leaders don't object to paying incentives.  What they struggle with is what kind of results they should reward, who should receive them, how they (the incentives) will be "paid for" and what the right balance is between short and long-term value-sharing.  These are difficult issues and create a lot of pain for those trying to make effective decisions in this regard. 

Balancing short and long-term incentives requires a clear pay philosophy about value creation and sharing.

Although there is no silver bullet answer for every company, there are guiding principles growth-oriented businesses should follow if they want to successfully navigate this terrain--and general rules of thumb that can help enterprise leaders envision the right balance they should anticipate between short and long-term incentives.  

Let's talk about five key principles first:

  1. Incentives should be paid only when value has been created to merit them.  That's the difference between an incentive and value sharing.  It should be paid from productivity profit--profit that is attributable to the contributions of people and not just capital assets at work in the business. Therefore, each business must first define what value creation means for its organization. This will likewise help define the threshold beyond which value-sharing can start occuring.
  2. Short-term value-sharing should reward the successful maintenance of the company's revenue engine. In other words, you want to reward the execution of the business model and have clear guidelines for how that will be measured. The business model defines how the company generates revenue.
  3. Long-term value-sharing should reward sustained, "good" profits. Profitability should occur regularly if principle number two is applied, however, good profits are those that build lasting value. "Bad" profits still show up on the books but come with an offsetting long-term cost--diminished customer or supplier relationships, lowered cultural morale, impaired growth leverage, etc.
  4. Those who participate in value sharing should be those in a position to impact value creation--which should be everyone.  I know that's a gross generalization, but ideally everyone's role has a value creation component to it. Otherwise, what's the purpose of that role? It may be harder to define for some roles in your organization, but it's an analysis worth making. If someone creates value, they should share in it. If they don't create value, why are they there?
  5. Neither short nor long-term value sharing should be all or nothing.  There are degrees of success in acheiving desired results and rewards should reflect that reality.  This doesn't mean there aren't periods when no value-sharing should occur.  There need to be minimum performance thresholds for incentives to be warranted. However, beyond those base targets, a range of benefit should be available.

When those principles are applied, rules of thumb can be more easily introduced and understood. Rules of thumb are just that--general practices that many organizations follow in attempting to implement effective incentive plan design.  They should not be viewed as standards that universally apply, as each business has its own nuances and priorities. 

With that as a disclaimer, here are some general guidelines to consider as you think about the balance that should exist between short and long-term incentives in your organization.

Senior Executives

  • Short-term--50%
  • Long-term--50%

Management

  • Short-term--60%
  • Long-term--40%

Rank and File Employees 

  • Short-term--75-90%
  • Long-term--10-25%

In the end, the exact ratio isn't as critical as developing and applying a philosophy of pay that defines how value is created and shared in the organization. If employees are going to become full stewards of the growth goals of the business, they must be treated as partners in their fulfillment.  Drawing the right balance between short and long-term value sharing creates a more unified financial vision for growing the business.

 

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Article Categories: Incentive Plans, Bonus Plans
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