An effective incentive plan is dependent largely upon the building it on the right premise. Stated another way, most incentive plans fail because they are built on the faulty premise. Company leaders create them+ with the intent of changing employee behavior. When they don’t, those leaders feel like their plan didn’t “work” and they become frustrated. The natural byproduct of adopting the wrong premise for a plan is employing the wrong metrics. So, let’s figure those two things out, shall we?
To design a bonus or other short-term plan effectively, you must start by correctly identifying the purpose of your offering. Sharing value with employees is a way to define the financial partnership you want to have with them. You are essentially giving your people a reason to share your mindset and vision for the company. Further, through the way you are paying them, you are identifying how they will participate in the value they help create on the way to building the future company.
The Primary Focus
Presumably, if you lead a business, then your attention each year is primarily focused on profits. Your business growth depends upon it. What, then, should be the primary measure upon which an incentive plan should be base? Yes, profit. This does not mean you can’t have other metrics and measures. But it does mean that profit should be primary. In other words, it doesn’t matter how many other measures the company or department or individual fulfills. If a certain profit threshold isn’t achieved, incentives are not paid.
This makes the development of other performance metrics easier to define. Everything becomes outcome based. The core question in building metrics becomes: “Will this outcome drive greater profits?” If the answer is not clearly yes, then that metric should probably be rejected or modified. And that leads to the next factor that must be addressed in defining incentive plan measures.
One Value-Sharing Philosophy, Two Performance Periods
You should not develop an incentive plan that improves profits today at the expense of sustained profitability. This happens too often. A company sets up an annual bonus plan that maximizes payouts for achieving short-term performance goals. This compromises employee decision-making. They may end up exploiting a customer, vendor or other department in their company to enrich themselves while eroding long-term value creation in the process. There may be profit still generated, but it’s bad profit.
The answer to this problem is to think in terms of two performance periods when building an incentive plan. One is the next 12 months. Here, the focus is on achieving outcomes that improve revenue growth, expand margins or lower costs (or all three) but without damaging sustained growth. The second is on rewarding enduring performance—results that drive business growth and increase shareholder value. This is achieved by ensuring your employee “partners” are focused on outcomes that will drive business growth (product development, acquisitions, new technology, expanded markets, etc.). Rewards for short-term performance are tied to profits. For long-term, they are tied to business value increase.
The primary metric for a short-term plan, then, it profit. The primary metric for a long-term plan is business value increase (which is really just sustained profits.)
For both performance periods, the role of the primary metric is to accomplish the following:
- Seek to improve performance by achieving outcomes that produce the desired results (increased profits and increased business value).
- Seek to create a sense of stewardship about roles and outcomes.
- Reward both short-term and sustained value creation.
It is important to understand that the purpose of value-sharing is not to change behavior and "motivate" employees, per se. Motivation is internal and your people will each have their own reasons to be committed to high performance. However, motivation is encouraged when employees roles and tasks are aligned well with their unique abilities and consistent with the purposes they want to serve or advance. Motivation is further engendered by a shared vision and values between the company and its workforce.
On the other hand, if indicators are not properly defined, an incentive plan can potentially deflate the motivation of employees. This happens when a member of the workforce doesn't feel as though there is alignment between his or her role and how rewards are earned. This creates frustration and disillusionment, two conditions that are at odds with a positive focus and a high-performance culture.
Two Core Approaches
Once you have established profit as your primary metric for your short-term plan, there are essentially two approaches to take in constructing the rest of your metrics. One is to use profit as the sole metric. The other is to identify other key performance indicators (KPIs) you would like to introduce in addition to the profit threshold or target you have identified. Let’s look at each.
Under this approach to building metrics, a company decides that it will allocate a percentage of annual profits to employees. The award amount is divided among employees based on a pre-determined formula. Typically, payouts occur at year end, but some companies prefer to make those payments quarterly.
As indicated, the focus of a Profit-Based Allocation is solely on annual profits. As a result, the incentive value created can be open ended (unlimited). This can be good or bad (more on that issue in a minute). The design of this kind of incentive is relatively simple; however, it is essential that it be accompanied by a strong performance management system. This is because in a profit-based incentive environment, rewards are driven strictly by company performance, not individual or department performance. As a result, a separate management system needs to be in place to reinforce the outcomes that have to be achieved to drive the right level of profits.
The Profit-Based Allocation has some inherent dangers or drawbacks. This approach does not always create the complete "line of sight" an organization would want to see fulfilled by virtue of its compensation strategies. Also, because the plan is centered solely on company performance, employee apathy can set in and morale issues can arise. Consequently, if there is a lack of a strong performance management system in the organization, this approach can be troublesome.
With those dangers in mind, in a "best practices" framework, a Profit Based Allocation should address and/or account for the following issues:
- Define profits - whether it will be some version of EBITDA, net income or some other measure. Also, the company must determine if there will be an economic “value-added” component to measuring profits, accounting for a certain return that must be achieved by shareholders before value inures to the benefit of employees.
- Select either a "Benchmark" or "Growth" Approach - establishing the baseline upon which contributions to the profit pool will be based. Most companies determine to set a standard upon which (or above which) performance must be achieved for incentive formulas to kick in. Others base incentives on the growth of profit each year - so as not to pay incentives during periods of stagnate growth.
- Identify Threshold - this ensures that a certain measure has to be achieved before any payments are made under the incentive plan.
- Select Percentage to Share (fixed or tiered) - this will establish the amount of profits (however determined) that will be distributed in the form of awards. This can be a fixed amount for everyone or different for various "tiers" of employees within the organization.
- Select Allocation Formula - to determine how the potential value will be communicated to participating employees (percent of salary, pro-rata allocation of pool, etc.)
- Determine Personal Performance Component - this is to define whether there will be a certain personal performance threshold that needs to be achieved impacting the degree to which an employee will/can earn benefits.
The theory behind the KPI approach is that improvements in the focus and execution of employees on the issues they are best positioned to impact will lead, ultimately, to improvements in profits.
A plan that uses KPIs can incorporate company, department or individual metrics—or all three. The value of the plan is typically capped, and its design can run from quite simple to very complex. What is essential in this approach is selecting the right metrics. This means you are going to identify indicators that will be used to measure performance in each area. For example, company metrics might be a combination of revenue growth and net income. Departmental indicators could be such things as improvement in company retention or an increase in the collection rate on accounts receivable. Individual metrics would be tied to personal performance goals and productivity factors.
Here are some examples of company and department indicators that we have seen used in the past effectively. Of course, their application will vary depending on industry and other factors.
The dangers with the KPI approach can include the following (among other things):
- Miscalculation (i.e., KPI improvements did not sufficiently offset failure to execute in other areas). This can lead to a company making incentive payments even though profits did not arise. This is why it is important to have a minimum profit target that must be met before incentives are paid. However, such a standard can be demoralizing if employees hit their targets but are denied payment.
- Gaming (i.e., employees learning how to achieve the KPIs but without respect to the profit goals). This can lead to intentional or unintentional failure to achieve profit objectives.
- Sandbagging (i.e., employees barely reaching KPIs while determining to carry-over performance into the next period). This can lead to failure to achieve full profit potential.
- Misalignment (i.e., forcing employees into behavior that moves them outside their skill sets and abilities). This occurs when extrinsic motivation overrides intrinsic motivation. The KPIs may be achieved while job satisfaction diminishes.
In our experience, KPI approaches work best if they incorporate the following elements.
Range of Incentive
Attractive target incentives should be established for each position. In general, growing companies size their incentives in a range of 25% to 100% of salaries for senior executives. Of course, lower ranges are set for the other tiers.
Components of Incentive Calculation
Next, the company should determine how much of an individual's incentive will be based on (a) company performance, (b) department/division performance, and (c) individual performance.
The determination of this weighting is predicated on the degree of impact each person (position) is deemed to possess relative to the associated result area.
Key Determinants (Drivers)
Metrics to consider for company performance might include:
- Productivity Profit
- Net Income-to-Budget
- ROTRI™ (Return on Total Rewards Investment)
- Net Free Cash Flow
Departmental metrics might include:
- New sales (for appropriate departments)
- Division profitability
- Customer satisfaction factors
- Production quotas
- Project criteria (time and budget)
Key Performance Indicators (KPIs) designed to measure individual performance fall into two categories: hard measurements and soft measurements. Hard measurements include specific metrics calculated to reflect on the direct control of the participant. An example of a soft measurement would be the "completion of a specific project by a specific date."
The incentive components should be established and communicated in advance of the incentive period (typically annually). The employee should be able to identify and understand the exact requirements associated with achieving his or her target incentive. For example, an incentive structure for a Department Head might be communicated as follows:
Incentive targets may be tiered to eliminate an "all or nothing" consequence. Commonly, three to five tiers are recommended. The payout results at each tier should be significantly greater than the preceding tier. Often, the plan grid (see below) can help produce this "tiering" effect.
Executives are often provided with clear measurement grids to help balance non-correlated or complementary goals.
Below is an example that could be used for a company-wide grid.
There is no one perfect solution to designing an incentive plan that will be effective for every company. As a result, the way a company approaches the ideal is to understand best practice standards and frameworks and then work within that structure to customize indicators, measures and metrics that are suitable for your business. The selection of the type of incentive plan and its associated metrics should be based a company's culture, business model and goals. Here we have introduced two effective approaches to developing incentive plan indicators. Our recommendation is that you make a decision about which works best for your company and then stay with it - polishing and perfecting it over time. In that context, you will want to measure the plans effectiveness by calculating the company's ROTRI. You will also want to measure and track you employees' commitment, engagement and execution.
But regardless of the design you select, start with the right premise and use profit as your primary metric.