It's that time of year when enterprise leaders look carefully at their businesses and ask: "What needs to change? How can we improve?" CEOs are looking at ROI and ROA (among other things)--and trying to determine how to squeeze more out of both. Everything is scrutinized. Somewhere in all of this compensation comes up. When it does, everyone sighs. The same questions are asked: "What needs to change? How can we improve?" But why the sigh?
The frustrated exhale stems largely from the sense that there just isn't enough of a connection between what people are paid and how they perform. The metrics and measures never seem to be quite right--no matter how hard everyone involved with pay design tries. It's exasperating because...well, compensation is the biggest budget item on the P&L and yet it isn't measured as other capital allocations are. Sound familiar?
This picture emerges in organizations that haven't yet figured out how to make pay a tool of accountability. So, let me clear up a little of the mystery for you. Here are 5 steps you can take to ensure your compensation strategies in 2015 are more "accountable."
- Establish a capital account. At a minimum, this should be made up of total shareholder contributions plus debt--and any other items owners deem to be related to their investment in the business.
- Define a capital charge. This is a percentage of the capital account that represents the return shareholders expect to receive before sharing value with employees. It's the cost of capital if you will. Some companies use their borrowing rate for this while others plug in a number that owners agree best fits their investment expectations.
- Calculate your productivity profit. This is arrived at by first applying the capital charge to the capital account and arriving at a number. Next, you will subtract that number from the net operating income of the business for the year. The difference is your productivity profit. The capital charge accounts for that part of the company's profit that is attributable to the shareholder's capital at work. The remainder can be credited to the impact of people at work.
- Make sure your total compensation investment is only paid out of productivity profit. The previous three steps help you define what value creation means in your business. It happens once shareholders have received a pre-determined return on their capital investment. Until that level of performance is reached, value should not be shared with employees. And all incentives should be paid out of productivity profit.
- Communicate this standard to employees. Help them understand your philosophy behind value sharing and teach them how they can impact productivity profit. Then align your performance management systems with those pay standards.
When rewards programs are developed in this framework, there is an inherent accountability dimension to them. Value sharing, especially through incentives, only happens once a threshold of value creation occurs. Once everyone understands this, there is a heightened sense of stewardship towards shareholder interests. In addition, people begin to see the connection between what is produced and what they receive. Shareholder value is strengthened and accountability improves.
To learn more about accountable compensation, tune into our webinar on January 27th at 8:30am PST "How Do I Marry Compensation & Accountability?"