The Upside of Incentive Compensation

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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“The Devil is in the details” – Anonymous

Incentive compensation is a practice by which employers pay their employees extra for performance “beyond normal expectations.”

This is one of those practices that business owners have had widely varying experiences with. Sometimes these plans work well and benefit both the company and the employees; sometimes they have no effect; and sometimes they’re a partial or even total disaster.

The concept behind these plans is fairly simple. When they work well, incentive compensation plans can create an increase in employee motivation and productivity, which can lead to improved profitability.

But when incentive comp plans don’t work well, they can actually create all sorts of problems. One of the worst things that happens is that employees can inadvertently be motivated to make decisions that are actually harmful to the company in order to increase their own pay (remember the Wall Street meltdown of a few years ago?).

Incentive compensation plans also won’t solve cultural, leadership, or management problems in a business. Companies with these issues would do well to address them at the source rather than try to improve performance via compensation plans. (See Lynn Truong’s post, 10 Myths About Employee Incentive Programs on OPEN Forum for a good discussion.)

So what makes the difference between a good plan and a bad plan? It usually comes down to plan design.

In their book, Pay People Right! – Breakthrough Reward Strategies to Create Great Companies, Patricia Zingheim and Jay Shuster suggest that the answer may be in re-thinking the way we think about incentive compensation in the first place. They recommend the term “variable compensation” rather than “incentive compensation.”

The difference is subtle, but it’s real. Instead of “incentivizing” your employees to do things differently or work harder in order to make more money (which can backfire), it makes more sense to simply tie a part of their compensation to company (or department) performance. When company or department performance improves, as measured by a performance measure that can sensibly be tied to a particular group of employees, then the employees get a piece of that improvement. If results don’t change, neither does compensation. If performance goes up and then down, then compensation goes up and then down.

The employees are guaranteed their base pay, and variable pay for most levels of employees is calculated at the department or group level rather than the individual employee level, so there aren’t any “winners and losers," which can be bad for morale. It’s not a competition; it’s just a part of the system and everyone is part of it.

This still leaves room for discretionary bonuses and individual pay hikes at the base pay level that are based on merit, so managers get the flexibility needed to hire and keep good people.

Thinking about trying this? Here are some tips to get you started:

1. Keep it simple. Choose one desired result that an employee group has clear influence over;
2. Start small – implement one new idea at a time;
3. Think outside the box a little. Additional compensation doesn’t have to be cash – it could be an extra vacation day, for example;
4. Make certain that the improvement is actually achievable. Don’t set people up for failure!
5. “Reward the try.” This is a term that animal trainers use to describe rewarding when an effort is made, even if success is not complete. In other words, don’t make the variable compensation amount an all or nothing proposition; let people benefit at any level of improvement.

Here’s an example. Let’s say that you have a small manufacturing company, and you’d like to reduce your labor costs by speeding up the production line. However, you don’t want quality to suffer.

In a typical week, your crew makes 1,000 parts at an acceptable level of quality, as measured by what percentage of the parts is rejected by your QC inspector. You will accept a 2 percent reject rate.

Let's say you’d like to increase production by up to 10 percent (anything over 10 percent would impact your overhead, which you'd like to avoid). You are happy to share some of the additional profits with your production employees.

Your plan might look something like this:

• When production for the week is 1000 parts, employees receive their base pay;
• If production goes up by 2 percent, as long as the QC reject rate does not increase, the production employees all receive a 2 percent bonus. If it goes up 5 percent, they receive a 5 percent bonus, and so on;
• There is no additional bonus for an increase over 10 percent (because an increase of more than 10 percent will not be profitable).

Of course this is just an example, and you have to run the numbers carefully and think through the ramifications of any plan before you implement it to make sure you don’t get any unintended results. But done well, a variable compensation plan can be a great addition to your strategy.