Incentive compensation plan confusion

by on June 17, 2009 · 0 Comment POSTED IN: HR Info Center

Show the links in your incentive compensation plan between personal performance, corporate performance, and bonuses

Confusion in an incentive compensation plan usually revolves around communication. Describe in clear detail the links between how an employee performs, how the company performs and the amount of bonus. Oftentimes, this is known as black box syndrome, where employees don’t have any idea what I need to do to achieve different levels of performance. At the end of the year I get a check and I’m not sure how anything was calculated or how this came about.

Effective design and effective communication go hand in hand in incentive compensation plan
The way to most effectively communicate this as well as to effectively design an incentive compensation plan is to assign percentages and make it an algorithm or a formula-driven result. In this example, we have two different measures for our annual incentive compensation plan – revenue growth and profit growth.

We’ve clearly identified that we are more interested in revenue growth than in profit growth by weighting them, revenue growth at 75%, profit growth at 25%. Then, I’ve also identified not only which is more important but what are our target levels of achievement.

And we’ve identified four different levels of achievement for each of those two metrics. The first would be identified as the threshold. So, what we’re saying is in order to have any payment earned for revenue growth, we have to grow by at least 12%. That is our minimum requirement before which we would start to pay out an incentive.

We say that because our target for the incentive compensation plan is projected growth of 30%. And if everything falls into place and everyone is working hard as an organization, we’re firing on all cylinders, we think it’s possible to do 35% revenue growth. That would be our stretch goal. That would be what we would consider a triple or maybe even a homerun.

Differing philosophies about maximum limits in an incentive compensation plan
At the same time, we’re also going to identify in this case, a maximum of 40%. Now, organizations can go different ways and different philosophies can push you in different directions in terms of identifying the maximum.

Some organizations would say, “If we far surpass our maximum, it’s because of the hard work of our employees and there should be a reward for that.” Other organizations would look at it and say, “You know what? Anything above in this case that 40% revenue growth, it’s probably not going to be attributed to hard work, to effort, to things going well. It’s probably going to be more of a windfall type of thing where we happen to win a lawsuit this year. And so, with the proceeds from winning that lawsuit, our revenue was up.”That’s not really something that we want to pay a bonus on. It’s not something that is part of our core business. And so, we’re going to cap out our incentive plan. Those same comparison points — threshold targets, stretch and maximum were also identified for our lower metric of profit growth.

What we’ve then done on the bottom – again, the issue is how do we communicate and get rid of the black box syndrome? In this example, we have a chief executive officer. We’re saying the target bonus percent is 40% based on 50th percentile base salary data of $200,000. So, at threshold, they would receive $30,000, target would be $80,000, stretch would be $180,000 and the maximum bonus would be $360,000.

We’ve also at the bottom then shown above target, what is that payout so that an employee would understand, in this case the CEO, if we exceed our target performance how much more money is in this for you? So to the CEO we’re saying, “If we can hit our stretch goals, that’s going to put $100,000 in your pocket, in this example, above just hitting the target.”

Edited remarks from the Rapid Learning Institute webinar: “Incentive Pay Plan Blunders That Can Cost You a Fortune” by Ed Rataj

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