Designing Effective Incentive Programs
Increasingly, organizations seek to utilize some form of variable compensation to motivate employees and align the goals of employees with those of the organization. By making a portion of every employee’s compensation variable, and measuring against clearly defined goals, the impact can be powerful in terms of employee motivation, engagement, retention, and the management of employee costs. When the company does well everyone benefits – but when targets are not met, compensation is limited to the fixed component only. These plans can come in the form of annual incentives, profit sharing, gain sharing, and profit bonuses. Whichever way they are structured they must make economic sense and be clearly understood by all parties to be successful.
When organizational and individual goals are aligned, through a well-designed incentive program, there is an intrinsic motivation for the employee to achieve success, that benefits all.
It can also lead to a more “open book” culture. When results and information are shared with employees, they develop a better understanding of the business. This can also lead to heightened trust between employees and management as everyone knows – “we are all in this together!”
It trains employees to think and act more like owners. When compensation is tied directly to performance – performance issues are identified and corrected timely, and the sense of urgency and personal ownership increases.
To develop meaningful and effective incentive programs, there must be a clear organizational strategy with associated multi-term goals. The purpose of incentive-based compensation is to influence behavior and create a mechanism for goal congruence between the organization and employees. Clear and identifiable organizational goals facilitate the development of appropriate divisional, department, and individual goals in support of them. Identifying desired behaviors that lead to desired outcomes, is a key step before the development of the metrics and the mechanics to measure them.
The best measurements of performance can now be selected. These will vary depending on the nature of the goals and associated performance criteria. Some metrics will be expressed in terms of production numbers and efficiencies. Some in terms of sales, margins, profits or expense levels. Some may be financial and others more operational in. They may be team-based or individual. The CEO may be measured by overall company performance while others may be incentivized on the performance of teams, departments or projects, or the achievement of certain goals or milestones. Daily or weekly KPIs and metrics may also be needed. These should be simple, actionable, and in support of prescribed goals.
All measurement metrics must be clear and transparent, and simple enough to provide ongoing reinforcement of performance expectations. Try not to exceed two or three performance criteria and associated measurements – to keep focus.
Performance targets must be realistic and attainable. There should also be an obvious and easily understood link between individual/team efforts and the achievement of the desired targets.
Start with the end in mind. Target a certain amount of variable compensation for a certain level of performance. With a spreadsheet, it becomes easy to test the assumptions at varying levels of performance, to see what happens at the extremes of the plan parameters.
Will there be minimum or maximum levels of payout? What if goals are missed by a small margin, should any incentive be paid, or none at all?
Once the measurement criteria and targets have been developed, an illustration and written summary should be produced. This should describe the overall plan, the measurement metrics, and the targets. It should also clearly explain how the incentive compensation will be calculated, paid and ideally should include a few scenarios. The purpose is always to motivate and positively influence behavior. If the plan is perceived to be overly complex, or the bar is set too high in terms of performance, it will have the opposite effect. In organizations where there may be skepticism or resistance, it is important to have open dialogue and communication, to encourage and obtain buy-in.
Consider who should be involved in the development of incentive plans and the components? Senior management or the whole team? A team approach can certainly promote transparency of process and may provide a lot of useful ideas in terms of what exactly motivates employees and how they might perform better at their jobs.
Information about results and performance affecting the plan should be communicated regularly, to keep folks engaged. Some companies keep a “scoreboard” or multiple scoreboards. These are in full view and track progress, and also may forecast the current incentive payout. Employees know whether they are “in the money” based on current information.
Consider how often the incentive calculations will be made, and the time intervals for payments? The time intervals used for calculation and payout need not be the same. For instance, calculations can be made monthly, with quarterly payouts. However, the advantage of more frequent payouts is the focus and relevance it brings in connecting today’s efforts with a tangible and attainable benefit. This must be weighed against the cash flow impact, and the fact that once made, incentive payments are a sunk cost. If company performance deteriorates substantially – it can wipe out all the prior gains.
In conclusion, variable incentive programs can be an excellent tool to motivate employees while achieving organizational goals. Sufficient time and attention must be given to the identification and development of the components of each plan and then tailored appropriately. Plans should be reviewed and updated regularly to ensure they are achieving the desired results and remain relevant and effective.
Martin Cobb is an Area President with FocusCFO, based out of Ann Arbor, MI