I recently talked with a business owner that thought their business could not afford an incentive plan for its employees. It was just too small and too early since it was a startup. His observation was that other business owners had tried bonus plans and had less than successful results. Do you feel the same way about your business? Should this really be the case?
In their book Profit Works, Alex Freytag and Tom Bouwer make the compelling case that your business can’t afford not to have an employee incentive plan. Why? You are missing out on expanded profits and retention of high-performing employees. Wouldn’t you like to increase your business’s performance in both of these key areas… especially in times of worker shortages and economic uncertainty?
Let’s start with a key retention and performance factor… sharing business financial and performance information. As highlighted in Profit Works, most employees believe the business they work for earns net profit margins of 30% to 50% of sales! Wow! The reality is that most businesses earn returns of less than 10%. The point is that many employees mistakenly believe the business owner is keeping all this incredible profit and not paying appropriately the people who help make it possible. If employees can get a periodic view of financial performance, education on why business profit is important to them personally, and how they can improve both the company mission and bottom line, then you can take the first step toward an incentive plan that will self-fund. This is an important concept laid out in Profit Works.
What does a self-funding bonus plan look like and how do you know you are not just giving away hard-earned profit?
According to Profit Works, a good incentive plan has three key components:
First, a self-funding bonus plan is a simple plan that is easy for everyone to understand. There are just a few clear measures, typically financial, that are routinely reported to everyone. And everyone knows how their job can impact at least one of the standards.
The second indicator of an effective incentive plan is that it creates positive behavior changes. Behavior change occurs when the plan combines financial transparency with a stretch-level but attainable incentive threshold with the potential for personally significant payouts to employees. This creates a “we” culture of accountability and teamwork.
Third, a good incentive program typically creates a pool from a percentage of incremental profits above a chosen threshold. It is not discretionary! If the company reaches the threshold, it will pay out the bonus per the yearly goals laid out in the incentive plan. This is vital to create trust.
Imagine that you are the sole owner of a business that generated $500,000 of pre-tax profit last year. You have five employees in addition to yourself. Your historical profit growth rate has been 20%, based mainly on your efforts to lead sales, manage operations, and control costs. You have now reached the point where you can no longer manage it all and yet you have indications that the business growth potential is much more. What profit pool might motivate employees to change behavior, think like a business owner, and generate incremental profit that the company might not otherwise achieve?
In this example, we will set the attainable stretch-profit threshold of $600,000 in pre-tax profit, the “natural” 20% profit growth rate the business has already demonstrated. We can create a pool where say 30% of every dollar above $600,000 goes to an incentive pool for distribution to employees based on the ratio of each employee’s wages to total wages. So, if the company achieves a profit of $700,000 then the pool is the $100,000 profit above the threshold x 30%, or $30,000. The total employee payroll is $300,000. Barring other incentive factors, an employee making $50,000 annually could earn a $5,000 bonus while the $100,000 employee could earn a $10,000 bonus. Ten percent bonuses begin to get attention and change the behavior of employees.
As a business owner, wouldn’t you part with $30,000 to net an additional $70,000 in pretax profit that you would not have made otherwise?
To understand more about the nuances and options available within intelligent, aligned, simple, and motivating bonus programs for small (or all) businesses, I recommend reading Profit Works by Alex Freytag and Tom Bouwer.
If you're interested in learning more about how an incentive plan can enhance your bottom line, or how a fractional CFO can help you implement an incentive plan, reach out today.
Jason Dean is Area President with FocusCFO and is based in Nashville, TN.