Compensation plans can take many forms, from the simple $15 per hour, to the complex negotiations around stock options, country club memberships, and company jets. Most of us fall somewhere in between. If we just focus on the cash part of the equation, there are two components:
- Base pay – your hourly rate, or your annual salary (presumably for working 40 hours/week), and
- Additional compensation offered to elicit behaviors that will produce positive financial results.
Well-designed compensation plans will stabilize and energize your workforce, keeping everyone focused on how they personally contribute to your company’s success. Bad comp plans can wreak havoc!
Put some thoughtful analysis behind your compensation plans or be prepared to watch your company’s profits go down in flames.
The base pay you offer employees should be competitive in your local market, with companies of your size. If you don’t know the “going rate” for roles in your area, I suggest you do a benchmarking study to find out. You need to know. This will be meaningful information for you when you are hiring, promoting, and conducting annual reviews. I can assure you that those who work for you – or who are considering it – know.
What you don’t want to do is wait for the market to tell you your pay ranges are too low. How does that happen? Best case scenario: You try to recruit for an open position and everyone – your network, your recruiter, your candidates – tells you the pay you are offering is too low. Worst case: You lose good employees to companies that do offer competitive salaries.
If you discover that your company’s pay structure needs a market adjustment, you have options:
- Develop a strategy to make the adjustment, in the timeframe that makes the most sense for your organization.
- Keep your salary levels the same and lower your skill-level expectations for new hires. Not a good plan! You will get what you pay for, but you will not get what you want.
- Ignore the problem and suffer the consequences. Turnover costs money. Turnover –> Low Morale –> Lost productivity –> “Sick” days for interviewing –> Recruiting time and fees –> Inevitably higher salary for new hire –> training –> lost productivity due to new hire learning curve –> company profits go down in flames!
It is important to remember that a good salary structure will be flexible enough to allow consideration of advanced education, professional certifications, level of experience, etc. That’s why each position should have a salary range. A position’s job description can be stratified by adding “Junior” or “Senior” to a title. This tactic also allows for salary growth commensurate with gained experience and can be especially useful in companies with relatively flat hierarchies.
Some companies will need to add some form of additional compensation for their comp plans to be considered competitive. Why? Because many people consider their salary to be compensation for showing up every day and being “average”. That’s how it works, right? “Average” gets to continue working, “Needs Improvement” probably doesn’t, ”Above Average” gets a bonus, and “Exceptional” gets a bonus and a promotion. Bonuses, incentive plans, and sales commissions are based on the concept of pay for performance. If your company is going to pay for performance, please make sure you understand the ramifications of your plan. You need to do thoughtful analysis.
The Year-End Bonus
While bonuses are typically not guaranteed – you are “eligible”, but payout is “discretionary” – they are often customary. The Year-End Bonus can be comprised of any one or combination of the following:
- The thanks-for-staying-another-year bonus – to recognize an employee’s continued years of service.
- The profit-sharing bonus – to share the wealth. Profits = bonus; no profits = no bonus.
- The merit-based bonus – to recognize the contributions of individuals to the company’s success.
The formula used to calculate a year-end bonus can be as simple as a flat dollar amount or stated percent of salary applied equally to everyone. Understand that if you utilize this method, and everyone – even low-performers – are paid, you are sending the message that this bonus is not based on performance, but on attendance. Your company, your choice. Just be sure this is the behavior you want to reward.
To bring merit into the process, I have seen companies apply a graduated percent of salary to review ratings. For example, an average rating gets you 5% of salary, above average is 15%, and exceptional is 25%. For this method to truly be effective in encouraging profitable behavior, the constructive feedback process should occur throughout the year. If people are surprised by their review rating, your process is broken.
Management Incentive Plans
Management incentive plans are offered to those in positions that can directly impact financial results and should therefore be based on goals and controls. That is, the manager (director, VP, etc.) should be incentivized to meet the company’s financial goals for the area(s) over which they have control. It is fruitless to measure someone on net income if they only have control over sales. That being said, it is appropriate to make a portion of an incentive plan contingent on total company results.
To be clear, this is compensation you should WANT to pay! If your plan is designed effectively, you will be paying an impactful (i.e., valuable) employee because they accomplished the financial goals you deemed critical to the success of the company.
Remember, you compensate for the results you want to achieve. The goals should not be so easy they could be achieved without this individual’s influence. On the flip side, the goals should not be impossible to achieve either. Typically, that means your manager will get their base bonus payout if they achieve budget. If you would like your managers to exceed budgeted profit goals, you can encourage that behavior by offering a higher payout rate for achieving stretch goals. If you cap a payout at the achievement of budget or pay a lower rate to achieve a stretch goal, do not be surprised if sales are pushed to the next measurement period. Compensate for the results you want to achieve.
Since this is the at-risk part of the pay equation, presumably for valuable leaders, make sure the timing of payouts is incentivizing as well. If it is your goal to push a significant portion of your management team’s total compensation from the weekly salary bucket into the at-risk bonus bucket, you should consider paying a portion of the bonus quarterly (especially plan components tied to sales), with the remainder payable at year end.
Sales commission plans should be easy, right? It’s a volume game – those who sell more product make more commission. And no sale is a bad sale. Unfortunately, that is not true.
Let’s say your company sells a product, accessories, and installation, but you pay commission only on the product and accessories – not on the revenue from installation (which is 30% of the cost of each sale). Sales reps in the audience, how are you going to close the sale? Maybe give the customer a discount on installation? Customers love that! Finance people, what’s the problem with this scenario? That’s right, by focusing only on the commissioned components of the sale, your rep has eroded the deal’s gross margin. You want profitable sales, but instead you are paying for sales at any cost. This problem can occur even if you pay commission on all sales. As long as a rep can discount sales and make it up in volume, the rep’s commission is safe. Your profits are not. High volumes at low margins can be a disaster! Make gross margin a part of the commission plan or actively control pricing. Watch your margins or watch your profits go down in flames.
If you choose to pay your sales reps a salary plus commission, be aware of this pitfall: If the salary is high, making the commission rate low, mediocre reps will simply live off of their salary, while your great sales reps will be discouraged that selling more product doesn’t really make them more money. Bad reps will ride it out as long as they can. Good reps will leave to work for your competition. Either way, no sales for you. Your company profits go down in flames.
Take It For A Test Flight
All pay for performance plans should be tested before release to understand probable payouts. For sanity’s sake, I suggest you also test the extremes. The low end, zero, is easy. But what are the chances – and the consequences – of zero?
Conversely, what could your top end look like? How much payout is “too much” for your company? Your first impulse may be to say, “But that will never happen.” I personally know of five separate occasions where comp plans allowed employees to earn considerably more than their employers intended – hundreds of thousands of dollars more.
What were some of their lessons learned?
- Plan components based on stock price appreciation should have carve-outs for the impact of acquisitions and divestments.
- Commission rates should be evaluated at least annually, especially during periods of meteoric price appreciation (or catastrophic decline).
- Collectability of accounts receivable should be somehow tied to payout of commissions.
- Employees whose only “fault” was selling a deal of the century for your company, earning an embarrassingly large commission in the process, WILL call their attorney if you decide you don’t want to pay them in full. And you will lose.
Look, no one wants to work for free. Even those billionaire CEOs you read about, who supposedly work for $1, get something else in return – stock, personal security details, housing, transportation…something. The rest of us need cash…and to understand our objectives…and to feel we add value…and to trust we will not be taken advantage of. A well-designed compensation plan will stabilize and energize your workforce, keeping everyone focused on how they personally contribute to your company’s success. Do not stand by and watch a poorly-crafted comp plan take your profits down in flames.