Implementing a Performance-Based Compensation System

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By Noah B. Rosenfarb, CPA

Compensation used to mean a fixed salary with annual increases. This model rested upon employee demands to be paid based on the number of hours worked and years of service. Today's compensation needs to reflect the “new” contract between employers and employees – where performance is rewarded regardless of effort or tenure.

Pay-for-Performance ("PFP") systems tie compensation directly to specific business goals and management objectives. To do this, companies must deliver competitive pay for competitive levels of performance, pay above market for exceptional performance, and reduced pay for poor performance. To achieve this, companies must match measurable and controllable performance targets to company objectives.

In PFP systems, employees’ compensation is composed of a fixed base salary and a variable component. The most commonly used variable components are:

  • Company equity (Phantom or actual) - the quantity and price to be paid are typically based on a percentage of value added as determined by the performance measurement system;
  • Bonuses - cash awards for extraordinary accomplishments or other activity-related distributions;
  • Gain sharing - distribution of a portion of results realized, based on performance versus plan.

These systems are designed to retain top-performing employees, motivate the desired performance, and control costs. If a company wants to pay for performance, it must define performance in very specific, objective, quantifiable terms, measure it and track it.

Defining Performance

It is critical to link compensation to your overall business strategy. To do that effectively, you must be able to identify the direction the organization needs to move and communicate the desired actions to get there. Compensation provides a very effective tool for getting employees to move in the same direction and follow the same path.

For example, suppose a young, growing company wants to increase market share. Its compensation plan needs to reward people for bringing in new customers and clients. In contrast, a more mature company might need a better balance between growth and profit. Accordingly, its compensation plan should equally reward activities that generate growth and profit. Another company might identify world-class customer service as one of its top strategic objectives. It would need to reward the activities (in all areas of the organization, not just the customer service department) that lead to outstanding customer service.

Results vs. Effort

Successful compensation plans pay for results. At the same time, they also need to recognize effort because no matter how hard employees work, sometimes they don't achieve desired results. People can work hard and not reach their goals, and you can't ignore that, especially when factors beyond their control impact their performance. Pay for results, but build into the plan other ways to reward and recognize hard work.

On the results side, you also have to distinguish between performance levels. Most compensation plans pay very little difference between average performance and outstanding performance. Effective plans have a very clear correlation between superior results and superior rewards.

Design Issues

How do you measure the goal? The way you measure results will have a huge impact on plan design. Do you intend to measure profit? Quality improvement? Customer service? Sales growth? A combination of different measures? Whatever the criteria, be very specific about what you intend to measure and how you will measure it. For example, if you measure profit, are you talking about before or after tax? Also, make sure you have a valid and reliable measurement system and process. Employees will not trust an incentive plan based on questionable measures.

Who participates in the plan? As companies move toward nontraditional work forces, this question has increasing importance. Most incentive plans include all full-time employees but exclude temporary, seasonal and contract help. Some companies require employees to be currently on staff or to have been on staff a certain period of time in order to qualify for the incentive pay.

How will the payout be determined? Flat dollar amount? Percentage of salary? Percent of profits above a certain threshold point? Whatever you decide, make sure employees understand the method of payment.

How often does the plan pay out? Incentive plans typically pay out monthly, quarterly or yearly. Keep in mind, however, that the shorter the interval between performance and reward, the more you will impact behavior.

An ongoing research study at the Wharton School of Business demonstrates that short-term, results-based work relationships often create a higher level of commitment than long-term relationships. The researchers believe this is because the short-term contracts give participants a very clear idea of what’s expected of them, what they’ll gain from delivering, the time limits of the job and the workload necessary to complete it successfully within that time period.

What are the threshold numbers? Some plans pay out after the first dollar of profit; others only after meeting certain minimum levels of return. If you’re attempting to incentivize hard-to-measure standards such as customer service or teamwork, you may need to experiment with thresholds. If so, explain to employees up front that the plan may require some experimentation. Otherwise, they may think you're manipulating the plan in order to avoid paying out the incentive.

Who has responsibility for administering the plan? To maintain credibility with employees, treat your incentive plan with kid-glove care. Assign an administrator who has the respect of employees and who will maintain a constant flow of information.

Who measures performance? Do not let the people responsible for measuring performance design the plan. No matter how honest your employees, the temptation to manipulate the data for personal gain may be too difficult to overcome, particularly with senior managers who stand to gain significant amounts of money by hitting the goals.

Will you pilot the plan? Many companies prefer to test the plan on one department or division before rolling it out to the whole company. This also allows time to make revisions and improvements.

Does the plan pay all monies due or does it have a holdback provision? Some plans have interval benchmarks but don't pay out until the annual goal has been achieved. Others pay in increments and then have a larger lump sum at the end. How you pay will depend on what you measure and what you hope to accomplish with the plan.

What is the life of the plan? All plans should have a "sunset," a designated ending point. This gives you the ability to adjust or periodically change the plan. Make sure to announce the sunset at the beginning of the plan, not at the end.

As a final check before installing a new compensation plan, ask the following questions:

  • Is the company paying for time or productivity?
  • Does the compensation program reduce the need for employee supervision or maintain it?
  • Will the compensation program encourage initiative and creativity or simply reinforce the status quo?
  • Does the compensation program automatically increase fixed expenses?
  • Does the compensation program reinforce company profits or simply pay for individual effort, regardless of company profitability?

Implementing the Plan

Consider a bridge program. Never decrease base pay in order to put in an incentive plan. Nothing will erode the trust level quicker. (The only exception is a turnaround situation where the company must cut pay in order to survive.) Instead, consider using a bridge program that maintains trust levels while allowing employees to get used to the concept of pay for performance.

A bridging program that combines elements of fixed wage and pay for performance allows employees to get more comfortable with profitability compensation. Plus, it allows you to make course corrections along the way. Test your new program for 90 days and then make adjustments as necessary. Always reserve the right to change the plan so that it benefits the customer, the company and employees.

Noah helps businesses enhance their profitability by improving business processes. He is available to discuss your business’ needs and can be reached at 973-287-0864 or [email protected]


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