What makes a successful variable compensation model?
In order to attract and retain the best talent, companies need to position themselves as market leaders and at the front-edge of professional development and innovation. Not surprisingly, according to the Society for Human Resource Management (or SHRM), one of the leading drivers of employee satisfaction is compensation. As companies have become more in tune with the psychology of employee motivation, as well as more competitive in offering unique forms of perquisites, there is one form of compensation that has remained a key motivating mechanism for revenue-generating functions: the variable compensation bonus.
The offering of variable compensation is a two-fold benefit: One, is that it is intended to encourage employee behavior and provide a reward for attaining certain performance targets (ie. sales, profitability, profit mix, or customer mix). At the same time, if such targets are not hit, full bonuses are not paid and the company is not unreasonably exposed to an underfunded financial liability. While commission-only compensation arrangements weren’t uncommon for sales teams historically, thus largely insulating the company from poor performance, companies are increasingly unable to attract talent with this structure. When combined with a base salary and benefits, variable compensation attracts talent, provides a living or even a premium wage, and aligns compensation with professional achievement toward company goals. It is a win-win-win for all involved.
Why do compensation programs fail?
Frequently, I work with companies on their compensation models and see them looking to market comps (comparables) to provide indications of salaries at par, and then adjusting them up or down to be more fair and equitable. A similar approach may be taken in constructing a variable compensation program. This is a common and well-accepted methodology. However, where many organizations go wrong is in the following four areas:
- They fail to align their corporate objectives with employee compensation models.
- They fail to update them at periodic intervals to ensure they always remain suitable to the company and employees.
- They inappropriately tie variable bonuses to drivers largely out of the control of the employee, thus creating a false impression that the compensation is incentivized.
- HR may be in the lead position to design such variable compensation models, but often does not consult FP&A despite HR’s lack a thorough understanding of the financial implications.
Companies need not create sophisticated compensation models to attract and retain the best talent. Quite the contrary. Rather than involve countless metrics involving countless customers, geographies, products, channels, or time-frames, variable compensation models should be straight-forward for both the company and employees. In my advisory experience, I often encourage variable compensation programs be aligned with accomplishment of 3 key bases:
- personal performance
- group performance, and
- company performance.
The first parameter of a variable compensation bonus we’ll examine is personal performance. Each quarter or year, employees should have their performance targets reexamined and reset. In addition, it’s often advisable to have some degree of personal performance goals set by the employee himself/herself so as not to create the impression that 100% of personal performance is dictated by the company or its leadership. Instead, the employee sets and takes greater responsibility and ownership for at least some of his/her own targets. In other words, there’s buy-in.
Goals for a personal performance assessment might include measures of: technical ability (skills, capabilities, education, and training), collaboration with others (team player adding value, proactive contributions), leadership development (taking initiative, taking responsibility), and business development (commitment for furthering one’s own network, commitment to furthering the business). Overall, we might apply a hypothetical weighting of 40% of the available bonus pool attributable to achievement of personal performance goals.
The second parameter of a variable compensation bonus comes from group performance. Assuming employees work within groups, departments, or channels, it should be encouraged that each employee has a degree of contribution to the achievements of the group. Like individual performance, most of these performance goals will be set by leadership; however, a degree of group performance goals should be set by the group’s management with contribution from individuals. Again, this encourages personal and group buy-in.
Goals for group performance might include measures of: business partnership value (tangible value being brought to other groups, proactive collaboration efforts with other groups) and direct group contribution (tangible value being brought to others within the group, striving for excellence within the group). Overall, we might apply a hypothetical weighting of 60% of the bonus pool attributable to achievement of group performance goals. At this point, with 60% of the pool attributable to achievement of group performance goals and 40% of the pool attributable to achievement of individual performance goals, 100% of the bonus pool has been accounted for.
Finally, the parameter of company performance will undoubtedly play the largest role in variable compensation. If an organization fails to perform financially, such shortcomings flow through to operating profit and thus diminish the size of a bonus pool. Despite a professional’s best efforts, if there are insufficient funds for bonuses, such a bonus will not be paid.
While HR may be in the position to design such models as the above, based upon peer comps and performance objectives, HR is often they are not in a position of understanding the financial implications. Ensuring there is appropriate allocation of SG&A to performance compensation will often be the responsibility of FP&A. When I have helped develop variable compensation models at the more than a dozen companies I’ve advised in this capacity, it’s required a triangulation between company, HR, and financial objectives. In other words, we have to ensure the program aligns with the culture and objectives of the company; it rewards people fairly, upholds their motivation, is comparable to peer groups, and obeys labor laws; and that it is prudently designed to increase and decrease in line with availability of financial resources.
In the above example, let’s assume a $75 million company anticipates an allocation of $2.5 million (or 3.33%) of revenue to the variable compensation bonus pool if the sales team exceeds its revenue target. The bonus pool will be distributed to individuals based upon the individual and group performance objectives highlighted above. If, instead, the company performs worse than expected, allocations across the sale professionals will stay the same based upon their individual and group performance objectives; however, the $2.5 million allocation will be reduced to a more tenable level of $2.1 million so as not to unreasonable erode the company’s profitability. Put different, the variable compensation program should be designed to flex so as not to dramatically affect the overall profitability of the company. In rare or exceptional cases, the leadership may choose not to diminish the bonus pool in relative proportion in order to retain sales talent it fears it may lose otherwise. Ultimately, this would lead to lower operating margin.
To summarize, when building a compensation program with variable components, HR should be encouraged to structure it in a way that best aligns with company, group, and personal performance. While many professionals may overlook the importance, it’s vital to allow individuals to have some say into how they will be evaluated and have at least some control over the variable portion of their total compensation. Finally, any variable compensation program should have the insight from FP&A to help determine how the model will impact the overall profitability of the company. Failure to take these steps may result in a multitude of programs. At best, it may result in a confusing set of incentives. At worst, it may result in a lack of alignment between every-day activities and objectives, a feeling of unfairness, employee disengagement and turnover, and margin erosion. In this way, HR and FP&A should be natural partners and allies in the development of variable compensation programs.