Playing now

Playing now

Incentive compensation that motivates

Back to search results

young woman in a cool office environment

When business conditions are challenging, employee productivity is more critical than ever. Motivational incentive compensation plays a vital role in raising and maintaining high productivity levels, along with some other benefits—if you play your cards right. Otherwise, it can be a waste of money, or even set you back.

In addition to increased productivity, properly designed and managed motivational incentive compensation (also called variable compensation) can promote efficiency, employee engagement, retention, and enhance your brand as an employer.

Most companies provide incentive compensation for senior managers. Some also provide it for line managers and non-supervisory employees. As dramatic changes ripple through the economy, incentive plans put in place during more settled times may need to be recalibrated.

In general, long-term (multi-year) incentive compensation, such as stock options and equity appreciation rights in privately held companies, are typically limited to the CEO and other “c-suite” members. Short-term variable compensation opportunities can be built into the pay plans for employees at all levels.

Motivational incentive compensation

A member survey by WorldatWork, a compensation professionals’ association, indicates the prevalence of various kinds of short-term incentive plans covering some employees at privately held companies:

  • Annual bonus based on criteria set at the beginning of the performance cycle: 85%
  • Discretionary bonus set after a performance cycle: 40%
  • “Spot” rewards (based on contributions as they occur): 34%
  • Team incentives: 22%
  • Profit sharing: 22%
  • Project bonuses: 13%

When incentive compensation is based on financial metrics, profitability is by far the most common (used by 77%), followed by revenue growth (49%), according to that survey. Common operational performance metrics include customer satisfaction, operational efficiency, service quality, and workplace safety.

Which employees typically receive incentive compensation? It’s important to have a consistent variable pay/bonus eligibility structure to avoid creating a confusing and haphazard system that could create resentment among employees who believe they’re missing out. Common eligibility classifications include job function, length of service, and exempt/non-exempt status.

Another way to define bonus eligibility is by the goal of each bonus program. For example, If the goal is narrowly focused, such as improving customer service, extra pay potential would logically be limited to customer-facing employees, without regard to specific job function.

Local labor market environment

Ultimately, your top consideration for incentive compensation eligibility is a combination of local labor market dynamics (what employers competing for the same talent are doing for their employees), and the specific kind of performance you are trying to maximize. It’s not obligatory to follow the crowd, however. You might become a pioneer in awarding incentive compensation to a category of employee that, at other local employers, lacks that opportunity. Doing so might result in your employees feeling special, and accompanying burst of performance.

Think carefully about the outcomes you are trying to achieve with an incentive compensation plan, and the performance metrics that reflect that outcome. For example, a goal like increasing corporate profits might seem like a logical outcome to build incentive compensation around, particularly if you’re looking for quick results.

But motivating quick results could come at the expense of longer-term goals. For example, does the kind of success you’re trying to achieve depend primarily upon doing what you’re already doing more efficiently, thereby improving current financial performance? If instead you’re looking at a longer time horizon, increasing employee skill levels and developing innovative new products and services might be better goals to build motivational compensation around.

The same principle of rewarding the right kind of outcome applies to short-term goals. For example, if a goal is customer retention, awarding bonuses on the basis of high customer service ratings might miss the mark. Customers might appreciate the good service, but still not remain loyal. Customer retention could be a better metric.

Set the right goal

Similarly, if increasing sales is a goal, rewarding sales reps only by the number of sales calls they make would not have the same effect as rewarding high sales numbers.

As noted, profitability is the most common target of incentive compensation based on financial criteria. But with so many puzzle pieces typically involved in increasing profitability, most employees might not know the best way to achieve that goal, nor be able to play a significant role in achieving it within the scope of their job.

To be motivational, an incentive plan needs to feature metrics that employees covered by that bonus believe they can move the dial on. This is also referred to as “line of sight”: Employees can see the impact of their individual efforts on their prospects for getting a bonus.

Similarly, when bonus formulas become complex, that line of sight can become curvy. Multi-factor goals “may be tempting,” warns compensation expert Candace Walters. But they should “focus on the few key absolute measures of performance.” She encourages employers to “omit behavioral and ancillary goals” that can be built into the annual review process.

Keys to success

Here are four additional pointers on creating an effective incentive compensation plan:

  • Make it achievable: An incentive compensation plan without challenging goals becomes an entitlement program, with no motivational potential. But the same lack of motivational potential results if targets are considered impossible to hit. Knowing how well your most and least motivated employees perform based on the metric you choose will help you set appropriate targets. (Note: a good HR analytics system can help you establish appropriate performance criteria.)
  • Make it timely: While annual bonus awards are common, it is often possible and desirable to pay them more frequently, such as quarterly. It should be easily seen and clearly described in employees’ payslips. You can make quarterly payouts pro rata based on annual goals. The risk is that you could over-reward an employee if performance craters towards the end of the year and the annual target is not achieved, but the downside can be outweighed by greater motivational potential of more timely awards.
  • Make it meaningful: Carefully weigh the cost of a potential bonus against the value to the business of its achievement, and be as generous as you can. The prospect of a “token” bonus, particularly when earning it will require significant extra effort, might be disregarded and even resented.
  • Make it understood: Ideally, you will have received some employee input when designing your incentive compensation plan. When you roll it out, take time to explain it to employees to ensure they understand not only how it works, but the broader business context for creating it in the first place.

As you would with any other significant business initiative, assess the results of your motivational incentive compensation plan against your original goals and expectations. How many employees achieved incentive compensation? What impact did the program have? Should you maintain it, scrap it, more modify it going forward?

You’ll need feedback from employees—both those who received significant bonuses and those who didn’t—to help with your interpretation of program results, and to inform your decisions about what to do next. You’ll also need to determine whether the behavior you’re trying to motivate is still consistent with your top business priorities.

Reimagine your HR process

When your people perform at their best, so does your business. Download our free guide to discover how you can transform your small business workforce.

 

Download guide

Subscribe to the Sage Advice Blog

Get our latest business advice direct to your inbox.

Ask the author a question or share your advice

When you leave a comment on this article, please note that if approved, it will be publicly available and visible at the bottom of the article on this blog. While your email address will not be publicly available, we will collect, store and use it, along with any other personal data you provide as part of your comment, to respond to your queries offline, provide you with customer support and send you information about our products and services as requested.  For more information on how Sage uses and looks after your personal data and the data protection rights you have, please read our Privacy Policy.

Sage Advice Logo