By Brad Hams
The most important element of an incentive plan is that it must be self-funding.
In other words, it must pay for itself. If an incentive plan does not pay for itself, then what you’ve created is simply a new expense. You’ve also created an entitlement (or as someone attending one of my recent talks so aptly put it, you’ve created welfare).
If employees are going to have the opportunity to participate in an incentive plan, then it’s their obligation to fund it. It follows, however, that it’s the obligation of leadership to teach them how, and to provide employees with the education, information, and tools employees will need to fund the plan. (I’ll break down several of these mechanisms in a few follow-up posts.)
Many (if not most) business owners and leaders look at incentives as if they were a budgeted expense.
I suggest you look at it this way instead: By implementing a smarter process, your profitability will increase from X to Y, and Y will be substantially greater than X. The organization now has additional profit dollars that are represented by the gap between X and Y, and the incentive will be a portion of that gap.
Given this, the incentive is not only self-funded, but it will also drive the profitability of the organization higher.
A LOT of incentive plans are ineffective — many of them so much so that they do actual damage to the organization.
Most often the design flaws are:
- The plan is not self-funded (most critical).
- The plan is too complicated, and/or is tied to operational metrics rather than financial results.
- Employers don’t provide employees with the education and tools they need to be active participants in funding the plan.
Given these flaws, the typical outcomes are:
- Since a link between performance and incentive has not been established, the incentive simply becomes part of their compensation, i.e., an entitlement. It will not change behavior toward improving financial performance.
- Once a plan has become an entitlement, employees simply feel cheated if there is a quarter without a payout.
In order to avoid such problems, follow these guidelines when designing your plan:
- To keep the plan simple and understandable, tie the incentive payout to only one measure: Profit Before Taxes (PBT).
- Ensure that the plan is self-funding by determining a minimum threshold of PBT required before payout. To do this, you must consider return on investment for ownership, capital for debt repayment, and capital for improvements or investments (among other needs).
- The plan should be broad-based, meaning everybody should participate.
- Pay the incentive quarterly as opposed to annually. The way to shape behavior is to keep the reward close to it. Hold back 50 percent of the payout each of the first three quarters to ensure cash flow is not negatively impacted in the event of a downturn.
- If possible, the plan should allow for roughly 10 percent of payroll as a payout at a stretch PBT goal.
In the short term, cash incentives such as I have described here can be helpful in engaging your employees toward driving the financial performance of the company. Having said this, it is important to point out that the incentive plan itself is unlikely to change behavior.
It must be tied to activities that we’ll lay out in upcoming posts:
- Teaching business and financial acumen to employees.
- Creating an environment of high visibility and accountability around funding the plan.
Prior to founding Ownership Thinking in 1995, Brad Hams was president of Mrs. Fields Mexico, and held leadership positions in a fortune 100 company. He is a lifelong student of business and finance, and holds a master’s degree in Organization Development and Human Resources. Brad is an internationally recognized consultant and speaker, and the author of Ownership Thinking: How to End Entitlement and Create a Culture of Accountability, Purpose, and Profit (McGraw Hill). You can reach Brad at: firstname.lastname@example.org.
Originally published: Sep 10, 2011