Does your incentive plan accomplish what you want it to do?
If not, don’t feel alone. In my 12+ years of helping companies work through their compensation issues, I have found that many (if not most) short-term incentive plans are ineffective. In fact, many incentive plans, although well-intentioned, actually damage the organization.
What are the components that typically render these plans ineffective and/or damaging?
- The plans are too complicated.
- They are tied to operational metrics rather than financial results.
- They are tied to individual or departmental performance rather than company-wide results.
- If they are tied to financial results (as they should be), employers typically don’t teach employees about finance.
- Employers don’t make it clear to employees that incentive plans must be self-funding.
- Employers don’t provide employees with the education and tools they need to be active participants in funding the plan.
- Employers don’t regularly communicate organizational performance relative to the plan.
- Wins are not celebrated.
These components inevitably lead to ineffective plans, which typically lead to the following outcomes:
- There is no connection between the incentive employees receive (or don’t receive) and the work they actually perform.
- Employees feel gratified to receive an incentive. However, it does not change their behavior because the link between the incentive and their work is not clear.
- Since this link is not established, the incentive simply becomes part of their compensation — an entitlement.
Ultimately, there will come a quarter (assuming this is a quarterly plan) where the business doesn’t perform well and there is no incentive payout. Since the plan has become an entitlement, employees feel that they have been cheated, and the plan actually ends up damaging morale.
DESIGNING A PLAN THAT WORKS
What does a well-designed incentive plan look like?
- Keep it simple. We recommend tying the incentive payout to one key performance indicator (KPI) — profit before tax (PBT). If a second KPI is utilized to fund the plan, it should be a balance sheet indicator that drives cash flow, such as average collection days or inventory turns.
- Ensure that the plan is self-funding. Identify the requirements the business must satisfy before any incentive can be paid. By analyzing these factors, a minimum acceptable (or threshold) PBT can be identified before which no incentive will be paid.
- The plan should be broad-based, meaning everyone should participate.Most plans are distributed in one of two fashions — equally among all employees or based on wages. Your method of distribution will depend on your company, your culture and the purpose of your plan.
- Pay the incentive quarterly as opposed to annually. The best way to shape behavior is to keep the reward close to it, and annual plans are too far removed from activity to have any impact on behavior. That said, it is important to withhold some of the incentive from each of the first three quarters in order to protect the company in the event of a downturn. We suggest paying 50 percent of the incentive in quarters one through three, banking the remaining 50 percent, and then making the final payment based on year-end results. With this approach, employees receive 12.5 percent of the annual incentive in quarters one through three and 62.5 percent at year’s end.
- The plan should be based on overall company results. Individual or departmental incentives create silos and take the focus away from overall company performance and stock value.
If possible, the plan should allow for roughly 10 percent of payroll as a payout. Keep in mind at all times that the plan must be self-funding.
FUNDING THE PLAN
The most important factor in any incentive plan is ensuring the company has the money to make the incentive payouts.
To fund the plan, start by identifying the leading, activity-based measures that truly drive financial performance, and get all employees focused on these. Examples include rework, accuracy, on-time delivery, fill rate, billable hours, waste, equipment utilization, average collection days, inventory turnover, average sale value, new product sales, qualified leads, close rate and more. By focusing on and associating these leading indicators with financial results, employees begin to link the two.
One of the most effective ways of funding the incentive plan is the regular and formal creation of rapid improvement plans (RIPs). RIPs are designed to formally attack areas of opportunity and improve them in a high involvement fashion.
For example, we recently worked with a construction company that had a 70 percent return-to-job rate to do some form of rework. They designed a RIP to reduce this to 30 percent in 90 days. A team of employees created and implemented the objective, actions required, financial impact on the company and some form of celebration. They created a visible scoreboard, monitored performance and made sure that everyone in the company participated. Upon achieving their RIP goal, which led to an immediate $200,000 in cost savings to the company, the employees celebrated with a bowling night.
Once the plan is underway, continually communicate the impact of the incentive plan to employees and to the company as a whole. Keep in mind that every time a RIP is successfully implemented, it funds the incentive plan, creates a learning experience and, ultimately, improves the value of the company. RIPs should become a permanent part of the culture, so that you always have one or two under way.
RIP YOUR WAY TO SUCCESS
To create and implement a RIP:
- Identify a KPI that, if improved, will have a huge impact on financial performance. Establish a goal with a clear deadline, such as “reduce rework by 50 percent over the next 90 days.”
- Identify a RIP champion and implementation task force. Get people involved from all areas of the business that touch the problem.
- Create an action plan that specifies in concrete terms who will do what, by when.
- Quantify in hard dollars the benefit to the company (i.e., cost savings) of fixing the problem. Create a theme, build a scoreboard and track progress toward the goal.
- Identify a prize and celebrate the win once the goal is achieved.
RIPs provide a powerful mechanism for improving performance and generating cost savings to fund the incentive plan. They can help to instill a whole new culture that links performance to incentive rewards and dramatically improves the financial performance of the business, which is the goal of any incentive plan.
In summary, short-term incentive plans can be a valuable support mechanism for driving improved business performance, but only if the mechanisms outlined in this article are utilized.
Brad Hams is founder and president of Ownership Thinking, LLC, a Denver-based consulting and training firm committed to unleashing the potential in businesses through education and involvement.