From the February 1996 issue of Entrepreneur

What's wrong with this picture? You've just nailed down a major new contract, and to celebrate you gather your employees together and tell them they'll all be getting a 10 percent raise effective immediately.

Sound familiar? Probably, because this approach to raises is the small-business norm--and, of course, employees are quick to applaud it. But compensation experts don't. In fact, according to them, just about everything is wrong with this picture.

That's because impulsive generosity is not a good motivation for giving pay raises. "You need to think about raises before you hand them out--long before," says N. Elizabeth Fried, a Dublin, Ohio, compensation consultant. "But small companies are usually unsystematic in their approach to pay raises--and that can be costly to the bottom line."

Horror stories abound of bosses who failed to think before acting. For instance? Fried recalls one boss who concocted a spur-of-the-moment salary-plus-bonus plan for his sales manager--whose compensation soon soared well into the six figures, an amount far above what the owner had anticipated. "He just hadn't given much thought to it," says Fried.

In other cases, employee turnover is mammoth because the business doesn't pay market rates (which can be obtained from the Bureau of Labor Statistics and, often, local chambers of commerce). Workers stay just long enough to pick up a skill--in effect, using the business as a school that pays them--then bail out to join better-paying competitors.

"To stay in business, you've got to think through the long-term impact of your compensation decisions," says Fried. "The main point is that compensation and pay raises have to be linked to the business's overall objectives. That's something too many entrepreneurs neglect--to their detriment."

Then you have to link company objectives with those of individual employees--and the place to do that is in employee performance reviews. Besides telling workers how you feel they are performing, tell them-in as much detail as possible--what they need to do to win a pay raise, says Novato, California, management consultant Christopher Hegarty. "A raise should be the outcome of a strategy the boss and employee have agreed on," he says, adding that you should tell employees the critical tasks that, once learned, will make them more valuable to the company.

Which critical tasks? You know your business and where each employee can most impact the bottom line. Those are his or her critical tasks, so spell them out. "Be as specific as possible. You want to take the mystery out of pay raises," says Hegarty.

In fact, demystifying the compensation system is crucial. "What do employees most want in compensation? Fairness. That's the answer we always hear," says Oakland, California, business consultant Charles Garfield. The better workers understand the system, the less apt they are to believe raises are rooted in favoritism or arbitrary decisions.

Besides fairness, employees also want a degree of generosity--a fact vividly documented in research conducted by Atul Mitra, an assistant professor of management at Lyon College in Batesville, Arkansas. According to Mitra, "Small raises can hurt employee motivation and morale." The reason? "Employees lose faith in the system. They stop thinking there's a link between pay and performance."

How small is small? Any raise significantly below 6 percent, says Mitra. "Unless a raise is that high," he says, "it won't produce the desired results in terms of employee productivity." But the good news is that bigger isn't always better. A 7 percent raise is likely to get Joe fired up--but a 14 percent raise probably won't get him doubly fired up. If raises are big enough to be considered raises, Mitra found any extra money will yield few additional motivational benefits.

Added Bonus

Even so, what if you don't want to commit to meeting that high a payroll, payday after payday? Join the club. That very resistance is why bonuses in lieu of raises are growing in popularity. The logic is simple: Like raises, bonuses--typically ranging up to about 10 percent of base pay--reward employee behaviors you want to see more of, but bonuses are only one-time hits on the business's treasury. That's why some 59 percent of companies are awarding employees some form of results--sharing payouts, according to a recent survey by Hewitt Associates, a human resources consulting firm in Lincolnshire, Illinois.

"Once a business is paying employees competitively, my recommendation is that bonuses be awarded," says Fried. "Merit raises increase an employee's base salary, and even if his performance falls, you're stuck paying him the rate he deserved last year." Furthermore, many other benefits--such as the employer's contribution to Social Security--"are based on salary, so a pay raise increases your other payroll costs, too. A small business cannot afford to let its costs run away. That's why bonuses are frequently the best strategy."

By all means, keep workers up to date in terms of inflation--usually through cost-of-living pay increases. But recently inflation has been minimal, so for substantial increases in their bottom lines, workers will have to earn bonuses.

How? That's the question, particularly since "you don't want employees to see bonuses as manna from heaven," says Fried. That means you want them to understand how and why they will get bonuses--as well as why they won't. Set up targets for workers to meet and, when they are achieved, then--and only then--hand out bonuses. But be cautious because "a bonus plan needs to support your business strategy. Will the employee behaviors it fosters create the additional revenues to pay for the bonuses? Ask yourself tough questions like that, and don't announce a bonus plan until you know the answers."

Once those concerns are satisfied, for a bonus program to work, "employees need to have significant ability to achieve the bonus," says Fried. That means shipping clerks won't be excited about a bonus that hinges on increased sales--how would their daily activities boost sales?--while a salesperson won't respond to a plan that gives bonuses for slashing shipping costs. "Often you need different plans for different employees," says Fried. Then, too, it's fair to tie bonuses to results--so set up a system where an increase in company profits is a necessary condition for triggering bonuses. "That's a common feature of many bonus plans," Fried says.

Once the plan is articulated in your head, explain it to employees. "You want them to understand it and buy into it," says Fried. "Do employees think the targets are reasonable?" Their support is critical because the measure of a plan is whether it changes employee productivity levels for the better. It won't if they think the idea is hooey.

A common upshot of a bonus program is that different employees get different-sized bonuses. Won't that unleash intramural animosity? No more so than giving varying pay raises would--and, in both cases, count on word spreading among workers as they compare notes.

Shouldn't that kind of talk be discouraged? Old-school business thinking certainly tried to stop it (some companies had official policies making salary discussions among employees an offense punished by termination), but that's silly because people will talk. So why not put their gossip to work for you?

Aubrey Daniels, an Atlanta management consultant and author of Bringing Out the Best in People (McGraw-Hill), gives an example of what to do when a disgruntled employee confronts you about a small bonus. "Just say, 'Would you like a bigger bonus?' When the employee says yes, tell him what he can do to make sure his bonus is bigger next time," says Daniels. "Be specific about the changes he needs to make."

Daniels adds that bosses should routinely engage in this sort of dollars-and-cents talk with all their employees. "This is exactly the sort of conversation that benefits the worker and your business. The more you do this, the better off you'll all be."