3 Key Questions to Ask When Designing an Incentive-Compensation Plan
A Note From The Editor
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We are big fans of incentive compensation for two reasons: First, a well-designed system can motivate employees to deliver the performance you want.
Second, if you structure the compensation system correctly, you will have plenty of money to pay your employee if he or she earns the incentive, because your company will have done well.
One caution, however, is that in our experience, employees will do exactly what you incentivize them to do, and not necessarily what you want them to do. That’s reasonable. It’s unfair to expect an employee to behave in a way that will not be in his or her economic self-interest. You don’t need to look any further than the recent troubles at Wells Fargo for an example.
As the business owner, you must ensure that you system is incentivizing the employees to do exactly what you want them to do. In designing an incentive-compensation system, you should consider three key questions:
Can you afford the incentive compensation system?
This may sound remedial, but we have seen companies that built systems that paid employees incentives even though the company was losing money. As an example, a salesperson at a small mechanical contracting business we know of received a commission based on sales revenue.
The salesperson, who bid the jobs, would reduce their price to increase his sales and, in like manner, his commission. However, the company actually lost money on each sale once it applied the direct costs and overhead. We suggested that the owners pay the salesman a commission based on the gross margin that the projects actually made. This provided the appropriate incentive not to cut the price too far.
Are there problems around discontinuities?
Discontinuities occur when a small change in revenue results in a large change in compensation. For instance, this can occur when one more dollar of sales rewards the employee with a different level of bonus. To illustrate: Imagine that a salesperson receives a bonus of $500 for sales exceeding $100,000.
In this case the system would result in $1 of revenue being worth $500 (reflecting the $1 difference between $99,999 and $100,000 worth of sales).
Big stair-steps like this can cause behavior you don’t want. For example, a salesperson who is close to the discontinuity at the end of the month might well start calling customers begging them to accelerate their orders so that he or she can get the bonus.
Worse, a salesperson who realizes that he or she cannot make it to the next step in the bonus plan this month might ask customers to hold their orders until after the first of the month so that the order will count toward the next month’s sales total. We saw this behavior in a collection agency where the company capped employee bonuses at a specific dollar level.
The agents would work hard to collect money until they reached their full bonus. Then, after reaching this level, many agents would ask the debtors to delay payments until the first of the next month. This was certainly not the behavior the company desired.
In general, bad things happen around discontinuities. Therefore, we recommend an incentive-compensation system that doesn’t have major stair-steps. These systems may be a bit more complicated to design. However, it is possible to create an incentive compensation plan where rewards grow in a straight line rather than one involving stair-steps.
Will you be happy if your employee performs significantly better than expected?
We’ve seen this scenario too many times: An owner designs an incentive compensation system and then gets angry when an employee hits it out of the park. This happened in a small property-management firm we work with. The new manager we had hired broke all previous measures for rent collection, occupancy and lease renewals.
This woman's stellar performance, instead of making the owner thrilled, caused him to regret the generosity of his system. So, think your own incentive compensation system through. If your employee does twice or three times as well as you think he or she can, you should be thrilled, not upset because your employee is making too much!
If you anticipate that this won’t be the case, rethink your incentive compensation system. It is simply too rich.
Incentive compensation systems are powerful motivators. However, unless they are designed carefully, they can cause more problems than they solve. Answering the three questions above will ensure you get what you want from your employees.