Choosing Incentive Plans

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February 21, 2012

"The right incentive plan properly implemented can drive your business ahead like a rocket ship. But if expectations increase faster than actual payouts-watch out for trouble!"

Incentive Plans Can Pull Companies Together!

Years ago the only employees offered incentive pay were sales personnel, piece workers, and top executives. Today most large corporations, and many smaller firms, offer an incentive package to all of their employees. Some kind of incentive pay is an important part of any compensation plan. Incentive pay shows appreciation and creates a sense of participation in the company's well-being that straight salary dollars, no matter how large, don't convey. A well-designed incentive-pay plan can also help pull people together, help point them in the direction you want them to go, and give that extra push that every company needs in today's competitive environment.

Profit-Sharing Plans Are Common

Profit-sharing plans are probably the most widespread incentive-pay programs at larger corporations. They are generally company-wide and made available at least to all full-time employees. Usually the company will contribute a small percentage of its pre-tax profitability to a pool, which is then divided among eligible employees. Division is typically prorated according to the base salary of each participant. Profit sharing is generally done on an annual basis. Profit plans work best at more established firms with relatively steady earnings. The criteria for the profit plan must be carefully defined in advance.

Profit Plans Don't Always Work

The advantages of a profit-sharing plan include: It pulls people together since everyone is on the same plan; it gets people to focus on profitability; and its cost to the company goes up and down in sync with pre-tax earnings. The disadvantages include: It echoes the base salary; it does not take into consideration performance during the year; it is focused on a single objective. For smaller companies with erratic earnings, profit-sharing plans can frustrate and irritate employees by creating expectations that are not fulfilled each year. Quite often we hear, I switched away from a profit-based incentive plan because I found that a small payout level, following a year of weak profitability, made a low morale situation even worse.

The weakness of profit sharing plans is that individual employees cannot see and know the impact of their own work and actions on the profitability of the company. Consequently, while employees enjoy receiving the profit sharing money, it gradually becomes more of an entitlement rather than a motivational factor. With profit sharing, employees receive the profit sharing money regardless of their own performance or contribution. 

Evolution in Profit Plans

Over the past 10 years, most companies have moved away, from ‘profit sharing plans’ where the majority of the payments were often placed in a trust for increasing the employee payout on retirement. Today, the majority are cash plans that typically appeals to a younger skewing workforce or one that tends to live paycheck to paycheck. Might be paid in cash (sometimes stock), but all bonuses are taxed as part of an employee’s overall wages. (In the USA there are some issues re Federal /state taxation issues)

Implementing a Profit Sharing Plan: Determine Your Purpose!

The most important step in implementing a successful profit sharing plan is to have a clear idea of what you want to accomplish through the initiative. Any successful plan will have clearly defined written terms, but there's plenty to consider when drafting the document. "What we've found with profit sharing programs is that if they're not really thought through, they can become a huge negative,”. One way to avoid this is to make sure you solicit input not only from the experts, but also from within. Include all sectors of your company in the discussion, as they'll all be getting a share of the profits. The process of drafting your profit sharing plan is highly individual and should cater to the company's individual needs and goals. Some of the most successful profit sharing and bonus programs have evolved each year as the CEO fine tunes different aspects of the plans that aren't working each year. You need to decide upon the formula in which you will allocate the profits among employees.

One of the biggest problems with a cash profit sharing plan is that people don't know how they can individually influence the overall profit of their company, "If you have a highly profitable year, everyone gets to participate in the profit sharing program, but nobody learns anything about the company or what they did to influence that profit." To make your plan successful, educating your employees is crucial.

This can even be as basic as making sure they understand the principles behind profits, and how they work. Even though front-line employees in administration or accounting may not control many factors that lead to profitability, such as marketing and pricing of products and services, part of the implementation of the profit sharing plan should seek to educate them of their community role, beyond their narrow job description.

The education is part of an ongoing communication process that is necessary to maintain a successful profit sharing plan. Without frequently communicating to your employees about what the company istrying to accomplish, and what the revenue targets are and how close they are to being met, the plan can become routine and a share of the profits can even become expected. "The worst thing that happens is, in a down year, when there are no profits; people are angry and upset because they don't know what happened. By communicating to them how the process works, you can combat any potential sense of entitlement amongst your employees. Open-book management, in which employees have extensive knowledge of the company’s financial information, can be effective strategies for helping employees understand the process.



I might stop here and say that most of these programs provide no incentive to anyone and never deliver the promised results. Why not? Because in 9 cases out of 10, they are not true bonus programs at all! They are simply profit-sharing programs, and there is a world of difference between the two.

By profit sharing, I mean the practice of taking a percentage of a company's profits, putting it into a pool, and disbursing it to the company's employees, usually sometime after the close of the year. Understand, I'm not saying that this is a bad thing to do, just that the benefits of doing it are limited. ‘the recipients seldom know exactly how they helped generate the profits, beyond just doing their jobs’. No doubt, they enjoy getting the money. They may even be grateful for it. But they aren't likely to think or act differently because of it or to be greatly motivated by it.

What's more, if they keep getting it, they will eventually come to expect it, depend on it. If they don't know what they've done to deserve the extra money, they will begin to view it as part of their regular compensation--that is, as an entitlement program. At that point, the profit-sharing check is a bonus in name only, no matter how much the amount may vary from year to year. Meanwhile, you're getting results that are the opposite of what you're paying for. You're promoting the same attitudes you had hoped to change by moving to variable pay in the first place.

A bonus program, a real bonus program, is altogether different. Its whole purpose is to make the company stronger, more competitive, and able to survive and prosper in the months and years ahead. Earning a profit is just part of it. What really determines a company's success, after all, is its ability to generate cash and make smart decisions about how to use it.

A good bonus program draws people into that process. It drives the value of the company by educating people, not with formal training programs but through the work they do every day on the job. It gives them the tools they need to make and understand decisions. It provides them with business knowledge they can use to enhance their own standard of living and job security as they're making a measurable difference to the company as a whole. There is no greater motivator in the world than the opportunity to make a difference, to contribute, to do something significant for yourself and your communities, by which I mean the people you work with, the company you keep. I'm not denying that money can be a motivator as well, but it has much more power when it's earned rather than bestowed. So what are the essential elements of a good bonus program? I believe there are four:

First, you need clear goals that people understand and accept because they've had a voice in setting them, goals that affect the health and the wealth of the entire community.
Second, you need to provide frequent feedback--on a weekly, even a daily, basis.
Third, you need to give people an opportunity to work with one another to achieve the goals.
Fourth, you need targets that require some effort. The payoff shouldn't be a sure thing. I'm not talking about having stretch goals, which are almost always demotivational, but neither should the targets be so easy that people can take them for granted.

A good bonus program is a kind of insurance policy. It gets everyone involved in going after a company's greatest weakness--something that represents a threat to its long-term survival. Such weaknesses can usually be expressed in the form of a financial ratio, but you don't start with the ratio. You start by asking people to talk about the greatest threats to job security. You bring them into a discussion of the company's vulnerabilities and then identify the ratio that targets the most critical one. That's your critical number. It's the number through which you can have the greatest impact on your company's value during the coming year. In effect, you put a bounty on that number and say, "By hitting these targets, we can drive out this big weakness and strengthen the company, and so we're going to give ourselves a reward if we do it."

Notice, I'm not saying profit should be a goal of the bonus program. I'm saying it should be a goal only if lack of profit is one of your company's greatest weaknesses. Even then, I'd say you should target a profit driver rather than profit. By profit driver, I mean the number that determines profit in your business— in the hotel industry such as the occupancy rate (nightly backs on beds): airlines (backsides in seats) or billable hours in a telemarketing business. (See Appendix A - The Logic of Profit-1996)

Why? Because you want people to think for themselves, to figure out in their own what they can do to improve the critical numbers. The better they understand the different elements of the business, the more likely they are to make the big plays. But, to make any play, they have to be able to see the connection between their actions, decisions, and participation, and changes in the critical numbers. That connection is difficult to perceive with profit alone, which represents an accumulation of everything that happens in the business over a given period of time. You're far better off with critical numbers in which the connection is clear, one that each person can relate to his or her job. Then people can use the number to identify the specific problems they must solve to reach the goal.

And they'll learn more as a result, because learning is problem-driven. People do more and learn faster when they're trying to solve problems. They teach themselves. With straight profit as a goal, they usually wind up depending on you to tell them what to do, and then they learn very little.

So what exactly is the management's role if not to tell people what to do? It's to provide constant

feedback on the program, to give it high visibility and total support. No bonus program will work if you don't work at it; people won't believe it or care about it. You have to sell the program all year long. You have to keep it out in front of everybody at all times. You have to use every tool in the book--learning maps, thermometers, weekly huddles, daily chalk talks, posters, balloons, celebrations, you name it. I suspect more bonus programs die from lack of rah-rah and hoopla than from any other single cause.

If our bonus program is a good one, it's delivering a huge message that should be easy to understand. We need to make sure the message is repeated over and over in ways that are interesting and fun. Because repetition is essential to education and education is what the bonus program is all about.

In fact, I know of no better way to teach people what it takes to be successful in business, and you don't have to take them away from their work to do it. With a good bonus program, you're providing on-the- job training in basic business skills. Every year, you have an opportunity to introduce a new ratio or concept and let people go after it, learning in the process how their actions affect their job security. There are a lot of ratios we can work on--including the debt-to-equity ratio, inventory accuracy, the current ratio, the charge-out rate, and return on assets, and diversification. That's a lot of education, and it will give us a very smart workforce, and a clear competitive advantage.

If we weren't educating through the bonus program, we'd have to set up all kinds of additional training programs at considerable expense, and they wouldn't be nearly as effective. Because education in this form is not a burden or a chore! It's a motivator. People like to use their brains on the job. They like to be smart. They like to be going somewhere, to feel that they've achieved something. With the right critical number, you can use a bonus program to create a whole series of little games in which people can expand their education, improve their standard of living, and see how they're making a difference-- all at the same time. And when the bonus comes, they know they've earned it. They know they're getting the reward because they took responsibility, because they increased the economic value of the company and strengthened the community. It's not a gift, and it's not an entitlement. It's payment for a job well done. And they come to expect and look forward to a new challenge in the following year, and another in the year after that.

With a profit-sharing program, you get none of that. You're just giving away money. You may please some people by giving them a chance to earn more if they work harder, but you're not giving anyone the tools to work smarter. People don't take responsibility for themselves. Whether they want to or not, they don't know how. As a result, you may wind up reinforcing the old bad habits you want to get rid of ‘the-us-versus-them, it's-not-my-job, just-tell-me-what-you-want attitudes of the past’. And when the level of profit sharing declines, its top management that gets the blame!

Of course, profit sharing does have one advantage: it involves a lot less work than a bonus program does. We may not see a need to invest the time and effort a real bonus program demands. Perhaps all we want is a carrot we can hold out to people at a time when we can't afford to give regular merit raises. If so, profit sharing may be just right. I like to get the maximum benefit from the dollars spent on bonuses, and knowing that everyone is worrying about the company's vulnerabilities, not just the CEO. Yes, you have to work at a bonus program, but it can be been worth everything you put into it. Quite simply, it can become of the most powerful tools for keeping jobs secure and any company strong.

Some areas of a Program we should consider!

A ‘bonus scheme’ but not based entirely on profit.
Where feasible we should designate groups within the company that have synergy and create goals and rewards that can suitably recognize their contribution and value to the overall success of the company. The parameters could include the recognition of:

  •   Service with the company – tenure coupled with absenteeism

  •   Ratings by their peers – how each is living up to the firm’s core values

  •   Function within the company (scale)

  1. A payment structure that provides for quarterly payments or shorter than annually.

  2. A customer satisfaction metric

  3. What financial metrics are critical for success – need to be improved

Profit will come by making all these things happen in unison.

Different folks, different strokes!

Bonus programs are as varied as the companies that offer them. No one program fits all needs. But most aim to encourage one of two basic corporate objectives: teamwork or individual accomplishment.

For companies with relatively flat organizational charts where most employees do the same thing

(manufacturing and banking, for instance), team-building techniques such asgroup-

incentive and gain-sharing plans help everyone pull together toward specific corporate goals.

  •   Companies that are more entrepreneurial or sales oriented may get better results by rewarding

    individual performance through a merit-based bonus program.

  •   Companies with high turnover or varied skill sets may want to consider competency-based, skill-

    based and Small-group incentive approaches.

  •   If there are already too many rungs on your wage ladder, you might consider broad banding, which

    allows for greater flexibility to reward top producers but still encourages teamwork.

Regardless of which plans you use, it's important to set realistic goals that your employees will view as fair and achievable. A 40-percent projected increase in sales may delight our shareholders and pump up the sales team, but we'll need a more conservative target to interest the rank and file.

"Small companies, we have found need to be a little bit more creative about all of the things that motivate people," "Many of them can't afford to compete with the larger companies. The key for them is, don't try to. Create an environment where people want to work for you for a fair and good wage, treat people right, treat people fairly, and give them an opportunity for creativity and to make an impact and give them a lot more contact with decision-making. You're not going to compete in pay, but you can do it in lifestyle and decision-making." "The bonus programs that tend to go wrong are the ones that aren't grounded in quantitative measures, they're totally qualitative. I call them the Santa Claus bonuses, “They breed expectations. People work hard, or at least they think they work hard. It sets people up for disappointment."By contrast, performance-based bonuses don't depend on you -- they depend on them.

Will everyone love a performance-based incentive program? Not likely. You can't have a goal of wanting to make everyone happy because people just don't tend to be happy about their pay, "I think the key is to make sure you're doing it in a fair and consistent way."  Download PDF version


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