Keeping Merit Increases Within a Budget

“Sorry I can’t give the performance rating that you deserve. My hands are tied! I’ve been instructed to only give out a fixed number of top ratings and I gave you a top rating last year. To be fair, I need to give the top rating to someone else, who also deserves it and didn’t get it last year.”

Have you ever heard or said words to this effect in an annual review? In this sad situation, the company is trying to use performance reviews to manage other metrics, typically ones that affect budgets. Of course, this invalidates the whole concept of a performance rating.

What is needed is an approach that lets performance ratings influence merit increases but keeps the impact within budgetary constraints. This article will present one such approach.

Adopting this approach has 3 distinct advantages over the situation in our little story:

1. Management will be able to set exactly how much will be spent on merit increases, regardless of what ratings are given.

2. Supervisors will be able to give the performance rating they think each employee really deserves.

3. Employees can rest assured that their merit increase, if any, will be directly proportional to their performance rating.

This approach has a few requirements to implement:

1. Define employee groups.

2. Define the performance rating scheme for each group.

3. Define the budget amount for merit increases for each group.

4. Assign a performance rating for each employee.

5. Run the calculations for each group and employee.

If you are confident that you understand those requirements or are impatient, you can skip to the “Run the Calculations…” section.

Defining Employee Groups

This step is so basic that it has probably already occurred in nearly every company. Whether existing groups can be used for this approach will have to be determined, but in most cases, they probably will. That said, performance and merit increase groups can be a little different than established groups, to account for other factors. There can be as many or as few groups as seem reasonable and the approach will still work.

Defining a Performance Rating Scheme for Each Group

Performance and merit increase groups should be structured based on the intended performance rating scheme to be employed. You might decide that the performance expectations of each member within each group should be similar and that a performance rating might be very detailed. On the other hand, you might decide that ratings will be very general and broad and will relate to the entire company. In the first case, you might have very detailed parts of the performance review that relate to different aspects of the job, each with its own evaluation criteria and scoring method. The scores would roll up into an overall performance rating. In the second case, you might have only 3 ratings such as “does not meet expectations”, “meets expectations” and “exceeds expectations”. Of course, the rating system you choose could be anything in between. The approach being presented here is not dependent on the complexity of the performance review method. The only requirement is that a single overall numerical value used as a rating can be derived for each employee.

Define the Budget for Each Group

Each group defined above needs its own budget amount that will be allocated for merit increases. It doesn’t matter what timeframe the budget amount covers, but the final merit increase amount will be for a single employee for that same timeframe. Of course, converting it to other timeframes may introduce rounding changes that can change the overall amount, but those should be very small.

Assign a Performance Rating for Each Employee

This step should be obvious and is probably already happening in most companies. Whether the method is novel (such as the employee suggesting their own rating) or more traditional makes no difference to this approach. All that is required is that the employee has a numerical performance rating assigned.

Run the Calculations for Each Group and Employee

Now that all the requirements are met, the magic can happen. Before presenting the formulas, here are a few definitions from the requirements described earlier.

N: Number of employees in the group. As mentioned, you can have as many groups as you want and as many employees in each group as you want. You run the equations separately for each group.

B: Budget allotment for increases for the group being considered.

r: Numeric equivalent of performance rating for an individual employee (i.e., 0, 1, 2, 3, or 1, 2, 3…10, or whatever you want).

R: Sum of individual ratings for all employees in the group.

m: A single merit allotment unit.

i: Merit increase for a given employee.

And here are the formulas:

1. r1 + r2 + … rN = R where r1 is the performance rating for employee 1 etc. for employee 1 to employee N

2. B / R = m 3. r1 * m = i1

4. So i1 + i2 + … iN = B This may be approximate, depending on your rounding method.

Here is what the process would look like for a group of 10 employees, with employee numbers 1 to 10 and with a budget allotment of $1000. As mentioned earlier, the time frame for this budget allotment might be annual, pay period, hourly, or something else. We’ll say that the performance ratings range from 0 to 10 (zero might be equivalent to asking yourself, “Why is this employee still employed here?!”). For simplicity, we’ll also say that the ratings for the 10 employees just happen to be equal to their employee number. So, the first formula gives us this:

1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55 So, 55 becomes our value for ‘R’

The value for ‘B’ is $1000 and the value for ‘R’ is 55, so the second formula yields this:

$1000 / 55 = 18.181818…

You can round that according to your desires. To stay under budget, truncate or round down. We’ll truncate, so 18.18 becomes our value for ‘m’.

Now we can calculate individual merit increases. Since, for simplicity, we contrived the rating to be the same as the employee number, the first column represents either or both the employee number and the rating. The second column is the calculated merit increase unit, and the last is the actual increase.

The total for all merit increases is under the budget by $.10. This example is intentionally a little extreme and not expected to be true to life, but it shows that the process works regardless.

If this represents an improvement to the way your company handles merit increases and/or performance bonuses, it might be worth bringing to someone’s attention. Hopefully, it can be a change for the better for everyone!