Selecting the Right Performance Measures for Your Incentive Plan
Two effective approaches to developing incentive plan indicators and all the associated factors a company needs to consider.
A successful incentive plan isn’t achievable unless it’s built on the right premise. Stated another way, most incentive plans fail because they are built on a faulty premise.
Company leaders create incentive plans believing they will impact employee behavior. When their plan doesn’t prompt the anticipated change, those leaders claim it “didn’t work” and become frustrated.
They then alter the plan metrics thinking that will solve the problem. But, if they started with the wrong premise, the new metrics only compound the problem.
So, let’s solve this dilemma, shall we?
Start with This Premise
To design a bonus or other short-term plan effectively, you must start by correctly identifying the purpose of your offering.
Your bonus plan defines the financial partnership you want to have with your employees. Sharing company wealth with them essentially does two things:
- Invites employees to share your vision for the company.
- Communicates the outcomes that need to be achieved to fulfill that vision.
Further, through the way you are paying employees, you are identifying how they will participate in the value they help create as they help build the future company; in other words, how they will be rewarded for achieving the outcomes their roles exist to produce.
The premise, then, upon which an incentive plan should be built is value creation.
The plan should grow out of a company philosophy which holds that employees will share in the wealth multiple they help create. As more value is created, more value sharing can occur. And that is the term that should be used to describe the incentive plan: value-sharing.
When you build a plan on a value-sharing premise, people are not rewarded for their behavior. They are rewarded for creating value. And the value creation that results in highest value sharing should be that which most aligns with shareholder interests. So, what might that highest focus be?
Choosing Metrics: Your Primary Focus
Presumably, if you lead a business, your primary focus each year is profit. Your business growth depends upon it. What, then, should be the primary measure you use to build your annual incentive plan? Profit!
This does not mean you can’t have other metrics and measures. But it does mean that profit should be primary. In other words, no matter how many other measures the company or department or individual meets, incentives will not be paid unless a certain profit threshold is achieved.
Once a company establishes a profit threshold, developing other performance metrics becomes easier. New metrics must be evaluated on a core question, Will this outcome drive greater profits?
If an outcome doesn’t result in greater profits, then that metric should probably be rejected or modified.
Why Companies Need Two Performance Periods
A Common Pitfall: “Bad” Profits
Companies should beware of developing incentive plans that improve profits today at the expense of sustained growth. Those are considered “bad” profits. And they occur too often.
Bad profits occur because business leaders unknowingly encourage them when they offer incentives rooted in the wrong premise. Here’s what I mean: A company sets up an annual bonus plan that maximizes payouts for achieving short-term performance goals. This compromises employee decision-making. They may end up exploiting a customer, vendor, or other department in their company to enrich themselves while eroding long-term value creation in the process. Profit is still generated, but it’s bad profit.
Reconsidering Company Performance Periods
The answer to this problem is to think in terms of two performance periods when building an incentive plan.
- Performance Period One: the next 12 months. Here, the focus is on achieving outcomes that improve revenue growth, expand margins, or lower costs without damaging sustained growth.
- Performance Period Two: long-term growth in the coming decade(s). This period focuses on rewarding enduring performance — results that drive business growth and increase shareholder value. Employees are encouraged to focus on outcomes that will improve business value (product development, acquisitions, new technology, expanded markets, etc.).
With these two periods distinguished, it makes sense that rewards for short-term performance should be tied to profits and rewards for long-term performance should be tied to business value increase. Why? Because the metrics correlate with the goals.
So, to summarize, the primary metric for a short-term plan should be profit. And for a long-term plan, the metric should be rooted in business value increase (which is really just sustained profits since you need profits to drive growth).
The distinction between short- and long-term metrics is necessary because it encourages employees participating in long-term plans to produce good profits since it works against their financial interest to think short-term.
Value-Sharing: What It Is and What It Is Not
For both performance periods mentioned above, the role of the primary value-sharing metric is to accomplish the following:
- Encourage effort toward outcomes that align with shareholder interests (increased profits and increased business value).
- Communicate the outcomes each person should prioritize in their role.
- Reward both short- and long-term performance.
Remember: value-sharing is not initiated in an effort to change behavior or “motivate” employees, per se.
Motivation is intrinsic, and each employee will have their own reasons to commit to high performance. However, motivation is facilitated when employees see alignment between their roles and tasks and how rewards are earned.
Plans with undefined performance standards or improper allocation of awards can potentially deflate employees’ motivation and create frustration and disillusionment — conditions that are at odds with a positive focus and a high-performance culture. Value sharing typically solves these problems.
Two Core Approaches for Short-Term Plans
Once you have established profit as the primary metric for your short-term plan, there are essentially two approaches you can take in constructing your plan.
1. Profit-Based Allocation
The design of this kind of incentive is relatively simple, but it is essential that it be accompanied by a strong performance management system.
Under this approach, a company decides that it will allocate a percentage of annual profits to employees. The award amount is divided among participants based on a predetermined formula. Typically, payouts occur at year end, but some companies prefer to make payments quarterly.
As indicated, the focus of this plan is solely annual profits. As a result, the incentive value created can be open-ended (unlimited), which maybe good or bad (more on that issue in a minute).
The design of this kind of incentive is relatively simple; however, it is essential that it be accompanied by a strong performance management system. Because rewards are driven strictly by company performance, not individual or department performance, a separate management system needs to be in place to reinforce the outcomes necessary for driving the right level of profits.
Basic Considerations for Profit-Based Allocation
Here are the basic steps for generating a successful Profit-Based Allocation system:
- Define profits. Will it be some version of EBITDA, net income, or some other measure? Also, the company must determine if there will be an economic “value-added” component to measuring profits, accounting for a certain return that must be achieved by shareholders before value inures to the benefit of employees.
- Select either a “benchmark” or “growth” approach. This establishes the baseline upon which contributions to the profit pool will be based. Most companies determine to set a standard upon which (or above which) performance must be achieved for incentive formulas to kick in. Others base incentives on the growth of profit each year — so as not to pay incentives during periods of stagnation.
- Identify a performance threshold. This ensures that a certain measure of profits (or benchmark improvement) is achieved before any payments are made under the plan.
- Select the percentage to share (fixed or tiered). This will establish the amount of profits that will be distributed in the form of awards. This can be a fixed amount for everyone or different for various “tiers” of employees within the organization.
- Select an allocation formula. This determines how the potential value will be communicated to participating employees (percent of salary, pro-rata allocation of pool, etc.).
- Determine the personal performance component. Define whether a personal performance standard will impact the degree to which an employee will/can earn benefits. If a component like this is employed, employee performance could modify their payouts up or down.
2. Targeted KPIs
The most essential step in this approach is selecting the right metrics.
The theory behind the KPI approach is that improvements in the focus and execution of employees on the issues they are best positioned to impact will lead, ultimately, to improvements in profits.
The value of the plan is typically capped, and its design can run from quite simple to very complex. The most essential step in this approach is selecting the right metrics.
The plan can incorporate company, department, or individual metrics — or all three. For example, company metrics might be a combination of revenue growth and net income. Departmental indicators could be such things as improvement in company retention or an increase in the collection rate on accounts receivable. Individual metrics would be tied to personal performance goals and productivity factors.
Here are some examples of company and department indicators that we have seen used in the past effectively. Of course, their application will vary depending on industry and other factors.
Dangers with the KPI Approach
There are a few dangers with the KPI approach that must be considered:
- Miscalculation (i.e., KPI improvements did not sufficiently offset failure to execute in other areas). This can lead to a company making incentive payments even though profits did not rise. This is why it is important to have a minimum profit target that must be met before incentives are paid.
- Gaming (i.e., employees learning how to achieve the KPIs but without respect to the profit goals). This can lead to intentional or unintentional failure to achieve profit objectives.
- Sandbagging (i.e., employees barely reaching KPIs while determining to carry-over performance into the next period). This can lead to failure to achieve full profit potential.
- Misalignment (i.e., forcing employees into behavior that moves them outside their skill sets and abilities). This occurs when extrinsic motivation overrides intrinsic motivation. The KPIs may be achieved while job satisfaction diminishes.
Must-Dos for KPI Plans
In our experience, the KPI approach works best if the company incorporates the following elements and steps.
Range of Incentive
Attractive target incentives should be established for each position. In general, growing companies size their incentives anywhere from 5% of salary for junior employees to 100% of salary for senior executives. The chart below displays an example.
Components of Incentive Calculation
The company should determine how much of an individual’s incentive will be based on (a) company performance, (b) department performance, and (c) individual performance. When determining this weighting, consider how much impact each person (position) is capable of having relative to the associated result area. The table below shows an example.
Pre-Determination
The incentive components should be established and communicated in advance of the incentive period (typically annually). The employee should be able to identify and understand the exact requirements associated with achieving his or her target incentive. For example, an incentive structure for a Department Head might be communicated as follows:
Tiered Awards
Incentive targets may be tiered to eliminate an all-or-nothing consequence. Commonly, three to five tiers are recommended. The payout results at each tier should be significantly greater than the preceding tier. Often, the plan grid (see below) can help produce this tiering effect.
Executives are often provided with clear measurement grids to help balance non-correlated or complementary goals.
Conclusion
There is no one perfect solution to designing an incentive plan that will be effective for every company. As a result, the way a company approaches the ideal is to understand best practice standards and frameworks and then work within that structure to customize indicators, measures, and metrics that are suitable for the business.
How a company selects its incentive plan and associated metrics should be based the company’s culture, business model, and goals. In this article, we have introduced two effective approaches to developing incentive plan indicators.
But regardless of the design you select, start with the right premise and use profit as your primary metric.
Originally published at https://visionlink.co.
