How to Create an Effective Incentive Compensation Plan

There are many ways companies can reward their employees for going above and beyond and performing exceptional work. One of the most effective, to borrow a line from a popular movie, is to "show them the money" by creating an employee bonus plan or incentive compensation plan.

But structuring an effective plan requires careful thought and strategy. Specifically, what do you hope to achieve with your bonus or incentive comp plan? Why are you creating the plan in the first place? Ideally, your plan should motivate employees to focus their efforts on activities that are directed toward achieving specific company goals.

Bonus vs. Incentive Plan

First, it's important to note the difference between a bonus plan and an incentive plan. An incentive is structured so that employees are incented to perform measurable tasks that lead directly to the accomplishment of company goals - increased sales or profitability, improved customer retention or acquisition, or the achievement of key performance indicators (KPIs), for example. Conversely, a bonus is a discretionary award given to employees after the fact - it is not necessarily aligned with company goals.

Given this, incentive plans are generally preferable to bonus plans for companies that view incentive compensation through a strategic lens. Among the challenges in creating an effective incentive plan are: 1) aligning the employee tasks (or goals) you're incenting with overall company goals; 2) making sure the employees' goals are measurable and; 3) setting employee goals that are achievable, but not too easy.

Employees' goals can be focused at the company, departmental or individual level. The primary drawback of setting broad, company-focused goals is that some employees might feel like they don't have much direct input into their achievement. For example, employees who aren't directly involved in sales might feel like there's little they can do to drive increased sales volume, or those not directly involved in customer service like there's little they can do to boost customer retention.

Structuring incentives around the achievement of departmental or individual goals may help employees feel like they have more control over their accomplishment. Individual incentive awards could be based on measurable improvement in personal productivity or an increase in personal billings, for example. Or, the compensation incentives of manufacturing employees could be tied to increasing production output or decreasing error rates.

Balancing Personal and Company Goals

Here are five suggestions to help you create an incentive compensation plan that will reward employees for achieving personal goals that also move the company forward in the desired direction:

1. Explain the plan clearly to your employees. Make sure all your employees understand how the plan works and what they must to do realize their incentives. Formalize the plan details in writing to help avoid confusion, and so you have a formal document you can refer back to if there are any misunderstandings.

2. Tie incentives to performance standards and goals that are finite and measurable. Goals shouldn't be open-ended, but should have a finite end date - usually the end of a quarter or year. And rewards should be tied to achieving performance standards that are specific and measurable, and upon which employees have some degree of influence.

3. Make sure there is enough "stretch" in the goals. Employees shouldn't be rewarded just for doing their jobs — this is what their salary is for. Their goals should stretch them to go above and beyond average performance, but not be so difficult that they aren't realistically achievable.

4. Design the plan so it's adaptable. Your company's strategies and goals will change over time, so your incentive plan should be dynamic enough to change with them.

5. Slant the plan toward your top performers. The employees who perform at the highest levels, and whose individual performance has the greatest potential impact on the company as a whole, should have the opportunity to earn the biggest rewards.

A Word of Caution

When structuring your incentive compensation plan, it's important to do so in a way that employees are not overly focused on the incentive to the detriment of other important aspects of their job. Otherwise, employees could engage in unwise actions in the pursuit of the incentive award. There are a few strategies that may enable you to avoid this scenario, including the following:

You have likely spent many years pouring sweat equity into building your business, and you rightly may want to reap the financial rewards of your labor by selling your company one day. Keep your focus on these value drivers in order to boost the sale price as high as possible.

  • Establish a cap or maximum on incentive payments (e.g., two times the target or no more than 100 percent of salary).
  • Have payment contingent upon company and/or division (not just individual) performance to goals (e.g., company performance must be at least 60 percent in order to fund incentive payments).
  • Require that a portion of the incentive payment be deferred for one or two years, with future payout contingent upon continued employment or continued employment and performance.
  • Reserve the right of executive management to make downward adjustments to incentives based on such factors as financial and individual performance or other behaviors inconsistent with company expectations.
  • Include a "claw back" provision whereby all or a portion of incentives must be repaid based on factors like inappropriate financials.
  • Adopt strong corporate governance, including active and effective oversight by executive management and the board of directors.
  • Ensure that your company's leadership and culture support and reinforce the appropriate and desired results and behaviors.

A well-structured incentive compensation plan presents a win-win scenario for your company and your employees. Enabling employees to reap financial rewards based on their performance will motivate many of them to work harder and smarter and make better decisions that are not only in their best interest, but are also in the long-term best interests of your company.

Be sure to discuss your incentive compensation plan with your company's labor counsel.

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