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Delivering incentive compensation plans that work.

Employees with "skin in the game" work harder and smarter. Though senior executives and salespeople have been the traditional recipients of highly leveraged compensation plans, line managers, sales support staff, marketing staff, engineering project team members and many other employees will also work harder and smarter with the right compensation plans motivating them.

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But why are there so many horror stories related to incentive compensation plans? How could a world-leading company like American International Group Inc. implement plans that paid out hundreds of millions of dollars in the same year the company almost went out of business?

The message is this: Incentive plans can be expensive, and the more expensive they are, the more effective they're likely to be. And because they're so effective, the more disastrous they can be if poorly conceived or executed. Moreover, with greater expense comes greater visibility--not only internally, but with the investment community and even the general public.

Creating incentive compensation plans that actually work involves: thoughtful, intelligent construction; clear, powerful communication to all of the recipients; and clearly identified roles. And the CFO is essential for ensuring the plan's success.

Intelligent Construction

A well-designed plan must face tests in a number of areas. In each, ask the following questions:

* Metrics tie to enterprise objectives. Do the compensation metrics (such as revenues, new customers, profits, completion timeliness, number of cold calls, presentations given, etc.) have a logical relationship to and impact on top-level corporate, functional or departmental objectives?

* Metrics are comprehensible. Can most employees understand the metrics on which their compensation is based? Do they understand how their actions affect these metrics? Are the metrics objectively measurable? Do the metrics routinely appear in regularly published management reports?

For example, it is fine to assert that, say, "return on net corporate tangible assets" (RONCTA) is highly correlated with stock price, but if employees don't understand how RONCTA is calculated or how their own performance relates to it, this assertion is meaningless.

* Plan works over a range of performance. Does the plan "behave properly" across the entire range of likely performance outcomes? Are overachievers properly rewarded? Do underachievers see smaller paychecks?

One method worth special attention is accelerated compensation plans. These are plans where the compensation rate increases as performance relative to target improves. For example: a sales commission plan where a sales rep earns $100,000 in commissions at exactly 100 percent of quota, $225,000 at 200 percent and $375,000 at 300 percent. Though extremely effective in attracting and rewarding star performers, these plans tend to be more complex and require extra care to implement.

* Plan is mathematically sound. Is the plan intuitively sensible from a computational perspective? Does the math work properly over the entire range of likely performance? What are the possible unintended consequences? Be especially wary of how the following characteristics can affect participant behavior:

Capped amounts. Will participants stop trying to improve on a metric once the payout cap is reached, or "sandbag" performance into future periods?

Binary payouts. These are payouts tied to achieving exactly 100 percent of the objective, with no payout for less and no additional payout for more. This approach does not motivate employees who are already achieving 100 percent or more. It also does not motivate anyone under 100 percent who sees no hope of reaching that goal.

"Orthogonal" plans. These plans tie compensation to several metrics at once. A common example is tying sales commissions to both total volume and the timing of production during the year. These types of plans can make compensation a useful tool for motivating employees to make intelligent tradeoffs in complex situations. Be careful, however, to avoid unintended incentives, such as rewarding production that drags into future periods.

* Amounts are meaningful. In a well-meaning effort to compensate for all important aspects of behavior, has your company "sliced and diced" the plan into so many individual, separately measurable components that the payout associated with each is so small that it's not worth much effort by the employee? This is a critically important tradeoff to understand.

* Plans are cross-supportive (not "fratricidal"). Various functional areas depend on each other for mutual success, but still have their own incentive plans. This is especially typical for sales organizations with multiple channels and for all the functional areas that salespeople depend on daily, such as pre-sales support, technical support, product marketing and business development.

Do the various plans encourage cooperation among these functional areas? Do they encourage channel conflict only up to a level that is normal and healthy in a typical organization?

For example: An engineering project team bonus tied solely to timely product completion will motivate the team to deliver the product as quickly as possible, regardless of quality. Basing the bonus partly on completion date and partly on some measure of product quality enables the team to make reasonable tradeoffs between the two.

The goal is to compensate everyone for performing in the way the company wants them to behave. If all of the plans meet that criterion, and there are still the conflicts described above, the problem typically is not with the plans, but with how the company's overall strategic direction has been articulated within the different functional areas.

* No "moral hazard." All incentive compensation plans encourage people to "push the envelope" at least a little bit, but does your plan make questionable or unethical behavior unreasonably attractive? If so, are there built-in controls and processes that make that sort of behavior easy to uncover?

For example: in enterprise software, revenue recognition is complex and requires open and honest communication between the sales and accounting departments. In such situations, it may be more appropriate to base sales commissions on orders, bookings, invoices or cash collections than on recognized revenue.

Clear, Powerful Communication

Designing the world's most intelligent, rational and elegant compensation plan will mean nothing if the participants don't understand how it works. Again, ask yourself the following questions in several key areas:

* Presentation is consistent and thorough. Are all communications about how the plans work clear? Do they show a level of care, quality and precision suggesting to employees that the company takes incentive compensation seriously? Does communication include a formal oral presentation in an appropriate forum and not just an email message?

* Tools are in place. Have the participants been provided with spreadsheets and other documents so that they can fully understand their plan? More importantly, can they play "what-if" and understand how much they might earn from future efforts?

* The company "sells" as well as "tells." Do communications include the why as well as the what, so participants understand how their individual performance is essential to the company's overall success? Does the company seem enthusiastic about the potential outcomes and the opportunity for many to share in its success?

Are the oral presenters senior enough to demonstrate that compensation is an important management focus and do they themselves understand how the plans work? Is 100 percent achievement perceived as actually being in the realm of possibility? If not, you're better off lowering both plan objectives and target compensation; most people are happier to earn 100 percent of a $2,500 target bonus than 50 percent of a $5,000 target, even though the money is the same.

* Administrators are trained. Have the people responsible for tracking performance and calculating payouts been properly trained to administer the plans? Do they understand how the plans work? Have the compensation metrics and algorithms been set up so that the plans can be administered without unreasonable additional effort and without putting the administrators into therapy?

Clearly Identified Roles

Incentive compensation plans that work require competent and effective involvement from a number of players across the organization, including:

* Board of directors (especially compensation committee members). Incentive plans are complicated. It's not enough to simply agree on who has incentive plans and what target compensation levels should be. Understanding how the plans really work--or a least having confidence that management has a deep understanding--is an essential element of good governance.

The board must also understand that a deal is a deal. If payouts seem, in retrospect, to have been inconsistent with corporate results, paying them as agreed is Jess destructive in the long run than the morale damage and employee turnover that can result when employees believe that compensation plans are nothing more than "serving suggestions."

* Senior management. The executive staff must articulate not only the overall corporate strategy, but the specific tactics to get there. Without this, it's impossible to identify the performance metrics at the heart of all incentive compensation plans. Senior management also acts as conduits of information between all the players, both above and below them in the hierarchy, and to do that effectively, they have to understand the plan's details themselves. For better or worse, incentive compensation is one area where it's unwise and dangerous to separate strategy from tactics.

* Implementers/administrators. It's essential that the people creating and administering the plans have the computational and technical skills to implement what was actually agreed upon and the communications skills to develop clear documentation. The ongoing administrators also need to understand the plans in detail and be able to articulate how they work to employees.

* The CFO in particular. The CFO role in delivering incentive compensation plans that work is unique and pivotal. Not only does the CFO have a foot in all three of the above camps--albeit indirectly through "face time" with the board--he or she is often the only person with the skill set, the knowledge base and the stature needed to play an effective role in each of these key areas: articulating, constructing, communicating and administering.

RANDALL BOLTEN (randy@painting-with-numbers.com) is CEO of Lucidity, a Menlo Park, Calif., consulting/coaching practice focused on enterprise finance tasks. He's a member of FEI's Silicon Valley Chapter and author of the forthcoming book Painting with Numbers: Presenting Financials and Other Numbers So People Can Understand You.
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Title Annotation:COMPENSATION
Author:Bolten, Randall
Publication:Financial Executive
Date:Sep 1, 2009
Words:1662
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