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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 sales·peo·ple  
Persons who are employed to sell merchandise in a store or in a designated territory.
 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.



But why are there so many horror stories horror story

Story intended to elicit a strong feeling of fear. Such tales are of ancient origin and form a substantial part of folk literature. They may feature supernatural elements such as ghosts, witches, or vampires or address more realistic psychological fears.
 related to incentive compensation plans? How could a world-leading company like American International Group
"AIG" redirects here. For other uses, see AIG (disambiguation).

American International Group, Inc. (AIG) (NYSE: AIG; TYO: 8685 ) is a major American insurance corporation based in New York City.
 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 See Chief Financial Officer.  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 metrics Managed care A popular term for standards by which the quality of a product, service, or outcome of a particular form of Pt management is evaluated. See TQM.  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 com·pre·hen·si·ble  
Readily comprehended or understood; intelligible.

[Latin compreh
. 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 Tangible Asset

An asset that has a physical form such as machinery, buildings and land.

This is the opposite of an intangible asset such as a patent or trademark. Whether an asset is tangible or intangible isn't inherently good or bad.
" (RONCTA) is highly correlated cor·re·late  
v. cor·re·lat·ed, cor·re·lat·ing, cor·re·lates
1. To put or bring into causal, complementary, parallel, or reciprocal relation.

 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 quota

In international trade, a government-imposed limit on the quantity of goods and services that may be exported or imported over a specified period of time. Quotas are more effective than tariffs in restricting trade, since they limit the availability of goods rather
, $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 Having to do with calculations. Something that is "highly computational" requires a large number of calculations.  perspective? Does the math work properly over the entire range of likely performance? What are the possible unintended consequences For the "Law of unintended consequences", see Unintended consequence

Unintended Consequences is a novel by author John Ross, first published in 1996 by Accurate Press.
? 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 pay·out  
1. The act or an instance of paying out.

2. A percentage of corporate earnings that is paid as dividends to shareholders.
 cap is reached, or "sandbag Sandbag

A stalling tactic used by management to deter a company that is showing interest in taking them over.

The company stalls in hopes that a more favorable company will take them over.
" performance into future periods?

Binary Meaning two. The principle behind digital computers. All input to the computer is converted into binary numbers made up of the two digits 0 and 1 (bits). For example, when you press the "A" key on your keyboard, the keyboard circuit generates and transfers the number 01000001 to the  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 At right angles. The term is used to describe electronic signals that appear at 90 degree angles to each other. It is also widely used to describe conditions that are contradictory, or opposite, rather than in parallel or in sync with each other. " 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 frat·ri·cide  
1. The killing of one's brother or sister.

2. One who has killed one's brother or sister.

[Middle English, from Old French, from Latin
"). 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 Moral Hazard

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the
." All incentive compensation plans encourage people to "push the envelope" at least a little bit, but does your plan make questionable or unethical unethical

said of conduct not conforming with professional ethics.
 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 terms governance and good governance are increasingly being used in development literature. Governance describes the process of decision-making and the process by which decisions are implemented (or not implemented). .

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 jesse, jess

a leather strap placed around each shank of a hawk used for hunting, for the attachment of a leash.
 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 Performance metrics are measures of an organizations activities and performance. Performance metrics should support a range of stakeholder needs from customers, shareholders to employees [1].  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 Adj. 1. agreed upon - constituted or contracted by stipulation or agreement; "stipulatory obligations"

noncontroversial, uncontroversial - not likely to arouse controversy
 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 stature /sta·ture/ (stach´ur) the height or tallness of a person standing.stat´ural

The height of a person.


the height of an animal in the standing position.
 needed to play an effective role in each of these key areas: articulating, constructing, communicating and administering.

RANDALL BOLTEN ( is CEO (1) (Chief Executive Officer) The highest individual in command of an organization. Typically the president of the company, the CEO reports to the Chairman of the Board.  of Lucidity lucidity /lu·cid·i·ty/ (loo-sid´it-e) clearness of´cid

Clarity, especially mental clarity.
, a Menlo Park Menlo Park.

1 Residential city (1990 pop. 28,040), San Mateo co., W Calif.; inc. 1874. Electronic equipment and aerospace products are manufactured in the city. Menlo College and a Stanford Univ. research institute are there.

2 Uninc.
, 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
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