Variable pay: linking salary to performance.

With the slowdown in the economy in the early 1990s, American business attempte to bring its ever-escalating payroll costs under control.

Cost-cutting programs included hiring freezes, downsizing/layoffs, lower raises and pay freezes and reductions. While these programs helped curb payroll costs, they didn't accomplish the goal of linking employee pay to organizational/individual performance. Increasingly, many believe traditional pay programs are not productivity related and that they simply continue to driv up the cost of doing business.

One approach to paying employees that both reduces fixed payroll expenses and creates a more direct link between pay and performance. This approach is commonly referred to as "variable pay."

In a recent Milliman & Robertson survey of 115 employers in the Southwest, abou 40% of the respondents indicated they have implemented some sort of variable pa program--such as gains sharing or lump-sum merit pay awards. This is up dramatically from a 1989 national survey of pay practices by the American Productivity Center that found only 30% had some sort of variable pay program.

What Is Variable Pay?

Organizations know variable pay by different names: profit sharing, group/team incentives, gains sharing, variable merit pay or performance sharing incentives What these programs have in common is they are incentive plans that cover most (if not all) employees while focusing on productivity objectives.

Under a variable pay program, an employee may receive--in addition to potential base salary increases--an annual or sometimes quarterly, lump-sum incentive award. The size of the variable pay award depends on the worker's base salary level, and individual, departmental and corporate performance.

Although people often refer to variable pay plans as "lump-sum salary increases," the term is misleading. Variable pay is closer to an annual bonus award than to a salary increase. Like a bonus, it must be earned each year.

"Lump-sum salary increase" suggests employees will lose nothing under a variabl pay program. In reality, while some employees lose nothing or even gain, others may find their total cash compensation declining in a given year. This feature allows a company to more effectively control its payroll expenses.

Although there is a variety of variable pay plans, this discussion is limited t variable merit pay and gains-sharing plans.

Variable Merit Pay

Under this plan, employees are eligible to receive variable pay awards--based o individual performance--in lieu of base salary increases or in addition to them Three basic types of variable merit pay plans are used the most.

Straight Bonus--This approach is most commonly used by companies that pay above the competitive external labor market (salary range mid-point). Generally, employee base salaries are frozen and all future pay increases are given as lump-sum bonuses.

The biggest drawback to a straight bonus approach is that base pay can eventually fall below competitive levels. To correct this, employers periodically increase the bonus to ensure total pay remains competitive.

However, companies must be careful not to rely only on lump-sum bonuses for compensating their general work force. When the size of bonus awards increases regularly, the mix between fixed and variable compensation can become unbalanced, with too many lower-level employees' total cash compensation placed at risk based on company performance.

Bonus/Base Salary Increase--This plan consists of two components:

* a base salary increase program equal to the yearly increase in the external market or cost-of-living index;

* a variable bonus award based on company and individual performance.

Employees with base salaries below the competitive external market are eligible to receive a raise, depending on their job performance and the cost-of-living increase, and a possible variable pay award based on their individual performance and the company's or department's performance.

Employees with base salaries equal to or above the competitive external market are only eligible to receive variable pay awards until their base salaries fall below the competitive market. Thus, all workers whose job performance is rated as "meets standard" or better have the opportunity to have their base salary increased to a level that meets the competitive market.

Employees whose job performance is rated as "below standard" will quickly find their base salaries and total case compensation at a competitive disadvantage. Those with base salaries above the competitive external market still may earn variable pay awards that aren't built into their base salary levels.

"Star Performer" Bonus/Base Salary Increase--This approach resembles the bonus/base salary increase method, except for one feature: the variable bonus awards paid to outstanding, or "star performers," can become part of their base salary if they are rated as outstanding for two or more consecutive years. Whil this program is more complex and expensive, it attracts and retains employees who are truly superior performers. Workers with job performances rated as less than outstanding but at least "meets standards" would be covered under the bonus/base salary increase approach.