The Key To Using Performance Incentives

By Marc Emmer

[dropcaps type=”circle” color=”” background=””]T[/dropcaps]he “Great Recession” was unlike any other downturn within our experience. Its effects were deep and sudden; many organizations have felt as if they had fallen off a cliff.

One key lesson of the downturn and the giant sucking sound that followed was that businesses must be prepared for the ebbs and flows of demand, and must minimize fixed costs. Pre-recession, many companies faced rising labor costs as a result of spiraling workers compensation insurance and health care rates.

Many entrepreneurial companies utilize informal, subjective incentive plans with very high proportion of cash compensation paid out in salaries. The result is that labor costs are somewhat fixed and not married to revenue or demand. The only way for companies to cut their labor expense (when they are fixed) is to lay off workers.

While almost every Fortune 500 company employs some sort of pay-for-performance system, adoption is slower in entrepreneurial environments. Thus pay-for-performance is emerging as an important opportunity for small and mid-market companies seeking to control their profitability.

The efficacy of pay-for-performance from a motivation standpoint has been subject to vigorous debate. Yet the broader implication for companies is undeniable: pay-for-performance allows an organization to align its organizational priorities and financial performance, with the compensation it pays to its employees.

Within my experience, there are three things best-in-class companies do well:

•  They have a clear vision of the future (strategy)
•  They convert the strategy into operational terms
•  They bring their employees along for the ride

An effective scorecarding system can be the conduit between strategy and creating a management system that drives the individual performance of employees. Only once the success factors within a company and the resulting scorecard measures are identified, can an effective pay for performance system be employed.

Pay-for-performance is highly controversial and making changes to compensation systems tend to be hotly debated. I always say pay-for-performance is a lot like capitalism, it is imperfect, but it is still the best system I know. Clearly, financial incentives work best when married with other forms of motivation (such as positive reinforcement). Incentives will only change behavior when they provide an adequate proportion of compensation (20% or more). Companies that are very good at performance management use incentives as part of a performance cycle where goals are set with employees (based on the underlying strategy), and their performance is managed through the course of the year (or whatever cycle is used). Incentives are only the culmination of much discussion about how an employee increases his or her productivity and skill sets.

Pay-for-performance can take on many forms. Within our firm, we advocate for a multi-bucketed design of such plans as follows:

Bucket 1 – The financial performance of the organization
Bucket 2 – Scorecard results (numbers shared by a department or across functional departments)
Bucket 3 – Individual contributions from the employee

Organizations utilize different buckets and weighting based on a number of variables, but financial results are often heavily weighted (as high as 50%). The bucketed approach provides a balanced solution to the most compelling problems with incentive plans.

When companies pay subjective bonuses, they create an entitlement, and expose themselves to legal liability (discrimination, wage and hour, etc.). Subjective bonuses often generate two undesirable outcomes. In some cases a company performs well but individual employees do not. When equal bonuses are handed out to employees, bonuses can reinforce poor performance. The reverse is also true. When an employee performs well and their company does not, if they receive no bonus, they are de-incented. Thus the bucketed system provides the most equitable of outcomes; most strong performers will earn some bonus when business is good and a lessor pay out when business is poor.

To launch a pay-for-performance plan requires effort and timing. Most companies establish a bonus pool to be distributed only after some minimum level of profit is realized. If an organization has historically paid out subjective bonuses, the roll out of a plan causes some distress. There are always employees who will fight the use of incentives. As a general rule, good performers like performance measurement, and poor performers do not. Deploying such a system requires significant managerial courage and discipline.

As rolling back salaries is implausible, one approach is to freeze salaries in a given year and incrementally increase the richness of a bonus pool until it reaches a level of contribution that is meaningful (this could take 3-5 years if you are starting from scratch). Over time, an organization can shift from a lack of accountability to one in which goal setting is expected, and the incentive plan is part of the DNA of the company. It is strongly recommended that companies adopt a scorecard first, and gain momentum around measurement before moving to pay-for-performance. When employees become aware that their contributions will be measured through numbers, they can become highly territorial about which numbers are used, which can defeat the process.

There has never been a better time to deploy a scorecard and pay-for-performance system. As employees have had to absorb pay cuts and lay offs, they have a greater sensitivity to the requirement that their organizations sustain a profit. Leveraging labor efficiently and marrying it to corporate performance has become a strategic imperative.

Finally, a thought from Dana Borowka, CEO of Lighthouse Consulting Services, LLC (www.lighthouseconsulting.com) and author of Cracking the Personality Code, that hiring the right people is key to future growth. If you would like additional information on raising the hiring bar, please click here to see an article on this subject:

Permission is needed from Lighthouse Consulting Services, LLC to reproduce any portion provided in this article. © 2014

Resources on this topic: Intended Consequences by Marc Emmer, The Compensation Handbook by Lance Berger

Marc Emmer is a speaker, author and consultant, recognized throughout North America as an expert in strategic planning and performance improvement. Marc is President of Optimize Inc. a management consulting firm specializing in strategic planning. Marc can be reached at 661-296-2568 or at [email protected].

If you would like additional information on this topic or others, please contact your Human Resources department or Lighthouse Consulting Services LLC, 3130 Wilshire Blvd., Suite 550, Santa Monica, CA 90403, (310) 453-6556, [email protected] & our website: www.lighthouseconsulting.com.

Lighthouse Consulting Services, LLC provides a variety of services, including in-depth work style assessments for new hires & staff development, team building, interpersonal & communication training, career guidance & transition, conflict management, 360s, workshops, and executive & employee coaching. Other areas of expertise: Executive on boarding for success, leadership training for the 21st century, exploring global options for expanding your business, sales and customer service training and operational productivity improvement.

To order the books, “Cracking the Personality Code” and “Cracking the Business Code” please go to www.lighthouseconsulting.com.