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What are Choices and
Comparisons of Incentive Compensation?
Q. Our
organization has executives, marketing people, managers, and quite a few
professional specialists on various forms of incentive compensation. In
the board room, we have never-ending arguments over which kind of incentives
work best, or whether they work at all. What are the comparisons?
A. When we say "incentive compensation," we
mean some kind of payments that vary with results, as contrasted to payments by
the hour or the week.
You can invent an unlimited variety of incentive
schemes, so there's no such thing as a "complete list."
Two useful questions to ask are:
1) Exactly what behaviors are we trying to
encourage, and how can they be measured?
2) Based on the answer to the first question,
should the incentive compensation tend toward broadly-based, or
narrowly-focused?
WHAT ARE WE TRYING TO ENCOURAGE AND
MEASURE?
The base pay of employees causes them
to show up on a daily basis and do something (usually). Therefore,
we're implicitly saying that we're trying to get some kind of "extra
effort" with incentive compensation. It's revealing to think through
exactly what this "extra effort" is.
Are we trying to get sales people to
make more calls, or press harder to close sales? That's fairly practical
to measure.
Are we trying to get clerical help to
process more paperwork, or factory workers to make more units? That's also
straightforward to measure.
However, imagine that we want an
employee to "be more careful" to avoid a rare but disastrous
problem. How do we know if someone is "being more careful" each
day, if the problem occurs rarely anyway?
We get into similar problems trying to
encourage and measure "being creative" or "promoting
teamwork" or "taking smart risks" or "thinking outside the
box."
THE RESULTS THEORY
One theory says that we can measure
behaviors by their results. That theory says that if sales go up, the
sales people must have worked better; if the company prospers, the executives
must have been more creative; if the project succeeds, each individual must have
made a fine effort. Obviously, this theory contains assumptions that
simply aren't true in all cases.
WHAT'S PRACTICAL?
We can generally encourage behaviors
that we can measure and reward. On the other hand, some of our employees'
most important behaviors stem from inherent talents, self-images, ambitions,
good-faith relationships, and personal values.
For these reasons, measurements and
rewards remain controversial:
For every manager who thinks straight
sales commission is the perfect compensation plan, you can find another who
disagrees.
For every investment analyst who
thinks that a $100 million executive bonus is a bargain for a successful year,
you can find another who thinks it was an overpayment.
WHICH WAY TO GO: BROADLY-BASED OR
NARROWLY-FOCUSED?
Imagine a spectrum, with broadly-based incentives
on the far left, and narrowly-focused incentives on the far right.
BROADLY-BASED
An example of a very broadly-based
incentive would be employee stock ownership. Some managers believe that
stock ownership provides an excellent employee incentive, since it rewards
employees for increasing shareholder value.
Others point out that individuals may
find it hard to relate their daily behavior to a stock price. In that
case, stock plans would have a very weak effect on daily behavior.
NARROWLY-FOCUSED
Examples of narrowly-focused
incentives would be factory piecework (in which workers get pay directly in
proportion to units produced) or straight-commission sales (in which sales
people receive money in direct proportion to gross revenue).
Proponents of piecework and straight
commission point out that employees obviously concentrate on "making the
numbers" to get the money. Critics interpret this
differently. They worry that employees may sacrifice quality or the
long-term interests of the organization in order to maximize the payout.
"BALANCED" PLANS
Concerns about too-narrow or
too-broad incentives have led to the development of many "middle of the
road" or so-called "balanced" plans over the years.
The common theme of all balanced
plans, is to focus narrowly enough so that employees can see how their
behavior triggers a money payout, while staying broad enough so that shortcuts
and sub-optimization don't take place.
Many balanced plans are called
"gainsharing." They compare a composite of current
measurements against some chosen point in the past. For instance, labor
dollars per sales dollar might be compared against a past reference. If
costs go down, a percentage of the savings go to an employee bonus pool,
according to a pre-announced formula.
Gainsharing plans can be designed in
an infinite number of ways. Famous proprietary names for historic plans
have included the "Scanlon Plan" and the "Rucker
Plan." Descriptions of these plans can be found in compensation
textbooks, along with hundreds of opinions on the World Wide Web.
"BALANCED" PLAN CRITICISMS
People criticize "balanced"
plans. Here are some of the most common
concerns raised about balanced plans:
1. Imperfect formula:
No matter what kind of formula you adopt, somebody will say that you left out
something important, or that the formula doesn't emphasize, prioritize, and
weight everything properly.
2. Too complex: No
matter what the plan, someone always complains that people don't understand
it; therefore the plan can't motivate people.
3. Payout caps: If
the plan hasn't any limits or ceilings on the size of bonuses, some executives
will complain that the plan is too "rich," and it "gives away
the farm." On the other hand, if limits and ceilings exist, people
will complain that the plan holds back rewards during boom economic cycles,
just when the organization needs retention and recruitment the most.
4. De-motivational:
If the organization suffers a couple of bad financial periods, and the plan
doesn't pay out any money, critics will say that it has lost all credibility
with employees, and has lost all power to do any good.
5. Unfair to others:
If the payout formula results in bonuses to some workers when others (who are
on different plans, such as executives or sales people) don't get any bonuses,
somebody is sure to call the plan "unfair."
6. Too easy: No
matter what time period gets chosen as the base of reference, somebody is sure
to claim that employees "weren't trying very hard" back then, so
making a bonus now is "far too easy."
7. Waste of money:
During an economic downturn, some executive will be sure to claim that all
past have been "sheer waste," because "look how cheap and easy
it is to hire great talent during this recession."
8. None of their business:
Executives may become alarmed if employees show interest in decisions outside
their traditional departments. Factory workers under a gainsharing plan
might become critical of manufacturing equipment choices. Sales people
under a gainsharing plan might become critical of the costs of
operations. These interests can be threatening and alarming to managers
and top executives.
INCONSISTENT ARGUMENTS
Many arguments persist over incentive
compensation, even though they're inconsistent with other beliefs and behaviors
on the part of the persons arguing. For instance:
Many executives who claim that
bonuses have no impact on the performances of lower-level employees, are
themselves the recipients of bonuses.
It's common to hear the lament that
employees should "share the risk," without taking into consideration
the capitalistic principle that risk-takers expect potential rewards.
NEED FOR POWERFUL CHAMPIONS
Criticizing an incentive compensation
plan is very easy. Trying to prove the benefits can be hard. That's
why it's vital to have plenty of top-level support and commitment for a plan as
possible.
--A brilliantly-designed incentive
compensation plan without strong top-level support, generally fails.
--A moderately-well-designed incentive
compensation plan that DOES have abundant top-level support, generally works in
some manner.
One common strategy is to hire an
extremely expensive outside consultant who does a thinly-disguised
"railroading" of a particular plan. This results in so much
momentum that the plan invariably gets put in place. After all, nobody
wants to waste those huge consulting fees or contradict the experts!
A better idea is to thoroughly educate
the decision-makers involved, and to openly examine the costs and
benefits. In that way, a real consensus can form, and there's a much
higher chance of long-term success.
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