The Right Conditions for Effective Incentive Plans
Since the 1960s, theorists and researchers have amassed an impressive body of knowledge around the topic of incentive compensation. Over my 25-year career in human resource and total rewards, I have struggled through most of this material – either through need or curiosity. However, while this published material is both insightful and valuable, most of it is far too technical and complicated for any practical application by the busy business owner whose focus is required in many different areas. Designing effective incentive plans will always require judgment and understanding of individual circumstances. However, it’s been my experience that almost any effective incentive plan must satisfy three basic conditions, which must be considered separately and in the proper sequence. While these conditions will seem intuitive and obvious, I am amazed by how often my clients violate one or more conditions when designing their employee plans.
THREE CONDITIONS FOR AN EFFECTIVE INCENTIVE PLAN
1. Start with Results You Want. In 1995, Steven Kerr authored a classic article, On the folly of rewarding A, while hoping for B (1), in which he highlights the importance of selecting the right measures for success. Shortcutting the process to select the ideal measurements of determining incentive awards is a very common misstep; but why? Without fail, every business owner I meet is crystal clear about the specific results he or she wants to drive business growth. In addition, very few are willing to trust employees 100 percent to achieve these results on their own. Consequently, many incentive plans I’m asked to “fix” for clients are failing because they reward employees more for activity (following a prescribed procedure or methodology) for getting results than for the results themselves. For example, one of my clients was having great success selling after-market equipment parts to clients around the world. He had adopted a strategy of leveraging outbound inside phone sales rather than placing sales representatives in the field. However, his incentive plan paid sales team members on the number of calls each made weekly rather than on the revenue dollars generated, percentage of calls converted to actual sales or other relevant outcomes. It was not surprising this plan did not produce the outcomes for which he had hoped. The sales team complained that the very premise of the plan treated them like children. In addition, many soon found ways to “game” the plan; such as by calling friends or existing customers multiple times. By the mechanics of the plan, this resulted in more payouts even with eroding revenues. Our first adjustment to the plan was to change the incentive measurement to reflect what the owner wanted – more customers and more revenue per customer. By holding each sales member accountable for certain revenue targets per month rather than bird-dogging them every minute, sales rose again, high and low performers were quickly identified, and the owner was free to focus on future strategies.
2. Employee Control Determines Line of Sight. How much control does each employee have over the outcome measure you are using to determine their incentive award? One of the annual incentive measures that we used for all employees when I was the head of human resources for a publicly-traded real estate organization in Florida illustrates this point. As a publicly-traded company, the company’s board of directors liked the idea of using Annual Earnings Per Share as a key measure to determine a portion or all of each employee’s annual incentive award. After all, what better measure to use from a shareholder’s perspective? Management gets paid when shareholders get paid under this measure. This measure makes perfect sense for the executive team making most of the strategic decisions. But does it make as much sense for an Accounting Manager? Many factors can affect an earnings number, such as timing of capital investments, tax deferral strategies and environmental factors affecting share valuations. Despite a strong alignment between plan measures and shareholder value, there was a weak alignment between lower management’s daily effort (“line of sight”) and the measure.
Another example: many organizations choose to implement profit-sharing plans, which provide rewards based upon divisional or company-wide performance. These plans can be alluring given their simplicity and implied fairness. However, with many aspects of division or organizational performance falling outside of the control of most individual employees, the “line of sight” between effort and reward will once again only seem relevant to the most senior and executive employees. In both of these measurement examples, mid-level employees were likely to view their incentive award as similar to winning a lottery ticket—having little idea what payout level would be earned until it was awarded.
3. Know Your Employees' Currency and Select Rewards Employees Value. Are the measures tied strongly to rewards that the employees value? If rewards are not significant or valued by the employee, their ability to drive discretionary effort to earn these rewards diminishes quickly. This can be due to rewards being too small, or delivered in the wrong currency or format.
Too Small. Suppose an employee works for a company with 250 employees, and participates in a plan in which 25 percent of profits are shared with employees as a year-end bonus. Suppose further that the employee has a good year, creating $1 million in profits for their company. What is his/her share? It is 25% x $1M / 250 = $1,000. The employee’s “commission” is only 0.1%. A firm would never use such a trivial commission rate for salespeople, so it is surprising that similar logic is so seldom applied to other employees.
Wrong Currency. Many executives believe money is the only useful reward for high performance, but for some employees it may be time off or flexible schedules. For others it may be growth and development opportunities. The same holds true for benefits...a new mother may high value time off or flexibility to work from home when kids are sick, while a person nearing retirement age may value 401(k) matching and guaranteed life insurance more more. Each employee has a currency that is the most rewarding. Understanding that can unlock great performance potential in you teams.
Wrong Format. One incentive plan format I implemented as the head of human resources for a large public company illustrates this problem well. In an effort to reserve cash and provide equity to incentive-eligible participants, we implemented an incentive plan, which awarded incentives in the form of both cash and shares when we paid the incentives. However, the stock portion of the bonus awards required an additional three-year vesting before the participant could receive the cash value for the award. As you can imagine this was very unpopular and a great lesson learned.
I made a similar mistake as the head of human resources for a Department of Defense contractor. After lobbying for annual incentives for all employees based upon company performance, I conceded annual cash awards and settled for granting annual awards in the form of a discretionary 401(k) profit sharing match. While the format was more beneficial for the organization, the participants felt disappointed by not being able to readily access their incentive award without penalty or a hassle.
Incentive-plan design should start with the basics. Effort should be directed at making sure that the right measures are selected to reflect the desired results, to put rewards reasonably within employees’ control and to yield awards that are timely and perceived as valuable.
(1) The Academy of Management Executive; Feb 1995; 9, 1; ABI/INFORM Global, pg. 7