Incentive compensation, an asset for employee motivation

The employee’s pay is often made up of two components:

• a so-called fixed component, which is made up of the basic salary set out in the employment contract
• a so-called variable component payable according to performance.

Definition of incentive compensation

The objective of incentive compensation is to incentivise individual and/or collective performance, and to recognise and reward this performance. Its aim is to motivate staff - i.e., to encourage employees to target their actions and adapt their behaviours in order to produce the level of qualitative and/or quantitative performance expected by the company.

Fixed Salary

Within the various components of an employee’s overall compensation, fixed salary is awarded in recognition of the job definition achievement. It takes into account the level of responsibility, execution of key skills and the employee’s experience levels. Its purpose is, therefore, to reward the three key components of an employee’s skillset: expertise, know-how and behaviour.

Other types of compensation

Companies may also make use other kinds of compensation measures, which must be validated within the overall package.

While these additional components of global package may evolve over time, they are not considered as “incentive ”. In fact, incentive compensation must always carry some requirement in terms of performance - in particular, individual performance.
Fringe benefits, profit sharing, stock options and free shares may all vary from one period to another for a company employee. However, these do not have the same motivational impact on team members, as their function depends more on recognition of a contribution to an overall result, or being part of a certain business category, than the incentive to achieve a result or requirement set by the company.

Variable compensation calculation tools

The variable component of the salary can be determined by using one of the following calculation tools:

• Commission;
• Employee ranking systems
• Sales versus target

Commission

This is the oldest but also the best known and commonest tool. It involves paying the employee a percentage of the profit (s)he generates.
This variable compensation model is used to reward an employee’s contribution to overall earnings. Commission is rarely capped and sometimes has an accelerator, at which point the employee receives a higher percentage.
It is the principle of “the more I sell, the more I earn” that is remunerated, but this does not introduce any notion of performance requirements. In this way, the employee sets his or her own targets. This is especially important when it is difficult to assess the potential of a product, market or sector.

Employee ranking systems

Ranking systems involve ranking employees from best to worst by distributing a budget envelope.

This calculation process is not used very often because it requires the entire budget to be spent, regardless of performance.

This calculation tool is preferable for challenges in particular and sometimes in the case of an innovative product launch with no market reference available.

 

 

 

 

Sales versus Target or performance bonuses

Sales versus Target (SvT) or performance bonuses are often considered the best solution. They tend to be popular in companies today, even beyond commercial purposes. As such, they are based on the payment to the employee of a target bonus once (s)he achieves the set objective. This notion of being required to achieve an objective can be put into perspective according to each employee’s potential as well as his or her work area, sector or even client portfolio.

Provided that objectives are set fairly, this is an excellent motivational tool for employees and also ensures they are paid qualitatively.

Incentive compensation aims to foster motivation, but it is not the only tool that can increase performance. The role of managers is essential, as are marketing tools and other elements. Moreover, a poorly-conceived incentive strategy can actually have negative effects on motivation levels.

Motivation circle

In order to understand the impact of incentive compensation on motivation, we must examine the full range of stages in an employee’s motivational journey.

1. Realistic objectives in order to avoid demotivation from the get-go
2. Proportionate effort: carefully adjusting the effort/reward balance
3. A balanced set of objectives to allow for variable and reversible compensation
4. Results that meet a clearly-defined objective
5. Value levels in accordance with the beneficiary’s expectations

When drawing up our variable compensation plans, the company issues a performance requirement to which a compensation scheme is attached.

The employee’s first instinct will be to assess the feasibility of the challenge they’ve been set, and whether it seems fair. There’s no point in asking a casual jogger to take the starting line at a marathon.

An employee will measure the efforts they need to produce in order to meet their objectives in terms of risk/reward. If the potential outcome is sufficiently attractive, they will want to get in the race, and above all will be incentivised to sustain their effort levels in order to obtain the best possible result.

In addition, the employee will be highly attentive to the intermediary and final results they achieve, in order to systematically verify their accuracy.
Finally, during last step in the motivation cycle, they will verify that the value of the compensation acquired in return for the performance delivered meets with expectations.

Throughout each one of these steps, any dysfunction in the system or a simple technical mistake can cause employees to fall out of sync with the motivation cycle. They may even produce the opposite effect to those initially sought, which is why it is so important to apply a meticulous approach when building bonus schemes.

Two conditions for effectiveness: variability and reversibility

The motivational nature of incentive compensation resides less in the level of challenge issued to the staff member (i.e. the bonus being sought for a given objective), and more in a combination of two conditions: the risk of losing and the perspective of earning a lot.

As a result, incentive levels can revert to 0 if the employee’s performance is far below the level expected. At the same time, a maximum bonus must also be attainable for a performance that significantly surpasses expectations.

Incentive is therefore variable based on performance, but also reversible - which means that, at the beginning of each performance cycles, all employees are once again in a position to achieve their bonus. The feeling among some team members that their bonus is guaranteed, or among others that they are locked out of the bonus scheme, are both pitfalls which can cause the company to miss out on achieving the best possible collective performance.

In order to enable variation and reversibility, the rate of incentive compensation must not be excessive. In practice, it has been observed that beyond an average rate of 30 - 40% of global package, the proportion of variable income becomes impossible to vary (on both a managerial and social level). Conversely, the objective set must be sufficiently significant to ensure that the employee is motivated by this component of their global pay. The level below which behaviour tends to be more opportunistic than voluntarist is around 8 - 10%, roughly equivalent to a month of fixed salary.

Establishing an incentive scheme in alignment with the overall company strategy

How to gain height? Start by asking the right questions, without trying to sprint straight for the finish line, but instead translating the company’s strategy or key objectives into a specifications’ document gathering the effects that your bonus schemes will need to produce.

Should we incentivise staff to aim for a single financial result, or should incentives focus on the way this goal is achieved? How far should you up the stakes - i.e. how do you manage selectivity and differentiation within the bonus scheme? What level of budget flexibility is acceptable? These are just some of the structural questions that need to be answered in order to construct a incentive scheme that can be shared by the entire company.

Know how to communicate and organise variable compensation

Transparency is a key component in the implementation of variable compensation. Five steps are necessary to implement it properly:

1. Prepare good communication at the start of the cycle. That way, everyone knows the exact rules for determining their compensation and objectives;

2. Organise follow-up meetings using good examples and highlighting areas for improvement;

3. Make intermediate follow-up calculations necessary to take charge of bonus schemes;

4. Give employees the opportunity to simulate their bonus based on the performance they expect to achieve; and

5.Communicate fairly and impartially at the end of the performance period.