Incentive Compensation

Q. I own a small business with about 10 employees. I have always paid my employees a salary or an hourly wage, but I’m considering implementing an incentive compensation system. Do you think this is a good idea? If so, do you have any tips for setting up such a system?

A.  We are strong proponents of incentive compensation systems. We’ve used them successfully both in companies we have run and with our clients many times. In our experience, people generally do what you incent them to do—people will act in their own best interest.

To be sure, there are incentives that go beyond compensation. The possibility of promotion or expanded responsibility can be a strong incentive. The desire for continued employment can also be a motivator. The hope for recognition drives some to perform. However, in many cases, we find that incentive compensation is a wonderful motivator for employees. Further, if you design the system well, when the employees earn large incentives, the company has also done well. Therefore, you’ll have the money to pay the incentives.

We think incentive compensation systems are a great idea. However, a word of caution is in order. There is little in business that is more powerful than affecting an employee’s pay. A well-designed system can be very positive, but I poorly designed system will do more harm than good. When setting up your system, these five tips will be helpful.

Easy to understand – To be effective, an incentive compensation program must be easy to understand. We worked with a brilliant manger—one of the smartest people we’ve ever known. He designed an incentive compensation system for his company’s sales force that paid them for doing exactly what he wanted them to do. It was a very precise system. Unfortunately, the sales force couldn’t figure out how to maximize their income. The overly complex system just frustrated the employees. Ultimately, he scrapped it in favor of one that was less precise, but much easier to understand.

Employee controls outcome – Ensure that the quality of the employee’s work will have a significant effect on the amount of incentive earned. The receptionist may not believe that his/her work will have an impact on the amount of profit the company makes. If that is the case, paying him/her a bonus based on company profit will not incent performance. It’s okay to have a small portion of an employee’s bonus based on something they don’t directly control, but the preponderance of their incentive should be in his/her direct control.

Align with company objectives – People will do what you pay them to do, so be very careful to ensure that you incent the behavior you want. If you pay people for the number of widgets they produce, you are likely to get a lot of widgets. However, if volume is all you pay for, the quality may not be what you need. Incentive systems must align closely with company objectives. We think it puts employees in an impossible position when doing something that will benefit the company reduces their compensation.

Amount – Studies show that for incentive pay systems to have a meaningful impact on performance, they have to represent at least 10 percent of an employee’s compensation. Less than this is generally too little to matter.

Frequency – Generally, systems that reward employees frequently, say with every paycheck are more effective motivators than those that pay out only annually. However, for more senior executives or people engaged in longer-term work such as a big construction project, it may not be feasible to incent more frequently.

A well-designed incentive compensation system can help you take your business to the next level. Following the tips above will start you on the right path. However, there are many complexities. Don’t hesitate to reach out for help if you don’t have experience in this area.

All opinions expressed on USDR are those of the author and not necessarily those of US Daily Review.

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