The goal of a bonus program is to motivate employees to achieve results in valuable way for everyone. In other words, they should be designed to get everyone from the receptionist to management to leadership to owners all “rowing the boat in the same direction”. Sometimes though, bonus programs are poorly set up, measure the wrong results, set people against each other and/or do not communicate what is happening until after the fact
Below is a brief history of bonus programs and some alternative options with some of the pros and cons of each.
In terms of base pay, COLA, (Cost of living adjustment based on the CPI-U) was used to provide increases. While not a “bonus”, it was used to recognize that inflation caused prices to increase and worker pay should increase with increasing costs. However, this became a problem when companies ran into financial trouble since their fixed expenses kept going up and they were unable to pay bills. We see COLA used dramatically less now because there is concern of more “volatility in the economy” and leaders have learned to be careful with fixed expenses. COLA was also a problem in some cases because it became viewed as an entitlement as opposed to “sharing in company success”. In many companies, employees that liked COLA believed that risk for employment and pay should be on the company and not on the employee.
Many leaders have used bonus programs based on results of the organization to replace the COLA. If the company does well, the employees do much better than COLA. If the company does not do well, then the employee bonus does not do well and may be less than COLA. With this approach, the alignment of employee and company risk and results is much closer.
It also provides better stability financially to an organization since the bonus is a variable instead of a fixed expense.
Bonus programs based on individual results have been used and successful, but the “team” focus frequently gets missed with this type of an approach. Many organizations we work with need to have strong individual results, but they also need a strong team approach in terms of handoffs of information, creativity and aligning the company’s resources and communication. This type of program can have the unintended consequence of “silo-ing” because each person is focused on his/her own KPI’s towards the bonus instead of the strategies and goals of the organization as a whole. This approach is only successful if leaders include other components into the individual bonus program, such as achievement department and divisional goals where the employee has direct influence.
Gross revenue was sometimes used as a determinant of bonuses to drive more team focus. For example, if the company hits $23 million of gross revenue, everyone on the team would get $4,000 each. The problem was that companies would generate lots of activity, but the activities were not necessarily profitable. This was perhaps better than the benevolent dictatorship approach to bonuses, but as any leader knows, more revenue does not mean more profit in reality. It also does not take into account varying levels of pay for each employee, so the $4,000 meant much more to some than others – which can result in a performance problem for higher paid employees. This issue also exists with “spot bonuses”, and so these should be carefully crafted to incent the desired result.
Net profit seems to be the best approach to aligning the company and ownership with employees. It points everyone to the same financial metric: what is left after expenses. Since taxes are an additional large component in net profits, some use the after tax net profit as the measure. This also gets more employees looking at expenses and changing what and how they do things to reduce costs.
The negative is that sometimes there are great strategic decisions made now that hurt this year’s profit and bonus, but will make a difference in year three and four. It is critical when using a net profit bonus to communicate clearly to employees monthly so they have a sense what is happening and are not surprised. They also need to understand how what is happening short and long term are related.
As they come to understand that linkage, they won’t be unhappy when bonuses go down temporarily as the long term approach begins to take hold. (This same communication rule is also important when pay reductions, layoffs, or early retirement packages will occur.)
To align everyone with the company and also to gain high level performance individually, a two tiered approach to bonuses works exceptionally well.
The first tier is that the company must make a profit over $X in order for there to be a profit pool. For example, let’s say the organization needs $500,000 net profit before it will pay a bonus and that it pays 20% of the after tax profit (over $500,000) into a pool. If $800,000 is the net profit then $300,000 is the after reserve net profit – $120,000 tax expense = $180,000. Twenty percent of $180,000 equals a $36,000 bonus pool.
The second tier would be a formal evaluation of each individual. If an employee got 83 points out of 100, they would receive 83% of their eligible bonus. In other words, if they were eligible for $2,000 from the $36,000 pool above, they would get a check for 83% of $2,000, or $1,660.
If we do bonus payouts annually, that feels too long to motivate most employees. For that reason, make an estimate of the bonus quarterly; pay out 60% or so of it to be conservative. At the end of the year, once all the financials are finalized, make a final distribution for the year that trues up what has been paid with what is owed. For this to work, it is important that regular communication is used so employees understand how it is working and realized it is formula based and not political. Having an outside party, such as a CPA, doing the calculations builds employee confidence in the process.
While there are many approaches to bonuses, and they each have their own merits, ultimately we want everyone to be rowing the boat in the same direction. Without that, employees, departments and divisions can be put into negative conflict with each other instead of helping each other. “A” players can get frustrated, “C” players game the system or cynically drain the enthusiasm out of the system.
Generational changes in the workplace, with their disparate motivations and values differences, also increase the complexity of designing a compensation structure. If you are struggling with how to design and implement a bonus program that is exciting, motivating and aligned with your short and long term strategy, call us at 800-786-4332, ext. 106 or email us at email@example.com.
Like bonuses, evaluations can’t happen once a year, for additional perspective see Bowling With Your Boss.