Incentive Compensation Designs

Recently, I was  involved in some conversations with business leaders about incentives and compensation schemes that companies offers in today’s tough economic situation This discussion was also mindful of the debates around  AIG’s bonuses to 73 executives where reasonable. And it asked the question is “What is the normal incentive scheme that most companies uses” and “ which one of them fits with my company?”

In this post I will discuss just some of the key areas on incentives we  considered.

The first common option we discussed is the bonus based compensation linked to absolute target. This incentive is triggered by meeting the committed target (measures)

e.g. the manager’s bonus is paid in additional 10% of base salary if his unit’s earning grows by at least 10%.  This option provides clear performance expectation and is eventually a straight forward performance evaluation. However, this option reflects a downward bias to forecasts to create easier target value with no incentive to provide accurate forecasts beyond the specific time period. More or less being negotiations game resulting a longer forecast cycles.

image

The second option was incentive compensation linked to forecast accuracy, where bonus varies with accuracy of forecasts committed

e.g. the manager’s bonus declines by 5% for every percentage point of deviation between forecasted and actual unit’s earnings growth. This option highlights the importance of giving accurate forecasts, and shows that under forecasting can be as unfavorable as over forecasting. Also this option reflects a downward forecasts to create targets that are easier to hit with more accuracy, and nothing beyond that committed target. With no incentive to provide accurate forecasts beyond specific period as the first option.

In practice, how can we avoid forecasts bias? In South Western Airlines (1), they discovered that having incentive compensation linked to overall profits works.  Making bonuses a proportion of a profits earned e.g. a unit manager is given 0.002 percent of the total year profit. With this scheme, forecasts are done unbiased, the cycle take less time and the staff provides best efforts to achieve highest profit.

As an aside, when you look at the culture of this high Kudos and point to point airline that walks the talk on performance even today in the face of economic adversity. Their incentive motivation in their case also goes beyond the technical and embodies a dichotic culture that is based on Pee-wee’s Playhouse style fun and life style. This is well summarized in the Fortune reported quote from south west then CFO Gary Kelly

“Keeping a hawk’s eye on costs is just as much a part of the company’s culture as its silliness”.

However, a debate of which business unit or department should have what percentage depending on which “measure” is always a concern.

In some companies, measuring over head counts could be the solution. Total profit comes from every staff’s effort in generating revenue and reducing cost, so everyone should have an equal share. There could be possibility of “free-riders” problem if applied in large organizations

SNAG-0015

Allocation using percentage of annual revenue generated is also another practical scheme. By calculating the portion of revenue earn in each department over the total company revenue gives the percentage of incentive compensation for that department.

Allocation by number of computers is also another popular choice that measures the number of computer used in each department over total number of computers in the company.

And rarely, allocating by time sharing, given the estimated amount of time spent for each cost center/business over the total hours for the month for the department.

For all the options given, in a simple organization like the one shown above, things should be easy and straight forwards. But for complex and large organization, this is considered a tough task not to mention business dynamics and changes within the organization.

Therefore, the challenges would be;

1. Which incentive compensation is best for your organization?

The answer could be either a single option like the ones described above or a mixture of options depending on department properties

e.g. Business Units uses profit sharing and Service Units using resource allocation. This is reflected in employment benefit package given to staffs both currently on payroll and new recruits on either a quarterly or annual frequency.

SNAG-0016

2. How to achieve it?

With the provided resource and capability you have.(Avoiding mistakes yet still able to deliver on time). How do we do it today? Most companies rely on the good old spreadsheet like Excel. [See my Dec 2008 post Merit & Bonus] But does that answer all the bells and whistles problems you face every month end? How can you control and manage it while consolidation is done by a junior staff?

-0-

In summary the conversation concluded by saying whatever incentive compensation options are used they should be flexible enough allowing changes, yet still allowing control over results to meet business requirements. Although the conclusion may sound easy, in reality, it is very hard to achieve without proper infrastructures.

Everyone was also in unison that a sensible game plan for the business was needed with acceptable performance levels able to be measured. Then this can be linked in such a way so the rewards can be equitably balanced and shared as incentives.

3 thoughts on “Incentive Compensation Designs

  1. Well basically I encourage mixed mode of incentive scheme. Equal distribution in Corporate level and Parformance based in Smaller Group. This help encourage co-operation among group and prevent free-rider as stated.

    Cheers!
    By Amnuay Mekchompu IT Solutions Consultant, Heading to corporate governance and Compliance
    —–
    Well yes for example say merit or profit to be distributed to all colleague.
    let say yearly incremental we need to analyze capability of overall corporation cost and revenue base forecast and then we can get appropriate incremental percentage.

    Then this percentage will be given out to all group or department for each team to evaluate based on each team individuals performance. Then we can encourage equal distribution of benefits over the pass year and also motivate team player for their individual nomination.

    These are my idea on incentive scheme. By the way Sales incentive and commission still need to be consider separately.

    Best regards,

    AM.

  2. The article was interesting. Though, speaking from my experience, this company that I am going to write is probably an exception. Even in the bad economic situation, the company still provides 100% full benefits to all employees (health, dental, vision) with no additional cost to employees. And 403 (b) is still 10% – 13% of your base salary. Not many companies can beat this incentive. However, they said, because of the current economic, the management is not going to have any salary increased. Yet, the company did not mention about 5% bonus based on their salary that they would earn. Well, The company I am talking about is a small company. Based on last year income tax, the top guy earned $450,000 last year. Isn’t that a nice pocket money of $22,500 on bonus?

    Titima To
    Managing Director at Amitit Tax Services

  3. Dr. Kitbamroong,

    Your article’s first premise is that one approach to incentives will work for more than one LOB, company structure and culture. Business models are complex, and I doubt there is a ‘one size fits all’ solution to the compensation issue. While it may be difficult to choose a specific compensation model for all members of a group, properly modeled analytics will reveal extremes and compliance with industry standards, allowing an organization to gauge whether it’s compensation package is competetive and reasonable.

Leave a Reply