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.
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
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.
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?
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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.
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It’s the time of the year again when many organisations are preparing plans and budget assumptions for year 2010. It may be good to time to dust off the steps we looked at in earlier articles budget assumptions, allocation and management of the budget.
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