Designing and Linking Compensation to Results

Incentive compensation can be of all kinds. From cash profit sharing, to gainsharing, to discretionary bonuses, stock options, to outright equity etc. If you look closely at how value is created in a company, you will come to the conclusion that value is primarily created by incremental gains in something. We will focus on gain sharing, and we have used this approach effectively because we believe in its premise. So if you as an employee contribute to a gain, we will share it with you and if you don’t produce a gain, we won’t.

Gain sharing can be set up for all kinds of company areas. Let’s look at a couple of examples.

Let’s take a manufacturer looking to reduce the cost per unit on its products:

The existing cost per unit for the manufacturer is $10.50.

The production department is given an incentive to reduce the existing cost per unit . They successfully reduce the cost per unit by 50 cents which when multiplied by the production volume leads to a gain of $500,000. This half a million dollars or a portion of it can be shared with employees participating in this gainsharing program.

 

Let’s look at another quick example.

A company wants to reduce its labor cost, and its existing labor cost is $4 million.

It installs a gain sharing incentive plan. The employees responsible reduce labor costs by 150,000 which can then be shared. The sharing percentage is up to management but here is how it could break down.

Company share for profits and/or working capital could be 60%. The overall company bonus pool could get 20%, the manager responsible could get 10% and the employee group with the biggest contribution to the goal could get an additional 10%.

Let’s talk about designing incentive compensation in your company. The first thing that you need to do is setup benchmarks. You need baselines on historical performance in areas you want to improve as well as targets of where you want to end up. These baselines can be measured not just against performance targets but also against a group of employees or against goals like accomplishing a strategic objective, etc.

These could be measured with financial key performance indicators or with non-financial targets like process improvement or customer service trends, etc. The compensation could be determined based on various inputs or a pre-defined structure.

For the implementation of this we have developed a cascading framework that links everyone and their Key Performance Indicators from the CEO, to the company, departments, and in some cases, the functions and processes and most certainly the managers and the employees.

Next we ensure that the key employee accountabilities and the Key Performance Indicators are linked. Then we connect these to predetermined incentive compensation. Incentivizing individual employees can be effective but it is only part of the puzzle. An individual is only one part of an overall chain of people and activities, which is why we group the company hierarchy in multiple levels. In this case; Group 1 is the CEO, Group 2 is the company, Group 3 is the department, Group 4 the manager, Group 5 the employee etc.

By grouping the various levels, it allows us to pick and choose who is included for incentive compensation. For example, a company-wide target, if met, could add incentive compensation to all employees, whereas certain things may qualify for incentives for an entire department and others may provide specific compensation for the managers in that department.

While incentive compensation plans can be complex, if implemented correctly they can be remarkably effective, especially if you connect employee performance and the underlying resulting gain to the right employee compensation.

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