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Incentive-Based Compensation Systems

Short-term incentive compensation is variable compensation that rewards achievement of specified results, typically measured over a period of 12 months, or less. You need to be careful to make sure your incentive plan designs are directly tied to the achievement of business objectives, so your total compensation expense will be higher only when your overall performance is strong.

When designing an incentive-based compensation system, there are some factors to consider:

  • Timeframe of objectives (a long-term objective should be supported by a long-term incentive plan. A short-term objective should be supported by a short-term incentive plan).
  • Employees' capacity to influence the achievement of business objectives.
  • Management's commitment to measure results and determine awards.
  • Funding and affordability.
  • Metrics and measurement frequency.
  • Eligibility and participation in the plan.
  • Administrative rules.

Before you start discussing the details of how to design and implement an incentive-based compensation system, it's important to note the best compensation plans don't drive employee behaviour. Instead, corporate culture should drive employee behaviour and incentive compensation should be used to reward the behaviour. In other words, compensation should be a reflection of corporate culture, not the other way around.

Why not offer your employees a weekly tab at a local restaurant, for example. If you make a deal with the restaurant, you might save some money, while your employees enjoy a great lunch.

Incentive System Metrics

When deciding how to measure employee performance used for incentive compensation systems, the business must define the specific KPIs it will track. The business must select metrics that are easily understandable and reportable, with reliable data. Factors that must be considered when deciding on appropriate metrics include:

  • Your business objectives and priorities, and how each specific measure helps achieve those objectives within the desired time-frame.
  • The appropriate number of measures required to ensure the plan emphasizes the desired behaviours and results. Too many measures can fragment an employee's attention and can be a challenge to administer. Too few metrics will likely ignore key business drivers.
  • The relative importance of each metric, and the weighting the measures, and how this might change with different levels of authority and influence.
  • How short-term measures impact longer-range business goals.
  • How the measures selected are impacted by employees.

Ultimately, the chosen measures will help reward employees by reflecting and encouraging certain behaviours. However, when considering the common effects that targets and compensation have on employee behaviour, you will need to be alert for unintended consequences of incentive compensation plan design. For example, an emphasis on efficiency may lead to a decrease in production quality because employees are focused on producing more and faster.

Often, metrics are a combination of individual, departmental and company KPIs and assigned different weights for an overall score.

Profit Sharing

Profit sharing plans provide direct or indirect payments to employees based on your company's profitability, in addition to your employees' regular salary and bonuses. Profit sharing plans are based on predetermined percentages that define the profit split between the company and the employees. These plans are put in place to help employees feel a stronger sense of ownership, and approach their work from that mindset.

Ownership and Stock Options

Stock ownership is another method to encourage employees to work and think strategically. When employees are in a position to reap the benefits of the company's long-term success, they will be more likely to work toward that end. They become more willing to take on extra work. They become more willing to conserve expenses. And they become more willing to cooperate with other employees.


One method of variable pay is Gainsharing. Gainsharing is a method of motivating and involving your employees by forming them into teams responsible for improvement. These teams solicit and review suggestions from other members of the workforce for operational changes that will result in gains for the business, either in increased revenue or decreased costs. The teams are permanent groups that meet on a regular basis to discuss ideas and suggestions, and may consist of management, employees, or a combination of both. The basic concept is that your employees have more to offer than just a pair of hands, and that those closest to the actual work should be the experts on how it could be improved.

With profit sharing plans, employees can easily become disgruntled if they feel their contributions to the whole are too small (as in the case of large global corporations), or if they feel like decisions are being made beyond their control (external market forces, taxes, lawsuits and other outside factors), which keep profits at a minimum. It can seem like individual actions don't have a direct connection to profitability and the disconnect between employee and employer can actually grow. Gainsharing aims to provide a better “line-of-sight” for employees so they can directly attribute their actions to gains experienced by your business.

When we get to Operations, we will see how Gainsharing complements operational initiatives, such as Total Quality Management, Lean and Six Sigma by engaging the workforce. At times when your business is going through changes in how you operate, Gainsharing can be used to involve your employees in the success of the transition, instead of using it strictly as an incentive tool.

If your goal is to reinforce longer-term thinking without sacrificing the benefits of increased “line of sight,” a portion of the employees’ share of the gain can be placed in a reserve account and paid to the participating employees at the end of each plan year. In periods of deficit performance, the employees' share of the loss is deducted from the annual reserve account. Employees will see consequences for worse performance and longer-term thinking is reinforced. If, at the end of the plan year, the reserve is negative, a company will typically absorb the loss and start the next plan year at zero.

GainsharingProfit Sharing
All employees on a team usually evenly share a fixed percentage of salary or dollars per hour worked.Employees share in profits based on individual performance.
Payout is more frequent, in order to improve “line of sight” and connection between employee operations and performance.Payout is less frequent, often annual.
In large corporations with multiple locations, gainsharing is usually based on a single location, so employees can retain direct “line of site” identification with the business results of their endeavours.Overall corporate profits are the pool employees share from, not individual locations.

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Team-Based Incentives

Some of the main advantages of organizing employees and work into teams with incentives:

  • It more clearly links the return on your investment with performance.
  • Teamwork opens communication pathways and spreads knowledge and experience around. This often leads to innovation and improvement.
  • It improves quality and consistency.
  • A group by nature has more skills, knowledge, competencies and experience to draw from than an individual.
  • Your company becomes more flexible and less dependent on individuals.
  • Your employees gain a birds-eye view of how the different pieces of your company fit together.

However, some of the notable disadvantages of organizing work and incentives into groups include:

  • Freeloaders – Some team members will have more skills, abilities or drive than others. This can cause problems, and decrease job satisfaction among your star performers. Peer reviews can help to keep everyone accountable.
  • Your superstars may have better ideas or strategies than the ones decided on by the group. You will have to take care to train your teams to carefully consider options.
  • It can be difficult to attribute success to a particular group or team that operates interdependently with others. One approach to deal with this issue is to include all teams that are interdependent with each other.
  • Some people just work better on their own. Forcing a square peg into a round hole won’t end up increasing production. You may have superstars at your company that are great individual performers, but don’t do well in teams. Keep your pay systems flexible enough that you don’t exclude major talent.

Team Based Pay-for-Performance Incentives

Team-based incentive programs are a meaningful way to link team performance and pay. They can be very successful, given the proper culture and environment. The challenge lies in properly defining, designing, implementing and communicating your plan.

You would all like to increase performance, but what does that mean? What should incentives be tied to? The following are a few ideas of performance-oriented items to consider attaching incentives to:

  • Sales targets
  • Production targets
  • Expense reductions
  • Deadlines
  • New clients
  • Low attrition rate
  • Safety
  • Rejected items
  • Returns
  • Project completion
  • Cost savings

Your employees will exhibit the behaviour that you reward, so make sure that it's aligned with your goals and strategic objectives.

You may wish to reward team members who make greater contributions than others in an effort to motivate your employees. If you're going to do this, you'll need to implement a procedure to measure individual performance.

This is something that does not necessarily have to be done by your managers. Team members themselves can be used to evaluate each other's performance, and consensus can be used for deciding on reward distribution.

Your plan has also got to be designed very carefully to ensure you're rewarding the appropriate behaviour.

The element of competition can creep into your teams if you're going to reward individual members according to their performance. At that point, team bonus payments can easily evolve into just one more method of merit pay, and the processes of dividing bonus money among individual members can have the same disadvantages as regular individual merit pay. There's also the added problem of differentiating between true performance and the results of a popularity contest when using peer evaluations.

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