What makes a successful variable compensation model?

Getting a good compensation model in place is key to attracting and retaining the best talent. But how can companies design the right bonus scheme — so they motivate professionals while protecting profitability? Let's explore the issues.  

Leading drivers of satisfaction

To attract top talent, companies need to present themselves as market leaders, positioned at the front of professional development and innovation. Compensation is part of this. According to the Society for Human Resource Management, it's one of the leading drivers of employee satisfaction.   

Companies today are more in tune with the psychology of employee motivation. They've also become more competitive in offering their unique selling points as employers. There is one form of compensation that has remained a critical motivating mechanism for revenue-generating roles: the variable compensation bonus.   

Offering variable compensation to employees has two clear benefits:   

• It provides a reward for attaining performance targets, including sales, profitability, profit mix, or customer mix.  
• If targets are not met, then full bonuses are not paid, and the company is not exposed to an unfunded financial liability.   

Variable compensation beats commission-only

Commission-only compensation arrangements in areas like sales largely insulate companies from poor performance. But today, companies with schemes like these are increasingly unable to attract talent.   

When combined with a base salary and benefits, variable compensation attracts talent, provides a living or even a premium wage, and aligns compensation with professional achievement toward company goals. It is a win-win-win for all involved. 

What makes a compensation model fail?

Frequently, I work with companies on their compensation models and see them looking to comparable market comps to provide indications of salaries at par and then adjusting them up or down to be fairer and more equitable. A similar approach may be taken in constructing a variable compensation program. This is a standard and well-accepted methodology.  

However, some companies slip up by: 

• Failing to align their corporate objectives with employee compensation models.  
• Neglecting to update them periodically, so they're still fit for purpose. 
• Linking variable bonuses to drivers primarily out of the control of the employee, thus creating a false impression that the compensation is incentivized. 
• Designing variable compensation models without consulting Financial Planning and Analysis (FP&A) and understanding the financial implications. 

Companies do not need to create overly complicated compensation models to attract and retain the best talent. There's no need to involve countless metrics, customers, geographies, products, channels, or timeframes. Rather, variable compensation models should be straight-forward for the company and its employees.   

In my advisory experience, I often encourage organizations that variable compensation programs should be aligned with three key factors: 

1. Personal Performance

This is the first parameter of a variable compensation bonus. Each quarter or year, employees should have their performance targets examined and reset. It's often useful to have some degree of personal performance goals set by employees themselves — so the process doesn't create the impression that the company or its leadership dictates 100% of personal performance. Instead, employees set and take greater responsibility and ownership for at least some of their own targets. In other words, there's buy-in.  

Goals for a personal performance assessment might include measures of:  

• Technical ability (skills, capabilities, education, and training)  
• Collaboration with others (team players adding value and proactive contributions)  
• Leadership development (taking the initiative and responsibility), and 
• Business development (furthering their network and the business).   

Overall, personal performance goals might have a hypothetical weighting of 40% of the bonus pool that could be attributed within a compensation model.  

2. Group Performance

A variable compensation bonus should also take account of employees' work within groups, departments, or channels — and how much they've contributed to the whole team's achievement.  Like individual performance, most of these performance goals will be set by leadership. However, some of these goals should be set by the group's management with contributions from individuals. Again, this encourages personal and group buy-in. 

Goals for group performance to factor into your compensation model might include: 

• Business partnership value (the tangible value being brought to other groups, proactive collaboration efforts with other groups).  
• Direct group contribution (the tangible value being brought to others within the group, striving for excellence within the group). 

Overall, we might apply a hypothetical weighting of 60% of the bonus pool to these group goals. This brings the total to 100% — once you add the individual performance goals we discussed before. 

3. Company Performance

Finally, company performance will play the most extensive role in variable compensation. If an organization fails to perform financially, any shortcomings will be reflected in operating profit and reduce the bonus pool size. If there are no funds available, bonuses will not be paid — despite an employee's best efforts. 

How to design a variable compensation model

While HR may be in the position to design the kinds of models we've discussed, teams may not grasp the financial implications. Making sure there's an appropriate allocation of Selling, General, and Administrative Expenses (SG&A) to meet performance compensation will often be the responsibility of FP&A.   

When I've helped develop variable compensation models at more than a dozen companies, the process has required a triangulation between the company's objectives, HR, and the organization's financial goals.   

We've had to ensure the program: 

• Aligns with the culture and objectives of the company. 
• Rewards people fairly, uphold their motivation, is comparable to peer groups, and obeys labor laws, and is designed to increase and decrease to match the financial resources available. 

So, let's assume a $75 million company anticipates an allocation of $2.5 million (or 3.33%) of revenue to the variable compensation bonus pool if the sales team exceeds its revenue target. The bonus pool will be distributed to individuals based upon the individual and group performance objectives.   

If the company performs worse than expected, allocations will stay the same, based upon individual and group performance objectives. However, the $2.5 million allocation will be reduced to a more tenable $2.1 million to safeguard its profitability reasonably. The variable compensation program should flex accordingly.  

In rare or exceptional cases, the leadership may choose not to reduce the bonus pool because leaders are so keen to retain sales talent that it might lose.  Ultimately, this would lead to a lower operating margin — and so leaders must be aware of the implications. 

Variable compensation must be aligned correctly

To summarize, HR should be encouraged to structure its variable compensation management model in a way that best aligns with the company, group, and personal performance.  It's vital to allow individuals to have some say in how they will be evaluated and at least some control over the variable portion of their total compensation. Any variable compensation program should also have insight from FP&A to help determine the impact on company profitability.  

Failure to take these steps may result in multiple programs that fail. At best, this may result in a confusing set of incentives. At worst, this may result in a lack of alignment between everyday activities and objectives, a feeling of unfairness, employee disengagement and turnover, and margin erosion.  In this way, HR and FP&A should be natural partners and allies in developing variable compensation programs.