The salary component that generates the most buzz and debate is variable pay (bonus). Show me the money!
"What is your salary?” Few questions cut as close to the bone and seem more personal than these four seemingly innocuous words! Designed and executed effectively, variable pay is a powerful tool to reward and motivate talent and drive the desired culture within the organisation. Get it wrong, and it can prove to be a millstone around the organisation’s neck.
In many organisations, the variable pay programme is highly subjective, arbitrary, and not well thought through. Far from having a positive impact on employee satisfaction, it leads to demotivation and disillusionment. Getting this programme right is often a major driver in pushing the organisation’s performance to higher levels. Developing an effective variable pay programme cannot be the sole responsibility of the Human Capital department. This requires the management team to come together to create a program that balances the organisation’s commitments to its shareholders and its employees. Key to an effective variable pay programme is to ensure that these 4 important design principles are followed while it is being developed:
- Aligned to organisation strategy and reinforces vision and values.
- Easy to understand methodology that can be communicated across the organisation.
- Meaningful pay-out to drive attraction, motivation and retention of talent.
- Simple and clear computation based on objective calculations, limiting subjectivity.
Cedar’s variable compensation pay-out framework is designed following these principles. It considers the grade of the individual, company and individual performance to help organisations drive an effective variable pay programme.
Pot of gold
The first step in developing a variable pay framework is having a coherent methodology to determine what proportion of profit should be distributed as bonus to the employees.
Defining a company performance index and having this approved by the Board at the start of the year is crucial. This is typically determined by developing a grid based on the achievement of actual versus targeted parameters (revenue, EBITDA, net profit, etc.) for the company. Two parameters are selected and form the axes of the grid, with various levels of achievement (from <80% to >120%) drawn along it. The pay-out as a percentage of profit is determined for each level of achievement across both axes. This percentage varies across industries and organisations. In extreme circumstances, and if any year ever qualified for that tag it was 2020, companies may also carry forward the bonus pool to the following year if they find their pool this year is too small to pay meaningful sums as bonus.
If there was an unlimited sum of money to distribute or a magical pot of gold that never ran out, only the most churlish and short-sighted management would refuse to distribute it among their employees. However, in reality, resources (profits) are limited and need to be utilised in an effective and safe manner. Perceptive organisations are able to develop effective non-cash reward programmes as a supplement to their cash-based variable pay programmes. Effective reward programmes are more than the handing out of gift vouchers and certificates en masse. It is about providing the employee with an experience that can be cherished. While a cash bonus gets lost in the total compensation, and soon forgotten, a reward in the form of an experience can be more memorable and valuable. The added benefit is that it allows the employee to acknowledge and speak about the reward with their peers. It is unlikely that employees will be discussing with their peers that: “I received a 25k bonus,” but they are far more likely to discuss ‘the amazing rafting trip’, or ‘the incredible cooking workshop with a MasterChef’ that the organisation offered them.
Who’s in, who’s out?
Defining the coverage of the variable pay programme is a sensitive decision and needs to be given due consideration before finalising. This is where the management team needs to think ‘big picture’ i.e., vision and values. These values must be reflected in the design of the variable pay programme. No two companies will have the same values and hence no two variable pay programmes will be the same.
Should the company take a more ‘socialist’ or ‘benevolent’ approach and include a wider base of employees in the programme, or should it drive a more ‘meritocratic’ or ‘competitive’ culture and restrict the base to a smaller set? The former approach sounds good until it comes time to distribute the bonus pool and organisations realise they are spreading the pool too thin and hence not delivering a meaningful bonus to anyone. The latter sounds perfect to drive a meritocracy until you realise the abrasive and demoralizing impact it may have on the culture of the organisation. There is no one answer that is universally applicable to this question.
One of the ways in which organisations tend to decide the coverage of the variable pay programme across grades is by looking at the proportion of the wage bill. Each grade is assigned the same proportion of the variable pay pool as their grade’s contribution to the wage bill. So even though senior management may account for only 1-2% of headcount, they could account for 12-15% of the wage bill. Hence, senior management would be eligible for 12-15% of the overall profit pool. In general, variable pay tends to form a more significant proportion of total salary the higher the employee is in the organisation.
The premise being that senior management tends to have a higher impact on revenue, profit generation, overall organisation performance and future development. They also carry the risk of losing out on a significant proportion of their salary if the company does not achieve its overall targets.
Discrimination? Yes please!
Once the company performance has been established and variable pay eligibility across grades determined, the final step is to quantify how much each employee will be paid. The individual performance ratings of the employees form the basis for this calculation. All employees within each grade are then distributed into quartiles based on relative performance, from high performers (quartile 1) to low performers (quartile 4).
The individual bonus pay-out should always be defined as a multiple of the employees’ salary. Having a fixed sum that is paid out for a particular performance level is a non-starter. Given the wide variance in salaries across and even within organisational levels, a fixed sum for a particular level of performance could end up being ludicrously high or low for a given individual. In general, a pay-out that is worth less than the equivalent of 2 weeks of salary is unlikely to have any positive impact on the employee.
Defining the multiples across each quartile is where the management team once again needs to hark back to the organisation’s values and vision. Some organisations prefer to have a smaller difference between the pay-out multiples for each quartile (for example - 1.25x, 1x, 0.75x, 0.5x), enabling them to pay out to more employees within the allocated pool. However, this method tends to reward even the average performers at the expense of not rewarding the star performers highly enough. Ideally, bonus pay-outs should be discriminatory in nature to clearly illustrate a ‘pay for performance’ culture (for example – 1.5x, 1x, 0.5x, 0). In this case high performers are rewarded more handsomely, realising the benefits of their performance, and others can see a clear path to earning a higher pay-out through better performance. Once again, though, there is no clear right answer. It all depends on the vision and values of the organisation and the culture that the management team wants to drive within the organisation.
From CX to EX
While delivering a world class Customer Experience (CX) has been at the forefront of most organisations’ minds, it is now imperative that they also focus on delivering a world class Employee Experience (EX). Employees at different levels respond differently to bonuses, awards, and rewards. An additional sum of money to a senior executive may not be as appealing as the recognition from peers. Similarly, a customised reward that creates cherished memories could be far more valuable to a Millennial or Gen Z employee starting off their career, than a bit of cash.
Management teams need to invest time and effort in developing an effective variable pay programme by understanding their organisational values and employees and delivering a programme that can align the two. As the scramble for high quality talent continues, an effective variable pay programme can prove to be a competitive advantage for organisations.
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