Create an Incentive Plan That Delivers More Than it Promises

Four Steps to Encourage Employees to be More Productive and the Company More Profitable

Last week’s blog reviewed the efficacy of compensation plans that are intended to incent employees to make the extra effort to add value to the company, by allowing them to share in a piece of the value created.  In theory, that makes sense because it aligns the interests of participating employees with those of the company. But the post also pointed out that many plans fail for a number of reasons:

  • They are often “cookie-cutter” plans developed by outside consultants who don’t understand the specific company’s value drivers;
  • Plans are often complicated, convoluted and difficult to understand;
  • Frequently they are structured for only the top executives;
  • The plans are based on targets that participants feel they have little power to influence;
  •  The “value drivers” that ultimately create increased value are not properly identified.

As mentioned in the previous post, years of experience has taught me that the concept of sharing value is by far the most effective way to motivate those who have the ability to add value to a company to actually do so. However, fair and effective compensation plans must be properly structured, implemented and supported. Here are the steps that I learned work best:

1.  Create, Don’t Copy

Management – with the approval of the board – must assume direct responsibility for developing the plan, because the foundation for any successful incentive compensation plan is that it is based on company-specific objectives, culture and value drivers. Only the management of a company has (or at least should have) intimate knowledge of these factors.

Admittedly, it is hard work to develop an effective company-specific incentive plan, so there is a tendency to abdicate this responsibility to outside compensation consultants. The rationale is that they have experience creating plans for other companies, and can give management numerous options from which to pick. The problem is that companies end up with cut-and-paste plans that are simply a copy-cat version of what other companies are doing, with very little sensitivity to the subtle nuances of their company’s culture and objectives. As such, they are significantly less effective.

2.  Design from the Bottom Up, Rather Than the Top Down

Unfortunately, most incentive compensation plans are predicated on the basis that only the CEO and senior management have the understanding and ability to add value to the company, so they are the only ones invited to participate.  However, to be truly effective, incentive plans should include all members of the organization, starting at the bottom and working up to the executive suite.Power

In reality, creating real value starts at the bottom of the organization, and is based on completing specific activities that, when taken together and multiplied, form the ultimate basis for increased value. That’s why the CEO and senior executives should be the last to receive the rewards of the plan, and their reward should be based on what others receive. A bottom-up structure provides incentives for everyone in the organization to make the extra effort that builds value.

Moreover, it incents management to support the efforts of those who have the power to increase value, because their own rewards are tied to what others receive.  An often-heard excuse for not including everyone is that “it would be too expensive.” This is such a lame (dishonest) excuse. If payouts are truly based on “new value created,” a plan that is inclusive and generates benefits from the bottom up may pay out more, but only if more value is created.

3.  Base Benefits on What Drives Value

Most employees don’t understand how macro values are created, and don’t believe they have the power to influence them. But most do understand their jobs, and if they are incented to do a better job, then ultimately increased value will be created.

The CEO and senior management must identify the specific activities that ultimately drive value. (If they don’t know what those value drivers are, they probably should not be in charge.) Management should also be able to calculate how much increased value is created when the performance of these specific activities is enhanced. For example, if “customer loyalty” is identified as a “value driver,” then those who have the power to positively influence customer loyalty should be rewarded for doing so.

The benefits for these specific activities should be identified and “pooled” during the course of the year, and then distributed among the various groups that created them. This provides a constant reminder and incentive, because individuals can see just how much value they are building for themselves.

These benefits are triggered when the company reports higher revenues, profits or equity. Benefits could be reduced or increased based on controlling expenses and higher than anticipated revenues or profits. Those in support positions, such as IT, legal and administrative, would be rewarded for supporting those charged with performing specific value driver tasks, by receiving a percentage of the benefit pool.

At the end of the year, the CEO and senior management would receive a factor of the total benefits paid to all others. For example, if the total “pool” for specific value driver activities is $3 million, management could receive an additional 50 percent of that amount as their benefit pool. This encourages management to focus on those who are creating the real value. The more others receive, the more management will receive.

At first glance, this approach to incentive compensation may seem complicated, but in reality it is very simple and easy to understand. That’s because the actions that drive value are broken down to simple, specific actions that all employees can understand and believe they have the power to influence.

4.  Make Incentive Payments Just Once

Of course, no benefits should be paid if value does not increase, but there also need to be benchmarks that trigger benefits. For example, profits must increase by 10 percent to trigger 50 percent of the benefits, and by 15 percent to trigger a full payout. This ensures that the cost of the incentives paid out is fully covered by the company’s increase in value.

The newly created value becomes the baseline for the next year’s incentive compensation plan. This prevents paying twice for the same value.

And the Moral of the Story …

Incentive compensation plans are a great idea and they work well when they are structured properly. To achieve this end, the plan must be developed by management and the value drivers must be company-specific. One size does not fit all.

The plan must be all-inclusive and benefits should be driven from the bottom up, where true value is created. Benefits should be determined by specific activities that drive value, and activated by the actual value created.

This approach is equitable, creates parallel interests and is easy for employees to identify with and understand. Most important of all, it provides real incentive for everyone to make the extra effort and add value for the company.

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