In today’s business environment, more than ever company leaders are examining the best way to use incentive plans to drive performance and achieve their growth goals. However, selecting the right performance measures often becomes a stumbling block to their success. They want to build a plan that leads employees to the performance they need while simultaneously aligning their efforts with the company's objectives, fostering a culture of excellence and accountability.
Unfortunately, company heads usually end up frustrated in this endeavor. Many find that the performance results of their people don't justify the volume of rewards payments they are making. And when they reshuffle their incentive plan metrics and still don't experience adequate results, they are led to ask: "Why do we even have an incentive plan?"
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What is the Purpose of Incentive Compensation?
If this is an issue you face, this article aims to provide some answers. It will help you understand the purpose of financial incentives in a business, the premise and core metrics upon which an incentive plan should be built, and how to determine the "support" metrics that will improve the likelihood your plan will produce the outcomes you want.
Understanding the Purpose of Incentive Compensation
Incentive compensation is a powerful tool that can significantly impact employee performance and organizational outcomes. It serves to reward employees for achieving results, thereby encouraging them to strive for higher levels of productivity and innovation. In the new economy, where agility and adaptability are key, incentive plans must be designed to recognize and reward the contributions that drive business success.
The problem is most incentive plans are built on the wrong premise and start with the wrong core performance metrics. While identifying specific measures that impact an incentive plan benefit are important, they should not be seen as devices designed to influence employee behavior. They must reinforce priorities associated with a person's role but are only relevant once core metrics have been achieved. And the core metrics should be tied to the fulfillment of well-defined company value creation thresholds. Once those have been reached, then other metrics have the role of emphasizing specific performance areas upon which an employee should be focused in his or her role.
The core metric for all annual incentive plans should be company profits. More specifically, it should be productivity profit. It might be a specific profit number or a percentage increase in profits, but the idea is that unless that minimum value creation threshold is met, there is no annual incentive payment. This empowers the company to safeguard earnings that need to be invested in growth initiatives while also protecting the shareholders' capital investment and interests.
The core metric for all long-term incentive plans should be company growth. Any reward for sustained performance must be tied to long-term value creation. And the best measure of that contribution is increased business value. This does not mean a company's long-term incentive plan must be equity sharing. For private companies, it usually isn't. However, there are multiple ways to link a long-term performance award to increases in company value. Phantom stock is one example.
To build the "perfect" incentive plan, you must first understand the core purpose of incentive compensation. That purpose should be the creation of a unified financial vision for growing the business. This can only happen if your incentive plans are built on the right premise and are rooted in the correct core metrics.
Once you have the purpose and premise for your plan, then you can start thinking about other measures and metrics that might influence the payout potential of your incentives. The rest of this article will provide guidance on that part of the incentive plan equation.
Aligning Incentives with Strategic Goals
To ensure that incentive compensation is effective, it must be closely aligned with the company's strategic goals. This alignment creates a direct link between individual performance and the broader objectives of the organization, ensuring that everyone is working towards the same outcomes.
Identifying the right performance measures requires a thorough understanding of the company’s business model and strategy and the current priorities for each. For example, if a company aims to enhance customer satisfaction, metrics such as customer feedback scores or net promoter scores could be incorporated into the plan. Similarly, if growth is a priority, revenue targets or market expansion metrics might be more appropriate.
The incentive plan should be designed to evolve with the company’s goals. As the business environment changes, so too should the performance measures. This adaptability ensures that the incentive plan remains relevant and effective over time, driving sustained success.
Choosing Support Performance Measures
Selecting the best performance measures to support the fulfillment of your core metrics should involve the following key considerations:
- Relevance: The performance measures should be directly related to the company’s strategy and financial goals. Irrelevant metrics can lead to misaligned efforts and wasted resources. For instance, a sales-driven company might focus on metrics like sales growth, customer acquisition rates, and average transaction values.
- Measurability: The metrics must be quantifiable and easy to track. This ensures that performance can be objectively assessed and rewarded. Qualitative measures, while important, should be supported by quantitative data to provide a balanced assessment.
- Achievability: While the goals should be challenging, they must also be attainable. Unrealistic targets can demotivate employees and lead to disengagement. It is important to set benchmarks that push employees to excel but are within their reach.
- Transparency: Employees should understand how their performance is measured and how it impacts their incentives. Clear communication fosters trust and motivates employees to achieve their targets. Transparency also involves providing regular feedback and updates on performance, ensuring that employees are always aware of where they stand.
Incorporating Key Performance Indicators (KPIs)
Key Performance Indicators (KPIs) can be good tools for measuring and rewarding employee performance. They provide a clear and concise way to evaluate progress toward strategic goals. However, when designing an incentive plan, it’s important to select KPIs that reflect the most important aspects of the business.
Common KPIs include financial metrics (e.g., revenue growth, profit margins), operational metrics (e.g., productivity, efficiency), and customer-related metrics (e.g., satisfaction scores, retention rates). The right KPIs will vary depending on the industry, the specific goals of the company, and the roles of the employees being incentivized.
For example, in a customer service-oriented business, KPIs might include average response time, customer satisfaction ratings, and issue resolution rates. In a manufacturing company, KPIs could focus on production efficiency, defect rates, and on-time delivery metrics.
Balancing Short-term and Long-term Goals
Effective incentive plans balance rewards for short-term achievements with meeting long-term objectives. Focusing on both ensures sustained growth (not just this year's results) and stability. Incorporating both types of goals into the incentive plan strategy ensures that employees remain focused on the big picture while also driving the current year's revenue and profit engine. But the long-term piece acts as an insurance policy against employees gaming an annual bonus plan for their personal financial benefit by producing a business that erodes customer confidence or dilutes "good" profits (think Wells Fargo a few years ago).
Short-term goals might include quarterly sales targets or project completion milestones, while long-term goals could involve market share growth, brand development, or innovation initiatives. This balance helps maintain momentum and keeps employees engaged now and over time.
Regular Review and Adjustment
The business environment is constantly evolving, and so too should your incentive plans. Regularly reviewing and adjusting the performance measures ensures that they remain relevant and aligned with the company’s strategic goals. This adaptability is crucial in maintaining the effectiveness of the incentive plan over time.
Regular reviews should involve analyzing performance data, gathering employee feedback, and assessing changes in the business landscape. This process helps identify any areas where the incentive plan may need adjustments and ensures that it continues to drive the desired performance and outcomes.
Conclusion
Developing an effective incentive plan strategy requires careful consideration of the performance measures that will drive company success. By building your plans on the right premise and with the right core metrics, you can better align employee performance with the company's goals and visions. Then, choosing relevant and measurable metrics, and balancing short-term and long-term objectives, enables your company to create a powerful tool for generating immediate and sustained employee and company performance. Regular reviews and adjustments will ensure that the plan remains effective in the face of changing business dynamics, empowering you to meet your growth targets regardless of what's happening in your industry or with the economy.
To dive deeper into this topic, read: What is the Purpose of Incentive Compensation?
