Incentive Compensation Plans A-to-Z
For companies in all industries, incentive compensation and bonus structures are valuable tools for enhancing performance and meeting company goals. Performance bonuses create alignment — connecting individual and team goals with the organization’s overall objectives.
Properly designing and implementing a bonus compensation structure requires looking to the future. It demands detailed financial planning around how performance may drive company revenues and how bonus payouts will impact the bottom line.
Planning for bonuses can be complicated by many variables:
- Will employees and teams achieve their bonus targets?
- If so, how much revenue will you generate?
- How will increased revenue translate into bonus payments?
- Are the bonuses working? In other words, how much are we paying for these additional revenues?
These variables are even further complicated by the size and complexity of today’s organizations. Enterprise organizations have sales forces with hundreds or thousands of members, a diverse range of product lines, and a broad array of territories, each with its own priorities and activities. At the end of period, some sales reps, products or territories will meet their targets, while others will not.
Bonus payments are real dollars. They must be factored into the financial planning of your company’s ongoing performance and its future growth. Consequently, the financial management of incentive compensation plans and bonuses is a complex process of forecasting, accruing and budgeting.
The starting point for planning incentive compensation and bonus structure is to forecast future performance. There are some key metrics and tools to help companies with their forecasting exercises.
What Metrics Help in Planning Incentive Compensation & Bonus Structure?
Historical Baseline
Once a company has a long-term dependable dataset of its performance, it can establish a historical baseline of incentive targets and bonus payouts.
The historical baseline can be used to estimate the likelihood that the organization will reach the bonus targets, and if so, by what degree. The historical baseline can also be used to assess the effectiveness of various incentive compensation plans and to what degree they can be realistically expected to increase performance.
The baseline can uncover questions such as:
- How much are you paying for performance?
- What is your overall payout for incentives such as bonuses?
- What are your compensation costs? How much are you spending to generate your revenues?
- What is the optimal payout dispersion? How to ensure the top performers are paid the highest and the low performers less?
What-If Analysis
A robust dataset is also useful for conducting What-If Analysis by examining different scenarios and the potential benefits, payouts and growth that may be realized from certain incentive plans.
Over time, this practice creates a more dependable historical baseline that will allow managers to properly project and analyze their compensation plans.
While bonuses have potential for increasing performance and raising revenues they present a budgeting conundrum.
What if you budget for a bonus that may not occur? Or what if you fail to budget for a bonus that does occur.
The metrics and tools described above – Historical Baseline and What-If Analysis – are essential for that can help in budgeting for bonuses.
Attainability
The historical baseline and the What If Analysis can help managers assess whether likelihood of whether individuals and teams can meet the targets, or whether the bonus levels are attainable.
Many companies follow the practice that where the analysis shows that reaching the targets is likely, then they budget for the payout. On the other hand, if the analysis shows that reaching the target is unlikely, then they generally do not budget the payout. When various levels of bonus payout are attainable, some companies have found it prudent to budget for the most likely achievable level.
As the incentive compensation system gets implemented and the teams pursue the companies goals, the financial departments must accurately track the performance levels and manage the payouts. As such, companies must account for the cost of growth along with their future cash needs.
Proper accruing needs timeliness and accuracy. Companies must focus on how and when expenses are reflected on the income statement.
In certain accounting practices, primary expenses such as bonus payments must appear on the statement in the same period that the sale is reported, regardless of when the commissions are paid. As the bonus payments go out, it is imperative that the payouts appear on the statement.
This can be challenging. In a homegrown or spreadsheet-based system, the accounting department will spend significant time and energy making the calculations rather than conducting strategic analysis.
Managing the incentive compensation and bonus plans can be complex. To realize the full benefits of Incentive Compensation Management (ICM), companies should leverage an automated ICM solution. ICM technology gives companies they need for forecasting, budgeting and accruing the compensation process.
Forecasting
In these cases, the automated solution is a valuable tool for strategic planning, and effective in producing a historical baseline and conducting “What If” analysis to explore the potential impact of different approaches.
With automation, employees and managers can test the impact of various work strategies by conducting “What If” analysis, using the system to forecast the bonus payouts from potential performance scenarios.
Budgeting
An automated system provides a platform for using historical baseline and What If” analysis to determine the attainability of target levels, then budget accordingly for bonuses.
Accruing
Each month, the automated system quickly records an incentive compensation accrual. An automated process also ensures that the entries are SOX-compliant.
Designing Incentive Compensation Plans
Creating an effective incentive compensation plan is tough. Your plan must achieve these things:
- Staying within the budget
- Attracting and retaining top talent
- Motivating the sales team to focus on corporate-desired behaviors
Satisfying all three, and managing the ongoing tension between them, is a difficult task. You have to create a program that’s both sustainable and highly competitive. To do that, you’ll need to take specific steps in the correct order. And factor in a host of variables.
The costs of a poorly designed incentive compensation plan is steep.
A poorly designed plan will wreak havoc on your organization. It will drain your profits, encourage the wrong behavior, and/or drive top level talent away. For the sake of your revenue goal, start with territory design and quota setting; then tackle the items below.
- How do we benchmark compensation for each particular role?
- Look at what your competitors are paying for simlar roles. Assure responsibilityes are clearly definited.
- How do we determine what fair-pay is relative to benchmarks?
- Align your budget with what you expact each particular role to produce.
- What is the best compensation plan design for each particular role?
- Simplicity is the key. Miring your team in complex plans will create confusion and decrease employee morale.
- How do we calculate the cost implications of our proposed compensation plan?
- Assure your sales revenue is growing with your sales commissions.
- How do we communication these decisions to the team?
- With complete transparency, down to every detail. This will increase employee trust and morale.
- Who should be part of the committee that approves these plans/changes?
- Your sales leader may call for mid-year comp plan changes. The HR leader should assist the CFO in assessing the current plan and proposed changes. A compensation analysis will help prevent knee-kerk reactions within your team.
- How do we measure the effectivess of our compensation plans?
- Measure payout against attainment. If you can’t meausre it objectively, do not pay on it.
Unleash Revenue Growth with an Accurate and Effective Incentive Compensation Plan
Remember that costs of a poorly designed comp plan are steep. High turnover, weak sales, and eroding profits are a result. A solid plan attract top talent, keeps them motivated, and maximizes profits. A thoughtful design process can bring huge revenue gains.
