Compensation Methods; the Pros and Cons By Kevin Dwyer Tuesday, 6th January 2009
How well does your compensation method match the needs of your organisation? Does your compensation method create unintended consequences that deliver an observed strategy and set of tactics that differ greatly and negatively from the intended strategy and tactics?
If your answers are; "Not very well" and "Yes", you are normal. If you answered "Very well", and "No", you work in a rare organisation or you are potentially blissfully unaware.
Most organisations operate with a salary only, or salary plus bonus (for the individual) scheme. Sales organisations and sales departments of large organisations often operate with a salary plus commission or a commission only compensation system. Another option not often used is the salary plus pool system. Salary and the pool may remain fixed with revenue, or float with revenue.
Which is the best compensation method? The question, unfortunately, only begs other questions. "How do you want your staff to behave?" is the first question one should ask of oneself when designing a compensation system.
Other considerations include what level of risk one wants employees to take, what degree of teamwork is required to be successful and how closely the organisation's financial performance is tied to staff performance. For example, a retail sales organisation's financial success is highly geared towards the salesperson's success. A research laboratory's success is highly geared towards individual risk taking (ideas) and team collaboration.
Salary, with or without salary sacrifice, is a good compensation system where individual risk taking need not be rewarded-other than through improvements in salary with career progression. Its other pros include: stable cost of doing business; easy to change accountabilities and roles; easy to administer; and high income security for the employees. Its major con is that it does not quickly reward successful short term risk taking.
Salary with a bonus is the most popular compensation system and yet it is one of the less beneficial compensation systems for most organisations.
The first con is that the bonus is usually tied to a budget number, operational quota or other target that has little relevance to the employee. The employee cannot see clearly how they may influence the performance to realise the bonus. Examples include an operations employee whose bonus is tied to profit and a local employee whose bonus is tied to the performance of a large geographical area.
For instance, consider a Chilean employee whose bonus is tied to the $US performance of the "South American" region. The payment of the bonus can easily depend on sovereign risk levels of Argentina and Brasil. What impact does that bonus arrangement have on the employee's work? The answer is very little other than disappointment when the bonus does not materialise and joy akin to winning a lottery when it does. The bonus is equated to luck rather than personal or team performance.
When it is clear that either a bonus will or will not be paid a couple of months before the calculation period ends, there is often a tendency for effort and intensity of performance to drop off.
Other cons include that they are often difficult to administer, are poorly understood by employees, and create difficulty in changing roles and responsibilities during the period of time that the bonus is calculated.
The pros of such systems is that they provide a better balance of income security and income at risk for performance and allow for a design that incentivises individual or team performance and short term risk taking.
Commission structures, usually constructed for sales teams, consist of two generic types: commission only and salary plus commission. The pros of commission only and to a lesser extent salary plus commission, are that they provide a high degree of flexibility tying remuneration to revenue and are easy to administer and understand.
The cons of commission schemes, particularly commission only schemes, are that they may lead to aggressive behaviour and provide low income security for employees. Additionally, whilst other compensation systems reduce the cost of sales as a percentage of revenue as revenue increases, commission schemes fix the cost of sales as a percentage of revenue, meaning that from an organisational perspective, higher volumes of sales are no more profitable than lower volumes.
Another issue which clouds the impact of commissions on behaviour is the choice of paying on billings or receipts. The former absolves the salesperson of the responsibility for making appropriate checks on prospects' abilities to pay. The latter makes it difficult to administer and may lead to aggressive collections behaviour.
A salary plus pool system offers what I think for most organisations is the best compensation system. The system works by creating a pool of funds which may be a proportion of revenue or a proportion of the overall budget or salaries budget. The availability of the pool is triggered by a single metric which the team can influence, for example, sales revenue, production volumes, project expenditure or costs.
The pool is divided amongst a team using a set of metrics which the individual can readily influence.
The metrics for dividing the pool should cover a range of behaviours as well as results. The number of metrics should number no more than four-more than that and individuals find it difficult to keep them top-of-mind. The metrics may change from quarter to quarter or year to year dependent on what is important in the operating environment at the time.
For example, elements to be assessed for a production plant may include three or four of the following:
Contribution to safety culture
Contribution to team ethic
Using a pool system with a defined team makes it more likely that individuals in the team will behave in such a way that the team gets the best result as it is their interest primarily to get the team result "across the line" and secondarily to contribute the most to it.
Another variation of the pool scheme is to have two trigger levels for two pools. One pool may be for an overall geographic region and another for a smaller region within the original geographic region, i.e. a state within a country, a country within a regional group of countries. Another alternative is a division within an organisation. A further alternative is for two sets of metrics within a triple bottom line set of objectives, for example, a pool for financial results and another for community engagement.
Compensation systems must be thought through from first principles to design them to achieve a behavioural objective. Following what competitors do is not enough because it is very likely that their compensation system is flawed in design when it comes to changing the behaviour of people.
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