Creating a Variable Pay Plan

Overall Strategy

Every variable compensation plan should have its own strategy. What is the plan intended to accomplish? There should be a viable case for its design, development, implementation, and maintenance. Documentation of this strategy and management support is critical to ensure success of the plan.

Organizational Readiness

• Business Life Cycle. Where in the business life cycle does your business fall? Does the plan support your business’ life cycle?
• Business Strategy and Culture. Does the culture of your business support a variable compensation plan? Is it a performance-driven culture that places high value on its employees?
• Management Support. Does your top management support the variable compensation plan? Without your top management support, the plan may not succeed.
• Business Goals and Objectives. Will your variable compensation plan support your business goals and objectives? Are the goals and objectives attainable over the performance period?

Compensation Competitiveness to the Labor Market

Prior to the development of a variable compensation plan, it is important to evaluate your market competitiveness. It is also important to know at what percent of market your business is paying base salary as well as total cash compensation for each eligible employee group.

Most businesses cannot afford to just add on significant variable compensation expenses. Will the attainment of the plan pay for itself (through increased revenue or decreased costs)? Will the variable compensation plan be phased in and paid in lieu of merit increases? Will there be a pay adjustment due to the implementation of a variable compensation plan?

Ideally, the assessment of the labor market will make it possible to evaluate the targeted incentive pay for the eligible employees (whether managed by salary grade or pay rate). Typically, a plan should not pay less than 5% of base salary at target to ensure the variable compensation payout is meaningful. It is also important not to pay too little and risk affecting an employees’ ability to pay for life's necessities. This should truly be variable pay.

Eligibility

Who will be eligible to participate in the plan? Will it be managed organization-wide or for a specific employee group? Will the eligible employee group affect the attainment of the desired goals and objectives? Will there be winners and losers or inconsistencies in the eligible employee group. For example, a sales team might want to include their administrative assistants in a sales compensation plan, but the peer administrative assistants outside of the sales department would not be participants causing potential conflict and inconsistencies. In this case, keep the eligible group to only “inside and outside sales employees/management.”

Plan Goals and Measurements

• Metrics. The plan’s metrics should complement the strategic plan of the business. Avoid metrics which compete with one another (e.g., revenue growth versus reduction of cost of goods sold), which can have a negative effect on the variable compensation plan.
  
  
  For a large group incentive plan, up to five financial and/or non-financial metrics over a designated performance period are typically identified as plan objectives. Most companies will select two or three financial metrics with revenue, EBITDA, earnings per share, and operating income being the most frequently used. Cash flow, net income, and revenue growth are also commonly used metrics. Non-financial metrics commonly include MBO attainment, performance, customer satisfaction, and operational efficiency.
• Scope. The scope will identify the breadth of the financial or non-financial metrics, such as individual, team, department, division, group, or organization.
• Weights. The metrics will need to be weighted to ensure an appropriate assessment of plan results. If a plan weights organization-wide revenue at 50%, division-wide revenue at 25%, and operating income at 25%, the plan’s metric is weighted to ensure a total of 100%.

Plan Costs and Affordability

It is important to assess the costs of the variable compensation plan at target, underachievement, and overachievement. Are the costs appropriate to the performance results attained by the organization? Is there an appropriate risk versus reward?

Can the organization afford the plan's costs both short-term and long-term? When determining the costs of the plan and payout provisions, be cautious of providing short-term payouts (e.g., quarterly) when the organization assessment is based on "annual" attainment. An organization may overachieve during the 1st quarter and 2nd quarter but miss targeted results in the 3rd and 4th quarter causing the organization to miss its annual attainment. Payouts during the 1st and 2nd quarter may not have been appropriate in this case.