There are 4 watch-words for developing a good incentive program: Relevant, Controllable, Measurable, and Objective.

  1. Relevant – the incentive program should be tied to meaningful business results. Define what matters to your business, what are your objectives for the year (improved customer service, increased revenue from new customers, better margins from existing customers, improved operating profit, etc.) and link your bonus to those objectives.
  2. Controllable – to the extent possible, drive the measures as close to the individual’s line of sight as possible. If the overall objective is improved operating profit, think about how each person can impact that measure and tie a portion of the plan to the specific results they can deliver that help achieve this goal. For Accounting, that might be an A/R balance target of $0 > 90 days. For Sales, it might be improved top line growth which provides more revenue to work with to cover expenses. For HR it might be better recruiting performance with less turnover.
  3. Measurable – if you can’t measure it, you can’t pay for it. Also, you need to be able to automate your measurements as much as possible or you will drive yourself crazy with the added administrative burden of calculating bonuses. For many roles, you will only need to calculate a bonus at most quarterly (for some annually is just fine). For Sales roles you will find yourself calculating pay more often, probably using more complex calculations, which is why sales compensation is a specialized compensation function and consulting discipline.
  4. Objective – you need to avoid subjective payouts at all costs. These are demoralizing and risk legal challenges. Pool approaches, though common in small companies, are often based on a subjective allocation (“we’ll see how much extra we made and then share that with the staff”), but this does not provide anyone with a goal or ability to take control of their potential payout. Instead, any bonus under this type of approach ends up being just additional pay with zero motivational value.

Another caution for small companies is to not base their employee bonus on final operating profit (after management/ownership has taken out their disbursements) as this creates a conflict of interest and lack of control in the outcome for employees, as the more the owners take in disbursements the smaller the profit to use for employee bonuses. The employee bonus amount should be determined prior to owner disbursement and budgeted for as a fixed cost rather than just a “sharing of the profits” at the end of the year.

Generally small companies start from the wrong end of the equation when thinking about bonuses. They ask “what do we have left over” rather than thinking about “what do we need to pay to get good talent, and how can we divide that pay up between salary and bonus for the maximum motivation.” Obviously the economics need to work out either way, and the second approach requires more management involvement in controlling staffing costs, but the bonus targets should be built into the budget, allowing for upside if company and individual goals are exceeded.

The right system can have a dramatic effect on productivity and morale, because people will know what is expected of them and what they can do to change the outcome, plus it creates a map for the company showing how everyone fits together to achieve his/her own piece of the puzzle that will lead to the company’s overall success…provided the 4 watch-words above are adhered to in the design. A program that uses measures that are irrelevant to the business, uncontrollable by the employee, not measureable, and not objective would of course have a profoundly negative effect!