Variable compensation - Why?
In many roles, a variable component of compensation is added to the pay plan. This could be in the form of an incentive, a bonus or a profit share.
Why is variable pay there as a component of compensation and where is it best added?
The case for variable compensation
Every individual is expected to deliver a predictable & measurable output when performing work.
In some roles, the amount and timing of this output can fluctuate. It can be higher, lower, sooner, or later than expected.
Variable pay is compensation for the anticipated but unpredictable outcome or output.
Since the outcome or output is expected to occur, the variable pay is part of the total pay plan.
However, since there a measure of uncertainty, the timing and amount of the payout are linked to the timing and quantum of the results. Deliver results, get paid.
Jeff is a salesperson. He is expected to win 8 deals this year. There is very high probability of at least 5 wins. While there is confidence that 3 more will also bwon, the pursuit effort, economic conditions and competitors could influence the timing and results.
For Jeff, a base or fixed compensation is set to compensate the high confidence / predictable level of output (5 wins) and a variable pay added on top of that which will pay out for any incremental deal won.
The accounts payable department of Widget Inc. has service levels to be met for the year. To motivate the team to better those SLA’s, a variable pay element is added to the compensation of all the team members. This gets paid if they exceed the set service levels.
Where fluctuation in output is expected to be small, the variable pay element in the overall compensation will be modest. On the other hand, if the total output can swing substantially, variable pay will constitute a commensurate large portion of the overall compensation.
Incentives, bonus’ and profit sharing are the three most common forms of variable compensation.
Incentives are paid, well, to incent someone to perform better.
These are offered up front with expected performance and the payout clearly defined. Do it, get it
Eat the veggie’s, get ice cream after dinner. Clean the room for a month, get to use the car for a date. Get $50 for each additional phone sold after the first 10. Make 100% of quota and get a holiday to the Bahamas.
All of these are examples of incentives – a reward for a clearly defined & desired outcome. Easy to predict what performance will accrue what incentive.
Incentives are best paid for actions on which the individual or group has a high control and can be motivated to do better.
A bonus is another form of variable compensation, and also intended to motivate individuals or groups to perform better.
If a bonus is also variable compensation for better performance, how is it different from an incentive?
It’s a thin line and here is where it tends to get drawn.
If the performance benchmarks and what will be paid for meeting/exceeding them are clearly defined up front and the individual or group can act on its own to reach the benchmarks, it’s an incentive. Defined upfront, high level of control on the outcome.
On the other hand, where assessment of performance is made after it is delivered, and then a judgement made if a variable compensation be paid and how much, it is a bonus. It’s after the fact, backward looking and very likely not guaranteed.
Incentives are predictable, bonuses are not.
Jeff is part of a sales team. At the end of the year, the team was the best performing sales team in the company and management decided that they should get recognition for it. A $10000 bonus was awarded to all the salespersons.
The accounts payable department delivered consistently high levels of service and there was substantial appreciation of this from many of the key vendors. To recognize this, the team was awarded a bonus in the form of a family holiday to Disneyland.
Good performance, judged after the fact and awarded = bonus
An employer may share a part of profits of a division or of the overall organization with its employees.
Since the actual profit is known only when achieved, it is an unpredictable number, and so is the profit share linked to it. In that respect, profit share is another form of a bonus.
When the final financial results were tabulated, Jeff’s organization exceeded its profit goals for the year.
The employer of the accounts payable team was the 2nd best performer in its industry in profit margin performance in 2021.
To recognize the contribution of employees in achieving the superior profitability, all employees were awarded 5% of their fixed pay as a profit share.
Where all or part of output can fluctuate or be unpredictable, variable compensation can be introduced to reward desired outcomes.
The greater the likely variability or unpredictability in performance levels, the higher the proportion of variable compensation component within the total pay package.
Incentives, bonus’ and profit sharing are three of the most popular forms of variable pay.
Incentives are forward looking – do this, get this
With bonus’ the payout is backward looking – you did this or this happened, hence here is something.
Profit share is another form of a bonus – dependent on the performance of the company as a whole.
Each of these forms of variable compensation can be used to encourage desired behavior and results and can be used individually or together to get to those outcomes.
Variable pay is the carrot – do it and get it. Something to work towards.
It has best impact on behavior & output when linked to outcomes which are easy to understand, simple to measure, and within the control of the individual or group.
References - Is incentive considered a bonus or commission? (motivationjob.com)
You may also want to read - Will performance impact fixed pay?