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Reward Considerations for Business Crisis #4: Variable Pay

11 May, 2020

During a crisis (such as the COVID-19 pandemic), businesses can fail, survive or find advantage. There are three numbers on the financial statements that will indicate a business’s fate: revenue, cash and.. payroll. An April survey of 4,000 SMEs in the U.S. found that most companies will hit a cash squeeze in 1 to 3 months. How long will your company’s cash last if you remain the current state?

Finance 101: variable costs are better than fixed.

Raw materials are a variable cost. When orders are down, thankfully you don’t need to buy as much raw material. Your utilities bill goes down when factories or office lights are down. Even your gig workers are a variable cost–when you don’t need them, they go away.. But when it comes to employees, salaries represent the single largest overhead expense in almost every business. There is a break=even point, the amount of revenue and margin dollars needed to cover the fixed costs of the business and turn a profit. All revenue is good, but not all revenue is good enough.

Compensation can be a variable cost.

Some companies, such as a very large south Asia-based semiconductor company, are well positioned due to their variable pay practices. Paying bonuses as large as 6 months, or even 12 months to managers, enables them to keep base salaries as low as 60% of market salaries. Quick quiz, which costs more: paying market salaries with 1 month bonus, or paying 60% of market salaries with a 6-month bonus? It depends. In times of strong performance, exceeding earnings goals, total compensation would be higher for this semicon. In an on-target year, however, total compensation costs would be lower (60% or market salary x 1.5 = 90% of market salary.) But in a bad year, such as in a crisis, this company is paying 40% less in total compensation than other companies. Sometimes a reward strategy is actually a business strategy, managed by HR. Imagine that.

Sometimes a reward strategy is actually a business strategy, managed by HR. Imagine that.

Terminology

According to WorldatWork, “Variable pay is compensation that is discretionary or contingent on performance or results achieved, and can be designed for any individual or combination of individuals… it is termed “variable” because the amount actually paid will vary based on whatever criteria the organization chooses.” (WorldatWork, GR6: Variable Pay) Variable pay encompasses bonuses, incentives and cash recognition practices.

There is a difference between bonuses and incentives, and before proceeding I want to set the record straight. Too many people simply refer to all variable pay as bonuses. This is nonsense among HR professionals.

Bonuses are simple, predefined sums of money that will be paid if you do x. If you do x, you will get y. That’s it. No formula. Bonus amounts might be pre-defined, or they may be completely discretionary. Examples include employee referral bonus, project completion bonus, retention/stay bonus, spot bonus, 13th month bonus or perfect attendance bonus.

Incentives have formulas for calculating the size of payment, based on pre-determined criteria, and are communicated in advance of the performance. Examples include corporate performance incentives, often called short-term incentives (STI), Associate Incentive Plan (AIP) or sometimes “bonus” because that’s a simple term everyone understands. But if it’s a formula-based payout, we in HR need to call it an incentive. According to this definition, sales commissions, long-term incentives (options, restricted shares, etc.), profit sharing, gain-sharing, revenue sharing and earn-out plans are all incentive plans/schemes.

It’s fine to brand your incentives as bonus plans, but when speaking to HR or C&B people, please do not call your corporate incentive plan a variable bonus; by definition, if it’s variable it’s an incentive, not a bonus. And please do not call your corporate incentive plan a variable incentive. All incentives are variable.

Smart Use of Variable Pay for a Crisis

So here are my suggestions for your consideration, in checking whether your variable pay practices are designed to help your business survive, or even find advantage when a crisis strikes. These are applicable in any economy but especially in times of crisis, because they will help ensure variable pay actually impacts results which in turn fund the payments.

  1. Use variable pay for a clear purpose, specifically to impact behavior. Behavior includes attract (join the company), retain (stay with the company) and perform (behavior and results). These behavioral objectives can be refined and put into the company’s own language around the value of talent, impact, contribution, competence, teamwork, engagement, etc. Be careful linking pay to behavior itself, as sometimes people do all the right things, try their hardest and still don’t get results, such as when there is a business crisis. Still, it’s behavior we want, because that what people control, theoretically at least.
  2. Set the mix of fixed and variable pay deliberately. People who receive 13 months of salary plus an additional 1 month of incentive (at target) would have a pay mix of 93/7. (13 months of fixed pay divided by 14 months of total target cash compensation, equals 13/14, or 0.93.) Ask yourself whether that is the right mix, considering who you want to attract or retain. Do you see your incentive merely as a “hygiene factor,” something which would be seen as a gap if missing, but otherwise taken for granted? Or do you intend your variable pay to be significant enough to get people’s attention.
    What is the right mix to impact behavior that drives performance? I would challenge whether 1 month of incentive payment makes much difference to change behavior, when there will already be a 13th month bonus paid regardless of behavior or results. Try this: tell your 10-year old he will get 107.7% of his normal allowance if he gets all B’s on his report card, and a “super stretch” award of 115.4% (double the bonus) if he gets all A’s. Although the allowance is paid weekly, he will have to wait til 3 months after the end of the school year. If his jaw drops, then the variable component is big enough. If he is not excited, then next year, do not increase his allowance, but instead change the variable portion significantly. Once you believe the incentive will actually make a difference in his grades, you have the right pay mix. Better to pay 2 dollars and get better results than to pay a dollar that makes no difference. In times of crisis (all the time actually), every dollar you spend must create more than a dollar of value.
  3. Once the reward is significant enough to motivate behavior change, make sure the performance targets are achievable. Sales or earnings targets set in Q4 2019 are no longer valid in most industries. Your employees have already concluded those targets are impossible. Even “threshold” performance is probably too high for many. Now is the time–in the midst of a crisis period–to revisit performance targets and thresholds, to ensure they remain “difficult but doable” just as they were pre-crisis.
  4. Keep the metrics simple and focused by type of worker. Segment your workforce and avoid one-size-fits-all. Sales people should generally be on a separate incentive arrangement from others. Blue collar, store-based, field employees, etc. should be incentivised on operational productivity, quality, customer satisfaction, attendance or other relevant metrics, but not on EBITDA which they neither understand nor impact directly.
  5. Avoid over-weighting individual performance. Whether you use traditional performance ratings, OKRs, MBOs, SMART goals or competency levels, any measurement or assessment of individual performance (or contribution or impact) is risky in times of financial crisis. If the company is running out of cash, you cannot afford to make promises to employees that their bonuses/incentives are dependent on their ratings. On a scale of 1 (low) to 5 (high), the average rating in most companies is around 3.2, even in a terrible financial year. There is generally no correlation between individual performance ratings and financial performance. If you feel a need to reward individuals–especially high performers–in a poor year, you can set aside a small budget for discretionary bonuses, while canceling other bonus payments due to weak financial results.
  6. Communicate at department level to support behavior change. Even if everyone’s incentive payment depends on profitability with no link to individual performance, every department manager can (and should) still explain to their staff how their efforts make a difference to the overall company results. Any line manager who is incapable of explaining how their department affects the financial results of the company should not be a manager.

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