Q. I run a small business and want to develop an incentive compensation plan for my salesperson. His goal is to sell $100,000 per month and he earns a base salary of $60,000. In months where he achieves his goal, I plan to give him an additional $500. If he sells $120,000, I would give him another $500 bonus. Finally, if he reaches $140,000 in a month I would give him $500 more for a total bonus of $1,500. Do you think this is a good idea?
A. We are big fans of incentive compensation for two reasons. First, a well-designed system can motivate employees to deliver the performance you want. Second, if you structure the compensation system correctly, you will have plenty of money to pay your employee if he or she earns the incentive, because your company will have done well.
One caution is that in our experience, employees will do exactly what you incent them to do, not necessarily, what you want them to do. That’s reasonable. It’s unfair to expect an employee to behave in a way that will not maximize his or her income. It is up to you to ensure that you are incenting them to do exactly what you want them to do. In designing an incentive compensation system, you will want to consider three questions:
1. Can you afford the incentive compensation system? At $100,000 of sales in a month, you will pay your salesman 5.5% of revenue (($5,000 of salary + $500 of bonus) / $100,000 of revenue). That’s probably fine if you have gross margins of 50%. However, if your gross margins are sub 10%, you might want to reconsider your plan. After the first bonus point ($100,000 of revenue), you are paying a bonus of 2.5% of revenue at each increment of $20,000 ($500 bonus / $20,000 of revenue). If you could afford the 5.5% you paid for the first $100,000 of revenue, you can surely afford this.
2. Are there problems around discontinuities? Discontinuities occur when a small change in revenue results in a large change in compensation. The system you have designed would result in $1 of revenue (the $1 between $99,999 of sales and $100,000) being worth $500. Big steps like this can cause behavior you don’t want. For example, a salesperson who is close to the discontinuity at the end of the month might well start calling customers begging them to accelerate their order so that he or she can get the bonus. Worse, a salesperson who realizes that he or she cannot make it to the next step in the bonus plan this month, might ask customers to hold their orders until after the first of the month so that the order will count toward the next month’s sales total.
In general, bad things happen around discontinuities. Therefore, we recommend an incentive compensation system that doesn’t have major discontinuities. For example, you might start paying your sales person a 2.5% commission for all sales over $80,000 for the month. That would mean that he would earn $500 of bonus for $100,000 of sales, $1,000 of bonus for $120,000 of sales and $1,500 of bonus for $140,000. Obviously, this would cost a bit more than the system you proposed, but it eliminates the problems with discontinuities. Clearly, the payout could be adjusted so that the cost of the incentive was lower.
3. Will you be happy if your employee performs significantly better than expected? We’ve seen it too many times. A CEO designs an incentive compensation system and then gets mad when his or her employee hits it out of the park and is making more than the CEO does. Think the incentive compensation system through. If your employee does twice or three times as well as you think he or she can, you should be thrilled, not upset because your employee is making too much. If this won’t be the case, rethink your incentive compensation system. It is too rich.
Incentive compensation systems are powerful motivators. However, unless they are designed carefully, they can cause more problems than they solve. Answering the three questions above will ensure get what you want from the incentive compensation system you design.