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10 Reasons Incentive Compensation Plans Fail

The theory behind incentive compensation is money motivates employees to perform well. Unfortunately, many contractors spend a lot of money on employee incentives and receive little value in return.

Employees may become angry with the company because their own expectations for bonuses are not met. Morale is hurt when employees work hard all year, yet the profits of the company still lag because employees are working inefficiently. Contractors that genuinely try to reward hard-working employees are frustrated when they realize they unintentionally created a negative company atmosphere. Unfortunately, this is what many companies face when they incorrectly design and implement incentive compensation plans.

 Getting Employees to Do the Right Things Consistently

A successful incentive plan must focus on achieving company goals by driving the right behaviors in employees. For instance, if the business aims to secure repeat business and work safely, the bonus system should compensate employees for good customer service, safe work practices and profitability. Bonuses based solely on project and/or company profitability do not drive important behaviors (such as safety, customer service and satisfaction, following best practices and inter-company teamwork) that lead to long-term company success. Long-term success is the end result of doing the right things consistently.

While it may seem counterproductive to focus on items besides profits, focusing solely on profits can be dangerous to a company’s viability.

The Top 10 Reasons Incentive Plans Fail

The reasons incentives plans (additional compensation paid to personnel as a bonus for the successful achievement of specific individual and corporate objectives) fail are common among companies and include the following:

1.  Poor Communication With Employees

Poor communication about the plan demoralizes personnel. Management must communicate the following directly to each participant in the plan.

  • The dollar amount of the bonus targeted for that employee with the understanding that it will be paid only if both the employee and company meet all their objectives.
  • Company objectives that must be achieved before the bonus is paid (e.g., achieving some threshold of profitability and meeting safety-related goals).
  • The objectives the individual must achieve personally in their position.

Most employees base their perspective on how the company is performing by how hard they personally are working. Management is responsible for communicating company performance throughout the year so employees’ expectations for bonuses align with reality. Keeping employees informed about company performance does not mean they need to know how much the company is making. If a company is budgeted to make $100,000 pretax profit this month but only makes $75,000, simply tell employees that the company is achieving only 75 percent of its profit goal.

2. The Strategy for the Company is Not Developed

One of the biggest failures of incentive compensation programs is they often do not take into account all the key drivers that will make the company successful. The best incentive plans promote behaviors that are consistent with the company’s strategic plan, marketing efforts, financial goals, productivity processes, and personnel development. For example, if the company performs negotiated, high margin, value-added work, the bonus should factor in the level of customer satisfaction. If the company’s strategic goal is to be involved in the local community, a portion of the bonus should be tied to an employee’s individual involvement in boards, associations, and other community events. Without purposeful linkage to the company’s strategy, incentive plans risk promoting behaviors that are contradictory to the stated strategy.

3.  Best Practices Do Not Exist

If the company lacks well-defined “best practices” in the field or does not drive financial performance through strategic or business planning, implementing an incentive plan alone will change little. The bottom line is employees may work harder, but their hard work may not significantly impact profitability. They will continue to install work unproductively, and the company’s business strategy will remain flawed. Examples of best practices that can significantly impact a construction business’ performance include:

  • a zero-injury workplace;
  • pre-job planning;
  • short-interval planning;
  • daily crew planning;
  • a bid-selection process;
  • an estimate-review process;
  • a change-order process;
  • post-job reviews;
  • people development; and
  • negotiated work.

4.  The Plan is Ineffective at Driving the Right Behaviors

If best practices are well defined but employees do not follow them consistently, it is the same as having no processes at all. The ultimate goal is profitability and providing an adequate return on investment to shareholders. Unless the company has a market niche or performs negotiated work that provides extraordinary profitability, the company’s best chance of success comes when its people:

  • work safely;
  • work efficiently by using best practices;
  • produce quality work;
  • satisfy customers;
  • motivate subordinates; and
  • communicate well with others.

5.  The Company Has a Poor Employee Performance-Evaluation Process

The employee evaluation process is a painful exercise in many companies. First, supervisors must write a short summary of a subordinate’s performance on subjective issues that often include:

  • job knowledge;
  • problem solving;
  • professionalism;
  • motivation; and
  • interaction with others.

These criteria are subjective and rather meaningless in driving the right behaviors in employees. The performance metrics for a controller may include the following objective (vs. subjective) metrics:

  • timely financial statements (statements issued by the 10th of the month);
  • accurate financial statements;
  • timely and accurate work-in-process reports;
  • age of receivables equal to less than 40 days of sales (assures cash flow); and
  • timely filing and payment of payroll and other tax returns.

Performance metrics for a foreman may include:

  • safety (as measured by audits and number of incidents);
  • quality (as measured by rework and customer surveys);
  • customer satisfaction (as measured by customer surveys);
  • labor budget to actual labor costs (ability to meet the labor budget);
  • total cost budget to actual costs incurred (ability to meet the job’s budget); and
  • schedule performance (ability to meet the schedule).

The evaluation process should tie in with the incentive compensation plan. The metrics identified for each position should be meaningful. Evaluations are of little value unless they are simple to create and provide periodic feedback (at least quarterly) to the employee.

6.   Performance is Measured by Profitability Alone

The common measurement of success is net income reported on a financial statement. However, it is not always the most complete measurement. Consider cash flows. Profits are meaningless if a business cannot collect receivables and runs out of cash. The worst case is the firm that must borrow money to pay bonuses. If the company is truly profitable, then cash should be available.

Many bonus plans in other industries are not driven by profits, but free cash flow. Free cash flow is the cash generated from business operations less the acquisition costs of new capital assets such as equipment, trucks and cars (regardless if they are financed or paid for with cash). A company that consumes most of its cash flow by acquiring new equipment will have little, none or negative free cash flow, but may be very profitable because the cost of new fixed assets is allocated over several years on a financial statement.

Other issues such as safety, customer service, quality, and developing subordinates are essential to the long-term profitability of the company and often are included as measures of success and performance.

7.  The Best People May Work on the Worst Jobs

In a project-based “beat-the-budget” incentive plan, the best people may suffer if they are placed on the toughest jobs. Sometimes the best job a field manager can do for his company is to save it from losing a considerable amount of money due to earlier estimating errors or unforeseen problems. In a project-based incentive plan, this ends up affecting the compensation of the best people because they spend the majority of time on jobs with little or no chance to beat the estimate unless some allowance is made.

8.  The Plan Promotes Divisional vs. Corporate Behavior

Plans that primarily provide bonuses for division vs. company-wide performance can promote “me first” behavior. The company’s success comes secondary to an individual’s own financial success. Under these plans, senior managers may go to extremes to promote their division at the expense of the whole company. Then the firm suffers. An exception is the bonus paid to foremen who save labor hours on a project. Labor hours are the main variable a foreman can control and are the best measurement of field productivity.

9.   Costs are Miscoded and Resources are Hoarded

There are many different tricks of the trade that field managers can use to make one project look good at the expense of another. Plans that pay bonuses based on the success of individual projects but do not set up any consequences for project losses promote a “me first” mentality at the cost of other projects. Field managers may fight over the best people and equipment, hoarding them without regard to any other projects in the company.

10.   The Incentive Plan Itself Causes Division

There is always some tension between estimating and operations. However, with some incentive compensation programs, when an estimator leaves something out of the estimate, it affects the project team’s compensation, adding to the tension. Additionally, if field managers are moved on and off jobs, issues about how to split bonuses arise because everyone will not agree on who really contributed to the project’s success.