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Create an Effective Incentive Compensation Plan

A successful incentive compensation plan focuses on achieving company goals by driving the right behaviors in employees. 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. How does a company determine if its incentive plan is effective? If the answer is “no” to any of the following questions, chances are the company is not getting the most benefit out of its plan.

  • Is there a defined corporate strategy that is communicated to the rest of the organization so employees understand what the company wants to accomplish?
  • Does the incentive plan drive behaviors that lead to the objectives outlined in the corporate strategic and business plans?
  • Are there well-defined and communicated best practices?
  • Does management know what competitors are paying for base pay and incentive compensation so the company can be competitive in its offerings?
  • Does the company have a threshold of financial performance that it must reach before a bonus pool is created (to ensure shareholders are compensated for their risk first)?
  • Do employees know the company must reach a threshold of profitability, safety performance and other goals before a bonus pool is created?
  • In addition to the company’s performance, do employees know what specific individual performance goals they must accomplish in to be paid all or a portion of their targeted bonus?
  • Do personnel receive periodic, objective feedback on their performance throughout the year in an easy-to-administer employee review process?
  • Do employees know how well the company is doing throughout the year because of proactive communication?
  • Des the company balance issues such as return on shareholders’ investment and profit as a percent of revenues with the potential amounts that can be paid under a plan?

Following are guidelines for creating an effective incentive plan.

1. Develop a Strategic Plan

Developing and communicating a formal strategic plan creates a unified direction for the company that provides a platform for performance expectations, decision-making and personnel development. Without a formal strategy, it is impossible to design an incentive plan that promotes behaviors consistent with overall corporate goals and strategies.

2. Develop Best Practices

The second step is to develop and implement standard best practices within the business. Developing best practices establishes expectations for all positions in the company and enables management to hold employees accountable for their performance. These best practices vary depending on the type of work, size of company and structure of the organization. The key is to identify the critical processes that affect business and then standardize and communicate them.Finally, employees must be held accountable for complying with and using the company’s best practices.

For example, one company might determine a formal pre-job planning meeting, change-order process, customer service and project-closeout process are their critical best practices. Establishing standard criteria for how to perform each of these processes creates a platform for accountability. Once established, employees can be evaluated based on objective criteria and an incentive program can be developed that compensates individuals for consistently doing the right things.

3. Determine Shareholders’ Required Return on Investment

Company performance standards must be met before any individual bonuses are paid. Employees work for a company and are paid a salary to carry out their job responsibilities. The expectation is if everyone performs up to certain standards, the company will be profitable. An owner should expect to be compensated for the risk that he or she takes beyond their salary. This means there is a certain level of financial performance the company must meet before any type of bonus pool is created. This financial performance is individual and determined by the owner’s expectations. Once the owner feels he or she has been compensated for risks taken, a bonus pool is established. Employees must understand that if the company does not perform to expected standards, no individual bonuses are paid out.

Return on investment may be defined as net income before income taxes divided by shareholders’ or partners’ equity in the business. Given the risk of owning a construction business, a minimum return on investment to shareholders should be in the range of 20 percent to 25 percent. Some contractors earn returns on investment of as high as 60 percent.

4. Create, Implement and Communicate the Incentive Compensation Plan

Benchmark how other companies are paying base and incentive compensation to their employees. The starting point for creating an incentive plan is to compare the current base compensation and employee bonuses paid in similar companies. Salary surveys are available from a variety of sources, including Personnel Administrative Services and the Bureau of Labor Statistics. Once it is determined how the company compares to other businesses, target bonuses can be set for each person in the plan according to their position and responsibilities.

Develop performance standards by position in the company. The next step is to set performance expectations for each position participating in the plan. This goes beyond creating job descriptions. A metric is a standard of performance. Employees’ bonuses are determined by how well each employee achieves his or her individual objectives.

This process may be used to set pay grades and performance  expectations for A, B, and C foremen, project managers and superintendents. For example, an A foreman submits accurate paperwork timely (including time sheets), and a C foreman does not. An A foreman has consistent profitability and beats the budget. A C foreman does not always achieve the budgeted profit. Pay scales are higher for an A foreman than a C foreman.

Create performance standards for the company. Remember, for an employee to receive a bonus both the employee and employer must perform. Once it is known what each person can expect to receive as a maximum bonus, add up all the bonuses to determine the dollar amount of exposure to the company. For example, if all the targeted bonuses add up to $500,000, determine the profit level the company must achieve to begin creating the bonus pool.

A specialty contractor plan might indicate that bonuses accrue as a percent of profits after a threshold level of profitability is reached in terms of dollars or profits as a percent of sales or equity (the shareholders’ return on investment).

As an example, the company might start accruing the bonus pool once the company achieves at least $1 million in net income before taxes. If it accrues a bonus pool equal to 25 cents on the dollar for profits in excess of $1 million, the goal of the bonus pool is achieved when the company earns $3 million in net income before taxes.

 Profit Level Required for Bonus Pool Creation

Total pretax profits                      $3,000,000

Less threshold                            –$1,000,000

Profits in excess of $1 million   $2,000,000

Bonus rate                                                x25%

 Bonus pool created                     $500,000

Profitability is almost always the key objective of an incentive plan. If safety is important, tie the thresholds for the payment of incentive compensation to specific goals such as the number of recordable incidents or lost workdays. A company trying to drive customer service will use the results of formal customer surveys to determine how much of the bonus pool is paid.

Formalize and communication of the incentive compensation plan. This communication and consequent understanding drives employees’ behavior to meet company objectives outlined in the strategic or business plans. Expectations must be communicated to everyone in the plan.  Generally, communicating only once is not nearly enough.

An incentive compensation plan is intended to drive the right behavior in employees. Whatever program is established for paying bonuses, management must communicate its expectations for performance and the behaviors required. Before developing a plan, it is important to look at the entire organization and determine the readiness of the company to pay incentives based on the right behaviors and performance.