Why Employee Incentive Plans Work
The main reason I find companies don't have incentive plans is not that they wont be helpful or that the owner is averse to paying out incentive. Its usually that owners see Incentive Plans as being complicated and potentially more harmful than good because it may cause employee dissension (Why did he get more than me?)
I stress keeping the plans as simple and as transparent as possible and teach that its a work in process with minor (or major) adjustments over time. I work hard to build in the fairness up front but I also listen to the employee feedback from the first few payouts and adjust the rules to be fair. In my experience, the payoff has always been huge, contrary to some Harvard Business Review that says otherwise. Just ask some of my clients.
Owners of companies generally feel that they care more about the company than their employees because the owner has a greater stake in the company's success. If this is true, then the answer to getting employees to give more discretionary effort to bring in profits is to give them an ownership stake in the company. But it may not be an option or a desire of the owner to give away ownership or stock in the company.
But there is another way to give employees an ownership stake. The idea is to give employees an opportunity to share in the profits of the company. That doesn't mean they share in all the profits. They share in the profits that come in above a set level; the level that separates a good company from a great company. By sharing in the rewards of a successful company, employees tend to care about how profitable the company is. For years, the most successful companies have used this technique to increase morale as well as drive up their profit levels.
Setting A Baseline
There must be a benchmark to start, for example 30% of gross profit or 10% net profit. Up to 30% gross profit or 10% net profit, no incentive will be shared with employees. This is because that level of profit represents an average return, an average company, a grade of C, meaning the company operated at only an acceptable level, not an outstanding level. That money is needed just to sustain the company.
So we must ask the people to be outstanding. Show them the rewards for earning returns above the 30% or 10% mark. Show them that they can make $500, $700, $1,000, $10,000 or more in incentive pay each year for driving the company's profits to beyond normal expectations.
Now they have an ownership stake. Now they have a reason to be more productive, to make sure quality meets the highest standard and that the customer is satisfied enough to return. This is known as an incentive plan and it is what Im proposing here. Below are some basic steps of a plan and the details of an actual plan that worked for one of my clients:
- Set a baseline profit level (Remember goals must be achievable)
- Decide on payout periods, methods and dates (Monthly, quarterly, semi-annually, annually)
- Decide on anticipated payout amounts based on an employees value
- Decide on an evaluation method for each employee type (performance evaluations are a must
- Communicate it with employees (The more transparent the plan, the fewer complaints)
- Measure, Payout and Follow-up
Below is an actual incentive plan set up for a company I consulted at. The end results (along with some other improvements in estimating and productivity) brought an additional $400,000 in annual profits for the $7 million dollar a year construction company. The owner shared over $110,000 with his non-management employees that first year. Every Incentive Plan should be set up differently and geared toward the company's particular circumstances.
Baseline Profit Level
(While I highly recommend basing non-management employee payouts on gross profit, this contractor was adamant that all his employees, mainly job superintendents, contributed to his operating expenses and he insisted on payouts based on net profits)
Based on our discussions and how the company performed in the recent past, (2% net profit last year) we set 6% net profit level as a baseline or benchmark of performance. (We could do this because we also had made several recent improvements in estimating methodologies). The 6% of sales net profit level represented an expected level of profit for the company in this years business plan. The majority of this 6% would be money for management bonus or funds put back into the company for equipment and growth. We decided that at least 90% all profit above the 6% would be distributed to non-management employees.
(The baseline profit level should be evaluated each year and can be lowered or raised by the owners at any given time based on market conditions or recent profit levels. Again I remind you that goals must be achievable or you ruin the whole concept)
We decided the payout in 2006 would be made once a year. (While I recommend payouts at least quarterly or semi-annually, this particular contractor felt he needed a full year to evaluate performance and profits so we agreed to one payout) The single payout was planned for December to coincide with a generally slow season and the holidays.
Payout would be a projection of final sales and costs at the end of December. 10% was held back in case profits came in lower by the end of the year. An adjustment payment would be paid out in January. (This has worked well, providing a nice little secondary check for everyone in January)
Individual payouts are based on the value that a person brings to the company. Typically value is decided by 4 things:
- Position title, impact on profit and authority (translated to a position factor)
- Full-time / Part-time status
- Performance Evaluation
A formula was devised based on the first three categories above. A dollar amount is achieved for each employee using these factors distributing all the money set aside for incentive pay that period. That amount is then multiplied by the performance review (set in percent) to dictate the final payout. (For instance if the first amount is $1,000 and the employee received a 95% rating, they are paid $950)
Money not paid because of reviews less than 100% can either be simply redistributed back to the gross amount, or set aside to be included in a future payout. This set aside is one of many ways the company can protect itself in case there is a downturn and profits in future quarters drop drastically due to performance or economic reasons. (A reminder here that rules of the payout should be put in writing and a signature denoting that they received a copy of the rules should be kept in each employee file)
Evaluations are based on an individuals performance during the current cycle. The evaluation of performance for each person within the group is designed to give a top rating based on 100%. A 100% score means an employee gets 100% of the set aside amount. Each score below 100% gets that designated percentage of the amount derived from the formula.
The plan should be communicated to all employees as soon as it is finalized so as to have maximum impact. Progress reports on how the company is doing against the plan helps keep interest keen and employees attentive to quality and productivity which are always profit drivers.
The results of a designated period (monthly, quarterly) should also be communicated in monthly meetings or handouts. (This is a great idea even without an incentive plan. Study after study shows that employees are always curious how the company is doing yet we are continually negligent to tell them unless it is bad). This will keep interest in the program and will ensure a feeling of ownership throughout the year among the employees.
Over time, baseline profit margins may be adjusted up or down. In better market conditions, when profits should be up, we should avoid raising the benchmark level too much. The more reward your people see, the better overall they will continue to perform. The impact this can have on good people is hard to measure but easy to imagine. Your best people expect and deserve to be well-rewarded for their work. They're the ones really driving the profit payout.
We should also refrain from lowering the mark too much in tough market conditions. We should instead ask our employee again to be excellent. We should ask them to rise to the occasion and find ways to overcome hardships and make profit in tougher conditions, to adapt to the market we work in.
And always remember its a work in process. There will always be a little discontent among certain employees. But then again those employees are probably the same complainers now that you don't have a plan. Complainers complain, regardless of what you do. If your plan is fair for the strong majority, then simply offer the employees complaining to quit cutting them an incentive check. This usually quiets the whiners.
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