LME008 – Performance Based Bonus – What you ought to know about it.
Does a performance based bonus really work?
Of course, as a manager and entrepreneur you are constantly looking for new ways to improve your operation. Your employee’s job is to support this and to pull on the same string with you.
For this reason, nearly all large companies pay their managers performance based bonuses.
Their annual income is split into a fixed and a variable portion. The company intends to motivates with the variable compensation. Therefore, they link it to the attainment of individual objectives.
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Does performance based bonus work for small companies?
You may now be asking yourself:
“Should we not also pay our sales team performance based bonuses? There must be something to it since all the other successful large companies are doing this as well.”
Wait a minute. First, let’s take a look and see whether variable compensation truly delivers on its promise:
Objectives of performance based salaries
Variable compensation is often referred to as performance based salary or performance related pay. What is the underlying idea behind it?
The company or the supervisor and the employee agree to objectives. The intent is to get the employee focused on the objectives.
To ensure this, the company only pays a portion of the employees income if he attains his objectives. The company hopes to motivate the employee into acting in the company’s interests.
If he is particularly diligent, he can even outperform his objective. The employee then receives even more than 100% of the agreed to variable income portion.
The proponents of performance related pay primarily list the following benefits:
- The variable portion motivates the employees.
- The company pays the employees for performance.
- Compensation management effort costs little, but gets good returns.
Do you also believe that variable compensation allows you to get more out of your employees? Well, let’s take a look at this in detail:
I find it astonishing that companies feel that they need to motivate their employees to act in the interests of the company. I thought, the employee has an employment contract. In this contract he signed the obligation to perform this service. The company pays him his salary for it.
Now the company assumes that the employee is likely to only perform a portion of his productive output. The company’s position is that the employee will not honor his contract. Why would the company even employ someone who is very likely to not honor his contract?
Compensation structures in large companies
But it gets even more confusing:
Let’s take a look at the compensation structure in a large cooperation. This is how it works:
The higher the employee within the hierarchy, the higher their income, and the higher is also their performance based pay.
For instance, the variable income portion of a department head is typically between 10% to 20%.
However, the variable income portion of an Executive Board member can be 50% or more.
Watch my YouTube video on performance based salary of managers:
Motivation of CEOs
It gets even more extreme for the variable portion of a Chief Executive Officer working for a company listed on the stock market. The stock options and other bonus payments are in the millions.
Come on: Does somebody like that really have to be motivated to do his job properly in order to honor his contract? Is this truly necessary?
Amazing: The CEO already earns a base income of EUR 500,000 and still has to be “motivated” with a variable income portion, stock options and other bonus payments to the tune of several million dollars.
Please do not take this the wrong way: The company should generously compensate the CEO if he is doing a good job. This should even be several million EUROS.
But a person like that does not have to be motivated! Either, he is intrinsically motivated, or he should be sent to hell!
Motivating lower-level employees
They are doing an outstanding job – although their organisations only pay a small fraction compared to the base pay of a CEO. Never mind a bonus and variable income portion.
What’s about the motivation of nurses, elderly caretakers, police men or soldiers? To the best of my knowledge variable income portions don’t motivate these people. Much more likely, these people are frequently highly motivated on their own.
As an aside: Even Presidents and Cabinet Secretaries are not motivated by variable income portions. That would really be beyond the pale!
Agree to objectives
During my 9 years as an employed Managing Director in a large international industrial cooperation, my compensation also included a variable component. My employees as well were paid based on performance.
Originally, I too was convinced that this performance based salary is fair and correct. But over time I became increasingly suspicious that something wasn’t working properly:
At the beginning of each year, I had a long meetings and objective discussions with each of my department heads. The meetings were always very important to me. Ultimately, we wanted to use these discussions to jointly paint a picture of the future, and to explore the options for the company’s and department’s direction. The idea was to find out what is feasible. The objectives from this were intended to be challenging but attainable.
The discussions actually went quite well with several employees. But in many cases the meetings were difficult because the employees sandbagged the objectives. They were not genuinely interested in finding out what was possible, and to set motivating objectives. Instead, they wanted to lower the bar for their personal objectives, in order to be assured of a maximum income with the least amount of effort.
Objective discussions turn into income negotiations
The more of these employee discussions I conducted, the clearer it became to me:
If an employee has a variable income portion,
every objective discussion is also an income negotiation.
This is counterproductive. As soon as the own income depends on objectives, most people are not motivated to even consider challenging objectives. I don’t even blame them. This is ultimately not in their interest. It even violates their underlying personal goals.
Employees become income optimizers!
Today, I am convinced that tying variable income to personal objectives is a waste. It frequently demotivates employees. In many cases, this linkage even has a more negative impact.
Let me tell you a terrific example for the damaging effect of a well intended objective that is coupled to income:
The Executive Board for a large telephone company issued a new customer bonus. Sales employees were to receive an additional bonus if they generated sales revenues with new customers.
What did the salespeople do? They prompted their long-standing customers to cancel the contracts, in order to sign them up as new customers. Instead of focusing on actual new business, they preferred to benefit from easily realized pseudo-new business.
When you create financial incentives you should not be surprised if your employees do not focus on the company’s success, but rather on how to maximize the incentive.
When bonus systems can be useful
The expectation of a bonus is only motivating and purposeful when routine assignments are processed according to 3 points:
- Simple rules apply.
- A clear-cut objective is set.
- The path is clearly described and easily understood.
But this is rarely the case especially in todays world. Here, you need employees who are creative, who think on their own feet and contribute, accept ownership, and are reliable.
You therefore need employees who are self-motivated, i.e. intrinsically motivated. They need to understand the purpose of their work. You should therefore not attempt to increase employee motivation with a compensation scheme! The individual sense of purpose will fall by the wayside. Do not attempt to compensate for deficient leadership by means of a compensation scheme!
How should you structure an alternative compensation scheme?
Treat your employees fairly and pay fairly and avoid common leadership mistakes.
Especially in a small company, you don’t need a complicated compensation scheme for this. All you need is common sense and empathy.
Take the following rules to heart regarding your employee’s incomes:
- Lead with objectives, but don’t tie the income to the objectives!
- Agree to a fixed income that correlates with the employee’s performance!
- If the employee demonstrates consistently good performance, you can increase his income!
- If the employee consistently underperforms in spite of support, you should reduce his income or separate from the employee.
- At the end of the year, pay a bonus to all employees if the company made good profits. If the company is doing well, then the employees should participate in this. That is fair. If the company is doing poorly, then it is also clear that a bonus cannot be paid.