Paying staff a bonus or other incentive is a well tested method of improving their commitment to the business' management goals. This recipe examines ways of doing this that have worked in practice.
Read this if: you want to know more about how bonuses should be constructed to drive the goals of the business. Many bonus systems are not well thought out and don't help to improve the things the owner/ operator really wants while costing money and raising the expectation of the staff. Learn about a whole range of techniques you can use to to construct a workable set of goals for your business that focus on achieving what you want.
Related to: part of the human resources materials in Profit Savvy so you may find other topics of interest in that category in the Profit Savvy 'Contents" menu
Degree of Difficulty: this is a yellow belt (introductory) article that should be useful to all levels of management experience.
Staff Bonus Scheme
There seems to be ample evidence that a well designed bonus scheme can incentivize staff to be more productive, more innovative or improve other aspects of the business operation the owner wants to focus attention upon.
The bonus goal is a statement that these company goals are so important, we will pay you to focus on them,.
It is a mantra in business that people will focus on whatever is measured which is why having the right metrics is so important (see Metrics ). In this instance, the point is made even clearer by paying staff to head down that path.
What's the Bonus Scheme for?
A bonus scheme can be used to (for example):
- Lead to higher profit
- Focus on some vulnerability of the business and incentivize staff to repair it.
- Create a team feeling that will spin off to other aspects of the business as well.
- Identify ongoing problems if progress is not being made towards the bonus goal fast enough.
In fact, if you don't have some sort of goal like one of the above in mind when you are designing a bonus scheme, you are quite likely just pouring money down the drain. Staff might be motivated but, in the absence of a goal, just what are they motivated to do?
Decide on Desirable Outcomes
So, the first step in a bonus framework most likely should be to decide what you want the staff to be doing.
Remember, staff will do whatever they think the boss has his/her eye on. What stronger indication of what the boss is looking at than where you are prepared to pay for results?
These are the Goals for your bonus scheme.
Like any good set of goals, they should follow the SMART formula (see here for more on SMART Goals)
Design a Successful Bonus Scheme
The business may have problems when:
- Staff don't trust management to run the scheme fairly.
- It seems to be arbitrary about who gets what.
- Business owner plays favourites - either more senior managers or only some departments receive bonuses.
- Staff only find out about their reward after the event closes so they have not been engaged in the process.
- When the company is operating with a 'lowest cost' producer in their industry strategy that leaves margin too tight to pay bonuses.
The characteristics of a successful bonus scheme include:
- Putting everyone in the same boat so all participate on an equal footing. All employees (regardless of seniority) receive bonuses using the same formula, which is clear, easily understood and made available to all in advance. It is not as simple as saying the more senior the staff member, the more they contribute so the more they should get. A quite junior person can have a great cost saving idea that the senior staff would never have due to their distance from the operational coal face. Some staff will be casual or part time workers. Possibly great ideas should be separately rewarded.
- Using the bonus scheme to encourage all departments to pull towards the same company-wide goals so that they share knowledge and resources willingly, for the greater good, rather than squirreling them away to boost their own chances.
- Limiting the bonus scheme to just a few goals. Too many goals makes it hard for people to keep them in their mind. Worse, the goals might be in conflict with each other if there are a number of them and pushing one up may damage the success of another.
- At least one goal should be focused on profitability as that helps to ensure survival and growth of the business.
- Another goal might focus on a balance sheet item, for example, inventory reduction or debt repayment. Again boosting the profitability of the business ensuring survival and growth.
- Alternatively, a goal could focus on a vulnerability that the business needs to patch, which would benefit from an 'all hands on deck' approach. For example, focusing on an over dependence on just a few major clients.
- Making people wait too long for the first bonus payment means that they will tend to forget about the scheme or leave their run too late (often called the homework problem - homework is almost inevitably left to the last minute no matter how much time was given to do it). A progress payment each quarter towards an annual goal will help to keep them focused. If any quarter is missed, that will also drive home that the game needs to be lifted to reach the annual goal.
- Frequent communication of the goal(s) driving the bonus and transparent scores are vital to keep people focused and engaged.
Money is Not the Only Bonus Avaialble
Money is probably the most common bonus but it is certainly not the only one avaialbe.
If people are on a good salary and therefore in a high tax bracket, much of the bonus can go straight to the tax office so the incentivizing impact is less than you would hope.
Some people are older and are past the day to day expenses of raising kids and paying for the house.
These two groups might be far more interested in a so-called "junket" of overseas travel, conferences, home office equipment and other similar non-cash incentives.
Properly choosen, these "junkets" might improve thier profssional knowledge and therefore make a contribution back to the business.
Younger people raising children or with higher household expenses and low tax, might be quite happy with cash.
The moral of the story is that one size does not necessaily fit all so you could offer choice in the bonus payout without costing you anything more.
Keep a Watchful Eye
Points to look out for once the bonus scheme is running:
- Once set, the ground should not change even if there are unexpected problems in the company. If the goal is tied to profit and there are unexpected problems, the profit goal may not be reached in any case so it is self regulating.
- If the goal is missed in any period, don't weaken and pay it out nevertheless. This will remove the competitive element and weaken the drive. It also sets up a precedent to pay out every time, which will lessen the importance of reaching the goal. Also, when the goal is close to being met by staff they may try even harder if they have sufficient notice of the potential.
- One has to be careful that the goals can't be gamed to get a successful outcome despite damage being done somewhere else. For example, cutting back on inventory might make a short term success with a goal but a longer term disaster if there is nothing left to sell.
- There are some things like safety that should always get maximum attention within the company and are not suited to a reward system.
- If there are a number of equally deserving candidates for the goals to receive a bonus, this gives an opportunity for a team approach to choosing the goals. This will allow all staff to participate in the process and thereby get some ownership of the process and the goal.
- The bonus should be announced and paid as soon as possible after the closing date so staff are rewarded for their efforts. In some countries, bonuses can be paid into retirement savings accounts with a better tax rate. It would be good to educate staff on such options as the money is saved for the long term and they may not understand that such an option exists.
- The goals should be definite and ideally sustainable improvements in the business and not a "vanity" metric (see Metrics) that is a flash in the pan e.g. rapid sales growth that is unprofitable.
- Bear in mind that staff will often not consider some of the business costs they don't see. Your business will pay tax and interest, property costs and senior staff overheads that the line workers do not really think about. Any bonus scheme has to appeal to them but must take these costs into account. It may be difficult to explain that a 10% increase in operating profit will be eroded by tax. They just see themselves working harder to give "the man" more money. Communication of these extra 'hidden' costs can help.
Let's say that increasing profit is a goal. For a business owner, this has two payoffs; they get more income and the value of their business (which is usually a 3-5 times multiple of their operating profit before tax and interest) also goes up.
The plan chosen is:
- Allow 20% of the increase in profit to be put into the bonus pool. With a tax rate of 30%, this is an after tax cost to the business of 14% as the bonus is tax deductible. The business therefore gets to keep 86% of the increased profit.
- To allow time for the business to ramp up once staff begin to see that it can work, it is decided to pay it on quarterly results and with an increasing proportion paid each quarter. In the first quarter, when staff are just coming to grips with the idea and results are likley to be lowest, just 10% of the bonus is paid. In Q2, 20% then 30% and lastly 40% in Q4 - totalling 100%. This also tends to make it harder to fudge a quarter because it gets caught up in the next one.
- If a goal is not achieved and a bonus is not paid in a quarter, the bonus is added to the next quarter's percentage. This costs the company no more and 'sweetens the pot' for the next quarter so that staff are even more incentivized to try harder.
- On the basis that the more someone is paid, the more senior and/or mission critical they are, the bonus is paid out in proportion to their salary for the quarter. This is a less than perfect system so great ideas might need some other form of incentive if that is considered fair.
- So that everyone can keep an eye on progress, the company accounts are published for all to see or, if it is not wise for full disclosure, a team of staff selected by all levels of staff get access to the accounts on a confidential basis. In any case, the bottom line metric for the goal - in this case operating profit - does need to be made available frequently enough for people to adjust their effort if coming in under the bonus goal. In this example we choose monthly.
- The accounts for the quarter are finalized, in this example company, by the end of the second week of the following quarter so the bonus is announced then and paid in the next pay run.
Jack Stack Approach
In his book The Great Game of Business: the only sensible way to run a business, Stack has developed a bonus scheme as part of a wider "open book" management approach that shares accounting and other management data very widely throughout the staff owned company. The bonus discussion begins in Chapter 7.
If you are thinking of an all inclusive approach to your business this is a very good text to get you started. If you had invested $1,000 in his open book business named SRC in 1983, it would be worth $3.4 million today (2013). By way of comparison, the same amount invested in Warren Buffet's Berkshire Hathaway would be worth $113,000. Stack clearly has some serious street creds!
See further book details under the Great Business Books Menu