Link Incentive Plans to Results Brad Hams

by Brad Hams

 Part 3 of 3  

In This Series:

Creating a culture of employees who think and act like owners can lead to amazing results, both financially and culturally. In this article series, Brad Hams shares three elements required to create an ownership culture:
  • Teach your staff business and finance fundamentals.
  • Focus employees on leading factors that drive your financial performance.
  • Create a broad-based, self-funded incentive plan tied to your company's increased profitability.

An incentive plan must pay for itself. If it does not, then what you have created is simply a new expense. You may have also created a sense of entitlement. If employees have the opportunity to participate in an incentive plan, then it should be their obligation and responsibility to fund it. However, it is the owner's obligation to provide employees with the financial education, measures and tools outlined in the first two articles of this three-part series to ensure employees produce the money to fund the plan.

Many (if not most) business owners consider incentives plans a budgeted expense, which might be why they are not enthusiastic about creating them. Incentive plans that are self-funded also drive a company's profitability. An incentive plan is meant to improve a company's financial performance and shape employee behavior accordingly. If financial performance does not warrant them, incentives should never be paid.

Having said this, most short-term incentive plans are ineffective. In fact, many incentive plans can actually damage a company. The following elements typically make incentive plans ineffective and/or damaging:

  • The plan is too complicated and is tied to operational metrics rather than financial results. If employees do not understand the incentive plan, they will not trust it.
  • The plan is tied to financial results, but the employer does not teach employees about finance or provide the education and tools to fund the plan.
  • The employer does not regularly communicate organizational performance in relation to the incentive plan.
  • The plan is tied to individual or departmental performance rather than company-wide results (multiple plans).
  • Wins are not celebrated.

Ineffective incentive plans typically have the following outcomes:

  • Due to the lack of training and engagement related to funding the plan, there is actually a very weak link between employee performance and incentive payouts (or lack of payouts). It is gratifying when employees receive incentives, however, their behavior does not change because there is not a clear link between the incentive and their work.
  • Since this link is not established, the incentive simply becomes part of their compensation.
  • Assuming this is a quarterly plan, no incentives will be paid in some quarters due to poor business performance. Since the plan has become an entitlement, employees may think they have been cheated, which damages morale.
  • If incentives are tied to individual or departmental performance, one or more of the following may occur:
    • Questions of fairness will arise, negatively impacting morale and performance.
    • Employees will focus only on their own objectives, and this may be at the expense of another area.
    • Some departments may receive payouts, yet the company may lose money.

Short-term, cash incentives can be helpful in engaging your employees toward driving the company's financial performance. However, the incentive plan itself is unlikely to change behavior. You must first teach your staff business and finance fundamentals, and focus employees on key performance indicators (KPIs).

Combining all of these techniques will create a culture of employees who think like business owners. They will become active participants in driving the company's financial performance. In addition to the financial benefits, employee retention rates will increase.

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Design a strong plan by using these guidelines.

  • Tie the incentive payout to only one measure-Profit Before Taxes (PBT)-to keep the plan simple and understandable.ยท If a second key indicator is used to fund the plan, I suggest a balance sheet indicator that drives cash flow, such as average collection days or inventory turns. I generally do not recommend this. However, if cash flow has been an issue, it may be a good idea.
  • Ensure the plan is self-funded. To do this, identify those requirements that must be satisfied before any incentive can be paid. These requirements will include (among other things): return on investment for ownership, capital for debt repayment and capital for improvements or investments (such as equipment). By analyzing these factors, a minimum acceptable (or threshold) PBT can be identified.
  • The plan should be broad-based, meaning everyone should participate. The incentive pool should be distributed in one of two ways: 1) equally among all employees, or 2) based on wages. Distributing funds equally among all employees is generally the best choice in small, flat companies (with few management levels), whereas distributing funds based on wages is more common in larger, complex companies.
  • Pay the incentive quarterly instead of annually. Annual plans are too far removed from activity. Behavior can be shaped by keeping the reward frequent. Having said this, it is important to withhold some of the incentive for each of the first three quarters to protect against a downturn. We suggest paying 50 percent of the incentive in the first three quarters and then calculating the final quarter payout based on how the company finishes the year. Not only will this protect the company's cash flow, but it will also act as a retention tool.
  • If possible, the plan should allow for roughly 10 percent of payroll as a payout at a stretch PBT goal. If your company has been unprofitable or marginally profitable in the three to five years prior to the incentive plan, this may not be possible. Let the numbers make the decision for you.

Brad Hams is founder and president of Ownership Thinking, a consulting and training firm that for 15 years has helped over 1,000 companies to unleash their true potential through employee education, engagement, and incentive strategies.  Find out about Brad's services, keynotes, book, annual conference, and more at www.ownershipthinking.com.