Saturday, October 30, 2010

4 Reasons Net Profit is a Poor Incentive Compensation Metric

The subject of incentive compensation systems comes up regularly in meetings of Chief Executive Boards International. One surprisingly consistent theme among business owners is, "I want everyone's attention to be on the bottom line." Of course they do -- that's where their attention is focused.

So they attempt to construct incentives using Net Profit as a metric and then work out some math around that number. If they implement such a plan, they figure out several years later that it's costing them real money (perhaps 5%-10% of their net profit) and buying them nothing in terms of employee behavior. Why? Several reasons:
  1. It's not meaningful on an individual basis -- Since everyone is included, there's not enough money to go around. People see bonuses of $100 here and there and it's lost in the roundoff error of their withholding.
  2. It's not fair -- The slackers get rewarded just the same as those who hit grand slams. As Andy Capp once said in the comic strip, "It's doing less than average that keeps average within reach."   In general, broad-brush (everybody wins) incentive comp schemes are just a way to make yourself feel like you're sharing your wealth.  They do nothing to drive behavior.
  3. They can't connect the dots -- The overriding reason this doesn't work is that the average employee just can't connect the results of his day-to-day actions with a term (Net Profit) he doesn't understand in the first place. Wish as you might, all the education in the world won't fix this problem. They're not owners. The deal they signed up for was to exchange hours of their lives for dollars.
  4. They can't control it -- There are a dozen factors outside their job description that drive Net Profit. In their minds, there's no material connection between their job and the goal.
These are a few of the fundamental "litmus tests" of Incentive Compensation design, and a broadly-inclusive Net Profit-based plan flunks several all of them. See: 8 Questions to Ask if Your Incentive Comp Plan Isn't Working

Still, you say, "I really like Net Profit as an incentive metric." Assuming you really want a Net Profit based incentive plan and you want it to actually drive behavior, you may be able to make that work by applying some simple rules:
  1. Limit the plan to only your key managers -- the 4 or 5 players who report directly to you and have leadership influence on their employees. That way, you're talking about enough money to matter to them. Hopefully, these are people who can connect the dots between their actions and Net Profit and you can focus your education efforts to that effect solely on them.
  2. Make the plan sensitive enough to pay out real money -- Don't pay from "first dollar" of net profit. Start the payouts above an annually-defined threshold, and NOTHING if that target isn't met. See: The #1 Incentive Compensation Plan Design Mistake
  3. Tilt the plan in favor of the house -- 4:1 would be 20% of Net Profit above the threshold (pay $20, keep $80). That way, no matter how much you're paying out, you're feeling good about it.
  4. Make it achievable -- The Net Profit payout threshold has to be below your net profit target, so the plan pays something at your business plan's target Net Profit (or "Par")
  5. Make the plan "rich" enough that it'll turn their heads. Properly constructed, these key managers should be able to earn bonuses of a least 10% of their salaries -- perhaps as much as 50% in a banner year. A plan constructed this way would probably pay a % of base salary, proportional to how much Net Profit beats the annual threshold.
As with any incentive plan, your mileage may vary. If you have an incentive plan based on Net Profit that drives employee behavior, please click "Comments" below and share that with others. Or share with us your plan design that's working, regardless of its basis.

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Terry Weaver

Chief Executive Boards International

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it 

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