The Variable Pay Conundrum: What to Measure? What to Reward?

As predicted by many, the economic difficulties of the past few years appear to have accelerated the decades long trend toward an increased level of variable pay in the overall cash package.  Recently released research from Hay Group finds that 39% of companies - globally - have already or plan to increase the proportion of variable pay in employees' cash packages and 26% are bringing more employees into their variable pay plans.  Why?  The number one reason reported (by 61% of respondents) was "better alignment with business strategy."

But what exactly does that mean ... and how do you make it work?  What metrics do you select to reinforce strategy?  On what elements of your organization's key objectives and priorities do you reward employees for making the needle move? 

In what is largely seen as a legacy of the downturn, the companies in the Hay study are moving away from "soft" measures (such as employee satisfaction) and putting  renewed focus on more quantifiable ones; 51% of companies said they were focusing more on financial metrics than before and 23% said they are increasing the emphasis on operational measures that drive specific actions or process improvements.  These moves are understandable in the context of the place where too many companies found themselves during tough times - with incentive plans too loosely tied to the bottom line, where plan metrics were met and awards were earned in a year when there were no profits from which to pay them.  But are these moves the right ones - for your organization?

How do you best align your variable pay plans with business strategy?

I don't have the answer (sorry), but I thought I'd share a framework that I find useful in selecting metrics for variable pay plan design.  I find it helpful to put measures into three categories:

Lead Measures

Lead measures are predictive of success, generally over a longer period.  They are forward looking by design.  Examples of lead measures might include market share, customer satisfaction or retention, employee satisfaction or engagement, or new product development.

Operating Measures 

Operating measures focus on day-to-day operations and activities.  Examples of operating measures might include output, productivity, or cycle time.

Lag Measures

Lag measures reflect success which has already happened, typically as addressed through the accounting system.  They are backward looking by design.  Examples of lag measures might include net income, return ratios (return on equity, return on sales, etc.) or EBITDA.

Ultimately less is more when selecting incentive plan measures (i.e. no more than 3 or 4); however, there is also a case to be made for balance.  It has been said that running an organization solely on the basis of lag measures is like steering a boat by watching its wake.  Given the choppy waters most companies are traveling in these days, that doesn't seem like a very smart or safe approach.

Lag measures are important, but they are not forward looking.  Lead measures are forward looking, but often softer and less crisply defined.  There are risks to focusing a pay plan exclusively on either category.

The design trick is to select the limited and balanced set of metrics that will ensure the plan has a sufficient tie to financial performance to be adequately funded, but will also focus discretionary effort and behavior on the one or two things that will help position the company for success down the road.  Classifying your potential plan metrics and elements as either lead, operating or lag can help in striking the balance that allows you to steer the "boat" in the right direction while ensuring that the resulting plan sits on a sufficiently sound financial foundation.

Good luck!

Comments

[Laura Schroeder]

That kind of says it all, Ann.

[E James (Jim/UncleJamie) Brennan]

Whenever anyone discusses performance metrics, I immediately think of the mantra: "quality, quantity, time, and cost." Virtually everything falls into one or more of those criteria categories.

[Ann Bares]

Thanks, Laura!

Jim:

Another good set of performance criteria. Whether the set from your mantra, or the outlook/time horizon based set I describe in my post, I think these provide helpful guidance and context for selecting the limited set of performance metrics for a variable pay plan.

Thanks!