Like most employers, you’ve probably been faced with the challenge of how to manage rising salary increase budgets, reward high performers, and sustain your organization’s financial health by meeting and exceeding margins achieved in past years. How do you manage these critically important yet competing demands? The best solution is to develop a variable pay program.
Variable pay: A solution to base pay management
Variable pay is one of the best solutions to confronting the problem of base salary increases. It is much less expensive to manage than annual base pay merit increases, doesn’t compound salaries over time, and can deliver meaningful rewards and additional compensation to employees without long-term hits to your margins.
Generally, it takes approximately $5 of variable pay to deliver the same financial effect of a one dollar salary increase. Additionally, base compensation costs account for about 20-25% of your revenue, whereas variable pay costs account for about 3-4% of your revenue (on average). As a result, variable pay can be a huge savings for any employer.
Executing variable pay: Paying for performance
Fundamental to variable pay is the issue of pay for performance. Variable pay requires differentiating pay by some factor, usually individual and/or company performance.
This means differentiating pay by performance and allocating all (or most) of your organization’s pay rewards to your highest performers and reducing rewards for your average or bottom performers. It also means that additional pay is entirely dependent on how your organization performs, which can ensure that your organization’s financials remain healthy and that financial performance targets are met year over year.
The trouble with pay for performance is in the execution. For it to work, you need a culture that rewards high performance; standard performance management systems which give employees the insights, tools, support, and clarity they need to reach their goals and managers the tools to evaluate and objectively compare performance; as well as meaningful payouts.
Here are proven best-practices for executing variable pay when it comes to managing these issues related to culture, performance, and payouts:
Culture
- Types of variable pay offered match the culture. For example, strong emphasis on teamwork = team-oriented variable pay.
- Leaders support a performance-oriented workplace and encourage rewarding “A-players.”
- Tenure, attendance, and other non-performance related factors are not considered when making decisions about pay, rewards, or promotions.
- Pay for performance is widespread. Everyone has the opportunity to earn more pay based on their performance – not just execs, managers, and sales staff.
Performance management
- Goals are clear and achievable. Employees understand how to accomplish their targets.
- A manageable number of targets are given – ideally 1 to 3 important goals.
- Accurate measures of performance are intact and not subject to extraneous factors.
- Performance is regularly tracked, monitored, and well-documented.
- Performance is well-managed. Employees are coaching, re-directed, and assisted in reaching targets.
Payout
- Payouts are substantial enough to be perceived as beneficial, motivating rewards.
- Differentiation of pay and/or rewards is enough to be meaningful for high performers. Strive for 2 times the average payout to reward your highest performers.
- Tiers for payouts are set to reward employees for meeting minimum goals as well as stretch goals.
- Minimum and maximum thresholds for targets and payouts are provided.
Variable pay programs are promising and highly effective. If your organization is challenged in sustaining its annual merit increase program and controlling base pay costs, variable pay can be an advantageous solution. Just keep these best practices in mind before designing a variable pay program to ensure that the program is successful and delivers results.
Additional Resources
Performance Management Services ERC can support performance management initiatives through performance management system development, performance review form development, competency development, consulting on performance management issues, performance management/goal-setting training for employees and supervisors, and more.
