Chapter 8 – What Kinds of Pay Plans Work
For good or ill, pay systems are very powerful. This power can work either for or against success. You should not change pay systems on a whim. Changing pay to the wrong type of system can have huge unanticipated negative consequences for your company or your paycheck.
The world is a more complex place that it was in hunter-gatherer times. While it is tougher to pay for performance today, there have been a number of studies on how to do it right.
We now will cover what a successful Eat-What-You-Kill pay system looks like. We then will give you the ingredients for a system that will work for you and your company.
Simply put, pay plans that work have only two requirements:
- They must provide Motivation.
- They must provide Alignment.
In other words, they must work for both employees and companies. Non-motivating plans do not work for employees. Plans that are not aligned with the company’s interests do not work for companies.
Each of these requirements has sub-requirements. We will start with Motivation. How do you get people to get up in the morning and work hard?
What do we mean by alignment? Companies must align employee’s interests with the company’s interests. When employees work hard to achieve personal targets that align with company interests, those efforts build company value.
8.1. Pay Plans that Work: A Motivating Plan What is a motivating plan?
There is a little more to designing a motivating plan than we have discussed to date. A motivating plan must be simple, clear, actionable, reliable, appetizing, and frequent. We will discuss each of these factors in turn. Simple and Clear. You would think that the reasons for this are self-evident. If employees cannot understand the plan, it is hard for them to do the right thing. Simple and clear plans should be more motivating. However, many plans are excessively complex. Companies that have scorecards to drive compensation (don’t ask) often have 15 to 20 factors the company averages to come up with bonus awards. Many old-style compensation systems give managers a laundry list of objectives. Each objective determines part of her bonus through a weighting scheme. A typical list from a recent L.E.K. Consulting client is:
1) Grow unit sales 10% 20
2) Grow earnings 5% 20
3) Improve customer satisfaction scores 15
4) Get product defect rate below 7% 10
5) Have a succession plan in place 10
6) Have good relations with local community 8
7) Open up new facility for new product 5
8) Avoid legal problems like we had last year 5
9) Be more organized during budget season 4
10) Be more supportive of other divisions 3
The above laundry list gave the manager a lot to worry about. However, it did not focus the manager on increasing the value of her division. The manager could have an awful year, with declining sales and earnings and still get 60% of her bonus. More terrible yet, by giving people a lot of things to accomplish, they often do none of it done well.
Worse yet, studies have shown that people given a long list of stuff to manage tend to throw out most of the list and dynamically manage only two to four things. If people naturally only focus on three things, why not start simple?
Good pay plans base bonuses on 2-4 factors.
Simple and clear plans work better.
Actionable. Good pay-for-performance plans use performance goals that people can directly affect. For lower-level staff especially, the goals should be tangible measures (number of units produced, wastage, sales closed, cycle time, etc.). The measure should be specific to the type and level of the employee. Companies should focus salespeople on closing sales. Companies should focus production staff on measures of production. Companies should focus senior management on overall cash flow and company value.
Reliable. Bookies pay out when the customer hits the numbers. The company should pay out if employees do the right thing. Companies should protect lower-level employees from factors outside of their control (like hurricanes or the performance of other units). If you use team-based awards, make the teams as small as possible (less than 100 people if possible).
Top-level managers do not like plans that result in a few big bonuses for some employees in a down year. Top managers always want to avoid paying out large bonuses in a down year when the senior managers screw up. If there is a price war that hurts industry profitability, they do not want to pay large productivity bonuses to plant workers. These top managers then try to motivate workers with a plan that says, “You get a large bonus for increasing productivity 50%, but this bonus can be cancelled if firm Return-On-Assets (ROA) is low.”
If you want to motivate workers, this type of plan is not smart.
First, it does not really motivate workers. Workers realize that they will look like chumps if they work hard, get the 50% productivity gain, and get no payout due to circumstances beyond their control. This “gate” on payouts prevents large payouts in bad times by not having the productivity gains in the first place. With gates or restrictions on payouts, you limit performance so that there are no payouts in good or bad times.
Second, you want to incent people to put forth extra effort precisely when times are bad! You do not want to reduce incentives in these periods at all.
The top-level managers should instead structure plans that payout reliably and not worry about paying a few big checks. Do not worry about paying your best salesperson more than the CEO if the salesperson really added more value that year than the CEO.
All staff hate the uncertainty that is caused by unreliable targets, un-actionable goals, complex systems, and hard-to-understand plans. Studies have shown that it takes much more money to motivate people when plans are uncertain (up to a factor of 2). Get rid of us much uncertainty as possible.
Appetizing. If you want to motivate people, you have to make it worth their while. As discussed above, managers expect employees to sacrifice themselves on the company altar for a bonus swing of 3-5% of base. This is not smart. Forget about motivating people with bonus swings of less than 10%. To get real action, target 20-40%. This gets attention.
People are smart. Employees will understand when the incentive is not worth their while. The saying in the old Soviet Union was that “Factory management would pretend that the rubles they were giving employees were worth something. Workers accepted this and pretended to work in return.”
A key to getting productivity is to create the possibility that the individual can earn as much as they could possibly earn at any competitor. Creating the opportunity to earn “top-dollar” attracts both the best people and their best effort.
While initially seeming somewhat paradoxical, having employees with the highest pay can lead to the lowest labor costs. With a smart pay plan that encourages productivity, a firm can get the highest productivity in the industry and lower its labor cost per unit of production to be the lowest in the industry. Five Guys shows how to do this.
Try to find a way to pay people as much as possible.
If you do it right, you will get the results that make it worthwhile.
Frequency. The worst incentive pay plan does not ever pay out. For a pay plan to motivate, it must pay out with reasonable frequency. The weekly shift plan that Five Guys put in was terrific in that people gunned for a tough but achievable award each shift. A once-every-three-years bonus is not as motivating as a monthly payout. A long-term bonus target that drifts out of reach for a substantial amount of time is not very motivating.
The above factors help you design a motivating plan, the first piece of a good Eat-What-You-Kill pay plan. The second piece to a pay-for-performance plan that works is alignment. We discuss this next.
A motivating plan must be simple, clear, actionable, reliable, appetizing, and frequent
8.2. What Kills Many Motivating Plans: Bad Alignment
It is sometimes difficult to create a pay plan that fully matches the interests of employees and their company.
It is a little bit like the three-wish stories. The genie always finds a way to fulfill the letter of the wishes, but somehow subvert the intent.
Unfortunately, pay plans can be like genie wishes. The employees usually fulfill the letter of what the company asks for in the pay plan. However, sometimes employees find a way to be paid that violates the spirit of the plan. The employer often finds that the pay plan overlooked certain contingencies and that the results are sub-optimal.
An example of the three-wish problem comes again from legends of mismanagement in the former Soviet Union. One revolved around a carpentry nail plant. A Soviet central planner decreed that success would be measured by the productivity of the plant as measured in kilograms of nails produced. The plant won awards, but all the production sat unused in warehouse.
The planner investigated and found that the plant had maximized production by making giant 10-kilogram spikes. The heavy spikes made it easy for the plant to maximize kilograms of production, but they were of little use in building houses. Determined to do better, the planner decreed next year that he would measure success by number of nails produced. The plant won awards again, but the production sat again unused.
The planner investigated again and found that the plant had maximized production by making tiny needles. These tiny needles made it easy for the plant to maximize nail count but were also of little use in building houses. Exasperated, the planner decreed, “Now I don’t care about production. Next year, you will be measured on how many nails are actually used by builders!”
At the end of the year, the planner checked and found that builders had built record numbers of houses and were very happy with their nails. He checked further and found that no nails were sitting in warehouses. Satisfied, he gathered the new awards and went out to the factory.
He arrived and was stunned to find the factory quiet with all the factory workers playing cards. He exploded at the manager, “How can it be that an award-winning plant is sitting idle?” The manager responded, “Well, you said you didn’t care about production and just wanted nails that builders liked. We just put in a big order with American nail factory and had the Americans ship direct.”
We now give a more real-world example of the problems you might find.
Take, for example, a retail store client of LEK Consulting. They tied the pay of individual local store managers to local store factors including local operating costs and local revenue. This sounds like a good plan, right? However, the client saw plunging sales per store (same-store sales) and mounting losses after putting in the new compensation plan.
To understand the problem they had, you need to understand what drives the profits of a retail store. Of course, you have different drivers for revenues and costs.
On the revenue side, the drivers are:
- The number of people of walking in the door (traffic)
- The percentage of people buying something (conversion)
- The average receipt size for people buying (ticket)
Thus, Traffic times Conversion times Average Ticket = Local Store Revenue. At this time, the company was only measuring local store revenue, and not these three components. The local store manager did not control how many people walked in the door (traffic). The local manager also did not control the selection and pricing of goods, so employees did not view ticket as very controllable. Thus, local managers viewed revenue goals as not actionable. Since the managers felt helpless on revenue, the managers shrugged and focused on costs.
Of course, a good store manager could focus on the people who walked in the door. A good manager would lead the staff to make sure a maximum number of people were welcomed and gently steered towards buying something. A good manager would focus on conversion, the percentage of people walking in that ended up buying something. A good manager could also focus salespeople on upselling and bundling accessories with the sale, and thus affect Average Ticket.
However, conversion and ticket was not an explicit focus of compensation, so managers turned to other drivers that were.
On the cost side, the local store manager controlled some costs but did not control others. Rents and utilities are fixed. A buyer at corporate sets the costs of goods in the store. The only cost under the manager’s control is the number of hours that staff work.
When the company looked at what was causing the sales and profit decline, it found that the big problem was not operating costs. Operating costs was well within budget.
When the company broke apart the cause of the sales decline, it found that traffic was OK, but conversion and ticket had declined substantially. This was puzzling.
They dug in a bit more and found that conversion and ticket were doing fine during the week, but had dropped off on the high volume weekend days. This was even more puzzling. Why should conversion and ticket drop only on Saturday and Sunday?
It turned out that a big cause was the way that managers were managing their costs. Managers were tracking their operating costs closely, hoping that cost control would help their bonuses. If they went a bit over in labor costs or some other item during the week, they would do the one thing clearly under their control and tell staff not to book any overtime on Saturday or Sunday, or just tell fewer people to come in.
Why was this cost control on weekends a problem? It turns out that the extra staff person to greet people and answer questions is critical to getting higher conversion and a higher ticket. The greeter who meets walk-ins and asks, “What are you interested in?” increases conversion from 15% to 30%. If you have no greeter, your conversion declines. If you do not have extra people to spend time with the customer, you do not ask the question “Do you need some new socks to go with those new shoes?” and your average ticket declines.
By over-focusing on costs and not on the important value drivers (conversion and ticket), the managers were digging a hole for the company. The managers performed according to their compensation plan, but the plan was not truly value-linked.
Put in a shorter way, you need to careful when you select the drivers of your compensation plan. When you put drivers in a plan, you will get employees to focus on them. However, if they are the wrong drivers, the company will sicken horribly. The company will tank as people focus on the wrong things.
As the Five Guys example illustrates, this is not rocket science. However, you need to do plan design carefully and deliberately. The next section covers how you can simply ensure that you align the interests of employees and the company.
8.2.Pay Plans That Work: Alignment
A plan that aligns interests of employees to the firm interests is self-funding, partly long-term, open-to-feedback, and value-linked.
We now discuss these factors in turn.
Self-funding. Bosses do not like to make investments with uncertain payouts. Bosses only want to invest if a profit on the investment is sure. Bosses do not respond well to: “Let’s pay employees more money up-front and maybe we get performance that covers the investment. Or maybe not. Maybe we pay a lot and lose money.”
Bosses respond better to investments in employee compensation that new, incremental performance funds. They prefer the funding to come from future excess performance rather than today’s investment funds.
Requests to pay people more have a better chance of succeeding if you make it clear new, incremental performance funds the new payouts.
However, many adopt new pay without some simple math to show that whatever turns out in the future, the plan pays for itself.
You need to say to your boss, “Here is the normal range of productivity increases. The new productivity bonus only starts to pay out when we get outside of the normal range (that is, no payout unless we get truly stellar incremental performance). If we double the normal productivity increases over the next year, we create $50 million of incremental profits, and we share $20 million of that $50 million with the people who made it happen.”
If the self-funding math is not clear, go back to the drawing board. If you do not make the self-funding clear, the plan will be either killed or implemented with emasculating conditions that make it look unreliable to staff.
Note that incremental profit goals are by nature self-funding but are also viewed as unreliable by staff. The trick is to set tangible goals (like production goals) that staff see as transparent and reliable by staff. Of course, you need to model the production goals to make sure that you generate enough cash to pay the bonuses (the profits self-fund the plan). To ensure that the tangible goals work, you need to model a wide variety of scenarios to prove that the tangible goals are self-funding. For more detail on how to show senior management that high payouts only come with incremental performance that pays for the payouts, please go to EatWhatYouKill.com.
Partly long-term. Plans that focus all employees on just today do not work as well as plans that focus beyond this month and this year. Short-term or annual bonuses work well, but the addition of long-term incentives also helps. Remember the studies above that said both annual incentive plans (bonus-to-base ratios) and long-term bonus plan participation (percentage of employees that are in long-term bonus plans) were important.
Why is long-term important? It is important because people can over-focus on the short term and hurt the value of the company. If people are solely compensated on this month’s profits, they will under-invest in advertising that builds the company’s brand and next-year’s profits.
Studies have shown that senior managers with long-term compensation (including more share ownership) leads to higher company value, more R&D investment, less stupid diversification, more employee training, and more development of new products.
In addition, L.E.K. Consulting studies of the stock market show that current profits of a company only account for 60-70% of the value of companies. Future profits account for 30-40% of a stock’s value. Stockholders want to see actions today that will increase future profits. If companies do not invest today for the future, companies will be revalued and drop 30-40% of their value.
Of course, we are all dead in the long long-term. Current results are more important. Especially for lower level staffers who do not affect the long term, short-term bonuses should be much larger than long-term bonuses. For lower level staff, the ratio of short-term bonuses to long-term bonuses should be between 90:10 and 70:30. For top managers, they should be 70:30 to 50:50.
Note that there is a balance between short-term incentives and long-term incentives. Short-term incentives are good for an operational business where mostly the same sort of thing happens every day (think a factory). Long-term incentives are good for creative, innovative businesses where things change very rapidly and where you need to incent people to try various things before they find success (think a Silicon Valley startup or an advertising agency). Both types of incentives are useful, depending on what you need.
If you just reward short-term performance (say a day-to-day profit share arrangement), you get an employee who fine-tunes the operation that he/she was given. They “exploit” the situation to maximize their pay, and avoid too much experimentation that could lead to a downturn in profit or their pay. For example, they may be unlikely to shift operations to a new, better location since the disruption may cause a drop in their earnings.
However, if you reward performance with weighting towards profits at the end of a comp period, you get an employee who might “explore” a bit more to find a better answer. Employees will then consider solutions that are more creative. They may consider shifting operations to a new, better location even if there is some short-term risk.
A couple of years ago, a group of UCLA and Berkeley professors set up a set of controlled experiments where several hundred people were asked to run virtual lemonade stands under fixed-pay and incentive contracts. They found that short-term comp plans made lemonade stand owners focus on fine-tuning (how to reduce costs of lemons) rather than finding a better place to locate a lemonade stand.
Then they gave a comp plan that had no profit sharing in the short-term, but did have a long-term profit sharing program that started after a while. There was no incentive to maximize profits in the short-term. Not surprisingly, the lemonade stand managers took more risks for a while. They experimented with new locations (some that worked well and some that did not). However, in the end (in this controlled experiment), the managers got better results with long-term incentives.
Generally, you also increase weighting on long-term incentives for senior management since they are required to have more creativity and make more choices. You need to give senior management some rope to experiment and even fail on their road to future success. A very harsh short-term comp system causes people to avoid all risk, and this can be bad. See the following image for an explanation of the issue.
Note that it is critical to have long-term plans of sufficient duration. A meta-study of 45 research studies on compensation practices found that the longer the incentive program’s duration, the greater the impact:
- Short-term programs of one week or less yielded a 20% performance increase.
- Six-month (or fewer) programs yielded an average 29% increase.
- Programs extending beyond one year produced an average 44% gain.
You need both short-term and long-term incentives.
Just short-term leads people to take no risks.
Just long-term leads to people not caring about today’s business.
You need both!
Open to feedback. It is stupid to motivate employees to act and, at the same time, prevent them from suggesting and implementing change. You do not want to hit the accelerator without taking off the parking brake.
If you do allow employees avenues to suggest change (competitions for good ideas, quality circle meetings for better quality, etc.), you win. If you allow actual employee participation in decisions, you gain the input of someone that may have more information than the boss. A good General trusts the input a good Master Sergeant who has the interests of the Army at heart.
Note also that employees will get discouraged if there is no way for them to suggest and implement change. The implicit message to them is that the only way to get paid more is to work harder. This limits their enthusiasm for a new pay plan. In addition, new ideas and the willingness to implement them can be of much more value than just working harder.
You unleash creativity by providing incentives to create value and by providing an avenue for employees to advise how to create the value. You cannot unlock value without both.
If the incentives are meaningful, employees will surprise you and break down walls to make things happen.
Employees become more than a means to an end. They become an asset that drives a business forward.
In addition, employees have more fun when management listens and views employees as assets.
Whether you are a staff member or a boss, it is more fun to be in an Eat-What-You-Kill company that incents value creation and allows it to happen.
Value-linked. You must link the plan to company value. You must carefully set the performance measures so that success on the measure clearly results in increased company value.
You need to fully investigate various future scenarios to make sure that success under the plan equals success for the company (no 10-kilogram spikes). This is surprisingly difficult in certain situations.
Remember the example of the retail store discussed above. The local managers were trying to the right thing by cutting employee hours on the busy weekends, not knowing that they were destroying value by forgetting to focus on converting shoppers that walked in the door.
You need to educate staff on how to create value. It requires a little work, but has high payoff. See EWYK.com for more details on how to link employee targets to company value.
A plan that aligns interests of employees to the firm’s interests is value-linked, self-funding, partly long-term, and open to feedback.
These are the basics of getting alignment between employees and the firm.
The next section gives you some tips, tricks of the trade, and traps. This hard-won advice should make implementing Eat-What-You-Kill plans easy and even more effective.