Performance Based Compensation Plan

From: Staffing

Performance Based Compensation Plan


Can you provide guidelines for developing a performance-based compensation plan?


Performance-based compensation plans vary by the “personality” of the organization. What follows is a set of guidelines for designing a plan, and you will need to think about what best fits in your company. We strongly recommend that you involve your executive management team in the key decision points so that the design of the plan creates incentives for the right employee behaviors and that all key stakeholders are on board with the program. Typically, a good rewards strategy combines a mix of different types of rewards designed to attract, retain and motivate individuals with the skills and dedication necessary to make your company successful. For the purposes of this answer, we will focus on the financial rewards (but don’t forget about the non-monetary ones too).

Step One: Define Your Pay Structure

Before you look at the pay for performance metrics, we recommend that you determine your pay structure. One effective tool in developing a pay structure is using pay grades or pay leveling, which provide salary ranges for specific job classifications. You can use a variety of methods to derive these grades/levels, from the more time-consuming point-factor method (where jobs are defined and compared to specific criteria and assigned points to determine the value to the organization) to job comparison/ranking (where jobs are compared to each other until you have a hierarchy of the importance of the jobs to each other from the top [CEO] to the lowest level job) to simple market pricing — simply paying the job what the market commands without considering internal equity structure. Then, you would price the jobs, either by some internally-derived standard or externally based compensation benchmarks based on position, industry and geographic area.

Step Two: Define Your Performance Measurement System

Consider how (and how often) you will evaluate employees based on your company-specific criteria. Are the performance measures based on your company’s strategic business plan, financial or sales goals and/or personal performance metrics or a combination of the above? Once you determine that, you can consider which tool you want to use to measure performance.

Step Three: Define Your Pay for Performance Metrics

Typically in a performance-based pay structure, employees are compensated depending upon performance tied to a set of criteria or goals. For example, if sales exceed a specific amount based on weekly, monthly or annual goals, the manager may rate and consider compensation increases. The basic theory for performance-based pay is that rewards drive desired employee behaviors (i.e. desired business results). There are many business studies that suggest that rewarding high performers, and not rewarding low performers, drives company performance. Make sure that your methods for evaluating performance are clear to your employees so there is transparency in the process to help ensure employee perceptions that they are being evaluated fairly and consistently to a common standard. Arbitrary or unclear performance measures can create the opposite of your intended effect as well as create claims of unfairness and discrimination. The types of programs we typically see are based on:

Employee performance tied to agreed-upon performance metrics that are reviewed regularly and adjusted as needed (these can be individual, team or organizational); and The employee’s compensation level tied to position in the salary range or market price.

The theory here is that, while you want to pay for performance, there is a limit to the “price” of the job. Once that ceiling is reached, employers typically use other forms of rewards not tied to base salary to reward their high-performing employees at the top of their salary ranges (lump sum bonuses, extra time off, stock, etc.). Other incentive-based plans might include include items like sales-based incentive plans, bonus programs, on-the-spot awards, time off, additional benefits, etc. Formal bonus programs (outside of sales incentive plans) are typically based on some percentage tied to salary range or level. To help in creating this “transparency,” some company pay for performance plans create and publish a matrix for employees showing the correlation between position salary range and performance rating. That way, actual merit increases are determined based on the assigned performance factor noted in the table and the employee’s position in the salary range. An example of this matrix is shown below, but depending upon your evaluation process and your merit budget it may appear differently. (Note: Ratings in order are Exceeds All Performance Metrics, Meets All and Exceeds Some Performance Metrics, Meets All Performance Metrics, Does not Meet All Expectations, and Unsatisfactory Performance.)

 Rating Exceeds All Exceeds Some Meets All Meets Some Unsatisfactory
 75 – 100%+ of salary range 5% 3% 2% 0% 0%
 50 – 75% of salary range 6% 4% 3% 0% 0%
 25 – 50% of salary range 8% 6% 5% 2% 0%
 25% or less of salary range 9% 7% 6% 2% 0%

**Many pay-for-performance plans create a greater differentiation in merit increases between the highest and lowest performers–this chart is for illustration purposes only.

Step Four: Monitor Your Plans for Desired Performance

The Final step is important–and compensation system can work or fail depending upon how it is used. Be sure to “inspect what you expect” on a regular basis to ensure that your salary dollars are being spent wisely and helping your organization reach the desired goals.