Case Scenario:
Navigant Consulting Inc., a Chicago-based management consultancy, is the product of more than 25 acquisitions over six years. No wonder that, until recently, its short-term incentive pay system was seriously flawed. There was no consistent method of rewarding performance.
"It was difficult to manage so many disparate tools," says Julie Howard, vice president and human-capitol officer. "It was a mess." Even companies with only one system are struggling to make it more effective.
So last summer Navigant redesigned the system. Its short-term cash bonus plan now consist of two basic elements: Incentive pay for Navigant's 400 senior professionals is based largely on the company's performance, while its 800 consulting and administrative staff are rewarded primarily according to individual performance.
It's too soon to tell fully what effect the change has had, though already the company is seeing reduced attrition. The hope is that the incentive plan will help the nearly $600 million (in sale) company recover from years of looses. So far, "people are very excited about it" says Howard, who has been touring the country to explain the program to employees. "Clarity is a big thing."
Navigant is one of an increasing number of companies that now offer incentive pay many non-management personnel, linking pay more closely to performance, as it shifts from fixed to more-variable annual compensation. In a survey of 2,400 companies last year, consulting firm William M. Mercer found that 56 percent provided incentive pay to employees below the executive level (65 percent when nonprofit health care companies were excluded).
But companies clearly are struggling to design their incentive pay programs in an effective way. The soul-searching is aimed at motivating employees up and down the line to help companies meet their overall goals. Of course, plan specifics vary with a company's culture, size, industry, and competitive position. But any winning formula must address the following question: To what degree should payouts be linked to the performance of the corporation as a whole; to that of an employee's division, plant, team or project; to the achievement of individual goals; or to some combination of all of these?
Consultants say incentive programs on the leading edge are combining goals and custom-fitting the combination to the rank of employees, much the way Navigant has done. At stake is nothing less than a company's ability to compete, and that challenge will only grow as the economy slows. No surprise then that CFOs are getting more deeply involved in design efforts. As the overseers of human resources, they view payroll expense increasingly as an investment of human capital, and incentive compensation as something that can improve the returns on that investment.
Unfortunately, theory does not translate easily into practice: in one survey of 771 companies, management and HR consulting firm Towers Perrin found that less than one-third of companies with incentive programs of any kind see a significant impact on results. Navigant nonetheless has high hopes for its new plan. If the revised incentive system is as effective as the company expects, says CFO Ben Perks, who help align the new plan with the company's goals, "itâ??s a win/win/win â?" for the employees, the company, and the shareholders."
Navigant isn't alone. Ever since the end of the recession of the early 1990s, companies have struggling to attract, motivate, and retain employees without greatly increasing fixed cost. Merit raises alone, however, have been insufficient to achieve those goals; the measly 4.2 percent on average that U.S. companies have budgeted in recent years for annual raises does not allow for significant differentiation among employees, according to Mercer. Long-term incentives such as stock options and restricted stock, meanwhile, may be more effective as a retention tool than as a goad to performance, and may be ineffectual in any case unless the market rebounds.
Incentive pay added to raises fills the gap, enabling companies to hand out greater rewards to deserving employees while minimizing cost, since the incentive shrinks in bad times. For greater cost savings, some employers are going so far as to replace raises with incentives over a phase-in period of a few years. Others have even reduced base pay for new workers while dressing up incentives.
Consultants believe that as the economy slows, the trend toward more-variable pay will continue. Global competition remains strong, and in a downturn, there will be a need to improve productivity. Indeed, companies may begin taking advantage of workers' growing job insecurity to implement new incentive plans that reduce base pay in turn for greater potential incentive rewards. Already, says Steve Gross, who heads the U.S. compensation consulting practice at Mercer, more troubled companies are saying, "if you don't accept these plans we're going to move the work offshore." For other, employee retention will remain a driving factor: "it took so much energy to hire these folks; we don't want to make them unhappy."
So far, according to the latest data available, incentive system program typically pay bonuses to all eligible employees based on the overall profitability of the company, at least among surveyed-the largest segment for any incentive plan type-used organization wide incentive plans in which payouts were linked to a companywide measure, and distribution were made from a pool in proportion to salary. This approach is not only straightforward, it also sends a clear message that "we're all in this together."
To be sure, many companies have been raising the bar in this area. Instead of paying out bonuses whenever a company achieves profitability, programs increasingly hold out until the company reaches a specified profit level. At that threshold, the company either begins paying a preset ratio of profit earned beyond that point or a predetermined bonus pool.
Consider a plan started by Boeing, which has been under growing competitive pressure. Boeing's program, first broad-based incentive scheme for 88,000 nonexecutive, nonunion employees, is based entirely on the achievement of a predetermined level of annual corporate performance-net profit minus a certain charge (which the company would not specify) in the first year employees could earn an extra 5 days of pay-on top of annual raises and rewards for some employees involved in certain projects-if the company met the target, and up to 10 days' pay if the company exceeded it. In the end, employees earned 7.85 extra days of pay.
"The intent was to offer the opportunity for all nonunion Boeing employees to share in the success of the company and get employees to think more like owners of the company," says Bruce Hanson, Boeing's manager of compensation and benefits. The program's massage, he say, is "a shared-destiny massage, as a company to move Boeing towards its overall profit target. We want to be engaged, ask questions, offer suggestions to the organization" to help reach that profit. The massage was reinforce by the company's decision to use the same performance metric in figuring executives' incentive pay-an amount that is then modified by an executive's individual performance against his or her preset goals. Another reinforcement: for this year, the board doubled the potential incentive rewards.
But tying bonuses to corporate-level results has a potential downside. While the top officers and even division managers spend their days on activities that directly affect a company's sales and profits, lower-level employees have little influence on overall results. The goal, therefore, is not within what consultants like to call their "line of sight." Furthermore, this kind of incentive system-as well as those based purely on the performance of the employee's plant or division-can breed resentment from those who believe they work harder than others who receive the same rewards.
Yet fewer companies link bonuses to each individual's performance on one or more specific activities. Among those that do is a retailer that pays sales clerks double time for any sick days they don't use. "You pay out if behavior milestone are achieved, regardless of profits, which is pretty direct and understandable," says Carl Weinberg, a principal at Unifi Network, the HR consulting subsidiary of pricewaterhouseCoopers.
One obvious drawback: companies may find themselves paying out bonuses at a time when the company has no profits and cannot afford extra payments. What's more, Weinberg says, "there is the risk that people will ignore other behaviors that you're not rewarding."
Yet companies such as Boeing recognize that they need to do more to motivate lower-level employees than tie incentive pay to corporatewide goals. Plat managers, Hanson says, are encouraged to translate the overall corporate economic profit target into goals specific to their factories, such as a cost saving and additional revenue. "We're continuously trying to do a better job at that," he says.
Other companies are going a step further by adding team and individual targets that must also be met to reap the full reward. And the resulting incentive brew is increasingly the norm. The Towers Perrin survey indicates the 62 percent of companies with the employee is measured against pre-established personal goals for the year. By providing reward for such specific goals, these employers are trying to directly influence an employee's behavior.
In these multi-target programs, the higher the rank of the employee, the more the bonus is linked to broader financial goals; the lower the rank, the more the bonus is linked to team or individual measures of operational performance as well as financial measures. Usually no bonuses are paid out to anyone unless the company makes a profit or reaches a threshold profit level, and then the size of an employee's bonus is based on that individual's performance against his or her personal goals. The link to corporate profits allows everyone a broader perspective and the ability to make decisions in light of the company's overall objectives.
Typically, each employee receives a scorecard listing a few goals for the coming year, against which the employee's manager measures progress during the year. The challenge is to set the goals correctly. First, the scorecard shouldn't have too many-consultants advise there three to five at most. Then, the course, the goals have to be the right ones for the company.
Consider the case of kitchen cabinet maker American Woodmark Corp., which implement an incentive pay system for its 3,500 employees. Previously, the Winchester, Virginia-based company had given employees just one annual priority. But it found that because workers were so focused on meeting that goal, they were neglecting other important concerns. For instance, the company found that when it instructed its managers to design incentives that would improve quality, productivity declined.
So American Woodmark adopted the scorecard approach, in which each employee's scorecard states goals for the company as a whole as well as goals specific to the employee's plant. "The scorecard allows us to get all of the key priorities defined," says William Brandt, chairman of the $400 million (in sales) company.
Corporatewide goals are divided into the areas of cost, quality, delivery, and safety. Lower-level goals are set to support those, so that if each of the 11 plants meets its targets, the result will be the achievement of the corporatewide targets. And if each team at a plant meets it targets, they will add up to that plant's targets, and so on down to the individual level.
According to consultants, the biggest potential problem with multi-target plans is their complexity. With so many different targets-qualitative as well as quantitative-they are tough to manage. But the hardest part is setting them up in the first place. "The biggest hurdle for companies to clear is to set goals, to determine job by job and person by person what the right goals are," say Laury Sejen, a compensation consultant at Watson Wyatt Worldwide.
That, indeed, is what Navigant's financial and HR executives faced last year when redesigning its compensation system.
Success is hardly guaranteed. In its survey, Towers Perrin found that only 20 percent of companies with individual incentives and 31 percent with team incentives reported that their pay-for-performance plans had a significant impact on business results. But results were even worst for companies with organiztionwide incentive goals: only 17 percent reported such improvement.
Still, some prominent management theorists believe that no variable-pay plan can work well. W. Edwards Deming, the famed management guru, believed that variable pay forced companies to rank workers against each other, setting up a competitive environment that could lead employees to work against each other.
However, communication may make a big difference. For starters, employees must know at the beginning of the year exactly what their bonus will be tied to. In fact, says Sejen, "our recommendation for best practice is for the manager and the employee to have a conversation" about appropriate individual goals. "The concept of employee buy-in is important."
During the year, "feedback has to be frequent," says William Abernathy, an incentive pay consultant who runs his own firm, Abernathy & Associates, in Memphis. "Annual is useless."
At American Woodmark, a team's performance relative to certain goals is posted daily or sometimes even hourly, Brandt says. Boeing delivers quarterly reports to employees on how well the company is performing against its target and what that might mean in terms of potential extra day's pay at year-end.
In the end, says Abernathy, a good plan requires lots of planning, and with that comes complexity. "You can make it easy," he says "but it won't work."
Required to answer:
Problem 1. Why is it important to include operating employees (non-managers) in the development and use of an incentive program?
Problem 2. What is the individual performance modifier that the Towers Perrin survey identified? Explain it in managerial terms.
Problem 3. American Woodmark's scorecard approach can be most effectively use with what type of organization? Employees?