Module 4--Developing a Variable Pay Plan Phases 3: Funding and Distribution Flashcards
Phase 3: Funding and Distribution
The final phase in the development of a variable pay plan consists of:
■ Determining performance targets and payouts
■ Funding the plan
■ Distributing plan earnings
Determining Performance Targets and Payouts
Determining Performance Targets and Payouts
Target plan performance is the level of organizational performance that would result when all
measures are met. The plan must provide a target payout significant enough to gain the participants’
attention and motivate them to achieve the targeted performance. Many plans also establish a range
of performance that can vary below and above the target performance.
■ Performance targets
* Setting baselines – A baseline is the point at which you begin to measure performance
improvement. Establishing a plan baseline is not an exact science. It must, however, be
reasonable to participants. Baselines may be set using either historical performance or
prospective performance.
* Setting performance targets – Target is a level of performance at which all performance
measures are met.
* Setting performance thresholds and maximums – the minimum and maximum levels of
performance at which a payout can be earned
■ Payouts
* Setting target payouts
* Setting threshold and maximum payouts
* Other considerations when setting payout levels
* Payout schedules
Baselines
Baselines
Historical performance:
■ May include historical average, recent experience, peak performance.
■ May be used when:
* Past performance is indicative of future performance.
* Previously achieved levels of performance have been acceptable.
* Business is projected to decline slightly.
* Seasonal or other volatility is predictable.
■ Should not be used when:
* A change in the production process (e.g., capital improvements) is likely to result in improved
performance.
* Prior or recent history was atypical.
* Past performance was below acceptable levels.
In some cases, the baseline may actually be set below the historical performance because
the business or process has changed and the new baseline recognizes the change. It is
an opportunity to communicate to employees what is expected and what is valued as
improvement.
Baselines set too low may cause an overpayment. Baselines set too high may
demotivate participants who feel target performance is unattainable.
Baselines: How Variable Is Performance?
Baselines: How Variable Is Performance?
Considerations for setting baselines based on historical data:
■ Low volatility
* Simple historical averages appropriate
* Trends should be taken into account
* Frequent payouts possible
■ High volatility
* Same as low volatility, except payout periods may be longer
* Measuring performance may require rolling averages
■ Aberration occurrences
* Same as low volatility, except drop aberration data from historical calculation
■ Seasonality
* Baseline may change season to season, based on comparable, previous periods.
Baselines for Prospective Performance
■ Target(s) with no history – Prospective performance refers to reaching or exceeding a target for
which there is no history or past experience.
■ Based on:
* Budget for the performance period
* Projected performance
* Peer company comparison
* Current business plan
■ Used when:
* Capital improvement made – A capital improvement or change in production process has
been made.
* No relevant historical data – Historical data is not relevant or there is no historical data.
* Set based on continuing trend – Baseline is set based on a continuing trend.
■ Examples
1. Reaching a specific target(s) in customer service when there are few, if any, data on past
customer service
2. Hitting or exceeding production, service or sales target(s) that are symbolic in themselves
(100 million in sales)
3. Outperforming a competitive peer group through economic cycles
Setting Performance Targets
Setting Performance Targets
Target performance is the level(s) of performance the organization expects to achieve during the
performance period if all performance measures are met.
■ Perceived as reasonable – Appropriately set targets require effort and hard work to achieve, but
are attainable. In short, targets should be perceived as reasonable by the participants.
■ Degree of difficulty in achieving target performance – Assuming the target-setting process
is valid and reliable, actual performance results over several performance periods would be
normally distributed around target performance.
* Plans in which payouts consistently approach or hit the top payout level indicate target
performance levels being set too low. These plans:
– Foster an entitlement mentality.
– Do not influence behavior.
* Plans in which there are consistently little or no payouts indicate targets being set too high.
These plans:
– Discourage participants.
– Foster distrust of management.
– Do not influence behavior.
* For ongoing plans, prior performance results should be analyzed.
Setting Performance Thresholds and Maximums
■ Threshold or minimum – The minimum level of performance at which a payout is earned. It can be
equal to the baseline (the minimum level of acceptable performance), or higher or lower than the
baseline depending on the rules established by the plan designers.
■ Maximum or cap – The level of performance at which payouts stop. It represents the maximum
amount of earnings under the plan.
* Provides built-in cost control and prevents unexpected payouts
* Limits upside earnings potential and may be a disincentive to performance after the
maximum is reached
Setting Target Payouts
■ Base pay relative to market – Target payout levels should be set with base pay levels in mind and
the organization’s desired cash compensation position relative to the market.
■ Payout relative to gains – If the plan is self-funded, the target payout will be in proportion to the
gains achieved.
■ Methods of allocation – There are different methods by which payouts can be allocated to
individual plan participants.
* Equal
– Each plan participant would receive an equal percentage of base pay. Actual monetary
amounts would vary by base salary.
– Equal monetary amounts awarded to each employee
* Graduated
– Actual payout pool as a percent of targeted pool applied to individual target payouts by
position or level in organization.
– Generally, the higher the person’s pay and position, the higher the target payout as a
percentage of base pay.
* Management discretion
– Pool distributed based on management’s judgment of individual performance, including
MBO or performance review.
Setting Threshold and Maximum Payouts
Threshold and maximum payouts are usually expressed as a percentage of target payout.
■ Threshold or minimum payout – The minimum amount that will be paid under the plan.
Example: Target payout = 10% of base pay for all measures
Minimum payout = 20% of target payout
If the organizational performance is at the minimum then:
Payout = 10% × 20% = 2% of base pay
■ Maximum or cap payout – The maximum amount that will be paid under the plan.
Example: Target payout = 10% of base pay
Maximum payout = 150% of target payout
If the organizational performance reaches the maximum then:
Payout = 10% × 150% = 15% of base pay
■ No cap – Some plans have no cap. There is no upper limit on the amount a participant can earn.
Example – a commission plan in which the participant earns 2% on all sales with no cap:
Sales Volume Commission Earned
50,000 1,000
500,000 10,000
5,000,000 100,000
50,000,000 1,000,000
Payout and Performance Exercise (page 127)
What are Other Considerations when Setting Payout Levels?
Other Considerations When Setting Payout Levels
■ Windfall – an award that is higher than expected due to an unplanned, extraordinary event that is
outside the participants‚ control
■ Cave-in – an award that is lower than expected due to events outside the participants’ control
Many plans allow for the adjustment of target measures in the event of a windfall or cave-in.
* A company may pay out a windfall as a sign of its commitment to the plan.
* A company may decide not to pay in the event of a windfall or cave-in if it is determined a
payout will undermine the pay-for-performance philosophy (this may however, affect plan
credibility in the future).
■ Management discretion – Management may reserve the right to adjust award levels due to
unexpected circumstances. Most companies try to minimize the application of management
discretion.
* Payouts should be audited to ensure pay equity.
■ Other issues
* Effect on benefits – determine whether payout earnings will count in the calculation of
benefits (e.g., retirement plans, life insurance)
* Global currency – determine whether payout for plan participants in foreign countries will
be expressed in home-country currency, local currency or a combination
* Change in control – determine the effect on payouts if ownership of the company changes
(typically applies only to senior executives)
Payout Schedules
Payout Schedules
Variable plan payouts generally are formula-based with a predetermined performance-reward
schedule. Payouts may be set up as a continuous, step, trigger or gatekeeper payout.
■ Continuous payout – Under this approach, the organization is paying for every increment of
improvement in the performance.
■ Step payout – Under this approach, the organization is paying a specified reward at
pre-determined levels of organizational performance. If performance falls between a level, the
payout falls back to the previous level.
■ Trigger payout – This basically is an all-or-nothing approach that is most common in bonus plans.
The accomplishment of a specific task or objective “triggers” the payout of a set amount. If
performance falls short, no payment is made.
■ Gatekeeper – Similar to a trigger, but used in multiple measure plans. A designated level
of performance must be achieved in a specific measure in order for there to be any payout,
regardless of how well the organization performs on other measures.
Funding the Plan
Funding the Plan
Funding is the method by which money for awards is generated. Regardless of the funding mechanism, the overall objective of variable pay plans is to generate more value to an organization
than they cost. Plan funding requires:
■ Methods of funding
■ Timing of funding
■ Financial modeling
Methods of Funding
Methods of Funding
■ Self-funded – The plan can be self-funded from the financial value of the improved performance.
This is often used when the plan measures are financial. Operational measures can also be used
if they can be easily converted into a financial value. For example, productivity improvements
can often be converted to financial savings based on increased production or reduced labor per
unit produced.
Note: Self-funded plans will still be accounted for as a line item in the organization’s budget.
■ Budgeted – When the improvement in a measure cannot be financially determined, the
organization may need to budget the required funding for the variable pay plan. Funding takes
place as part of the normal accounting process.
■ Combination – Often a variable pay plan will have both financial and nonfinancial measures.
This combination of measures can result in funding by only the financially based measure or by a
combination of the financially based measure and budgeted funds.
Timing of Funding
Funding can occur in advance of, during, or after the performance period.
■ Prospective funding
* Awards are budgeted in advance – budgeted money can be reviewed every year.
* Most common way to budget and expense award amount; some organizations allocate a
portion of merit budget for recognition.
* Budget can be determined by a percent of payroll or monetary amount per employee (e.g.,
0.01% of payroll or 25 per employee).
* As a general rule, a 1% budget of wages can generate 5% awards on average if 20% or less
of the population receives recognition awards.
■ Fund as you go
* Award costs are accrued during the performance period based on progress toward meeting
stated goals.
* Works well for significant awards where there can be a substantial variation in payout
amount, or when the results are funding the award.
■ Retrospective funding
* Paying for rewards after the fact.
* Amounts are not budgeted for and may be paid for from other sources.
* Simple and easy for small monetary amounts.
Financial Modeling Process?
Financial Modeling
1. Identify how much money is needed
* Estimated payouts, if performance targets are reached on every measure, can be calculated
based on the method of allocation.
– Equal percentage of base pay (plus overtime where appropriate) for all employees.
❙ Total payroll = 30 million
❙ 7% payout at performance target on all measures = 30 million × 7% = 2.1 million
– Equal monetary amount to plan employees.
❙ Payout at performance target = 2,100
❙ 1,000 employees × 2,100 = 2.1 million
– Graduated percentage of base pay based on level of plan employee
- Identify value of improvement for each measure
* Monetary value
– Profit improvement at performance target = 4 million (incremental)
– Productivity improvement at performance target = 1 million (incremental)
– Total monetary value = 5 million
* Value-added return
– It can be difficult to calculate the gain on most nonfinancial measures.
❙ Customer-focused measures – employee satisfaction, customer satisfaction,
value chain
Example – a gain of 3 percentage points in customer satisfaction
What would it cost in system / product changes to improve customer satisfaction?
❙ Operational measures
Does improvement add value?
* Total funding
– Monetary value of profit and productivity improvement = 5 million, plus
– Value-added improvement = priceless
Financial Modeling (continued)
3. Calculate the financial return
* Net return on payout (ROP)
gain – payout
payout
× 100
(5 million – 2 million) / 2 million = 3 million / 2 million = 1.5 or 150% net return on payout
1.50 net earned for each 1 invested plus 3 percentage points in customer satisfaction
* Gross return on payout (ROP)
gain
payout
× 100
5 million / 2 million = 2.5 or 250% gross return on payout
2.5 gross earned for each 1 invested plus 3 percentage points in customer satisfaction
- Model payout scenarios
Now that the plan targets have been determined, you can begin to model what the expected
payouts would be at varying levels of performance. This will be important for the accounting
function if the plan will require an accrual. You may be asked to provide updates during the
performance period based on changes in projected performance so the accrual rate can
be adjusted.
* Model payouts at performance measure extremes
– It may seem unlikely that either extreme (minimum or maximum) will be achieved
for performance measures, but business conditions may change drastically and in
unexpected ways. It is important to provide management with the full range of payout
possibilities.
– Audit models to ensure highest performance is rewarded at the highest level and that
individuals are appropriately compensated.
* Consider changes in:
– Base salary levels (e.g., mid-year merit increases, promotions)
– Eligible participants (e.g., high recruiting, layoffs)
* Consider payouts in relation to noncontrollable events
– Consider situations in which employees would receive little or no payouts because of
non-controllable events (cave-ins).
– Consider ways employees might max out payouts through no effort of their own
(windfalls).
Distributing Plan Earnings
■ Form of payment – will be determined by the plan objective and plan type and will fall into one of
three categories:
* Cash – Percent of base pay, lump sum, variations by level. Cash is the most common form
of payment.
* Noncash – contribution to retirement plan, merchandise, gift certificates, travel.
* Stock – stock grant, stock options.
■ Frequency of payout – determines how often payouts are made
* A more frequent payout may reinforce behavior, if the reason for the payout is communicated
and the reward is significant.
* Less frequent payouts are larger, can minimize administration costs and will help smooth
short-term variations in measures.
* Payouts typically are made monthly, quarterly, semi-annually or annually. Payouts can also
be made randomly, as in the case of recognition awards.
Example: 5% target payout at 60,000 annual salary
■ Timing of payout – considers how long after the measurement cycle incentives will be paid
* Immediate (spot award)
* Short-term, tied to work cycle (daily, weekly, quarterly)
* Annual
* Project or project segment duration
Final Approval
Throughout the design process, it is important that key decision makers have been kept informed,
either formally or informally, about the progress and direction of the plan. Senior management
should not hear about the plan for the first time when it is presented for approval. In fact, providing
a variable pay tutorial to acquaint the approval committee with the basics of plan design a few
weeks prior to the approval presentation will facilitate a smoother presentation. It will help keep the
discussion from getting off track on definitions or lengthy explanations.
In presenting the plan for approval, it is important to address the following key points:
■ Statement of design team objectives – The team objectives that were implemented prior to the
design of the plan set the stage for the presentation. If a cross-functional team was used, very
brief introductions may be useful to reinforce the notion that the plan was developed with input
from several functional areas, not just HR. This will aid in the “buy-in” of the management team.
A team member outside of HR should make the presentation to further this.
■ Goals / objectives of plan – This should address, at a high level, what the needs of the
organization are and how the plan will address those needs.
■ Plan overview – including the measures, eligibility (who is covered), plan periods and plan payout
■ Financial impact – including expected gains or improvement, possible payout ranges (if
thresholds and maximums apply), and the correlation of the two (what the organization is getting
for what it’s paying out)
■ Implementation plan – including timing, communication plans, and leadership’s involvement in
the roll out
■ Seek senior management support
* General approval to implement
* Agreement to support the roll out process
* Commitment to support the objectives and model the desired behaviors
* Commitment of management to take ownership of the plan
■ Consider beta testing – Senior management may be reluctant to implement a new plan or make
significant changes to an existing plan, especially when those changes could have a significant
financial impact to the organization. One way to evaluate plan effectiveness before committing
to major financial rewards is to conduct a beta test using more nominal awards, such as
recognition or noncash awards.
- Which of the following would most likely be a reason to use prospective performance instead of historical performance in setting baselines?
A. When past performance is indicative of future performance
B. When previously achieved levels of performance have been acceptable
C. When a capital improvement or change in the production process has been made
D. When seasonality or other volatility is predictable
C. When a capital improvement or change in the production process has been made
- In defining payout criteria, the minimum level of performance at which a payout is initially earned is known as what?
A. Threshold
B. Target
C. Cap
D. Baseline
A. Threshold
- Which of the following best describes a graduated payout allocation?
A. The pool would be distributed based on management’s judgment of individual performance.
B. Each plan participant would receive an equal percentage of base pay, but actual monetary amounts would vary by base salary.
C. Equal monetary amounts are awarded to each employee.
D. The actual payout pool as a percent of targeted pool is applied to individual target payouts by position or level in organization.
D. The actual payout pool as a percent of targeted pool is applied to individual target payouts by position or level in organization.
- Which of the following is a type of payout schedule?
A. Threshold payout
B. Step payout
C. Frequency of payout
D. Windfall payout
B. Step payout
- It might be best to use a budgeted method of funding, when:
A. Operational measure can be easily converted into a financial value.
B. Funding of the plan is only provided by financially based measures.
C. The financial value of improved performance can be measured.
D. Improvement in a measure cannot be financially determined.
D. Improvement in a measure cannot be financially determined.
- Which one of the following items needs to be determined for the distribution of plan earnings?
A. Management discretion
B. Timing of payout
C. Net return on payout
D. Value-added return
B. Timing of payout
