Basic Variable Pay Plan Design

Tuesday, August 10, 2010

Variable pay can be, in its most basic form, an incentive plan, a bonus plan or any reward used to direct the employee's performance behavior to the next higher level. A sales representative’s commission earned from selling specific quantities of products or services at or above some fixed sales level is a form of variable pay. A bonus paid to a production line worker is also a kind of variable pay in recognition of a higher production level. Variable pay plans in one form or another have been around for decades and have gone under various names, i.e., bonuses, commissions, incentives, rewards, … etc. What generally differentiates a variable pay plan from a simple bonus or commission plan is its design, which attempts to improve performance in a careful and well planned and well thought out manner.

I once worked for a company that took scrape aluminum and reprocessed it into specification alloys for the automotive industry. During that reprocessing large amounts of expensive materials and in some cases, dangerous chemicals were used. If the furnace operator incorrectly added these materials or chemicals at the wrong time, in the wrong amounts or in the wrong combinations, several thousands of pounds of molten aluminum were often worthless. It might require a day or more to pour off the current worthless batch, recharge the furnace, bring the batch to the proper specification mixture, and pour the contents. A very expensive mistake to overcome, coupled with the real possibility of a missed shipment date, customer relations issues, wasted materials, and labor and fuel costs.

A variable pay plan would have looked at all of these factors and others, in an attempt to increase the likelihood that the furnace operator would understand his role in the process, as well as the financial and customer relations impact of potential mistakes. Consider that there are some factors the operator cannot control; however, a variable pay plan would use controllable factors in the design of the plan, such as when, how, and in what quantities alloy materials were added to the base aluminum.

At another employer, a large insurance company, our sales representatives certainly had incentive plans to sell more business, however those plans failed to factor in the quality of the group business sold. So a representative would sell coverage to groups without any consideration as to how profitable the group would be, the likelihood the group could be retained at renewal time, how difficult the administration would be. Thus, a representative might sell twice the amount of business as a peer but the company would actually take a loss on those groups due to the “quality” of the business sold. A well-designed variable pay plan might consider factors such as, group profitability, future renewals and retention, administrative factors, and even aspects around the future growth of the group and referral business.

Therefore, the design of a variable pay plan is unique to the industry, organizational unit, and even the culture for which it is being built. A plan design for aluminum reprocessing will not work in the insurance industry. A variable pay plan built for US workers may not appeal to workers in Asia or South America. Variable pay designs can be very complex or a simple design can be found that will drive to the root cause of a performance issue very effectively.