Module 2--Types of Variable Pay Flashcards
What are the THREE CATEGGORIES of VARIABLE PAY
Three Categories of Variable Pay
There are three categories of variable pay: incentives, bonuses and recognition. Within each of these categories there are specific types of variable pay plans.
Although there exists an almost limitless number of variations, most variable pay plans can be grouped into one of three categories:
■ Incentives
* Criteria determined in advance – The criteria and objectives for performance and the reward schedule are determined in advance and communicated to participants.
* Amount of payment can vary – The amount of the payment can vary with the level of performance.
* Monetary or nonmonetary – Rewards may be monetary (cash or equity) or nonmonetary (merchandise, travel, etc.).
* Self-funded or budgeted – The plan is self-funded (generates its own savings) or budgeted.
* Nondiscretionary
* Formulaic
■ Bonuses
* Completion of specific task – Rewards typically are contingent upon completing a specific task or objective.
* Amount determined in advance – Amounts typically are negotiated in advance.
* Monetary – Payments usually are cash, although sometimes equity is used.
* Budgeted – The plan usually is budgeted.
* Nondiscretionary
COMPLETION OF ONE ACT. AMOUNT DETERMINED IN ADVANCE
■ Recognition
* Criteria broadly defined and subjective – Criteria for the award are discretionary and often defined in broad terms (such as “above and beyond” work or “exceptional customer service”).
- Awarded spontaneously – The award is given more spontaneously than incentives or bonuses.
- Decision made after the fact – The decision to acknowledge employee contributions is made after the fact, usually without
predetermined goals or performance levels. - Focused on behaviors – The focus is on recognizing, promoting and replicating behaviors (versus results) that support company objectives.
- Monetary or nonmonetary – Rewards may be monetary or nonmonetary.
- Budgeted – The plan is often budgeted at the corporate or business unit level.
- Discretionary
Identify the variable pay category for each of the following examples (incentive, bonus, recognition):
- Jane received an additional 5,000 in compensation for remaining with the company through year end, while Carlos resigned in November and received nothing.
At the staff meeting, Linda’s supervisor presented her with a 100 gift certificate for staying late three weekends in a row to complete an important project.
- Company XYZ implemented a plan with a target payout of 10% of base pay, and actually paid 12% because results exceeded plan.
- Incentive
- Recognition
- Bonuses
What are the TWO TYPES of INCENTIVE PLANS?
Short-Term (one year or less) AND Long-Term (3-5 YEARS)
What are the THREE SHORT TERM Incentive Plans?
Short-Term Incentive Plans
Short-term plans consist of plans for which desired results will be achieved in one year or less. The various types of short-term incentive plans include:
■ Profit-sharing
■ Performance-sharing
■ Individual performance-based
Profit-Sharing Plans
Profit-Sharing Plans
■ Share profits with employees
* Plans normally include a predetermined formula for allocating a share of the profit among participants and for distributing funds accumulated.
■ Base rewards on financial performance
* Typically, rewards are based on financial performance. Common performance measures include: revenue, net income, earnings per share (EPS) or other financial ratios.
■ Typically include entire organization
* All employee groups within an organization or large business unit typically are eligible.
■ Payout in equal or graduated amounts
* Awards can be a common amount for all employees.
– Equal monetary amount
– Equal percentage of base pay
* Awards can vary by employee / employee groups.
– Different monetary amount
– Different percentage of base pay
* Some plans may include individual performance hurdles.
What is the objective of PROFIT SHARING PLAN OBJECTIVE?
Profit-Sharing Plan Objectives
■ Foster employee identification with organization’s success – increase employee identification with the organization’s financial success
■ Create a common focus – create a common focus on important financial objectives of the organization and provide an opportunity to publicize and educate on financial measures
What are the PROFIT SHARING PLAN Approaches?
Profit-Sharing Plan Approaches
■ First-return plans (sharing all profits) – start paying on the first profits earned.
* Example: 10% of gross operating profit will be distributed to eligible employees.
■ Threshold plans – payout to eligible employees for performance in excess of fair return on investment, which is reserved for stockholders.
* Example: 10% of gross profit over 5 million will be distributed to eligible employees.
■ Operating budget plans – In not-for-profit organizations, there is no profit metric, but an operating budget can be substituted for that metric.
■ Peer company comparisons – Senior management selects measures of performance and a group of competitor or peer companies to compare against. The fund is created based on performance relative to peer group results, with an increasing pool for improved relative performance.
What are some CONSIDERATIONS for PROFIT SHARING?
Considerations for Profit-Sharing Plans
■ Promote awareness / focus
* Highlight the key financial objectives and goals for the performance period of the organization.
* Promote a common understanding among employees.
■ Pay out only when company has profit
* Ensure financial responsibility by paying out only when the company’s financial results warrant.
* Organization profit is one of the key performance measures that shareholders and key stakeholders look at.
■ Employee ability to influence overall profits
* Awards are based on group or corporate performance, and not on differences in individual performance.
* Many plan participants may have little or no ability to have a material impact on company profits.
* Results affected by external factors (e.g., economic, geopolitical, legislative) outside the control of employees may have a substantial positive or negative impact on the plan.
* Employees may focus on obtaining short-term financial results, which in fact may be detrimental to the long-term health of the organization.
■ Simple administration
* One plan with corporate measures can be managed centrally, keeping administrative costs low.
* Can include most / all employees on the same plan, making communication and
education easier.
* Typically only one or two financial measures are used.
What are PERFORMANCE SHARING PLANS?
Performance-Sharing Plans
■ Define performance by select criteria
* Performance is defined in terms of selected criteria (e.g., quality, customer satisfaction, responsiveness, productivity).
* Standards are established and incentive awards are made contingent upon meeting those standards, typically at the business unit or organization-wide level.
■ Focus on more than financial results
* Similar to profit sharing, but involves more measures than a single financial performance measure
■ Exist at all organizational levels
* Can be an organization-wide, organizational unit or team-based plan
■ Measure performance based on predetermined objectives
* Examples: performance improvement plan (PIP), peer comparison, target performance, productivity gains
■ Are defined for a specific period
* Should be reevaluated for effectiveness at the end of each period
What are PERFORMANCE SHARING PLAN OBJECTIVES?
Performance-Sharing Plan Objectives
■ Improve organization’s performance – Focus on specific performance improvement objectives and provide incentive opportunity for employees according to how well performance improvement is achieved.
■ Foster employee identification with organization’s success – Increase employee identification with the organization’s success, as measured by multiple factors.
■ Increase employee understanding – Increase employee understanding of what is important to the organization by communicating the basis upon which success is measured.
What are PERFORMANCE SHARING PLAN APPROACHES?
■ Financial: this perspective views organizational financial performance and the use of financial
resources examples
■ Customer / stakeholder: this perspective views organizational performance from the point of
view the customer or other key stakeholders that the organization is designed to serve
■ Internal process: views organizational performance through the lenses of human capital,
infrastructure, technology, culture and other perspectives that are key to breakthrough
performance. This replaces ’capacities’.
■ Organizational capacity (sometimes called “learning and growth”): views organizational
performance through the lenses of human capital, infrastructure, technology, culture and other
capacities that are key to breakthrough performance
What are some Considerations PERFORMANCE SHARING PLANS
Considerations for Performance-Sharing Plans
■ Promote awareness / focus
* Highlight the key objectives and goals for the performance period of the organization
* Promote a common understanding among employees
* Promote teamwork in accomplishing multiple objectives
* Viewed as a “win-win” for both the company and employees
* Link performance and rewards
■ Self-funding
* Payments can be funded by the financial gains made as a result of implementing the plan.
■ Employee ability to influence overall performance
* The ability of plan participants to have a material impact on selected measures should be
considered.
■ Flexibility of design
* Plans provide considerable flexibility of design, rather than emphasizing any single aspect of
company operations.
■ May increase administrative requirements
* Requires considerable time and effort at the start of the performance period to document
anticipated performance levels.
* It is important to research performance measures for practicality and performance history.
Implementing measurement systems may be very expensive or operationally impractical.
* Plans with multiple measures are more complex and require an effective communication and
education plan.
What are INDIVIDUAL PERFORMANCE BASED PLANS?
■ Base payouts on individual performance – Individual performance is used as the basis for payouts.
■ Focus on more than financial results – Like performance-sharing plans, individual plans may involve more measures than just financial performance.
What are INDIVIDUAL PERFORMANCE BASED PLAN OBJECTIVE?
Individual Performance-Based Plan Objectives
■ Focus on personal performance improvement
■ Increase employee understanding – Increase employee understanding of what is important to the
organization by communicating the basis upon which success is measured.
■ Link rewards with personal performance
What are some INDIVIDUAL PERFORMANCE BASED PLAN APPROACHES?
Individual Performance-Based Plan Approaches
■ Performance against predetermined objectives (e.g., management by objective [MBO] plans) –
Rewards are earned for the accomplishment of predetermined goals and objectives set for the individual.
■ Output-based (historically known as piece-rate plans) – Frequently used in certain industries
or occupations where the work is repetitive in nature, and where employees have a high level
of control over their production rate. The time taken is not used to determine pay, simply the
amount or number produced.
* Historically used by homeworkers, and then widespread in factories in the first half of the
20th century.
* Largely disappeared in developed countries, but still prevalent in developing countries, for
example in the garment industry.
* One variation is to pay a premium for exceeding a set rate of production (units made per
hour/day or ”standard output”).
* Piece work can benefit homeworkers in enabling them to be flexible in their working hours,
and it can benefit employers, who have no need to measure time on the job, nor provide
workspace.
Fixed wage - ‒In some countries, employers must pay piece workers a fair wage, using the
following method:
– Find out the average number of tasks or pieces completed per hour; for example workers
may produce on average 12 shoes per hour.
– Divide this number by 1.2 so that new workers wonʼt be disadvantaged if theyʼ’re not as
fast as the others yet; in our example we divide 12 shoes by 1.2 which is equal to 10
shoes produced.
– Divide the hourly minimum wage rate by that number to work out the fair rate for each
piece of work completed. If the minimum wage rate is $13 per hour, workers must be paid
at least $1.3 per shoe they make ($13 divided by 10).
– Once this rate is set, the actual time spent on production is not recorded or measured.
■ Commission – A predetermined incentive amount for each discrete unit of sales made by the
salesperson. It is commonly expressed as a percent of each sales amount (revenue), percent of
gross margin (profit), or a monetary amount per unit sold.
* Typically used for salespeople or individuals who influence the sale.
* Effective sales incentive plans must be matched to the type of responsibilities expected of
the salesperson. These areas of responsibility generally fall into one of three categories –
customer identification, customer service and customer persuasion.
* Commissions typically represent a higher percentage of cash compensation than other
incentive types. In some cases, 100% of the individual’s cash compensation (i.e. base
pay plus short-term incentives) is earned through commissions. This is known as straight
commission. Straight commission does not apply in countries where there is a legal
minimum (basic) wage in place.
* Designed to:
– Reward individual effort and drive results
– Create singular focus on sales volume
– Motivate sales success by tying the incentive directly to sales results
What are some CONSIDERATIONS FROR INDIVIDUAL PERFORMANCE BASED PLAN APPROACHES?
Considerations for Individual Performance-Based Plans
■ Reinforcement of performance culture
* Accomplishment is directly controlled by the individual
* Diminish entitlement mentality that base pay programs often produce
* Promote competition within work groups (could be positive or negative)
■ Narrow vision
* May focus individual on personal goals to the exclusion of organizational goals
■ Wide variations in pay
* Wide variations in pay among employees is possible
* High achievers may equal or exceed pay levels of supervisors
* Pay levels may not correlate with tenure (discounts seniority)
■ High levels of administration
* Management commitment required to set, monitor and assess goals on an individual basis
* Complicated to calibrate the relative difficulty of individual plan objectives
* Difficult to budget and may be problematic if a high percentage of employees exceed
individual objectives
* Require sound measurement system and ongoing review
What are THE TWO TYPES OF LONG-TERM INCENTIVE PLANS?
Long-Term Incentive (LTI) Plans
Long-term incentive (LTI) plans include those for which desired results will be achieved in more than one year. The period of measurement is most often from three to five years. Types of LTI plans include:
■ Equity-based
■ Nonequity-based
What are EQUITY-BASED PLANS?
Equity-Based Plans
■ Create equity interest – Use company stock to create an equity interest in the company and
foster identification with shareholder interests.
■ Based on stock performance – The value of the award is based on the performance of the
organization’s stock.
■ Pay out using stock or cash – Actual awards may be in the form of stock or cash.
The terms “stock” and “shares” are used interchangeably.
What are EQUITY-BASED PLANS Objectives?
■ Align employees with shareholders – Management / employees are aligned with shareholders.
Employee interest in the organization’s profitability and success often is limited to the desire for job stability. Equity rewards help to create an ownership culture in which employees take a greater interest in the factors driving long-term business success.
■ Conserve cash – In many cases, equity awards, such as stock options, allow companies to provide competitive compensation without the use of cash (however, the company may be subject to a
noncash charge to earnings).
■ Create wealth – Allow eligible employees to build wealth through equity value / appreciation.
■ Increase retention – Equity plans can be a strong retention tool, especially using the feature of multi-year vesting requirements.
What are EQUITY-BASED PLANS APPROACHES?
Equity-Based Plan Approaches
■ Appreciation only – Employees receive appreciation in stock price.
* Stock options – Employees are given the right or option to buy company shares at a specified price (usually the prevailing share price at the time the award was made) during a specified period of time in the future. If the price of the stock rises over time, the employee can then acquire the stock at the specified price and sell at the higher price, keeping the difference.
* Stock appreciation rights (SARs) – A plan in which the company grants an employee the right to receive a monetary amount equal to the future appreciation of its stock. SARs are similar in design to stock options except that actual stock is not used.
■ Total value – Employees receive entire value of stock.
* Stock grant (or stock award) – plans that provide stock to the employees without any cost to them (recipient is responsible for income tax)
* Restricted stock – stock grants that are contingent upon remaining with the organization for a stated period of time. Stock may not be sold until the restriction period lapses.
* Performance shares – plans that award shares or stock (or its cash equivalent) contingent upon achievement of certain predetermined external or internal performance goals
What are the Considerations for Equity-Based Plans?
Considerations for Equity-Based Plans
■ Align employee / shareholder interests
* Benefit the organization by aligning employee and shareholder interests toward common goal(s).
* Focus employee attention on stock price and corporate performance.
■ Retention
* Widely accepted form of variable pay.
* Although equity plans can be a strong retention tool, they can also lose their retention value if the stock price falls below the grant price. The use of total value plans can mitigate this issue.
Note: Many employees sell their ownership interest as soon as the rules and regulations allow them to do so.
■ Stock performance may not reflect employee performance
* Could have limited impact on plan objectives as stock price may not reflect employee performance.
* Influences outside employee control may affect the value of the stock.
* Does not provide motivational value if the value of the stock does not appreciate.
Considerations for Equity-Based Plans (continued)
■ Communication challenge
* Can be difficult to communicate to employees.
■ Shareholder approval
* Many equity-based plans require approval of the shareholders.
* The use of stock for employees increases the number of shares and therefore dilutes earnings per share (EPS) for common shareholders.
■ Limited eligibility
* Equity-based plans typically are reserved for a relatively small percentage of employees at the top of the organization. This can be negatively perceived by the rest of the organization.
What are Non-Equity Based Plans?
Nonequity-Based Plans
■ Not based on stock performance – long-term incentive plans in which the determination of the reward is not based on stock performance
■ Pay out using cash – Awards typically are granted in cash, although stock may be used.
What are the objective of NON EQUITY BASED PLANS?
Nonequity-Based Plan Objectives
■ Reward long-term performance – to reward individuals or groups for their long-term performance related to organizational measures. Plans usually are three to five years in duration.
■ Focus on specific goals and objectives – to focus attention and effort, awards are based on the achievement of specific goals and objectives
■ Conserve stock – Organizations with stock may not wish to use it as part of an incentive plan.
What are Nonequity-Based Plan Approaches?
■ Performance unit plan (PUP) – A plan in which a fixed number of units are granted with a stated value per unit. Based on the attainment of the stated goals and objectives at the end of the performance period, the awarded value of each unit can increase or decrease (usually to zero below some threshold level).
■ Book value plan – A plan that bases awards on the increase in the book value of the organization over the performance period. Book value is defined as total assets minus total liabilities. These
plans typically are used in private companies where no publically-quoted stock exists.
■ Multi-year performance plan – A plan in which cash payouts are earned and paid over a period of years, with a portion of the payout earned in each year.
