An effective incentive compensation plan is fair, truly rewards top performers and helps support the organization's strategic goals.

Today’s economy is difficult and unpredictable for the contractor. There are fewer jobs to bid, and those that are available are often being “bought” so that companies can keep their workforce busy. Unemployment in the construction industry has soared to 19.4% or 1.8 million construction workers.¹ With this economic backdrop, short-term incentives have taken a backseat in many companies.  

Short-term incentive compensation plans, or annual bonus plans, are ideally designed to reward employees commensurate to their performance. These plans come in all shapes and sizes, ranging from formula-based to fully discretionary plans. No matter the plan design, payouts should reflect a company’s ability to pay them. When the economy is good and backlogs are large, short-term incentives can be a large part of an employee’s total compensation. Conversely, when backlogs are few and revenue and income are down, bonus payouts should reflect this.  

In recent years, companies paid out bonuses so consistently that many employees have come to view these payouts as just another part of their annual salary. This sense of entitlement is an unintended consequence stemming from several factors. The first is that ownership feels compelled to pay bonuses even in years of marginal or poor financial performance. This approach, while generous, often undermines the motivational value of incentive plans in which strong performance is rewarded by cash. A second factor leading to a sense of entitlement is the lack of effective communication of plan parameters to employees. Not communicating performance levels that earn payout is the same as having a discretionary plan. The underlying issue with both factors is a lack of clarity, i.e., employees having a clear understanding of how their performance and actions affects their bonus payouts. By not effectively communicating the details of an incentive compensation plan, employees may be confused as to what needs to be done to achieve a bonus and may expect a payout even when performance does not justify one. 

Entitlement issues become obvious during tough economic times. As companies continue to shed expenses and focus on labor costs, they should also reevaluate incentive plans to ensure that they effectively drive performance. 

What constitutes an effective short-term incentive plan? The answer to this question depends on the company. What is its mission, short- and long-term goals? To develop an effective compensation plan, a company must first have a pay philosophy. This philosophy should be developed thoughtfully and communicated across the organization at best, but at minimum, company leadership should create and embrace clear incentive plan objectives. Ideally, this philosophy will provide a framework around which effective incentive plans are built and administered. Generally, an effective short-term incentive plan is one that the company can afford in all economic conditions and will drive employee performance in a way that supports the company’s mission and goals.

Bonus Pool Funding

Developing a viable incentive plan requires determining how the bonus pool will be funded and distributed. It requires modeling the various design elements to ensure that funding expenses do not exceed expectations. Effective communication to participants regarding performance expectations, and how performance affects payouts, is a requirement of a good incentive plan. Participants should clearly understand what needs to be accomplished to achieve a bonus and what will happen if performance levels are not met. Effective communication will assist in developing trust between management and employees regarding the plan. 

There are various designs for building a plan that functions in both good times and bad. Using financial metrics for pool funding ensures the company can afford payouts. Funding can be based on company, division, project-level performance, or any combination of these. 

Company-level Funding

Funding at the company level is typically based on broad measures such as: 

• Return on equity
• Net income
• Operating profit
• Cash flow

These measures are effective at ensuring that ownership’s required rate of return is achieved prior to any incentives being paid out, as well as making sure that the company can afford the plan. Because the result are not diluted across divisions, all employees work together equally in achieving the required financial results. However, these plans may not work well if a firm wishes to drive divisional performance, since the whole-company approach minimizes performance shortfalls in any single division. Additionally, employees may have difficulty understanding financial measures and senior management may be reluctant to communicate financial performance to employees. Since these plans encompass the entire organization, individual employee performance has, for the most part, minimal impact on overall financial performance. 

Division-level Funding

Plans funded at the group or division level can be based on the following measures: 

• Gross profit
• Division operating profit (after division or corporate overhead)

Division plans are very effective at holding employees accountable for group performance. Implementing such a plan is a good way to improve the performance of marginal divisions. Group measures drive a sense of “team” and individual performance has a direct impact on the group’s performance. The advantage of divisional-level funding is also its biggest drawback in that it can drive groups to work counter to the overall good, such as hoarding resources and competing against others to the firm’s detriment.

Project-level Funding

These plans typically cover operations groups and can include the following measures: 

• Percent of gross profit
• Cost savings percent, i.e. labor
• Margin gain and fade

Project-funded plans are easily understood by participants and form a direct connection between employee performance and the resulting financial rewards. As with division-funded plans, project-based plans may result in participants taking actions that enhance their particular projects but are detrimental to the division or company as a whole. Additionally, such plans may motivate participants to manipulate project performance for their gain. A significant disadvantage of project-based plans is the fact that project performance may not accurately be reflected.   

For instance, XYZ Construction has a complicated project that is over budget and seriously behind schedule. They ask Fred Smith, a seasoned and exceptional senior project manager, to get the project back on track. Fred brings the project from over-budget and behind schedule to break-even and on time. If XYZ’s project-based incentive plan rewards only for financial performance, Fred may get little or no bonus due to breaking even, while another project manager who was lucky enough to land a simple project gets a large bonus. This failure of the plan to take into account factors other than financial performance might make Fred think twice the next time he is asked to save a project. 

Every company should establish a certain level of return it wants to achieve. What is considered an acceptable level of return for today’s economy is likely very different from what was acceptable two to three years ago. This minimum level will set the baseline for the funding of a bonus pool. The minimum level of return is not set in stone on a year-over-year basis. The plan should be flexible enough to meet the needs of the business and business environment. However, any changes that are made to plan parameters should be made at predetermined times throughout the year (i.e., beginning of the fiscal year or the start of Q3). Evaluating plan performance regularly and making changes at prescribed times throughout the year simplifies communication to employees regarding goals. It also limits the perception that the plan is being manipulated by senior management in order to control plan funding.  

To illustrate the funding of a bonus pool, we look to Acme Construction. Acme is a specialty contractor with $2.5 million in net profit before taxes for 2009 and $10 million in equity. For the purposes of this article, return on equity (ROE) will be used to demonstrate funding. ROE measures a company’s return against ownership’s investment for a particular year. This measure is valuable because ownership, especially construction industry ownership, needs to achieve a significant return for its investment in a high-risk venture. ROE is widely used and can be a good indicator of overall company success. Keep in mind that ROE targets can vary significantly depending on the type of contractor as well as their financial requirements, i.e., bonding, growth plans, etc. 

In Acme’s example, the owner requires a 20% rate of return on his investment, which is calculated by dividing net profit before taxes by start of year owner’s equity.

Exhibit 1: ROE Calculation

Return on Equity =

Net profit before taxes  Owner's equity

 

Using the calculation in Exhibit 1, Acme has devised a test for ensuring that no payouts occur until the firm’s ROE requirements are met. Exhibit 2 below shows how this test works. 

Exhibit 2: ROE Test

Return on Equity Test (ROE)                                     Owner's Equity   $10m Required ROE (%)   20% Required Net Profit   $2m         Owner's Equity        = $2.5m $10m = 25%         Is ROE (%) >= required ROE (%)?  Answer - Yes

To attain the required 20% ROE, Acme needs at least $2 million in net profit. In actuality, the firm brought in $2.5 million in net profit, resulting in an ROE of 25%. So, the company did exceed its return in equity requirement. 

Once this threshold is met, the question now is how to allocate funds into the plan. One way to do this is to channel a portion of net profit above the ROE target into the fund. In this example, the owner of Acme Construction will allocate 50 cents on each dollar of net profit into the pool up to a point, after which 15 cents of every dollar will go into the pool. The point between the 50 cent and 15 cent allocations is where net profits exceed what would be expected from normal business operations and instead are the result of management’s/ownership’s actions. Additionally, Acme has placed a cap on funding once a certain threshold is reached. 

Exhibit 3 shows how the pool funding occurs. The x-axis represents net profit dollars while the y-axis shows bonus pool funding in dollars. Notice that, in the bottom left hand corner, no dollars go into the pool until the ROE requirement is met. The line labeled as standard BP (bonus pool) funding shows the 50 cents for every net profit dollar going into the pool. At the point where the net profit reflects management and ownership’s efforts (Excess BP Point), the allocation level drops to 15 cent for every net profit dollar. Pool funding stops once funding reaches a certain level. 

Exhibit 3: Pool funding  

 

Bonus Pool Distribution

Once the plan is funding, these funds must then be allocated to individual participants. How this allocation takes place will determine how effective the plan is at driving participant performance. The more closely payouts are tied to an individual’s performance, the greater the plan’s effectiveness at driving performance.

Target Bonus

One of the most effective methods of funding is to establish target bonuses for each participant. Target bonuses are typically a set percentage  of annual salary that an employee can earn in an annual bonus.  

Target bonus percentages are typically set at the grade or job level. Target levels are typically not set for individual participants. There are several ways to establish target bonus percentages. The most common ways use external or internal job worth to determine the target bonus amount. External job worth involves using total cash compensation data from salary surveys. Internal job worth is established through the use of a job hierarchy (or other job evaluation method) where each participating job is ranked in descending order by importance to the organization. Once that is established, target bonuses are assigned to each job level with the jobs considered most important to the company receiving the highest target percentages. These target percentages are then multiplied by the individual employee’s salary to calculate the potential bonus that the employee can earn.  

The target bonus is the starting point for determining the actual bonus payout. Two adjustments are typically made to the target bonus in determining final payout amounts. The first adjustment increases or decreases the target bonus amount to reflect the actual funding level. The second change is made to reflect the employee’s performance. Making these adjustments drives a strong link of pay-to-performance.   

To make the first adjustment to reflect actual pool funding, a bonus pool multiplier is determined. This multiplier is calculated as follows: 

Bonus Pool Multiplier     = Actual Bonus Pool Funding Level Target Bonus Pool

The actual bonus pool funding level is the amount allocated from the net profit above the ROE target. The target bonus pool is simply the sum of the target bonus amounts for all participants. For example,  pool funding is $3,000,000 and the target bonus pool equals $2,500,000.

Bonus Pool Multiplier   = $3,000,000 $2,500,000  =  1.2

The bonus pool multiplier shows what percentage of the target bonus has been funded. Because the actual pool funding is larger than the target bonus pool, the bonus pool multiplier is greater than one. This multiplier is an important concept in that it adjusts individual target bonuses up or down depending on how much money is funded into the bonus pool. If the company has exceeded financial expectations for a particular year, then each person on the plan will have the opportunity to earn more than the target bonus. The opposite result is also true in the case of underperformance. When the company does not meet financial expectations or just barely exceeds them, the incentive plan will fund less than the target bonus pool. As a result, each person’s target bonus would be adjusted downward. In the calculation above, all target bonuses are multiplied by 1.2 to reflect the larger pool. 

Exhibit 4 shows the target bonus adjustments with a bonus pool multiplier greater than one (1.2).

Exhibit 4

JOB TITLE	SALARY	TARGET BONUS %	TARGET BONUS	BONUS POOL MULTIPLIER	ADJUSTED TARGET BONUS
Project Manager	$80,000	15.00%	$12,000	1.2	$14,400
Superintendent	$70,000	15.00%	$10,500	1.2	$12,600
Project Engineer	$65,000	12.00%	$7,800	1.2	$9,360
Estimator	$60,000	10.00%	$6,000	1.2	$7,200

Exhibit 5 shows target bonus amounts adjusted for a multiplier less than one (0.8).                                

Exhibit 5

JOB TITLE	SALARY	TARGET BONUS %	TARGET BONUS	BONUS POOL MULTIPLIER	ADJUSTED TARGET BONUS
Project Manager	$80,000	15.00%	$12,000	0.8	$9,600
Superintendent	$70,000	15.00%	$10,500	0.8	$8,400
Project Engineer	$65,000	12.00%	$7,800	0.8	$6,240
Estimator	$60,000	10.00%	$6,000	0.8	$4,800

The hallmark of a plan that effectively drives performance is a direct link of employee performance to pay. In other words, participants have a clear understanding of how their actions may affect their pay. Employees have some degree of control over company financial performance through expense minimization and revenue maximization, but, depending on the level of funding, most do not have a strong link to these measures. 

Including individual employee performance as a factor in the incentive compensation plan creates accountability between individual performance and a bonus payout. Better performers over the course of a fiscal year can earn more than their potential target bonus while lower performers will earn less, or possibly no bonus at all.  

This link of pay to individual performance is accomplished by developing a payout table tied to performance ratings (See Exhibit 6). Notice that an employee receiving an overall rating of 4.5 would receive an adjustment to his or her target bonus of 125%, whereas an employee receiving a rating of 2.0 or less would receive no bonus.   

Exhibit 6: Payout table

SCORE	TARGET BONUS % ADJ
Score 4.5 – 5.0	125%
Score 4.0 – 4.4	115%
Score 3.5 – 3.9	110%
Score 3.0 – 3.4	100%
Score 2.6 – 2.9	75%
Score 2.1 – 2.5	50%
Score <= 2.0	0%

Exhibit 7 takes the table shown in Exhibit 6 with a bonus pool multiplier greater than one and adds the performance rating adjustment. 

Exhibit 7

JOB TITLE	TARGET BONUS	BONUS POOL MULTIPLIER	ADJUSTED TARGET BONUS	PERFOR-MANCE RATING	RATING %	FINAL BONUS AMOUNT
Project Manager	$12,000	1.2	$14,400	4.5	125.00%	$18,000
Superintendent	$10,500	1.2	$12,600	3.6	110.00%	$13,860
Project Engineer	$7,800	1.2	$9,360	2.4	0.00%	$0
Estimator	$6,000	1.2	$7,200	3.3	100.00%	$7,200

Exhibit 8 includes the performance rating adjustment with the multiplier less than one. 

Exhibit 8

JOB TITLE	TARGET BONUS	BONUS POOL MULTIPLIER	ADJUSTED TARGET BONUS	PERFOR-MANCE RATING	RATING %	FINAL BONUS AMOUNT
Project Manager	$12,000	0.8	$9,600	4.5	125.00%	$12,000
Superintendent	$10,500	0.8	$8,400	3.6	110.00%	$9,240
Project Engineer	$7,800	0.8	$6,240	2.4	0.00%	$0
Estimator	$6,000	0.8	$4,800	3.3	100.00%	$4,800

Exhibits 7 and 8 demonstrate the power of linking pay to performance. Through clear communication of performance measurements and an effective performance management process, employees understand how their actions will affect their bonus payouts. Implementing such a plan is a great way to transition from a culture of entitlement. However, keep in mind that this process will only be as good as your performance management system, and the pay-for-performance link will be broken if the performance management process is not embraced by participants.  

Sharing System

This is an alternative to the target bonus distribution method. Once the funding level has been set, each functional group or individual employee would “own” a portion of the bonus pool. This percentage can be based on job targets or set at management’s discretion. In the table below, the total pool amount is $100,000. Exhibit 9 shows for each participant the maximum number of points possible as well as the number of points actually earned. In this example, the total number of points earned is 400. Looking at Jack, his 100 points earned is 25% of the 400 total points awarded. Hence, he will receive a quarter of the pool, or $25,000. 

Exhibit 9

Name	Position	Performance Points (Max Possible)	Performance Points (Earned)	% of Total Earned	Bonus
Jack	Project Manager	120	100	25%	$25,000
Bill	Controller	70	0	0%	$0
Tom	Superintendent	100	80	20%	$20,000
Jack	Accounting Clerk	20	20	5%	$5,000
Larry	V.P. Operations	250	180	45%	$45,000
Sue	Estimator	40	20	5%	$5,000
	Total	500	400	100%	$100,000

Other Incentive Methods

Discretionary

Discretionary bonuses can utilize a funding method as described above with distribution at management’s discretion, or both funding and distribution can be at management’s discretion. The advantage of such a plan is that little (if any) communication of financial information is required, and management has full flexibility in rewarding for behavior, performance, effort, etc. However, of the plans mentioned here, discretionary bonuses are the least effective at motivating and driving performance. When plans are discretionary, managers typically communicate very little about how the amount was determined, thus the tie between performance and pay is severed. This disconnect frequently leads to a culture of entitlement. Frequently, employees see discretionary bonuses as simply an extension of their paychecks. The trend has been away from purely entitlement plans and towards plans that give employees at least a clearer understanding of how their actions can affect their pay.   

All types of plans, even formulaic versions as described above, need to include some flexibility for addressing unusual circumstances. In the example where payouts are distributed via a target bonus system, managers would be able to add a discretionary amount to the adjusted payout, with discretion amounts limited to a percentage of the actual bonus pool (typically 10%). 

Goal-sharing

Goal-sharing plans engage and reward employees for continuous improvement. The most effective plans have employees and managers working together to set goals that do not conflict with other areas of the organization. Effective goals should be: 

• Simple
• Specific and measureable
• Challenging yet attainable
• Aligned with financial and non-financial goals

Payouts may be based on individual and group contributions against organizational goals. These plans are effective at driving change throughout an organization. 

Incentive compensation can be an important tool when it comes to attracting, retaining and motivating your best employees. An effective incentive compensation plan is fair, truly rewards top performers and helps support the organization’s strategic goals. With excellent communication and training, transparency is achieved. With that clarity of understanding by participants, the incentive plan drives performance. Additionally, an effective plan balances the need to reward top performers while protecting the profitability of the company.
 

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