Creating Incentive Plans That Actually Incent Employees

You're a new sales manager or HR professional and you've been tasked to create an incentive plan either for your team or for management. Now what?

Although incentive plans are meant to incent employees to perform, not all plans achieve what they were set out to accomplish. That's why it is important to analyze the advantages and disadvantages of various incentive plan components to determine the plan that will promote the highest levels of performance while at the same time, encourage ethical behavior. This is especially true for salespeople and managers/executives because they work with customers and are responsible for achieving company earnings targets.

Sales Personnel: Lump-sum Bonuses

Lump-sum bonuses are earned at the end of a specified time period, such as monthly, quarterly, or annually, when a salesperson achieves a specific level of sales or sales quota. While they are not the only way to incent salespeople, "72% of firms use bonuses in their sales incentive contracts, whereas only 58% use commission rates, the next most common form of incentive pay" (Steenburgh, 2008, p. 235).

Lump-sum Bonuses – Advantages & Disadvantages

The main advantage of lump-sum bonuses is that they incent salespeople to strive for high levels of performance and to reach sales targets they otherwise might not accomplish. "Quotas are set so as to provide salespeople with objectives that are challenging and worth being achieved. In order to enhance salespeople's performance, management grants them some reward when they reach a pre-specified performance level (the quota) which is higher than the level they would have achieved otherwise" (Steenburgh, 2008, p. 236). While lump-sum bonuses encourage salespeople to achieve higher sales, there can also be drawbacks.

The first disadvantage is that the motivational effects can disappear once quotas have been met. Ever heard of salespeople playing golf instead of working once they reached their quota? The second disadvantage is that lump-sum bonuses may tempt salespeople to manipulate order timing. This happens when salespeople either push out new orders to the next period when they have already achieved quota, or, by pulling in orders from the future period when they are falling short of their quota (Steenburgh, 2008, p. 236).

While there are advantages and disadvantages, an analysis should be undertaken to determine the optimal design for salesperson compensation – which may actually be a combination of base salary, commission rates, and lump-sum bonuses.

Management Incentives

Management incentive plans can also be difficult to create. While it is the duty of managers to work to maximize shareholder wealth by working for what is in the best interest of the company, not all managers act on behalf of the company at all times. Including stock options in management/executive incentive plans are often used because they "appear to reduce excessive aversions to risk by giving managers incentives to increase firm risk instead of avoiding it" (Sigler, 2009, p. 763).

Unfortunately, without a well-thought out implementation plan, executive stock options can produce four problems:

• Managers can become wealthy not by the merits of their performance, but by merely being in the right place at the right time. This is because "payoff from the option includes the firm's stock price increases due to industry and general market trends" (Sigler, 2009, p. 764).
• Stock options might not actually serve as an incentive. This happens when "stock price declines after executive stock options are issued with the result of the options being way out of the money" (Sigler, 2009, p. 764).
• Managers are often allowed to exercise their options any time and "[w]hen managers exercise their options and sell their shares, the pay-performance incentive is gone. This forces the firm to issue more options or find other means to entice their managers to take risk" (Sigler, 2009, p. 764).
• Dilution of stock ownership can occur when managers exercise their rights (Sigler, 2009, p. 764).

Companies may address the disadvantages in several ways:

• To ensure managers are paid based on their own performance, not the movement of the market, the exercise price of the stock options can be adjusted for market forces by indexing the options to the S&P 500 Index. If stock price declines after issuing the stock options, companies may choose to re-price the options by lowering the exercise price or even issue more options to the executive at a lower exercise price. This serves to align the interests of the executive with the shareholders.
• Companies may also choose to restrict the exercise timing of stock options. "Being able to anticipate when shares are sold in the public market can allow the firm to plan when another stock option issue will best serve the company and continue to provide managers with incentives to perform" (Sigler, 2009, p. 764).
• Finally, to off-set the dilution of stock ownership that can occur when managers/executives exercise their stock options, companies may "buy back shares at the market price" (Sigler, 2009, p. 764). Although the use of stock options in management incentive plans can help focus executives on longer-term company growth, careful planning needs to be undertaken prior to implementing so as to reduce the many disadvantages that can occur.

Incentive plans are used to encourage employees to perform at high levels of productivity. Because there can be many variations to incentive plans, it is important to analyze the advantages and disadvantages of potential incentive plans prior to implementation. Determining the optimal incentive plan design will not only help improve performance, it will promote ethical behavior that is in the best interest of the company and shareholders.

Thanks to Lisa Quast / Forbes.com LLC™
http://www.forbes.com/sites/lisaquast/2011/09/19/creating-incentive-plans-that-actually-incent-employees/