What is Incentive Compensation?
Incentive compensation is a form of variable compensation paid to employees that is tied to the achievement of pre-defined targets. This variable compensation is either a component of their total compensation (supplementing base salary) or an additional reward (bonus) on top of an employee’s total salary.
Incentive compensation may be monetary or non-monetary. As with employee rewards programs, the objective is to align individual or team efforts with the company strategy to drive business growth: The more effort the employee makes to move the organization forward, the better off they’ll be.
In this article, we’ll look at some common types of incentive compensation, review their benefits, and understand the elements of successful incentive compensation plans. To round it off, we’ll discuss real-life examples of successful incentive compensation programs.
Types of Incentive Compensation
We can broadly divide incentive compensation into monetary incentives (such as bonuses, commissions, and stock options) and non-monetary incentives (such as extra paid time off and development opportunities).
Monetary incentive compensation consists of financial rewards for meeting or exceeding predefined targets. This includes bonuses, commissions, and various means by which an employee can financially benefit from the company’s success.
Bonuses are financial rewards given to employees as part of their contracts (non-discretionary bonuses) or paid in addition to total compensation as a reward (discretionary bonuses). Examples of bonuses are:
- Spot Bonus: A monetary reward for recognizing excellence in the short term. Spot bonuses are discretionary in nature.
- Retention Bonus: Companies pay retention bonuses to employees for staying with the organization for a predetermined period. Retention bonuses are often standard practice at a company and therefore expected. This is a good example of a non-discretionary bonus.
- Signing Bonus: A signing bonus is a one-time payment to motivate top talent to join an organization. This incentive is more likely to be used in highly competitive industries.
- Performance Bonus: Typically tied to individual performance, a performance bonus rewards employees for meeting or exceeding performance goals against set benchmarks.
- Referral Bonus: Businesses can reduce hiring costs by leveraging their existing employees' networks. Referral bonuses are an incentive for employees to partake in talent acquisition efforts. It is also a means to reward employees for bringing successful new hires to the company.
- Holiday Bonus: A monetary gift around the holiday season is one of the more common employee perks. Many organizations use holiday bonuses to make employees feel valued. The timing of the reward usually depends on where a company is located. This type of bonus would only be discretionary if it is not a contractual aspect of employment.
An integral part of sales compensation, commissions motivate sales performance by rewarding sales reps with a percentage of the sales they generate. Depending on the industry, commissions may substantially increase after a sales rep exceeds a certain threshold.
Where bonuses are, generally speaking, awarded over and above an employee’s full salary, commission-based pay is common for roles that have monthly targets. It is therefore a regular part of an employee’s income.
Gainsharing is a type of incentive payment to employees for successfully executing cost-saving or productivity-enhancing initiatives. The final payouts are linked with the gains the employee initiatives generate and can be easily distributed using compensation management software.
Employees receive a portion of the company’s profits in a profit-sharing program. This type of reward directly incentivizes employees to contribute to the company’s overall profitability.
Profit sharing is different from gain sharing in that it rewards employees on the basis of overall profitability instead of improved productivity or cost-saving. It differs from commissions in that the value of the payout is determined by the company’s overall performance, not just that of the individual.
Stock options allow stakeholders to buy company shares at a pre-defined discounted price. This kind of employee incentive is especially suitable for startups that might be short on cash but can use their growth potential to attract and retain top talent.
Non-monetary incentives are rewards that do not involve direct financial benefits. A well-designed non-monetary incentives program addresses emotional needs such as recognition and belonging, or time off. Some employee recognition statistics indicate that a majority of workers prefer non-monetary incentives to financial ones.
Here are some common types of non-monetary incentive compensation:
Extra Paid Time Off
This incentive allows eligible team members to take additional paid time off work, depending on whether they reached a predetermined target, or as a spot reward. Employers can designate certain times of the week or month for claiming the reward or offer more flexibility and let employees decide for themselves.
Learning and Career Development Opportunities
This approach opens up new career growth opportunities, which is a powerful motivator. An employer can, for example, promise a promotion or a temporary leadership role based on reaching certain pre-set targets.
This category includes rewards in the form of experiences like incentive travel, tickets to a concert, spa days, skydiving, and so on. This form of incentive compensation allows top-performing employees to create memories and associate positive experiences with their success at work.
Benefits of Incentive Compensation
There’s ample evidence that most organizations believe in the potential benefits of incentive compensation. A 2021 study by World at Work on Incentive Pay Practices revealed that almost all (99%) publicly traded companies and 93% of privately held companies use some form of short-term incentives.
Well-designed incentive compensation plans benefit organizations in several ways, including improved motivation, higher employee engagement, and individual accountability.
Incentivizing the correct type of behavior and areas of focus means employees are working in alignment with company goals to achieve high-value results.
High Employee Engagement
By nature, incentive compensation acts as a form of employee recognition for work that is well done and goals that are met. This kind of affirmation and acknowledgment are powerful tools for motivating employees and keeping them engaged with their work. Their engagement is, after all, in their own interest when it is incentivized.
A Definition of Success
By outlining the behavior that triggers incentive compensation, a company creates a definition of success. An employee who does not display any of these rewarded efforts and outcomes can therefore also see how accountability lies with them, which mitigates suspicions of bias.
Clear expectations let employees know precisely what the organization expects from them and the rewards for success. Defining success allows top performers to move up and lower performers to know precisely what they need to achieve for course correction.
A Recruitment Marketing Tool
Promising a structure where delivering great results translates into higher earrings or rewards makes your organization desirable for top talent. The best talent in the industry seeks out the best incentive compensation programs.
When employees are motivated to bring their A-game, their individual contributions amount to higher organizational performance.
Consider a scenario where a sales team has no incentive compensation and no tangible reason to work harder to achieve their targets. By comparison, a sales team that receives higher take-home pay when their targets are met will likely work harder to make that goal a reality.
Characteristics of the Best Incentive Compensation Plans
The best incentive compensation plans are aligned with the company’s goals, are well understood, and make employees stakeholders in their own level of compensation.
Alignment with Organizational Goals
For any incentive compensation plan to be successful, alignment with organizational goals is an absolute must. As the name suggests, the incentive compensation program should incentivize the behavior and outcomes that the company considers a priority.
Take, for example, the hypothetical scenario where a company wants to increase sales, expand into international markets, and improve customer satisfaction in a certain fiscal year.
The incentive compensation plan for the year should accordingly assign rewards for meeting those sales targets, allocate additional rewards for international sales, and recognize customer service agents who meet the highest customer satisfaction scores.
Once the incentive compensation plan is finalized, human resources should communicate it to the relevant teams in the clearest terms possible. This includes the targets, the KPIs, the associated incentive compensation, and the underlying organizational goals that drive them.
Furthermore, pay transparency is key so the methodology behind incentive compensation calculations should be clear to all employees. If your team doesn’t know how the structure works, they may develop misplaced expectations, leading to frustration and disappointment.
Establishing quantifiable KPIs for every performance measure is challenging for businesses. This is especially true when measuring behavioral KPIs, such as eagerness or attitude.
Disagreements over subjective KPI assessments may lead to a potentially demotivated workforce. It is therefore critical to keep targets that trigger incentive compensation completely objective and quantifiable.
The best incentive compensation programs are also primarily concerned with measuring output rather than input. For example, a salesperson should be incentivized based on closed sales, not the number of sales calls they make.
The best incentive compensation plans are flexible and open to change if circumstances change.
Business environments are dynamic and an organization’s priorities can change accordingly. Monthly, quarterly, or semi-annual reviews of the plan can help organizations stay on track.
Effective incentive compensation plan designs incorporate employee feedback regularly. What’s working and what isn’t, which incentives need modification, and whether the targets are realistic are all relevant questions in an effective feedback process.
A target that triggers incentive compensation can only be a motivational tool if the employee feels they are capable of reaching it.
All employees should have a fair opportunity to earn rewards. This means taking into account the nuances of how targets and rewards apply to each level of the workforce and customizing the program accordingly.
For example, field sales staff who may be dealing with individual or smaller customers should have a different reward system when compared to a regional account manager who may be dealing with large business clients.
It’s one thing to have a fair and transparent incentive compensation plan and another to ensure all eligible employees receive their rewards in a timely manner. Doing so would likely help maintain higher levels of motivation and avoid employee frustration. Your team has delivered - don’t leave them hanging!
Modern organizations use automation tools such as incentive compensation management (ICM) software to plan, communicate, track, and calculate incentive compensation. ICM software can help with the following tasks:
- Forecasting team performance based on historical data.
- Simulating various incentive compensation scenarios and analyzing outcomes for easier decision-making.
- Implementing performance management best practices
- Integrating with the organization’s tech stack, such as CRM and HRMS platforms, to retrieve the necessary organizational data.
- Providing dashboards to employees so they can track their performance in real-time.
- Ensuring compliance with local labor laws.
- Maintaining audit trails for compliance and dispute resolution.
- Saving thousands of hours by performing complex incentive compensation calculations within seconds.
- Generating detailed reports and insights on the effectiveness of incentive compensation programs.
This is especially important as an aspect of scalability. Incentive compensation plans for startups may start simple, but as businesses grow, the level of complexity may also go up. Consequently, employees need better ways to understand the bigger picture. Personalized dashboards through modern ICM software can help overcome this challenge.
Human Resources must find the right balance between fixed and variable pay. If the variable component is too big, employees become susceptible to poaching by competitors. On the other hand, if the fixed component is oversized, you run the risk of making your teams complacent.
Real-World Examples of Effective Incentive Compensation
The best employers in the world often dream up fantastic employee incentive ideas and offer some of the best incentive compensation benefits to attract and retain top talent. Here are some examples of incentive compensation in the real world.
In 2021, Apple announced it was changing executive bonuses to include an environment, social, and governance (ESG) modifier. The more an executive “acts within the company’s social and environmental values”, the higher their cash bonus.
Even though the company didn’t reveal how the modifier calculation would come into play, the announcement demonstrated a commitment to encouraging sustainable practices throughout the organization. It is also perfectly alleged with their goal of becoming a carbon-neutral organization.
Incentive Compensation for a Cause
Top-tier companies understand that their role goes beyond just business operations. They actively embrace their responsibilities as corporate citizens as well. Recognizing the importance of community involvement, HP motivates its employees to give back through volunteer work.
Employees who dedicate at least ten hours every quarter to such activities receive generous rewards. The incentives include monetary donations, such as $50 to their chosen charities, exclusive employee discounts, and additional paid leave.
HP collaborates with the Network for Good to implement this initiative, and the organization has highlighted their joint incentive strategies in a case study.
In January 2023, Delta Airlines announced a sum of $500 million in profit sharing with its 90,000 employees. The airline funds its profit-sharing with 10% of the first $2.5 billion in profits and 20% of the profits in excess of $2.5 billion.
The company has shared over $9.2 billion with its employees since 2010 as part of its profit-sharing program that keeps employees dedicated to the company’s success.
Employees have the option to take the entire payment in cash or contribute a part of it to their 401(k) account.
Final Thoughts on Incentive Compensation
The best employers recognize that the right incentives can make all the difference. From cash rewards for performance to incentivizing volunteering, businesses are finding creative ways to incentivize and align their teams.
The result is a more motivated workforce and a thriving corporate culture. It's a win-win for everyone involved.