What it means
Pay follows measurement. When a bonus depends on a number from the accounts, that number becomes a target, and every judgement that feeds it gains a quiet sponsor.
The usual metrics are profit, earnings per share (the profit attributable to each share), return on equity and return on assets. Each metric steers behaviour in its own direction.
Profit targets encourage cost cutting and pulling sales forward, return measures can discourage investment in new assets, and earnings per share can reward share buybacks as much as better operations. None of these is wrong, but each has a side effect that the scheme designer should expect and plan for.
Timing games are the classic abuse. Shipping extra stock in December, delaying maintenance or choosing accounting policies that flatter the bonus year are all rational responses to a number with money attached.
Goodhart's law captures this: once a measure becomes a target, it stops being a good measure. Design can soften the effect.
Using several metrics, comparing performance with peers instead of a fixed number, paying over several years and adding clawbacks (the right to recover bonuses already paid) all reduce the reward for gaming one figure. Pairing a profit target with a cash flow measure also catches profit that exists only in receivables.
Control of the measurement rules matters just as much. If the manager who earns the bonus also decides the accounting policies and which items are excluded from the calculation, the target is partly self-marked.
Boards and owners should define the rules and permitted adjustments in advance, or the target becomes fiction. Sales commissions belong to the same family.
Commission on revenue alone, with no link to margin or collection, produces exactly what it asks for: big, cheap and unpaid sales. Review any scheme each year against strategy, because a target that fitted last year's priorities can fund this year's mistakes.
In practice
Real-world examples.
Example
A listed manufacturer pays executives partly on earnings per share and partly on cash conversion. The cash measure prevents a bonus built on profit that has not turned into money. Executives who push sales onto slow-paying customers would see the cash half of their bonus shrink.
Example
A software firm pays its sales team a commission on new contracts but only after the customer has paid the first invoice. Reps now chase collection as well as signature. Contract quality improves because a deal that never pays earns nothing.
Example
A family-owned bakery pays its operations manager a bonus on reported profit. The owner's accountant writes the measurement rules, including which one-off items are excluded, before the year begins. Nobody can argue afterwards that the rules were moved to suit the result.
Formula
Calculation
A typical structure is:
Bonus = base salary x target bonus % x (actual profit / target profit), subject to a cap
Suppose a plant manager has a base salary of $100,000 and a target bonus of 20%, so the target bonus is $100,000 x 20% = $20,000. If actual profit is 110% of target, the formula gives $20,000 x 110% = $22,000. If the scheme caps the bonus at 150% of target, the cap is $20,000 x 150% = $30,000, so the $22,000 is paid in full. Had profit reached 200% of target, the formula would give $40,000 but only the $30,000 cap would be paid.Case study
Seen in the real world.
Fictional example: Bergamot Foods, an invented producer, paid plant managers a bonus on plant operating profit. Maintenance spending fell 40% over two years, and then a freezer failure destroyed $1,300,000 of stock.
The company rebuilt the scheme around three measures: profit, equipment uptime and audit scores, with payment spread over three years. Maintenance returned to normal levels.
The illustrative lesson is that a single accounting target will be hit, and the unmeasured costs of hitting it can be larger than the bonus saved. Bergamot's board now asks one extra question of every proposed target: what would a manager do to hit this number that we would not want them to do?
Watch out
Common mistakes.
- Paying on one accounting number and then being surprised when managers manage that number.
- Letting the person who controls the accounting policies also set the measurement rules for their own bonus.
- Using absolute targets that pay windfalls for market luck instead of managerial performance.
Questions
People also ask.
Why use accounting numbers at all?
They are audited, familiar and available for almost every business, unlike market prices for private firms. They also give managers a clear scoreboard they can influence.
How do you reduce gaming?
Use several metrics, peer-relative targets, deferred payment, clawbacks and independent measurement rules. No design removes gaming entirely, but each safeguard raises its cost.
What is the biggest single-metric risk?
Underinvestment, meaning cutting spending that pays off later in order to hit this year's number. It is hard to spot because the damage appears after the bonus has been paid.
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