What it means
Bonuses come in several distinct shapes and the differences matter. A discretionary bonus is awarded at management's judgement, a contractual bonus is owed if defined targets are met, and a signing or retention bonus is paid simply for joining or staying rather than for performance.
The business logic is about converting fixed cost into variable cost. A company that pays $70,000 salaries with a 15% bonus target has committed to $70,000 per head in a bad year, not $80,500, which protects cash when trading turns down.
Most schemes multiply several factors together. A typical structure takes a target bonus as a percentage of salary, then adjusts it by a company performance multiplier and an individual performance multiplier, so both the business and the person have to do well for a full payout.
Accounting treatment catches people out. If employees have earned a bonus by the year end, the cost belongs in that year's profit and loss account as an accrual even though the cash leaves months later, and forgetting this overstates profit and understates liabilities.
Poorly designed schemes reliably produce poor behaviour. Paying salespeople on revenue with no margin condition invites heavy discounting, and paying on annual targets alone encourages people to push sales into the next period once this year's maximum is locked in.
In practice
Real-world examples.
Example
A software company runs a quarterly sales bonus paid only on deals with gross margin above 60%. A representative closes $400,000 of business at 55% margin and earns nothing, which is the scheme working as intended rather than failing.
Example
An engineering firm offers a $15,000 retention bonus payable after eighteen months to keep specialist staff through a major project. Two of five engineers take it, and the firm treats the cost as project overhead rather than as a reward for performance.
Example
An accountancy practice accrues $340,000 of partner and staff bonuses at its December year end, even though the payments land in March. Omitting the accrual would have made the year's profit look roughly $340,000 better than it was.
Formula
Calculation
Bonus payable = salary x target bonus % x company multiplier x individual multiplier
A marketing manager earns a salary of $80,000 with a target bonus of 15%. The target amount is $80,000 x 15% = $12,000.
The company misses its profit plan slightly, so the board sets the company multiplier at 0.9. The manager personally exceeded her objectives and receives an individual multiplier of 1.2.
The payout is $12,000 x 0.9 x 1.2 = $12,960. Her total cash compensation for the year is $80,000 + $12,960 = $92,960, and the employer also carries payroll taxes on the bonus, so the true cost to the business is higher than the headline figure.Case study
Seen in the real world.
The following is a fictional, illustrative example. Denbury Tools, an invented distributor of workshop equipment, paid its twelve sales staff a bonus of 3% of the revenue each person generated, with no other conditions. Revenue grew 22% in a year and the sales team celebrated a record bonus pool of about $410,000.
Gross profit told a different story. To hit their numbers the team had discounted heavily, and the average gross margin fell from 34% to 26%, so on revenue of roughly $13,700,000 the business earned about $3,560,000 of gross profit rather than the $4,660,000 the old margin would have produced. Denbury paid record bonuses in a year when it made materially less money.
The fictional finance director redesigned the scheme for the following year: 6% of gross profit rather than 3% of revenue, with a floor of 30% margin below which no bonus accrued on a deal. Revenue growth slowed to 9%, margin recovered to 33%, and both gross profit and the bonus pool ended higher than under the old design.
Watch out
Common mistakes.
- Treating a discretionary bonus as if it were guaranteed, which creates an expectation that becomes very hard to withdraw without damaging morale.
- Paying bonuses on revenue or activity rather than profit, which rewards volume the business may not actually want.
- Leaving the bonus accrual out of the year end accounts because the cash has not been paid yet, which overstates profit.
Questions
People also ask.
When should a bonus be accrued in the accounts?
As soon as the employee has done the work that earns it and the amount can be estimated reliably, not when the payment is made.
Are bonuses taxed differently from salary?
In most systems a bonus is ordinary employment income taxed the same way as salary, though the timing of a large payment can push someone into a higher band for that period.
Can an employer withdraw a bonus scheme?
A genuinely discretionary scheme can usually be changed with notice, but a contractual scheme, or a discretionary one paid so consistently it has become custom, is much harder to remove.
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