What it means
Most pay packages have a fixed part and a variable part. The fixed part, the salary, pays for turning up and doing the job, while the variable part rewards outcomes such as revenue won, profit earned, costs saved or targets hit.
Performance compensation is that variable part. Common forms include sales commission, annual bonuses, profit-sharing pools, long-term incentive plans and share options.
Each ties pay to a measure, and the choice of measure shapes behaviour. A bonus based on revenue encourages sales volume, while one based on profit encourages care about costs and discounts.
Designing the scheme well is harder than it looks. The targets need to be stretching but achievable, the measures need to be hard to manipulate, and the pay-out needs to be large enough to change behaviour without bankrupting the business.
Poorly designed schemes have led to staff chasing short-term numbers, such as booking sales early, at the expense of the long-term health of the company. For the finance team, performance pay has accounting consequences.
Bonuses are accrued as an expense during the period in which they are earned, even though they are paid later, and share-based awards are measured at fair value and spread over the vesting period. A business that offers large variable pay also has more flexible costs, because pay-outs fall automatically in a poor year.
The nuance is that money is not the only driver. Research on motivation suggests that for creative or complex work, a large bonus can crowd out interest in the task, so many firms combine performance pay with recognition, development and clear goals.
In practice
Real-world examples.
Example
A software company pays its account executives 8% commission on new contracts. One executive closes $400,000 of contracts in a quarter and earns $32,000, which makes her total pay rise sharply in a strong quarter. In a weak quarter the same plan pays little, so the cost to the company falls automatically.
Example
A manufacturer shares 10% of annual profit above $2,000,000 among its factory staff. When profit reaches $3,000,000 the pool is $100,000, which is divided equally and encourages everyone to cut waste. Because every worker shares the pool, colleagues also have a reason to help one another.
Example
A start-up grants its engineers share options that vest over four years. The options reward long-term growth in the company's value and give staff a reason to stay. If the company is sold or listed, the options may be worth far more than a salary rise.
Formula
Calculation
Total pay = base salary + (bonus rate x result above the threshold)
Suppose a sales director has a base salary of $120,000 and earns a bonus of 2% on revenue above a threshold of $5,000,000. Revenue for the year is $7,500,000. The revenue above the threshold is 7,500,000 - 5,000,000 = $2,500,000. The bonus is 2,500,000 x 0.02 = $50,000. Total pay = 120,000 + 50,000 = $170,000, of which the variable part is 50,000 / 170,000 = about 29%.Case study
Seen in the real world.
Brightwater Retail is an illustrative, fictional chain that paid store managers a bonus based only on sales. Sales rose, but profits did not, because managers discounted heavily to hit their numbers.
The finance director redesigned the scheme so that 60% of the bonus depended on store profit and 40% on customer satisfaction scores. A manager with a target bonus of $20,000 could now earn 20,000 x 0.60 = $12,000 from profit and 20,000 x 0.40 = $8,000 from satisfaction.
Within a year average discounts fell and store profit improved, although some managers complained about the new measures. The illustrative lesson is that people do what they are paid to do, so the measure must reflect the result the company really wants. Brightwater now reviews its bonus measures every year, in case staff have found ways to meet them without helping the business.
Watch out
Common mistakes.
- Linking pay to a single easily gamed measure such as revenue, which can lead to behaviour that harms profit.
- Setting targets that are so hard that staff give up, or so easy that the bonus becomes a disguised salary.
- Forgetting to accrue bonus expense in the period it is earned, which overstates profit in that period.
Questions
People also ask.
Is performance compensation the same as a bonus?
A bonus is one form of it, and the term also covers commission, profit sharing, share awards and other pay that varies with results.
How much of pay should be variable?
There is no universal answer, but sales roles often have a large variable part, while support roles usually have a small one, and the right mix depends on how much the person controls the result. A role with little influence over outcomes is a poor fit for a large variable element.
Can performance pay be taken back?
Many companies include clawback clauses that allow them to recover pay if results are later restated or misconduct is found. Regulators in some industries, such as banking, require these clauses.
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