Building a better carrot
Navigant Consulting Inc., a Chicago-based management consultancy, is the product of more than 25 acquisitions over six years. No wonder that, until recently, its short-term incentive-pay system was seriously flawed. There was no consistent method of rewarding performance.
"It was difficult to manage so many disparate incentive tools," says Julie Howard, vice president and human-capital officer. "It was a mess." Even companies with only one system are struggling to make it more effective.
So last summer Navigant redesigned the system. Its short-term cash bonus plan now consists of two basic elements: Incentive pay for Navigant's 400 senior professionals is based largely on the company's performance, while its 800 consulting and administrative staff are rewarded primarily according to individual performance.
It's too soon to tell fully what effect the change has had, though already the company is seeing reduced attrition. The hope is that the new incentive plan will help the $244 million (in sales) company recover from two straight years of losses. So far, "people are very excited about it," says Howard, who has been touring the country to explain the program to employees. "Clarity is a big thing."
Navigant is one of an increasing number of companies that now offer incentive pay to many nonmanagement personnel, linking pay more closely to performance, as it shifts from fixed to more-variable annual compensation. In a survey of 2,400 companies last year, consulting firm William M. Mercer found that 56 percent provided incentive pay to employees below the executive level (65 percent when nonprofit health- care companies were excluded). That's up from 54 percent in 1999.
At the same time, companies have been offering variable pay to a greater number of their employees. Since 1997, the Mercer survey showed, 49 percent of respondents with incentive plans have increased the number of employees eligible to participate in the plans.
But companies clearly are struggling to design their incentive programs in an effective way. The soul-searching is aimed at motivating employees up and down the line to help companies meet their overall goals. Of course, plan specifics vary with a company's culture, size, industry, and competitive position. But any winning formula must address the following question: To what degree should payouts be linked to the performance of the corporation as a whole; to that of an employee's division, plant, team, or project; to the achievement of individual goals; or to some combination of all of these?
Consultants say incentive programs on the leading edge are combining goals and custom-fitting the combination to the rank of employees, much the way Navigant has done. At stake is nothing less than a company's ability to compete, and that challenge will only grow as the economy slows. No surprise then that CFOs are getting more deeply involved in design efforts. As the overseers of human resources, they view payroll expense increasingly as an investment in human capital, and incentive compensation as something that can improve the returns on that investment.
Unfortunately, theory does not translate easily into practice: In a survey at the end of 1999 of 771 companies, management and HR consulting firm Towers Perrin found that less than a third of companies with incentive programs of any kind see a significant impact on results. Navigant nonetheless has high hopes for its new plan. If the revised incentive system is as effective as the company expects, says CFO Ben Perks, who helped align the new plan with the company's goals, "it's a win/win/win--for the employees, the company, and the shareholders."
Navigant isn't alone. Ever since the end of the recession of the early 1990s, companies have been struggling to attract, motivate, and retain employees without greatly increasing fixed costs. Merit raises alone, however, have been insufficient to achieve those goals; the measly 4.2 percent on average that U.S. companies have budgeted in recent years for annual raises does not allow for significant differentiation among employees, according to Mercer. Long-term incentives such as stock options and restricted stock, meanwhile, may be more effective as a retention tool than as a goad to performance, and may be ineffectual in any case unless the market rebounds.
Incentive pay added to raises fills the gap, enabling companies to hand out greater rewards to deserving employees while minimizing costs, since the incentive shrinks in bad times. For greater cost savings, some employers are going so far as to replace raises with incentives over a phase-in period of a few years. Others have even reduced base pay for new workers while dressing up incentives.
Consultants believe that as the economy slows, the trend toward more- variable pay will continue. Global competition remains strong, and in a downturn, there will be a need to improve productivity. Indeed, companies may begin taking advantage of workers' growing job insecurity to implement new incentive plans that reduce base pay in return for greater potential incentive rewards. Already, says Steve Gross, who heads the U.S. compensation consulting practice at Mercer, more troubled companies "are saying, 'If you don't accept these plans, we're going to move the work offshore.'" For others, employee retention will remain a driving factor. "'It took so much energy to hire these folks, we don't want to make them unhappy,'" he adds.
So far, according to the latest data available, incentive systems typically pay bonuses to all eligible employees based on the overall profitability of the company, at least among large companies. The 1999 Towers Perrin report found that 44 percent of the companies surveyed-- the largest segment for any incentive plan type--used organizationwide incentive plans in which payouts were linked to a companywide measure, and distributions were made from a pool in proportion to salary. This approach is not only straightforward, it also sends a clear message that "we're all in this together."
To be sure, many companies have been raising the bar in this area. Instead of paying out bonuses whenever a company achieves profitability, programs increasingly hold out until the company reaches a specified profit level. At that threshold, the company either begins paying a preset ratio of profits earned beyond that point or a predetermined bonus pool.
Consider a new plan started last year by The Boeing Co., which has been under growing competitive pressure. Boeing's program, its first broad-based incentive scheme for 88,000 nonexecutive, nonunion employees, is based entirely on the achievement of a predetermined level of annual corporate performance--net profit minus a certain charge (which the company would not specify). In the first year, 2000, employees could earn an extra 5 days of pay--on top of annual raises and rewards for some employees involved in certain projects--if the company met the target, and up to 10 days' pay if the company exceeded it. In the end, employees earned 7.85 extra days of pay.
"The intent was to offer the opportunity for all nonunion Boeing employees to share in the success of the company and get employees to think more like owners of the company," says Bruce Hanson, Boeing's manager of compensation and benefits. The program's message, he says, is "a shared-destiny message, as a company to move Boeing toward its overall profit target. We want you to be engaged, ask questions, offer suggestions to the organization" to help reach that profit. The message was reinforced by the company's decision to use the same performance metric in figuring executives' incentive pay--an amount that is then modified by an executive's individual performance against his or her preset goals. Another reinforcement: for this year, the board doubled the potential incentive reward.
But tying bonuses to corporate-level results has a potential downside. While the top officers and even division managers spend their days on activities that directly affect a company's sales and profits, lower-level employees have little influence on overall results. The goal, therefore, is not within what consultants like to call their "line of sight." Furthermore, this kind of incentive system--as well as those based purely on the performance of the employee's plant or division--can breed resentment from those who believe they work harder than others who receive the same rewards.
Yet fewer companies link bonuses to each individual's performance on one or more specific activities. Among those that do is a retailer that pays sales clerks double time for any sick days they don't use. "You pay out if behavior milestones are achieved, regardless of profits, which is pretty direct and understandable," says Carl Weinberg, a principal at Unifi Network, the HR consulting subsidiary of PricewaterhouseCoopers.
One obvious drawback: Companies may find themselves paying out bonuses at a time when the company has no profits and cannot afford extra payments. What's more, Weinberg says, "there's the risk that people will ignore other behaviors that you're not rewarding."
Yet companies such as Boeing recognize that they need to do more to motivate lower-level employees than tie incentive pay to corporatewide goals. Plant managers, Hanson says, are encouraged to translate the overall corporate economic profit target into goals specific to their factories, such as cost savings and additional revenue. "We're continuously trying to do a better job at that," he says.
Other companies are going a step further by adding team and individual targets that must also be met to reap the full reward. And the resulting incentive brew is increasingly the norm. The Towers Perrin survey indicates that 62 percent of companies with organizationwide incentive plans include an "individual performance modifier," in which an employee is measured against preestablished personal goals for the year. By providing rewards for such specific goals, these employers are trying to directly influence an employee's behavior.
In these multitarget programs, the higher the rank of the employee, the more the bonus is linked to broader financial goals; the lower the rank, the more the bonus is linked to team or individual measures of operational performance as well as financial measures. Usually no bonuses are paid out to anyone unless the company makes a profit or reaches a threshold profit level, and then the size of an employee's bonus is based on that individual's performance against his or her personal goals. The link to corporate profits allows everyone a broader perspective and the ability to make decisions in light of the company's overall objectives.
Typically, each employee receives a scorecard listing a few goals for the coming year, against which the employee's manager measures progress during the year. The challenge is to set the goals correctly. First, the scorecard shouldn't have too many--consultants advise three to five at most. Then, of course, the goals have to be the right ones for the company.
Consider the case of kitchen-cabinet maker American Woodmark Corp., which implemented a new incentive pay system for its 3,500 employees in 1993. Previously, the Winchester, Virginia-based company had given employees just one annual priority. But it found that because workers were so focused on meeting that goal, they were neglecting other important concerns. For instance, the company found that when it instructed its managers to design incentives that would improve quality, productivity declined.
So American Woodmark adopted the scorecard approach, in which each employee's scorecard states goals for the company as a whole as well as goals specific to the employee's plant. "The scorecard allows us to get all of the key priorities defined," says William Brandt, chairman of the $400 million (in sales) company.
Companywide goals are divided into the areas of cost, quality, delivery, and safety. Lower-level goals are set to support those, so that if each of the 11 plants meets its targets, the result will be the achievement of the companywide targets. And if each team at a plant meets its targets, they will add up to that plant's targets, and so on down to the individual level.
According to consultants, the biggest potential problem with multitarget plans is their complexity. With so many different targets-- qualitative as well as quantitative--they are tough to manage. But the hardest part is setting them up in the first place. "The biggest hurdle for companies to clear is to set goals, to determine job by job and person by person what the right goals are," says Laury Sejen, a compensation consultant at Watson Wyatt Worldwide.
That, indeed, is what Navigant's financial and HR executives faced last year when redesigning its compensation system.
Success is hardly guaranteed. In its survey, Towers Perrin found that only 20 percent of companies with individual incentives and 31 percent with team incentives reported that their pay- for-performance plans had a significant impact on business results. But results were even worse for companies with organizationwide incentive goals: only 17 percent reported such improvement.
Still, some prominent management theorists believe that no variable- pay plan can work well. W. Edwards Deming, the famed management guru, believed that variable pay forced companies to rank workers against each other, setting up a competitive environment that could lead employees to work against each other.
However, communication may make a big difference. For starters, employees must know at the beginning of the year exactly what their bonus will be tied to. In fact, says Sejen, "our recommendation for best practice is for the manager and the employee to have a conversation" about appropriate individual goals. "The concept of employee buy-in is important."
During the year, "feedback has to be frequent," says William Abernathy, an incentive pay consultant who runs his own firm, Abernathy & Associates, in Memphis. "Annual is useless."
At American Woodmark, a team's performance relative to certain goals is posted daily or sometimes even hourly, Brandt says. Boeing delivers quarterly reports to employees on how well the company is performing against its target, and what that might mean in terms of potential extra days' pay at year-end.
In the end, says Abernathy, a good plan requires lots of planning, and with that comes complexity. "You can make it easy," he says, "but it won't work."
Hilary Rosenberg is a contributing editor at CFO.
Talk about variable pay.
Lincoln Electric Holdings takes the idea about as far as it can go, and the company benefits during both good times and bad as a result.
Lincoln Electric's sales and earnings fell sharply in the first quarter of 2001 from the previous year, and things look grim for the second quarter as well. At most companies, that would be a recipe for job cuts.
Not here. The Cleveland-based maker of arc welding and cutting products has a no-layoffs policy. And it has stuck to that policy in part because it holds to another unusual policy: no base salary for its 1,800 U.S. production workers.
For 62 years, Lincoln Electric, a nonunion, Nasdaq-listed company with more than $1 billion in sales and $78 million in income last year, has paid its manufacturing employees solely on the basis of how much each person produces, plus a profit-sharing bonus. In good times, employees are required to work overtime (within reason), which saves the company from having to hire, says CFO and treasurer Jay Elliott. Consequently, in bad times, instead of laying people off, Lincoln cuts out the overtime hours and, if necessary, shortens the regular workweek as well.
During boom times, Elliott says, the long hours elicit some "negative feelings" from employees. But now, he says, "they look across town and see LTV Steel laying off people, and Ford and the auto- supply companies laying off people, and they understand--they've got a job, and they're going to have a job." --H.R.
While Navigant Consulting's new system is far more coherent than the
mishmash that preceded it, the
program nonetheless remains intricate.
For Navigant's senior professionals, an incentive pool begins to be formed only after the company's cash-flow margin--earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by revenues--reaches 10 percent. The greater the margin beyond that point, the greater the percentage of it that flows into the bonus pool.
"These senior employees have more ability to impact the company's performance than lower-level employees, so we want them to be compensated based on that ability," explains CFO Ben Perks.
How the actual allocations are made depends on the employee's performance against personal and broader company goals, as spelled out on a scorecard. Top managers judge each scorecard using both financial and subjective measures (the subjective measures include such areas as effectiveness in leadership, mentoring, and marketing). Based on those decisions, they divide up the pool.
The consulting and administrative staff, meanwhile, share in a bonus pool funded with a percentage of revenues equivalent to competitive targets in the industry, regardless of profits.
Each lower-level employee receives scorecards with quantitative targets, such as chargeable hours for the year, and qualitative ones, such as teamwork and management skills. A greater portion of his or her bonus is attributable to individual performance achievements than it is for the senior professionals. "We want them to keep their eye on themselves and whether they're continuing to grow professionally," adds Julie Howard, vice president and human-capital officer. As rank increases in the lower-level group, division and company performance play ever-greater roles, and individual performance shrinks in importance. For instance, the ability to meet individual goals accounts for 90 percent of an administrator's bonus, 70 percent of a senior consultant's bonus, and 50 percent of a senior manager's bonus.
Despite the complexities of Navigant's new system, Perks is adamant about the need to adjust incentives according to rank. "Our belief is that senior professionals are responsible for managing revenues down to the EBITDA line, by bringing in profitable business," he says. "Younger employees are not bringing in as much business, so it's fairer to base their bonuses on revenues."