Pay For Profits

How the most competitive companies around are "incentivizing" their compensation systems.

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BACK IN THE LATE 1960s, SHANNON & Luchs Co. was just one of a dozen or so small real estate brokerage businesses in Washington, D.C. Its managers were all paid in accordance with the norms of the industry, and they received the standard merit raises and bonuses at the end of each year. Then, around 1970, the company overhauled its executive compensation system. In addition to their regular salaries, division heads were given the opportunity to earn a percentage (10% to 25%) of the net profits of their respective divisions, adjusted for overhead and other expenses. The result: sales and profits took off. Today, Shannon & Luchs is one of the largest and most profitable real estate companies in the United States. Company president Foster Shannon gives full credit to the compensation system.

Such tales may sound too good to be true, but they are becoming increasingly common as more and more companies turn to incentive pay as a means of achieving strategic objectives. The trend is easily the hottest one ot hit the compensation field since the cost-of-living raise. It involves a whole different approach to compensation, one that is geared toward achieving future objectives, rather than rewarding past performance. To date, thousands of businesses have adopted such systems, and those that try it swear by it. Most practitioners will tell you that -- in addition to fostering phenomenal results -- incentive compensation allows them to recognize the movers and shakers in their organizations, the people who make things happen, and to inject a new sense of vitality and purpose into the company as a whole.

Testimonials aside, the trend reflects important changes in the business environment. As inflation has declined, companies have found it harder to justify the big raises that were common in the 1970s and early '80s, and so they have begun searching for new ways to keep employees motivated. Even more important has been the pressure of increased competition, forcing companies to become ever more efficient and profitable.

Among the first to move in the direction of incentive compensation were the Fortune 500 companies. A study by Hewitt Associates, in Lincolnshire, Ill., shows that more than 90% of the nation's largest companies had short-term incentive plans as early as 1980. These plans made it possible for participating managers to earn bonuses totaling 16% to 55% of their base salaries, given the achievement of certain operating or financial targets. Since then, thousands of smaller businesses have set up incentive plans of their own.

On the surface, at least, creating an incentive-pay program doesn't appear to be difficult at all -- provided you understand where your company is, and where you want it to be. You have to know, or instance, what you're shooting for, whether it's more profitability, higher sales, better service. As a wise man said, if you don't know where you're going, the odds are you'll wind up somewhere else.

Once you are clear about your objectives, however, the rest falls into place. First, you have to decide who to include in the plan. If you want to increase profitability, for example, and if your business is composed of relatively autonomous operating units or product areas, you may well decide to focus on a handful of key managers -- the ones with the leverage to make sure their respective units make money. On the other hand, you may have a company like Riley Gear Inc., in North Tonawanda, N.Y., a $6-million manufacturer of precision gear systems, whose success depends on its ability to deliver quality products on time at competitive prices. Since every employee plays a role in achieving the company's productivity goals, all 90 of them receive a quarterly bonus check when targets are met.

Of course, you also have to choose the performance criteria by which you'll hold people accountable. Here, your decision is almost entirely a function of your goals. Indeed, two identical companies might deliberately choose different performance criteria. One, for example, might decide to reward nothing but sales growth as a way to spur aggressive selling, while the other might target profits or quality control. The latter business would, in effect, be telling people to say no to some business opportunities. But each company, in its own way, would be encouraging the kind of behavior it wanted.

Then again, some companies might want their employees to pay attention to more than one goal at a time. For several years, Nicolet Instrument Corp., a Madison, Wis., manufacturer of medical and chemical testing equipment, calculated its management bonuses using a formula that took into account both sales growth and return on assets. With two important goals to balance, says chief executive officer and president John Krauss, there were no rewards for leaning too far in one direction. Other companies accomplish the same thing by establishing separate incentive pools tied to the achievement of different objectives.

Whatever measures you choose, they must be readily comprehensible to the employees they affect. If employees don't know what kind of performance you are trying to encourage -- or why it's important -- they aren't likely to respond as you intend. You either have to explain what you are trying to accomplish, or choose other measures. By the same token, the performance criteria must involve aspects of the business that the affected employees can control and monitor. That means providing them with the data -- monthly sales figures, production reports, profit statements -- that will show them how they are doing.

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