HUMAN RESOURCES

You Get What You Pay For

Considerations to heed if you are thinking of incentive compensation.
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If you want money to talk, you'd better be clear about what it's supposed to say

Just a few years back, incentives were hot. Pay-for-performance plans were the cutting edge of compensation strategy. The press hyped them. Managers tried them. Consultants got rich off of them.

What's happened since? Were incentives, as advertised, the panacea for work-force ills? How did they operate when companies actually used them? In other words, has practice lived up to theory?

Let's find out. -- B.G .P.

Five years ago -- a couple years sooner than most people -- Jim Bernstein found Truth.

By then his young business had survived its infancy and, as a provider of health-risk information to insurance and industrial companies, had become steadily if unspectacularly profitable. Now, Bernstein wanted more. He wanted General Health Inc. to grow. But how to make that happen? he wondered. Then it came to him, the managerial magic wand that could transform stasis into growth: incentive compensation.

It made such simple sense. You want your company to get from A to B. More important, you want your employees to want your company to get from A to B. So you put a price, a reward, on B's head -- a bounty no respectably materialistic worker could ignore. Then you watch your people gun for it.

What Bernstein wanted, specifically, was for General Health's revenues to grow from $1.8 million to $2.7 million in a year. The company's margins were firm, so it stood to reason that the sales growth would convert into profit growth. Perfect. The company would blossom. Life would be sweet.

With this happy sequence in mind, Bernstein promised all 30-some employees that, if the company hit the sales target, each would get an extra month's pay.

It worked. In fact, it worked too well. The incentive plan had immediate impact. "It was incredibly motivating," Bernstein recalls. Instantly, General Health began booking business faster than ever before. Unfortunately, it was soon evident that the increased volume was creating problems. As sales shot up, the expense of generating and servicing the new accounts -- the product literature, computers, support staff, and so on -- also went crashing through the roof. The company's bottom line, which had habitually shown 10% pretax profits, turned dangerously red. "We thought there were enough mechanisms in place to control our costs," explains Edwin Russell, a director who headed General Health's compensation committee. "But the volume of orders was creating amazing pressures to spend money.'

Luckily, the company addressed the problem before it was too late. Bernstein installed a new incentive program -- one that balanced the desire for growth with the need to control costs and maintain adequate cash flow. Salespeople were still encouraged to bang down doors, but other employees were rewarded both on the basis of company profits and on their ability to meet specific goals. The manager in charge of computers, for instance, was measured by his ability to meet his budgeted cost structure. "The thing about incentive plans," says Bernstein, shell-shocked but wiser, "is that people take notice. You can meet your goal -- and run yourself right out of business.'

* * *

Bernstein is not the only CEO who has found this out. All across America, managers just like him have been flocking to incentive systems -- often called pay-for-performance plans -- in a spirited attempt to simultaneously fire up and control the businesses they're trying to build. The idea isn't new. It's been around ever since managers began fretting about the consequences of boosting pay without bettering results. But only in the past few years has the notion of putting significant dollars at risk become the norm. Nowadays, says Lester B. Jackson, president of Compensation Consultants Inc., in Scottsdale, Ariz., "entitlements are out. Companies want improved results before they hand out pay increases, and there's more willingness to experiment.'

What once was an avant-garde idea has quickly become conventional wisdom. The genie is out of the bottle, and it's almost inconceivable that it will go back in. Companies such as General Health have lived with incentives for a while, and we're beginning to see how they work. Incentive compensation, in practice, has a history. And history has its lessons.

As the General Health episode suggests, getting incentive plans in proper alignment can be difficult. Not that the principles themselves are flawed. If anything, experience shows they're more persuasive than imagined. "People are going to try to take you where the money is, whether you like it or not," says Jim Mullis, a principal and compensation consultant with Ernst & Whinney, in Atlanta. So you'd better be comfortable with where you want to go.

At many businesses, the problems begin right away, with the definition of company goals. Most CEOs have an intuitive sense of the direction they want to move -- be it increasing sales or profits, or improving quality. If you've never experienced the power of incentives, picking a goal might seem tame. The risk, however, as General Health found, is that setting up one objective against all others can unleash forces beyond your control. When General Health began pushing sales, the feeling was that profits would take care of themselves. After all, Bernstein understood the cost structure of the business -- or so he thought.

In retrospect, notes director Russell, one might have anticipated that the drive for sales would throw things out of whack. After all, the name of the game was booking orders, not saving paper clips. "Ask people to focus on X and they go hell-bent for leather on it," Russell says. "They forget about Y.'

So there's a lesson here: before picking a goal, prepare yourself for what will no doubt happen when people begin shooting for it. Depending on the circumstances, you may want to rethink your objective or at least figure out how to monitor what happens. "Unless you watch it," says Mullis, "incentives can take on a life of their own.'

* * *

It would be nice if having the right goals was all you needed to make incentive plans work. Unfortunately, successful goal selection is just the beginning. Companies get equally snarled up in figuring out the best ways to measure progress toward those goals. For better or worse, the technique you use for keeping score -- both for the company as a whole and for individuals -- is critical. It sets the course. And the wrong yardstick can be just as dangerous as the wrong goal.

Consider, for example, what happened at Lillard Co., a $30-million heating and air-conditioning distributor based in Concord, Calif. Lillard's was a case of the right goal but the wrong way to measure it. For many years, Lillard rewarded its six branch managers on the basis of gross profits they generated in their own territories -- the profit on products sold, before deducting operating expenses, which were paid by headquarters. The problem was that what triggered the bonus wasn't the gross profit dollars, it was the percentage margin.

During the 1970s and early 1980s, when the company was growing, it didn't seem to matter that bonuses were calculated in this manner. "High volume led to high profit," notes Bob Callegari, vice-president for operations, so the company was covered. Headquarters was getting enough cash from the branches to easily handle branch expenses, pay out incentive awards, and have something left over. But in 1983, the market softened in some parts of California; paying bonuses that were indexed according to gross margins became suicidal. The percentage margins were still there, but low volume meant that the dollars weren't. "We had managers who were getting bonuses even though their branches were losing money after expenses," says Callegari. "In a bad market, it was like writing checks on a zero balance.'

Given the circumstances, then-owner Emery Lillard decided to make fundamental changes. The first thing he did was scrap the margin system and begin basing the branch managers' bonuses on gross profit dollars. Then, in an attempt to upgrade their management skills, Lillard went a few steps further. He also tied their pay to return on assets, and to inventory and receivables management -- things they had never had to worry about under the previous compensation system.

Clearly, says Callegari, the new measurement system was more demanding of managers, and some of them were apprehensive about the change. Every month, for instance, they saw their own P&Ls. The higher their return on assets, the bigger the slice of gross profits they got to keep -- up to 35%. "But after a year or so," he says, "everyone was doing as well or better than before. And the company became a lot more profitable.'

* * *

Once you get it right -- suitable goals, good ways to keep score -- you can hope that the most difficult part is over. But don't count on it. The track record shows that the most difficult part may be when performance prevents the rewards from kicking in.

Some compensation specialists say the decision should be easy. "If a guy falls flat on his face, you have to be willing to say, 'Tough luck,' " argues Eugene Nawrocki, a consultant at The Wyatt Co., in Wellesley, Mass. Sounds reasonable, but what about morale? How do you balance commitment to the plan with fear of mutiny?

Very gingerly, says Mike Guthman, partner at Hewitt Associates, in Rowayton, Conn., especially when you're dealing with people you don't want to lose. "If a plan isn't paying out and people think it should be, then you've got to deal with that," he says. It doesn't matter if the problem is the result of an act of God or an unfortunate decision. "Letting the chips fall" isn't always possible.

The truth is that there's no easy way to make incentive plans work -- not if you want to stay in control of the business. But just being aware of that should give you a head start. "Once you're out where the rubber meets the road," says Donald T. Sagolla, principal in charge of management consulting at Peat Marwick Main & Co., "you can't just hold people to three or four objectives and stand back. There's a lot of managing to do, and as we know, managing takes two things: time and courage.'

* * *

CHANGING STRATEGIES

Looking to compensation for an edge

Companies with a performance appraisalsystem that made changes in it: 16%

Companies with an annual incentiveprogram that made changes in it: 12

Companies without a performanceappraisal system that are planning to develop one: 11

Companies without an annual incentiveprogram that are planning to develop one: 12


POSNER'S LAWS

Creating incentives for your company? Here's what to think about

Now that we've lived with them a while, two things about incentive compensation plans are certain:

1) They work.

2) Because they work, you'd better be careful about exactly how you set yours up.

So here's help. The troubles companies have had with their incentive programs suggest keys to keep in mind as you devise a system of your own.

* Don't copy. Every company is different, which means every plan probably ought to be, too. What's more, most plans have problems, so if you mimic one, you'll run the risk of magnifying its mistakes. This doesn't mean you can't get ideas from competitors -- just be skeptical about using them.

* Make the goals different for everybody. Wonderful as it sounds to have everyone shooting at the same target, it's important to go the next step and define objectives for individuals, too. In the company's revised plan, for instance, General Health Inc. tied the product development manager's bonus to meeting tight schedules.

* Poke holes in your system. If you devote some time to thinking about the weaknesses of your completed plan, you'll end up with a better one. Had General Health done this, for example, the company might have installed better cost controls before forging ahead.

* Don't walk away. Incentive plans send strong messages to people, so make sure they're hearing them right. Keep in especially close touch with employees as the plan is being implemented. Listen to their reactions. Remember that it takes time to communicate both the spirit of the system and how it works, so be sure you're prepared to give it.

* Follow the money. When the plan starts paying out, see who's getting the bonuses. If the rewards aren't going to the people you expected, you may be rewarding the wrong kind of behavior. Even before you get to this point, give some thought to what you'll do if it appears your plan is having unintended effects.

Last updated: Sep 1, 1988




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