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.'
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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.'
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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.
