The anatomy of a bonus program

I'm a tinkerer by nature and a turn-around manager by experience. I buy troubled businesses, get them operating at a profit, and then sell them when the mundane details begin to outweigh the challenges. Over the past 16 years I've done that with three companies. But the company I currently own, Jamestown Advanced Products Inc., is different from the others. For one thing, there aren't many mundane details left for me to handle. My employees solve most of the problems by themselves.

Jamestown Advanced Products is a metal-fabricating business I started three years ago as the result of a telephone call from a friend. At the time, I was president and owner of another metal fabricator in Jamestown, N.Y., which I was about to sell. In fact, I had been looking forward to taking some time off, but the call forced me to reconsider my plans.

My friend had been doing subcontract work for a large building-products company that was importing industrial plumbing assemblies from Korea. Hoping to improve turnaround time and quality, it wanted to shift to a domestic supplier. The deal represented about $1 million of business a year, my friend said. We would be expected to produce fabrications in various sizes and models, and about 40% of the work would involve special orders to be turned around in less than two weeks. Custom work of that sort requires a manufacturing process significantly more flexible than the one my company had been using, so I would have to start a new company if I decided to accept the offer. But the business was mine, I was told, if I could commit to producing and delivering the specified quantity of metal products every week. And one other thing: I'd have to do it at the same price the Korean supplier was charging.

That was a challenge I could get interested in. To help me make my decision, the building-products company was willing to share all sorts of information, including the amount of product it intended to buy and the prices it would pay. From that, I was able to construct a projected income statement. The good news was that the numbers seemed to work, indicating a pretax profit margin of 12%. The bad news was that the numbers worked only as long as I could hold direct labor expenses to 11% of sales. And labor, I knew, would be difficult to control, particularly when so much product was being made to order.

Nevertheless, I went ahead and made a proposal to the company. I said I would start a business to fabricate the products it wanted, deliver them within the specified time frames, and charge the same price as the Koreans. But since the start-up required an investment of about $600,000 for machinery and working capital, I wanted a long-term contract. Otherwise, I might be forced to sell off the equipment at a loss if the relationship soured.

We settled on a three-year contract. The customer, for its part, made a commitment to buy a certain amount of goods each year and to provide regular projections of its delivery needs. We also came up with a formula for raising prices based on increases in the cost of raw materials. Finally, we agreed the customer could terminate the relationship only if I failed to meet its quality standards or deliver on time.

And so I had a new business.

In looking at my situation, I could see only one variable that could make or break the company, and that was labor. Not that my estimates of output per man-hour were unrealistic. But I knew they required a work force that wanted to meet and sustain a high level of productivity. And I do mean want. In my experience as both an employee and a manager, I've found that employee attitudes are a major factor in productivity. After all, every owner would like employees to strive for higher and higher levels of output, but they seldom do. The problem is that workers (even ours) are somewhat cynical about management. They quickly lose their motivation if they see their productivity increasing and they don't get the lion's share of the gain.

But with this company, I had an advantage. I could arrange things however I wanted. So I decided to set up a serious bonus program, one that would give employees as much incentive as I had to keep labor costs below 11% of sales.

The idea was simple: I would pay them decent base wages, totaling 11% of sales. If employees got the labor costs below 11%, I would pay them the difference in the form of a quarterly bonus. If labor costs went over 11%, of course, the difference would be coming out of the company coffers. I put all that in writing.

In addition, I agreed that at the end of every week, I would provide sales totals, gross payroll numbers, whatever employees thought they needed to check out the system. If they didn't trust me, they could (with a little effort) verify the numbers on their own. The feedback would be almost immediate, so they could study the results with an eye toward improvement. I thought it was feasible for them to produce at a labor rate of 9%, in which case they could be earning quarterly bonuses of up to $1,500 each.

We started gearing up in October 1987 with just four production people. All of them got $6 an hour, which was about the norm for similar jobs in our area, and I didn't promise to pay more until they earned more. Employees seemed to like the idea of being rewarded for efficiency. As far as I was concerned, that was most important. We could teach them how to operate equipment. It's much harder to persuade people to accept a completely different approach to compensation.

Employees spent the first few weeks getting used to the equipment and building prototypes. They knew what was expected of them in terms of output, and everybody thought it was doable. Then, in early December, we began building products according to our customer's production schedule. Immediately people saw how hard it was. For one thing, they were still learning their jobs. The engineer, for instance, would write programs with errors in them. The operators of our numeric-control turret presses would put clamps in the wrong position, then smash them. Or they would bend pieces of metal too far or not far enough, which would make it hard for welders to weld pieces efficiently. I knew it would take time to get production up to speed, and I had budgeted for it. But the employees were disappointed at our slow progress.

During the first two or three months our labor costs were almost 50% above the target. We were spending $16 per $100 of goods instead of $11. Since there were no supervisors, I played the role of foreman and cheerleader. When the employees had a good week, we analyzed why they had been more efficient; when they had a bad week, we looked for reasons.

As we went along, I shared as much information as I dared to. Every week I would tape a sheet of paper with three numbers on it to a metal post: the past week's production, our direct labor cost, and the percentage of labor to production. I avoided talking about profits -- or the lack of them -- for fear that employees would think the business was going to fail. Instead, I talked about cash flow and performance relative to plan, both of which, I explained, were right on target.

After we'd been at it for about four months, people could see signs of improvement. By then, we had 10 or 11 production employees, and labor costs had dropped to about 13%. There were still peaks and valleys, but employees, for the most part, were encouraged. I'd walk through the plant, and they would always have ideas for streamlining production. They would say, "What about moving these components from here to there?" or, "Why don't we produce parts in bigger batches?" My role as cheerleader and foreman began to diminish.

As we moved into the summer of 1988, however, we lost some of our momentum. In June we had a surge of about $300,000 in orders, representing more than 40% of the $700,000 in production we had planned for the entire year. Our people, who were working a lot of overtime already, couldn't keep up, so we had to bring in six new employees. They weren't trained, of course, so our efficiency suffered. That was a big psychological setback for the people who thought they were closing in on their bonuses. But we had no choice: we had to satisfy our customer.

For about three months we were running three shifts. We had 18 people working in production and 4 others (including myself) backing them up. I gave out small raises in an effort to encourage the employees who had been trying so hard, increasing their base pay from $6 an hour to $6.75. Ironically, the increases added to the payroll cost, which made it somewhat harder for people to qualify for the bonus. But since there hadn't been any bonuses yet, nobody cared.

It was a tough summer. Among other things, it was brutally hot, and the plant had no air-conditioning. Morale was low. Two of the original employees got called back by companies from which they had been laid off, and they left, taking jobs that paid about $10 an hour. They said they had lost confidence about hitting the bonus targets anytime soon. Frankly, so had a lot of other people. Whenever employees expressed their doubts to me, I would take them through the numbers again. We would look at the improvement in performance since the spring. Now that they were getting more efficient, I said, they had to learn how to think beyond the task at hand, to order materials in advance so they wouldn't run out.

In early fall the situation began to improve. We caught up on production and could eliminate our third shift. Because it was by far the least efficient one, we thereby lowered our labor costs significantly. That brought us down to 10 production people. By October they were working in the bonus zone. Week after week labor came in below the 11% target, running from 9% to 10.4%. I kept setting aside money to pay out at the end of the quarter. As people saw the total rising, they were thrilled, and so was I.

But after seven straight weeks in the bonus zone, something happened: we stopped shipping goods. In itself, that was not a problem. We had to have periods during which we could build up our inventory of standard goods so we could handle the special orders with a minimum of disruption. It was all part of the plan.

However, employees saw the inventory accumulating, and they got nervous. Talk of layoffs spread through the plant. I tried to address the employees' fears, explaining why we needed a reserve of finished products. Nobody, I told them, was going to be laid off. But no matter what I said, people were scared by the sight of growing inventory. In response, they started working less efficiently. By the end of the quarter the bonus was wiped out.

As you might expect, this turn of events deflated a lot of employees. They knew they had had the money in their hands, and they had blown it. For my part, I really wanted them to earn a bonus. To the extent that the inventory had thrown them off, I felt partly responsible for their failure to get it. I also believed that when they finally saw a bonus check, it would motivate them tremendously.

So just before Christmas I called the employees together. I told them I would pay the bonus based on their performance in the first seven weeks of the quarter. I said we would never do this again, but I wanted them to know we were really serious about the system. Then I handed out the checks. Under the formula we'd worked out, the bonuses averaged $372 a person.

It worked. During 1989 we paid out a bonus check every quarter, and the employees earned every cent. The bonus payments, which averaged $340 in the first quarter, grew to an average of $771 in the last quarter. Granted, our sales increased from $1 million to about $1.4 million, which played a role. But most of the increase was the result of rising productivity. We were doing more work with 11 people than we had done the previous year with as many as 18.

As time went on I could see the change in employees' attitudes. Before we were making bonus payments, workers didn't seem to care if we spent money on overtime because of a production snag. It was the company's nickel, not theirs. But once they crossed into bonus territory, they saw that production problems were costing them money, and they became very diligent about finding ways to improve.

Meanwhile, they were operating increasingly on their own. We would just give them a general overview of our production needs for the following week, and they'd take it from there. They knew that the faster the work got done, the more they stood to make. To speed up the process, they began telling one another how many parts they needed, when, and in what order. Some would even come in early to lay out their parts on pallets. We tried to help them save time by putting phones at each workstation, so an employee could call a vendor directly if, say, a machine malfunctioned.

Along the way, the problems began to change. In the early days they had generally involved things or systems -- faulty materials, for example, or poorly organized work flow. But now, more often than not, the bottlenecks were people. We had a brake-press operator, for instance, who was having trouble keeping up. One day I walked into the plant and found a shouting match going on between him and another employee, who had run out of things to do. We asked her to operate the machine for a while. After a little practice, she began processing the work a great deal faster than he could. Now when we get backed up on the brake press, we usually ask her to run it on overtime. In addition to the extra hours, she has since received a raise, which also increased her share of the quarterly bonus pool.

As the bonus system has evolved, so has the pay scale. I handle that myself, setting everyone's base wage, and the information is not public. In the beginning, I assumed employees would keep their wages secret. I was wrong. I've found that everybody knows about any change in wages within minutes. In deciding on wages, I simply try to be equitable. Every so often, I sit down and list employees in descending order according to their value to the company. The list is never posted, but people are aware of it. They know that when they become more efficient or learn a new skill, I'll adjust their pay. As a matter of policy, I don't lower anyone's wages, but employees who don't get raises wind up with smaller percentages of the overall bonus distribution. Clearly, there's an incentive for people to improve.

The system isn't for everybody, however. Some people, I've found, can't handle the responsibility, and others don't like the pressure. Last November, for example, we moved to a new plant and added some people in the process. I thought we might become overstaffed, but -- for reasons I still don't fully understand -- we lost three employees in three months. One guy came in one morning, left a half hour later, and never came back. Another fellow, a product tester, fell behind and stopped checking for quality; people were furious with him (returns eat into the bonus) and pressured him to leave. The third person became a prankster. Among other things, he set a pile of rags on fire with a welding torch. Why anybody would do that is beyond me. I fired him.

We now have a total of eight people working in production, and we're producing more goods more efficiently every month. Production people earn from $6.50 to $8.75 an hour before bonuses, which have lately averaged more than $1,115 a quarter. At the beginning of 1990, moreover, I decided to sweeten the pot. Instead of allocating 11% for direct labor, I've set the figure at 12%, thereby paving the way for even bigger bonuses down the road.

Meanwhile, the system is still evolving. Recently we've had to deal with the issue of tardiness, which upset several employees. One person's late arrival, they said, disrupted everyone else's schedule and ultimately reduced the bonus pie. Under the old rules, a tardy employee lost some wages but still received a full bonus at the end of the quarter. The others thought that wasn't fair. We batted the issue around for several months. How much lateness or absenteeism could employees tolerate? How punitive should they be? Finally, last winter, we agreed on new rules. Employees could be tardy -- defined as one minute late -- or absent without notice no more than five times a quarter. Beyond that, they would lose the entire quarterly bonus, which would be divvied up among the other workers. The new policy went into effect during the second quarter. In June, just as the quarter was coming to an end, two employees went over the limit.

A couple of people felt bad about this development. They thought the penalty was too harsh. The arguments got kind of nasty, so I called a meeting. Someone proposed that the offenders be paid half the bonus they would otherwise be entitled to. I suggested we put it to a vote of all the employees who were eligible for the bonus under the new policy. It was a secret ballot. They unanimously agreed to give the two employees half of their shares.

In the wake of that incident, the employees decided to revise the policy. A person can still lose the quarterly bonus by being late or absent without notice more than five times, but from now on that share will be rolled over into the next quarter's pool, which will then be divvied up by everyone according to the formula. We'll see how that works.

Looking back over the past three years, I can see how my role has changed along with everyone else's. I no longer spend much time pumping up the organization and helping people make decisions. I don't set employment policies, either -- the employees do. Yes, I sometimes serve as a kind of referee, but they come up with the options. We have a bookkeeper who handles the payroll and the day-to-day financial matters. My daughter Wendi does the purchasing and production scheduling.

And me? I concentrate on the issues involving the company's long-term direction. I'm also responsible for finding more business. At the moment, I'm negotiating to add some new product lines, and I feel under considerable pressure. There are eight people out in the plant, getting better at their jobs all the time. Before too long they will be able to produce more than we can ship. At that point, it will be important for us to have additional work.

So that's my problem right now. I have to admit, it's a good problem to have.

Jon W. Wehrenberg is the founder and president of Jamestown Advanced Products Inc., a metal-fabricating company headquartered in Jamestown, N.Y. n