Incentive Compensation System - or - How Not to Give a Bonus

An incentive compensation system is a compensation system that is supposed to provide an incentive for employees to meet an objective, and then reward them accordingly. Most of the incentive compensation systems that I have seen are complete failures. Why? Because they are planned and implemented poorly. They are missing the two most important ingredients - employee trust in management and a true reward for accomplishing an objective.

Let me explain. How often do you hear employees say one of the following:

• We usually get our Christmas bonus around December 15.


• I wonder how much my bonus will be this year.


• I hope my bonus is as big this year as it was last year.

When employees are making these kinds of statements, their company does not have an incentive compensation system. It is simply giving normal compensation as an extra paycheck. That is how NOT to give a bonus. When a bonus becomes a normal part of compensation, it is not a bonus, it is simply standard compensation.

A "bonus" or incentive compensation payment is a reward for achieving a specific objective. The objective needs to be set by an employee's supervisor. It must be measurable and have a specific date attached to it. It must be discussed clearly with the employee. "Improving communications" is not a measurable objective. "Writing and distributing a monthly newsletter to 100 specific customers by the tenth day of each month" is a measurable objective. "Achieving $100,000 of sales of Product A by December 15" is a measurable objective. Telling an employee, "increase sales this year and there will be something extra for you," is not clearly discussing your company's incentive compensation system with the employee.

The employee should know exactly what his/her bonus will be and when it will be paid if the objective is achieved. Thus, by having a measurable objective the employee knows if the objective was or wasn't achieved, how much he/she will be receiving and when. No guessing or assumptions.

The second ingredient is employee trust in management. It is sad but true that most employees do not trust management when it comes to receiving financial information about the company. Why? First, most employees do not understand the financial end of the business. How often have you heard an employee say, "That didn't cost the company a single cent. They just wrote it off."

Secondly, employees don't see financial statements. Most small businesses don't share their financial information. When it is not shared, employees assume there is something to hide and/or the company is "making millions."

I personally do not believe that you can build this trust simply by sharing the financial information. Some employees will insist that "the owner keeps two sets of books" - a charge that I have heard all too often, because of the employee's lack of financial understanding. Thus, when an incentive plan is developed, it must be based on the EMPLOYEE MEETING A MEASURABLE OBJECTIVE, not the overall performance of the company. The trust must come from the owner or manager always paying the bonus EXACTLY as he/she promised and on the date it was promised -regardless of the overall performance of the company.

If the employee achieves the objective and you fail to pay the bonus because the company had a bad year, you have destroyed all trust.

Let me end where I started. A bonus must be a reward for achieving a measurable objective. It will provide incentive for the employee to work to achieve the objective only if the employee knows that he/she will receive it regardless of external factors, how much compensation to expect, and when it will be paid.

I would appreciate hearing your comments on this subject.