Compensation and reward KPI best practices

This is probably one of the most frequently asked questions: what KPIs should we use for the compensation system? In this article, I’d like to review the best practices about using, or in the most cases not using, reward KPIs. 

Linking performance to reward is easier for those employees who work in sales. It is a general practice that these employees have a low basic salary, but as a result of profit sharing their earnings are high. There are a lot of working models for this case, still disputable, in this article I’d like to focus on a reward program for employees that are not involved in sales directly.

Choose the KPI and the form of the reward program by BSC Designer.com

In this article I did a short classification of possible approaches to the reward system. Don’t take these levels as the levels of business maturity. Any business chooses one or another reward model because of the specific business environment and the current business objective. There is no absolute true about which approaches should be used.

Why employee need reward. XY Theory.

The first question is why do employees need to be rewarded? The reward is supposed to increase the motivation of an employee. Talking about motivation we can use Maslow’s hierarchy of needs (Maslow 1970), Herzberg’s motivation-hygiene theory (Herzberg, 2003) and McGregor XY Theory [1].

According to McGregor’s “Theory X” people hate work by their nature and need to be managed with the “carrot and stick.” In contrast, his “Theory Y” recognizes that people are actually motivated by self-esteem, creativity and personal development.

In this article I’ll use a simple XY Theory framework, as it describes possible types of employees’ behavior and what is more important, the managers’ attitude in these cases.

Level 1. Compensation defined by performance KPIs

The basic idea of linking a compensation plan to KPIs is simple. We want to track the performance of our employees and if they are performing well, we want to give them a bonus because a bonus supposed to motivate them to deliver even better results.

This approach is basically wrong for several reasons:

  • It is hard to measure the performance of an employee.
  • What we actually need is not a high performance, but achieving of  planned business outcomes.
  • A bonus doesn’t stimulate an employee to deliver better results in a long-term perspective.

Common characteristics of this level: 

  • Managers follow “Theory X” approach.
  • KPIs measure performance.
  • KPIs have fixed target values.
  • KPIs are assigned to individuals.
  • Reward is paid yearly, quarterly and/or monthly.

Level 2. Compensation KPIs are linked to strategic objectives

The better approach will be to use a strategy map, present business objectives with cause-and-effect connections and align a KPI so that top managers could track the impact of each employee on achieving ultimate business objectives, like it was discussed for HR ROI [2]. Still, it is really hard to execute this approach. Check out an article by Stacey Barr where she lists 5 reasons why pay-for-performance can never work.

Technically, this approach is better, as now a compensation plan is linked to business objectives. But according to some research [3], only 39% of FTSE 350 companies clearly link bonus KPIs to strategic objectives.

Common characteristics of this level:

  • Managers say they follow “Theory Y,” but actually continue to follow the “Theory X” approach.
  • KPIs measure important business outcomes.
  • KPIs have flexible targets.
  • Reward is paid yearly or quarterly.

Level 3. Rewards are not paid in cash, but are invested

On this level employees are not compensated with financial bonuses at all. The idea is that why should one be paid twice (first time with a salary and second time with a bonus) for the same job?

Jeremy Hope in “How KPIs can help motivate and reward the right behavior” [4] shares an interesting example. The author quoted Herb Kelleher, chairman of Southwest Airlines when he is speaking about employee compensation:

  • “If somebody was working just to be compensated, we probably didn’t want them at Southwest Airlines. We wanted them working in order to do something in an excellent way. And to serve people.”

Southwest Airlines has a bonus program, but employees won’t see funds soon as the company invests them in an employee retirement plan.

Common characteristics of this level: 

  • Managers follow “Theory Y” approach;
  • There are no KPIs for rewards;
  • The whole company is rewarded according to base salary;
  • Rewards are not paid in cash, but are invested into the retirement plan or in purchase of shares;

Reward program in Apple

In a previous article I mentioned that Apple  can afford to have a higher than industry average turnover rate, and still find and retain the best talents in the industry. What about their reward system?

According to information available for the public, Apple suggests its employees stock purchase plan and product discounts. For example, in 2012 Apple was giving its employees a good discount on new Mac and iPad. Well, this might be considered as a reward as well as an employee engagement program.

Apple’s senior executives are in the list of Top 5 best-paid. Besides base salary they were paid compensation in the form of stock. This was done with a specific purpose: “to retain the company’s executive team during the CEO transition.” As for Apple’s CEO Tim Cook the new initiative links Cook’s stock award to the company performance index in the Standard & Poor’s 500.

It looks like Apple doesn’t follow advice of Henry Mintberg (see the “Level 4″ section) and still have a reward program in the form of stock shares linked to a performance index. Probably they have mastered some new way to spend rewards wisely or simply have enough cash to allow this way of doing business.

Level 4. Fair pay, no bonuses

Henry Mintberg, a professor at the Faculty of Management at McGill University suggests an even more extreme point of view. In his article [5] for The Wall Street Journal he doesn’t suggest any cure to the problem of executive bonuses, he just says that “the problem is that they [executive bonuses] exist”!

Author consistently talks about five reasons why executives should not be paid any bonuses. As a possible alternative he names paying bonuses to all employees according to their base pay (similar to what was discussed on Level 3), but still sees that there is a possible problem as performance can never be evaluated correctly taking into account a long-term perspective.

It is obvious that to be able to operate on this level a company needs to have a strong leadership 100% focused on “Theory Y” way of working with employees. Also, the company should have an established brand among potential candidates to be able to afford filtering out employees that are looking for compensation plans.

Common characteristics of this level: 

  • Leadership according to “Theory Y” approach.
  • There are no reward KPIs.
  • There is no compensation or profit-sharing programs.
  • Employees are paid fairly, no additional bonuses are paid.

Where is the Golden Mean?

As we can see there are different approaches to compensation programs. There are companies like Apple that follow a traditional model, but there are ones like Southwest Airlines that prefer to focus on retaining people that are not looking for bonuses.

The executive compensation practice might be something that doesn’t help or even makes damage (see ideas by Henry Mintberg mentioned on Level 4), but they still are used widely.

For now I’d formulate this best practice regarding a reward system:

  • Choose the form of the reward program according to your current business challenges.
  • Don’t link reward programs to an employee’s performance.
  • Link reward programs to business outcomes that are connected to the strategic objectives.
  • Consider the shift from rewarding individuals to rewarding the whole company.
  • Avoid rewards in the form of cash, as stock purchases work better.
  • When possible find talents that are happy to work for a fair salary only.

Reference

1. Douglas McGregor, The Human Side of Enterprise, 1960, McGraw-Hill

2. Aleksey Savkin, Calculate a Talent’s ROI to Improve All HR KPIs, 2013, BSC Designer

3. KPIs, Performance & Reward, Paula Kager, Dirk Lindenbergh, Global Enquity Organization

4. How KPIs can help motivate and reward the right behavior, Jeremy Hope, 2013, IBM Software Business Analytics

5. No More Executive Bonuses!, Henry Mintzberg, 2009, The Wall Street Journal

Aleksey Savkin is a business performance expert at BSC Designer. His areas of expertise are Balanced Scorecard, KPIs, Business Performance Management. Aleksey is the author of a number of articles and books on Balanced Scorecard.

Posted in HR

Video Manual

Strategy Maps in BSC Designer - Video Manual
Video ManualMore videos for BSC Designer.

BSC Designer Users Say

Loading...


Call me back

Do you have any questions? Let us know the best time to call you.

Articles about Balanced Scorecard and Key Performance Indicators

Find here more articles...

BSC Lessons

Download BSC Designer and we will follow up with you with lessons about the Balanced Scorecard:

Trending Diagrams and Articles

Find here more articles...

Follow us on Facebook

What is your biggest challenge with the Balanced Scorecard?

View Results

Loading ... Loading ...