8 Steps to Engage Employees with an Incentive Compensation Plan

Our guest blogger today is Howard Cox, CPA, CMA, CIA. Launching his career with a Big Four firm in 1983, Howard established his own practice just four years later—and, in late 2001, merged his independent CPA firm into Somerset CPAs and Advisors' operations. Currently, Howard focuses on general Business Advisory, Mergers and Acquisitions and PPACA Compliance engagements, and also conducts informative presentations for clients, as well as outside events.

Position Scorecards help maximize the return on investment from your players by creating a culture of discipline and accountability. You can further increase engagement by ensuring that your compensation system aligns your players’ best interests with overall team goals. This is accomplished through integrating Position Scorecard results into an overall performance based incentive compensation system.

Malcolm Gladwell provides a three-part formula for creating meaningful work in his book Outliers - The Story of Success; [Autonomy + Complexity + (Effort = Reward)]. Position Scorecards provide for Autonomy and Complexity (parts 1 and 2 of the formula). Leadership defines the results that you want, but not the method to achieve them. Balancing all of the objectives on the Scorecard creates complexity as well. Now, we move forward to the third part of the success formula by focusing on designing an ROI-based incentive compensation system that is a win-win from every stakeholder’s perspective.

From your Team’s perspective, incentives need to be competitive in the current labor market. From the Company’s perspective, sustainability accomplished through balance sheet strength and sufficient liquidity are of primary importance. From the Shareholder’s perspective, they must have a reasonable expectation of a return commensurate with risk incurred. So, the above sets forth a kind of triple bottom line that you must balance in incentive compensation plan design.

Since a picture is worth a thousand words, we have provided an example to illustrate how to successfully balance these goals. To follow along with the example, download this attachment. (Figure I encompasses the first seven steps of this process and then Figures II, III & IV each illustrate the eighth and final step.)

Step 1

Determine the shareholder ROI calculation driver. The general rule is this is the retained earnings of the company as of the prior year-end.

Step 2

Designate pre-incentive income. This is designed to allow the user to test the outcomes at a full range of potential results for the year (conservative, middle and best case).

Step 3

Calculate the minimum level of profitability that must be reached before the commencement of the funding of any incentive pool. This is dependent on a variety of real-world factors such as capital expenditure budgets, current level of debt service, bank and bonding company requirements just to name a few. Step 3 accomplishes two critical objections of plan design by protecting what we refer to as the Financial Foundation of the enterprise and also establishes a bare minimum acceptable return to shareholders.

Step 4

Mathematical model to arrive at the incentive funding pool at any level of illustrated profitability as well as the allocation of that overall pool across appropriate categories of employee contribution. The model is designed to fund zero into the incentive pool until the minimum level of profitability is achieved from Step 3, and then to escalate the rate of funding at each incremental tranche of profitability achieved thereafter. This creates motivation to drive the Company to higher and higher levels of profitability.

Step 5 

Break down incremental retained earnings (profits in excess of minimum target already established less in Step 3 less the portion allocated to the benefit of the employees in the incentive pool) between layers that represent tax owed based on assumed tax rate and that which represents remaining funds available for retention or distribution to shareholders.

Step 6

Proof of cash to visually represent the flow of funds from the years earned profits.

Step 7

Executive summary to illustrate employee and shareholder returns at the estimated level of profitability.

Ideally in step 7, we arrive at a result where at a realistic level of budgeted profitability, we can achieve a meaningful incentive to the team as well as a market return on investment to shareholders. We have already provided for the third component of our triple bottom line in step 3 with the calculation of the minimum level of profitability to be achieved for enterprise sustainability. If this triple bottom line cannot be achieved at present realistic levels of projected profitability, then further work is necessary on the company’s core economic model.

Step 8

In our example, Figures II, III and IV provide examples of how the Position Scorecard results are integrated into the incentive compensation plan design. Each employee in every category identified will know their potential objective incentive allocation if the Company’s budgeted profitability is achieved. Each player on your team also must understand that their actual award will be based on the level of their individual contribution towards their Position Scorecard accountabilities. Lastly, Figures II, III and IV provide an example of how a subjective pool created by employees not hitting 100% of their goals for the year can be allocated based on Leadership’s complete discretion.

It will be an ongoing responsibility of Leadership to ensure that their players are informed periodically on an interim basis as to the company’s performance towards budgeted objectives. Every employee will already be aware in real-time regarding their individual Position Scorecard performance. So the combination of the knowledge of company and individual performance will ensure no surprises when year-end bonuses are announced.

Photo Credit: iStock by Getty Images