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How To Structure Your Bonus Plan

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I am a huge believer in bonus plans and yet I see far too many small companies not offer bonus plans. Let’s do a quick Bonus Plan FAQ:

Why don’t they offer bonus plans?

I suspect it is because they worry that they will not have the money to pay out at the end of the year.

Why should you offer a bonus plan?

Bonus plans, structured properly, can be motivating. They can align an employee’s efforts with the company’s objectives and can help drive retention.

When I started at Advertising.com, few things excited me more than my boss telling me: “Last year we hit 173% of goal. We are at 143% right now.” When I looked at my target bonus and did the math, I got excited. Low base be damned, that was a big check. It is exciting to crush your goals.

How big a bonus do people need?

The real question here is how large does the bonus need to be to change behavior. I think a 25% bonus creates a huge change in behavior. A 10% bonus makes people happy: That is more than a month’s salary! A bonus smaller than 5% does not create big behavioral changes. A bonus smaller than 2% might as well be zero.

At one place I worked, I was told that the bonus could be between 10% and 45% based on achievement of company goals. Lofty claim, but as every employee there will tell you, despite this claim, the bonus every year was 10%. As my former boss at this employer said to me: For a claim like that to be credible, there has to be a year, somewhere, sometime, when they pay out the 45%. Employees know what is crazy and what is real.

How would you structure a bonus plan?

Glad you asked. Here is a simple approach: Conventional wisdom says that a bonus consists of two parts: Funding the pool, then splitting the pool.

Funding the pool means getting the money to pay out bonuses. If you are just getting started with your bonus plan, I think you do that something like this: You have a revenue target this year of X and a profit margin target of Y. For example, you have a consulting company and your goal for this year is to get to $1m in sales and $200k in profits. That is like consulting company financial model 101. So the salaries you pay out to the company are probably on the order of 1/3 of the revenue: $330k. So if you want to offer a 15% bonus to all of your employees, you need to set aside $50k. This means that monthly you have an “expense” of setting aside $4k for your bonus pool. (15% of monthly salary expense) Including that expense, you want to get to 1m in sales and 20% margin. So we have a starting point for funding the pool. Now, the pool gets smaller for failing to achieve goals and the pool gets bigger for over-achieving. Typically, people talk about having an “accelerator” for over-achieving on goals. Regardless, the model might look something like this.

At less than $800k in revenue or less than 15% margins (whatever some reasonable number is – a number that would be bad but not completely disaster), the bonus goes to zero. At $800k and 15% margins, the bonus pool is funded at 5%. You can then draw some lines from there that help you fund the pool with varying amounts between 5% and 15%. Similarly, you might say: If we exceed $1.2m in revenue with margins at 25% or greater, the pool becomes funded at 25%. If we exceed $1.5m, the pool gets funded at some greater amount (40%?) – we accelerated it. The point is that at some not completely insane number greater than goal, it grows much faster. There is probably a margin component here as well, but my point is that if revenue goes up but margin stays flat, that is still pretty amazing for a small company and the ownership can carve out a little more profit to give back to the employees – that is where the acceleration dollars frequently come from. Typically the idea is that at a certain point, ownership starts splitting incremental profit dollars with employees (maybe 50/50 at peak acceleration).

Pick a number that can be achieved. When CEOs at medium or large companies with boards and investors and things like that pick this number, they pick it like they will be fired if they don’t achieve it. If you pick overly ambitious goals as your target, you set up everyone for failure. Stretch goals are for the accelerator. Realistic goals are for the basic number.

So now you have a pool of dollars – maybe 10%, maybe 20% of total employee salaries. Employee reviews suddenly mean a lot! Somehow you do them, but the point is that your top 10% of employees should get 2x their target percentage. And the bottom 20% get nothing. And the rest get something approximating the target and you have some extra funny money to spread around.

When do you distribute bonuses?

Annual bonuses can be distributed whenever. A lot of companies also use this to drive retention in ways that aren’t fun for employees. Tools like: We do annual reviews 30 days after the period ends (February 1 for people on the calendar year) and then payout bonuses on April 1. So now people would be crazy to quit before April 1 – You leave a free month or more of salary on the table!

What else could I do?

Once you have this framework, you can do a lot of different things. Some consulting companies, rather than having an annual bonus, have a per project bonus based on profitability calculations associated with that specific job. Some people do this quarterly.

Many (virtually every) large companies have different target bonuses for different titles (more senior people have larger targets – 10% for the rank and file, 15% for VP, 20% for SVP, 25% for CEO, stuff like that). This just requires that you accrue money into the pool at slightly different rates for salary by title. If you are big enough to have this kind of striation, then it is probably not hard to do the math.

Finally, many larger companies with more mature plans segment out the corporate achievement from the personal achievement to varying degrees. This recognizes the oft-claimed “I can’t affect how well the company does” whine. So a junior person with a 10% bonus plan may have that bonus funded regardless of corporate achievement. The CEO only gets paid if the company achieves its goal (100% tied to corporate performance). The VP may be 50% personal achievement (funded regardless of corporate goals, tied to his achievement of MBOs) and 50% corporate goals. But remember there is no accelerator for these people – there is just divvying up the pool of cash created by the aggregation of people at their level.

But I can’t affect GOAL X!

You hear this a lot from junior people, but you shouldn’t let that bother you. We gave people utilization targets at previous employers and heard from junior people all the time, “But I can’t control my utilization”. That might sound true on face, but let me tell you this: Our best consultants never had a free moment, yet our most problematic consultants struggled to find people that would take them on. Somehow, performance was correlated with utilization in a highly constructive way. The more awesome your work output was and the more awesome you were to work with for both our teams and our clients, the busier you found yourself.

Secondly, we wanted people motivated to get busy. You should look for work. If you think you are about to run out of things to do, you need to start asking around. If we offer you work, but it is not as “awesome” as you were hoping it would be, we want you to think for a second before you tell us that it is not good enough for you.

Thirdly, if we are struggling to keep people busy, your utilization is probably going to be the least of your bonus worries in a second.

Why did you recommend tying everyone to corporate goals then?

I kicked off this post with the supposition that you didn’t have a bonus plan yet. If you don’t, and you want to introduce one, the most pressing problem is usually arranging to have the cash exist to support one. Tying it to corporate goals is the best way to ensure that achievement of bonuses only happens if there is cash in the bank to support it. If the goals are missed, then the company simply transfers the “bonus reserve” expense into the coffers of profit to make the year whole.

Similarly, I recommended an annual plan because an annual plan gives you time to save cash, makes you less sensitive to AR/AP issues, and is easy to administer. Many people will tell you that more frequent bonuses motivate people more because they are more tangible.

How can ownership game the system?

There are a lot of ways to get ahead in this system if you are ownership. First, you typically don’t pay a bonus to people that join in Q4 of that year – yet you are taking dollars out to fund plan. These dollars later drop to the bottom line. Furthermore, many people quit through the course of the year – those people were having dollars reserved for them the whole time, yet their bonus goes “poof” when they quit.

In large organizations, typically the CFO socks those dollars in a rainy day fund for resolving any conflicts that arise in the bonus process (“OK, I will increase the pool for your division 1% more to help you out”) or if you need some extra money for a hire outside of budget.

This also helps when you have varying bonus goals and you want to move the needle a little more for a guy that gets a big payout. Now you have a little slush fund to help goose his payout a bit without taking money from other people.

Finally, another key trick is that you pay out on people’s base salary paid out, not on their actual base. So if someone joined July 1 and makes $90k/year with a target of 10%, then their eligible bonus at plan is actually 10% of $45k – they only received $45k in pay that year. This actually makes a lot of sense because the business was only accruing bonus dollars for that person for half the year – 10% of the $45k was accrued.

2 Responses to “How To Structure Your Bonus Plan”

  1. Dave Says:

    My boss just promoted someone to asst. manager and said that my bonus will now be split between the two of us.! Have you ever heard of this, is it normal? And how should I react?

  2. brent Says:

    Not nearly enough information about you to render an opinion, but it sounds like it’s time to job hunt.