Variable compensation is a type of employee compensation that fluctuates based on factors such as individual performance, company performance, or the overall economy. While traditional forms of compensation, such as salaries and hourly wages remain fixed regardless of these conditions, variable compensation ebbs and flows with results. The goal of a variable comp plan is to align employee behaviors with desired business outcomes to ensure the highest level of productivity possible. There are four primary benefits of variable compensation:
Better alignment – Employees are rewarded when desired business outcomes are achieved.
Greater engagement – Employees who are engaged in their work are more productive and contribute more to the company’s success.
Better retention rates – When employees feel like they can make a real difference in their job and earn more money by doing so, they are less likely to leave the company.
Increased creativity – Variable compensation plans can encourage employees to come up with new ideas and be more creative in their work.
Charlie Munger once said, “Show me the incentive, and I will show you the outcome.” If you want better performance, you have to reward behaviors that produce better results. If you want employees to be more engaged, you need to give them a reason to care about the outcome and not only the outputs. That’s what a variable compensation plan can do.
The first component of a thoroughly designed variable comp plan is an employee scorecard that outlines the key activities, success metrics, and core processes that your business needs to track by role. Creating this scorecard should be a collaborative effort between management and the employee to ensure that everyone is aligned and bought into the variable comp plan.
What are key activities?
Key activities are high-value actions that, if done consistently, will produce the desired business outcome. When you're trying to come up with key activities, it often helps to work backward, starting from the desired outcome. I'll use a football analogy to drive this point home.
The team's ultimate goal is, of course, to win the football game. To win the game, the team has to score points and prevent the other team from scoring points. To score points on the offensive side of the ball, you have to gain positive yardage, get first downs and eliminate penalties and turnovers. In this example, positive yardage, first downs, and minimizing turnovers/penalties are the key activities.
In the screenshot example shown above, we've shared four potential key activities for an employee working in a public relations role. The number of pitches and the number of media placements are two activities that produce the desired outcome (traffic from the media sites).
When it comes to key activities, it's important to abide by the less is more rule. The goal is to keep employees hyper-focused on the highest-value activities. Any more than 5 key activities tend to be confusing and overwhelming. Likewise, when you have a lot of activities to track, you complicate the math on the variable comp side. When explaining this to clients
What are success metrics?
The next step is to identify success metrics. Success metrics are analogous to points scored. Returning to the football metaphor, positive yards and first downs are important activities but they must lead to touchdowns or at least field goals to ultimately matter. In public relations, media placements are desirable but they must send traffic to the company's website in order to be beneficial. It is important to note that there is a big difference between outputs and outcomes. Outputs are the things that get done (pitches, media placements), while outcomes are the real results of our efforts (website traffic). A good variable compensation plan indexes on rewarding outcomes as opposed to outputs.
How to document your core process in the scorecard?
In the final step, you need to identify the core processes that must be followed to get the job done at the highest quality possible. Here again, it is helpful to think in reverse. Ask yourself, what actions prevent or distract us from scoring points (or hitting our success metrics). In football, poor clock management, missed tackles, and penalties hold the team back. In public relations, not maintaining an updated media list or failing to properly manage the client relationship will cause issues downstream. The purpose of a process is to avoid self-destructive and counterproductive behavior. Keeping track of process infractions in the scorecard ensues discipline and incentives employees to pay attention to detail.
Once you've identified the key activities, success metrics, and core procedures for the scorecard, the next step is to assign point and dollar values to round out the compensation plan. In a follow-up article, we'll share how we build the compensation side of the scorecard for our clients. In closing, we cannot stress the importance of getting the incentive right before tying in the economics. Rewarding the wrong activities or failing to select the right success metrics is like calling a Hail Mary play on fourth and inches - poor execution and a very low chance of success.