Incentive Payment Thresholds—Making Them Work for You
Annual incentive plans generally use “thresholds” to set a minimum standard of performance below which results will not be rewarded. Think of the performance threshold as the fence over which one must jump before they can begin to earn their annual incentive or bonus dollars. The use of the performance threshold is generally what separates performance-based incentives from traditional commission or profit sharing plans.
Shown below are two typical examples of incentive plans where thresholds are used:
- A sales rep has an annual goal to sell $3,000,000 in their territory or within their assigned accounts. The rep will not earn any incentive until at least 75% of their annual goal (or $2,250,000 in sales) is delivered. After that the rep will earn a prorated incentive (just like a modified commission) for every dollar of sales over $2,250,000. That rate of incentive (in percent of sales dollars per $000) may also increase with higher levels of performance and after the annual goal is achieved.
- A VP of Operations is tasked with increasing year-end plant inventory turns (where inventory includes: raw materials, in-process production inventory and finished goods) to 6. If they meet that objective they will earn $20,000 at the end of the year. If the VP of Operations does not achieve the 6-turn goal but does achieve at least 5.5 turns (still an improvement over the prior year), an annual bonus of $5,000 is earned. Below 5.5 turns, no annual incentive is earned. Again, the VPO will earn a prorated incentive (just like a modified commission) for increases in performance over 5.5 turns.
Do these plans look familiar? They should for they are representative of commonly used reward tools and practices for sales forces and operating managers.
Thresholds can be strong performance communicators when used correctly. But, they can also backfire or lose much of their effectiveness depending on how they are employed or calibrated. Let us look at 3 common issues or problems that arise with performance thresholds that will negatively impact the underlying effectiveness of an annual incentive plan:
- The annual performance goal is poorly set—it is either much too high or too low. When this happens the plan loses its meaning and motivational impact in general. Hence, if the goals are meaningless so are its incentive-plan performance thresholds. And, who cares about the threshold anyway at that point?
- The performance threshold is set too high—i.e.: at 95% of the annual goal. When goals are set too high they become—what we call—“all or nothing plans.” While this situation most often meets management’s needs (“hit your numbers, or else!”), the “or else” can result in many sales reps or managers who will not earn an annual incentive. This, in spite of the fact they came close to their annual number—albeit somewhat low. Of course if goals are set too low to accommodate that high threshold, everyone hits their goal anyway and the reward-elements of the plan are pretty much meaningless. [Those darn goals again.] As a solution, we find that setting performance thresholds in the 75-80% of annual goal range generally strikes a good fairness compromise of progress versus fully-achieved results. But be careful, for if thresholds are set lower than ~60% of the annual goal, your plan begins to resemble a complicated commission plan.
- The incentive earned at threshold (minimum acceptable performance) is too high—say $15,000 versus and an annual bonus of $20,000. When you pay out too much at the bottom of the incentive scale you greatly diminish the meaning of the payout for achieving the goal (in this case, the $20,000). As a solution, we advise that only small bonus payouts (compared to the full-annual bonus) be earned at threshold performance. You will seldom go wrong with this approach.
OK, enough of this numbers and pay plan design-speak.
We have been designing these types of pay arrangements for over 30 years and have seen goal-based incentives (with their associated performance thresholds) come in and out or pay-plan vogue. But whether in or out, they are likely here to stay. What you can see from the above discussion is that these types of plans are much more complicated than the commission plans that they originally were designed to replace, and have many more moving parts. Hence, they are inherently harder for management to design and ultimately control.
As noted above, there are a number of issues and problems that impact the use of annual incentive plans with performance thresholds. We have offered some solutions and practices to overcome these. However we believe that a better approach is what we call pay-plan diversification.
This is the use of a mix of pay-plan design vehicles (such as commissions, annual incentives with performance thresholds or bonuses) together. For example, a sales force can earn both monthly commissions combined with periodic bonuses (both earned and paid) based on achievement of their annual sales goal. With this type of approach you have picked the best features of both types of plan and will greatly simplify your new pay plan for a potential win/win outcome. Further, problems with performance thresholds are minimized or totally eliminated.
Having problems with you goal-based incentive plan and the setting of those pesky performance thresholds? If so, try using diversification next year.
Wilkening & Company has designed over 100 sales, manager and executive pay plans during the last 30 years. If you want to talk about your current sales or manager pay plans or further discuss pay-plan diversification, feel free to call at (847) 823-5090 or write at firstname.lastname@example.org.