Incentive Compensation Explained: What It Is, Why It Matters, and How to Get It Right

Besides learning about how much money they are going to earn, most employees want to know what behavior is going to be rewarded and if it feels like the reward is fair enough.

That is when incentive compensation comes into play. It is more than just a pay calculation process because it lets employees know what is valued by the company, which results are considered important, and how their contributions can help the organization grow.

In this blog post, I am going to explain what is incentive compensation, why it matters, its types, advantages, disadvantages, and best practices for creating effective compensation schemes.

What is incentive compensation?

This is basically the extra pay received by employees depending on how they perform.

Contrary to salary payment, where people are paid depending on what they do, it is a way of rewarding employees in terms of their achievements. This could include making sales, keeping clients, working hard, making profits, and growing the company.

Some of these achievements may include getting bonuses from managers at the end of each quarter or sales commission for salespeople once they close a deal.

So, if you are wondering what is incentive compensation in simple terms is, it is a structured way to motivate employees by rewarding them for achieving the outcomes that matter most to the organization.

How does incentive compensation management work?

This encompasses controlling and optimizing the processes related to the development, monitoring, measurement, communication, calculation, and management of the incentive program.

This starts by setting the goals of the organization, such as financial success, efficient sales, retention, or profitability. This goal can be translated into measurable performance metrics for the respective employees or departments.

Secondly, an organization determines the details of its incentive program, which include the manner of payments, qualifications, performance metrics, frequency, and authorization process of the program. Once the program is underway, it becomes necessary to measure performance periodically so that everyone knows where he/she stands.

Finally, the last step entails measuring the impact of the program in motivating employees through rewards. In general, the entire management of this process is not only concerned with payments but also with ensuring employees know how performance translates into reward.

Why is incentive compensation management important?

They concentrate on what is incentivized. In case of a reward scheme based on revenue alone, they may neglect the margin or the quality of service to customers. In the case of individual targets only being rewarded, teamwork would be jeopardized.

With efficient incentive management, alignment, motivation, and trust will arise. The employees will understand their goals, the management will have visibility of their progress, and the leadership will easily identify areas of improvement.

Incentive pay Management is also essential in scaling. What can be done manually for a small group may not work for a bigger one, such as a sales team.

Specific types of incentive compensation

Its structures can take different forms. However, each form of IC will depend on the position being considered, as well as organizational and other conditions that require certain kinds of behaviors.

Performance-based bonuses

These types of payments are made when employees meet certain goals. Goals may be either individual or organizational (such as increasing profits, completion of a project, and so forth).

Restricted Stock Units, or RSUs

Restricted Stock Units refer to the company stock that is transferred to an employee with a vesting period in mind. RSUs promote long-term thinking and help in retaining talented people in growing companies.

Profit-sharing bonuses

This kind of payment is suitable for organizations that are interested in having their employees consider profit-related matters, as well as spending and earning.

Commission-based payments

They are widely used among salespeople. Payments are calculated according to closed contracts and generated revenues. The scheme of commission payments must be clearly defined to avoid misunderstanding.

Benefits of incentive compensation management

When done right, this will foster a performance culture. It will give everyone greater clarity, motivation, and a bigger stake in business results.

It enhances goal clarity

An effective incentive pay program provides clear guidance for its employees. They know exactly what is expected of them and what their performance should be.

It boosts performance

The use of incentives will motivate workers to work harder. It is especially true if rewards are attainable and relevant for each worker.

It ensures that effort leads to business growth

Alignment is one of the main advantages of managing incentive pay. An employee can clearly see how his or her individual or team efforts are contributing to business objectives.

It fosters transparency

With proper tracking and reporting on performance, an employee will no longer have any doubt about where he/she stands and what has been achieved.

It aids retention

An employee is more likely to remain with an organization if he or she feels that the effort is valued and appreciated. Incentive pay can be used effectively to retain people, particularly 

high-performing individuals.

It enables the management to detect performance shortfalls

Through adequate tracking of incentives, the management will know who underperforms, which groups require performance improvement, and whether targets need to be revised.

Drawbacks of incentive compensation

Despite numerous advantages of the Performance-based incentive system, there are also some disadvantages that should be taken into account in case the incentive program is badly developed or implemented.

It may encourage short-sighted behavior

If an incentive scheme rewards its members for achieving some short-term objectives, they may lose sight of the overall picture, as they will try to focus only on short-term accomplishments. Thus, for example, the members of a sales department may prefer closing deals that will have an immediate effect, though the client is not interested in them.

It may encourage unhealthy competition

Incentives, of course, may act as good motivators. However, sometimes they also trigger fierce competition among employees, thereby adversely impacting teamwork and learning.

It may be too complex

Sometimes, the terms of an incentive program include a variety of clauses, slab rules, and even mathematical operations, making it challenging for employees to understand them.

The payment dispute can occur

Due to incorrect calculations, delays, non-eligibility, and other mistakes made manually, employees can face payment disputes. This problem can be frequent in those cases when an incentive pay scheme uses spreadsheets to manage it.

Best practices for designing effective incentive compensation plans

This plan design needs to balance business acumen and people skills. It should be easy enough for employees to understand and robust enough to serve the needs of the business.

Start with business goals

Determine what you want to accomplish before determining how much the employees will earn. Is it growing revenue, maximizing profit, retention, market development, productivity, or customer satisfaction?

Make it easy for employees to understand

The plan is not effective if employees have to read several explanations to comprehend it. The plan must be able to articulate clearly the target, measure, rationale, timing, and exceptions.

Choose the right metrics

The metrics chosen should be relevant, measurable, and controllable by the individual employee. Do not choose too many metrics; otherwise, there would be diluted focus.

Salespeople could use revenue, collections, margins, new business, or target attainment, while others could base theirs on projects delivered, productivity, or quality.

Maintain the balance between individual and team performances

An effective strategy usually entails a balance between personal accountability and teamwork. In case everything revolves around the personal performance of an employee, teamwork will be negatively impacted. On the contrary, if everything focuses on teamwork, the highly productive employees might not be acknowledged.

Implement transparency

The incentive programs should not keep employees unaware of their achievements until the date when their pay is released. Transparency will enable employees to realize areas requiring improvement before they become serious.

Update the incentive program frequently

The needs of the business environment are always changing; therefore, the incentive programs should be updated often to determine if they are still motivating the employees to do what is required.

Do not focus on outcomes alone

Outcomes are critical, but how employees get the results is equally important. The incentive program should not encourage any unethical conduct from employees.

Consider using technology

Manually tracking incentives may work for small companies, but become risky when the size of the firm increases. Technology will reduce any risk.

Conclusion

However, the concept of incentive pay does not only involve paying someone extra. The key concept of Performance-based pay resides in the connection between objective, motivation, result, and reward.

When implemented efficiently, incentive pay programs can improve motivation, accountability, transparency, and performance. On the other hand, inefficient implementation of such a tool will lead to misunderstandings and even conflict.

It all comes down to the way such a system would be implemented and run. For employees, this involves understanding which goals need to be achieved. Managers would know the time for taking action, while for leaders, it provides information regarding the effect of incentives on the performance of their employees.

Here comes the part that JOP Edge plays.

Through integrating your existing systems within a single solution, JOP Edge allows obtaining a better picture of sales performance, incentive state, and team accountability. Instead of learning about whether the employee reached the goal, lagged in achieving it, or required help at the end of an incentive program, you can get more specific insights earlier.