Variable compensation

Author:
Josh Steinfeld

Read time: 5 minutes
Published date: July 17, 2024

Learn how variable compensation works, including how to motivate your employees with variable pay, pros and cons, and the different types of variable comp.

Contents

• What is variable compensation?
• Why offer variable compensation?
• Types of variable compensation
  • Commissions
  • Bonuses
  • Profit-sharing
  • Performance-based incentives
• Pros and cons of variable compensation
  • Pros
  • Cons
• Best practices for variable compensation
• Make better offer letters

If you’re looking for a way to inspire your team to go above and beyond and drive business impact, implementing variable compensation—which directly links pay to performance—is a powerful way to achieve this goal.

What is variable compensation?

Variable compensation is the portion of an employee's pay that fluctuates based on performance, achievements, or overall company success. Unlike fixed salaries or base pay, which remain consistent regardless of personal or business performance, variable compensation creates a direct link between an individual's efforts and their financial rewards.

While smaller companies typically reserve performance-based pay for revenue-driving roles like sales and leadership, larger organizations often extend variable compensation (such as annual bonuses) to employees across various teams. This model directly ties earnings to individual achievements and company performance, incentivizing employees to maximize their business impact. By aligning personal success with organizational goals, companies can foster a high-performance culture and drive overall growth.

Why offer variable compensation?

By offering a variable pay plan, companies can create a win-win situation where employees are rewarded for their contributions and the organization benefits from improved performance. Variable employee compensation can help:

1. Align individual performance with company objectives
2. Improve employee motivation and engagement
3. Increase employee retention
4. Attract top talent
5. Create a results-oriented culture
6. Increase flexibility in managing labor costs

Types of variable compensation

Different types of variable compensation can help you achieve different business goals, so let’s look at why you’d want to offer each type.

Commissions

Commonly used in sales roles, commissions are based on revenue generated or deals closed. This form of variable pay directly rewards employees for their ability to drive business growth. For example, a salesperson might earn a 5% sales commission on every sale they make, incentivizing them to close more deals and potentially earn significantly more than their base salary.

Bonuses

Bonuses are one-time payments awarded for achieving specific performance targets or milestones, either individually or as part of a team. Bonuses can be tied to key metrics like project completion, customer satisfaction scores, meeting quarterly goals, or employee referrals. They give a tangible reward for exceptional performance and can be a powerful motivator for employees to go above and beyond their regular duties.

Profit-sharing

Profit-sharing is when a portion of a company's profits are shared with employees, fostering a sense of ownership and shared success. Unlike stock options or stock awards, profit-sharing doesn’t grant ownership in the company. It’s when companies distribute part of their profits in cash to employees on a quarterly or annual basis. Profit-sharing is somewhat common in LLCs and S-Corps because it’s relatively easy to implement and aligns well with the pass-through taxation structure, as well as in professional services companies like accounting or law firms, and employee-owned companies.

Profit-sharing plans can help align employee interests with your company's financial performance, encouraging everyone to work towards improving overall profitability. It's particularly effective in creating a sense of unity and shared purpose within the organization.

Performance-based incentives

Performance-based incentives are tied to individual or team performance metrics. Incentive pay can be customized to focus on key performance indicators (KPIs) that are crucial to the company's success. For instance, a customer service representative might receive an incentive based on their average customer satisfaction rating, while a product manager might be rewarded for successful product launches.

You can use a combination of these to create a comprehensive variable compensation plan that aligns with their unique goals and culture.

Pros and cons of variable compensation

Like any compensation strategy, variable pay comes with its own set of advantages and disadvantages.

Pros

Variable compensation can:

• Improve productivity and employee performance: By directly linking pay to performance, it can motivate employees to put in their best effort and achieve higher levels of productivity.
• Align employee efforts with company goals: Variable pay helps ensure that employees are focused on the goals that matter most to the company, creating a unified direction for the entire organization.
• Attract and retain high-performing talent: High-achievers are often drawn to companies that offer the potential for higher earnings based on their performance.
• Provide flexibility in managing compensation costs: During lean times, companies can reduce their compensation expenses without resorting to layoffs, since the variable portion naturally decreases with lower performance or profitability.
• Encourage a results-oriented culture: Variable compensation fosters a workplace environment where outcomes and achievements are valued and rewarded, promoting a high-performance culture.

Cons

Variable compensation can:

• Create uncertainty in employee earnings: The fluctuating nature of variable payments can lead to income instability for employees, potentially causing stress and financial planning challenges.
• Lead to unhealthy competition among team members: If not carefully structured, variable compensation programs can cause employees to prioritize their own success over teamwork and collaboration, damaging company culture and long-term results.
• Be complex to administer and communicate: Variable compensation programs often involve complex calculations and may be difficult for employees to fully understand, potentially leading to confusion or mistrust.
• Inadvertently incentivize short-term thinking over long-term goals: If not balanced properly, variable compensation tied to short-term metrics might encourage employees to prioritize immediate gains over long-term company health and sustainability.
• Present challenges in setting appropriate performance targets: It can be hard to establish fair, achievable, and meaningful performance goals or metrics, especially in roles where output isn’t easily quantifiable. Poorly set targets can lead to demotivation, gaming of the system, or misalignment with overall company objectives.

Best practices for variable compensation

Implementing an effective variable compensation plan requires careful planning and execution. Here are some best practices to help you create a strategy that helps drive positive business impact:

Set clear, measurable objectives

Establish specific, quantifiable goals that are directly tied to your company's overall objectives. These should be challenging yet attainable, encouraging employees to stretch their capabilities without becoming discouraged.

For a sales team, that might look like setting a target to increase quarterly revenue by 15% year-over-year, with tiered bonuses for achieving 100%, 110%, and 120% of the goal. This objective is specific, measurable, tied to company growth, and provides incentives for exceeding expectations without being unrealistic.

Ensure transparency

Clearly communicate how the variable compensation plan works, including pay structure, how performance is measured, and how rewards are calculated. Transparency builds trust and helps employees understand how their efforts contribute to their earnings.

Align with company culture

Your variable compensation plan should reflect and reinforce your company's values and culture. For example, if teamwork is a core value, consider including team-based incentives alongside individual rewards.

Balance short-term and long-term incentives

While short-term incentive payouts, like quarterly bonuses, can drive immediate results, it's crucial to also incorporate long-term incentives, like stock option grants that vest over time. This encourages sustained performance and aligns your employee’s efforts with the company's long-term strategy.

Regularly review and adjust

The market is constantly changing, and your variable compensation plan should evolve with it. Regularly reviewing your comp plan's effectiveness and making adjustments as needed is crucial to maintaining employee engagement.

For example, if there’s a market downturn or recession and you don’t adjust your sales representatives’ quotas, it could cause your sales reps to phone it in because even if they give 100% they’re not going to hit their sales targets and earn more.

Provide frequent feedback

Don't wait until the end of the year to discuss job performance. Offer regular feedback so employees understand how they're tracking against their goals and what they need to do to improve.

Ensure fairness

Design your plan to be equitable across different roles and departments. While the specific metrics may vary, the opportunity to earn variable compensation should be consistent.

Educate managers

Ensure that managers understand the variable compensation plan thoroughly and can effectively communicate it to their team members. They play a crucial role in motivating employees to hit their goals and stay engaged.

Make better offer letters

If you're offering variable compensation, you'll want to make sure prospective employees understand the full value of their compensation package.