Upside, Downside, Leverage, and Dispersion
My preceding two articles discussed pay mix in compensation and the need for finding the right balance between salary and incentive, in proportion to the level of prominence of the role. Now we turn to some of the more exciting mechanics of incentive design, the ones that create truly motivational incentive plans – upside, downside, leverage and dispersion.
The Secrets of a Motivational Incentive Plan
Upside is the amount of pay that a top performer can earn, and downside…well…you can guess that one…it’s how much risk there is on the downside for a poor performer. Leverage refers to the plan design ratio of the top 10 percent (decile) performer relative the median performer, and dispersion refers to the amount of leverage that a plan actually achieves. So let’s unpack these one at a time.
Generally speaking, you want your team’s performance on your incentive plan to result in a bell curve, with the following “look”:
No more than 10% of the employees should be below “threshold” (the minimum acceptable level of attainment on the plan, which often means they are earning no incentive pay)
50% to 60% of the employees should be earning at or above “target” (the expected payout level for hitting quota or goal which is tied to market competitive pay and your desired pay mix for the role)
About 10% of the employees should be at or above “excellence” (a really good level of performance that you wish EVERYONE in your organization could hit)
The amount of pay you tie to each of these marker points determines the motivational value of your plan. If you pay $1,000 for reaching quota, and you pay $0 for not reaching threshold…then the downside of your plan is $0. If you have a straight line commission with no threshold, then your plan has no real downside, as even moving one load will result in some incentive pay. If your overall plan has a base salary in place, then your plan should have downside. Typically we recommend paying roughly 25% of the target incentive (in this example, that would be $250) when threshold is reached. You want a bit of a cliff at threshold to encourage as many people to get above threshold as possible. Remember, you want 90% of your employees earning above threshold pay. Those that are below for too many pay cycles are probably not long for the company.
The amount you pay at excellence is your leverage factor, and this typically should be two to three times the pay at target. So, if your target pay is $1,000 then your pay at excellence should be $2,000 to $3,000. This ratio is generally determined by the amount of pay at risk, and how difficult it is to reach “excellence.” If you have more pay at risk for the role (for example a 50/50 pay mix), then you should have a 3x leverage factor (or possibly more). If you have an 80/20 pay mix, then a 2x leverage factor is just fine. For admin staff with a 90/10 pay mix, 1.5x may be plenty. Setting this marker helps you determine a variety of things about your plan mechanics. If you have a tiered commission plan, then it guides you to the numbers you need to use to ensure the leverage factor is reached at the excellence level. Here is a quick example using a monthly retroactive (back to the first dollar) commission plan:
Threshold of $15,000 in GP$ should pay $250; rate at $15,000 = 1.67% ($250 / $15,000)
Target of $25,000 in GP$ should pay $1,000; rate at $25,000 = 4.00% ($1,000 / $25,000)
Excellence of $40,000 in GP$ should pay $2,000; rate at $40,000 = 5.00% ($2,000 / $40,000)note: all dollars are illustrative and are not recommendations about performance and or pay for any role
Test Your Incentive Plan Economics
Now, of course you need to test the economics to be sure that you can afford to pay 5% at $40,000 a month in GP$ (including salary expense). But notice how this plan creates the motivational drive to want to get to $40,000? The payout is $400 higher than if we’d kept the 4% rate on all GP dollars above $25,000. You should set the high bar (“excellence”) at about the point where your top 10% performer lands (if you have 100 performers, this would be the 10th one from the top). This helps create that bell curve I talked about earlier. Historical performance determines “excellence” and then you set the leverage factor to help drive a higher level of pay to your top ten percent performers.
Upside refers to the amount of pay one can earn at excellence or above, and often helps explain if a plan has a cap or not. If the “upside is unlimited” then there is no cap. If the maximum payout is 3x the target incentive, then in our example the maximum upside would be $3,000 a month, with an excellence payout of $2,000. So you would tell a potential recruit that the upside would be $2,000 to $3,000 a month. In most cases for brokers, it would be unusual to put a cap on an individual component of an incentive plan (why would you want them to stop moving loads?), however, there are some industries where capacity can be limited (e.g., trucking) and it may be in the company’s better interest to limit the amount of total sales, and focus instead on getting more of the right type of sales.
Dispersion...A Test for The Motivational Value of an Incentive Plan
The last concept to cover is dispersion. This refers to an after-the-fact check on the health of your incentive plan and all it takes is a simple Excel calculation. On your spreadsheet that lists all of the incentive payouts (do not include salary payments) for employees, group the employees by role (so all inside sales are together, all carrier sales are together, etc), and then apply this formula to the incentive payouts for a single role:
Note: You should substitute the actual location in your workbook of the incentive payouts for A1:A30; in your case it may be D10:D567 depending on how your data is arranged and how many employees you have in a role.
The result should be a number between 1 and 5, but it’s highly likely that it will be between 1 and 1.5. What this tells you is the ratio between the top 10 percent performer’s pay and the median performer’s pay. If you designed your plan to have a 3x payout at excellence, and your dispersion is 1.25, then you have a problem. Either the median level of attainment is too high (and your costs are probably running amok), or the excellence level is set too high for people to actually reach it (and your plan is not providing the motivational value it should). One of the most common problems with 100% variable plans is a lack of dispersion. This is because so much of the incentive is actually serving the function of a base salary: providing the employee with steady enough income to allow for house and car payments. It can also be problematic to have too much dispersion. If your ratio is more than 7, then you may not be using a valid goal setting or expectation setting approach, resulting unreasonably high payouts for some members of your team. It may be that they have house accounts or other types of business that is easier to move, but is being counted the same as the freight being moved by the masses. You may think this is not a problem, but that “high end” payout, if perceived as out of reach for the masses, or unjustly earned, may actually create a toxic environment for the bulk of your employees. Further, these “super rich” top performers often create a barrier for management, keeping them from making sound business decisions that would be in the best interest of the entire company, out of fear of losing these performers and their accounts. But this is a topic for another article.
In summary, in order to gain motivation from the incentive plan, you want your incentive plan to be truly variable…with meaningful upside and downside, which rewards top performers, while encouraging bottom performers to work hard to move themselves up the curve.
This excerpt was originally published in the June 2014 issue of The Logistics Journal.