“Depending on the level of responsibility and business line, the variable component represents one to three months of the employee’s base salary. The pay-out (i.e. the ratio between the bonus paid and the target bonus) is four per cent less after several years of stability (84% in 2020 compared to 88% in 2019)” – Deloitte study, Individual Compensation 2020 (deloitte.com).
Budget overruns exist as soon as it comes to budget and financing. Like other company budgets, marketing, purchases, IT, compensation management and particularly incentive compensation, they are no exception to the rule, and there is a real risk of overspending unless safeguards are put in place.
It is important to remember that the budget for incentive compensation plays a central role in human resources management policies, more specifically in compensation management. How do you avoid exceeding the budget for incentive compensation? Controlling the budget envelope makes it possible to maintain team trust, but also to preserve a company’s economic sustainability.
Whether in sales or support functions, overrunning the incentive compensation envelope can quickly turn out to be costly and jeopardise your company’s economic balance. So, how can you prevent nasty surprises and control your budget?
In this article, find out what budget envelopes for incentive compensation are and how to avoid a budget accident!
Budget envelopes and budget accidents
“At the level of companies, organisations and associations, budget overruns can lead to financial losses, company failure and the withdrawal of funding from other projects.” (What is a budget overrun? What does it mean for your cash flow? - 20/20 (repurchasecredit.com).)
It is important to define what a budget envelope is, as well as a budget accident. A budget envelope is a sum of money which a legal entity makes available to another legal entity or a natural entity. In the context of incentive compensation, the budget envelope corresponds to the overall envelope of incentive compensation planned for all employees over a year or a performance cycle given when a particular target or set performance is achieved.
We also speak of a budget accident when the actual use of the budget deviates from the projections made. For instance, if a company sets itself a 3% growth target for the year, it will set a related budget, which will therefore be decided on by the financial department. But what if it achieves 5% growth rather than 3%? A company might have feasibly planned to spend 120% of its budget to achieve 5% growth, but if it ultimately spends 140% of its budget to achieve this same growth, a budget accident occurs. It should be noted that the behaviour of a budget envelope depends on the calculation engine used (performance bonuses, commissioning or ranking) and especially on the progression of the selected bonus.
Understanding incentive compensation budgets
“You can specify in your sales representatives’ employment contract that the commission scheme or the method of calculating incentive compensation will be regularly reviewed according to your company’s sales strategy or the tools made available to the sales employee under their contract” – Amarris Direct, accounting firm.
Any form of remuneration is a cost to the company
Remuneration is a major strategic issue in companies. However, when we talk about remuneration, we actually mean payroll expenses. Employers therefore need to understand that all forms of remuneration, whether fixed or incentive compensation, are a cost to their company and that they have to be included in a budget to keep the company economically stable.
Incentive compensation is by definition variable. Assessing its cost in advance can be a risky business, hence the need to implement budget control tools and to be able to accurately simulate the behaviour of the envelope in line with the performance achieved.
Each form of incentive compensation serves a different purpose
Profit-sharing, incentive schemes and employee savings schemes are incentive compensation schemes that benefit from tax relief and may seem be a good way of limiting the cost borne by the employer. However, other incentive compensation schemes that appear more costly at first glance are likely to offer a better return on investment and create more value.
Incentive compensation is therefore one of many ways of thoroughly analysing a company’s objectives and the resources at its disposal so that it can set an incentive compensation budget which achieves the right balance between performance and cost control.
How do you set an incentive compensation budget?
“Incentive compensation mechanisms which involve setting consistent objectives (SMART) have a positive impact on employee behaviour: they encourage employees to make more effort and to become more involved in their day-to-day tasks” – Fabien Lucron, development director and incentive compensation expert at Primeum.
To set an overall incentive compensation budget, you need to consider the two main aspects of incentive compensation.
First of all, how will you distribute it among your employees: do you need to motivate as many people as possible to achieve the desired performance, or should you be more selective and allocate the budget to a small number of over-achievers? The answer essentially depends on the nature and structure of the business in question.
Secondly, you need to define the progression of the bonus, taking into account the above elements while respecting the performance hierarchy. The more employees are affected by the incentive bonus, the harder it becomes to propose a progression curve that takes off. However, if the bonus only concerns certain employees, it becomes more difficult to motivate all the other employees. The company has to position itself strategically.
Don’t go for the easy option with commissioning
“[...] Commission-based compensation comes with its own terms of use and advantages, notably its simplicity. That said, it has the disadvantage of never introducing any performance requirements” – Fabien Lucron, development director and incentive compensation expert at Primeum.
To avoid overspending, some companies prefer commission calculated as a percentage of sales, for instance. When a company decides that the bonus percentage is 5% of the turnover, the incentive compensation budget is completely linear and the budget is fully controlled, although this is not a guarantee of its profitability in any way.
However, it is important to keep in mind the intentions behind incentive compensation. Employers use it to try and reward performance at a specific moment in a specific context, encourage employee commitment over time and offer compensation which is not necessarily due so that employees don’t rest on their laurels. With a simple commission system, an employee who achieves 90% of the expected performance will receive 90% of budgeted bonuses, whereas this 10% performance gap can be very costly for the company.
Since companies favour less linear, more progressive yet still continuous forms of incentive compensation, it is now harder to calculate incentive compensation budgets, but tools exist to produce accurate and reliable simulations. Let’s not forget that schemes can include qualitative criteria resulting in equally complex budget considerations.
Adapting incentive compensation budgets to the economic context
“Companies need to communicate with their employees very quickly if they plan to revise their targets upwards or downwards, specifically as regards the analysis methodology they have used to make their decision” – Fabien Lucron, development director and incentive compensation expert at Primeum.
With performance-based incentive compensation schemes, such as performance-based bonuses, companies can give themselves enough flexibility to respond to changes in the economic environment.
As we have seen with the COVID-19 crisis, many companies had to reduce their targets to cushion the blow from the crisis, and sometimes increase these targets to avoid windfall effects during the recovery after several months spent in an atypical market context.
To avoid potentially overrunning the budget, incentive compensation has to be managed as an investment in performance, and the budget behaviour decided on must take into account the intrinsic profitability of company activity.
