Why incentive plan fails:

The Top 10 Reasons Incentive Plans Fail

The reasons incentives plans (additional compensation paid to personnel as a bonus for the
successful achievement of specific individual and corporate objectives) fail are common
among companies and include the following:
1. Poor Communication With Employees
Poor communication about the plan demoralizes personnel. Management must
communicate the following directly to each participant in the plan.

The dollar amount of the bonus targeted for that employee with the understanding
that it will be paid only if both the employee and company meet all their objectives.

Company objectives that must be achieved before the bonus is paid (e.g., achieving
some threshold of profitability and meeting safety-related goals).

The objectives the individual must achieve personally in their position.

Most employees base their perspective on how the company is performing by how hard
they personally are working. Management is responsible for communicating company
performance throughout the year so employees expectations for bonuses align with reality.
Keeping employees informed about company performance does not mean they need to
know how much the company is making. If a company is budgeted to make $100,000
pretax profit this month but only makes $75,000, simply tell employees that the company is
achieving only 75 percent of its profit goal.
2. The Strategy for the Company is Not Developed
One of the biggest failures of incentive compensation programs is they often do not take
into account all the key drivers that will make the company successful. The best incentive
plans promote behaviors that are consistent with the companys strategic plan, marketing
efforts, financial goals, productivity processes, and personnel development. For example, if
the company performs negotiated, high margin, value-added work, the bonus should factor
in the level of customer satisfaction. If the companys strategic goal is to be involved in the
local community, a portion of the bonus should be tied to an employees individual
involvement in boards, associations, and other community events. Without purposeful
linkage to the companys strategy, incentive plans risk promoting behaviors that are
contradictory to the stated strategy.
3. Best Practices Do Not Exist

If the company lacks well-defined best practices in the field or does not drive financial
performance through strategic or business planning, implementing an incentive plan alone
will change little. The bottom line is employees may work harder, but their hard work may
not significantly impact profitability. They will continue to install work unproductively, and the
companys business strategy will remain flawed. Examples of best practices that can
significantly impact a construction business performance include:

a zero-injury workplace;

pre-job planning;

short-interval planning;

daily crew planning;

a bid-selection process;

an estimate-review process;

a change-order process;

post-job reviews;

people development; and

negotiated work.

4. The Plan is Ineffective at Driving the Right Behaviors

If best practices are well defined but employees do not follow them consistently, it is the
same as having no processes at all. The ultimate goal is profitability and providing an
adequate return on investment to shareholders. Unless the company has a market niche or
performs negotiated work that provides extraordinary profitability, the companys best
chance of success comes when its people:

work safely;

work efficiently by using best practices;

produce quality work;

satisfy customers;

motivate subordinates; and

communicate well with others.

5. The Company Has a Poor Employee Performance-Evaluation Process

The employee evaluation process is a painful exercise in many companies. First,
supervisors must write a short summary of a subordinates performance on subjective
issues that often include:

job knowledge;

problem solving;

professionalism;

motivation; and

interaction with others.

These criteria are subjective and rather meaningless in driving the right behaviors in
employees. The performance metrics for a controller may include the following objective
(vs. subjective) metrics:

timely financial statements (statements issued by the 10 th of the month);

accurate financial statements;

timely and accurate work-in-process reports;

age of receivables equal to less than 40 days of sales (assures cash flow); and

timely filing and payment of payroll and other tax returns.

Performance metrics for a foreman may include:

safety (as measured by audits and number of incidents);

quality (as measured by rework and customer surveys);

customer satisfaction (as measured by customer surveys);

labor budget to actual labor costs (ability to meet the labor budget);

total cost budget to actual costs incurred (ability to meet the jobs budget); and

schedule performance (ability to meet the schedule).

The evaluation process should tie in with the incentive compensation plan. The metrics
identified for each position should be meaningful. Evaluations are of little value unless they
are simple to create and provide periodic feedback (at least quarterly) to the employee.
6. Performance is Measured by Profitability Alone
The common measurement of success is net income reported on a financial statement.
However, it is not always the most complete measurement. Consider cash flows. Profits are
meaningless if a business cannot collect receivables and runs out of cash. The worst case
is the firm that must borrow money to pay bonuses. If the company is truly profitable, then
cash should be available.
Many bonus plans in other industries are not driven by profits, but free cash flow. Free cash
flow is the cash generated from business operations less the acquisition costs of new
capital assets such as equipment, trucks and cars (regardless if they are financed or paid
for with cash). A company that consumes most of its cash flow by acquiring new equipment
will have little, none or negative free cash flow, but may be very profitable because the cost
of new fixed assets is allocated over several years on a financial statement.
Other issues such as safety, customer service, quality, and developing subordinates are
essential to the long-term profitability of the company and often are included as measures of
success and performance.
7. The Best People May Work on the Worst Jobs
In a project-based beat-the-budget incentive plan, the best people may suffer if they are
placed on the toughest jobs. Sometimes the best job a field manager can do for his
company is to save it from losing a considerable amount of money due to earlier estimating
errors or unforeseen problems. In a project-based incentive plan, this ends up affecting the
compensation of the best people because they spend the majority of time on jobs with little
or no chance to beat the estimate unless some allowance is made.
8. The Plan Promotes Divisional vs. Corporate Behavior
Plans that primarily provide bonuses for division vs. company-wide performance can
promote me first behavior. The companys success comes secondary to an individuals
own financial success. Under these plans, senior managers may go to extremes to promote
their division at the expense of the whole company. Then the firm suffers. An exception is
the bonus paid to foremen who save labor hours on a project. Labor hours are the main
variable a foreman can control and are the best measurement of field productivity.

9. Costs are Miscoded and Resources are Hoarded

There are many different tricks of the trade that field managers can use to make one project
look good at the expense of another. Plans that pay bonuses based on the success of
individual projects but do not set up any consequences for project losses promote a me
first mentality at the cost of other projects. Field managers may fight over the best people
and equipment, hoarding them without regard to any other projects in the company.
10. The Incentive Plan Itself Causes Division
There is always some tension between estimating and operations. However, with some
incentive compensation programs, when an estimator leaves something out of the estimate,
it affects the project teams compensation, adding to the tension. Additionally, if field
managers are moved on and off jobs, issues about how to split bonuses arise because
everyone will not agree on who really contributed to the projects success.

Effective incentive plans:

Recruitment and Retention Effects
Implementing a pay for performance system has been shown to
resolve organizational problems because it aligns the preferences
of firms and employees. In addition, creating a pay for
performance system serves as a sorting mechanism to identify
and attract the most capable employees. This type of system has
shown that individual pay incentives significantly improve
productivity.5
Pay for performance systems have further been proven to have
two advantages for organizations: attracting more high-quality
employees and motivating employees to exert more effort at their
jobs. There is some risk involved with pay for performance
systems, and the incentive effects of the system may negatively
impact risk-averse employees since they have a fear of failure
under this plan.[4]
Productivity Implications
Daniel Pink, author of Drive: The Surprising Truth about What
Motivates Us, asserts that using carrots and sticks to motivate
is counterproductive to motivation and productivity. Companies

that have switched from salaries to individual incentives have

increased productivity dramaticallysome by as much as 44
percent. Linking pay to performance not only motivates but also
helps to recruit and retain the most talented employees. New
graduates seek to join organizations that make use of
performance-related rewards, and they have long-term loyalty to
these organizations.[5] The use of variable pay has also grown in
popularity, as 67 percent of companies offer some form of
variable compensation to employees below the executive level.
Likewise, the practice of compensating managers below the
senior executive level with stock options and other forms of longterm incentives has risen dramatically. This is because
performance-sensitive pay aligns the interest of all levels of
employees with the interests of shareholders.[6]
Features of Effective Plans
Top Management Support
Supervisors must understand the incentive pay process in order
to support and administer it. Oftentimes, a lack of understanding
causes managers to ignore or adapt the process as they see fit.
Moreover, if supervisors are not trained on how to measure
performance, the process will not be standardized across the
company.[7]
Having buy-in from key stakeholders is crucial for the success of
an incentive pay system. For example, if top management does
not support such a program, lower-level managers will place little
importance on effectively administering the program. Hence, a
lack of top management support often leads to a lack of
accountability.[8]
Communication
Consistent and methodical communication is necessary when
implementing an incentive pay plan. It will ensure employees
understand what is expected of them while decreasing the
likelihood of morale problems that result from misinterpretations
of how incentives are awarded.[9] Furthermore, one survey found

that just 25 percent of respondents communicate to specific

employee groups, but of those that did, 74 percent said it was
either an effective or very effective strategy.[10] American
Airlines used effective communication to successfully implement
its compensation plans, as discussed later in this report.
Performance Management
Oftentimes, a flawed performance management system is the
main reason an incentive pay system in not successful. When
designing a performance management process that will be linked
with pay, it is imperative that both employees and managers
know what the individual goals are, how they will be measured,
and how they will be compensated when achieved.
Managers must also be careful to ensure that there is adequate
differentiation between high and low performers. If mediocre
employees are given an average merit increase, they will perceive
that their performance is adequate. Conversely, if excellent
performers only receive a little more in incentive pay than
average performers, they will perceive that the company does not
value their performance.[11]
Appropriate Rewards
The amount of incentive a company should offer to an individual
depends on current income, amount of effort needed to invest,
likelihood of obtaining the reward, acceptance of risk, equity of
reward and contribution, and industry standards. A minimum for
incentive pay is considered to be 5 to 15 percent of an individuals
base pay.[12]
Considerations before Implementing a Plan
The best compensation plans take into account several key
considerations. Before instituting a pay for performance system,
companies should define which employees should be eligible for
the program. Furthermore, it is important for companies to
determine the role of equity in a total rewards framework from
the perspectives of the employee and employer, as well as in

terms of cost. Steps should be taken to (1) review the current

objectives and purpose of the equity plan; (2) identify alternative
rewards; (3) develop a communication plan for how the
effectiveness of the program will be measured; (4) gather
employees perspectives via surveys, focus groups, or internal
research; (5) gather external market information; (6) determine
the costs; (7) develop recommendations for design change; and
(8) create the communication plan. The communication strategy
for the program should encompass the value employees place on
various rewards and how the changes will be perceived by
employees. It should then monitor and manage employees
reactions to the changes in their compensation structure.[13]
Objectives of a Broad-Based Incentive Plan
When creating an incentive plan, the organization has to
determine and clearly define the goals for the program. The
objectives should be aligned with the business strategy. These
goals should be utilized to shape the incentive plan as well as the
expectations and objectives of individual employees.[14] A main
reason why incentive plans fail is because they are introduced as
an inflexible process.[15] The incentive plan should be first
implemented on a small group of employees in order to determine
the flaws and rectify them before implementing them across the
enterprise. Once the plan is implemented, it should be regularly
adapted.[16]
If companies want a pay for performance system, the firm should
define the desired performance and establish methods of
measuring it first. Then, connect goals for individuals, for business
units, and for the company. Meanwhile, track everyones progress
and periodically give back the data to raise everyones awareness
of the program.[17] Sixty-two percent of compensation
professionals report that their organizations did not attempt to
measure the return on investment of their compensation
program.[18]
Degree of Uncertainty

In addition, organizations must consider the degree of uncertainty

when implementing a pay for performance plan. When the firms
earnings are highly variable, too much uncertainty associated
with the realization of outcome-based incentives can cause
employees to reduce effort or take actions designed to reduce the
variability of their pay. It is best when organizations have
compensation systems that have components of both high base
pay and high variable pay.