How to Design an Effective Bonus Plan

So, what are the key ingredients of an effective bonus plan? This question is one that I have wrestled with over a number of years. Based on experience, I have learned that a bonus system should incorporate 5 specific elements to in order to be an effective motivator. I discuss these below.

My philosopy of bonuses is straightforward. A person's paypacket is for his or her regular work. The paypacket should suffice as appropriate compensation for someone who performs as expected. If she performs her duties as requested, and does an adequate job in that effort, then the paypacket is her reward.

A bonus, on the other hand, is a reward for doing something more and it has a two fold objective. It is, foremost, compensation for work performed at a level above what is expected. But it is also a tool. A very effective tool I might add. It allows a CEO to put a spot light on a specific objective that must be accomplished in a particular time period. Achieve that objective, and you will be rewarded with cash or stock remuneration. It is this aspect of the bonus that I like best. People can be motivated by money. If you want to motivate a person to achieve a certain objective, put a price tag on what it is worth to you. When an employee hears "get that system installed and operational in one quarter and you will earn £20,000 in bonus money", that tends to focus his mind on making sure it happens.

Now, onto the elements that must be incorporated in any bonus plan to maximize its effectiveness.

Timely - This means quarterly, not annually. An annual bonus simply takes to long to bear fruit. Also, consider the challenge of laying out a specific set of objectives in January that will still be relevant to the company in December. Not very likely. The quarterly bonus has one more attractive dimension. It gives the management team and the board a reason to evalute people on a frequent basis - and adjust priorities as needed. That is extremely valuable.

Meaningful - The reward being offered has to be a motivator. What that extra pound or stock grant amount is depends on a lot of factors. Just make sure the bonus matters.

Predictable - The best bonus plans are ones in which a person can easily calculate what he is going to earn. This means emphasizing objective measures of performance. I hate subjective standards when it comes to bonus plans. Making an employee guess what he might earn is not a motivator. Lay it out in with simple maths. To that end, the components of the bonus calculation should include no more than 3 variables. For instance, a head of Operations might be bonused on 3 measurements: COGS, product shippments and customer satisfaction results. I have seen too many bonus plans with 15 + factors driving the bonus award. That is too many. It makes it nearly impossible for the employee to quickly assess how his contribution to a given task will affect his bonus. And ultimataly, you want him thinking that way. You want to influence how he spends his time. When an employee must make the inevitable trade-off between doing one thing versus another, you want the information provided by the bonus to guide his efforts.

Consistent - The structure and mechanics of the bonus plan should be remain consistent over time (as much as possible). This means that things like the payout frequency (quarterly), the bonus amount (% of salary for instance) and the number of variables in the bonus (2 or 3 is best) should remain constant. What can change - and likely should - is the specific activity or result that the bonus will be based on. For instance, the Head of Engineering may have her bonus for Q2 based 50% on the delivery of a certain product and 50% on hiring objectives. The next quarter, all of her bonus might be based on opening an offshore development center by a certain date. It is fine to change the specific activity being bonused, what should not change (at least not often) is the method by which a bonus is calculated and paid.

Fair - The purpose of a bonus is to motivate certain behavior to obtain certain results. So it makes a lot of sense to ensure that the employee can actually influence the results she is being bonused on! That is what I call fair. Seems obvious but it doesn't happen often enough. In my opinion, "group goals" suck! Remember what the bonus is for. It is to communicate to the employee what you - the CEO or board - find important and to motivate him to achieve certain results that you desire. This requires a bonus scheme that he can influence.


My final advice. As you put together your bonus plan, ask yourself, is the reward being offered Timely, Meaningful, Predictable, Consistent and Fair. If so, you probably have the makings of a bonus plan that will drive the results you are looking for.

(with thanks to Big Billy)