Insights

In this series of articles, we’ll review some of the most common mistakes that privately held companies make in approaching the question of incentives, before looking at a sketch of what I have seen work well.

Mistake #4: All or nothing

The problems with tying bonuses to budget are exacerbated when the bonus is made on an ‘all or nothing’ basis, such as, ‘You hit budget you get a bonus, you miss budget, you get nothing.’

This structure puts further pressure on budget preparation as negotiating the budget down by just one dollar could make tens of thousands of dollars difference to the take home pay of the manager.

When performance is close to budget in an all or nothing plan, managers are encouraged to do any of the thousand short term things that are at their discretion to improve performance. You may have seen some of these before:

• cutting back on training;

• cutting back on research and development;

• cutting back on advertising;

• asking too much of their people;

• deferring the hiring of new people until the new financial year;

• discounting or providing generous payment terms to bring forward sales into the current financial year;

• deferring maintenance expenditure;

• arguing the interpretation of accounting treatments.

And so on. The list is only as long as the creativity of managers. But this is the key point: instead of spending time on sustainably growing the business, all or nothing incentive plans provide so much pay off for that last few dollars, it’s very tempting for managers to spend their time making decisions that boost short term financial performance and deliver them a bonus, and ignore what really matters to the business, its long term growth.

And of course, if performance is safely over the budget, there is no incentive to make the most of a good year in an ‘all or nothing’ bonus plan. The incentive scheme is effectively dead once budget is reached.

In fact the incentive is to hold back any more upside, as out-performing the budget by too much will weaken the manager’s negotiating position going into the next round of budget discussions. In this circumstance it pays to defer revenue till next year. It pays to bring forward expenses. This is not the behaviour any owner would want, but the behaviour that is encouraged by an all or nothing incentive plan, especially one tied to budget.

Ultimately, an all or nothing plan does damage at a deeper level of the business. The bulk of managers who ‘short term’ the business gain no pride or sense of achievement from their behaviour and the employees who watch on and suffer the consequences become cynical and detached. It can be a very costly error to make in incentive plan design.

In the next article we’ll look at the problems with paying out all of an incentive in one year.