Andy Grove, co-founder of Intel and Silicon Valley demi-god, teaches that managers have two ways to generate more output from their teams: training and motivation. Training increases the inherent capability of a team member; motivation harnesses that capability to produce output.
One of the easiest ways to motivate a team is with the possibility of more money. Enter, the incentive program – a formal scheme that encourages staff to behave in a particular way, by offering rewards. The most recognisable incentive program is commission based – for example, sales people are encouraged to generate more revenue by offering them a percentage of the value of monthly gross sales. But incentive programs can come in many different flavours, depending on the nature of the organisation and the teams involved.
Although there are various ways to motivate and reward employees (including through an Employee Share Scheme), we describe the essential elements, characteristics and common pitfalls of a traditional incentive program.
Why Create an Incentive Program?
The purpose of an incentive program is to increase the value of the output of its participants. It achieves this by:
- Recognising and rewarding strong performance;
- Aligning individuals’ interests with organisational goals;
- Encouraging behaviours that create a more cohesive and productive team; and
- Supporting personal and career development of individuals.
Recording and rewarding performance also sends a message that your organisation values outcomes. It gives your team the freedom to excel in any manner that achieves the targets prescribed by your incentive scheme. This builds trust and can reduce the need for close managerial oversight.
Essential Elements of an Incentive Program
Incentive programs consist of three key elements: KPIs, targets and rewards.
KPIs, or Key Performance Indicators, are the metrics that matter to your business. They should help to measure the performance of your organisation against its objectives.
A great incentive structure measures both output and input KPIs.
Output KPIs measure the performance or output of an organisation. They are the result of using inputs for a particular purpose and should represent the value generated by the business. Output KPIs are the backbone of an incentive program as they allow management to measure the value created by a team and compare this to a previous period or the output of another team. Output KPIs are also called ‘lagging indicators’ – they are easy to measure but difficult to influence directly.
Input KPIs measure the activities or inputs required to generate output. These are sometimes called ‘leading indicators’. They are easier to effect than lagging indicators but have a less direct impact on business objectives.
For example, a sales organisation aiming to grow its gross revenue could track the number of new leads as an input KPI. This is a ‘leading indicator’ of revenue growth because more new leads usually create more sales and more revenue.
Input KPIs are useful because they give management a ‘leading’ indication of whether the business will achieve its goals. But since input KPIs don’t directly represent the value that a team is generating for the business, they should not be used in isolation. Rather, input KPIs should be paired with output KPIs to give a more accurate view of business performance.
A program should avoid tracking more than 4 or 5 KPIs at a time. Doing so could create competing incentives and confuse program participants. Instead, it should focus on a small number of KPIs, but maintain the discretion to adapt KPIs to changing business needs.
For example, a software startup targeting rapid growth could measure growth in website traffic, website users and revenue. When its objective shifts to profitability, it could measure products per customer and gross profit. Make sure you give your team sufficient warning before changing KPIs.
Targets refer to measurable milestones that reflect the activity (input) or performance (output) of a team. Targets are most valuable when they are objective – when the achievement of a target is a matter of fact, not opinion. This ensures consensus as to when a target has been met.
Targets should be difficult, but not impossible, to achieve. A difficult target will encourage your team to rise to the challenge. An impossible target is discouraging.
Finally, set targets at a level that generates additional benefit for the organisation. Remember, an incentive program should motivate teams to produce more value. This is why management is willing to give away value in the form of rewards. If your program does not generate more value than it gives away, then you should adjust your targets (or rewards).
Rewards are the benefits a team that meets or exceeds its targets will earn. The size and type of reward offered are crucial to the success of an incentive program.
Rewards that are small may not have a sufficiently large motivational effect to change behaviour. Rewards that are too large could cost the organisation more than they’re worth. To strike the right balance, you should consider this principle:
Both the individual and the business should share in any additional value that the motivating effects of an incentive scheme creates.
Rewards are the individuals’ share of the added value. This needn’t be an equal share, but it is important that the rewards under the scheme should grow proportionally with the added value to the business. Importantly, “added value to the business” should be calculated on a gross profit basis. Consider the following example.
The sales team at Widgets Pty Ltd. typically generates $10,000 in monthly revenue. This month, management introduced an incentive scheme. The only KPI is revenue and the monthly team revenue target is $12,000. Management knows that the cost to produce and sell a widget is 30% of the sale price of a widget. So the gross profit margin is 70%.
The scheme works well and the team sells $12,000 worth of widgets; that’s $2,000 more than the pre-scheme monthly revenue. This represents added value to the business (or gross profit) of $1,400 ($2,000 additional sales * 70% gross profit margin). Management should offer part of the additional value to the sales team in the form of a reward.
If the team sells $14,000 in the following month, then the additional benefit of $2,800 (($14,000 – $10,000) * 70%) should be shared with the team. That is, the reward should grow in proportion to the additional value to the business.
The type of reward is also important. Cash is the simplest and most obvious reward. Its value is easily measurable, and it provides the most flexibility for the recipients. But non-monetary rewards like team dinners or events often serve the additional purpose of bringing a team together. Recognition and celebration are an important, informal way of reinforcing an incentive structure.
Non-monetary rewards can be used as a supplementary reward. For example, if a particular team meets its target then it could earn a cash reward, paid to each team member. Also, if all teams achieve their targets, then the whole company could share a celebratory dinner on the management team.
The suitability of non-monetary rewards will depend on your organisation and your people. Sometimes it’s easiest to ask your team what they prefer. It’s also prudent to first seek advice regarding the potential tax implications of providing non-monetary rewards, before including one in your incentive program.
Characteristics of a Great Incentive Program
An incentive program that consists of KPIs that are aligned with the organisation’s goals and that rewards teams for exceeding difficult – but achievable – targets, has all the essential elements of a functioning scheme. But how can you take your program from good to great?
Targets, Processes and Mechanics are Clear.
To effectively change the behaviour of program participants incentives should be easily understandable. It’s the responsibility of the program’s designer to make sure that participants understand:
- The purpose of the program;
- The KPIs – why they are important and how they are calculated;
- The effort required to meet the targets; and
- The reward they should expect to earn if they meet or exceed the targets.
Also, participants should be able to calculate the additional reward for putting in the extra effort, allowing participants to visualise potential rewards.
Equal Performance Should be Rewarded Equally.
A scheme that favours one individual or team over others could create adverse behavioural change. Incentive schemes use psychology to motivate participants. But an unfair or inequitable scheme will have a demotivating effect and could create discord in your organisation – not to mention that it’s unethical.
The nature of your organisation or product could create inequity, even where rules and guidelines are applied equally. When assessing the equity of your program, it’s important to take note of both the rules and the circumstances in which it operates.
For example, imagine two sales teams at Widgets Pty Ltd., under the same incentive scheme, which sell different products. Team A sells red widgets, and Team B sells blue widgets. The teams’ only KPI is gross profit. Imagine a scenario in which a celebrity takes a selfie using a red widget and the product becomes fashionable overnight. Naturally, Team A, which sells red widgets, will be at an unfair advantage, even under a seemingly equitable scheme.
KPIs Reflect the Activity of the Individuals to Whom They Relate.
There should be a logical and proximate link between the actions of the participants, the KPIs and the rewards so as to have a motivating effect. If the link is too remote, it’s difficult for a participant to see the impact that their work has on the organisation and their reward.
For example, an IT support team should probably not have revenue as a KPI. The impact of the team’s work on revenue is too remote. A more proximate KPI might be system uptime or number of outstanding IT service requests or average time to resolve service requests. These are more directly within the control of the IT team and are clearly linked to its actions.
The ‘proximity’ characteristic also refers to the timeliness of payment of a reward.
The general rule is that this month’s result should reflect this month’s activity and rewards for this result should be paid in this month. By measuring and rewarding results as close as possible to the activity that generated them, we reinforce the value-adding behaviour.
KPIs Can be Directly Affected.
Participants must feel that they can impact a KPI to have a motivating effect. A reward of one million dollars, offered to an adult to grow a foot taller would have no effect on her behaviour – she cannot change her height, no matter the potential reward.
The best KPIs are directly actionable and show the impact of additional activity or effort. This works well in theory but, for most organisations, the complexity of running a business means that KPIs are not always directly actionable. Treat this as a principle, rather than a rule.
Easy to Track, Measure and Change KPIs.
Implementing an incentive program incurs administrative costs. Measuring KPIs, tracking them in reports and analysing the results takes time. Building tools to automate and display KPIs requires an upfront cost. The simpler your scheme, the lower these administrative expenses.
A simpler scheme is also more adaptable – a team with one or two KPIs can quickly change its behaviour to focus on a different pair of KPIs from quarter to quarter. On the other hand, a team with 4 or 5 KPIs and a convoluted bonus structure will have difficulty adjusting to change.
These principles describe theoretical best practices. In the real world, designing an incentive program is rarely this simple. In fact, these principles will often conflict with one another. For example, to make a scheme more equitable, you may need to sacrifice clarity or simplicity. Achieving the right balance for your organisation is the key.
It’s essential to assess the impact of your scheme on your business objectives and the morale of your team periodically. By making tweaks based on this feedback, you’ll improve the balance each month.
A well-designed incentive program can motivate a team to perform far beyond its previous achievements. The offer of reward and our natural competitiveness can achieve astounding results. However, these same phenomena have a way of producing psychological barriers to performance in equal measure.
Take note of these common pitfalls to make sure your program creates output, not ire.
1. Participants Feel Their Actions Are Not Rewarded
KPIs should reflect the work of your team. And rewards should be paid accordingly. But some activities of your team will fall outside of your incentive program. This is okay. You should not try to track and reward everything.
Activities like sales and customer support lend themselves to an incentive scheme. They are directly linked to the business’ goals (growing revenue and keeping customers happy, respectively), are easy to track and are directly actionable by each team.
An activity like training and supporting peers is less suitable to measure and reward. While important to the organisation, it’s hard to quantify and track. Such behaviours should be encouraged by other means.
2. Bottom Performers Resent Top Performers
Incentive programs encourage competition – between teams and/or individuals, depending on the structure. The natural competitive spirit is one of the motivating forces that we are seeking to harness.
But competition can breed resentment, especially when one individual or team consistently ‘wins’. The lower performing cohort may feel that the scheme is unfair, or that they have no chance of winning so, “what’s the point?”.
To address this issue:
- KPIs and targets should be reviewed and adjusted to maintain an even playing field; and
- Management should coach the lower-performing team, to lift its performance.
This article focuses on motivation. But we should also remember the training element of Andy Grove’s management dichotomy. By investing in coaching and training, we can lift an underperforming team’s output directly (by building capability) and indirectly (by restoring their motivation).
3. Bottom Performers Hide Their Underperformance in Team-Based Schemes
A team-based scheme – one in which KPI targets are measured for a team in aggregate – aims to encourage teamwork. If one member is dragging his feet, his peers – seeing their chance to earn a reward slipping away – should support and coach him to lift his performance.
But team targets can also create a veil behind which an underperformer can hide. For example, a team of five which consists of four high performers and one underperformer may still meet its target. In this case, the underperformer earns a reward despite his weaker effort.
This situation calls into question the benefits of team-based targets. Their suitability will depend on the degree of teamwork required to execute the incentivised activity. For example, a team of accountants that includes senior and junior members requires each team member to perform separate but mutually reinforcing tasks. In this case team targets are appropriate. The hierarchy within the team will reduce the likelihood of a rogue underperformer.
Mechanics: Making It Work
Similar care and effort should be applied when designing the mechanics of an incentive program. The smooth and accurate execution of calculations and payments will reduce the occurrence of frustrated participants. Keep these three tips in mind when executing.
- Payments should be regular and on time – you wouldn’t make salary payments late; apply the same discipline to reward payments.
- KPI tracking should be in real time – building a dashboard (whether it’s automated or drawn on a whiteboard) will increase engagement with the scheme.
- Maintain discretion to redress unfairness – no incentive scheme is perfect and unexpected circumstances can create undesirable effects. Exercising your discretion to reward an unlucky participant will build trust.
Financial Incentives Are Not the Only Motivation Tool
An incentive scheme should not try to solve every organisational problem. No scheme will align incentives entirely.
You can also encourage certain behaviours through less formal forms of motivation such as encouragement, celebration, a shared mission and loyalty to the firm. Finally, remember that “leading by example trumps everything else” (more wisdom from Andy Grove). There’s no substitute for walking the talk.
Remember to use all the tools available to you to get the best performance from your staff.
The final consideration is the legal characterisation of your program. The key question here is whether or not the arrangement forms a contract on the part of your organisation and each participant or whether you maintain ultimate discretion as to whether rewards are ‘payable’.
If the arrangement forms part of each employment contract, your organisation could be liable, without discretion, to pay a bonus to participating employees if they meet certain targets. This may also limit your ability to make adjustments to the scheme, which could mar its success.
On the other hand, your team may feel there is insufficient ‘buy in’ from management if the program is not codified in a contract.
Ultimately the decision will depend on each organisation. We advise you to speak with an employment lawyer before commencing an incentive program.
A well-designed incentive program harnesses psychological forces to motivate a team to be more productive. Participants feel more impactful and more valued as they contribute to the organisation’s goals.
Take care in designing and executing an incentive program. Balancing the characteristics of a great program and tailoring the essential elements to your organisation will increase the chance of success.
Remember to maintain the discretion to adjust the scheme as business needs change and to redress unfairness. Finally, consider the legal characterisation of your team and your scheme before implementing.
Think we’ve missed something? How do you motivate your team? Let us know your thoughts on LegalVision’s Twitter page.