Over Simplified Bonus Programs Can Lead to Negative Results

Sep 19, 2013

A few weeks ago I was visiting with a client who is the owner of a very successful manufacturing facility. We were talking about our business backgrounds and this owner mentioned to me that one of his earlier jobs was working for a manufacturing company where he was offered an annual incentive bonus arrangement. This bonus was based on management’s identification of several factors that he was expected to achieve and his bonus was based on his level of success at meeting these predetermined goals.

His conclusion, like many others in his same position, was that if somebody is willing to provide him hard and fast goals based on several financial ratios that he would always make those goals so that he would receive the maximum pay available. That led to a conversation about how incentive payroll systems can work against the company and force employees to “hit” certain targets to the exclusion of all others.

I have seen various incentive bonus programs that are mathematically based. My experience indicates that in order to get a balanced approach (from the employee relative to overall improvement of firm profitability and cash flow) the actual formula for computing the bonus ends up being so complex that most employees are unable to grasp it and thereby manage it.

As soon as you come up with one or two mathematical computations, unless the employee’s job is extraordinarily narrowly defined, the employees will do what is necessary to make their goals to the exclusion of all other financial concerns.

I have several favorite stories on this subject. One of them was related to a client who was experiencing stock-out interruptions in his production line. When raw materials were improperly inventoried, his production line would be down, sometimes for extended periods, until the stock-out conditions were rectified by some extraordinary means to get product in the door. In an effort to avoid such stock-outs in the future, the owner gave his purchasing agent a goal that had the purchasing agent earning maximum bonuses if there was never a stockout on the shop floor.

By the next year the employee had earned the maximum bonus because the stockouts were completely eliminated. However, the company’s inventories had ballooned to such a point that the cash management had become a daily chore because so much of the working capital was tied up in extraordinarily large inventories which were necessary to ensure that the purchasing agent achieved his maximum bonus.

The moral of the story is that if you are going to implement a discretionary bonus plan to achieve balanced company-wide positive results, a formula based plan has to have many different measurements to be successful overall. Simple one time or two-part formulas will only work with those employees with the narrowest of all possible job responsibilities.

Consider setting general goals for the employee with an overall review of operations for which the employee is directly responsible. Therefore, he or she must achieve specific goals but still remain accountable for positive results in all areas of their responsibilities. The ultimate call should be left to the judgment of a senior member of management who has a more comprehensive view of the employee’s overall impact to the company. That kind of a bonus arrangement, particularly in a closely held environment, forces the employee to achieve positive results in all of their given areas without excluding one part or another. There are numerous examples I can cite, some of them humorous, where overly simplified bonus programs created unexpected negative results.

Categories: Cost Accounting