A growing number of companies use a variable compensation plan, which links a portion of an employee’s earnings directly to performance. It is a form of payment that goes beyond a standard base salary and fluctuates based on achieved results. This approach is designed to reward employees for their contributions to the company’s success.
Defining Variable Compensation
Variable compensation is a component of an employee’s pay that is not guaranteed and must be earned. Unlike a base salary which remains consistent, this “at-risk” pay fluctuates based on performance. This performance can be measured against individual, team, or company-wide goals.
The amount of variable pay an employee receives can change with each pay period, quarter, or year, depending on the plan. By tying compensation to specific outcomes, companies aim to foster a culture where employees are invested in achieving business objectives.
Common Types of Variable Compensation Plans
Bonuses
Bonuses are one of the most common forms of variable compensation. They are one-time payments awarded for achieving specific, predetermined goals. These goals can range from individual performance targets to the successful completion of a team project or overall company profitability. Bonuses are paid out annually or quarterly and serve as a direct reward for past performance.
Commissions
Commissions are a form of variable pay used in sales roles. This model compensates employees with a percentage of the revenue they generate from the sales they close. For example, a salesperson might earn a 5% commission on every deal they finalize. This structure directly incentivizes employees to drive business growth.
Profit-Sharing Plans
Profit-sharing plans are a type of variable compensation where a company distributes a portion of its profits among its employees. These plans are designed to cultivate a sense of ownership and shared success, as employees benefit directly from the company’s financial achievements. Payouts are made on a quarterly or annual basis and can be given in cash or as contributions to a retirement account.
Stock Options and Equity
Stock options and equity grants provide employees with an ownership stake in the company. Stock options give employees the right to purchase company stock at a predetermined price, while equity grants offer direct ownership of shares. This form of compensation is common in startups and high-growth companies, serving as a long-term incentive to align employee interests with the business’s success.
Gainsharing
Gainsharing is a group incentive plan that rewards employees for improvements in operational efficiency and cost savings. Unlike profit-sharing, which is tied to overall company profits, gainsharing is linked to the performance of a specific group or department. When the team achieves cost reductions or productivity gains, a portion of those financial gains is shared with the employees in that group.
Advantages for Employees
One of the primary advantages for employees is the potential for higher earnings beyond a fixed salary. This structure provides a clear link between effort and financial reward, giving employees a greater sense of control over their income. By excelling in their roles, employees can significantly boost their overall compensation, which can lead to increased job satisfaction and engagement.
Advantages for Employers
For employers, variable compensation plans are a tool for aligning employee actions with company objectives. By tying financial rewards to key performance indicators (KPIs), companies can ensure employees are focused on goals important to the organization’s success, which fosters a results-oriented culture. These plans also offer financial flexibility by helping to manage labor costs. Since a portion of pay fluctuates with company performance, compensation expenses are lower during less profitable periods. Furthermore, offering performance-based incentives can be a differentiator in attracting and retaining high-performing talent.
Potential Disadvantages and Risks
For employees, the primary drawback of variable compensation is income instability. Since a portion of their pay is not guaranteed, their earnings can fluctuate, making financial planning more challenging. This can create a high-pressure environment where employees feel constant stress to meet targets, which may lead to burnout. From an employer’s perspective, designing and administering these plans can be complex. It requires careful planning to set fair and attainable goals, as unrealistic targets can demotivate employees instead of encouraging them.