What is Variable Compensation?

March 14, 2024

100 executives leading businesses with annual revenues between the range of $100 million and $1 billion were surveyed, and 2/3 anticipate continued hiring challenges in 2024.

Variable compensation explainedIn response to this obstacle, it has become clear that a competitive base salary alone is not sufficient to attract and retain talent. Variable compensation is one strategic tool that companies are employing to win the talent battle. This compensation trend directly rewards high-performing employees when the company succeeds. But what is it exactly, and how can it benefit your organization?

What Is Variable Compensation?

Simply put, variable compensation is a portion of an employee's income that fluctuates based on pre-defined performance metrics. It's distinct from a fixed base salary, offering an opportunity for higher earnings tied to individual, team, or company-wide achievements. This approach fosters a results-oriented culture, motivating employees to go the extra mile and align their efforts with organizational goals. Bottom Line: it drives desired performance.

There are two main categories of variable compensation, Short-Term Incentives (STIs) and Long-Term Incentives (LTIs).

A short-term incentive plan pays for performance periods of one year or less, as opposed to long-term incentive plans that pay for performance over longer periods typically ranging from 3-5 years. According to World at Work’s report on Incentive Pay Practices, 93% of privately held companies surveyed in 2021 have STI programs and 51% have LTI programs.

What’s the Difference Between Variable Compensation and Commission?

Most people are familiar with commission-based positions. Your insurance agent, your realtor, and many sales roles across industries are either fully or partially commission-based. But commissions are just a subset within the larger concept of variable compensation.

The biggest difference is that commission is almost always tied directly to sales, whereas variable compensation can be determined by any pre-defined metric or performance measure. As an example, a safety manager may receive variable compensation based on the number of accident-free days on a job site, a metric that has nothing to do with sales.

Additionally, where a commission generally results in a cash payout, variable compensation models can use an unlimited variety of performance-based rewards.

Key Elements of a Variable Compensation Model

Clearly Defined Metrics: Everyone appreciates a bonus that a generous owner or board of directors awards at the end of a highly profitable fiscal year. But this is not variable compensation if the bonus is not tied to predetermined metrics or goals. Metrics including financial measures are established to measure individual, team, or company performance. This could include sales targets, customer satisfaction ratings, productivity, quality, profitability, or project completion deadlines. If those targets are achieved or exceeded, the employee earns additional compensation.

Communication & Transparency: Eligibility, program details, performance expectations, performance period, and payout schedules must be clearly defined and adhered to for employee understanding and buy-in.

Benefits of Variable Compensation

Attracting & Retaining Top Talent: Competitive variable compensation packages can lure high performers and incentivize them to stay. The Harvard Business Review noted in 2021 that, “83% of the 250 largest S&P 500 firms use a formulaic annual incentive plan.” This is otherwise known as variable compensation.

Compensation trends may come and go, but when it comes to talent attraction and retention, ignoring variable compensation could be costly.

Increased Engagement: Aligning individual goals with company objectives fosters a sense of ownership and commitment. Connecting variable compensation with job performance gives supervisors and employees one more touchpoint, and any engagement effort can contribute to job satisfaction and reduce the risk of “quiet quitting.”

Improved Performance: The potential for higher earnings can incentivize employees to exceed expectations and drive better results.

Cost-Effectiveness: Variable pay rewards performance, not simply time spent, potentially leading to cost savings for the organization since if the company or individual does not perform, then the variable pay is reduced or not paid at all. In other words, the costs are not fixed. Conversely if the plan is well designed, the results being rewarded are typically helping to fund the incentives paid.

Variable Compensation Examples

Salesforce: A pioneer in cloud-based CRM, Salesforce offers a robust variable compensation program. Sales reps earn commissions based on exceeding individual and team sales quotas. Some employees are also offered equity compensation packages designed to encourage employees to stay in their positions.

EY: The global professional services firm implements a variable compensation program that considers individual, team, and firm-wide performance metrics. This multi-layered approach motivates employees at all levels to contribute to the organization's overall success.

Building a Variable Compensation Program

Implementing a variable compensation program requires careful planning and consideration that can be broken down into four main steps.

Four Essential Steps:

  1. Define your goals: New programs are most likely to succeed when they are driven by goals, rather than developed as a reactive response to a new trend. What do you hope to achieve with the program? Applicable goals may include boosting sales, improving productivity, increasing profits, , increasing customer satisfaction, and driving innovation. These measures ideally should link back to a company’s business strategy or operating plan.
  2. Choose performance metrics: You have a goal, now it’s time to measure the results relative to those stated objectives. Performance indicators relevant to your organizational structure must be reviewed at regularly scheduled intervals. This gives employees a chance to step up their performance to reach the incentive target. It also allows supervisors and employers to evaluate the motivational effectiveness of the chosen rewards.
  3. Create pay structure transparency: Establish clear and fair rules for calculating and distributing variable pay.
  4. Communicate the program effectively: Clearly explain the program details to employees and address any concerns or questions. In addition to any one-on-one or group discussions about your variable compensation program, the above details should be documented so both employees and employers are equipped to hold one another accountable.

Variable compensation, when implemented thoughtfully, can be a powerful tool for driving performance, enhancing employee engagement, and attracting and retaining top talent. However, it requires careful planning, clear communication, and ongoing evaluation to ensure its effectiveness. By understanding its core principles and leveraging real-world examples, you can craft a variable compensation program that aligns with your business goals and fuels your organization's success.

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