Variable compensation | Definition, types, pros & cons
When your organization only offers a fixed salary, you risk paying your employees to be at their jobs — instead of paying them to do their jobs. The result may be demotivated and unengaged employees.
Adding variable payments to your compensation plan can solve this problem. Variable compensation rewards employees based on their performance, not on the number of hours they spend in front of their laptops.
If well-managed and adapted to your business needs, variable compensation could be the solution you need to give your employees an engagement and performance boost.
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What is variable compensation?
Variable compensation is pay that gets added to an employee’s base salary. It’s “variable” because the amount can change between pay periods; organizations with a variable compensation plan typically pay their employees at least 8% to 19% of their base salary as extra.
Although there are different types of variable compensation, they’re usually performance or growth-based. That means employees get paid more when they meet or exceed targets (or when the company reaches its growth goals).
Why offer variable compensation?
If you’re already paying your staff a fair monthly salary, you might wonder why you should consider a variable compensation plan. Here are three convincing reasons to add variable pay to your compensation management plan:
- Create alignment between employees’ daily tasks and company objectives — Variable pay links rewards to specific goals that fit into your organization’s overall objectives. This encourages the whole team to work towards the same goals and means they’re more likely to achieve them. For instance, if employees have sales targets consistent with their business’ overall targets, the company will be more likely to meet its annual sales quota.
- Incentivize employees to perform at their best — Variable pay encourages employees to perform better for the chance of a reward. A well-managed compensation plan also shows your people what to do to get recognized with a cash bonus or other benefits.
- Retain employees and find talent — Some employers offer variable pay as a hiring and retention strategy. Cash incentives can appeal to high-performing employees because they provide opportunities to earn more and get rewarded for working effectively and making valuable contributions.
What businesses are suited to the variable compensation model?
All kinds of companies can adopt variable compensation, and many do: 76% use some form of variable pay. But organizations performing sales and offering services are most suited to the variable compensation model, as it’s easier to measure the relationship between revenue and employee performance.
For example, the employees at a software company have a lot of potential to boost their organization’s revenue — the sales team by talking to leads and closing deals, the developers by designing a successful product, and the customer support team by helping customers have a positive experience.
Types of variable compensation
When working on your compensation planning, you can pick and choose from the different variable compensation types — which we’ll introduce below. Many companies use more than one (or even all) at the same time.
Commission is a kind of payment that employees receive based on how much revenue they generate for the company directly — usually a flat percentage of their sales or other profits. However, sometimes businesses use tiered commission structures where percentages change as employees reach higher sales targets. For instance, a salesperson might make 5% on all sales up to US$1,000 and 10% on sales above that.
Most commission-based jobs combine variable pay and a fixed salary. For example, sales reps earn variable pay of around US$11,000 and a base pay of US$73,000. Some commission-based jobs (like real estate agents and telemarketers) have a high ratio of commission pay to fixed salary, relying heavily on that portion of their income.
Bonuses are lump-sum payments that employers use to reward their people’s hard work and accomplishments. The main difference between a bonus and commission pay is that bonuses aren’t directly proportional to the revenue an employee generates. Employers often decide whether to award employees bonuses (and how much) using performance appraisal forms and individual objectives and key results (OKRs).
But bonuses don’t have to be an all-or-nothing situation. Employers can decide on payment bands for different levels of achievement. For example, you could award someone 15% of their salary for meeting targets and 25% for exceeding them.
Management by objectives (MBOs)
MBOs is a strategy where management helps each staff member set the targets they need to reach for extra pay. There are usually five steps to the process:
- Decide on or revise company-wide objectives
- Trickle those objectives down through the company and translate them into measurable objectives for each role
- Have employees tailor the objectives to themselves
- Follow and support each worker as they try to achieve their objectives
- Evaluate staff’s progress and award extra pay when they reach or exceed objectives
A key feature of MBOs is that employee goals should follow the SMART framework: goals that are specific, measurable, acceptable, realistic, and time-bound.
With profit-sharing, employers divide a percentage of the organization’s annual or quarterly profits between employees. That means each employee’s bonus depends on the company reaching its target revenue instead of individual performance.
Employers can determine how much of their profit they want to share and how much each employee receives. For example, you can base the percentage on role, performance, time with the company, or a combination of those criteria. Some companies even decide to award the same amount to their entire workforce as a one-time payment for a remarkable quarter.
Pros of variable pay
There are several benefits to variable pay; just remember that you’re more likely to get your desired outcomes if your business is well-suited to a variable compensation plan.
Improving employee experience
Fixed salaries are stable and predictable, but they don’t acknowledge individual employee successes. And your people crave recognition.
Although variable pay isn’t the only way to recognize your employees, it’s a great way to show them they’re valued. For instance, you can use variable pay to reward top performers for outstanding results. That way, your staff will know that you appreciate their contributions and that their work within your organization is making an impact.
When you measure employee engagement in companies that prioritize recognition, you’ll notice the effect it can have. In a recent survey, 89% of companies agreed that recognition improves the employee experience, and workers who receive recognition are 73% less likely to suffer from burnout and four times more engaged.
Keep in mind that financial reward isn’t the only form of recognition, so try to combine it with other types like feedback and praise.
Keeping your organization competitive
Reports show that 57% of companies are increasing their salaries in response to the tightening labor market. This can quickly turn into a bidding war for talent.
But this isn’t an ideal situation for anyone. Businesses have to eat into their profits to ensure they hire the right candidates — or else lose them to competitors. Meanwhile, employees get paid based on demand for their role instead of their qualifications or contributions to the company. This is a surefire way to breed resentment from less in-demand departments where employees are working equally as hard.
Variable pay is a fair way to hold onto talent and stay competitive. You can attract desirable candidates and retain employees by offering them an opportunity to earn variable compensation. That is, provided you already provide a good base pay with benefits and have an interesting incentive pay scheme.
Better employee performance
Variable compensation can motivate workers to perform at their best. With a potential incentive, your people are more likely to produce excellent results and work more effectively. For example, a sales rep will likely try harder to close deals if they’re awarded a percentage of the earnings.
Plus, employees often expect a degree of variable pay in roles like sales and marketing. If you only offer a fixed salary, you might struggle to find top candidates for open positions or discourage existing employees from trying their best to reach their full potential.
Cons of variable pay
When businesses don’t introduce incentives-based pay correctly, they may face some of the problems below.
We discussed how variable compensation plans can keep you competitive in a tight labor market. But companies may find themselves in lose-lose situations if they don’t plan effectively, as offering variable pay can also affect your bottom line.
And why? Even at the best of times, it’s hard to strike the right balance between rewarding high-performing employees and staying within a reasonable budget. And this balancing act involves lots of planning — a crucial step that some organizations unfortunately skip.
Managing a complex compensation plan
Depending on your company’s size and structure, managing variable compensation can be complicated. You need to figure out:
- Your variable compensation budget
- Which types of compensation pay suit your business
- Which roles qualify for variable pay
- Which criteria you want to use to measure performance
- What percentage or amount you want to award to employees
- How you’re going to evaluate each employee’s performance or results
Implementing a variable compensation plan may be time-consuming and stressful. But if you cut corners, it’ll likely backfire.
Developing a toxic workplace environment
Companies introduce variable pay to motivate employees, but a poorly managed compensation plan can have the opposite effect.
Instead of driving your people towards a common goal, variable compensation may encourage a cutthroat mentality. Employees might avoid sharing tools, be reluctant to collaborate, and compete for resources to ensure they meet their targets.
Variable compensation can also cause tension if your base pay isn’t enough to provide employees with a good quality of life. As variable pay isn’t a sure thing, employees may become anxious about whether they’ll be able to cover costs with their fixed salary. This will negatively impact employee experience and make it easier for competitors to lure people away with better offers.
Providing incentives to increase employee engagement
Variable pay could be a great addition to your compensation management plan. Incentives like bonuses and commissions can motivate employees, boost productivity, support recruitment, and retain talent.
But is variable compensation enough to help your employees reach their full potential? Leapsome offers a more holistic approach that looks after your people financially, emotionally, and developmentally.
Our people enablement platform combines compensation, engagement, feedback, and professional development to close the loop and find your people’s key drivers. With Leapsome, you can cover all your employees’ needs.
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