“Wow! That was more like it,” said Annie as we left the Skywalk on the 50th floor of the Prudential Tower last Friday night. “That party had some high energy going for it. Those people must really have had a good year! ”

My wife had listened to the company CEO toast the staff of 40 for “the best year ever” in its 20-year history as the champagne glasses were passed around prior to the surf ‘n turf dinner. And she had heard the buzz as people table- hopped introducing spouses and other guests to their co- workers, the camaraderie fueling a strong start for the New Year.

In contrast, three weeks earlier we had attended another weekend holiday party in a side room off the manufacturing floor of a different client. The employees and guests were equally well-dressed, the food and drink equally plentiful, but the attendees were broken into small knots of people–segregated, it turned out, by work groups. The party lacked cohesion; the total group wasn’t unified. Despite the best efforts of two musicians, the spark was missing. It was hard to believe that the second company was also finishing the best year in its four decades, one year after one of its worst years ever.

The difference? The first company was a team – well-integrated, mutually supportive, jointly committed to a very positive top and bottom line, feeling rewarded by their party venue, and very much aware that a further reward would show up in their January paychecks. The second group functions largely as autonomous workers at individual work stations, each contributing a discrete operation, but having no stake beyond the weekly paycheck. They may have gone from worst to first, winning the industry Super Bowl in 2005, but the view from the side room looks like the same old sandlot to most of them.

To his credit, the owner of the second company, Mark (not his real name) is fully aware that his corporate culture breeds skepticism, if not cynicism, about management’s efforts to improve productivity, to develop teams, to integrate work flow. The forty men on the floor have seen sales increase by 50% while the paychecks for the old hands have actually declined – additional personnel and newer, more productive equipment have reduced overtime. Mark is more than willing to share the rewards, but only if it will change behavior, improving individual commitment and productivity.

As I think of the continuum of employee incentive systems that my clients have initiated over the years, at opposite ends of the pole are a) individualized incentives in which people are rewarded based on a specific set of metrics and b) group incentives which result from the performance of the entire company. Within this lies a broad spectrum of gradations involving objective and subjective measures, contingency payouts, relative vs. absolute performance, participatory vs. top-down goal- setting, etc.

In my experience, good incentive plans are characterized by seven essentials:

1. Incentives which reward positive behavior and outcomes in the context of overall company goals – for the individual, for the work group, and/or for the company. The standard job with the standard effort gets the standard paycheck. The bonus is for achievement above and beyond the standard.

2. The more immediate the reward, the more committed the action. Owners and top managers may take the long view of strategy and compensation, but the time horizon for many of those who turn out day-to-day product is next week’s check.

3. Some contribution to, if not control, of the outcome. Without this, the employee has little reason to change. Education is critical to everyone’s understanding of how he/she contributes to the whole.

4. Keeping it simple. The more conditions that are attached to the reward structure, the more likely people are to try to “game” the system. And it can drive a controller nuts trying to keep track of multiple permutations.

5. Regular status reports. People want to know the score. Are we making it or not? How am I doing? Most importantly, what’s the likelihood of a payoff, soon?

6. A continuous feedback loop to evaluate how the system is working. If it’s not producing the desired effect, scrap it. Incentive programs are a two-way street: when you establish the bonus formula, make sure there’s a quid pro quo and be doubly sure that you retain final discretion regarding disbursement.

7. Prompt payout. There’s nothing more deflating for an employee to hear than “You’ve earned it, but we can’t afford to pay it right now.”

Mark’s management team has decided to scrap the old bonus structure, which was based on achieving monthly production and revenue targets. Too many critical elements were simply out of the control of the work group. Instead, they’ve gone back to the basics: “when the tide comes in, all the ships go up.”

Having enlisted my help to educate the staff about “what happens to the profits,” the owner has committed 20% of the “free cash” (see sidebar) in 2006 to a bonus pool which, with a repeat of 2005, should be equivalent to three or four weekly paychecks for everyone on the staff.

When that happens, they’ll be making their own music at the 2006 holiday party, perhaps even with a better window on the world.

Alligator Bites

“Cash-based incentive pay plans are supposed to accomplish two major goals. One, obviously, is to motivate employees. The other is to turn a corporation’s largest single fixed cost – payroll – into a partly variable cost that can float up and down with the fortunes of the business. It is well established that such plans often fail at the first task if they are too vague…

“According to ‘The Knowledge of Pay Study: E-mails from the Frontline,’ a 2002 survey published by WorldatWork of more than 6,000 managers and employees at 26 organizations, only 24 percent of employees agree that their cash bonus plans actually change their behavior. Sibson Consulting senior vice president Peter LeBlanc, who conducted the study, thinks that if salespeople and executives (who typically are highly attuned to incentive pay) were excluded from that group, that percentage would drop even further.

“Moreover, few employees actually understand how their pay and performance are connected; only 28 percent say they know the size of their bonus ‘well before it is paid.’ Indeed, even ‘right before it is paid,’ 41 percent of employees do not know the amount. ‘In other words, there is too much discretion in the eyes of employees,’ sums up LeBlanc. The only way cash bonus plans work, he adds, is if they are transparent. That means employees must understand exactly how performance – both theirs and the company’s – translates into dollars on their paychecks, and they need frequent updates. ” [emphasis added]

– Tim Reason, a staff writer, published in CFO Magazine

Draining the Swamp

It’s critically important to be able to fund the pay-out of performance rewards on a timely basis. Occasionally, especially in the midst of rapid growth, the need for working capital increases in order to fund rising inventory and/or receivables. This, in turn, simply sucks up cash generated by operating profits. And cash surpluses attributable to depreciation may be paying down equipment loans or servicing other debt.

Before you commit to that bonus plan which is over and above your regular budget for wages and salaries, push the numbers just a bit further to see if you’ll have the cash to pay for your success. As I outlined to client number two (see main article), he needs to know what his total obligation will be to repay principal on his bank loans in 2006, and he needs to have a good idea of what he’ll be committing from internal cash (not from more bank loans) to purchase new equipment.

Repayments of debt principal plus capital purchases are uses of cash outside of the normal operating budget. At a basic level, they are offset by operating profit and depreciation as sources of cash. Thus, the first use of profit is for debt and internally-financed equipment.

So what level of profit do we need before we start seeing “free cash” to apply to incentive payouts? The equation looks like this:

(Principal payments on debt) + (unfunded capital equipment purchases) – (total depreciation and amortization expense) = profit-sharing baseline.

In my client’s case:

$300,000 + $50,000 – $228,000 = $122,000 (profit- sharing baseline).

Anything above $122,000 should be available, in part, to the bonus pool.