Creating an Effective Employee Pay Structure

Determining the best way to compensate employees is difficult.  Pay too little, and your best people will leave.  Pay too much and your cost structure will hamper competitiveness.  There are many types of bonus systems, paid time off policies, and base compensation pay practices. Which ones have the best balance of ease of administration and efficacy?

Base Compensation

Market pay data is now available for free on the internet.  This is a good place to begin finding information.  For instance, Salary.com has a free tool that shows that a Java developer in Austin makes about $77,000 per year on average.  This sort of data is very valuable for making quick decisions about how far out of whack your current pay rates are for your key employees.

Warning: Don’t send an employee to this site until you’ve looked at it first as if through their eyes.  They might find out that they’re underpaid, and it’s better if you discover this first and start solving the problem on their behalf.

Larger firms are more likely to create pay ranges for job categories based on the value of those job types to the company, and then put a value on each job position in the pay range.  This is subjective and time consuming.  Annual job evaluations are used to peg each employee somewhere in the range for his job position.  A new fad is to use a balanced scorecard methodology to set pay rates for people based on how strategic the job is for the company.  For the vast majority of companies, however, this would be better as part of the bonus plan rather than base compensation.  Connecting bonus plans to strategy is described below.

If the employee is paid by the hour, time tracking automation systems can be used to keep track of hours worked, feed the payroll system, and eliminate buddy punching (if that’s a problem for your workforce).  Some of these systems place emphasis on punch rounding, an example of which is paying people in 15 minute increments.  Increasingly, companies are just paying for every minute worked since it is simpler to automate, easier to understand and more fair.

Paid Time Off (PTO)

In the relentless talent wars of today, PTO policies based on seniority in the industry rather than seniority in the company are becoming more common.  General PTO plans that specifically state that unused PTO evaporates when the employee leaves the company for any reason allow you to give more PTO to the ones that stick around.

Generalized PTO plans are simpler to understand and administer than those that separate sick and vacation days, and they favor healthy, honest employees.  Plans that include a specific number of sick days encourage people to lie about being sick, forcing the company to play detective.  In our modern information-based economy where most workers must be treated as volunteers instead of slaves, this creates the wrong culture.

If you pay people to be sick, they’ll find a way to get sick.

If you’re subject to the Family Medical Leave Act, you should split that accrual off from other PTO in order to ease the task of reporting this data to the federal government.

Incentive Pay

Bonus plans are where compensation structures get powerful and interesting.  The purpose of a bonus structure is to further your company’s strategy.   That means you have to have a strategy that is well formed and clear enough to build a bonus program around.  Many companies don’t have that.  They exist on inertia – they have a strategy, but it’s an implicit one.

Before you have a strategy, you have to have a vision.  Then you can develop key performance indicators and build your bonus plans on those.  How do you find a vision?  It’s easy.  Ask yourself, “What does my company do that makes the world a better place?”  It’s probably what people are paying you for.  Doing more of that is your vision.

Martin Luther King Jr. had a morally compelling vision: multiracial peace with justice.  Your business needs a morally compelling vision, too, if you want to hire the best and retain them.  At my company, our vision is to enable people to invest their time wisely on work that the market rewards them for.

King had a strategy to achieve his vision: nonviolent protest.  If he’d had a key performance indicator (KPI), it might have been something like ‘number of violent incidents per protester’ and he would push his organization to reduce that metric over time.

KPIs are metrics that tell you if you’re achieving your strategy and how fast.

Once you have a vision, a strategy and a few KPIs, you’re ready to develop bonus plans around them.  Here are a few examples of how to do this for a consultancy:

Billability

Let’s assume that part of your strategy is to keep consultants highly billable most of the time.

Billability, more typically termed ‘utilization rate’, is the percentage of time in a given period during which an employee or set of employees are working in a revenue producing capacity.  You must configure your timesheet system to track whether work is considered billable to the customer or not.  Then utilization for any period, group or person is found by the formula B divided by T, where:

B = billable hours for the employee or group in the period

T = all hours worked for the employee or group in the period

Most organizations are trying to keep utilization above 70% or so.

So your incentive system might give a consultant a bonus of 3% of his annual salary in any quarter where his utilization rate exceeds 70%.  If he does this all year, it’s a 12% bonus.

Percentage of projects profitable

Here is a KPI that can really turbo charge your business.

Consultancies often have projects which lose money for the company.  Due to an inadequate understanding of costs, many of these go unnoticed.  Suppose that you set a strategic goal for your company of ‘no unprofitable projects’.   Getting direct per-project cost data from a timesheet system is easy.  Getting indirect data (such as sales or accounting time) correctly applied to the direct costs increases complexity.  Connecting all this to revenue data gives you per-project profitability.  Once you have that data you can work on your KPI of percentage of profitable projects and try to maximize it.  The formula for this KPI for a given time period (usually a quarter of a year) is:

Per Project Profitability (PPP) = # of profitable projects  /  # of projects

And you should seek to maximize this number.

So your individual bonus program might take the percentage per project profitability for a given individual and apply it to his maximum possible bonus per quarter.  For example, if Joe worked on ten projects and three were profitable, his PPP would be 30%.  If his maximum quarterly bonus is $10,000, then he would get $3,000 that quarter as incentive pay.  This would encourage him to make all the projects he’s working on profitable and avoid the ones that are not, which may be the behavior you’re looking for if ‘no unprofitable projects’ is your strategy.

Other Considerations for Incentives

Some companies will hire a person with the idea that his bonus will be metrics based and then delegate the measurement of those metrics and the awarding of that bonus to the employee’s manager (or in some cases to the employee himself).  This rarely works well.  Accountants have known for centuries that processes are more effective when duties are separated.  For example, the person who deposits daily sales into the bank is not the same person who records those sales in the accounting system.  This increases accuracy and eliminates fraud.

Likewise, the process for awarding KPI-based bonuses should have duties separated.  The person who calculates the metrics should be different than the person who collects the data for those metrics and the award of the bonus should be a separate duty as well.  There should be an approval mechanism that is adhered to.  If not, you will soon fall into a pattern of awarding certain people their maximum bonus every quarter regardless of how successful they were on their objectives.

That’s a big mistake, and a common one.

Conclusion

If your base compensation is out of kilter with market averages for various job categories, look on the internet at the free information that is available and start working to fix that problem.  If your PTO plan separates vacation and sick days, merge them.  For bonus programs, make sure they’re tied to the company’s strategy and that they can be implemented in a way that doesn’t depend solely on the discipline of one manager.  Seeing compensation in this light will drive your company’s success, which ought to be your main focus.

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