The fact that the recent furore over bankers pay has given the term ‘bonus’ a bad name is a cause for concern as, when used appropriately and designed well, bonus schemes are a useful tool of management.
Indeed, the problems of the investment banking industry could have been avoided if the following basic rules had been followed:
- Aligned to the business. The reward should always be linked to the goals of the organisation. I know that this sounds obvious but it is surprising how many organisations fail to observe this most basic of rules.
As an outstanding (and amusing) example of bad practice, I was recently told a story about an American fast food company who specialise in selling fried chicken. The person who told me the story was an independent consultant who had been asked to visit one of their restaurants to discover the reasons why that particular restaurant was so successful.
On arriving at the restaurant he congratulated the restaurant manager on being the most successful in the country and asked him what his secret of success was. The manager explained that the company measured their relative success on the basis of ‘chicken efficiency’. This was the percentage of chicken that was sold each day relative to the amount that had to be thrown away. In other words, if you cooked too much chicken, your chicken efficiency would be low, cook the right amount and it would be higher.
When asked how he consistently achieved chicken efficiency of nearly 100%, he explained that he stopped cooking chicken at 9 pm each evening (the restaurant closed at 10 pm) and, if people turned up asking for chicken after they had run out, he told them they would have to wait until he cooked some more. In most cases, they didn’t bother waiting and so they lost the business. When asked whether this approach was in the best interests of the business he replied; “It makes no sense to turn away business but it is the best way of ensuring high percentage chicken efficiency, and that’s what I get paid on.”
- Keep it simple. It is a fact that incentive schemes work – pay people on sales and you will sell more, pay them on profits and you will improve your profitability, pay them on cost savings and your costs will fall. The danger is that when people who don’t fully understand bonus schemes see this they think; “Wow! You can make anything happen with a bonus scheme!” They then get to work developing really complicated schemes that they see as an alternative to actually managing people. If only life were really that simple!
I recall the case of an IT company that decided that it was not sufficient that the sales force should sell hardware, software or services, it wanted everyone to sell all three. It therefore included an element in the bonus plan called ‘business mix’, which set minimum targets for each element. If you failed to achieve the minimum target for any one element, the bonus payment was reduced by 50%.
For some sales people the targets were easily achieved, and therefore irrelevant. For others they were more challenging, which created an incentive for them to find a way around the rules. In those cases, most of the sales people simply explained the stupidity of the scheme to their customers, bundled the things they were finding difficult to sell with the items the customer wanted and discounted their cost off the overall deal. The net result was that the customer paid the same amount, the sales person received their bonus, the people who invented the scheme thought it was working but profit margins fell as the company was effectively giving products away.
- Focused on the real tasks. Once you have defined what it is you would like to target your people on, you then need to ensure that the results you will be measuring are directly linked to the efforts of the individuals concerned.
For example, I once did some work with a sales director who felt that his salesforce were under performing.
The salesforce were targeted on revenue, all had the same annual target and all had similar sized territories. This all seemed reasonable but on further investigation I found that each sales person had, on average, more than 100 customer accounts. Now I don’t care how good a sales person you are, no one can actively manage relationships with over 100 customers! When we then looked at the proportion of the business that each sales person won as a direct consequence of their actions relative to the total amount of business they were credited with, the figures ranged from around 20-40%.
This meant that if a person worked hard and did exceptionally well they might achieve 110-130% of their on-target bonus, whereas if they took life easy they could guarantee that they were not going to earn much less than 80-90%. The result was that life was just too easy for the slackers and not sufficiently rewarding for the high performers.
As a consequence, we set up a separate service to manage the smaller accounts, revamped the bonus scheme and halved the size of the salesforce. Within 2 years sales had doubled while costs fell by more than a fifth.
- Proportionate to the effort. To be effective the bonus scheme needs to make payments that are of a sufficient size to make a noticeable difference to the recipient’s standard of living.
Most people who receive a bonus will also receive a base salary. The purpose of the salary is to provide the employee with a guaranteed income so that they can meet their regular expenses. But I see it as more than that – I see the salary element as providing the employer with the right to enforce certain values, standards and disciplines and to expect a minimum level of effort and commitment. The bonus is to provide the individual with the incentive to over-achieve and to allow the earnings of different people to vary in line with the results they deliver.
This approach only works well when the ratio of the bonus to the salary elements are kept within reasonable limits. Obviously, if the bonus is too small it will not have a significant impact on performance, but the more serious consequences occur when the bonus element is too large.
The reason too large a bonus is a problem is because it diminishes the control the organisation has over the individual – which is precisely the problem many of the investment banks have encountered.
For example; imagine that you have a salary of £75k and that each year you expect to earn an additional £25-50k in bonus. In this scenario, you are likely to pay close attention to the company’s policies and procedures as most of your income comes from your salary. A promotion therefore could lead to a significant increase in income.
Now imagine that your salary is still £75k but that your potential bonus this year is £1m. In this scenario, the potential upside of achieving your bonus is so great that the salary is completely irrelevant. You are not working in this company because of its career opportunities and you are not really interested in its policies and procedures – you are here for the bonuses and nothing else! The company therefore has little or no control over its employees – which is precisely what happened in the case of Nick Leeson at Barings Bank, to quote just one of many examples.
While it is undoubtedly true that the bonus schemes in the investment banking industry will have been a significant factor in causing excessive risk-taking, it does not follow that all bonus schemes are bad. Far from it, when structured appropriately, a bonus scheme can be a major contributor to outstanding success.
In planning bonus schemes for your own organisation, just remember the following: First, think carefully as you are likely to get what you wish for – if that is not what you really need, think again. Second, remember that the people who will be paid by your scheme have a significant incentive to find loopholes in it – if there are any, they will find them. And lastly, take account of the design criteria mentioned above.