Certain roles in the company call for a bonus as part of the total compensation plan. But what criteria should be used for determining the bonus payout? Common choices include company-level, department-level, individual or some combination of these. These are different from sales commission plans (see related article titled “5 Golden Rules for Setting Sales Compensation Plans“) and are commonly called Management By Objectives (MBOs). The original concept of the MBO was introduced by Peter Drucker decades ago. And although the way MBO bonus plans are administered has evolved over time, it is still is an important part of many management systems today. This article will explain the basic components of an MBO bonus plan and some tips for administering them. I’ve also included an MBO template for you to use.
Company-Level vs Individual Targets
The spirit of an MBO is to reward for individual performance and sometimes also team performance. It’s true that the company-level targets are (hopefully) highly scrutinized and well thought out by the management team. They’ve already been well vetted before you find yourself considering them for incorporation into bonus plans. But how much does any one individual contribute to the overall company’s performance? You might find that you’re paying them a bonus while actually doing less than what’s expected in their job description. Oops!
The closer you get to setting targets on individual performance, the more direct impact the employee will have on their earnings. The trade-off is individual targets are sometimes harder to set than you might think and the possibility for wide degrees of under/over-achievement also exists. So you’ve really got to be careful. Below are some key rules of thumb to keep in mind:
Alignment
Any MBO line item that is based on individual performance should also be tied to company-level and/or department-level goals for the period. Think of a cascading effect. In a perfect world, if individual objectives are met across the company, then it’s likely that department objectives will be met, which means the company objectives will be met. This is just sound management practice in general but when bonus plans are in place the principle should be preserved. To better understand ways to align your employees’ actions with company goals, see Joel Trammell’s post titled Are Your Employees Misaligned?
Focus
Usually, MBO plans are set and paid each quarter. As such, you should only define 2-3 objectives that have compensation tied to them, even if the employee has more than 2-3 quarterly goals. Compensating on four or more objectives causes a couple of problems. First, the amount of money tied to any given objective isn’t enough to cause the desired motivation. Second, a key reason for having a bonus plan in the first place is to promote extra focus and prioritization.
Simplicity
If a particular objective requires a magic decoder ring to figure out if/when/how compensation will get paid, you’re in trouble. Instead, use simple language.
Clarity
This can sometimes be at odds with trying to be simple but it’s important to minimize accidental misunderstandings. One way to do this is to include definitions or examples in the description of the objective. Then make sure to have a discussion about each objective with the employee and ask them to tell you what they think success means.
Subjective Criteria
It’s best if the bonus plan elements have quantifiable metrics that are easily measurable. If you must include subjective criteria, try to describe how the criteria will be applied. For example, imagine a line item that says, “The bonus will be paid based on how successful the marketing campaign is.” What does “successful” mean? Instead, try something like this: “The bonus will be paid based on the overall reach and awareness generated from the marketing campaign as evidenced by social media activity, online and print press coverage and inbound inquiries.” Even though you haven’t set quantifiable targets, you’ve at least described the criteria that will be used to make the subjective judgement.
Quality
Be careful to just set a target without any qualifiers to ensure quality. You should assume the employee will do whatever is necessary to achieve the target. For example, imagine you set a target to “Produce a joint press release with XYZ Corporation”. Doesn’t it matter what the press release is about? Doesn’t the resulting exposure gained through online and print media matter? Include quality-based attributes with your MBO descriptions or prepare to suffer the consequences of “gaming the system”.
Underachievement or Overachievement
Each line item in the MBO plan has a compensation amount associated with it. So what happens if the target is partially achieved or exceeded? If the criteria are quantifiable, it’s easier to accommodate paying more or less than the stated bonus amount. But with subjective criteria it’s harder. First, you need to make it clear in the description if the bonus is “all or nothing”. If not, how will the bonus payment be determined if the target is partially achieved? What if it’s exceeded?
Even with quantifiable results, the payout doesn’t need to be linear (ie – 65% performance = 65% payout or 145% performance = 145% payout). Instead, you could say something like “If you reach at least 75% of the target, this bonus will pay out at 50% and if you reach 150% of the target, this bonus will pay out at 125%”. MBOs aren’t the same as a sales commission plan and don’t usually need a high degree of granularity in the payout scale. But it’s often appropriate to include some milestone payments for under/over-achievement rather than have all line items be “all or nothing”.
Mid-Term Progress Report
You wouldn’t have assigned bonus compensation to things that aren’t really important. After all, the employee already gets a base salary to do their required job. But rather than wait until the end of the bonus period to assess the performance, have a progress report discussions with the employee throughout the bonus cycle. Hopefully your management system already calls for monthly manager-to-employee communications about goals and performance. If not, at a minimum you should have a conversation in the middle of each MBO performance period. It not only gives you a chance to measure progress against obviously important projects but it also gives a second opportunity to make sure the bonus descriptions are clear and to avoid surprises.
MBO plans can be a highly effective tool but they require more effort than most new managers think. Anytime you assign compensation to specific tasks, the affected employees will pay very close attention and won’t be tolerant of any lack of planning or foresight on your part. So please use one of my mantras when it comes to bonus compensation of any sort: “measure twice, cut once”.
Click the graphic to the right for an MBO template I’ve used in the past (scroll down to the Compensation Resources section of the page). Floating over some column titles in the spreadsheet will reveal comments I’ve embedded to provide further explanation.