What is incentive based compensation?

What is incentive-based compensation?

Incentive-based compensation, also known as variable pay, is a form of remuneration where an employee’s earnings are tied to their performance. Unlike fixed salaries, incentive-based compensation is designed to motivate and reward employees for meeting or exceeding predetermined goals, and is often used in sales.

For employees to qualify for incentive-based compensation, there are often eligibility requirements such as job role, tenure, and the achievement of specific performance benchmarks.

Incentive payments can be made monthly, quarterly, annually, or upon the completion of specific projects.

Types of incentive-based compensation

There are several types of incentive-based compensation, including:

• Bonuses: One-time payments awarded for achieving specific performance goals.
• Commissions: Payments made based on the volume or value of sales made.
• Profit sharing : Distributions of a portion of the company’s profits among employees.
• Stock options: Grants that give employees the right to buy company shares at a discounted price after a certain period.
• Performance shares: Stock units awarded based on achieving certain performance targets.

Advantages of incentive-based compensation

• Motivation: It can drive higher levels of productivity and engagement as employees strive to meet performance goals.
• Alignment of interests: It aligns your employees’ goals with your company objectives, fostering a sense of ownership and accountability.
• Attraction and retention: It can help you attract top talent and improve retention, especially if your company has a reputation for generous bonuses.

Disadvantages of incentive-based compensation

• Measurement complexity: Accurately measuring performances and setting fair targets can be complex and time-consuming.
• Potential for unintended consequences: It may encourage short-term thinking or even reckless behaviour if not designed carefully.
• Equity and fairness: It can be challenging to ensure that your incentive structures are perceived as fair and attainable by all employees.

Examples of incentive-based compensation

• Sales: Sales representatives often receive commissions based on the value of the sales they generate, incentivizing them to close more deals.
• Executive compensation: Company executives might receive bonuses tied to the company’s financial performance, stock price, or other strategic goals.
• Customer service: Customer service representatives might receive bonuses based on customer satisfaction scores or resolution rates.