Variable Compensation Plans: Types, Benefits & Limitations

In this article, I’ll start with the six different types of variable compensation plans. These are commission, bonus, management by objectives (MBO), profit-sharing, gainsharing, and non-monetary rewards. Next, I’ll list the advantages and limitations of variable pay plans. These include complexity, reduced profitability, and workplace toxicity.

Imagine living on a remote island and leaving is not an option. You can go to one restaurant and eat the only dish they serve. Pasta!

Since it's the only source of food, you go there every day. But eventually, you get bored of it and eating becomes a chore.

Then one day the restaurant introduces two new items: pizza and garlic bread.

You’re ecstatic. Eating has become fun again!

Companies that rely solely on fixed salaries to motivate employees run the risk of becoming like the first version of the restaurant: a place where people go because they have to, not because they want to.

If you want your employees to enjoy coming to work every day, you have to spice things up. Offer them more than just a fixed salary to strive for.

How can you do that?

Three words: Variable compensation plans!

In this article, I’ll discuss the six most common types of variable compensation plans, as well as the benefits and limitations of implementing these plans.

6 Common Variable Compensation Plans

Variable compensation is that part of an employee’s pay that is not fixed. It’s paid over and above the employee’s base salary.

Variable compensation comes in many forms and is usually dependent on the employee meeting (or exceeding) certain performance targets. In some cases, it may also depend on company performance.

But, for the most part, variable compensation depends on employee performance.

Let’s look at the six most prevalent types of variable compensation plans:

1. Commission

A commission is a portion of revenue given to someone who helped generate that revenue. This someone is almost always from the sales team.

For example, if John closes a deal worth $10,000 and his commission rate is 10%, then John’s commission will be $1,000 on that deal.

There are a variety of commission plans to choose from.

Some are simpler, like straight commission plans where you offer a fixed rate for each deal. Others, like tiered commissions, take a little more planning because commission rates increase as reps close more deals.

2. Bonus

Unlike commissions that are mostly given to sales reps and can vary based on revenue, bonuses are lump-sum payments awarded to employees from any team and for any reason.

Let’s look at some common types of bonuses:

• Spot bonuses are given to an employee for outstanding performance in a particular role or task.
• Referral bonuses are given to employees who refer applicants that are successfully hired and spend a certain amount of time with the firm.
• Retention bonuses are used to incentivize those employees who want to quit to stay back at the firm.
• Signing bonuses, or sign-on bonuses, are offered to new employees as an incentive to join the firm.
• Project bonuses are given to teams and/or individuals that successfully complete a project, usually within the stipulated budget and timeframe.

3. Management by objectives (MBO)

Management by objectives (MBO) is where managers have one-on-one sessions with their employees to set performance goals for them.

These goals are then listed in each employee’s individual MBO plan and commissions are calculated based on how well employees achieve their objectives.

MBO is an effective strategy because you’re involving the employee in the goal-setting process, thereby instilling a greater sense of purpose within them.

That said, this strategy only works if your employees’ individual goals align with your business goals.

Want to create your own MBO plan?

Here’s an ultimate guide on management by objectives to help you along.

4. Profit-sharing

As the name suggests, profit-sharing is when a company shares some of its profits with its employees through bonuses. The higher the profits, the larger the bonuses tend to be.

Profit-sharing bonuses are usually given once a year — assuming, of course, the company had a profitable twelve months before that.

Examples of profit-sharing bonuses include:

• A manufacturing firm announcing a $2,000 bonus for all employees at the end of a good year.
• A retail store awarding a fixed rate bonus to each employee, to be calculated at 10% of their base salary.

Note: Individual performances are not considered in profit-sharing plans.

5. Gainsharing

Gainsharing is a type of variable compensation where employees are offered financial incentives in exchange for increasing company productivity.

This productivity could be in one or multiple areas such as:

• Higher revenues.
• Increased output.
• Fewer errors.
• Better customer service.
• Quicker production times.

Gainsharing bonuses are often paid out monthly since it allows managers to monitor team progress more frequently and make any changes to the plan if needed.

6. Non-monetary rewards

Sometimes merely acknowledging a job well done — either in the company newsletter or during team meetings — can do wonders for an employee’s confidence.

When it comes to designing non-monetary rewards to motivate your employees, you can get as creative as you want.

Here are some suggestions to get you started:

• Letting employees work on their own projects during company hours.
• Offering extra leaves.
• Assigning more responsibilities.
• Congratulatory posts on the company’s social media accounts.
• Employee of the month/quarter trophies.

Top 4 Benefits of Variable Compensation Plans

Let’s look at the four main benefits of variable compensation plans:

1. Increased productivity

A well-executed variable compensation plan will always push your employees to work harder because they have much to gain.

Consequently, you reap the benefits of higher workforce productivity — be it in terms of more revenue, improved customer experience, better products, etc.

2. Better employee retention

If your variable pay plan is lucrative yet achievable, your more talented employees will probably be coining it in. This will make them likelier to stick around.

In exchange, you get to build a stronger, more agile workforce that is loyal, hardworking, and helps you make good on your business plans.

3. Planning and administrative flexibility

The beauty of variable compensation is, well, its variable nature. You can choose any plan you like, run it for as long as you need, and make changes as often as you want (all the while keeping your employees in the loop, of course).

For example, if you want to pay the variable component only after the money comes in, you could choose a plan that ties commissions to collections instead of revenue.

Or if money is tight and you want to motivate your staff with minimal investment, you could opt for one of the non-monetary reward ideas in the previous section.

4. Aligned employee and employer goals

Variable compensation is your best bet when it comes to aligning employee efforts with company objectives. All you have to do is design a plan that drives the right behaviors.

Needless to say, this helps you stay competitive in a global marketplace that’s becoming increasingly unforgiving with each passing day.

Limitations of Variable Compensation Plans

Variable compensation plans have a few limitations, too. Let’s see what they are:

1. Complexity

I’m not going to lie — some variable pay plans can get really complex.

Take tiered commissions, for instance, which I mentioned at the start of this article.

Setting different commission rates for different quotas makes calculations tricky enough. If you add things like roll-ups and clawbacks on top of that, your payroll is going to have a field day.

Unless, of course, you have solid systems in place!

The more complex your variable compensation plan, the simpler your setup ought to be. Fewer moving parts make for a more cohesive work engine.

2. Reduced profitability

While variable compensation plans help you stay competitive, the payouts can also hurt your bottom line if you don’t execute the plan well.

For example, if you don’t factor in market trends or seasonal changes into your plan, you could end up paying your reps massive commissions that weren’t exactly earned.

3. Toxic work culture

Variable pay plans that aren’t planned or managed well can lead to a seriously toxic work environment.

For instance, sales reps might refuse to share tools or critical information with other reps for fear of losing out on commission. Or if your targets are too high and only a few employees are hitting them, the rest of the team might become bitter and bad-tempered.

Key Takeaways

When done right, variable compensation plans can provide tons of benefits like improved productivity, employee retention, and more.

But if you want to introduce it simply because your competitors have one, you might be better off without it.

Go through this article to do your own research, vet your strategies, and clearly define the goals for your plan.