Variable Compensation: Types, Pros & Cons

Variable compensation structures are add-ons on top of the basic salary. They’re based on performance metrics, business results, team performance, and other determining factors. Variable pay is a key motivator for your sales teams and aligns their individual goals with business goals. A carefully crafted variable pay structure can ensure healthy bottom lines and motivate your team. In this blog, I’ll cover the different types of variable compensation structures, their advantages, and their disadvantages.

Variable pay is a type of compensation that varies based on specific performance metrics or business results. This pay is often offered in addition to an employee's regular salary.

Variable components can be bonuses, commissions, profit sharing, and other performance-based rewards.

Organizations usually pay their people at least 8% to 19% extra as a variable on top of their base salary. The goal of variable pay is to incentivize employees to meet and exceed business goals and to align their individual performance with the company's overall success.

In this article, I’ll highlight the common types of variable compensation plans, their advantages, and disadvantages.

Top 5 Types of Variable Compensation Plans

Typically, variable compensation is an add-on to the base salary. There are several types of variable compensation programs in sales that can be used to incentivize and reward salespeople for their performance.

Here are the different types of variable compensation programs:

1. Bonus

This type of variable compensation pays salespeople a lump sum of money as a bonus for meeting or exceeding specific sales targets or milestones.

Bonus example:

A manufacturing company offers its sales team a bonus of $10,000 for every $1 million in sales they make in a quarter. If a salesperson sells $3 million worth of products in a quarter, they would earn a bonus of $30,000.

Bonuses are a great way to incentivize salespeople to work harder and reach their sales goals. Here are the most commonly used bonuses:

  • Retention Bonus: This bonus is paid to encourage your people to stay in the company longer.
  • Project Bonus: Every time a project is completed, a project bonus is awarded to the representative.
  • Referral Bonus: Referral bonuses are given when the sales representative gives a recommendation for another during the hiring process. Sign-on Bonus: This bonus is paid to new hires to accept an offer.

2. Incentive

This type of variable compensation pays salespeople a percentage of the total sales they make. The commission rate can be based on the total value of the sale, the profit margin, or a combination of both.

Incentive example:

A real estate company pays its agents a commission of 5% of the total sale price for every home they sell. If an agent sells a $500,000 home, they would earn a commission of $25,000.

Incentives are a great way to align company goals with representative goals and reward them for achieving their targets.

3. Recognition

Recognition-based variable pay is rewarded to sales representatives if they achieve a goal, or milestone or crush their targets for the given period. It’s also rewarded to reps who make the most sales in a given period of time.

Recognition-based payouts are tied to the salesperson's achievements and sales targets or KPIs.

Recognition example:

A telecommunications company holds a quarterly sales contest, offering the top salesperson a $5,000 bonus based on the number of new customers signing up in a quarter.

Recognition-based rewards are used to create a team of high performers. It induces a competitive spirit and is a great way to motivate and engage salespeople.

4. Management by Objectives (MBOs)

Management by Objectives (MBO) is a process that enables organizations to create strategic goals. They’re often based on the SMART framework that emphasizes goals to be specific, measurable, acceptable, realistic, and time-bound.

It’s a five-step process:

  • Company-wide objectives are decided for the year.
  • The objectives are trickled down through the organization for teams to translate them into their relevant context.
  • Every employee tailors their objectives for the year.
  • Colleagues are then given visibility on each other's targets, and they support each other to achieve them.
  • The progress is evaluated in a monthly, quarterly, or half-yearly cycle to follow through and notify the upper management about key milestones achieved.

5. Profit-sharing

Profit-sharing allows salespeople to share in the profits of the company based on their performance.

The profit amount that can be shared is determined based on three parameters:

  • Salesperson's individual performance.
  • Performance of the entire sales team.
  • Company’s performance and revenue generated.
Profit-sharing example:

A software company shares 5% of its quarterly profits with its sales team based on its individual sales performance.

If the company makes a profit of $1 million in a quarter, and a salesperson generates $200,000 in sales, they would receive 5% of the profit, or $10,000.

3 Key Advantages of Variable Compensation

Variable compensation not only increases the payout amount but also provides the following benefits:

1. Boosts productivity

Variable compensation can increase productivity by linking compensation directly to performance. This enables salespeople to:

  • Sell more.
  • Perform better.
  • Encourage behaviors that are aligned with the organization.
  • Take new risks and achieve targets.

Additionally, representatives in order to perform better - improve their skills and knowledge. This creates a sense of growth and development that leads to increased engagement, motivation and better results for the organization.

2. Improves employee engagement

In order to crush assigned targets, representatives feel motivated to work closely with their managers and understand their performance expectations.

This leads to open and frequent communication, which can foster a positive working relationship and increased engagement. This in turn leads to increased retention and lower attrition rates.

3. Promotes healthy competition

Variable pay systems recognize and reward individual performance, rather than team performance. This creates healthy competition among sales representatives as they strive to outperform their colleagues.

Additionally, sales representatives are motivated to set personal performance goals as they strive to earn the highest rewards.

2 Major Disadvantages of Variable Compensation

Even though variable pay has its benefits it can also be detrimental and challenging if not implemented properly.

Here are the two major drawbacks of variable compensation:

1. Can be less profitable

Companies can find themselves in a pickle if they don’t plan their variable pay structures properly. It can be challenging to strike the balance between rewarding high-performers and also staying within their set budget.

While overcompensating your representatives can affect your bottom lines and profits, under compensating them can lead to:

  • Low team morale.
  • Decreased motivation.
  • Poor performance.

That is why planning is a crucial step and companies should discuss it with their finance team before deciding on payouts.

2. Can be difficult to manage

Variable payment structures are hard to implement as they’re complex and time-consuming. They also require detailed performance metrics and data tracking systems.

Moreover, these pay systems can be detrimental to long-term progress if not defined properly.

To avoid this, representatives need to start prioritizing meeting their targets over developing strong relationships with customers and building long-term sales strategies.

Wrapping Up

A well-designed variable pay structure can improve sales performance, boost employee motivation, and increase team profitability.

Moreover, by linking compensation to specific performance targets creates a clear incentive for sales representatives – driving results and bottom lines for your organization.

However, it’s important to consider the potential drawbacks of variable compensation, such as complexity, fairness concerns, and the risk of unethical behavior.

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