Performance calibration: determining the relationship between performance and reward
Performance calibration refers to how performance measurement is linked to the reward opportunities and is the most challenging aspect of annual bonus design. It is a balancing act: on the one hand, if performance targets are set too low relative to the level of reward, management is over rewarded for achieving poor performance; on the other, if targets are set too high, good performance is under-rewarded and the plan has a de-motivating effect on participants.

There are several approaches to establishing the appropriate performance scale, or the relationship between threshold and stretch, for an organisation. By far the most prevalent relates the bonus targets to budgeted numbers, but it requires a robust budgeting and goal-setting process. The advantages are that the bonus target-setting process becomes part of the annual financial calendar and different divisions have the flexibility to set their own targets to reflect their individual circumstances. However, the major downside, previously referred to, is that there is scope for management to manipulate the numbers to set soft targets.

The following chart illustrates a fairly typical performance scale which recognises a disproportionately greater reward is appropriate for exceeding the target than for achieving:

Self-funding
Many organisations have a management annual bonus plan in place that is self-funding, ie, the estimated cost of the bonuses is included in the performance targets. Self-funding is a ‘reasonableness’ mechanism used to ensure that the payouts are commensurate with the level of performance achieved and that the business can afford to pay the bonuses.

Conclusion
A management annual bonus plan can be a very cost-effective way of motivating management to drive higher performance without increases in fixed employment costs and is also helpful for attracting talent. This is particularly important for smaller organisations where the scope for other forms of incentives, such as share options, is limited.

It is important to give some thought to the design and to consider the different outcomes under different circumstances. These can range from generous payouts unsupported by significant performance improvements to a failure to pay even though individuals have worked hard and effectively. Modelling of the potential outcomes is a useful way to test how a plan will work in practice.

Richard Lamptey is a principal with Mercer Human Resource Consulting. Leena Beejadhur is a senior associate, also with Mercer. They can be contacted at richard.lamptey@mercer.com or leena.beejadhur@mercer.com