By Leena Beejadhur and Richard Lamptey, Mercer Human Resource Consulting

An annual bonus plan is probably the most effective incentive tool available to companies for influencing management behaviour to deliver short-term business results. As the eventual payout is based on performance over one year or less, a properly designed plan will ensure executives are rewarded for achieving objectives on which they have most immediate impact. The reward earned is typically paid out in cash, although many public companies are increasingly opting for a combination of cash and shares for senior executives.

Not only a key motivational tool for management, annual bonuses also enable organisations to more flexibly control their employment costs. While salary increases become embedded and have a knock-on effect on other remuneration elements, the cost of the annual bonuses is variable, depending on the level of performance achieved.

The time is nigh… but not for all
An annual bonus plan may not be appropriate for all organisations. For example, some smaller companies may find the administrative burden of operating a plan outweighs its potential benefits. Fast-growing businesses may find it too challenging to set performance targets more than a few months ahead, while other firms may not possess management information systems capable of measuring performance effectively.

In the right corporate context, successful annual bonus plans tend to share some characteristics:

If these conditions are absent, the effectiveness of the bonus plan as an incentive is significantly reduced. Participants may see the plan as a black box, with end-of-cycle payments coming as either a pleasant surprise or a shock, and reinforcing their perception that there is little or no relationship between their achievement (or lack thereof) and the bonus payment. This is especially true in smaller businesses that have an owner¡¦s pocket approach, i.e., bonuses are paid at the discretion of the owner and may be more influenced by personal whim than by individual or corporate performance.

Determining the criteria for participation: who's in and who's out
Eligibility for participation is typically restricted to those individuals at management level who have a significant impact on an organisation¡¦s performance, including executive management. That said, determination of the cut-off point can be quite fraught: being able to participate in an annual bonus has a symbolic as well as a monetary value, and there is constant pressure to increase the eligible population. But there are several factors that can be considered to determine eligibility:

• The nature of the industry and the workforce profile
  Companies with a majority of low-skilled workers operating in manufacturing will often restrict participation in the management bonus scheme to the top cadre (although they may operate other types of bonus arrangements such as recognition awards and sales incentives). The converse is true in, say, a financial services company, where the annual bonus plan spans most layers of management.
• The size of the business
  Smaller organisations tend to have, in relative terms, a higher proportion of their management team with influence over the overall business results, and hence, a relative higher proportion of participants.
• The performance measurement level
  The degree of line-of-sight is also a key determinant for annual bonus participation. Annual bonus plans tend to go further down organisations where performance is measured at corporate, business unit and individual levels compared to those that only measure performance at the corporate level.
• Market practice
  Several surveys provide information on annual bonus eligibility, which can be used as a guide to determine the cut-off point. Mercer's Total Remuneration Survey (TRS) 2005 shows management bonus plans often extend down to junior management:

Award opportunity: how much is enough?
The annual bonus award is normally expressed as a percentage of salary and increases with seniority – the higher the proportion of pay is 'at risk' the more one can influence performance. For example, a finance director's annual bonus may be targeted at 20% of salary, with a maximum of 40%, while a more junior executive may have a target of 10% of salary and a maximum of 15%.

Not surprisingly, target awards are made for delivering target performance and maximum awards for maximum performance, with the target bonus opportunity typically being about 50% to 60% of the maximum. The maximum is a cap on the overall bonus payments; it allows organisations to effectively control the cost of the annual bonus plan and helps to ensure executives are not tempted to make short-term decisions which maximise their personal rewards to the detriment of long-term health of the organisation.
There are two other reference points that are used: 'threshold' performance is the level below which no bonus is paid; organisations also occasionally make ¡¥stretch¡¦ awards above the maximum level in order to reward exceptional performance.

Award opportunities tend to be linked to market practice for organisations of similar size and complexity, operating in similar industries, although the level of performance required may vary. How organisations position their opportunity levels with respect to the market should reflect their remuneration strategy and be taken in the context of the overall package.

Measuring performance
It is crucial the performance measures selected for the annual bonus plans take into account both annual budgets and strategic business plans to ensure that they are consistent with long-term objectives. The measures should not only be within the control of participants but also be easily measurable over the performance cycle.

It is also important that plan targets are not derived solely from the budget numbers. This is to help prevent 'gaming' in the budget-setting process to ensure that maximum bonus can be earned without undue effort.

In practice, performance is measured by key performance indicators (KPIs) such as profit, contribution, shareholder value, earnings per share or economic value added. It is also common to use a combination of two or three financial measures with non-financial measures linked to strategic objectives, such as new product development or growth in market share.

Historically, the performance measures used have been part of the financial statements. Increasingly, businesses are adopting a more holistic approach, using a scorecard (which may or may not be a 'Balanced Scorecard'), which recognises the importance of non-financial measures such as people management and internal processes, on long-term financial success. The KPIs derived from the scorecard then form part of the performance assessment process.

Level of seniority and job role (i.e. functional or divisional) will also determine the weighting between corporate, divisional and individual measures. For example, an HR director incentive would be based on a combination of corporate and individual performance measures whilst a Divisional Director, at the same management tier, would be measured on a combination of corporate, divisional and individual performance.
An illustration of potential weightings at different management levels is shown below:

The approach described above is an additive approach where the sum of the achievement against the various performance conditions determines the total annual bonus payout. A different, but commonly used, approach is for individual performance to be a multiplier of the payouts calculated from achievement of the corporate and/or divisional objectives.

How do you determine the relationship between performance and reward?