Josh Patrick
Business owners often have bonus programs put in place for rewarding their employees for good work. Sometimes the bonus programs are based on individual performance and other times it’s based on company performance. In most instances, the employees are not sure what the bonus monies they receive are based on.
Adam Aardvark had a bonus plan in his company. He always paid the bonus to his people two weeks before Christmas. He always made his bonus payments based on company profits. He decided that if his company showed a 3% profit he would pay a bonus. Most years his employees got a bonus, but they were never sure why or when they would get their bonus.
If you give your employees a bonus one year they appreciate it. The second year you give a bonus they start to expect the bonus. The third year it becomes part of compensation. If you don’t communicate why your people get a bonus and for some reason you don’t or can’t pay the bonus in the third or fourth year, they will often resent the company.
Step One – Decide to share your information
I believe that having clearly stated metrics for setting bonus programs in your company are crucial. I like to use return on assets as a baseline for deciding what the trigger point is for having a bonus paid.
You will have to share information about your company performance if you want to use company performance measurements to trigger your bonus. Many owners don’t want to share any company information with their people. If you want to have an effective bonus plan, you must have a plan with transparency that shares company performance numbers in a way that your employees can understand.
Adam was scared of sharing his company performance with his employees. He was convinced that his people would all want raises once they found out what the cash flow for the company was.
I encourage all our Clients to try an experiment with their employees. Ask three people in your company the following question: Our company did x amount of sales last year, what do you think our profit was? Most of the answers we regularly see is between 40% and 60% of sales being profit. In other words, if you company does $5,000,000 in sales, most of your employees think you make between $3,000,000 and $5,000,000 in profits.
The second thing we find is your employees don’t care how much money you make. They care how much money they make. Our employees compare what they get paid to others in similar positions. If they feel they are fairly compensated, they don’t really care how much money you make.
Step Two – Use metrics to decide what your bonus will be
The next step is to find a way to communicate company performance in a way that your employees can understand. We often suggest that the number you use for your employees is cash flow or EBITDA (earning before interest, taxes, depreciation and amortization).
The number that we want our Clients to use in figuring out what the right EBIDTA is return on assets. The formula for return on assets is total assets divided by total sales times pre-tax profit. Adam’s company had the following profit statement:
| Sales | $5,000,000.00 |
| Operating Costs | $4,200,000.00 |
| Profit before depreciation and Interest | $800,000.00 |
| Depreciation | $300,000.00 |
| Interest. | $150,000.00 |
| Profit before taxes | $350,000.00 |
| Total Assets | $1,500,000.00 |
Adam’s business had a asset turnover of 3.3 ($5,000,000 divided by $1,500,000). His return on sales was 7%. This made his return on assets about 23% (3.3 times 7%). He decided to make the trigger point for his bonus program a 20% return on assets. This translated to a cash flow level of approximately $700,000.
Adam now had some solid numbers to use as a design for his bonus. The numbers allowed Adam to have an adequate return for his company, put money aside for growth and have enough to pay bonuses that the company can afford. Adam’s only problem was how much of the cash flow should he put towards his bonus program.
Adam knew that the following cash needs were important for the company:
| Money for reinvestment | $200,000.00 |
| Personal needs | $100,000.00 |
| Bank repayment | $300,000.00 |
| Total Cash Needs | $600,000.00 |
| Excess Cash | $150,000.00 |
Adam realized that he had excess cash of $150,000. He was willing to allocate 50% of the excess cash towards his bonus program. Backing into this final bonus number he decided that if the company had a 20% return on assets, he would allocate 10% of the cash flow towards the bonus program.
He projected that the trigger amount for a bonus program was $700,000 in cash flow. If his budgeted numbers were achieved he would be paying $75,000 in bonuses to his employees.
Adam now has a simple system he can communicate to his employees. He used a sophisticated financial model for deciding what the trigger points are. Transferring those numbers to a cash flow figure make it easy for him to communicate the trigger points to his employees.
Step 3 – splitting up the pie
Adam has now decided how much money he wants to put in the pie. He has always split bonus payments up as a percent of payroll. He was wondering if there was another way that could be used that would reward longevity as well as more responsible jobs.
We often suggest that bonus programs be distributed based on a grid that takes into account length of service and job responsibility. Adam had decided that the following grid would be used:
| 1-3 years of service | 1 point |
| 4-7 years of service | 2 points |
| 7-11 years of service | 3 points |
| 11+ years of service | 4 points |
| Entry level worker | 1 point |
| First level supervisor | 3 points |
| Manager | 9 points |
| Senior Manager | 15 points |
If Adam had a entry level worker who had been with him for four years, this person would have 2 points. One of his senior managers had been with the company for 15 years would then get 19 points.
When bonus payments were made, Adam would add up the total amount of points and come up with a monetary value per point. Adam’s company might have a total of 200 points. This would then be divided by his bonus payment of $75,000. Adam found that he had a point value of $375 per point. In this example, our entry level worker would receive a bonus of $750 while his senior manger with lots of experience would receive a bonus of $7,125.
Using both job responsibility and years of service allows the lion’s share of the annual bonus go to employees who help drive the profit of the company. At the same time we have put together a system that allows all employees to understand the value of staying with the company and moving to more responsible positions.
Step 4 – let your people make your company better
Having a bonus system based on key metrics in your company is a good place to start. To have your people work towards making better bonuses you should have measurement systems in place to help your employees improve the processes in your business that drive cash flow, return on investment and better profits.
Adam liked the idea of sharing profits based on return on assets. He also felt that even though his ROA was 23%, it could easily be driven to 30%. He thought he knew what needed to be done in the company to achieve this higher performance level.
Adam understood what actions were needed in his company to drive his return on assets to a higher level. He needed to have systems in place for letting his employees know what those actions were and measurement systems to track their progress.
Adam decided to provide graphs and tables on the key areas on his business that could be improved. He met with the managers responsible for those areas and taught them how to use charts to track progress in section performance. Adam asked his managers to meet with their employees to ask for their cooperation in finding ways to make the key metrics move in a positive direction.
Adam started holding monthly company meetings. At these meetings he reviewed company financial performance. He also went over the measurements that were being made in the company and started teaching his employees how improvements in the drivers of the business would come back to them in the form of higher bonuses.
Following the four steps above allows you to compensate your people for great company performance and allow them the opportunity to make the company better. Adam now had a framework in place to make sure his company got an adequate return and make enough money for himself. He also had a way of sharing profits in a fair manner with the people in his company who helped his company have better returns and profits.
This case is hypothetical in nature and provided for educational purposes only. Actual results may vary depending on circumstances.