How Incentive Compensation Drives Organizational Results in Consulting Companies

Introduction

Consulting firms rely primarily on the skills of their employees to attract clients and deliver services.  As a result, their financial compensation models reward individual effort and productivity, as well as team work and institutional focus, in order to enhance financial results for the whole organization.^[1]

Since at least the 1990s, variable incentive compensation has been an integral component of “pay for performance” in many consulting or advisory firms.  These firms are perpetually in competition for top employee talent and use incentive compensation as one component of a rewards strategy.  “Pay for performance” is based on the theory that financial rewards can drive employee behavior and that properly compensated employees deliver better results for the organization or “you get what you pay for.”  Moreover, high performing employees will not stay with the organization if their contributions are not recognized and rewarded.

Types of Compensation Arrangements

Compensation arrangements may include a variety of components to reward exceptional performance, achievement of specific goals (financial, operational or behavioral), development of specified skills, or some combination of all of these.  Whether individual or team performance is the measure, the purpose is to align employee efforts around particular goals and objectives determined by the organization, to attract and retain top employee talent, and to motivate and develop employees in ways that increase their value to the organization.

No one type of incentive plan is right for every organization.  Successful plans are designed with care to target specific and measurable goals while minimizing unintended consequences. Plans can be categorized as team or individual based on the types of goals or objectives desired.

Here is a summary chart of common short-term incentive structures. (The terms are discussed below the chart.)

Individual achievement features of compensation plans include the following:

1.  Performance based annual plans reward top performing employees based on a review of performance and contribution over some period, typically a fiscal year.  Generally, in the consulting industry all employees are eligible for performance-based incentives.  These emphasize individual productivity and results and recognize employees for job excellence.  This type of incentive plan is closely linked with the performance management process.

• Employees may set goals at the beginning of the measurement period, and/or may be reviewed on a set of expectations for their position, or both, to assess overall performance and contribution to the overall firm goals.
• Goals and performance measurements are based on the employee’s career level to ensure a clear understanding by the employee of how the employee’s contributions impact larger organization objectives – the more senior the employee, the larger the portion of the incentive that is tied to the organization results as a whole.
• At management and executive levels, the incentive plans often combine both individual and group measures as management-level employees have more impact on the financial results of the enterprise.
• At more junior levels, individual measures are more typical in order to differentiate pay and reward the most valuable performers, even in years when the company does not achieve all of its performance goals.
• Bonus targets can be anywhere from 5-50% of base salary with more senior employees, who have the most control over the overall firm results, having the highest targets.   Actual payouts can range from 0% when goals are not met and performance is substandard to in excess of target for extraordinary performance, with the range of financial payouts determined in the plan design.

2.  Commission plans are based on sales of services.  In consulting, sales are often team efforts and commission plans may be restricted to dedicated sales professionals who do not actually provide the consulting service.   Commissions are set as a percentage of revenue generated (as it is recognized or collected) based on agreed upon metrics that define the persons or persons that made the sale and/or contributed to closing a deal.  Firms that do not use dedicated sales teams may task other senior employees (partners or managing directors) with primary responsibility for generating sales.  Even when there is a dedicated sales team, senior employees are usually part of sales teams and will have sales responsibilities as an element of their incentive plan goals.

3.  A discretionary bonus plan is a simple plan in which management decides whether to fund bonuses after assessing financial, operational and any other relevant factors in the period.  These plans give management maximum flexibility but can be viewed with suspicion by employees because they are discretionary and it may not be clear to employees what the employee needs to accomplish and what reward can be expected.  Another risk is that, if bonuses are paid out year after year regardless of performance, they can be deemed by law as legal entitlements and a form of deferred compensation, which undercuts their value as incentive compensation.  Discretionary plans do little to help employees understand what is expected of them or to incent excellence.

4.  Spot award programs are a management tool to recognize contributions as they occur such as extraordinary effort undertaken to finish a project during a short time-frame. The award often takes the form of a small bonus or gift card accompanied by public recognition and thanks for exceptional effort or demonstrating company values that enhance the work environment.  Spot award programs need to be broad enough that many employees receive them over time, but not so ubiquitous that they are meaningless.  The programs are often designed to promote a positive workplace and to build organizational culture.

Group achievement features of incentive compensation plans include the following:

1.  Team incentives can be awarded to the entire organization, a department or a project team.

• Specific objectives are set with corresponding payouts and the team shares in the reward if the objectives are met.
• Individual target amount for each team member or position are typically set.
• Team incentives are not common in consulting reward programs.^[2]  Team incentives are more often “add-ons” to the regular incentive plan in situations where the stakes are high and the successful outcome of a project or strategy will have an outsized impact on the organization.

2.  Profit sharing and gain sharing plans are the simplest to administer because they establish a percent or dollar amount of revenues, year over year revenue increases, or profits that are used to create a pool of funds to be shared with employees if profit goals or financial and operational improvement targets are met.

• Gain sharing plans focus on savings generated by improved operational performance that employees can directly impact and are more common where teamwork and collaboration are important.
• In profit sharing plans, the organization earmarks a portion of pre-tax profits to a pool shared by employees based on role or weighted by salary.

These types of plans do not permit differentiation based on performance and contribution but in small organizations they can help to focus employees on growth and profitability and create a sense of common destiny without creating a large administrative burden.

Each of these types of incentive plans can be effective at motivating and rewarding employees when carefully constructed.  Poorly planned and constructed incentives at best are a waste of money and at worst can have damaging and/or unintended consequences.  A variable incentive plan should sit on top of a base salary structure that is equitable and fair, and that employees understand and trust.

Compliance with Local Laws

Incentive plans must also conform with local laws.  In certain European countries, for example, a plan that pays bonuses year over year may become an entitlement at law, effectively increasing fixed costs for the organization and eliminating the incentive features.  In certain states in the U.S., plans intended to encourage employee retention by paying out only to those actively employed on the payout dates, typically 2-3 months after the measurement period, can be challenged in the courts by employees who are fired or who resign prior to the incentive payout date.  The courts often decide that those terminated  employees are entitled to funds equal to the incentive compensation that would have otherwise been payable based on the portion of the measurement period during which the employee was actively employed. 

Developing the Plans

Human resources, finance and legal professionals need to work collaboratively to draft the incentive plan with guidance from executive leadership of the organization. Once there is agreement on the basic type of plan and its features, funding should be modeled to ensure affordability.  Financial models prepared by the organization to fund the plans must anticipate payouts under different scenarios.

Firms start by setting growth targets for the whole organization.

• First, they set the team or division targets that will contribute to the organization goals.
• Then, the team or division sets the targets for individual employees in their group, so that at each level employees see how their efforts contribute to the organization goals.

It can be tempting to create a wish list of goals, but effective plans focus on a small number of critical high-impact areas.  Employees get confused if there are too many goals or if performance standards are not clear.  They need to see that they have an opportunity to achieve an award if they perform well for their organization.

Funding the Plans

Funding of the plans can be budgeted but self-funding is more common.  Self-funding mechanisms can be based on the organization’s achievement of its financial plan or revenue and profitability growth.  As the financial plan is achieved or revenues hit growth targets, the revenues generated are used to fund the incentive plans, which are then used to pay the incentives to employees. In a performance-based plan, employees need to understand that a plan that is fully funded does not mean that everyone will receive their target incentive – the individuals must also meet their individual performance targets.  Full funding means that those who achieve their goals or perform at the expected level can expect an incentive payment.

Communicating the Plan Features

Communicating the plan clearly and making it transparent helps employees understand how the plan works and how their efforts to enhance the company results can help them earn an incentive. The linkage to “performance management”, how goals are set and how employees are evaluated, ensures employees understand what their individual and team objectives are and what is expected of them and the company.

Conclusion

Short-term incentive plans, especially those that drive employees to achieve superior performance, need not be prohibitively expensive.  Plans can be self-funded and start with modest payment targets.  Successful consulting firms find that variable compensation plans lead to increased employee effort and job satisfaction, and secondarily enable the organization to attract and retain the best people.  A well-designed plan can be a strategic differentiator for the organization and drive positive performance for the business.

The Society of Human Resource Management website (www.shrm.org) and World At Work (www.worldatwork.org) contain articles that further explain incentive compensation and strategies for successfully implementing incentive plans.  Certain articles require a membership subscription to access but there are many available free of charge.  An article that reviews research into the importance of performance evaluation in creating an effective incentive plan is available on Researchgate (www.researchgate.net): Designing Incentive Plans: New Insights from Academic Research by Michael Gibbs (December 2012).

[1]  Professional service organizations of experts that advise clients in the business and non-profit sector for a fee are usually identified as consulting or advisory firms.  Services vary widely across organizations as does their size.  Some can have a handful of employees and others tens of thousands of employees.  The largest consulting firms advise the large multi-national companies and have operations in dozens of countries around the globe and in turn generate annual revenues in the billions of dollars

[2]  In the course of a year as most people in consulting firms work on multiple teams and multiple projects—not on one team-Individual performance-based incentives are more typical.

Mary Sawall is a human resources executive with more than 25 years' business experience in professional service firms ranging from start-ups to large publicly traded global organizations, and from rapidly growing to distressed organizations.  Her most recent professional experience was Senior Adviser at The Precision Medicine Group, a specialized medical research company dedicated to supporting the development and commercialization of personalized medicines and therapies.  Previously, she served as Management Director and Vice President of Human Resources of Huron Consulting Group, a multi-national consulting firm.  She is a graduate of Notre Dame and she received a Master’s Degree from Yale University and a degree in business administration from Cornell University.