It is the age-old debate for any business. What compensation structure should you offer to keep senior managers motivated, fairly rewarded and, at the same time, encourage them to act in the best interests of the company?
The ink is now dry and the dust has settled on our budget planning process at Arrows Group Global (AGG). Almost 20 iterations later and I’m confident we have a solid plan in place.
One of the most critical issues for me during months of budget discussions has been setting the incentive plans for my management team. The consulting industry is sales-led, so it is normal from day one to offer base salaries with bonus targets. But, at a senior management level, there is an even greater expectation that part of the compensation package is linked to business performance – reflecting a higher involvement in decision-making.
Changing behaviour through compensation
Here’s a spoiler: there is no ‘one way’ for creating incentive plans. At AGG, we set bonus targets for our managers based on either EBIT or Gross Profit. I’ve worked to both myself. What experience tells me, is that the choice can make a huge difference to how people behave.
EBIT vs Gross Profit
EBIT = ‘Earnings Before Interest & Tax.’
Calculated as revenue minus expenses (excluding tax and interest). Also known as ‘operating profit’. It focuses on a company’s ability to generate earnings from operations.
Total revenue / sales minus the cost of goods sold. Costs only include variable costs, like materials, equipment, contract labour etc. Costs do not include fixed costs, like rent, marketing, salaries or office supplies.
For and against EBIT-based incentives
In my experience, EBIT-based targets drive the following positive and negative behaviours:
- Under EBIT targets, the individual takes responsibility for the outgoing costs of the business as well as driving revenue. That means you can trust them not to be too exuberant with costs
- They are more aligned to your interest as a shareholder – which is the bottom-line profit
- It brings a high-level of trust. They will typically behave as though it is their own business
- It can be very motivating for employees to have an extra sense of ownership and accountability.
- Managers can get too sucked into operations and cost-savings instead of top-line revenue. Saving £100 on a printer isn’t important if you’re missing out on £1,000 of sales
- Managers prone to penny-pinching won’t want to invest – e.g. in staff training or entertaining. They will think of short-term annual results, instead of the long-term importance of looking after and retaining employees.
- Another effect of EBIT short-termism may be reluctance to hire new people as it’s an added cost, or firing people too quickly if they’re not performing
For and against gross profit-based incentives
The same exercise, but this time on the behaviours when compensation is tied to gross profit:
- It keeps people thinking about the top-line and bringing revenue into the business
- If someone is valuing your business – private equity companies, banks etc. – they’ll be most interested in your gross profit. So, arguably, it is better for increasing the value of your business
- It leads to a longer-term view, looking at the growing enterprise value
- They are more likely to hire new people and take time to train them and improve their performance
- If EBIT compensation makes people too tight with money, gross profit can have the opposite effect. Managers may become overly generous with entertainment costs as they don’t affect their target
- You need to have another party keep an eye on their expenditure. The behaviour is less likely to be that of someone who feels like it’s his or her business too.
A split-incentive solution
My view, having tested and worked under various types of compensation plan, is that only a small number of people should have a bonus based primarily on EBIT. It should be reserved for senior individuals who have an additional long-term motivation through, for example, equity shares.
For everyone else, they should be targeted on gross profit. Or, better yet, a split-incentive solution where, say, 80% of their bonus is from the gross profit of their team and 20% from the EBIT of the team (or company). This provides the right balance between long-term and short-term behaviours.
And finally – never under-estimate the need for a strong Finance Director, who can strike the balance between releasing money when necessary and not saying yes to every request. They will be greatly helped by a watertight budget. Which explains why we didn’t settle our budget until version 20 …