Pay for Performance

Are any of these scenarios familiar to you?

The co-op has just hired a new general manager with the experience and skills needed to help the co-op realize its ambitious growth plans - but the new manager's salary needs seem unaffordable to the co-op.

A major competitor has entered the co-op's market, and the co-op is in danger of losing key staff- especially the general manager - because of its relatively low pay.

The board has some concerns about the general manager's performance and wants to create some incentives for improvement in key areas.

As the co-op's market has become more and more competitive, the board has come to see the need for a manager who is highly motivated and more entrepreneurial than when the co-op had the market to itself. However, the board is unsure how to reward and retain such a skilled manager.

These are common and difficult situations faced by many co-op boards of directors. Indeed, there are many issues of concern represented in this collection of scenarios. However, one common aspect - how to provide adequate compensation for a skilled and successful general manager - has a solution: a pay for performance plan. Such a plan provides increased compensation in exchange for increased performance. Also called "incentive-based compensation" or "bonus plans," these systems are completely flexible and can be adapted to fit a wide variety of needs.

The idea is a simple one: the general manager is paid a base salary, but then is eligible for additional compensation based on achieving certain pre-approved tasks or goals. By structuring the general manager's compensation in this way, the co-op has the advantage of not having to commit to increased pay up front - without any positive results on the part of the manager. Pay for performance helps make compensating the manager a win/win: the co-op enjoys the benefits of improved performance and the manager enjoys enhanced compensation as a result of his/her hard work.

Pay for performance is a concept that makes a lot of sense, especially for general managers. (Pay for performance systems may also be valuable for other co-op employees, but that is beyond the scope of this article.) Most managers greatly appreciate the challenges posed by and the rewards available through such a system. For the co-op and the board, pay for performance offers many advantages:

  • Pay for performance makes it clear to the general manager what areas should receive priority attention.
  • Bonus pay ensures that a minimum level of financial performance is reached before paying management beyond a base amount.
  • Managers are motivated to achieve a high level of performance.
  • This system allows the co-op to share the rewards of good performance with those most responsible for achieving results.
  • The board's work is focused on setting clear standards of performance (directing) and then giving management the authority to handle details (managing).

Perhaps most importantly, pay for performance systems enable a co-op to attract and retain highly qualified, motivated management. As the grocery and natural foods markets become more competitive, it will be harder and harder to retain well-qualified managers. Pay for performance systems make it possible to offer the manager increased compensation contingent on achieving desired results.

Most of the potential disadvantages of pay for performance plans can be addressed by careful plan design. Plans can be designed to make sure that managers don't emphasize short-term results at the expense of long-term survival. Though most plans use quantitative goals as the basis for incentives, they can be designed to incorporate qualitative goals and criteria. There is also a concern that such a compensation system will serve to attract managers who care little for the broader aims of the co-op (such as building responsive and responsible consumer-owned businesses or bringing "economic justice" to the marketplace) and will only attract managers who are interested in the compensation. But again, additional pay for the manager is based entirely on achievement of goals defined by the board of directors.

Two rules to keep in mind

There is no one best way to design a pay for performance plan - a factor that is an advantage but also can provide the first stumbling block. But don't be deterred. The flexibility of performance plans allows them to be adapted in a wide variety of ways to fit a wide range of needs. There are just two absolutes to keep in mind:

  1. The plan must be motivating to the manager. It doesn't really matter what the board thinks should be motivating; if the plan doesn't inspire the manager, it will not live up to its potential.
  2. The plan must be clear to all involved - the board and the manager. It will be extremely frustrating to the board and to the manager if, after spending a year focused on a list of key goals, the manager finds out that his/her expectations for compensation are not the same as the board's.

The first step for boards interested in setting up a pay for performance plan is to spend some time setting clear goals or priorities for the manager's work; up to three is best, no more than five. Discuss these goals and priorities thoroughly and clearly with the manager to make sure that the list matches his/her assessment of the co-op's needs. Ultimately the board will set the priorities, but it is best to use management's expertise and experience to make sure that the board's analysis is comprehensive and that the manager embraces this list as the areas of priority attention for the upcoming year.

These jointly agreed-upon goals form the basis of the criteria that must be met; this is the first of two key elements of a pay for performance plan. Here are some examples of criteria that could be used:

  • achieving or exceeding budgeted net income (profit)
  • achieving or exceeding targeted rate of return on assets
  • accomplishment of designated goals (increasing the percentage of sales to members, increasing the gross margin, improving personnel systems)
  • improvement in a key area (market share, solvency, quality of customer service)
  • increasing the co-op's working capital

The second key element is the amount to be paid: how much performance pay will be available ifthe criteria are met. Here are some examples of amounts:

  • 2% of the co-op's pre-tax net income (profit)
  • up to 40% of the manager's base salary
  • 25% of the manager's potential bonus
  • upto$5,000

Issues to consider

In making these decisions, some issues to consider are:

What is the relative balance between the manager's base salary and performance based pay? Some managers are willing to accept very low base salary with generous incentive pay options. Others are not quite comfortable with such a balance. A particular manager's preference will probably be heavily influenced by the type of criteria being used for the incentive as well as more personal factors - his/her own tolerance for risk and personal financial needs. However, many managers are willing to accept a below-market base salary if the incentive could add up to above-market pay. The board and manager will need to negotiate this one.

How will short-range criteria be weighted against longrange criteria? Obviously the board doesn't want to create a situation that rewards the general manager for making short-range decisions that benefit the general manager but are harmful to the co-op in the long run. It's important to keep both in mind. Perhaps two of three criteria can be based on short-run performance (improving profitability, increasing gross margin), with the other based on improvements vital for the long term (upgrading equipment, increasing market share, developing a staff training program).

Will any of the incentive be available if the goal is only partially achieved? For some goals, it makes sense to have an "all or nothing" incentive; for others this is not necessary. If the incentive will be graduated, it is most important to keep the system simple; avoid systems where the incentive pay increases with each incremental improvement in performance. For example, if the goal is profitability:

  • no incentive pay if 75% of budgeted net income (profit) is not achieved
  • 40% of the incentive is available if net income equals at least 75% of budgeted net income
  • 100% of the incentive is available if net income exceeds the budgeted amount

Keep the steps simple and clear and keep the steps to a minimum; there is not much to be gained from a complex system.

If qualitative criteria will be used, how will accomplishment be measured for these areas? For example, if the goal is improving customer service, how will such an improvement be assessed? Who will measure achievements in these areas, and on what basis will such an assessment be made? An improvement should be measurable or observable in some way. Work this out in detail in advance.

Will any of the bonus be available to be awarded on a discretionary basis? Some boards and managers like having some discretion in awarding performance pay - to be able to reward management for dealing well with unpredictable matters or to increase compensation for arbitrary reasons. However, it is advisable to have only a small portion of incentive pay, if any, be discretionary. The purpose of pay for performance is to focus management's attention on key goals. It is very de-motivating to managers to have compensation based on criteria that are unclear, not known, and totally at the board's whim. If at all possible, make it clear what general criteria the board will use for such discretionary bonuses.

Sample plans

Following are some general examples of plans being used by consumer co-ops with their general managers. In some cases, the plans are very simple and straightforward; in others there are many levels and different aspects to the plan. In each case, the board has selected the criteria based on its priorities for the co-op's future.

A. General manager receives 2% of pre-tax net income based on profitability.

B. General manager receives up to 40% of base salary:

  • 25% of base salary based on meeting budgeted net income
  • 15% of base salary based on accomplishment of goals:
    • making progress on a long-range project (e.g., developing management depth)
    • creating new membership materials
    • improving personnel systems (timely evaluations, new employee orientation, etc.)

C. General manager receives up to $7,000: $5,000 based on improving customer service and $2,000 at the board's discretion for satisfactory overall performance.

D. General manager receives up to 1.5% of pre-tax net income:

  • 50% of bonus based on meeting or exceeding budgeted net income
  • 20% ofbonus based on improving co-op's market share
  • 30% of bonus based on improving reporting to board and timeliness of financial statements

E. General manager receives up to 60% of base salary:

  • 30% of bonus if co-op increases capital (member investment plus retained earnings) to at least 40% of assets
  • 30% of bonus based on completion of a comprehensive and high quality five-year plan, including a thorough market analysis and plans for co-op expansion
  • 40% of bonus discretionary - to be awarded for quality of overall work and development of internal (staff) capacity to handle and manage growth

As these samples illustrate, a pay for performance plan is adaptable to the unique priorities and situation of any co-op. It is most common for such plans to incorporate profitability as a primary criteria or the basis of the bonus amount, but other goals can round out the focus. For undercapitalized coops facing pressure to expand, performance pay maybe based on increasing the co-op's capital base (see sample plan E, above). And qualitative goals can easily be incorporated as long as there is some agreement in advance on how they will be measured.

Designing your plan

As noted earlier, it is most important that a pay for performance plan be motivating to the general manager. One option for designing a plan to fit your co-op may be for the board to give the manager some overall guidelines (the most important concerns of the board, the general structure favored, the criteria to be emphasized) and ask the manager to research and then draft a proposed plan for the board's consideration. But, no matter how the plan gets drafted, make sure that there is a thorough and open discussion between the board (or a committee) and the manager about the plan. The value of such a plan is not that you have one in place, but that it motivates the manager to perform at a level that brings payoffs to the co-op and all of its members.

See other articles from this issue: #070 May - June - 1997