Preface: “Hard work most often leads to success, but it’s not every day, and it’s not every week. It will pay off at different times over the course of your career.” Quote from Sallie Krawcheck
Implementing a Bonus Plan in Your Business (Segment III)
Credit: Jacob M. Dietz, CPA
Evaluation
Jonas suggests that Reuben and Justin implement the new bonus plan for the next quarter. They agree to sit down and review the bonus plan after at least the next two quarters and see how it is working. They should likely tweak the bonus plan to get it working properly.
Manufacturing Example
Suppose that after several quarters Reuben and Justin are delighted with their new variable pay bonus program. In fact, they are so delighted that they tell their neighbor Jaden, who is also a businessman. Jaden really values the idea of aligning his employees’ goals with his goals. Armed with a copy of the bonus plan that Reuben and Justin implemented, he excitedly goes back to his office to implement a bonus plan.
The excitement melts away as Jaden realizes that the bonus plan designed for car washing does not work well for Jaden’s manufacturing company. His employees punch the time clock in the morning and then get to work manufacturing wood structures in the shop. They punch out for lunch, and then they punch in again for the afternoon. There is no tracking of billable versus non-billable hours. The only way Jaden’s company gets paid is when they sell a wooden structure. It doesn’t matter if they made the wooden structure in 10 hours or 30 hours, or if they were efficient or inefficient. The customer pays them the same price.
Jaden calls his accountant Jonas, and together they discuss the nature of his business and what metrics (standards of measurement) might work. As part of the discussion, Jaden shares his goals for the variable pay program.
- He wants to align the goals of the employees with his goals
- He wants to increase profits
- He wants to share a portion of those increased profits with his employees
- He wants to fairly compensate the employees so that they continue to work for him and can provide for their families
As they brainstorm for ideas for a bonus plan, they come up with these ideas to base the bonus on:
- Total units manufactured
- Total square feet of units manufactured
- Reduction in gross labor percentage
Jaden and Jonas agree that in Jaden’s specific situation, the best method is to give the employees a bonus based on a reduction in the gross labor percentage.
How will they calculate the bonus? Fortunately, Jaden’s financial reports are accurately prepared every month and examined and adjusted as necessary. By looking at historical reporting, Jonas and Jaden can easily see that his average direct labor percentage is 28%. That means that for every $100,000 of sales, Jaden pays $28,000 to his employees, on average. They structure the bonus so that for every 1% decrease in direct labor percentage below 28% (excluding the bonus), the employees get a bonus equal to roughly 30% of it, as calculated on a spreadsheet.
How will the employees earn the bonus? It is earned by striving for efficiency and productivity. In the past the employees produced $100,000 of sales per month and were paid $28,000 per month. That calculates to a 28% direct labor percentage. If, by striving to improve with the new bonus plan, the employees manage to start producing $110,000 of sales per month while maintaining labor at $28,000, then the direct labor percentage would then drop to 25%. That calculation is 28,000/110,000. The difference between a 28% direct labor percentage and a 25% direct labor percentage, with $110,000 of sales, is about $2,800.
The variable pay bonus plan calls 30% of it (about $840) to go to the employees. 840/28,000 is a 3% bonus for employees that month. Ideally, the extra bonus for the employees will compensate and reward them, and the extra profitability from increased productivity will reward the owner.
Jaden and Jonas agree to monitor the bonus plan over the next quarters to see if it is working to improve the company by aligning goals, and what tweaks and modifications may help make it more effective and fair.
Segment III