Measuring Employee Productivity and Incentive Compensation Plans By Lee Evans

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1 Measuring Employee Productivity and Incentive Compensation Plans By Lee Evans Nearly all builders suffer heavy cyclical swings in income, and they would prefer to pay employees high compensation during good years and at a low level in poor years-- at least in theory. Accordingly, many builders keep base pay at or even a little below competitive salaries and supplement this in good years with incentive compensation-- bonuses and/or profit sharing. Ideally, incentive compensation should be paid in direct proportion to and linked with results people achieve or to their productivity, but there are many practical problems involved in measuring productivity and in implementing incentive compensation plans. Because of these problems, many builders procrastinate about measurement and simply implement poor or unworkable plans. Productivity varies greatly from firm to firm, and you should know what results your firm is getting at least in broad general terms. Sales volume (closed sales) per employee will give some indication of productivity. I cannot say what it should run in your firm. In one study I did of builders who attended an advanced financial management seminar I gave, the range was from$180,000 to $1,646,000. The average was $537,000. Generally the firms that had approximately average volume per employee were more profitable than those at the extreme ranges. You should know what this ratio is for your firm, both in terms of the total firm and for major departments. Graph the data for several past years and watch the trend in future years. Doing this by quarterly data might be helpful. Other general data might be related to such measurements as square feet per man hour for crews in framing, trim, or in any other trade where you hire and control crews. Or, this data can be developed and graphed for supervisor man hours. Similarly, you can trace such things as dollar volume per employee hour for such work as processing invoices. The concept of Management by Objectives implies that the builder sets objectives for the enterprise and cooperatively sets goals with the people in the firm. The goals must be quantified and then systems will measure progress toward the goals. Measurement can be in terms of four factors -- quantity, quality, timeliness, and cost. To the greatest extent possible the normal control systems should be used to measure the results people get. For example, most firms could measure work performance at lower levels in the company through several systems; scheduling systems can measure timeliness; accounting, budgeting, and cost accounting systems can measure costs; and quality control systems of various types can give a rough estimate of quality. Quantity measurements are usually readily available in most firms. Thus, measurement of the results superintendents or sales personnel get is relatively easy compared to measurement of people in finance of accounting, design, or general management.

2 I have developed a tool that I call Position Guides to help set forth specifications or standards for key people in a firm. Draw a T on a piece of paper and on the left side show results expected for each key person categorized by the four measurement factors listed above. On the right side and opposite each measurement factor, list how the results will be measured. To the extent possible results should be stated in quantifiable standards, such as average days per house from start to completion; dollar or percentage variances changeable to supervisory, estimators, or purchasing people; dollars to correct quality deficiencies or number of items on walkthrough lists. This should be the result of internal inspections and turnovers, such as superintendent to warranty service manager, rather than customer walkthrough lists, which vary according to the customer and not necessarily quality of the product. Efficiency of sales people can be measured through such things as percentage contract conversions out of prospects and traffic, follow-up calls, shopper evaluations, and so forth. To make this kind of system work a standard must be set and/or agreed upon by subordinate/superior and with bonus dollars or points tied to this standard. Then bonuses are usually increased for performance above the standard and decreased for substandard performance at predetermined graded levels. Performance of executives in charge of people on the firing line is reflected by productivity of the people they supervise, so departmental summaries are helpful. For example, one builder pays a bonus to his operations manage each month that production efficiency exceeds 100%, providing quality and cost measurements are satisfactory. In addition, however, specific goals can be cooperatively set for each executive in the firm. For example, a goal for the controller might be to install or convert a computer system. Specific steps in the process and the final result can be set forth along with time schedules and cost budgets. Such goals for improvement can be established for each executive and results can be measured. Specific bonus awards can be established and agreed upon for each such goal, but generally incentive compensation systems get shaky for executives high in the organization. At low levels in a company much of the emphasis is on doing work which adapts to measurement fairly well, but as you go up in the organization more emphasis is on management creative and nonrepetitive. Many of the results of this management work can only be crudely measured. Generally as one goes up in an organization, it takes longer and longer to see and validate results of that person s work. In some cases top executives make decisions that can never be proved to be right or wrong. Nevertheless, crude measurements are better than none, and builders should take this into account in establishing bonus plans. Then, temper such plans with a judgmental plan for part of the bonus compensation to help keep good people when results cannot be achieved because of things not controllable by the executive. Profit sharing plans may be especially useful to supplement or even replace bonus plans that are not based on good measurement systems. Profit sharing plans are based fundamentally on the concept that good productivity of the team of people in the firm will result in good profits. This may or may not be true because other things, such as recessions, cannot be controlled by the team. Regardless of this the concept of profit sharing can accomplish some of the basic objectives of incentive compensation plans. Overhead expenses can be controlled at the base pay level in poor times and rewards can

3 be given in good times. A weakness is always present that a team member may not have really contributed to productivity and profits but still may be rewarded. Some of this can be taken into account in weighting techniques of the relative value of each job to accomplishment of the objectives in the firm. Several problems must be considered in profit sharing plans. First, it is necessary to determine what percentage of the profits will be put into the profit pool to be divided. This might range form 10 to 35 percent, or even more, depending upon the desires of the owner(s) of the firm. If the builder wishes to first put money back into the equity of the firm for future growth, say at the rate of 20 to 30 percent of equity at the beginning of the year, then the amount going to the profit pool can be larger than otherwise. Next, a formula must be devised for distribution of the profit pool to eligible participants. Eligible participants can be selected individuals in the firm or every employee; but be careful on this and get good tax advice before going too far, especially if it is tied to retirement benefits. There are three basic patterns in use for distribution, plus many variations of these types. In one method the pool is divided among recipients based on the percentage of what each person s base salary is compared to the total salaries of all included persons. In a second format, point values are established for each position. For example, the value of the president s job might be 20 points, the sales manager 16, the production manager 15, and the controller 12. These points are added, and each person would get his share based on the relationship of the points for his job compared to total points for all included jobs. In the third format, points are multiplied by salaries and this is related to the total. This generally will result in fairly great top-heavy compensation. For example, the president usually gets the most salary and also his job gets the highest points. Thus, when these two items are multiplied together it usually further exaggerates the amount he gets out of the pool. Many variations of these methods are used. Sometimes a direct approach is made by simply assigning percentage of profit revenues to each job without regard to profit pools or distribution techniques. For example, it might be stated that the president will get 5% of the profit, the sales manager 2 ½ %, the production manager 2%, the finance vice president 2% the controller 1% and each superintendent ¼%, etc. Profit sharing can be paid out in various ways. It may be paid in cash immediately after year end. The golden handcuff concept can be used to pay, say, 33-50% the first year and the balance spread over the next two or three years if the person is still with the company! And, of course, it can be tied to a pension plan. Again, get advice from tax attorney or CPA before you proceed very far. There are many other cautions to observe in designing productivity measuring and compensation plans, so do consider the following points in designing your plan. 1. Do not make the mistake of assuming that people will work harder or smarter simply because they get more money. Nearly every study on motivation refutes that more money will produce greater

4 productivity, assuming, of course, that base pay provides for most necessities. 2. If you use a profit sharing plan, employees should have access to profit information; and profits must not be rigged in their estimation. 3. Compensation systems should not be so complex that employees cannot understand them. Keep the systems as simple as possible. 4. The size of payments to base pay is important. Most builders who have had experience with the plans try to keep the incentive compensation payment fairly high in proportion to base pay but may cap it off somewhere around base pay level. 5. Watch out for the runaways in which you could pay excessive amounts in any given year simply because you neglect to calculate the effect of future windfalls, large volume, or unusual profit or bonus conditions. Nearly always runaways are detrimental to future relationships. 6. Make sure your plan discriminates between low and high producers. Systems should help keep good employees and also encourage low producers to seek employment elsewhere. 7. Use of several different plans simultaneously can result in good flexibility. If you have only a fixed formula profit sharing plan, you could lose good employees when you have a down year and other companies are doing well. 8. Get competent tax help. There are many tax pitfalls in whatever you do in the extra compensation area. 9. Try to avoid building in obligations or high expectations by employees for future poor years. 10. Be fair and equitable in treatment of employees. 11. Do give employees a full report at year end on the value of all compensation including bonuses, profit sharing, and all other fringe benefits. In summary, supplementary compensation plans can have a very beneficial effect in a firm. If a plan is well conceived, it can help retain good personnel. It can have positive motivating effects when payments are tied directly to results achieved. Poorly conceived and arbitrary plans can reduce motivation and drive good people out of

5 your firm. Think through your objectives and design your plans carefully before you talk loosely to key people about what you might do. Good Luck!!