Employee compensation, A cfo.com e-book

CFOeBook

Employee Compensation

Striking the balance to best recruit, retain, and motivate

top employees.

Employee Compensation is published by CFO Publishing LLC, 51 Sleeper Street, Boston, MA 02210. Mary Beth Findlay edited this collection, with assistance from Jenna Howarth, Caitlin Hegarty, and Stephanie Scott.

Copyright © 2013 CFO Publishing, LLC. All rights reserved. No part of this book may be reproduced, copied, transmitted, or stored in any form, by any means, without the prior written permission of CFO Publishing, LLC.

ISBN 978-1-938742-45-3

EMPLOYEE COMPENSATION

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TABLE OF CONTENTSFOREWORD: KEEP YOUR COMPENSATION COMPETITIVE 4

YOUR MOST IMPORTANT ASSET? DETERMINING THE VALUE OF TALENT 6 Managing MVPs: Power from the People 7

FROM VALUE TO COST: OPTIMIZING COMPENSATION 12 Expensive Errors: Seven Common Compensation Mistakes 13 The Worst Thing You Can Do to an Employee 16 World Wages: Budgeting for Global Success 18

INCENTIVE COMPENSATION: STRATEGIC IMPLEMENTATION 20 In Practice: Incentive Compensation & Supply-Chain Performance 21 On Target: An Incentive to Control Incentive Pay 23

CONCLUSION: PAYING YOUR WAY TO GREAT TALENT 26

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FOREWORD: KEEP YOUR COMPENSATION COMPETITIVE

T he unemployment rate, though edging down, is still higher than most economists consider consistent with a fundamentally healthy economy. But by another measure

of fiscal health – the level of compensation being paid to those who are working – these are boom times.

PayScale, which claims to have the world’s largest salary database, publishes a quarterly index that tracks changes in average total cash compensation based on information provided by the millions of people per month who complete a survey on the firm’s website. At any one time the database represents about 3 percent of U.S. employment, says Katie Bardaro, PayScale’s lead economist.

Average total cash compensation among employed people, which was generally stagnant from 2009 through 2011, rocketed up last year and is continuing its surge this year. The rate of increase was greater in the last quarter of 2012 and first of 2013 than at any time since the index was established at the beginning of 2007.

Quarterly increases from the corresponding year-earlier quarter leaped, starting with the first quarter of 2012, from 0.7 percent, to 2.0 percent, to 2.6 percent, and to 3.5 percent by the end of last year. For this year’s first quarter the increase was again 3.5 percent.

That doesn’t exactly mean that the people who filled out the survey a year ago have gotten a 3.5 percent raise. “The index does not follow salary increases for specific people,” Bardaro says. “Rather, it tracks the market prices for jobs.” The database is constantly being refreshed; PayScale gets about 4 million unique visitors to its website each month, and the salary index uses recently input data.


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FOREWORD: KEEPING YOUR COMPENSATION COMPETITIVE

PayScale believes the recent salary explosion was driven by overall better economic performance and pent-up pressure to increase compensation following the limp 2009-through-2011 period, says Tim Low, a vice president at the company. In fact, over a four-quarter period that began in the second quarter of 2009, the salary average actually retracted each quarter.

Aside from the national upward trend in salaries, another notable shift that has emerged in the past year is that pay is growing faster at small employers (up to 99 employees) than large ones (1,500-plus employees). In the most recent quarter, that gap was immense: 5.5 percent at small companies, 2.5 percent at large ones. Until the second quarter of 2012, in only one quarter had compensation increases been greater for smaller employers – and that was at the index’s beginning in first-quarter 2007.

PayScale attributes this change of circumstance to “a fundamental shift in the job economy and talent market, whereby small companies are increasingly competing in the same playing field for talent as large companies and must come to the table with comparable offers,” says Low.

In a highly competitive market, human capital makes all the difference. In order to draw in and retain this human capital, employers must offer strategic compensation packages. And with upward trends in average compensation, they must be sure their offers are good enough to entice the employees that will create value for the organization.

Benchmarking pay for specific positions and people against industry competitors and other companies in their state and of their size is a good start. But it doesn’t stop there. Finance executives have much to consider, including incentive compensation packages, pay structure transparency, and risk mitigation. This eBook will equip CFOs to make strategic decisions to acquire and maintain the talent that drives their success.

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YOUR MOST IMPORTANT ASSET? DETERMINING THE VALUE OF TALENT

“Executives should accept and act on the idea that financial-performance metrics need to focus on returns

on talent rather than solely on returns on financial capital.”


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MANAGING MVPS: POWER FROM THE PEOPLEI f a company’s most important assets are indeed

its people, as corporate executives parrot endlessly, that’s news to investors, analysts, and even, as it turns out, many companies.

It is hardly a secret that the industrial economy that prevailed for two centuries has evolved into a talent-driven, knowledge-based economy. Still, extant accounting standards define “assets” mostly in terms of cash, receivables, and hard goods like property, equipment, and inventory, even though the value of many companies lies chiefly in the experience and efforts of their employees.

Public companies are required to disclose virtually nothing about their human capital other than the compensation packages of top executives, and most are happy to report only that. The furthest most companies will go in reporting on human capital within their public filings is to mention “key-man” risks and executive succession plans.

More than two decades ago, Jac Fitz-enz and Wayne Cascio separately pioneered the idea that metrics could shine a light on human-capital value. From their work grew the notion that formal reporting of such metrics could add value to financial statements. That discussion simmered quietly for many years, but recently it has grown more bubbly, as some of the best minds in human-capital management and workforce analytics work hard to influence the acceptance of such reporting.

Some are crafting detailed structures for what they generally refer to as human-capital financial statements or reports, which would complement (but not replace) traditional financial reporting. Their goal is to quantify a company’s financial

results as a return on people-related expenditures, and express a company’s value as a measure of employee productivity.


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capital reporting yet, but they might not need much prodding. Upon hearing for the first time about SHRM’s project, Matt Orsagh, director of capital-markets policy for the CFA Institute, said that, “it sounds fabulous. I want all the transparency and inputs I can have. Quantifying the worth of human capital would be fantastic, because right now you have to take it on faith, and I don’t know if I can trust it.”

Predictably, some CFOs are less enthusiastic. “It’s a fair point that the balance sheet doesn’t recognize the value of human capital, and certainly not the full value of your intellectual property,” says John Leahy, finance chief at iRobot, a publicly traded, $400 million firm. “For a high-growth technology company like ours, there is significant intrinsic value in the know-how and innovation of our people, which is why we’ve traded over the last couple of years at a fairly attractive multiple.

“But I cringe when I hear talk about more reporting requirements and disclosure. Those requirements are very burdensome for a small-cap or midcap company. Further financial reporting and disclosures would just add to that burden.”

It will be a difficult task to measure, quantify, and report on human-capital value, observes Mike Lehman, the former longtime CFO at Sun Microsystems who now heads finance at Palo Alto Networks, a large and fast-growing private company. And, he opines, companies won’t actually begin doing such reporting for many years, if ever. Still, he calls SHRM’s effort “worthy and valiant.”

While finance understands the true demands of reporting like no other department within a company, some say there is no reason to resist or fear the advent of human-capital reporting, even in the short term. In the same way companies like to be on best-places-to-work lists because it helps attract talent, says Siow Vigman, an interim division CFO and vice president, finance, for musical-instrument retailer Guitar Center, they should strive to be ahead of the pack in human-capital transparency. “If you know that what you’re showing will bring investors, why shouldn’t it be a standard that companies would want to shoot for?” she says.

Such transparency would benefit any company that’s involved on either side of an acquisition, observes Sanjeev Singhi, a controller at $1.9 billion, publicly held B/E Aerospace who is currently working on his fourth M&A deal. Like Vigman, Singhi serves as an advisory board member for the Human Capital Management Institute, a for-profit

To be sure, finance and human-resources executives alike have long considered many important aspects of human-capital value to be unquantifiable. That’s why an effort by the Society for Human Resource Management, less-granular than some similar efforts but very well organized, shows promise to have a sizable impact. SHRM’s Investor Metrics Workgroup, in conjunction with American National Standards Institute (ANSI), is developing recommendations for broad standards on human-capital reporting. The group plans to release its recommendations for public comment early in 2012. Should ANSI certify the standards, the next phase would be a marketing campaign aimed at investor groups and analysts, encouraging them to demand that companies provide the information.

If demand for that data were to reach a critical mass, then presumably accounting-standards setters would eventually look at adopting some type of human-capital reporting, and the Securities and Exchange Commission and other regulators would subsequently get involved. Of course, that’s a grand vision, and even its most optimistic proponents admit that it will take at least a decade, and probably twice that long, to materialize fully.

But the SHRM group’s chair, Laurie Bassi, is confident that the effort will succeed, however long it may take. “It’s going to serve as a catalyst for change,” says Bassi, a labor economist and human-capital-management consultant. “When investors start to demand this information, it’s going to be a wake-up call for many, many companies. For some well-managed, well-run firms it won’t be a stretch, but others will be hard-pressed to produce the information in a meaningful way.”

Bassi says that the driving forces behind the effort boil down to two things: “supply and demand, or, you might say, opportunity and necessity.”

On the supply/opportunity side, advancing technology and lower computing costs have greatly eased the collection and crunching of people-related data, enabling companies to get their arms around what’s going on with their human capital in a much more analytic, metrics-driven way than was possible a few years ago. The demand/necessity side is that, driven by macroeconomic forces, human-capital management is emerging as a core competency for employers, particularly those in high-wage, developed nations.

Something for (Almost) EveryoneInvestors and analysts aren’t demanding human-


If your human capital is so valuable, why not invest in it? Read the CFO eBook Valuable Lessons for more about the ROI of training.

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consulting, research, and software firm.

A Deeper DiveThere is, of course, a very sizable elephant in the

room: Whatever its ultimate value, how, exactly, do you report on human capital? More pointedly, is there a way to go beyond the broad type of information that the ANSI standards will stipulate and create human-capital financial statements that match the rigor and precision of traditional financial statements?

Absolutely, says Jeff Higgins, who has almost certainly created the most scientific, detailed solution to that challenge. His work illustrates how a metrics-driven approach can capture human capital’s impact on financial performance.

Although Higgins now considers human-capital metrics his life’s work, his résumé is steeped in finance. He is a former divisional vice president of finance for Johnson & Johnson and a former CFO of Klune Industries. In those jobs he became so interested in effective people management that he eventually took a job running compensation and human-capital analytics for IndyMac Bank. Most recently he launched the Human Capital Management Institute, where he is CEO.

His sample “Human Impact Statement” is, he says, analogous to the traditional income statement. Higgins has also created two other documents: a human-capital asset statement (parallel to a balance sheet) and a human-capital flow statement (cash-flow statement), but he considers them somewhat less important than the impact statement.

An underlying premise of the impact statement is that the average business gets a return of one dollar for each dollar of non-human-capital spending, and that profit is created by human effort. As Higgins frames it, how much money does an empty room make? Zero. Ditto for a bank branch with no bankers, or a plane without a crew.

“Executives should accept and act on the idea that financial-performance metrics need to focus on returns on talent rather than solely on returns on financial capital,” Higgins says.

Much of today’s investment marketplace is based on metrics and ratios derived from traditional financial statements. Human-capital financial statements can be a tool for achieving similar standardization, measurement, and identification of best and worst, improving investors’ ability to assess a company’s potential long-term performance.

For example, Higgins’s human-capital impact

statement includes a “human-capital ROI ratio” and a “return on human-capital investment,” or RHCI. The former measure compares return on revenue (net of non-workforce costs) with the total cost of workforce (or TCOW, a term coined by Hewlett-Packard). TCOW includes all salaries, other wages, cash or equity compensation, and benefits for all employees, including temporary or contract workers. On the sample statement, for the current year the hypothetical company’s human capital returned $1.30 for every dollar spent on the workforce.

RHCI involves a similar equation but compares TCOW with a selected operating-profit metric, like net operating profit after taxes or profit after tax and minority interests. In the example, for the current year the hypothetical RHCI is 18.5% of every dollar spent (or, when expressed like the other metric, a return of $1.185 on the workforce).

The two calculations often produce similar results, but they tend to diverge depending on how human-capital-intensive a business is. For example, telecommunications firms and some utilities generate revenue with fairly little human involvement once infrastructure is in place, pushing the human-capital ROI ratio higher.


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The total shown at the bottom of the Workforce Productivity Impact box takes into account TCOW as well as revenue, profit, and market capitalization per full-time-equivalent employee. (It is a complex calculation; Jeff Higgins welcomes requests for further information on this and other calculations in his sample statement.)

The Management DanceThe Talent-Management Impact section of

the sample statement is presented as a series of scorecards, each based on a set of advanced metrics linked to financial results, that quantify value creation or destruction. As shown at the bottom of the page, the statement concludes that $40.17 million of the $41.29 million Workforce Productivity Impact is a result of talent-management policies and activities.

For example, the Recruiting and Hiring segment looks at such things as how long it takes to fill key revenue-producing positions, lost revenue attributable to such openings, and the cost difference between hiring internally and externally. The total recruiting and hiring impact adds up the value of those calculations, with a multiplier factor based on quality of hire (something few companies measure).

The quality-of-hire index is based on five factors: the 90-day new-hire turnover rate; the percentage of job requirements met by new hires; satisfaction surveys of new hires and their supervisors; the percentage of new hires that become high performers; and the number of qualified applicants per open position.

Similar calculations are used to quantify the financial impact of other major components of talent management, which also employ indexes as multipliers that help determine the financial impact:

Mobility. “Career-path ratio” is the ratio of promotions

to total movements (including transfers, sideways moves, and demotions) within the organization. If the ratio is too low, you’re not doing enough promoting from within, which can impact the bottom line if you’ve already identified in the Recruiting and Hiring segment that it is less costly to grow talent internally. If the ratio is too high, you’re doing too much promoting, which also costs money because it puts too many people into high-income positions. The mobility-impact calculation also factors in the differential in compensation costs for internal versus external hires.


Leadership and Management. The “talent-management index” is like the

quality-of-hire index, except it measures leaders’ performance in finding high performers and optimizing mobility. The “managerial bench strength” index measures the percentage of managerial positions for which at least one other person is qualified. “Management span of control” measures the number of direct reports per manager; the lower the number, the higher the costs.

Training.The “training-effectiveness index” takes into

account the retention rate of high performers before and after training, productivity or performance before and after training, training investment per employee, and employee satisfaction with training.

Performance and Engagement. The “employee-engagement index” is really just

a score; here employers can plug in the results of employee-engagement surveys. Regarding the “employee-engagement revenue-linkage impact,” Higgins says it is “probably the most difficult one for an average company to figure out.” He relies on established bodies of work that estimate what, say, a 10% increase in engagement is worth to a business. By contrast, high-performer productivity impact is easier to figure out.

Turnover and Retention. This entails a more straightforward calculation

than any of the other talent-management metrics, and it is the only one that shows a consistently negative impact.

Despite its detailed methodology, it seems clear that even Higgins’s impressive effort to calculate the financial impact of human capital can’t avoid the fact that there are subjective elements of talent management that defy quantification. But don’t try to get him to admit it. “I don’t live in that world,” he says. “I get up every day trying to quantify everything. I would acknowledge that there are things great leaders and managers do that we cannot yet quantify. But over time, good ones leave a track record of how they manage people that is very quantifiable.”

Experts in the field increasingly see Higgins as a dominant force and an advocate for change. “Jeff has merged human-capital analytics and financial accounting into a new configuration,” says Fitz-enz. “As a result, we can at last unequivocally connect human effort to business results.”

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Too Much Detail?Not all who are close to the subject of human

resources are so sure that breaking down financial results in terms of human-capital investments would be a valuable addition to financial reporting.

“I’m of two minds on that,” says Ellen Hexter, senior adviser on enterprise risk management for The Conference Board and co-author of a recent white paper on managing human-capital risk. While she likes the idea of shining a light on the impact that human-capital issues have on organizational success, she sees “a danger that if it all gets boiled down to numbers, it could become a compliance exercise, and you wouldn’t necessarily be dealing with the big issues that needed to be dealt with.”

Also, Hexter notes, financial statements by nature are backward-looking, whereas her work lies in anticipating and planning for risks. She is familiar with and complimentary of Higgins’s work but says she doesn’t see that it much addresses human-capital risks.

But to Higgins, risk management and the disclosure of human-capital risks are at the heart of all efforts to connect people-related metrics to financial results.

“The risks and disclosure sections of companies’ public filings are huge, with everything under the sun in there to minimize liability,” he says. “But with no visibility into the efficient utilization of the typical firm’s largest expense, one need not be an expert to recognize that some organizations have significant unreported human-capital risks.”

CFO Summary

• Technological advances are making it easier to collect and analyze human-capital data.

• While analysts and investors seem enthusiastic, some CFOs are wary that increased reporting requirements would be a large burden for smaller companies to undertake.

• One method to calculate the financial impact of human capital, devised by Jeff Higgins, includes analysis of the following areas: mobility, leadership and management, training, performance and engagement, and turnover and retention.

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FROM VALUE TO COST: OPTIMIZING COMPENSATION

“Organizations that have been giving only limited to modest raises in this difficult economy may not be

diligently measuring where their pay stands relative to the market. As a result, they may be overpaying some

employees, even though they are not giving large raises, or they may be underpaying some employees, which could

cause valuable talent to leave.”

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EXPENSIVE ERRORS: SEVEN COMMON COMPENSATION MISTAKESA n organization’s compensation expense is

an investment in talent, which requires a return, just like any other investment. Even though return on compensation (ROC)

is harder to measure than the return on traditional capital investments, prioritized investments in talent produce better returns than homogenous or entitlement approaches.

Despite their best intentions, organizations can make mistakes that sabotage their plans to improve their ROC on rewards for top-performing employees. Seven such mistakes are discussed below.

Neglecting to Benchmark Pay PracticesOrganizations that have been giving only limited

to modest raises in this difficult economy may not be diligently measuring where their pay stands relative to the market. As a result, they may be overpaying some employees, even though they are not giving large raises, or they may be underpaying some employees, which could cause valuable talent to leave.

Charting each employee on an ROC matrix that compares employee performance to the market rate or benchmark for the employee’s salary will help determine how the organization is compensating its employees relative to the market. It will show whether each employee’s compensation could be considered a discounted investment, an at-market investment or a premium investment. The organization can then use this information to make individual investment decisions regarding employee compensation.

Although most employees should fall in the

squares of the matrix where their performance roughly equals the market rate of their salary, that is not always the case. For example, although Employee A might be considered a discounted investment and Employee B might be considered a premium investment, neither position is necessarily wrong. The organization needs to take into account factors such as the employee’s compensation history, rate of advancement, leadership potential, and other factors to determine if the person’s compensation investment is acceptable.

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Failing to Align All the Organization’s Goals

An organization’s goals must be aligned so all its units, managers, and employees are working individually and together to achieve objectives that have been established by the CEO and the executive team.

The CEO and the executive team set goals for the organization and its executives. It is up to each unit to determine what it must do to achieve those goals. The organization’s various units then need to coordinate their goals to determine what must be done collectively. For example, if one of the organization’s goals is to improve its talent management initiatives, then HR, finance, and other departments that would be affected need to determine what role each must play in achieving that goal. After unit goals have been aligned, the next step is to set the goals for the organization’s managers and, finally, each individual employee.

Using Limited Pay-for-Performance Differentiation

When it comes to rewarding performance, many organizations fall into a trap that might be called the “peanut butter spread,” where the rewards are spread thinly but evenly among everyone in the organization. If the organization’s annual increase budget is 3%, everybody gets 3%. Although this is easy to administer and defend, it does nothing to improve the organization’s ROC. In order to make an investment, the organization has to prioritize who should get what and make difficult choices rather than taking the path of least resistance.

It may be difficult to differentiate when the salary-increase budget is small. But one effective strategy, carving out dollars from salary-increase budgets and incentive pools explicitly to reward high performers, leads to more effective investments in talent.

Even with a modest salary budget, say 2.5%, if 0.5% is carved out for high performers, average performers get 2%, and if 25% of the population are high performers, they can get as much as 4.5% increases. The same concept holds true for funded bonus pools. When communicating reward decisions, allocations from the high-performer pools can be used as a tool to recognize top talent while managing the expectations of the broader workforce.

Not Calibrating Performance Management Data

Calibration – or sharing and adjusting of decisions across a group, rather than allowing managers to make decisions on their own – guarantees the integrity of the data used to make reward decisions based on employees’ contributions (i.e., pay for performance). In an organization without calibrated performance data, managers’ individual standards of performance may lead to inequitable ratings and pay investments, which lowers motivation.

In some organizations, calibration is handled by the human-resources department. More effective, however, is having the organization’s leaders meet and calibrate the data themselves. The prospect of a leader trying to justify the position that there are “no poor performers” in his or her group is often enough to encourage employee differentiation. Formal performance management calibration sessions, within and between functions, will ensure that performance standards and ratings are applied consistently.

Avoiding Transparency in the Pay SystemOrganizations that communicate a pay philosophy

and the rationale for pay decisions, and that place appropriate context on how they arrive at individual decisions, are more likely to have employees motivated by compensation than those that manage compensation in a “black box.”

Employees are more accepting of an unfavorable pay decision when they understand how it is made and believe that everyone in the organization is subject to the same system. Without transparency, employees tend to feel that their compensation is being controlled by their manager rather than by an organization-wide system.

Moving Too QuicklyOrganizations that want to enhance their ROC

by improving how compensation drives employee motivation should recognize that change does not occur overnight. It is better to execute a few changes well than to implement broad changes poorly. Implementing a series of prioritized changes over several compensation cycles will give the business time to properly absorb change into the culture and produce the desired impact. It will also improve employee buy-in for the compensation system. Moreover, any mistakes will be easier to correct before they become entrenched.

Too often, organizations with a vision for the future have an aggressive desire to implement change swiftly and with a heavy hand. When this


Compensation isn’t the only area in which employees are looking for transparency. Check out Is Healthcare Transparency at Hand?

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CFO Summary

• The first step in determining whether employee compensation levels are acceptable is establishing a benchmark—how your employee compensation compares to market rates.

• When approaching distribution of a salary-increase budget, allocate some portion to top performers. This will sufficiently reward the most valuable employees while maintaining general expectations.

• Calibrating performance management data can help ensure that ratings and reward decisions are made equitably and motivate improvement.

• If your managers are making compensation decisions, make sure they have the training and communication skills to be properly accountable.


occurs, program results often fail to match the rhetoric, further demotivating employees and challenging the organization’s credibility.

Failing to Empower ManagersOrganizations that hold managers accountable for

pay decisions also need to give them the training and tools they need to do the job effectively. In many cases, managers have only a pool of dollars and loose allocation guidelines. The best compensation investments are made when managers can leverage all of the appropriate pay, performance, and business-planning data available throughout the organization.

Giving them more sophisticated information will help them effectively allocate salary and incentive pools. Such information includes external market competitive benchmarks, internal average salary benchmarks, time in role/role history, performance rating history (i.e., longer-term performance data), compensation history, depth of responsibility and role criticality, and talent scarcity assessments.

Managers also need interpersonal and relationship skills training on how to have meaningful compensation conversations with employees and not just read a script. The goal is to be able to blend a business conversation with a performance management conversation to create a developmental conversation that clearly demonstrates what the employee needs to do to improve his or her compensation.

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TOO MUCH OF A GOOD THING: WHY OVERPAYING EMPLOYEES IS A BAD THING

I n pinpointing the worst thing you can do to an employee, we’re excluding things that are illegal, unethical, immoral, or unsafe. Otherwise, the worst thing for an employee is obvious to

us though perhaps not to others: paying her or him significantly more than a free-market wage.

What? The worst thing you can do is to pay someone too much? We can see people’s hands going up volunteering to receive that type of harsh treatment. But the results are often devastating for the employee.

We’ll define a free-market wage as the amount of money the employee could reasonably expect to earn after losing his or her current job and being forced to find work. It is what the free market would pay a person with the education, experience, and skill set of the employee in question.

We are talking about situations in which employees are paid 50% or 100% more than they could get elsewhere. If you think that doesn’t happen, think again. We’re aware of a company that has to pay low-skilled employees working on a government job $12.50 per hour while their other employees, doing exactly the same work for private-sector customers, are paid $8.00 per hour. The reason: the government requires that the workers on its jobs be paid on a union wage scale. If the workers making $12.50 per hour were to lose these jobs, could they find jobs paying as much? Not likely ― they are making 56% more than the free-market wage.

When an employee is significantly overpaid, several things happen. In most cases, employees do not recognize that they are overpaid. It’s human nature: most of us believe we are worth more than we are paid. At the least, we think we are paid fairly. It’s a very unusual person who recognizes that his or her compensation is well above what he or she could earn elsewhere and adjusts his or her lifestyle to compensate.

The second thing that happens is that overcompensated employees, not recognizing the precariousness of the situation, build a lifestyle that cannot be sustained by less than their current income. For most, even if they know they can’t replace their income, they behave as though they can. People stretch to buy the biggest house for which the bank will approve a loan. They buy new cars with debt and leverage themselves to the hilt.

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Spending on “extras” chews up cash, and savings are minimal. Often it takes the current level of income just to service the debt.

Then, the unthinkable happens. The goose that laid the golden eggs is gone. It could be a plant closing or a layoff, or perhaps a company could replace the overpaid employee at a substantial savings to the business. For example, a company that operated call centers wanted to be on Fortune magazine’s list of best places to work in America. To achieve that, it offered above-market-rate compensation, extremely generous benefits, three to five weeks of vacation, and numerous other perquisites such as fun days. The company made Fortune’s list. Then, the economy turned down and things got tight. A bright, young analyst figured out that the company could save millions by outsourcing its expensive call-center operations, and the party was over.

Paying significantly above market rates to employees who cannot justify the premium through increased output is not only irresponsible, it’s an abrogation of the company’s fiduciary responsibility to its shareholders.

Most people who find themselves out of work will try to replace the income they have just lost. They believe they can, because they think they are worth what they were making. Refusal to accept lower-paying jobs lengthens unemployment and makes matters worse. They try to hang on to the lifestyle they built, not realizing they will never again attain their former level of income. We’ve seen cars repossessed, foreclosures on homes, broken marriages, and even suicide.

Of course, blue-collar workers are not the only ones subject to this phenomenon. Many white-

collar workers and elite athletes have met the same fate. Having worked very hard for years to make it to the pinnacle of their sport, they proceed to build a lifestyle that requires their current level of income to sustain it. The minimum salary of an NFL player is currently about $375,000 per year. Unfortunately, the average number of seasons a player spends in the NFL is three and a half, and most have no prospect of making that kind of money once their playing days end. Too often, when the ride is over, their world comes crashing down and they find themselves destitute. The list of former star athletes who met with financial ruin includes such household names as Mike Tyson, Scottie Pippen, Lawrence Taylor, Dorothy Hamill, Rollie Fingers, Bjorn Borg, and Johnny Unitas.

It may sound odd, but yes, in our years of experience, we have found that the most unfair thing an employer can do is to pay an employee significantly more than a free-market wage. Doing so sets the employee up for financial ruin when the gravy train comes to an end. We’ve seen it time and time again.

CFO Summary

• While it may seem kind to pay employees more than market rates, employers are actually doing them a disservice in the long run.

• Employees that get accustomed to receiving an excessively high level of pay are reluctant to take lower paying jobs in the future and oftentimes fail to adopt their lifestyles to true market wages.

The job search process has changed. Read Do Social Networks Trump Résumés?

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WORLD WAGES: BUDGETING FOR GLOBAL SUCCESS

A privately-held software company based in California is starting to pursue new sales in Europe. The company has already opened a U.K. office as its headquarters

in the region, and is now charting its course into other European countries. As executives there begin to budget for these efforts, they are struggling to understand country-level requirements, in part because they are in a bit of a rush. In particular, they are concerned about whether or not they have captured all important expenses. While they can use their U.S. and U.K. expense bases as a starting point, there will be items that are materially different in

other European countries, and if these are not properly captured and planned for, they could have a negative material effect on their budget.

The largest category of expenses the California company expects to incur in Europe is labor. In this case, employee compensation plus employer contributions to social security and insurance represent nearly 80% of their expense base. Why so high? Here are a few components:

Market norms for salary and benefits in Europe are likely to be higher than in the U.S.

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In the U.S., this California company offers salespeople nominal salaries, with up to two-thirds of compensation riding on commissions. It is also the cultural norm that it — and most U.S. companies — does not offer benefits such as company cars nor car allowances, and that annual vacation is two or three weeks.

If the company were to offer this package to potential sales candidates in Germany, it would not only be hard-pressed to get anyone to interview for the position, it would also be in violation of certain labor laws for failing to meet the minimum vacation requirements. In Germany, salespeople expect a much higher salary and smaller commission, a company car or car allowance, and for the employer to pay half of the health insurance. Last but not least, the legal minimum required vacation in Germany is 20 days, or four weeks.

Labor-related taxes can vary significantly country to country.

If you were to apply an average percentage, say 15%, across the board for employer-related social security and insurance contributions for all countries in your budget, and you have a large number of people in France and Belgium, the budget-to-actual differences will be material.

For example, the employer’s social security and

related insurance contribution costs as a percentage of gross compensation for the California-based software company are as follows:• UK: 13.8% with no ceiling• Germany: 20.18% with a ceiling of €66,000

(U.S. $94,000)• Belgium: 35% with no ceiling• The Netherlands: 35% with ceiling up to

€40,000 (U.S. $57,000)• France: 42% with no ceilingComparing the U.K. to France, the cost of social

security and related insurance contributions varies 28.2%. Multiplied across four sales people in France with an overall package of € 200,000 ($284,000) per person annually, the difference is over € 225,000 ($320,000). This is a material difference for most companies.

CFO Summary

• Employee compensation practices vary greatly across countries. In order to recruit top talent you must tailor your compensation packages to the culture and laws.

• When moving overseas, make sure you are familiar with the new costs, such as social security and related insurance contribution costs.

International companies face more challenges than compensation practice discrepancies. Read more in The Global Company’s Challenge.

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INCENTIVE COMPENSATION STRATEGIC IMPLEMENTATION

“To be sure, companies have long reserved incentive compensation plans for senior executives, salespeople

and others who directly affect revenues and earnings. But now, some are extending incentive plans down through the organization. Corporations have also begun linking compensation packages to broader operational metrics

like customer satisfaction, inventory turns, and cycle times.”

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INCENTIVE COMPENSATION: STRATEGIC IMPLEMENTATION

IN PRACTICE: INCENTIVE COMPENSATION AND SUPPLY CHAIN PERFORMANCEY ou can spend millions on enterprise

resource planning (ERP) software. But unless employees throughout the business use new technologies effectively, the potential

efficiencies may be lost.So how can senior managers get employees to buy

into E-business initiatives?By paying them for it.To be sure, companies have long reserved

incentive compensation plans for senior executives, salespeople and others who directly affect revenues and earnings. But now, some are extending incentive plans down through the organization.

Corporations have also begun linking compensation packages to broader operational metrics like customer satisfaction, inventory turns, and cycle times.

“Incentive compensation plans used to be just for salespeople,” says Mark Stiffler, president and chief executive officer of Synygy, a provider of enterprise incentive management (EIM) software. They are now being rolled out to include most company employees, he adds.

The benefits of using compensation as a way to push through initiatives that can increase corporate performance, such as E-business, seem to be catching on with CFOs.

“We get business from finance departments, especially, that recognize the big potential return on investment,” comments Stiffler.

Bob Ferrari, senior research analyst at AMR Research, says incentive compensation plans are increasingly being linked to E-business initiatives. “This is a new concept that will catch on eventually,” he claims.

Ferrari, a former employee of Sun Microsystems, says Sun is on the cutting edge of incentive compensation. At Sun, pay is predicated not only

on traditional metrics, like profitability and revenue, but also on customer satisfaction, he adds.

“Sun has a quite intricate customer-satisfaction index—a combination of on-time delivery to customers, return rate, and other quality metrics,” he comments.

Within Ferrari’s business unit at Sun, compensation metrics was weighted toward the supply chain, he says.

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“On-time delivery, inventory turns, [and] customer satisfaction were all tied into pay,” Ferrari says. At the start of each year managers clearly laid out the performance metrics by which his unit would be measured and the specific ways in which employees could contribute to those metrics, thus potentially increasing their total pay, he adds.

“If our unit was going to put in an application, such as [an] SCM application, that was intended to impact inventory turns across the division, the incentive portion of employee compensation was predicated on that business metric being achieved,” says Ferrari.

A Sun spokesperson declined to comment on the specifics of the company’s incentive compensation program for “competitive reasons,” saying it is sensitive information. But she generally confirmed Ferrari’s account.

“Once compensation is tied to specific metrics being met, things begin to happen,” says Ferrari. Things become very clear for people, and they become more interested in the ways they can affect the metrics driving the overall business strategy, he adds. Incentive programs can thus be an effective means of aligning processes with corporate goals.

“My experience is that [incentive compensation] tends to modify behavior very quickly,” asserts Ferrari.

A 1999 study by compensation consultants Towers Perrin found that 40 percent of 770 American companies surveyed offer some form of incentive-based compensation to all their employees, not just salespeople or upper management. And Hewitt Associates survey found last year the 78 percent of the 856 businesses polled have at least one type of variable pay plan in place, up from 70 percent in 1999 and 47 percent in 1990.

Besides rolling incentive compensation plans out to more employees, companies are also making them more complex.

“These plans now include many different measures of performance and a wider variety of data,” says Stiffler.

Today companies can get large amounts of accurate data about inventory turns, cycle time, delivery performance, and customer satisfaction that they couldn’t get in the past, he contends. The newly available data stems from supply chain management (SCM) and customer relationship management (CRM) applications.

Companies now have the information they need to measure employee performance and thus link compensation more effectively to it.

There’s one potential pitfall of tying pay to performance, however. Because companies often cut base salaries when they institute incentive compensation plans, employees could become uncomfortable with having their salary linked to metrics that may or may not be met, and they may leave, says Synygy’s Stiffler.

“But the flip side is maybe you want to lose those people anyway,” he contends. “That’s the deadwood.”

To be successful, an incentive compensation plan done in connection with an E-business initiative must be accompanied by extensive education and training, says Craig Ulrich, a principal at William M. Mercer, Inc., a human-capital consulting firm. “First there is education and training that needs to go on, separate and distinct from compensation,” he says.

If employees are not convinced of the concrete benefits of new systems and how they affect E-business initiatives, then an incentive compensation program will not be very effective. For E-business projects to be successful, companies must also have a clear understanding of how their work processes will become more efficient as a consequence of their investments.

Only when these steps have been taken can companies begin to tie the success of E-business initiatives to employees’ paychecks, Ulrich cautions.

CFO Summary

• Traditionally, incentive compensation goes to top executives. But extending incentives to lower ranking employees can encourage enhanced performance.

• Applications in areas such as supply chain management and customer relationship management provide valuable data to measure employee performance.

• Make sure everyone is on board. Employees must be convinced that the incentive compensation plan will benefit them and companies must understand how the investment will generate increased efficiency in work processes.

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ON TARGET: AN INCENTIVE TO CONTROL INCENTIVE PAYW hen it comes to establishing incentive-

compensation targets and weighting the measures used to calculate payouts, CFOs who are not heavily involved in

the process – especially where non-executives are eligible for bonuses – are making a mistake.

At least, so says Juan Pablo Gonzalez, a partner at management-consulting firm Axiom Consulting Partners, whose specialties include talent acquisition, development and rewards.

Investors have grown increasingly more attuned to compensation matters since the Securities and Exchange Commission, under the Dodd-Frank Act, required public companies to give shareholders a nonbinding advisory vote on executive-pay programs as detailed in proxy statements, starting in 2011.

The so-called “Say on Pay” votes apply only to the compensation packages of a company’s chief executive, CFO, and three other most highly paid officers. But, says Gonzalez, Say on Pay for senior executives has opened the door to greater investor scrutiny about a whole range of incentive-compensation issues. This year, with salaries relatively flat and bonuses and short-term incentives comprising a larger share of employee compensation, CFOs certainly will be answering more questions about the details of their payout policies and how those policies serve the interests of shareholders.

“CFOs don’t often get involved with human-resources issues, but when it comes to incentive compensation, they should,” says Gonzalez. “At a minimum, the CFO’s team should be involved in running payout calculations and performance curves against various assumptions about the company’s performance. But the greater value is in having the CFO look behind the numbers to assess

whether bonuses are really driving the behavior that supports company strategy.”

Some are doing so, Gonzalez notes. For those who haven’t been involved, now is a good time to start. Since many companies release bonus payments in March, it’s common for management to follow up with a review of incentive-compensation policies and practices in April or May to see how they can create better alignment between compensation and performance in the following year. “The CFO should step in sooner than later,” he says.


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Make Sure Bucks Are in the EquationAmong the more enlightened is Dan Gallagher,

CFO at Town Sports International, a $500 million publicly held company that operates 160 health clubs in the United States. Town Sports offers incentive compensation for its executives and club managers. The HR and operations department offer suggestions about how to structure the incentives, “and I usually counter with something else,” Gallagher says.

For example, five years ago the company was making such extensive use of secret shoppers at its clubs that the idea arose to base half of the club managers’ incentive pay on the secret shoppers’ scores. “I nuked that right away,” the CFO says. A club could “buy its way” to higher scores by hiring more housekeepers and “extra-friendly staff,” meanwhile burying themselves in a financial hole. “There always has to be financial metrics in the dialogue, and if the CFO is not involved those metrics can be underplayed.”

What Town Sports ended up doing instead was set a minimum threshold for secret-shopper scores below which club managers were not eligible for a bonus. For those who qualified on that count, half of the bonus was based on membership gain and half on a club’s “controllable profit,” an EBITDA-like measurement that excludes rent and a few other items not under the manager’s control. “It means they shouldn’t be overspending on payroll and shouldn’t be leaving the lights on and things like that,” says Gallagher.

The same criteria remain in effect today for club managers and also for regional business and operations directors. For upper-level executives, bonuses are based 60% on EBITDA, 20% on revenue, and 20% on return on assets.

The performance measurements Town Sports uses adhere strictly to one of Gonzalez’s key tenets: the plan has to be simple. “If you give people 17 different things to focus on, you’re not going to change their behavior,” the consultant says. “You’re just going to confuse them. Then they’ll throw their arms in the air, keep doing their jobs the way they always did, and hope they get paid.”

Going back about eight years, Town Sports’ plan was far too complicated, says Gallagher. “If you went into the field on any given day and polled 50 club managers, half of them didn’t understand how the calculation worked.” Keep it simple so employees always know whether they are tracking to the plan, and new ones will more quickly understand the

company’s goals.

Tailor the Program to Industry NormsThe incentive-compensation program is even

simpler at Aptiv Solutions, which performs research on a contract basis, in the sense that not only is every bonus-eligible employee subject to the same measurements, but with few exceptions everyone gets the same percentage payout. “Our overarching philosophy when it comes to incentive pay is that there are no winners on a losing team,” says Matt Bond, the company’s finance chief.

The payout is based on revenue, EBITDA, and the amount of new contract work Aptiv lands. Leaders of the company’s 15 business units have their own individual targets but achieving them has no influence on the payout. “They are mindful of it, with the idea that if they get their units’ business up, it will help them get their bonus,” Bond says. About 35 percent to 40 percent of Aptiv’s work force is in the bonus program.

Aptiv finds that the nature of the company’s business makes the homogenous payout sensible. “If you dissect us down to our skeleton, we’re a professional services firm,” he says. “Billable hours is one of the key drivers. If individual business units aren’t linked at the top, people may hoard customers, activities and resources to maximize their business unit at a cost to the organization as a whole.”

The company does get its business-unit leaders to submit target levels each year for the three metrics the company uses to calculate incentive payouts. Often the submissions are “obscenely low,” an example of what Gonzalez calls the “sandbagging approach.” In addition to under-promising results, people may slow down near year-end after targets are achieved, if the program is not structured properly.

In Aptiv’s case, performance levels higher than target numbers trigger payout multipliers. As for the initial low-balled targets, they don’t actually have any effect, Bond says. “We go out to the organization for input on what each business unit can commit to, but it’s not communism where we let them rule the roost. We have a set of numbers in mind. I have to take our overall targets to our three private-equity owners, who want to see upward-focused graphs.”

Make It Complex – If You Have To Sandbagging is more of a concern at the American Bankers Association (ABA), which has traditional nonprofit activities but also for-profit ones that


Sometimes CFOs must get involved in areas that are typically covered by HR. For a look at the relationship between these two departments, read Finance and HR: Strangers in Each Others’ Lands.

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CFO Summary

• When designing incentives, human resources and operations may offer suggestions, but CFOs ultimately determine the financial value that should be incentivized.

• Keep the plan simple so employees understand their targets.

• A CFO may not be able to identify individual contributions, but he or she will be able to recognize the overall level of performance. Let the executive vice president for a group decide how to distribute a bonus pool.

generate about $100 million of revenue per year.During the budgeting process for 2013, the

ABA had to do substantial negotiating with the organization’s sales team to “get the number to where we realistically thought it ought to be, given the economy and where the banking industry stood,” says CFO Robert Eady.

But while the ABA worked with Axiom Consulting for two years to overhaul its incentive-pay program, it didn’t end up with the degree of simplicity that Gonzalez espouses.

“For us it’s kind of complicated,” says Eady. At one end of the sales spectrum is cold calling regarding products and services the organization offers to its members. Eady calls that “pure sales, a one-on-one, close the deal kind of thing.” At the other end of the spectrum is membership sales, which is very important to the organization because it collects $34 million in member dues annually. That’s hardly ever a one-on-one sale; Eady may get involved, as might the ABA’s government-relations experts, for example, depending on what interests the potential new member. Ultimately there could be up to six people involved in the sales process.

That’s part of what makes structuring an incentive program difficult for the ABA. The other part is that the spectrum of sales activities is broad, and what kinds of payout criteria and weightings make sense varies greatly across that spectrum. There are also four different revenue-generating groups, each with an individually designed plan. Some are individual commission-based plans. Some are plans where a group that reaches its targets triggers the creation of a bonus pool, to be doled out by the executive vice president over that group based on team members’ individual contributions.

Sources for Employee Compensation:“An Incentive to Control Incentive Pay,” David McCann, CFO.com, April 15, 2013. Copyright © 2013 CFO Publishing LLC. “Budgeting for Global Success,” Bill Hite, CFO.com August 10, 2011. Copyright © 2011 Bill Hite.“Employee Pay Spikes Nationwide,” David McCann, CFO.com, April 18, 2013. Copyright © 2013 CFO Publishing LLC.“Power from the People,” David McCann, CFO Magazine, November 1, 2011. Copyright © 2011 CFO Publishing LLC.“Seven Common Compensation Mistakes,” Jason Adwin, CFO.com, December 15, 2011. Copyright © 2011 Jason Adwin. “Sun Uses Incentive Compensation to Boost Supply-Chain Performance,” Jennifer Caplan, CFO.com, March 26, 2001. Copyright © 2001 Jennifer Caplan. “The Worst Thing You Can Do to an Employee,” Doug White & Polly White, CFO.com, October 25, 2011. Copyright © 2011 Doug White & Polly White.

Overall, suggests Gonzalez, “A CFO is not necessarily in a position to assess how well everyone eligible for incentives does their jobs, but he’s in a great position to evaluate how the combination of all those efforts contributes to different levels of organizational performance.”

In that regard, one final note of caution: be careful about how many people you make eligible for incentive pay. If you go too far down in the ranks, you may bog down the organization. “You may end up spending an awful lot of time trying to come up with something for the clerical person to do against which to pay the incentive, and trying to come up with ways to measure that person’s performance, to pay out an award that may not be all that substantial,” Gonzalez says.

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CONCLUSION: PAYING YOUR WAY TO THE TOP

I n a world where we like to put a nice, neat value on every element that contributes to the success of a business, valuing human capital seems to be the next big trend. Despite the

difficulties that such an exact measurement entails, most employers would concede to the general strategic importance of their human capital.

Even if most companies do not yet have a metric for measuring the value of their talent, they all confront this value indirectly through what they pay for their talent. Managing your employee compensation is key for both recruiting and retaining top talent while motivating your employees to optimize important drivers of performance.

We hope this eBook has served as a useful guide to best practices in employee compensation. Here are some important takeaways:

Talent is best rewarded when you pay your employees the market rate for a given position.

Paying them too much more places them at a disadvantage in the long run, and paying them too much less will cost you some of the best people.

Incentive compensation can be a useful tool when extended beyond top executives.

Just make sure your incentives are strategically chosen and clearly explained. Incentivizing the wrong metrics or keeping employees in the dark about the procedure will drive away any potential benefits.

Complex compensation plans are risky. Auditors are taking on an increased role in

compensation plan review to help mitigate some of this risk. Be very careful about misreporting because even time will not erase your liability.
