The Salary Sage

Goal Setting & Probability of Achievement

When designing incentive plans, the question often arises "how hard should it be to reach target?" There are many theories about this, but in general I follow this approach:

I like to set Threshold (i.e., the minimum level of performance below which there is not payout) so that there is 1 in 5 (20%) chance they WON’T be met. This is important. Thresholds should never be set so low that they are virtually guaranteed. When that happens, the company very well might be making payments and getting nothing of value for them. On the other hand, if Thresholds are too difficult to achieve, too many people will fail to reach them and the incentive plan will be perceived as unrealistic resulting in many participants not even trying.

I like to set Targets (i.e., the desired or expected level of performance) so that incentive plan participants have a slightly better than 50/50 chance of hitting them. Am I a “softy?” Maybe, but I prefer to look at it this way – Success breeds success. And I would much rather have people hitting targets more often than not for the confidence that provides. Yes, you may say, but aren’t you giving away money? No, because I always make sure that the company’s return on performance is greater than that of the employee. That way, I can always be sure that the Company is better off having the results than not having them. Yes, you might add, but what if the company would have had the results anyway? To this I would answer, you might get away with that for a while, but eventually employees are going to feel used and undervalued and either leave, or worse yet, their body will keep coming to work but they’ll leave their brain at home.

As for Outstanding, that should be a real stretch. I like 10% because that suggests that one year in 10 someone could reach or exceed them. Said another way, if 10 people are given the same goal one might reach the Outstanding level of achievement. Going beyond Outstanding can be a very good thing for both the employee and the company (provided the goals are set right). This is the stuff myths are made of. When someone goes beyond outstanding, the word gets out and, if you play your cards right, everyone will be imagining it might happen to them. And good things happen when people dream!

In summary, when goals are calibrated correctly, in any given year (or on any given measure), you would have 80% of employees "in the money" by being above Threshold (20% would be below Threshold and earn no payout), 50% to 60% at or above Target, and 10% at or above Outstanding.

Establishing the right probabilities of achievement when setting goals is something of an art form and it can take am few years to get it right. If you keep the probabilities mentioned above in mind and check actual results against them each year, you can fine tune your performance predictions until you reach the right overall levels of achievement.

Check out Incentive Plan Builder for more information on goal setting.

Even If you Can't Measure It, You Can Still Use It

If you have read anything about designing incentive plans, you have probably encountered the perception that the only measures suitable to include in well-designed incentive plans are those that are objective and quantitative. We are told that subjective measures (or measures involving some level of management discretion) should always ruled out in favor of measures that are cut and dried, back and white. But in so doing, as a manager, you deny yourself access to many of the behaviors and outcomes that are most the most critical to success. These are the so-called intangibles.

THOSE PESKY INTANGIBLES

Most experienced managers will tell you that it is not years of experience or the level of a person’s education or the amount of training someone has received that sets them apart from their peers – it is something much more subtle. These things go by a wide variety of names:

• Professionalism
• Leadership ability
• Work ethic
• Conscientiousness
• Empathy
• Drive
• Sensitivity
• Quick study
• Flexible
• Creative
• Innovative
• Personable
• Dedicated

It seems like every company is constantly searching for people with these attributes. And when someone fails, it is often because they lack one of more of these characteristics. In fact, experience is best thought of not as the number of years someone has been doing their job, but in terms of how many of these qualities they managed to acquire during those years.

So if these, intangibles are so critical to success on the job, why are they so rarely included in incentive plans? The answer, I believe, is two-fold:

1. Because it is believed that these characteristics are not measurable and are therefore poorly suited to incentives, and
2. Because the person doing the measuring (i.e., the person’s manager or supervisor) lack these qualities making them a poor judge of whether or not they exist in others.

So in order to ensure that these essential success measures find their way into incentive plans, we must overcome each of these objections.

MAKING THE UNMEASURABLE MEASURABLE

Perhaps the easiest way to think about this is by way of analogy. Few people would deny that of all human endeavors, the one that places the greatest emphasis on measurement is sports – especially college and professional sports where considerable money is involved. With so much at stake, little can be left to chance or discretion. This is why athletic contests are carefully measured and monitored by time clocks, score boards, and distance markers. What’s more, participants in these sports are scrutinized and compared based on an endless array of statistics (batting average, RBIs, on-base percentage, ERA to name a small handful in only one sport).

But the seeming objectivity in sports merely an illusion -- In many instances, the subjective opinion of the referee, umpire or judge determines whether or not something actually occurred. A hitter’s batting average is a good example – it is heavily influenced by the umpire’s opinion of balls and strikes – a subjective measure. In almost every football game, a long yardage gain or touchdown is called back based on a referee’s subjective call. And this doesn’t even take into account malicious intent and game fixing by officials that has been prominent in the news lately. So even in the sports, which most people would consider to be one of the most measurable, objective and quantifiable environments around, it is heavily influenced by discretion and judgment.

Staying with the sports example for another moment, let’s look a bit further. One could say that baseball is a mixture of subjective (e.g., balls and strikes) and objective (number of runs scored) measures. However, there are entire sports where the winner is determined entirely based on judgment and discretion. Take for example, gymnastics, diving, ice skating, synchronized swimming, and freestyle skiing. Few people would dispute that these are all highly demanding and exceptionally challenging activities requiring extreme dedication, the pursuit of perfection, and skills of the highest order. Yet all are measured by entirely by judges. How is it then contestants can spend years perfecting such sports when success is so highly subjective? They answer to this question is the key to figuring out how to use subjective measures in business.

The reason that subjective sports are even possible is the existence of rules. And not just any rules, but highly specific, extremely meticulous guidelines that spell out in excruciating detail exactly what the judges are looking for. Just glance at the rule books from any major sport and you will see what I mean – they are as technical and detailed as any legal document. The existence of these rule books not only makes the contest fair so that participants can accept the outcome, but it also makes it possible for them to practice effectively by knowing in advance how they will be judged.

So now let’s apply this analogy to business. The so-called soft-skills mentioned earlier that are so crucial to success in the workplace are analogous to the sport we want an employee to learn. So if you, as the coach, want this employee to be able acquire the necessary skills you must do the following:

• Create clear rules that describe the specific behaviors you wish that person to exhibit.
• Clarify how you are going to determine whether or not success has been achieved (e.g., direct observation, surveys, interviews, personal conversations, etc.)
• Specify exactly who will be doing the measuring (e.g., the person’s boss, their peers, others within the organizations).
• Establish clear outcomes they must accomplish (this is analogous to an athlete’s practice regime).

Here is an example from the Leadership Effectiveness measure in Incentive Plan Builder:

THRESHOLD -- Demonstrate leadership skills appropriate for a member of the leadership team. This includes, but is not limited to, maintaining the proper attitude, presence and demeanor at all times; being visible and available to all employees; representing the Company both internally and externally in a professional manner; maintaining a positive, productive optimistic attitude; effectively controlling anger and frustration; establishing and maintaining effective working relationships with all staff, customers, and vendors (as appropriate to position). Threshold performance will be achieved when generally positive feedback is received by the CEO when he periodically contacts a cross section of employees and members of the management team requesting comments on leadership style and skills. It is okay for some areas for improvement to have been noted, but no substantive issues can have occurred. Success on this measure will be determined by the CEO

TARGET -- Consistently positive feedback is received by the CEO when s/he periodically contacts a cross section of employees and members of the management team requesting comments on leadership style and skills (see areas above). No areas for improvement have been noted and no substantive issues have occurred. Success on this measure will be determined by the CEO.

OUTSTANDING -- Unsolicited positive feedback has been regularly received by the CEO from a variety of employees at different levels and in different parts of the company. No areas for improvement have been noted and no substantive issues have occurred. Success on this measure will be determined by the CEO.

As you can see, these goals clearly describe what will be measured, how it will be measured, and who will do the measuring. These (plus when it will be measured if applicable), are the key elements to successful goal-setting for subjective measures.

MAKING THE MEASURER CREDIBLE

On of the key failings of subjective measures is the lack of credibility of the person doing the measuring. All too often, the person doing the measuring has less skill than the person they are measuring. This situation occurs frequently in sports. After all, how many professional basketball referees or baseball umpires have ever played the sport as well as the people they are judging?

When it comes to business, however, there are two unavoidable aspects to this reality. First, regardless of how competent or incompetent the manager is, and regardless of whether the employee approves of them or not, the judgment of the boss matters. That privilege comes with the job. Unfortunately, major discontent in this area usually leads to the employee voting with their feet which is an unacceptable outcome.

The second unavoidable reality, which is related to the first, is that the company suffers incompetent managers at its peril. This is where the sports analogy and the business analogy part company. If a manager is going to judge others on their skill level in an intangible area, they simply must possess that skill themselves. If they don’t, then the person above them should be putting the skill on their incentive plan before it goes on their employee’s plan. And so it goes all the way up the line. If you make it all the way to the CEO and still can’t find anyone who possesses the skill, it is time to reevaluate either your talent or your definition of success.

Hopefully you are now convinced that there is a place for subjective measures on incentive plans and are willing to give them a try. It takes some practice, but it is a skill well worth learning. Eventually, you will find yourself pinpointing a person’s key weakness and developing specific measures to strengthen that weakness. When you are able to do that, you do both your company and your employees a huge favor.

MEASURE OF THE MONTH -- Lifestyle Goals

The results from a recent experiment at General Electric Company caught my eye. In it, they found that workers who were paid up to $750 to quit smoking were three times more likely to stay off cigarettes than those who were left to their own devices. GE was so impressed with these results that they plan to expand the incentive program nation-wide next year. They estimate that it will help the company reduce the $50 million spent annually on extra health and other costs for smoking employees.

These results don't surprise me at all. In fact, I have been a proponent of adding lifestyle goals to incentive plans for years. Toward that end, I have included lifestyle goals as one of the measures in my on-line incentive design tool, Incentive Plan Builder.

But helping employees quit smoking is not the only way you can assist them with the achievement of personal goals. There are many other interesting approaches.

DEFINITION

The achievement of specific personal goals that the Company wishes to encourage and promote (such as community service, quitting smoking, losing weight, saving for college, getting an MBA ,etc.)

CALCULATION

Depends on the goal chosen. The more specific you can be, the better the outcome.

WHEN TO USE THIS MEASURE

More and more these days, businesses are realizing that employees have lives outside of the office and what they do at home influences their work and vice versa. There is considerable talk about work-life balance, healthy lifestyles, stress management and contribution to the community. Many businesses feel uncomfortable crossing the line between an employee's personal and professional lives. But more and more, companies are realizing the importance of blending the two. Lifestyle goals encourage employees to do things for themselves that also benefit the business. The two most obvious examples are quitting smoking and losing weight but others are discussed below.

HOW TO USE THIS MEASURE

Below are several examples of what might fall under the general category of Lifestyle Measures:

• Personal Financial Goals
• Intellectual Achievements
• Professional Development
• Artistic Pursuits
• Health and Fitness Goals
• Work/Life Balance
• Lifestyle Changes
• Spiritual Pursuits
• Personal Travel

WHO IS THIS MEASURE BEST FOR?

Proposing lifestyle goals to an employee can be a delicate matter. It is usually better to discuss them with the employee in advance rather than including them on the incentive plan without the employee's prior knowledge or support. However there are times when an employee needs a little push. Highlighting the issue in the incentive plan and tying some money to it might be just the push they need.

MEASURE OF THE MONTH -- Company Valuation

 

This month, we are featuring Company Valuation. At the end of each year, perhaps your first and best measure of success is increasing the value of the business. Here are some guidelines on how to make Company Valuation a successful incentive plan measure.

DEFINITION

The economic value of an owner's interest in the business.

CALCULATION

In publicly traded businesses, the company value is easily calculated based on share price. However, in privately owned businesses a different approach is required. In such circumstances, calculating the value of  the business is approached from several different angles in order to arrive at a reliable figure. This includes:

1. Multiples of earnings
2. Discounted cash flow analysis
3. Book value
4. Sales price of comparable companies

Because there is often so much riding on the actual valuation, it is almost always essential to rely on accredited valuation professionals.

WHEN TO USE THIS MEASURE

Valuation is used to determine the price that a buyer might pay to purchase the business. In addition, valuation tools are often used to resolve ownership disputes and to estimate the value of a partner's ownership interest for buy/sell agreements and other business and legal purposes.

Increasing company valuation is a primary goal for most business owners. It is rarely used in incentive plans, however, because acquiring a formal valuation is a time consuming and expensive proposition. The one exception to this is ESOP companies. Companies owned by their employees under an ESOP are required by law to secure formal annual valuations by accredited valuation professionals. And since increasing the value of the business is fundamental to the success of an ESOP, company valuation is an ideal measure to include on all incentive plans in ESOP companies.

HOW TO USE THIS MEASURE

Incorporating company valuation into an incentive plan is simple -- you merely estimate the desired year-over-year increase and add it to the prior year's valuation to create the target for the new year.

WHO IS THIS MEASURE BEST FOR?

This measure is suitable for any employee in an ESOP company, but it should be weighted most highly for executives (i.e., 40 to 60%). It is also useful for lower-level employees, but since they have little influence over the final valuation, it should not be highly weighted (i.e., 10%).

CAN THIS MEASURE BE GAMED?

There is some potential for gaming this measure. Assuming you are dealing with an ethical and honest valuation professional, there are two likely possibilities. The first is that the company may have consciously or unconsciously withheld critical information that might effect the valuation. The second is that the owners of the business might do things which have an adverse impact on the valuation (such as taking out a loan, making major purchases, taking cash out of the business, etc.). It is important when setting valuation goals to take these things into consideration up front so they don't have an adverse (and unexpected) effect on employee incentive payouts.

MEASURE OF THE MONTH -- Customer Satisfaction

Each month, The Salary Sage features a performance measure from Incentive Plan Builder. These measures are intended to offer you on a wide range of options suitable for including in your company's incentive plan programs.

This month, we are featuring Customer Satisfaction. Every business has customers, and how satisfied they are with your products and services determines the success of the business. Here are some guidelines on how to make Customer Service a successful incentive plan measure.

DEFINITION

The likelihood that customers will return to purchase additional products/services and/or recommend these products and services to others.

CALCULATION

Customer Satisfaction can be measured directly (by calling the customer, conducting surveys and/or focus groups) or indirectly (by tracking referrals and/or positive references to other customers/prospects. If you use a formal survey, once you establish a performance baseline, it is possible to set goals based on measurable improvements against this baseline.

WHEN TO USE THIS MEASURE

For a company that already has a Customer Satisfaction survey and a baseline of historical performance, all that is required is to set goals to improve this performance. For companies that have not yet developed a survey (or have not administered it long enough to have a reliable baseline) this must be done first. But that doesn't mean you can't set goals to get these things done. In fact, many companies in this situation develop a 3-year plan:

• In the first year they set goals to develop the survey.
• In the second year they set goals to establish the baseline.
• In the third year (and beyond) the set goals to improve performance against the baseline.

HOW TO USE THIS MEASURE

There are ten commonly accepted elements of Customer Satisfaction:

1. Quality
2. Value
3. Timeliness
4. Efficiency
5. Ease of Access
6. Environment
7. Teamwork
8. Service Behaviors
9. Commitment to the Customer,
10. Innovation.

Measuring Customer Satisfaction usually involve a survey where the customer ranks the company's performance on a number of these elements using a scale (i.e., from 1 to 5).

WHO IS THIS MEASURE BEST SUITED FOR?

This measure is equally useful for employees directly involved in customer service. Many companies use this measure for executives and senior managers in order to ensure they never lose sight of the importance of keeping customers happy.

MEASURE OF THE MONTH -- Environmental Responsibility

Each month, The Salary Sage features a performance measure from Incentive Plan Builder. These measures are intended to offer you on a wide range of options suitable for including in your company's incentive plan programs.

This month, we are looking at Environmental Responsibility. Businesses are becoming very interested in encouraging managers to focus on doing everything they can to protect the environment. One excellent way to do this is is to add a measure to management incentive plans. Not only will this encourage managers to focus on the issue, it will reward them when they do. Here are some guidelines on how to do it.

Definition

Reducing the company's environmental footprint

Calculation

Calculating environmental responsibility normally involves some or all of the following elements:

1) Developing environmentally sustainable processes and products.

2) Reducing energy, chemical and raw material consumption.

3) Minimizing the business’ carbon footprint.

4) Making responsible decisions about outsourcing products and services.

5) Tracking the costs and savings associated with implementing environmental policies and practices.

When to use this measure

As businesses proliferate and grow to meet the increasing product demands of the world's growing population, countries are challenged to establish regulations to protect their environments. Throughout the world, environmental regulations are emerging at unprecedented levels. Companies unaware, unable, or unwilling to respond proactively to these demands may find themselves confronting substantial fiscal risk, market closures, or even criminal prosecution. Companies that deal effectively with these challenges have found that they can reduce their impact on the planet while simultaneously improving financial performance.

How to use this measure

Effective deployment of this measure involves the following key steps:

1) Questioning wasteful practices and implementing programs and processes that promote profitability and benefit the planet.

2) Providing detailed and actionable engineering, legal, facilities and product-specific recommendations.

3) Collaborating throughout the organization to meet environmental goals.

4) Measuring and monitoring results.

Accomplishing these improvements requires the involvement of the CEO and other members of the senior leadership team to define the business benefit of environmentally responsible business practices, then helps them form a commitment towards accomplishing these practices. Furthering the commitment to environmental responsibility requires training multi-level teams aimed at identifying wasteful processes, unnecessary materials, and business opportunities.

Who is this measure best for?

Every company has the potential to both reduce its environmental footprint and save money at the same time.

MEASURE OF THE MONTH -- Regulatory Compliance

Each month, The Salary Sage features a performance measure from Incentive Plan Builder. These measures are intended to offer you on a wide range of options suitable for including in your company's incentive plan programs.

This month's measure is Regulatory Compliance.

Definition	The company's ability to successfully conform its operations to applicable specifications, standards, or laws.
Calculation	Effective regulatory compliance normally includes some or all of the following elements: Oversight by appropriate personnel. Due care in delegating decision-making authority. Effective communication to all levels of employees. Reasonable steps to achieve compliance which includes systems for monitoring auditing and reporting suspected violations without fear of reprisal. Consistent enforcement of compliance standards including disciplinary measures. Reasonable steps to respond to and prevent similar offenses upon detection of a violation.
When to use this measure	This measure should be used for organizations and positions where there is substantial risk of fraud, environmental waste discharge, tax offenses, anti-trust offenses, food and drug violations, infection, or contamination. This is particularly true in industries closely regulated by the government such as health care, food, and pharmaceuticals.
How to use this measure	Recent highly publicized cases of regulatory violations have dramatically increased awareness of and concern for regulatory compliance. This has spawned complementary efforts by a number of regulatory and law enforcement authorities and  executive agencies (such as the Environmental Protection Agency, the Department of Health and Human Services, and the Department of Justice's Anti-Trust Division).  Many of these agencies have developed (or are developing) model compliance programs. Industry and peer organizations are forming to share best practices for compliance training and awareness. Effective compliance usually involves taking advantage of these types of resources and not attempting to go it alone.
Who is this measure best for?	In highly regulated industries there should be at least one executive who has a major portion of her/his incentive plan (i.e., 20% or more) tied to effective regulatory compliance. It is often prudent to supplement this with a smaller weighting (i.e. 10%) on most or all of the other members of the executive team. You should also consider which of your lower-level managers' and directors' incentive plans should also include this measure.
Can this measure be gamed?	The problem with this measure is that it tends to be all or nothing. In years when there are no violations payouts can become almost automatic and in years where a problem arises it doesn't get paid at all. This situation can be avoided by defining measures around initiatives that consistently improve your organization's state of readiness and reduce risk. This is usually a better approach than measuring infractions after they occur.

MEASURE OF THE MONTH -- Economic Value Added (EVA)

I think it was the early 1990's when I first heard about the term Economic Value Added or "EVA." I was working with Hay Management Consultants at the time and seemingly out of nowhere clients started asking about it. Developed by the management consulting firm Stern Stewart, EVA caught fire when several high-profile corporations, including Coca-Cola, GE and AT&T started to use it internally to measure wealth creation on behalf of shareholders.

For a while there, it was all the rage, and consultants across the nation were scrambling to learn more about it. What they found was a complex series of formulas that seemed more at home in classrooms than a meeting rooms. Those who took the time to master it (I made a run at it back then), soon learned that the only thing more difficult than learning EVA was explaining it to others. Thankfully, it soon died out and became a compensation footnote like Ganisharing and Broad-Banding.

But last week it popped up again when I received a call from a compensation manager who had been asked to look into it by his executive team. He was interested in learning more about EVA as a possible incentive plan measure. We agreed to talk later after I updated my information (and memory).

To prepare for the call, I pulled up some old files and did an extensive internet search. Here is what I learned:

• EVA still has a loyal following, but it appears to be mostly with consulting firms and finance experts as opposed to executives and line managers.
• The concepts have continued to expand turning a once complex measure into a nearly unintelligible one.
• To counter this perception, those actively involved in promoting this measure have adopted the strategy of proclaiming the measure to be simple in hopes that this will make it so. Stern Stuart, the leading consulting firm involved in this type of work and the company that trademarked the term EVA declares on its website that "EVA® is a simple and clear indicator of when a unit is creating value." They offer the visual aide below as evidence.               Hardly a ringing endorsement for simplicity!

• Investopedia remarks that the "EVA metric basks in a mystique of complexity, but . . .this complexity is only an illusion." It then goes into a 7 chapter explanation effectively undermining this assertion. See http://www.investopedia.com/university/EVA/default.asp
• There are many ways to comute EVA. A quick search revealed these little gems:

           (Net Sales - Operating Expenses - Taxes - Invested Capital) x (Cost of Capital)

           (Return on Capital - Cost of Capital) / (Capital Invested in Project)

           (Invested Capital) + (Present Value of Future Economic Profits)

All right, so what's the bottom line?

Economic Value Added (EVA) is a financial performance metric used to calculate the true economic profit of a business. Unlike EBIT which is an accounting measure, EVA is an economic measure that is based on the idea that a company must cover both its operating costs and its cost of capital. EVA indicates the amount of wealth created or destroyed over a specific period.

As an operational metric, EVA helps managers clarify how they create value. Generally, they do this either by 1) Investing additional capital that produces returns above the cost of capital, 2) Reducing capital employed in a business, 3) Improving returns by growing revenues, 4) Reducing expenses or by reducing the cost of capital.

Because it relies on invested capital, it is more suitable for analyzing asset-intensive firms (those whose value comes largely from tangible assets on the balance sheet) that exhibit somewhat predictable growth trends. The best use of economic profit tends to be in traditional and mature industries. It therefore has less relevance for firms whose value is based largely on intangible, off-balance-sheet assets. That is why EVA has shown limited success in high-tech and service-oriented companies.

EVA pulls together into one measure several more common (and generally understood) measures (such as EBIT, ROIC, ROE, and free cash flow). Because of its complexity, and because most employees are going to have impact over one or more of the components of EVA (as opposed to the entire measure), in most cases it is preferable to reference in an incentive plan the component that is most relevant to the particular employee.