Fixed vs variable pay: the right ratio

Updated: Aug 29 2005, 05:30am hrs
The trend of variable pay is not new, but it was not implemented by many companies earlier. The concept was first introduced during the early 1980s when an individual's earning was divided into two portions-fixed and variable pay packages. The move was most likely triggered by the increasing sense of competitiveness, both for more business as well as for better talent.

Fixed pay is sufficient for an employee to live comfortably. The variable pay was originally designed as a huge incentive for an employee to exceed expectations; thus increasing profitability of the organisation and in turn being rewarded. The reward being directly proportional to the quantum of expectations.

Most companies today have a fixed and variable component in their salary i.e. some amount of the pay comes to the individual at the end of every month and another component will only be payable in case the person or the company is able to achieve certain milestones. The percentages (fixed vs variable) vary with the years of experience and the more senior a person is, the more his/her compensation becomes variable.

"The reason this has been adopted is because companies need to keep their top 20 percent happy with salaries that are higher than the market and this is not possible unless they have a variable component in the salary. Only then the organisations will be able to reward people based on their performance and market dynamics, and not on the years of experience that they have," explains Gautam Sinha, CEO, TVA InfoTech.

This has now become a common practice in the IT industry and even when companies announce salary hikes there are differentials in the amounts that are awarded to people.

Says Manoj Tandon, Assistant Vice-president, CSC India, "At senior levels we have the concept of variable pay. The idea is that the fixed component is there to do the job, whereas the variable component is for going beyond the job. We are gradually introducing the variable pay to lower levels as well. There are two aspects to it-one is that the employee should not feel confused, and the second and the most important part is that people at various levels should gradually adapt to it and enhance their performance accordingly to reap benefits."

The ideal ratio

The ratio of fixed to variable pay depends upon the level of the employee in an organisation and the responsibility attached to his job. "The ratio of fixed to variable component, as a norm, varies based on role the employee plays. As a rule, the hunters i.e. the employees engaged in the sales activities, usually have a larger variable than the farmers i.e. the employees in the execution role. In the Indian conditions, for the sales portfolio the ratio of fixed to variable can be as much as 60:40, while in the countries like the US it could be as much 30:70," says Sreenivas Chakravarthi, HR Head, Aditi Technologies.

For non-sales roles, most companies normally follow an 80:20 ratio depending on the person meeting his or her objectives. However, a role that determines profitability of either a business unit or an organisation might warrant a ratio of as much as 60:40.

Popular thumb rule ensures that the variable pay is directly proportional to the level or responsibilities-owing to the contribution an employee is able to make to the revenues or growth of the organisation. The exception comes for stand-alone roles like the sales where your existence directly affects top-line revenues.

Problem arises when the performance cannot be measured against the revenue. In BPOs for instance, variable pay packages may not be successfully implemented as it is difficult to measure the employees' performance in terms of revenue generated.

However, the fact is that variable pay does act as a performance enhancer. The form of variable pay could be different in different organisations. For some, it is just a way of reducing the tax burden of employees, while for others it's the non-monitory incentives that do the trick. Yet others have schemes like profit sharing to keep the motivation levels of employees soaring high. "We have a profit sharing plan in place, where depending on the companies performance (profits) a certain component gets distributed to all the employees. But the amount that is given to a person will depend on the contribution that he has made. This is done twice a year," says Sinha.

Impact on productivity

Most organisations have determined that merit pay plans do not provide sufficient reward for the employees who consistently perform in an outstanding manner. Indeed, merit pay plans have lost their 'merit' and become entitlement plans, wherein all employees are given salary increase. With the pressure to provide salary increase to all, there is little left to reward the key employees. This has led to the wide-scale adoption of variable pay.

Such plans can be individual-based, team and/or organisation-based. Incentives can be developed in the forms of profit sharing, team incentive pools, awards for achievement against defined objectives, gain sharing, cost savings or management discretion. Yet, some organisations are designing plans that are destined to fail, since they have not considered a process for determining the need and value of variable pay plans.

"We have always had variable pay (project incentives, deadline bonuses, completion incentives etc) except for very junior entry level employment," says Chakravarthi. Employees have been either non-committal or positive because variable pay has always given them the incentive to work with quality. The variable pay increases incrementally with exceeding achieving targets and objectives. For example, if an employee got a 100 percent of his pay for 100 percent achievement, he would end up making 125-130 percent of the committed pay if he over achieved the objectives by 120-125 percent.

Motivation is the key benefit here as employees get an incentive to perform. They have to stretch their goals and hence are more productive. It also reinforces the feeling that the organisation is sharing it profits with the employees, thus creating a sense of belonging among them. It differentiates between the high and mediocre performer. "If used carefully, an organisation can use variable pay plans to fight attrition in a big way," states Tandon.

The flip side

Variable pay packages could also lead to strife among performers and non-performers, especially when biases while measuring performance are involved. Says Chakravarthy of Aditi, "The flip side is that it can cause discontentment among employees when the measuring system used to measure objectives is not robust and has more than a little amount of subjectivity." In the Indian scenario because of the psyche which exists that a bird in hand is worth two in the bush, employers might be in a difficult situation if the variable pay goes beyond the perceived acceptable levels. "If one were to take an average across functions, 75:25 would be a palatable ratio for fixed is to variable," adds Chakravarthy. Opines Tandon of CSC "I don't think there is any flip side to it as long as there are no biases involved. But it surely enhances productivity."

Variable pay packages can also make some employees complacent in the long run. The awards and recognition can make him too sure of himself beyond a point. Thus, it is important that the variable components are fairly distributed among different employees. Moreover, employees should be made to see it as a challenge to avail of those benefits and should be made to strive for it. The first time an employee receives an award, he or she perceives the reward as performance-based and greatly appreciates it. The second time the perception is that its a reminder and reinforcer of the performance. The third time an employee receives an award, the perception can be that it is an entitlement.

Organisations must strongly guard against permitting variable pay plans to become entitlement plans. "Beyond the regular salary hikes given to every employee, the variable component, especially the non-monitory incentives, should be regarded as a means to reward extraordinary performance. Very often for employees, it is not the reward but the idea of getting appreciated and recognised for their performance that triggers the craving to outshine others," says Sinha.

Communication-the key

The key to avoid such strife lies in good communication. Variable pay plans are often confusing, and employees do not understand them properly. This leads to a feeling of being cheated by the company among the employees.

Explains Sinha, "An organisation can design the best plan, but if employees do not understand-how it works, how will they benefit, and what is expected of them-it will fail."