What is variable pay?
Variable pay is compensation given to an employee that goes above and beyond their regular work responsibilities to contribute to the organization's performance.
The goal of variable pay is to encourage behavioral change. Variable pay is determined by both an employee's and the organization's performance and is usually awarded in addition to the employee's fixed compensation.
Types of fixed pay vs variable pay
| Fixed pay | Variable pay |
|---|---|
| Basic salary | Annual/short-term incentives |
| Overtime pay | Sales bonus or commissions |
| Allowances | Profit sharing |
| Shift differentials | Profit sharing |
| 13th month (fixed) | Long-term incentives |
| Other bonuses |
What are examples of variable pay?
Performance bonus
A performance bonus is a discretionary payment made after the fact based on the performance of an individual, group of employees, division or business unit, or the entire workforce.
Sales commissions
A sales commission is a pre-determined monetary payment paid as incentive compensation for selling a product or service. It is often calculated as a percentage of the gross sale price or a fixed sum per unit sold. A commission-only compensation plan is also known as full commission or straight commission.
Profit-sharing plan
A profit-sharing plan allows employees to partake in the company's profits. Employees are compensated based on the company's performance and profits, which are determined quarterly or annually.
This is given to employees in a variety of formats. It can be expressed as a percentage of profit in cash or equity. Many organizations include profit sharing in their retirement plans for employees. This gives employees a sense of 'ownership' over the organization.
Referral bonus
An employee receives a particular amount of money for referring candidates for a job or customers for a particular program.
Types of variable pay
There are three categories of variable pay:
1. Individual
Variable pay is defined by each employee and their output. There is an obvious correlation between a person's efforts and variable pay, which is typically related to overall performance rating.
Variable pay could take the following forms:
- Piece rate system: Salaries are determined by the number of pieces produced by the piece rate for one unit)
- Bonus: A one-time payment made to an employee in recognition of their performance
- Special incentive programs: Such as cash or recognition awards
- Commission: Sales commissions.
2. Group/Team
This sort of variable compensation either provides the same sized reward for all employees in the group or various sized rewards for each member based on their contributions. It promotes teamwork and has the ability to modify and maintain critical team behaviors. I
t reduces the emphasis on individual achievement and mandates the measurement of team performance. This team bonus typically draws team members.
Unique variable compensation in this category includes:
| Gainsharing | Goalsharing |
|---|---|
|
This type of pay involves employees sharing a prize based on their productivity and performance. As performance improves, so does your employees' share of the cash gains. Gainsharing is self-funded, thus the 'gains' must be measurable. It is often paid quarterly and is linked to indicators of output, quality, cycle times, waste/scrap, safety, etc. |
This is a program that sets goals to support the company's mission. For instance, it could aim to boost overall client happiness. When a target is attained, personnel receive pay. However, it is not self-funded (as gainsharing is). |
3. Organizational
Profits are distributed among staff to boost productivity, morale, and organizational performance. Some examples of variable pay in this area include:
- Employee stock plans
- Executive stock options
- Deferred compensation.
How does variable pay work?
Variable pay is typically announced to employees in advance as an incentive or used as a bonus later on. It is frequently distributed as a proportion of the fixed compensation, depending on the position and level. Some jobs have higher variable pay than others (for example, sales and leadership positions).
The pay mix of total variable compensation versus total compensation cost is commonly expressed as a percentage of total compensation. To calculate an employee's total variable pay mix:
| Total variable pay / Total compensation cost * 100 = Variable pay % |
|---|
Advantages and disadvantages of variable pay
Advantages:
- Talent management: Variable pay helps retain high-performing goal-driven staff, as employees that feel they are well compensated are less likely to leave. It also differentiates reward for those employees who contribute more.
- Economic: It aids in balancing out the salaries of employees. It is an element of remuneration that is self-funded and acts as a pressure valve. It also links pay with the fortunes of the business.
- Motivation: Variable pay related to performance increases productivity and motivation. It helps focus attention on specific areas of performance and results and reinforce and modify employee behavior.
- Talent attraction: Variable pay makes an employer competitive.
- Inclusion: This type of pay helps give a clearer identity to each department and team and enhances team membership for individuals. It also fosters more cooperation and a sense of shared identity.
- Competition: It meets competitive market norms, practices, and customs and also helps organizations avoid unduly high fixed basic salaries.
Disadvantages:
- Perception of unfairness: If the proper payment structure is not in place, it can cause the perception of unfairness and create jealousy within the organization.
- Cost: It can be costly for an organization if not implemented correctly.
- Recency bias: Variable pay can be susceptible to recency bias. As performance appraisals form part of a big part of variable payout, managers sometimes tend to rate an employee on their most recent job performance instead of how they performed the entire year. As a result, it rewards input and effort and not the result.
- Competition: Difficulty can arise in the form of unhealthy competition, making it difficult to foster collaborative teams.
