Variable Pay – Meaning, Types, Advantages and Disadvantages

Employers may offer variable pay to incentivise and recognise their employee’s job performance. It’s an extra payment that may be given in forms other than cash and can accompany a salary.

This blog delves into variable pay, its meaning, types, advantages and disadvantages.

What is Variable Pay?

Variable pay is a cash incentive given to employees for outstanding performance or achieving specific objectives. It motivates employees to be more productive and achieve their goals. It is usually granted quarterly, half-yearly, or annually as a bonus, incentive, or other monetary rewards on top of their monthly salary. This type of compensation, also known as performance-linked pay, is a common practice in many organisations.

Variable pay plans are designed to engage and motivate employees to improve their work performance and retention rates. These plans typically include a method of goal setting and OKRs (Objectives and Key Results) that serve as a basis for determining the variable pay of each employee. The goal-setting process can involve setting specific targets, timelines, and performance metrics to help employees get what is expected of them and how their performance will be evaluated.

The OKRs are then used to measure the employees’ progress towards achieving their goals. The goals can relate to individual, team, or company-wide performance. Once the goals are achieved, the employee is rewarded with the corresponding variable pay.

Reasons to Offer Variable Pay

The reasons employers offer variable pay are as follows:

• Generates Accountability: Variable pay helps generate accountability among employees. When employees are given a stake in the outcome of their work, they feel a greater sense of ownership and responsibility towards achieving the desired outcomes. This increased sense of ownership and responsibility leads to higher employee engagement, motivation, and commitment, resulting in better performance and higher productivity.
• Base Salary Can Be Reduced: Employers can save money by offering performance bonuses and commissions in addition to base salaries. This allows employees to earn more money based on their job performance. Employers can offer lower base salaries while allowing employees to earn more money. This system motivates employees to work harder and contribute more to the company. Employers must ensure that their variable pay programs are fair, transparent, and effective in driving performance.
• Retention and Attraction: Extra financial incentives and rewards for excellent work can help organisations attract and retain skilled employees. These rewards may include bonuses, stock options, profit sharing, and performance-based pay. By providing these incentives, organisations aim to create a work environment that interests top talent and drives employees to perform at their best. This can lead to higher retention rates, increased productivity, and a more engaged workforce.
• Develop a Framework for Work Progress: Supervisors are responsible for evaluating employees’ progress in an organisation. To track progress, they establish metrics that measure employee performance. These metrics help incentivise employees and create an objective assessment system that highlights areas for improvement. This framework benefits the organisation by fostering a continuous learning and development culture.
• Encourage Performance-Driven Culture: A performance-driven culture motivates employees to do their jobs better and contribute to the organisation’s success by offering bonuses or variable pay. It emphasises accountability, goal-setting, and continuous improvement. By motivating employees to excel, organisations foster a sense of ownership and pride in their work, leading to increased job satisfaction, productivity, and, ultimately, higher levels of success for the company.
• Clear Work Expectations: Establishing clear work expectations ensures a productive and successful working relationship between an employer and employee. When both parties clearly understand what is expected from the job, it helps minimise misunderstandings and confusion and promotes a sense of accountability. Clear work expectations also help set realistic goals and objectives, which can be tracked and measured for progress. This allows the employer to provide constructive feedback and support to the employee when needed and helps the employee stay focused and motivated to achieve the desired outcome.
• Promote Teamwork: Teamwork is important for a company’s growth and success. Incentivising employees based on team and departmental goals can encourage them to work better in teams. This can improve collaboration, communication, and support among employees, which can help achieve business objectives efficiently. Employees who work together towards a common goal also tend to have higher job satisfaction and engagement. By incentivising team goals, employees can feel a sense of ownership and accountability for their work. This helps create a positive work culture and boost employee morale and productivity.
• Manifest Recognition and Appreciation: Employees who feel appreciated and valued at work are more likely to be motivated to improve their skills. Recognising and acknowledging their hard work and contributions can achieve this. Providing opportunities for professional development and acknowledging achievements and milestones can foster a positive work environment. By prioritising recognition and appreciation in the workplace, companies can invest in the growth and success of their employees, resulting in a more robust and productive workforce.

Types of Variable Pay

The following are the different types of variable pay:

Individual Incentives

Variable pay is a type of compensation based on an employee’s performance and productivity. It is a form of incentive pay designed to reward employees for their hard work and contributions to the organisation. Employees’ variable pay is directly tied to their output, meaning they have a clear line of sight between their efforts and their pay. The various forms of individual incentives offered by an organisation are as follows:

• Piece Rate System
• Bonuses
• Sales Commissions
• Special recognitions
• Attendance bonuses
• Safety awards

Team/Group Incentives

This type of compensation can be the same for all employees in a group or different for each member, depending on their contribution. When implemented correctly, it can effectively reinforce teamwork and preserve vital team behaviours. However, it can also weaken the focus on individual performance and requires team performance measurement. This approach to compensation is generally referred to as a team bonus and is often used to attract team players who value collaboration and working towards a common goal. It’s important to note that the success of a team bonus program is highly dependent on how well it is designed and communicated, as well as how effectively it aligns with the goals and values of the organisation. The various forms of team/group incentives offered by an organisation are as follows:

• Gain sharing
• Labor-cost reduction
• Quality improvement
• Goal sharing

Organisational

Organisational variable pay is a compensation strategy that distributes a portion of company profits to employees to enhance productivity, morale, and performance. It aligns employee interests with long-term growth through employee stock plans, executive stock options, and deferred compensation. This fosters shared success and motivates employees to contribute to the company’s growth. The various forms of organisational incentives offered are as follows:

• Employee stock options
• Profit-sharing
• Deferred compensation
• Executive stock options

Examples of Variable Pay

Here are some examples of variable pay:

Performance Bonus

A performance bonus is a reward given to employees based on their performance. It serves as an incentive to motivate individuals, groups, or entire workforces to achieve specific goals or objectives. The bonus amount is discretionary and can be awarded to individuals, groups, divisions, or the organisation as a whole.

Sales Commissions

A sales commission compensates sales representatives for successfully selling a product or service. It is a pre-determined, direct cash payment that serves as an incentive to motivate sales representatives to achieve their sales targets. The commission is usually calculated as a percentage of the gross sale amount or a flat amount for each unit sold.

Profit-Sharing Plan

A profit-sharing plan is a program that allows employees to receive a portion of a company’s earnings. This amount is based on the company’s performance and profits over a specific period, usually quarterly or annually. Companies offer profit sharing in various forms, including cash or stock-based rewards. Additionally, many companies include profit sharing in their retirement plans, giving employees a sense of ownership.

Referral Bonus

Many companies practice incentivising their employees to refer potential job candidates or customers to their programs. In these cases, the employees receive a certain amount of money as a reward for their efforts. This referral bonus system benefits the employees and helps the company find suitable candidates or customers for its programs.

Differential Pay

Differential pay is an additional payment given to an hourly wage to compensate for particular circumstances or working conditions. For instance, employees may be entitled to differential pay for holiday work. Shift differentials, such as night shifts, may also be given to employees outside regular business hours. Unlike overtime pay, no federally mandated differential pay can incentivise employees to work in irregular circumstances. For example, if a hospital struggles to hire overnight janitorial staff, they may offer an increased wage for overnight employees as a shift differential.

Piece Rate System

The piece rate system determines salaries based on the number of pieces an employee produces for one unit. This system is commonly used in manufacturing industries, where employees must produce a certain number of units within a given time frame.

Special Incentive Programs

Special incentive programs are designed to motivate employees to perform at their best. These programs can take the form of cash or recognition awards, such as gift cards, paid time off, or public recognition for outstanding work.

Gain Sharing

Gainsharing is a compensation system that rewards employees based on their productivity and performance. The more they perform, the more they share in the financial gain. Gainsharing is a self-funded program, and the earned gains must be measurable. These gains could be profits made, savings achieved, or costs reduced. The reward is typically paid quarterly and is linked to specific measures such as output, quality, cycle times, waste/scrap, and safety.

Goal Sharing

This program sets specific objectives that align with the company’s mission, such as enhancing customer satisfaction. Compensation is distributed among employees upon achieving this goal, but unlike gainsharing, this program is not self-financed.

How does Variable Pay work?

Variable pay is a type of compensation communicated to employees in advance as an incentive or a bonus after the fact. It is typically a percentage of the fixed pay, and the amount varies depending on the employee’s position and level. Some roles, such as sales and leadership positions, tend to receive a higher proportion of variable pay than others.

The pay mix of total variable compensation versus total compensation cost is typically expressed as a percentage of the total compensation. The pay mix of the total variable pay of an employee can be calculated by:

Total Variable Pay / Total Compensation Cost X 100 = Variable Pay

Who receives Variable Pay?

The people who usually receive variable pay are as follows:

• Risk Takers: Employers can offer variable pay to reward employees who perform hazardous labour. This work may include crane operators, loggers, and construction steel labourers. The idea behind variable pay is to incentivise employees to take risks for a monetary award. In most cases, these employees can earn differential pay or performance-based pay. This can motivate workers to perform at their best and take on challenging tasks.
• Sales Representatives: Sales professionals in industries like jewellery, vehicles, or luxury items often receive variable pay as commissions. This incentivises sales representatives to develop effective techniques to make more sales, which can help increase the company’s revenue. The option of variable pay also gives employees a sense of ownership in the company’s success when they can share in the profits. This can lead to higher motivation levels and increased employee retention rates.
• Leadership Roles: Due to their senior positions, leadership roles, such as managers or team leaders, may receive variable pay. These positions require greater responsibility, so offering additional pay to motivate leaders is common. Employees in these roles may receive performance-based pay or profit-sharing variable pay.

Advantages of Variable Pay

The advantages of offering variable pay are as follows:

• Talent Management: Implementing a variable pay structure in an organisation is highly beneficial for employee retention and motivation. This is because employees who receive compensation that they perceive as fair and equitable are likelier to feel valued and remain loyal to their employer. Furthermore, variable pay allows for differentiation in rewards based on an employee’s contribution to the organisation, thereby incentivising high-performing employees to continue to excel and contribute to the company’s success.
• Economic: An effective compensation strategy must consider many factors, including employee performance, industry benchmarks, and the company’s overall financial health. One way to achieve this balance is through using a self-funded element of remuneration, which can help stabilise salaries and provide an important pressure valve. By implementing this type of compensation strategy, companies can create a more equitable and sustainable compensation system that benefits both employees and the organisation.
• Motivation: Rewarding employees based on performance can significantly impact their productivity and motivation. By aligning rewards with specific goals and objectives, employees are more likely to focus on the areas that matter most to the organisation. Moreover, variable pay can also help reinforce and modify employee behaviour. Employees who receive a bonus or other incentive for achieving a particular performance target are likelier to repeat the behaviour that led to that success. Conversely, if employees fail to achieve a performance target, they may be less likely to repeat the same mistakes.
• Talent Attraction: Offering variable pay, such as bonuses, commissions, and profit-sharing, can give an employer a competitive edge in the job market. Employers can attract and retain top talent, increase employee motivation and engagement, and drive business growth by allowing employees to earn additional income based on their performance and the company’s success. Additionally, variable pay plans can be tailored to meet the specific needs and goals of the organisation, allowing for greater flexibility and agility in responding to market conditions and changing business needs.
• Inclusion: Implementing a designated pay structure tailored to each department and team greatly benefits organisations. This type of pay provides a clear identity to each department and team and enhances team membership for individuals by fostering a sense of belonging and camaraderie. This promotes cooperation among team members and cultivates a shared identity that can positively impact team dynamics and overall organisational culture.
• Competition: Organizations must adhere to the industry’s norms, practices, and customs to remain competitive. This not only helps them stay relevant but also allows them to attract and retain top talent. In addition, by avoiding unduly high fixed basic salaries, organisations can maintain a more sustainable compensation structure that is fair to employees and financially responsible for the company.

Disadvantages of Variable Pay

The disadvantages of offering variable pay are as follows:

• Perception of Unfairness: One of the major concerns in any organisation is the payment structure. If the payment structure is not properly defined and implemented, it can lead to the perception of unfairness among employees. This perception can cause jealousy and resentment within the organisation, leading to a hostile work environment. This helps employees feel valued and rewarded for their hard work, increasing job satisfaction and motivation.
• Cost: If an organisation does not implement a process or system correctly, it can result in significant costs. These could include expenses related to the initial implementation and ongoing maintenance and repairs. Furthermore, an incorrect implementation may lead to inefficiencies, errors, or even security breaches, which can negatively impact the organisation’s reputation and bottom line.
• Recency Bias: Variable pay is tied to employee performance but can be susceptible to recency bias. Managers may rate employees’ performance based on their most recent work rather than considering their performance over a more extended period, potentially rewarding input and effort over actual results. To avoid this, organisations should ensure their performance appraisal process accounts for an employee’s overall performance.
• Competition: In some cases, creating a harmonious and productive team environment can be challenging due to unhealthy competition among team members. When team members are focused solely on outdoing each other, it can create a culture of rivalry and mistrust, making it challenging for individuals to work together collaboratively towards a common goal. This can lead to a lack of communication and cooperation, decreased motivation, and decreased overall productivity. Cultivating a positive and supportive team culture that encourages healthy competition and collaboration is essential so everyone can work together to achieve shared objectives.

Calculation of Variable Pay

The basic formula used in calculating a salary package is as follows:

The package = Fixed Pay (X% of total package) + Variable Pay (100-X% of total package)

The fixed salary package amount is received monthly, while the variable amount is received after a certain period (quarterly, semi-annually, or annually).

For example, suppose an individual has a monthly salary of Rs. 30,000, with Rs. 25,000 as fixed pay and Rs. 5,000 as variable pay, which is given every quarter. In that case, the variable pay can be calculated as follows:

First, find the percentage of variable pay:

5,000 (variable pay) divided by 30,000 (total salary) = 0.1667 (or approximately 16.67%).

Next, calculate the variable pay for each quarter:

0.1667 or 16.67% (variable pay percentage) multiplied by 30,000 (total salary) = Rs. 5,000.

So, at the end of each month, the individual will receive Rs. 25,000 as fixed pay.

At the end of the quarter (3 months), the individual will receive Rs. 5,000 multiplied by 3, which equals Rs. 15,000.

Traditional Pay vs. Variable Pay

Employees can receive traditional pay based on an hourly wage and variable pay, which is used to motivate employees to improve their performance or reward them for hard work. There are differences between the two payments:

• Payment Method: Traditional pay is usually given to the employee through check, direct deposit, or cash. Employers can award variable pay in cash, stocks, or gifts. While traditional pay is typically distributed regularly, variable pay can be given at any point during the pay period.
• Purpose: Traditional pay is the standard compensation for work, while variable pay is an incentive to encourage employee performance, retention, and job satisfaction.

Variable Pay vs. Fixed Pay

Variable pay and fixed pay are the two primary types of pay structures. Variable pay is compensation that can fluctuate and is often linked to an individual’s performance, such as bonuses or commissions. On the other hand, fixed pay refers to a stable, unchanging salary or wage that is not impacted by an individual’s performance.

How to Create a Variable Pay Plan?

The steps given below should be followed to create a variable pay plan:

• Pay Attention to the Organisation’s Culture and Resources:  When designing a variable pay plan, it’s crucial to consider the unique resources and culture of the organisation carefully. The variable pay structure should align with the cultural values and promises made by the organisation to its employees while also considering the financial resources available. Building and nurturing trust between managers/supervisors and employees is essential for successfully implementing a variable pay plan. This trust is key to ensuring that the plan effectively motivates and rewards employees while maintaining fairness and transparency.
• Create Easy-to-understand Plans: Creating variable pay plans that are easy to understand is crucial for ensuring that employees comprehend the rules and regulations outlined in the plan. When the information is conveyed clearly, it helps employees grasp the structure of the variable pay plan and its associated rewards. On the other hand, overly complicated variable pay plans can lead to confusion among employees, potentially diminishing the motivational value of the program.
• Maintain an Updated Plan: To ensure the variable pay plan effectively motivates and retains employees, keeping it updated with the current organisational conditions is essential. This means that incentives and bonuses should reflect current market trends and the company’s financial performance, business objectives, and employee expectations. To achieve this, it’s essential to regularly review and analyse the plan’s design, metrics, and payout structure and adjust them accordingly. This will help ensure the plan remains competitive, fair, and aligned with the company’s overall compensation philosophy and talent strategy.
• Connect Variable Pay with Performance: When it comes to compensation, connecting variable pay to performance is crucial. It ensures that employees are motivated and recognised for their efforts. To make this connection, performance should be the main factor determining bonuses, incentives, rewards, and recognition. To make this work, employers must establish clear metrics for measuring performance and communicate them effectively to employees. This includes setting specific goals and targets, providing regular feedback and coaching, and recognising and rewarding top performers.
• Make Variable Pay Inclusive: To design effective incentive plans, it’s essential to consider individual differences. A one-size-fits-all approach may not work for all employees, and it’s necessary to avoid penalising high performers who exceed group limits. A sound incentive system should be flexible and adaptable and may need to be tailored to different organisational departments. By making variable pay inclusive and considering different employee groups’ unique needs and preferences, organisations can design incentive plans that motivate and engage employees, leading to better performance and greater job satisfaction.

Eligibility for Variable Pay

All employees who work for a registered company are eligible for variable pay, but the payouts vary depending on the department. Employees’ compensation as variable pay may differ based on their role, department, or seniority level.

At more senior levels, the compensation is usually linked to the organisation’s overall performance rather than the performance of individuals or teams. In sales roles, variable pay is commonly based on the performance of individuals, while directors and managers usually have their variable pay linked to the performance of their teams.

Benefits of Variable Pay

The benefits of variable pay are as follows:

• Increased Employee Productivity: Implementing performance-based pay is an effective way of increasing employee productivity. When employees are incentivised to work harder and produce results, it can lead to a sense of accomplishment and motivation to continue performing at a high level. However, the success of such a system is contingent upon its ability to improve business outcomes, such as increased sales or growth. Simply offering incentives without a clear connection to business results may not yield the desired level of productivity and can even lead to decreased employee morale.
• Promotes Employee Engagement: Variable pay is a payment method that allows employees to earn additional income based on their performance, productivity, or other measurable outcomes. This approach can increase employee engagement by encouraging talented employees to work harder and achieve better results. Variable pay can be valuable for recognising and rewarding employee contributions and improving job satisfaction, motivation, and overall engagement.
• Improved Organisation Performance: Organisations often use variable compensation plans like commissions to drive better performance and motivate employees to achieve their goals. This type of compensation directly links employees’ pay to their performance, giving them a tangible incentive to put forth their best effort and achieve their targets. By showing employees how their efforts contribute to their income, the company can also recognise and reward their value, which can help to build a more engaged and motivated workforce.
• Offers Financial Flexibility to the Company: Variable pay is a compensation model offering companies significant financial flexibility. In this model, employers pay their employees based on the revenue generated by the business. Unlike a fixed salary, variable pay allows the employer to adjust the amount paid to the employee based on the company’s financial performance. Variable pay is an excellent way for businesses to incentivise their employees to work harder and create a sense of ownership in the company’s success. Additionally, it allows the employer to manage payroll expenses, making it an attractive option for companies looking to optimise their finances.

Challenges of Variable Pay

The challenges of variable pay are as follows:

• Unfair: In certain situations, variable pay can be perceived as unfair. This can happen when there is an unequal distribution of bonuses among employees, with some receiving a significantly higher percentage than others. Additionally, when targets are primarily aimed at particular departments or individuals, it can create an imbalance in who receives the most compensation. This can be demotivating for those not receiving their fair share and can lead to a sense of resentment and lower morale in the workplace.
• Overperformance: One potential issue that may arise in a workplace is the problem of overperformance, where some employees become overly invested in their performance due to the desire to receive a bonus or incentive. For instance, some employers offer attendance bonuses to employees who come to work even when unwell. This may lead to employees prioritising their attendance over their health, potentially putting their well-being at risk. Additionally, employees may engage in other behaviours, such as working long hours or taking on too many tasks to improve their chances of receiving a bonus, leading to burnout and decreased productivity.
• Additional Cost: In some instances, employees do not allocate enough funds to cover bonuses, incentives, and rewards. As a result, organisations may need to bear the additional costs associated with an increase in variable pay amounts. These costs can include the direct compensation paid to employees and the administrative expenses related to managing and disbursing these payments. This can strain an organisation’s budget and require careful consideration of financial resources and priorities.
• Unsustainability: Incentivizing employees through bonuses or rewards may not be sustainable in the long run. Employees may lose interest, or the targets may become increasingly challenging, making it difficult to continue providing financial rewards. Alternative approaches include creating a culture of recognition or offering non-financial incentives like additional time off or professional development opportunities.

Conclusion

Variable pay programs effectively motivate employees, encourage high performance, and align their interests with the organisation’s goals. By carefully designing and implementing such programs, companies can create a culture of accountability, engagement, and excellence that leads to sustainable growth and competitive advantage in today’s dynamic marketplace.

Frequently Asked Questions