The number one question we get asked by all our clients is how much a bonus should be. I’m not joking when I answer, “it depends”. It really does depend on a lot of factors. In the last several years I’ve seen bonuses benchmarked in a lot of different ways. There are just about as many methods for benchmarking bonuses as there are ways to calculate bonuses. Most commonly a bonus or financial incentive is benchmarked either as part of a position’s total compensation package or reported alone as a percentage of salary. Those methods work for benchmarking against others in your field, but they don’t tell the whole story. That story is told when you ask, “what did you do to get your bonus?” My intent with this blog is not to provide an alternate benchmarking method, but to provide some guidelines on helping your team understand the whole story. And most importantly set expectations around your financial incentives.
Whether you call them bonuses, incentives, commissions, profit sharing, rewards or one of the dozens of other terms companies use, everyone is referring to basically the same thing. A financial incentive paid to an employee in addition to their standard paycheck. A company typically uses their extra income (profits) to pay these incentives. The general concept being that the more profitable a company is, the more a bonus or financial incentive will be. While great in concept, the execution of financial incentives has been very poor with most companies over the past several decades. Employees are too removed from why a company pays a bonus or oftentimes the company leaders even forget why. Bonuses then become an expectation instead of something earned.
Bonuses and Expectations
How do we get back to making the bonus something that is earned instead of what I was told at my first job? “You’ll get a bonus every year that’s about an extra paycheck.” It’s a wonder it was merely an expectation, and I was disappointed when I got the same as the guy who coasted through the year.
A couple years ago I came across a concept that someone suggested would be a good approach for companies to use to distribute their earned profit. The concept they introduced has proven to be a sound method of allocating profits among key stakeholders. The key stakeholders included: Owners, Employees, and the Company. While they suggested a more complex way of distributing profits, I’ve developed a simplified version based on working with hundreds of companies to set up their incentive compensation plans. After paying taxes, a company should distribute 1/3 of its profits to the shareholders, 1/3 to the employees and 1/3 for reinvestment into the company. The 1/3 set aside for employees is what can be distributed as bonuses or financial incentives.
Some may say that there’s no way you can set aside 1/3 of your profits for your employees. I agree. There’s no way you can afford to. Your company’s profit margins.
aren’t high enough to allow that kind of profit sharing. Your commitments to shareholders and the company should come first. Instead, I recommend committing to share that much when your margins are as high as your market can support. This simple table demonstrates the concept.
As an example: Company A has 40 employees and finished 2022 with $5M in revenue at a 20% profit margin. Their average salary is $60k/year. Based on those numbers, Company A will be sharing 25% of $1M dollars in earned profit or $250k. That’s an average bonus of $6,250 per employee. You’ll notice that the average bonus is about 10% of the average salary. We’ve found that incentive payments of 10% of annual salary are a reasonable average bonus amount per employee. Companies with employees that fall into the high-performance category could expect bonus amounts anywhere up to 20% or more of their annual salary.
And this is the foundation of a pay for performance plan.
Pay for Performance: P4P
The better a company performs, the more profit there is to share. So now when I’m asked how much they should be paying in bonuses, I respond, “commit to sharing up to 1/3 of your annual profit in bonuses when your company performs well.” From there it’s simple math to calculate what your average bonus and what percentage of salary your average bonus will be. Check out our Pay for Performance Guides found here.to understand how a pay for performance bonus plan is helping companies reward their employees for helping them become a high-performer.