Fixed vs variable pay: the right ratio

By Kusum Makhija

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 fixed and variable components 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 according to the years of experience and the more
senior a person is, the more his/her compensation becomes variable.

“The reason why 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 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
variable pay to lower levels as well. There are two aspects to it—one is that employees
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 on 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 the role an employee plays. As a rule, the hunters i.e. employees
engaged in sales activities, usually have a larger variable than the farmers i.e. employees in
execution roles. In the Indian conditions, for the sales portfolio the ratio of fixed to variable
can be as much as 60:40, while in countries like the US it could be as much 30:70,” says
Sreenivas Chakravarthy, Vice-president, People Depa-rtment, 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 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 since 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-monetary 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
company’s performance (profits) a certain component gets distributed to all 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.

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 Chakra-varthy.
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 targets and objectives. For example, if an employee has got 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 its profits with its employees, thus creating a sense of belonging
among them. It differentiates between high and mediocre performers. “If used carefully, an
Impact on productivity

Most organisations have determined that merit pay plans do

not provide sufficient reward for the employees who The idea is that the fixed
component is there to do the job,
consistently perform in an outstanding manner. Indeed, merit whereas the variable component is
pay plans have lost their ‘merit’ and have become entitlement for going beyond the job
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, as they have not considered
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 on
issues of biases while measuring performance. Says Chakravarthy of Aditi, “The flip side is
that it can cause discontentment among employees when the 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 pay,” adds Chakrav-arthy. Tandon of CSC however
believes that there is no flip side to it as long as there are no biases involved.

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. This needs to be avoided.

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-monetary 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.” Moreover, the balance between the fixed and variable
component of the pay is an important aspect for any organisation. A large part of the pay
coming as variable pay can lead to a feeling of dissatisfaction among employees.

The idea therefore is to design a variable pay plan in such a manner that it is easily
understood by all and more importantly, should not act as a deterrent to good performance.
“Personal biases of managers towards their subordinates while appraising their performance
can act as a deterrent to performance, if the employee thinks that he is not been given a
fair deal. Uniformity of procedures and criteria is extremely important,”
emphasises Tandon.

Variable pay compensation is often linked to incentivizing employee performance, and giving the
employee a way to share in the reward for being productive. While not applicable for every situation,
a great many organizations have instituted different types of variable pay systems with different
levels of success. Many organizations take a look at many employee compensation methods for the
purpose of enhancing productivity in the workforce, and variable pay for executives and managers
as well as regular employees are generally considered. It is not uncommon to find some form of
results oriented variable pay systems.