3719724, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Compensation and Pay Mix: Part 2 - Personnel Costs By Andy Klose - Associate Partner In this series of articles, we are highlighting an aspect of remuneration str-’ +y that is often not given sufficient attention: The ratio of fixed and va. 2 pay to total cash compensation (also known as "pay mix"). nips. venconresearch cominisghticompensation-and-pay-mix-par-2-personnel-costs sno3119724, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Benchmarking Surveys About Insights Contact In this Part 2 we will discuss how pay mix affects the financials of firms, especially with regards to personnel costs. In the upcoming Part 3 we will examines how pay mix should be adjusted in relation to the total cash compensation offered and how benchmarked market percentiles are the most effective indicator of competitive positioning. And, in the final Part 4 we will assess how pay mix may influence firms’ culture and performance, we will examine how pay mix may influence firms’ culture and performance. | Part 2: Bottom line up front: The higher the total cash compensation, the higher the variable pay as a proportion of total cash compensation (or in other words, the pay mix is "riskier" because a larger proportion of pay is performance related). In companies with a well-designed performance appraisal system, underperformers may "finance" the additional variable pay needed to reward overperformers. But the cost effect is only one consideration: companies will achieve significantly better overall results if more employees over-achieve their targets, which will also have a positive impact on the bottom line. Introduction For professional services firms in particular, hiring the right people, motivating them to perform at their best and retaining top talent are critical to success. In an ideal world, the solution would be very simple: companies pay their en ees the highest salary relative to all other “competitors for talent” (wi.._.1 could be market participants within the same industry, but also in -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 21103119124, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisor Benchmarking Surveys Y About InSights Contact Services In the real world, however, the interests of stakeholders other than employees, such as the owners of the company, stand in the way: owners are interested in sustainable profits and above-average growth rates, and are therefore generally only prepared to pay above-average salaries to employees if they also perform exceptionally well. Pay mix as a means of offering higher total cash compensation For this reason, higher pay - in certain jobs - is usually strongly or directly linked to the achievement of results and performance. In professional services firms, especially for client-facing or sales staff, this is often achieved through variable pay components such as bonuses. Generally, there is an inverse relationship between the amount of total cash compensation and the ratio of fixed to variable and total cash compensation (hence, the pay mix): The higher the total cash compensation, the higher the variable pay relative to base salary and total cash compensation (or in other words, the “riskier” the pay mix). The following example (Table 1 and Exhibit 1) illustrates this: Assume that the following three offers relate to comparable positions with comparable future prospects and development opportunities, etc., offered by three comparable companies with similar brand, status, market and growth prospects, etc.: -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 3it03119124, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisory Benchmarking Surveys Services ADOUt Insights Contact Variable Pay 40 30 20 Total Cash 100 95 90 Variable Pay in % of Base Salary 67% 46% 29% Variable Pay in % of Total Cash 40% 32% 22% Table 1: Three offers with different pay mix (hypothetical and illustrative examples) os ‘Total Cash 30 Variable Pay Ey Fim a Fitm 2 itm 3 Exhibit 1: Three offers with different pay mix (hypothetical and illustrative examples) In the example above, Firm 1 offers the highest total cash compensation (100) with the lowest base salary (60) and the highest ratios of variable pay to base salary (67%) and variable pay to total cash compensation (40%). On the contrary, Firm 3 offers the lowest total cash compensation (90) with highest base salary (70) and the lowest ratios of variable pay to base salary (29%) and variable pay to total cash compensation (22%). Firm 2’s offer is in between the other two offers. In essence, the higher the total cash compensation offered, the more money is “at risk” (due to performance- related variable pay). Pe mance appraisal and pay mix -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 403119724, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Benchmarking Surveys Services ADOUt Insights Contact ee eee] Base Salary 60 65 70 Variable Pay 40 30 20 Total Cash 100 95 90 Variable Pay in % of Base Salary 7% 46% 29% Variable Pay in % of Toto! Cash 40% 32% 22% Performance Appraisal Process Expected Distribution of Performers Fixed Portion of Personnel Cost (Base Salary) Variable Portion of Personnel Cost highest (when all are (va ble Pay) Total Personnel Cost Financial / Cost Evaluation Often less concerned in between ‘with appraisal of individual performance Expected to be more detailed (and costly) Bell-curved" (few low, “Bell-curved" (BU Fan gency,shatall are many 100% andfew expected to be 100% performers high performers) narrower) e lowest inbetween highest lowest (when all are 100% performers) epee! 100% performers) highest (when all are — in between (when all 100% performers; but are 100% performers; lowest (when all are detailed performance performance appraisal 100% performers, but appraisal provides provides limited "cost less potential for "cost “costoptimization" optimization" optimization") potential) potential) + 4 : Table 2: Three offers with different pay mixes. Please note that all of the examples are simplified and for illustrative purposes only. As illustrated in the example above, when analysing variable pay (which in most cases is “pay for performance”), it is also important to address the issi'- of performance appraisal. In our practice, we often see that co ilies are more inclined to use a more sophisticated system to assess -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 5103119124, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisory Benchmarking Surveys Services About Insights Contact variable pay is relatively low (or some companies do not offer variable pay based on individual performance at all, but rather, for example, a bonus based on company results or performance). The amount of effort put into individual performance appraisals has an impact on the outcomes for both the employee and the organisation: A more detailed performance appraisal may also lead to more diverse performance outcomes, i.e. performance outcomes may look rather “bell- curve” shaped, i.e. some high performers, many on target performers and some low performers. Less sophisticated performance appraisal systems on the other hand will often lead to more heterogeneous performance results (i.e. a narrower but steeper bell-curve with fewer high and low performers). And, in companies where individual performance is not assessed, there will be no differentiation at all. Accordingly, the expectation is that all employees will have the same level of variable pay (or bonus). In the example above, assuming that all employees perform at 100% of their targets, Firm 1 is expected to have the highest total personnel costs, Firm 3 the lowest and Firm 2 in between. On the other hand, the more sophisticated the performance appraisal, the greater the potential to differentiate between employees and thus “optimise” personnel costs, while still paying good and exceptional performers according to their contribution. More diverse distribution of performers in performance appraisal On the other hand, from the company’s point of view, a more differentiated assessment of individual performance usually results in a potentially wider range of variable pay costs, i.e. if more employees over-achieve their targets, the company will have to pay out more variable pay. Conversely, if me ->mployees do not achieve their targets or under-achieve, the co. yy will have to pay out less variable pay. Compared to the example -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis e1103119724, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Benchmarking Surveys . About InSights Contact overperformers. Based on the same three offers from the previous example, the following example (Table 3) examines three scenarios in which the distribution of achievers is changed: ore High- performers << So cececerecors corso Base Salary o 6 wlio 6 m|o 6 7m Variable Pay o » »/|o 2» m|o » w Total Cash so 5 90 | 10 35 9 | 10 9% 9% Von Pyn 0 Boe hay ee No.of employees » » 0 |» » |» » ~ of which are High-performers: 3 2 oO 2 By 0 1 o oO ~of which are On target performers 5 8 w|/s 8 w|]6 @ w ~of which re Low-performers oe oe ee ee | Variable Pay ortigh-performers perhead) ggg, ar caer ca Pree ae an (ea 106of sore mendoned wae pt as Pay for On-target performers (per 40 0 ” 0 » 40 20 » Variable Payfortow-performers(perhesd) =o) ~Sas_' sags | sows itd] st 4 ent Budget Variable Pay for High-performers 180 90 0 120 4S 0 60 oO oO Budget Variable PayforOntargetperformers 240 © 240mm | 240 © 240 2m | 40200 m0 Budget Vaiable Pay for Lowperionners Pa ol Eom| a ee oe | en Total Budget Variable Pay wo 0 am | mo 3m 20 | 360 20 20 aan Ta Swe aa ep oie |p| 2ilo|p |e Table 3: Three different scenarios for each of the three firms’ offerings in terms of individual performance and impact on staffing costs. In the example above, Firm 1 uses a more detailed performance appraisal, wb s likely to result in more diverse performance outcomes: more high pe. “ers, less on target performers and more underperformers compared -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 703119724, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisory Benchmarking Surveys Services About InSights Contact Obviously, Firm 1 has the highest variance in its total cost of variable pay (from 360 to 440 in the three scenarios). Company 2's variance in terms of total variable pay costs is lower than Firm 1's (from 270 to 330) and Firm 3 will not see any change in its budget if the performance of individuals changes. This also means that Firm 1 and Firm 2 can “save” up to 10% of their variable pay budget if more people underperform (which is by no means a target, but if it happens, it also saves money). Personal performance and pay mix affect personnel costs Since base salary is a “fixed” component of personnel cost, variable pay is the only component which may fluctuate according to distribution of performers, and thus, so will the total personnel cost (Table 4): Variable Pay ao || 308 |) 20) ||| Son) tong) feo) || eaos | | on | 20: Voriable Poy in 36 of Base Soary om 6% 28 | om sows am | ow am 0m No. of Employees 1 10 so | 10 of which are On-target performers 6 8 10 6 Total Budget Variable Pay -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis ano3119124, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisory Benchmarking Surveys Services About Insights Contact in this example, Firm 1's total budget tor personnel costs will vary the most (between 960 and 1,040), Firm 2’s will vary a little less (between 920 and 980) and Firm 3’s will not vary at all. The cost effect is only one aspect: Firm 1 will achieve significantly better results in the first scenario if more employees over-achieve their targets, which will also have a positive effect on the company’s results, growth and so on. Conversely, Firm 3 has no impact on its personnel costs, regardless of whether or not its employees perform. On the other hand, Firms 1 and 2 may save some personnel costs when employees do not perform. Finally, all the above concepts are less relevant (or even counterproductive) for “creative” jobs or for jobs where meaningful and measurable metrics cannot be defined (such as some administrative jobs). In summary, the pay mix can also have significant implications for both the employee (in terms of “money at risk”) and the company (e.g. higher personnel costs if more employees overperform and vice versa). In companies where there are clear performance appraisal systems in place, underperformers may “finance” the additional variable pay needed to reward overperformers. But the cost effect is only one consideration: Companies will achieve sig icantly better overall results if more employees over-achieve their targets, which will also have a positive impact on the bottom line. On the other hand, no differentiation at all in terms of personal performance can have a negative impact on the “motivation” of high performers (which will be discussed in more det: Part 3). We at your disposal for further questions and suggestions regarding how ,ou optimally design the pay mix (and/or remuneration systems) for -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis eit03119124, 10:18AM Compensation and Pay Max Part 2 - Personnel Cosis Advisory Benchmarking Surveys Services About InSights Contact heads the firm’s consulting unit. Vencon Research International is a leading provider of compensation benchmarking and research as well as of compensation and performance- related consulting services for professional service firms, especially for audit and tax, management consulting, and IT services firms. Vencon Research International provides services to a full range of clients in more than 75 countries worldwide and is proud to name more than 85% of the world’s major consulting and/or professional services firm its clients. MENU SURVEYS 0d Benchmarking Consultant Salary Survey Surveys Partner Compensation Advisory Survey Services Consultant Benefits Survey About Administration & Support Insights Staff Survey Contact Special Request Surveys Imprint Modern Slavery Policy Privacy Policy = © Vencon Research International & -ntps:wwvenconresearch,cominisghticompensationand-pay-mocpar-2-personnel-cosis 10110 Cop"