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Article:

How Bonuses Work

Bonus programs reflect a company's definition of success, how that definition is measured, and the extent to which that measure is met.

Bonuses are similar from company to company. The reason is that most companies subscribe to a pay-for-performance philosophy whereby bonuses are tied to two important measures: how well you are doing with respect to your manager's expectations; and how well your company is doing with respect to its expectations.

Individual and group performance goals are hard to set, because they should be neither too ambitious nor too easy to achieve. It is best for employees to set next year's performance goals once current year results are known. However, the manager should resist the temptation to base an employee's performance goals on an outstanding year. When that happens, both employee and manager can become disappointed. In these instances, managers often give their employees discretionary bonuses at the end of the year to make up for the loss of performance-based bonuses.

Managers also give out discretionary bonuses - bonuses that are not tied to a formal performance target - when it is too difficult to establish formal performance goals.

Depending on the bonus program and your level within the organization, your bonus may be determined not only by your own performance, but also by the performance of your team or work group. Some companies use a 2 X 2 payout grid with individual objectives on one axis and a corporate goal on the other. Under these types of bonus programs, your actual bonus can range anywhere from half your target bonus to double your target - or nothing.

In some bonus programs, the company may have to meet targets of its own for anyone in the company to receive a bonus. For example, the company may need to meet a certain minimum in net income; or a certain level of customer satisfaction; or a certain competitive position in the market. This minimum is usually 80 to 85 percent of what is required for the bonus target to be met.

Inclusion of nonfinancial goals such as market share or customer satisfaction is relatively new, reflecting a deepening understanding of operational measures that indicate the economic health of the company. When the number of goals includes many variables reflecting not only your primary responsibility, but also how you manage your relationships throughout the organization, your bonus grid becomes what is known as a "balanced scorecard." This approach is becoming popular because companies recognize the complexity of a position's contribution to the company and want to evaluate its performance holistically.

Range of Bonus Payouts
Annual incentive bonuses are meant to be motivational. They are designed to reward employees for fulfilling their responsibilities and for delivering superior results. Bonus targets and their associated payouts reflect a range of expected levels of performance.

Just think of a star baseball pitcher who has an incentive clause in his contract based on the number of games he wins. For winning 15 games, he will get $1 million; for 20 games he will get $3 million; and for 23 games he will get $7 million. This is what an annual incentive bonus plan looks like.

As a bonus plan participant, you are that star athlete who is rewarded for performing at a level appropriate to your ability. You are also rewarded for having a great year.

If the goals given to you are unrealistic, you and your boss can be in for disappointment and trouble. Annual incentive programs are built around the expectations that the company has of itself and of you. Bonus plan participants can expect to achieve minimum acceptable performance (i.e.—for their boss to remain happy with it) and receive a bonus payment 90 percent of the time and achieve target level of performance or better at least 60 percent of the time.

Expected performance levelLevel of difficultyLikelihood of achievementPayout as a percentage of target opportunity
Minimum (acceptable)80% of target90%50%
Target--60%100%
Maximum120% of target15%200%

Source: Salary.com.

Suppose that your target bonus is 20 percent of a base salary of $100,000 and you performed at the maximum performance level. That means you would earn 200 percent of that 20 percent bonus, or 40 percent. This would result in a $40,000 check ($100,000 x 20%(your target bonus) X 200% (payout level)).

In most industries, the target bonus percentages are similar, and depend on salary. Exceptions include the high-technology and investment banking industries. In nonprofit organizations and healthcare, bonuses remain rare.

Typical Bonus Levels as a Percentage of Salary

Base salaryTarget bonus (%)
Less than $75,0000*
$75,000-$99,99910-15
$100,000-$149,99915-20
$150,000-$199,99920-30
$200,000-$299,99930-40
$300,000-$499,99940-60
$500,000 or more60-100

*Bonuses for this range are not typical, and if rewarded, are usually discretionary.