How to Create a Variable Compensation Plan: With Examples

The business environment is becoming increasingly competitive, with several organizations trying to compensate their top talents in innovative ways to motivate, reward, and gain their loyalty. However, a recent study concluded that only one in three US employees agree that they have received enough recognition for their hard work.

This further emphasizes the importance of implementing a variable compensation plan for companies in any industry. For HR professionals and business leaders, understanding how to design and execute an effective variable pay program is crucial for driving business success while aligning workforce efforts with strategic objectives.

In this article, we’ll discuss everything you need to know about variable compensation plans—their definition, importance, types, pros, cons, and calculations, and a step-by-step guide on creating an effective one.

What is a variable compensation plan?

A variable compensation plan is a pay structure where part of an employee’s total earnings depends on achieving specific performance metrics, company results, or other predetermined criteria, rather than being entirely fixed like a base salary.

This supplementary pay can fluctuate, rising or falling based on how well an employee performs or achieves specific goals. A variable compensation plan's key characteristics include:

• Performance-based

• Flexible and dynamic

• Supplementary to base pay

• Goal alignment

Common examples of variable pay include bonuses, commissions, profit sharing, stock options, and team-based incentives. By linking your organization’s salary planning strategies to performance, a variable compensation plan is an effective way to drive positive business results and improve employee engagement.

What is the importance of variable pay?

Variable pay plays a vital role in modern compensation strategies because it brings tons of benefits while still giving your company enough flexibility in compensation and cost management. Some of its key importance is listed below:

• Motivates employees to excel: Directly linking pay to performance fosters employee motivation because they are incentivized to work harder, achieve specific targets, and drive business success.

• Employee and organizational goal alignment: Variable compensation ensures that employees’ efforts are focused on achieving the company’s strategic objectives, creating a culture of accountability and results within the workplace.

• Attracts and retains top talent: In a competitive job market, offering variable incentives can differentiate your organization and appeal to high-performing candidates seeking growth and financial rewards.

• Improves engagement and morale: Recognizing and rewarding achievements fosters a sense of value and satisfaction among employees, leading to higher engagement and loyalty.

• Provides cost flexibility: Variable compensation allows organizations to manage labor costs more effectively, adjusting rewards based on company performance and economic conditions.

Total compensation management is key to making way for effective variable compensation plans. Assess your organization's current compensation practices and see which possible rewards and bonuses could fit your workforce. You can also utilize Compensation Planning Software to centralize your plan in one comprehensive solution.

Types of variable compensation plans

Variable compensation plans may come in different forms, each suited to the varying business needs and workforce dynamics of your organization.

Keep in mind that your company may or may not implement all of these types of variable pay. You might even need more, depending on the type of industry you’re in:

1. Pay-for-performance or incentive pay: These are lump-sum payments awarded for achieving and/or exceeding the company’s predefined goals, such as project milestones and sales quotas. Take note that this could be either individual or team compensation, and usually fixed costs.

2. Sales commissions: This is the most common type of variable compensation, which is based on a percentage of sales closed, usually implemented in sales compensation plans involving sales teams or sales reps.

3. Profit-sharing: Employees receive a share of the company’s profits, aligning their interests with overall business success.

4. Stock options and equity: These are long-term incentives that grant employees ownership stakes, encouraging retention and sustained individual performance.

5. Recognition rewards: Non-monetary or small financial incentives for outstanding contributions or innovative ideas.

6. On-target earnings (OTE): Combines a base salary with achievable performance incentives, providing a structured yet flexible approach to compensation.

How to calculate variable pay

Naturally, calculating variable pay highly depends on the type of plan and the metrics used by your company. Here are some common methods:

• Percentage of base salary: For example, a 10% annual bonus based on the employee’s salary if targets are met.

• Commission rates: A set percentage (e.g., 5%) of sales revenue generated by the employee.

• Profit-sharing formulas: A predetermined percentage of company profits is distributed among eligible employees.

• Goal-based payouts: Fixed amounts awarded for achieving specific milestones, such as project completion or customer satisfaction scores.

Remember—the key is to ensure that the calculation method you choose is transparent, easy to understand, and directly tied to measurable outcomes. This way, employees will have a clear context on how their performance is evaluated to earn well-deserved rewards.

How to create an effective variable compensation plan

Designing a successful variable compensation structure requires a strategic approach that balances business objectives, employee motivation, and fairness. Here’s a quick step-by-step guide for you to follow:

1. Step 1: Establish clear and realistic goals

   The first step would be defining the objectives your variable compensation plan aims to achieve. Are you looking to boost sales, improve customer satisfaction, or increase productivity? Keep in mind that your goals should be:

   • Specific: Clearly state and establish what needs to be achieved.

   • Measurable: Use quantifiable metrics to evaluate employee performance (e.g., sales targets, project deadlines, quotas).

   • Achievable: Set realistic expectations based on historical performance and market conditions.

   • Relevant: Align your goals with broader business strategies.

   • Time-bound: Specify deadlines or performance periods.

2. Step 2: Communicate employee expectations

   Transparent communication is essential for the success of any variable compensation program. Employees must understand key details such as:

   • How to earn variable pay

   • What is expected of them (KPIs or key performance indicators)

   • When and how payouts occur (monthly, quarterly, annually, etc.)

   Regularly reinforce these expectations through training, documentation, and ongoing feedback throughout the implementation of your variable compensation plan. It also helps to strengthen your organization’s talent management system for better results.

3. Step 3: Ensure fairness and transparency

   A well-designed variable compensation plan should be perceived as fair and equitable by all employees. You can achieve this by using objective metrics, a standardized criterion, eliminating bias, and providing clear documentation about everything.

4. Step 4: Conduct regular reviews and evaluations

   Naturally, you may encounter certain challenges and roadblocks along the way. What’s important is that you understand that business needs and workforce dynamics can change rapidly.

   Therefore, make sure that you regularly review performance data, gather employee feedback, analyze input on what needs to be improved, adjust specific performance targets and metrics, benchmark goals to align with the latest industry trends, and evaluate your variable compensation plan regularly.

Variable compensation plans: Pros and cons

Before implementing a variable incentive program, it’s important to weigh the advantages and potential challenges your company would face during the process:

Advantages:

• Motivates high performance

• Drives better productivity

• Aligns with company goals and interests

• Boosts employee engagement

• Increases employee retention and satisfaction

• Provides improved cost management and flexibility

Challenges:

• Introduces uncertain earnings for employees

• May increase workplace stress and anxiety

• Potential for bias and discrimination

• Emphasize the unnecessary importance of short-term goals

• It may not be suitable for all job functions in every industry

A well-designed variable compensation strategy has the potential to make or break your company’s workforce management strategies. But with careful planning, transparent communication, and regular evaluation, HR professionals and business leaders can leverage variable compensation as a strategic advantage in today’s competitive market.

Utilizing the Compensation Planning Software will help you stay ahead of the competition by promoting an all-in-one solution to pay practices with increased efficiency, centralized planning, and streamlined collaboration.