Productivity-Based Incentive Pay

One woodshop owner's take on how to calculate and pay bonuses so they will effectively motivate the workforce. November 19, 2008

A lot of people on this forum express frustration with managing employees, whether it is how to keep them, motivate them, or implement a profit sharing plan that doesn't get taken for granted, etc. Over a period of several years, I have come up with most or all of the requirements for a good plan. It is working incredibly well for my company, and may be useful for yours.

I started a door shop 14 years ago, now have around 45 employees. We have had lots of changes and growing pains over the years, but now have a great company, a stable workforce, I work around 10 hours/week most weeks, and make great money, so I assume we are doing this business thing, especially our incentive plan, right.

It is important to start from a solid premise. Some of the basic premises I try to follow are these...

You don't make money unless you are getting lots of quality work out the door. This means the sales have to be there, sales and production must work together, production must get a good quality product out the door, etc. Everyone must work together as a team to make this happen.

Reward people on what they have control over, but keep it simple, and have a strong orientation on production output, don't overemphasize other things that don't directly impact profitability. Small incentives for good attendance or such are great, but don't overshadow the main goal: getting quality product out the door.

Profit is what the people with "profit responsibility" get rewarded with. If someone does not have control over pricing and sales and production and purchasing and investing, then they should not get rewarded based on profit numbers. This means the owners, and president if there is one, are the only ones that get rewarded based on profit alone.

Avoid a system where bonuses can be paid out at the same time the company is losing money. But how to do this without a true profit-based plan? By setting a hurdle, and by being conservative in its design. This I will try to explain as we go.

Now we are at the point of designing an incentive system that focuses on production output. This will apply to almost everyone in the company. As mentioned, all the different functional aspects of the company will have to work together. It doesn't do any good to reward Sales for great numbers if Production can't get it out the door. Plus, if they sell more than you can make, you will just be ticking customers off, etc. What if Sales can't keep up with Production? Now you have a problem that everyone in the company is interested in getting solved. You should have a great sales force/person that can get the work. If not, this is a real problem to the health of your company, and will need to get fixed. Problems will have to be solved, as you know. Plus, if Sales sells jobs that are difficult to get out the door, then they will be hurting their own production bonuses.

In a nutshell, we bonus people for production that exceeds the level needed for my minimum acceptable profit. Each product we make has what we call a Work Unit, but is just a restatement of Labor Minutes so it will fit onto a daily work schedule. In other words, I can't put 7000 minutes per day on Microsoft Project, so we use a much smaller Work Unit number so we can create a daily schedule. The more work units (labor units) they get out, the more bonus.

Too complex for now? Just use minutes. You probably use a time factor when figuring out how to charge customers, right? Let's say you get out 20 cabinets a day on average, and the labor is 14 people x 7 1/2 hours x 60 minutes/hr = 6300 labor minutes. 6300 labor minutes per day is your current average output. But you may get people arguing over the minute assignments to each product and service, so it helps to separate the issue with my Work Unit, which is much harder for people to argue with.

1) So for now I will use minutes. Assign labor minutes to each product and service you offer, regardless of how you charge. If it is a job that has to be produced or a service rendered, you want the crew to do it as efficiently as possible. Do not distinguish between cheap and expensive labor. Sometimes a carpenter has to take the garbage out, and sometimes a helper is learning to do a carpenter's job, so it doesn't matter, and you want to keep things simple. The labor minutes are the same for all materials, and you should also be tracking labor costs per labor minute.

6300 labor minutes / 20 cabinets = 315 labor minutes per cabinet in our example. (No, it will not be that easy to assign labor minutes to all the actual products you make!)

2) The owners must decide what their minimum acceptable profit is for each month, except maybe December. They deserve this. This is their return on their investment, just like you want a return on investment if you buy a stock or a bond. Owning a business is risky, so it should be at a level they are OK with it if the company just does OK that month. 6 - 8% is OK in my book. This is an individual thing. This is theirs, no one can touch it. They can take it all home, or decide to invest it back into the business. Their call.

3) Determine how many labor minutes of output are required to make their 7% profit in a 20 day month. Remember, I said this would be a conservative calculation. Some months have up to 23 days. We must use 20 days of output.

Let's say you get $500 per cabinet (I know my numbers may be way off - just examples). This is $500 / 315 labor minutes = $1.587 revenue per labor minute. The owners will want to track this number (Revenue per Labor Minute) to see when it drops off, and to watch it grow after a price increase. Yes, it fluctuates with the different materials used, but still is a useful number.

Let's also say that you determine it takes 6000 minutes a day x 20 days = 120,000 labor minutes in a month, or 120k x $1.587 revenue per labor minute = $190,440 revenue in a 20 day month to make their 7% profit. Cool. No one gets a production bonus at 6000 labor minutes a day, but the owners do get their profit, even in a short month.

4) Determine Incremental Profit for Incremental increases in Production output. Say your margin is 50%, so if 1% of $190,440 = $1904, you have to invoice twice that, $3808 of product, which is $3808 / $1.587 rev per l.m. = 2400 labor minutes of work to gain an additional 1% profit.

See where I am going? 2400 labor minutes / 20 days = 120 labor minutes a day over the required 6000 labor minutes will net an additional 1% profit for the company. This is what you will start sharing with the crew.

Make it easy. Use round numbers. I will do this as an example: 200 additional labor minutes a day, on average, will equal about $3173 additional profit at the end of the month. It makes more sense to use easy numbers when motivating based on numbers. We will use 200 for our example.

5) Figure out how to share it. I think that about 25 - 30% of the incremental profits should be paid out in production and other incentives. Now you make a spreadsheet with everyone's wages, and start plugging in percentages of their wages as bonuses, and play with it until you get the right mix of bonuses. A couple of things: At this point, use 23 day months to figure what someone's wages are for the month. We are going to be conservative, to guarantee we are making a profit before bonuses are paid out, right? This is important. Item 2 - Your payout must take into account all payroll costs. For us, this is about 1.18 times base pay, to account for taxes and workers comp, etc.

So... 25% x $3173 = $793 to be paid out, but divide by payroll costs, $793 / 1.18 = $672 gross paid out, payroll costs will equal the $793 amount.

Take out the owner(s), and in our 20 person company, you have 19 people to divide the $672 among. On the spreadsheet, everyone in the same position will get the same percentage. People talk, don't they? You don't want one floor guy bragging that he makes a higher percentage than others. He already makes a higher dollar wage, so his bonus will be higher since it is a percentage of his hours worked in the month x base pay. Everyone besides the owners gets a production bonus offered. Even maintenance, bookkeeping/accounting, human resource, everybody. This keeps a team focus on production. And junk that gets remade doesn't count toward their bonus! Supervisors get a higher percentage, and the Production Manager gets a huge percentage for each incremental increase in output, so a significant portion of his pay is from attaining high production output. If the Production Manager just achieves the minimum acceptable profit, their pay should be very modest as a result. If the Production Manager cannot regularly achieve and exceed the minimum acceptable profit, assuming the work is available, then the owners should be on the lookout for a replacement, or take some other remedial action.

You have now determined what you think is a workable production incentive program, and have tweaked it with other things, too, like the 2% attendance bonus for perfect attendance we pay, and are ready to present it to the shop. Tell them this is a work in progress and will change every month for awhile until you get it down right. You give them a sheet saying what their bonus will be, and show how the percentage will accrue for each increase in production output.

It will essentially say something like, "For each 200 units of average daily output above 6000 units, you will receive 1% of your base pay x hours worked in the month as a performance incentive, paid the following month." You also will note in the meeting that in March and June you had average outputs of over 7600 units per day, so that would mean you would have made an additional 8% plus other (attendance?) bonuses. This is a time to challenge them. Ask them what they want the output to be this month, and I guarantee someone will be piping up with some big numbers, big enough to make you bite your tongue to keep from telling them that is just not possible. Give this some time, and you will be shocked at what they can accomplish once everyone gets focused.

Note: It is important to keep track of the completed jobs at the end of each day. One day might be 2000 units, and the next might be 15000, so you will daily announce the previous day's output, and the monthly average-to-date. To do all this you have to be determining the number of units in each job as they get booked, and of course any modifications to the job that get made mid-job.

I also do an incentive program for our accountant that rewards collections, to minimize accounts past 60 days and minimize bad debts. She gets dinged bad for both of those. To top it off, if the shop runs out of work, they get to go home with pay for the rest of the day. This keeps them humping when they think the work is getting low. We found that if they slow down, it is hell to get them to speed back up. Plus, if they have been getting great numbers, they deserve this. To keep this from happening, we give Sales two hours off if they go the whole month without letting the shop go home early. But if they oversell, they will just have ticked off customers, but they are very good at the balancing act and keeping just the right amount of work on the schedule.

Forum Responses
(Business and Management Forum)
From contributor D:
Good stuff - thanks.

From the original questioner:
I'm going to add a really important point; I don't know if it is clear.

In my example above: "Let's say you get out 20 cabinets a day on average, and the labor is 14 people x 7 1/2 hours x 60 minutes/hr = 6300 labor minutes."

You have determined the metric that each cabinet represents 315 minutes = 6300 min/20 cabinets. But now you have instituted a great incentive system, and your guys are motivated, and they start getting out cabinets in an average of 270 minutes. Do not change the metric from 315 minutes. The incentive system will topple like a house of cards.

See, you have already made a metric that says you receive $1.587/minute of production. You get the same amount per cabinet - 315 minutes x $1.587/min - whether they take two days or 10 minutes to make that cabinet. You know that you need 6000 minutes/315 minutes per cabinet = 19.04 cabinets a day to achieve your required minimum profit. "Minutes" becomes a misnomer as your production efficiencies increase. You see why we use "Production" or "Work Unit"?

If you regularly deflate their production numbers by changing the minutes per cabinet, you will have a mutiny on your hands. Plus if you did this, you would have to recalculate the hurdles for incentives. Don't bother.

After 10 years, your shop may be getting out product in a fraction of the time, but either everyone is getting wealthier than a Saudi king, or you have invested in a building and lots of equipment, and have the overhead to prove it. You do need to recalculate the incentive hurdles every time there is a significant change in your overhead structure.

You typically have a mix of products. If the relative time it takes to make different products or services changes, which it will over time, you will need to adjust the units assigned so that your overall Revenue/Unit remains the same. I have sat here a while trying to figure out how to explain the calculations, but it's just confusing me, so I need some more time, maybe review an old spreadsheet.

From contributor P:
Do you have a problem with attendance? It seems like there would be a potential for workers to be inclined to call in sick more than they might otherwise.

From the original questioner:
I don't understand your question. If they call in sick, they miss a day of work, miss a day of pay, get written up if they show a pattern of abuse, do poorly on their reviews/raises, get the scorn of their team leaders, loss of confidence from management, etc.

From contributor P:
That was a stupid question on my part; I was thinking of another shop that pays their employees when they don't have work. He must be doing a few things right - they make furniture and have to compete head to head with the imports and still has almost doubled his sales in the past 10 years, I think about 40 million. Point is that he has a similar plan to yours, which makes me say hmm. He didn't say a lot about the flavor of the month business philosophies.