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Figuring Incentive Plans' ROI

HR Magazine, July 2006You spend a lot on incentive plans, so you'd better make sure youre getting your moneys worth.

At HomeFederal Bank, based in Columbus, Ind., it will not be a major challenge to determine if a new incentive plan introduced at the branch level is paying off. The plan awards points to employees based on the number of accounts opened and products sold. Although the plan has been in place for only a few months, Diane Trout-Cummins, assistant vice president and marketing director, knows exactly how to determine the plan’s return on investment (ROI).

The first step is to calculate how much sales increased for a given period since the plan took effect, compared with the like period the previous year. Presumably, any increase will have been stimulated by the incentive plan. But to get a more precise picture, any increase attributable to the bank’s growth or to other factors rather than the incentive plan would have to be set aside.

Then, knowing the sales increase attributable to the incentive plan, the bank can calculate the ROI for the plan.

Even though measuring incentive plans’ ROI can often be as straightforward as it is at HomeFederal, most companies don’t do the calculations. In a survey of more than 600 HR, compensation and finance executives conducted last year by the Philadelphia-based HR consulting firm The Hay Group and Loyola University of Chicago, 62 percent of companies reported they do not attempt to measure their incentive plans’ ROI at all.

About half of the companies that measure ROI in some manner—about 20 percent of all the companies surveyed—said their measuring is done informally through discussions with management.

The other half—about 18 percent of all the companies surveyed—said they measure ROI formally by comparing the company’s investment in human capital with financial and productivity measures or by assessing employee and management attitudinal data.

Neglecting to measure incentive plans’ ROI, many experts maintain, doesn’t make business sense. “Companies would never invest millions of dollars in a capital project without knowing the ROI for that investment, but they do it over and over again with their incentive dollars,” says Catherine Dovey, SPHR, a principal with Dovey HR Strategies in Seattle.

If Not, Why Not?

Whether a company measures the ROI of its incentive plan can depend on whether it views compensation as a cost or as an investment. “Most companies try to minimize costs and optimize investments,” says Tom McMullen, U.S. rewards practice leader with The Hay Group in Chicago. “Even companies that say incentives are an investment often treat them as a cost to be minimized.”

Moreover, incentive plans that have been in place for some time tend to operate on autopilot with only occasional tweaks to weightings or measures. If a company does not keep a plan current, it is unlikely to measure its ROI, according to Peter LeBlanc, managing partner with Axiom Consulting Partners in Cary, N.C.

Then there are the difficulties of matching plans with results. Some incentive plans are designed to achieve intangible goals such as teamwork, which do not easily lend themselves to financial analysis. And in some instances it’s hard to isolate the impact of the incentive plan from myriad other influences that can affect company performance, such as conditions in the economy, a merger or acquisition, or key management decisions.

For example, Autodesk Inc., a software producer in San Rafael, Calif., has had several high-performing years since it revamped its annual incentive plan, says Mike White, vice president of human resources, yet he and his colleagues find it difficult to measure the incentive plan’s true ROI. “We think that the plan has produced great results,” he says, “but it would be hard to show a full cause and effect between the incentive plan and overall company performance.”

Autodesk’s incentive plan pays out based on divisional (70 percent) and corporate (30 percent) profit and growth, and it is built on specific performance drivers that are communicated thoroughly to employees. In addition, the plan’s results and its funding level are updated and communicated quarterly.

“We have an intuitive sense that the plan has contributed to the company’s success, but we can’t separate its ROI from the financial results generated by other factors, like a clarified company strategy, acquisitions or key people hired,” White says. “We haven’t done a detailed cause-and-effect financial analysis.”

White realizes that knowing intuitively that the incentive plan has a positive effect on company performance may not be enough to satisfy company executives indefinitely, particularly if payouts under the plan start to be viewed as disproportionately higher than employee contributions to financial results. “That might lead to conversations and suggestions that the money paid to employees through the plan could be used elsewhere to better effect,” he says.

Using the Tools at Hand

If a company sees value in measuring the ROI of incentive plans and is willing to commit time and resources to gather and analyze the relevant data, it will generally find that the tools it needs are readily available.

Incentives based on project completion or meeting specific budget targets have a relatively straight line to ROI. Money saved from avoiding delays or budget overruns increase the bottom line.

To be sure, it is easier to determine the ROI of a plan with a concrete and easily measured objective, such as an increase in sales or production, than that of a plan with a less tangible goal, such as effecting cultural change or improving teamwork. But with strong analysis and reasonable financial assumptions, companies can make the attempt to measure the ROI of almost anything.

The crucial step, many experts say, is to include ROI analysis from the start. LeBlanc says, “The conversation about incentive plan ROI really begins with being very clear about what the company wants from the incentive plan.” This means having a clear set of objectives and a compelling reason for the plan to exist. After all, if the company does not understand why the plan exists or what it is supposed to accomplish, there is no way to measure the plan’s ROI.

It is also important for the company to determine how it will know if the plan has achieved its goal, and how to track and report such data, LeBlanc says. “The trouble is that a lot of companies are not very specific about what they want the plan to accomplish, so there is no way to measure ROI.”

Terri Allender, a senior consultant with Level 5 Consulting in Bend, Ore., says, “HR executives need to talk about ROI at the beginning so that there is agreement around how much of the results will be attributable to the incentive plan and whether the data for that metric can be collected.”

For example, if the plan is designed to foster teamwork or increase customer retention, how will the company measure improvements in those areas? In many instances, HR will have to partner with other departments or functional areas to gain access to the necessary data.

If such a conversation doesn’t occur until after the incentive plan has been designed and implemented, the plan becomes vulnerable to suggestions that it is being credited for results after the fact. Allender says, “There is more credibility for results when companies do this up front.”

Back to the Beginning

ROI should be not only a topic during incentive plan design but also the driving factor in that design, says Brent Longnecker, president of Longnecker and Associates, an HR consulting firm in Houston. In effect, he says, the design of an incentive plan should be based on the level of ROI that the company wants the plan to generate and on how much the company is willing to invest to reach that desired level of ROI.

“Incentives with clear goals, metrics and outcomes create an automatic ROI that is built into the plan,” Longnecker says. Ideally, the plan’s funding should be based on the achievement of quantitative objectives that change as the business changes, while the company uses qualitative objectives, such as customer satisfaction levels or an individual’s performance appraisal, to allocate the final payouts.

This is the approach taken by New York-based Edge Electronics, a distributor of commercial and military electronic components. The company developed an incentive program to reward its salespeople throughout a lengthy sales process rather than only after an order ships.

“Some sales happen quickly, and other sales are longer-term because the customer requires a customized design and that takes time,” says Adrienne Giannone, CEO of Edge Electronics. “To entice salespeople to invest time in selling these more complex product designs, we pay an incentive for each design that is registered and another incentive when the customer orders a prototype, in addition to the commission paid when the customer places an order.”

Giannone notes that the company had focused on the best way to measure the incentive plan’s ROI from the outset. Once the plan has been operating for six to 12 months, the company intends to calculate incentive payouts’ ROI using a formula that factors in total sales, gross profits and average selling price. The company’s overall goal for the plan is to increase sales by $10 million annually.

Over the longer term, the company will also look at whether the plan has had an impact on sales recruiting and retention and on vendor satisfaction as the company increases the amount of customized design work it sells. Overall, “measuring incentive plan ROI is not as complicated as it sounds,” Giannone says. “You measure what you pay out and what you get in, and if there is a profit, it is a good plan.”

Beyond Financial ROI

Of course, financial ROI is not the only way to measure the value generated by an incentive plan. “Just because companies don’t measure ROI doesn’t mean that there isn’t some assessment of a plan’s value going on,” LeBlanc says. Employee attitude surveys, customer satisfaction indexes and other tools can provide insights into a plan’s impact that do not translate neatly into direct financial measures of an incentive plan’s success.

Joanne Sammer is a New Jersey-based business and financial writer. Her articles have appeared in a number of publications, including Business Finance , Consulting , Compliance Week and Treasury & Risk Management .

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