By Dave Burstein, P.E. – There are two categories of bonuses:
Reward System – At the end of the year, the owner or a small group of principals decide how much money they will pay in bonuses. They then decide who should get how much based on a subjective assessment of those who are eligible.
Incentive System – At the beginning of the year, each eligible employee is told what are the criteria for receiving a bonus the following year. At the end of the year, the firm pays bonuses based on these criteria.
The biggest advantage of a reward system is flexibility. The owner(s) can use whatever criteria they deem appropriate at the time. The biggest advantage of an incentive system is that it lets the employees know ahead of time what is expected of them and, hopefully, influences their behavior accordingly. However, if the incentive plan is too rigid it often leads to employees spending more time figuring out how to game the system than how to actually improve performance. This is especially true when it comes to incentive plans tied to specific formulas.
A good compromise is to advise your eligible employees of the factors that will be considered in next year’s bonus plan but stop short of providing a mathematical formula. This approach combines some of the advantages of both methods.