What is a variable compensation plan?

What Is A Variable Compensation Plan

Do you run a business and want to help your employees reach their full potential? Do you want them to love coming to work every day, no matter how hard things get? If so, you might want to look into compensation based on performance.

When I talk of “compensation based on performance,” I’m referring to a variable compensation plan. This type of system is designed to motivate employees and increase their productivity while also rewarding them with financial bonuses.

In this blog, we’ll discuss what a variable compensation plan is and explore why this kind of a system can be beneficial for both employers and employees alike.

What is variable compensation?

Variable compensation (also called performance-based pay or pay-for-performance) is a type of compensation structure in which employees are rewarded based on their individual performance rather than a fixed salary or hourly rate.

It typically varies from one employee to another and can be measured using metrics such as sales numbers, customer satisfaction ratings, or team goals. This type of payment by performance rewards system helps to motivate and retain top-performing employees to stay with the organization for longer periods of time.

As a result, it can be beneficial to companies that utilize this pay structure, as it can help drive company success and improve its overall productivity.

What are the types of variable compensation?

Individual incentive plans

Individual incentive plans are a popular form of the variable compensation plan. These plans reward individual employees, rather than the entire team or organization, for excellent performance. Individual incentive plans help motivate employees by encouraging them to work harder and smarter to achieve their targets.

An individual incentive plan typically consists of base pay plus bonus payments for achieving preset goals or milestones. The bonus payments might take the form of cash bonuses, awards, prizes, stock options, or some other reward that reflects the success of the employee’s efforts. Some individual incentive plans also include long-term incentives such as profit-sharing or gain-sharing agreements that divvy up profits among workers based on how well they’ve done over time.

Individual incentive plans give senior executives and team leaders an effective tool for recognizing and rewarding great work without breaking the budget. By paying attention to goals that individuals hit, companies can foster a culture of accomplishment — inspiring each employee to strive even more efficiently and creatively to reach new heights in their jobs!

Departmental bonus programs

A departmental bonus program is a type of variable compensation plan that offers bonuses to employees based on the performance of their specific departments. This is an incentive structure that can encourage better performance across the entire organization.

For example, say you have a retail store. A departmental bonus program might award bonuses to staff based on sales and customer service ratings within each store department. Bonuses could be based on how well the shoe department performed, for example, or how efficiently the backroom team managed restocking and replenishment processes.

By specifically targeting individual departments, rather than company-wide goals, each employee can see the direct impact they are having on their own areas of responsibility. This type of transparent system encourages higher levels of motivation and involvement in their teams’ day-to-day activities. Additionally, it helps ensure that no one person or team gets too much credit for success or too much blame for failure.

Profit-Sharing plans

A profit-sharing plan is a type of variable compensation plan that allows employees to share in the profits of their company. This is often provided in addition to wages, bonuses, and other incentives. With this type of plan, a percentage of the profits is distributed among eligible employees each year.

Profit-sharing plans benefit the company by encouraging employee loyalty and engagement. Employees feel invested in the success of their company, which leads them to feel motivated to work hard and reach high-performance levels. Furthermore, these plans tend to attract top talent since they provide additional money when the company does well.

Finally, these plans also benefit employees financially since they may receive a substantial bonus on top of their regular salary if the company has an exceptional year with significant profits.

Performance shares/stock options

Performance shares (sometimes called stock options) are a form of variable compensation or bonuses awarded to employees based on their performance. They provide direct financial incentives, which can have a positive impact on employee morale and productivity.

Performance shares and stock options involve the awarding of company stock, usually at a discount from current market prices. The goal is to reward employees for meeting specific performance targets that result in an improved value of the company’s stock. This encourages employees to maximize their performance and, with any luck, contribute to increased profits for both the employee and the company.

The exact amount of stock each employee receives depends upon individual performance as well as organizational targets. As such, they are an effective way to reward and incentivize employees while keeping costs down compared to other types of bonuses or raises. They also benefit employers by creating an engaged workforce that is invested in the success of the business.

Recognition awards

Recognition awards are an important part of any variable compensation plan. It’s important to recognize the outstanding performance and achievements of your employees in order to ensure that they stay motivated and satisfied with their job.

A recognition award can be as simple as verbal recognition given at team meetings, or it could be even more elaborate, such as an all-expenses-paid vacation package or a gift card. No matter what type of recognition award you offer, make sure that the employees understand that the reward is for their hard work and dedication.

Another great addition to any variable compensation plan is to reward team effort rather than individual accomplishments, so everyone feels appreciated when goals are achieved. This type of recognition award encourages collaboration among colleagues, ensures that each person is contributing to overall success, and reinforces the company culture you have created within your organization.

Employee referral programs

Employee referral programs are a type of variable compensation that rewards employees for referring new talent to an organization. They serve as a cost-effective way to attract quality job candidates, cultivate team engagement and appreciation, and promote collaboration within the workplace.

When done right, employee referral programs can result in higher job satisfaction and better performance among referred employees. That’s because referred hires typically have an easier time getting acclimated to the company culture. They also tend to be more likely to stay with the organization longer than their non-referred counterparts.

Referral programs can also help you access talented candidates who may not otherwise be identified by traditional hiring methods such as job boards or recruiting agencies. When employees have detailed knowledge of your company culture, they’re in the best position to identify potential candidates who will fit well into your organization.

In addition to different types of incentives like monetary rewards or gift cards, employee referral programs are usually accompanied by recognition ceremonies for referred hires and those responsible for bringing them into the fold. This helps motivate other employees to participate in the program by highlighting its successes.

Challenges of administering a variable compensation plan

It’s no secret that having a variable compensation plan in place can be a great way to reward employees for hard work, creativity, and innovation. But administering a variable compensation plan can also be a challenge for employers. Here are a few of the common challenges of administering a variable compensation plan.

1. Establishing a fair compensation structure: Every employer has a different idea of what “fair” compensation looks like. It’s important to consider factors such as the employee’s job scope, performance, and experience when deciding how much to pay. Establishing a structure that is fair to everyone can be difficult.

2. Incorporating performance goals into the plan: Performance goals should be used to measure an employee’s success and set them up for success in the future. A variable compensation plan should reflect these goals and reward employees accordingly.

3. Managing expectations: It’s important to manage employees’ expectations when it comes to their compensation. This can be difficult, as employees may have unrealistic expectations of what they should be paid.

4. Ensuring compliance with state and federal regulations: Variable compensation plans must adhere to state and federal regulations, such as the Fair Labor Standards Act. Employers must ensure that they are in compliance with these regulations.

5. Keeping track of changes: As laws and regulations change, employers must keep up with these changes and adjust their plans accordingly. This can be a time-consuming process and can be challenging to keep track of.

Administering a variable compensation plan can be a challenge, but with careful planning and consideration, employers can ensure that their plans are fair and compliant. By doing so, employers can ensure that their employees are rewarded for their hard work and dedication.

How to design variable pay plans to incentivize and engage your team

1. Mission-Oriented

When it comes to designing effective variable pay plans for a business, the most important first step is to develop incentive plans that are mission-oriented. Companies and business leaders must have a clear, defined goal in mind and know what they hope to accomplish with the plan before they begin designing and implementing it.

No two businesses are alike, so having a mission-focused approach when creating an incentive plan will ensure that any design aligns with the company’s overall objectives. Divisional and department heads can create specific functional goals that work in tandem with overarching financial goals, which will provide tangible examples of how employees can achieve success while working towards the greater mission of the organization.

Finally, a strategic planning session should take place as part of consulting projects when designing variable pay plans. This helps cement the desired vision and focus needed for high-performance implementations throughout every tier of the organization. Clear communication on expectations is paramount during this process so everyone involved understands what their role is in carrying out the organization’s mission. This puts everyone on the same page from day one and allows them to be justly rewarded accordingly should these expectations be met.

2.Clear line of sight

Strong business leaders have understood the importance of aligning an individual’s contribution to a variable pay incentive plan that ultimately increases performance and engagement from their team. By setting goals and providing meaning, and financial opportunities for employees to hit those goals, there is now a clear line of sight between employee engagement, employee performance, and business success.

When designing a variable pay plan for your team, you should make sure that the goals are clearly defined. The goals should be meaningful to everyone involved—not a random number with no context behind it—and realistic enough that achieving them is possible. When tied to a financial opportunity for hitting these goals, employees will typically become more engaged in their work because they know there’s something at stake.

For members of your team who need extra motivation or are difficult to motivate, connecting targets with rewards can be an effective way to raise performance levels while increasing overall morale. By explaining the goals in detail along with incentives available upon completion or advancement towards set objectives; individuals are able to see exactly what’s expected of them in order for them to receive compensation.

3. Make use of the discretionary component

Incorporating a discretionary element into variable compensation plans is essential for business leaders to monitor their employees and reward or reprimand them based on performance. This element gives those in leadership roles greater control over the outcome of awards and offers employees more ownership in the process. Employees understand that effort and performance can be rewarded with higher pay, encouraging them to engage and do their utmost to achieve it. Ultimately, a discretionary component in variable compensation plans helps ensure that performance and leadership expectations are properly aligned.


Creating variable compensation plans can be a powerful incentive for employees by rewarding them for superior performance. To ensure proper design and analysis, companies need to utilize specialized software such as Varicent.

Varicent SPM software simplifies the process of designing variable compensation plans and provides meaningful insights into how the plan may influence employee motivation. With its precise calculations, Varicent helps make informed, data-driven decisions, enabling organizations to offer appropriate rewards that encourage employees to be more productive. Ultimately, this leads to improved overall productivity for the company

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