I can’t give you a definitive answer on this one. There are all kinds of bonus programs out there. Some are pretty common, some (based on an individual company’s needs) are unique, and some haven’t even been dreamed up yet. I don’t think you will ever get broad agreement on which is the best way to go. All I can do is tell you what I have found works well with lean and why. I have found that companies implementing lean can benefit from incentive plans. That said, given that the things that need to happen to become lean are, in almost every area, the exact opposite of what you would do in a traditional batch company, I am not suggesting that traditionally managed companies run out and blindly adopt this approach. If, however, you have already started down the lean path or plan to, these ideas will keep you on the right path and help you go faster.
Before you design any incentive plan you must really understand what you are trying to incent and why. With lean we are trying to focus on removing the waste in our own operations in order to be able to deliver more value to our customers over long periods of time. This is the only way to increase enterprise value, which in the end is the best measure of whether a company’s strategies have been successful. Removing the waste is the daily work and core strategy of a lean company. To be the most effective at this we have to create a learning environment such that every employee can learn to see and contribute ideas on how to remove the waste. All functions within the company must have the same objectives and work together to achieve common goals/strategies.This means that teamwork is very critical to a successful lean turnaround. No one should be in fear of losing employment as a result of the gains, and in fact should understand how they can benefit personally from the gains that are made.
In effect we need to create incentive plans that will drive the following behaviors:
1. Create a learning environment where every employee helps to remove the waste
2. Assure that teamwork is the norm and all functions work toward a set of common goals
3. Establish a system where the gains are shared and everyone knows what is in it for them
So, with that in mind lets talk about some of the things I have found to work as well as a few things not to do.
As I mentioned above, lean is strategic, and your focus should be on removing the waste to deliver more value to your customers than your competitors can. Along the way, however, you will, as a tasty side benefit, get tremendous reductions in cost, inventory, floor space, defects, complexity, and lead times (to name a few). The best ideas to remove the waste that creates these benefits will always come from the people who are doing the work. Your value-added workers. As a result, you should be willing to share these financial gains with them. The gains will be so big that you can easily do this and still grow your overall earnings.
The plan we had at Wiremold, established decades before by the company’s founder but not paying out much until we started lean, is an excellent model to follow. We took 15% of the pre-tax earnings, divided it by the total straight time wages for the period (we paid profit sharing quarterly) then took the resulting percentage and multiplied it by each individual’s straight time wages for that period to get the amount of the check that he/she received at the end of the quarter. There were no gimmicks or moving targets. We shared profits from dollar one, quarter by quarter, with no clawbacks. Results were posted monthly; and paid out quarterly. Everyone in the company from the CEO on down was in the plan. Before we implemented lean the plan was paying out at about 1%. We stated that our goal was to make profit sharing equal to 20% of everyone’s pay, as we felt this was a level that would get everyone’s attention. We actually achieved this a few quarters but settled in around 10-12% on a regular basis.
This was our approach for creating a short-term incentive. It certainly reinforced the message we were sending with lean. For example, each kaizen we did was producing tremendous gains and it didn’t take our operators long to say, “Hey, I used to run one machine and now I run eight, where’s mine?” A very valid question. The answer was simple: profit-sharing.
THE 401K PLAN
With profit-sharing as our short-term incentive, we also needed something for the long term that would give employees an ability to build some personal wealth. Here we used our 401K plan. We encouraged everyone to join this plan (we got participation to be more than 90% but we had to work at this) and then matched their contributions with company stock. The result could not have been more perfect. A little over 9 years after we started lean we sold the company with a gain of just under 2,500% in enterprise value. The employees who created the value collectively through the 401K plan were the biggest stock holder, so they got the biggest part of the gain.
In my opinion, incentive programs tied to piece parts are not good--even in traditional batch companies. It won’t work at all for lean, as it is difficult to control quality and leads to production imbalances: 300 hundred bases and 100 covers, for example. Complicated profit-sharing programs like gain-sharing, or plans that propose to share a percentage of gains in excess of the budget (which of course is a moving target), are too hard for employees to understand, and they feel you are just playing with them if you keep moving the target up. Make it as simple as possible.
BONUSES FOR SENIOR STAFF
For most companies. the competitive nature of the marketplace means that in order to attract the caliber of senior executives you need, you will have to offer an annual bonus program and stock options or some other form of longer term incentive. How should this be structured? Let’s think about that. To become lean, all functions have to work together as a team. This means you can’t use the traditional management by objective (MBO) approach where each VP has a part of his/her pay based on personal goals. More often than not this results in having functions work against each other. For example, telling the VP of Operations to level load the factory while incentivizing the sales VP to bring in big batch orders; or telling the Manufacturing VP to cut inventory and the Purchasing VP to cut pennies on each purchase price, which he does by making big batch buys that increase inventory.
Another thing to consider, and most people never think of this or may disagree, but in my experience, the things you do to improve your balance sheet are the things that will drive your earnings. Increasing inventory turns is a good example here. In order for both inventory turns and customer service numbers to both rise you need good quality, lower costs and shorter lead times. Shorter lead times will drive sales growth by gaining market share etc. All of these results of course will increase your earnings.
In addition, you want to give the senior team a chance to make their bonus, or at least a good part of it every year, otherwise the bonus can become a disincentive. I’m not suggesting setting soft budgets here by the way. But if the economy, or your industry, goes into a recession after you have set the budget then even the best management team will be unable to reach the earnings budget. They can however always deliver more cash flow even in a down year.
So what I have found to be the best formula for a management team bonus of a company implementing lean is:
Earnings = 40%
Working capital turns = 40%
Strategic targets = 20%
The working capital turns in this formula need to be based on the 12-month moving average to prevent doing stupid things in the last month of the year. Likewise, the strategic targets should not be easy layups but things that will really move the company forward and there should not be too many of them (4-5 is a good target). Each senior manager might have a different bonus percentage as a target. For example, the VP of sales target is 40% of base pay and the VP Human resources is 25%. In order to encourage teamwork, there should be no individual component as mentioned above. Every member of the team gets paid based on how the whole team does. If the result is 85% of the target then everyone is paid 85% x their individual target percentage.
You can take care of individual performance in how you set their pay increase, how you award new stock options or how you determine what their bonus percentage is. Encouraging the senior management to act like a real team, where their teamwork is evident to every employee, is essential for a lean turnaround to be successful. Don’t do anything to pit them against each other even in subtle ways.
There are many different ways to incentivize people. In my experience, the approach above works very well for companies doing a lean turnaround. I’m sure there could be even better ways which I would love to hear about. These are only my suggestions. I hope they help but I think everyone should do what they feel is best for their own situation.