What is Variable Pay and What Are Its Advantages?

Variable pay is defined as “direct compensation that does not become a permanent part of base pay/salary and which may vary in amount from period to period,” according to the Society of Human Resource Management (SHRM). Business reasons for implementing variable pay compensation programs include the following:

• Economics: based on organization’s ability to pay
• Competitive practices: attracting and retaining high performers
• Employee motivation: reinforces successful behaviors
• Employee communications: underscores and promotes priorities

Variable pay includes the following components:

• Annual bonus
• Incentives
• Commissions
• Cash awards
• Lump sums

Annual bonus and incentive pay plans have long been considered as once-a-year ‘fun’ funds.  They are not recognized by most employees as significant elements of their pay-for-performance package.

With traditional systems, a high-merit increase is granted based on the previous year’s performance. This approach guarantees that the employee retains that rate regardless of future performance.  In effect, this reward has increased annual fixed costs; and companies pay for past performances year after year. 

Short-term variable pay opportunities challenge the model of using standard base pay merit—which recognizes performance (achievement of results)—for granting salary increases; and with good reason. In today’s market, most employees do not view merit increases as reflective of a reward. Although merit and pay adjustments should reflect market movements, pay-for-performance should be kept as variable as possible.

In a variable situation, the employee/department/company has to “re-earn” that reward level every year. This approach is more in tune over time with the variation in performance of both the individual and the organization. Organizations without variable pay components should consider designing a plan that offers financial flexibility to deal with:

• variability in markets;
• employee performance;
• company success;
• economic changes and more. 

Variable pay components can be a formidable financial management tool when used to accommodate and compensate for individual performance variations as well as changing financial times. 

How Foreign Countries Use Variable Pay
Several Far East countries mandate variable pay as a portion of employees’ compensation. The intent is to protect the working population from layoffs used to cut short-term business costs. On a large enough scale, such ‘quick fix’ solutions have the potential for longer term spiraling effects such as economic recession or depression.  

During weak financial times, the variable compensation component is not paid; thereby cutting employment costs and suppressing mass layoffs (used to achieve similar cost savings).  These accrued cost reserves are redirected to keep the business afloat until the cycle turns around; qualified staff are retained and kept actively working toward success. 

In stronger financial times, bonus opportunities should be quite rewarding.  Whether based solely on company performance, or combined with an individual performance factor, ‘multipliers’ may be used for outstanding results.  

Variable Pay Success Depends on Regular and Meaningful Communication
It is crucial that variable and merit pay programs are communicated regularly and so that all levels of employees clearly understand. At minimum, the information and details should be provided in a comparable, annualized context to effectively promote meaning to the employee. 

A combination pay package typically outpaces the sole merit increase when reaching target goals.  If the employee isn’t cognizant of the intent and purpose of the pay for performance plan, then management is missing out on receiving a return on the investment. 

In a variable pay situation, the employee, department and company “re-earn” the reward levels every year. This method has advantages for the business and the employee. Variable pay is based on an organization's ability to pay, and the program reinforces successful employee behaviors.