How to Use Variable Pay in Your Small Business

Variable pay, or compensation contingent on meeting management objectives, can influence employee performance. Learn what it is and how to use it in your business.

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You have to spend money to make money. It’s an adage few can refute.

Variable pay is one of those business expenses which, when effectively implemented, can yield handsome returns.


Overview: What is variable pay?

Variable pay, also called incentive pay, encourages employees to meet company objectives.

Business owners use variable compensation programs to influence employee performance. Employers reward employees with compensation that fluctuates according to measurable objectives.

Variable pay kicks in when employees reach financial goals such as a sales quota, or qualitative benchmarks such as productivity standards. It can also incentivize employees to take on undesirable shifts.

Variable pay is often combined with fixed pay like salaries, which employees earn regardless of employer-promoted incentives.

Compensation to employees, variable or fixed, is subject to payroll taxes.


Types of variable pay

Variable pay comes in many forms, but the result is the same: cash in your employees’ pockets.

The list of variable pay examples is long, but they mostly fall into four categories.

1. Performance bonuses

There is no better feeling than earning a performance bonus after a successful project or year of hard work.

A performance bonus is cash compensation for meeting or exceeding a goal. Employers often use a sliding scale to award performance bonuses, and the bonus amount increases with more impressive results.

For example, a dog groomer is set to earn a 10% bonus on his salary for grooming 500 dogs in a year but can receive a 20% bonus for grooming 750 dogs.

Bonus amounts can be a percentage of an employee’s base pay or a fixed dollar amount.

Bonuses may also be tied to group performance. If you run a manufacturing facility, you might offer a small bonus to all employees when there are no incidents for 30 days.

Not all bonuses are based on performance. Other bonus types include:

  • Signing bonuses for accepting a job
  • Retention bonuses for staying at a company for a given period
  • Referral bonuses for recommending a job candidate who is hired

2. Profit-sharing plans

When a profit-sharing company reaches its revenue or profit targets, it distributes a portion of profits to employees in one of three forms: cash bonuses, company stock, or retirement plan contributions.

As an employer, you get to decide how much, if anything, to distribute to employees. Your company technically doesn’t need to turn a profit to have a profit-sharing plan.

Retirement plan contributions offer the largest dollar-amount impact on employees. Employer contributions to employees’ traditional 401(k) are tax-deductible and aren’t subject to Social Security and Medicare taxes.

It’s complicated to set up a profit-sharing 401(k) plan, but they’re a great employee retention tool.

Only corporations can issue stock to employees, so you’re likely choosing between a cash bonus or retirement plan contribution. Survey your employees to see which motivates them more.

3. Sales commissions

Commissions are a portion of company sales paid to the person responsible for the sale. Compensation packages for sales staff usually consist of either pure commissions or a mix of base pay and commissions.

Sales commissions are a percentage of the sale amount minus discounts and returns. For example, a jewelry salesperson might earn a 2% commission on every piece he or she sells and a $15 hourly wage. The more jewelry sold, the more money made.

Align your commission structure with your management objectives. Some business owners use a variable commission scale in which the percentage commission rate increases after an employee’s net sales pass a certain threshold.

For example, once the jewelry salesperson reaches $15,000 in net sales for the year, the commission rate increases to 3%.

Before you implement a sales commission, consider what will happen when a customer returns a product, refuses delivery, or doesn’t pay. Some businesses pay commissions after the business’s return window has closed and the customer has paid.

Commissions can be paid with, or separately from, your employees’ regular paychecks.

Use draws against commissions to ensure a steady paycheck for salespeople whose only compensation comes from commissions.

4. Differential pay

Holiday and shift differentials are additional compensation to incentivize employees to work outside traditional business hours or on holidays.

Differentials are not federally mandated like time-and-a-half overtime pay. Shift differentials are additional compensation for irregular shifts. Holiday pay operates the same but applies to all shifts worked on a holiday.

Say you own a storage business that’s open 24/7, and you’re having a hard time getting employees to take the night shift. And when they do take the shift, you find them asleep in a vacant storage unit the next morning.

Keep your employees awake by adding a night differential of $10 per hour for the 11 p.m. to 7 a.m. shift. An employee whose base pay usually is $15 per hour earns $25 on the overnight shift ($15 hourly wage + $10 shift differential). It has been said that an extra $10 per hour works better than coffee to keep an employee alert.


Benefits and disadvantages of offering variable pay

Weigh the good and bad before deploying a variable compensation package.

Advantages of offering variable pay:

  • Variable pay boosts employee retention. It’s not always easy to retain your top talent, and you’re not alone in the struggle. A top concern for 66% of employers is retention, a Payscale report found. It’s no secret that money can keep employees from seeking their next opportunity. If you’re trying to right-size a high employee turnover rate, add variable compensation to your employee retention toolkit.
  • Your competition probably offers variable pay. Seventy-three percent of employers budget for variable pay, according to the Payscale report. If you’re not offering variable compensation, your competitor might.

Disadvantages of offering variable pay:

  • Some variable pay programs don’t apply to all employees. An accountant can’t benefit from a sales commission plan. A salesperson with no set hours can’t benefit from a shift differential. A company’s variable compensation plan should include opportunities for all employees to earn variable pay. It can take time to devise these programs.
  • It’s expensive. In many small business budgets, there’s simply no room for additional compensation. Businesses that already operate on razor-thin margins should wait until they’re in a better position to offer compensation packages with fair fixed compensation and a small, sweet variable pay plan.

How to implement a variable pay system

Follow these steps when writing your company’s employee benefits policy.

Step 1: Go shopping in the variable pay store

Think about what targets you’d like your employees or your business to hit. Align your incentives with those goals.

For instance, say you own a car dealership. To achieve your revenue goals, you need each car salesperson to sell 50 cars in a year.

Give your salespeople a modest commission on each car sale and an annual bonus after selling 50 cars. You could even consider raising the commission rate after hitting that target.

Choose variable pay options that you think will be effective in your business.

Step 2: Write a variable pay policy

Make your variable pay plan as explicit as possible. To make variable pay work, employees need to know what they’re working toward and what they’re eligible to earn.

In your policy, explain:

  • What variable pay the employee can earn
  • What the employee has to do to get the variable pay
  • When and how the variable compensation is paid
  • Whether the variable pay is contingent on factors outside of their control such as company sales or other employees’ performance

Step 3: Track performance and make timely payments

Establish an employee performance review process. Set up regular meetings with employees to discuss their progress toward goals tied to variable pay.

As the owner of a car dealership, look at your sales tracking software before you do payroll to calculate commissions and track who’s entitled to a bonus. For most types of variable pay, you treat it just like regular pay.

Consult a payroll professional before processing payroll for bonuses for the first time. Your payroll tax calculation depends on whether the bonus comes with a regular paycheck or as a separate payment.

You should regularly complete payroll reconciliations to make sure your payroll software is properly taxing variable pay.

Step 4: Incorporate employee feedback

Make sure your employees are enjoying their variable pay incentives. It’s wasted money unless your employees are willing to work hard to earn the extra cash.

Say you initially offer a profit-sharing plan that contributes to employee retirement plans. Ask them periodically if that’s the best motivator, or if a quarterly cash bonus would be more effective.


It’s invariably effective

Employee retention is fundamental to strong company growth. Use variable pay to keep employee satisfaction, retention, and performance high.

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