Compensation and Reward KPI Best Practices

This is probably one of the most frequently asked questions: what KPIs should we use for the compensation system? In this article, I’d like to review the best practices about using, or in the most cases not using, reward KPIs. 

Linking performance to reward is easier for those employees who work in sales. It is a general practice that these employees have a low basic salary, but as a result of profit sharing their earnings are high. There are a lot of working models for this case, still disputable, in this article I’d like to focus on a reward program for employees that are not involved in sales directly.

Choose the form and KPIs of the reward program

In this article I did a short classification of possible approaches to the reward system. Don’t take these levels as the levels of business maturity. Any business chooses one or another reward model because of the specific business environment and the current business objective. There is no absolute true about which approaches should be used.

Why employee need reward. XY Theory.

The first question is why do employees need to be rewarded? The reward is supposed to increase the motivation of an employee. Talking about motivation we can use Maslow’s hierarchy of needs (Maslow 1970), Herzberg’s motivation-hygiene theory (Herzberg, 2003) and McGregor XY Theory [1].

According to McGregor’s “Theory X” people hate work by their nature and need to be managed with the “carrot and stick.” In contrast, his “Theory Y” recognizes that people are actually motivated by self-esteem, creativity and personal development.

In this article I’ll use a simple XY Theory framework, as it describes possible types of employees’ behavior and what is more important, the managers’ attitude in these cases.

Level 1. Compensation defined by performance KPIs

The basic idea of linking a compensation plan to KPIs is simple. We want to track the performance of our employees and if they are performing well, we want to give them a bonus because a bonus supposed to motivate them to deliver even better results.

This approach is basically wrong for several reasons:

  • It is hard to measure the performance of an employee.
  • What we actually need is not a high performance, but achieving of  planned business outcomes.
  • A bonus doesn’t stimulate an employee to deliver better results in a long-term perspective.

Common characteristics of this level: 

  • Managers follow “Theory X” approach.
  • KPIs measure performance.
  • KPIs have fixed target values.
  • KPIs are assigned to individuals.
  • Reward is paid yearly, quarterly and/or monthly.

Level 2. Compensation KPIs are linked to strategic objectives

The better approach will be to use a strategy map, present business objectives with cause-and-effect connections and align a KPI so that top managers could track the impact of each employee on achieving ultimate business objectives, like it was discussed for HR ROI [2] and for Marketing ROI [3]. Still, it is really hard to execute this approach. Check out an article by Stacey Barr where she lists 5 reasons why pay-for-performance can never work.

Technically, this approach is better, as now a compensation plan is linked to business objectives. But according to some research [4], only 39% of FTSE 350 companies clearly link bonus KPIs to strategic objectives.

Common characteristics of this level:

  • Managers say they follow “Theory Y,” but actually continue to follow the “Theory X” approach.
  • KPIs measure important business outcomes.
  • KPIs have flexible targets.
  • Reward is paid yearly or quarterly.

Level 3. Rewards are not paid in cash, but are invested

On this level employees are not compensated with financial bonuses at all. The idea is that why should one be paid twice (first time with a salary and second time with a bonus) for the same job?

Jeremy Hope in “How KPIs can help motivate and reward the right behavior” [5] shares an interesting example. The author quoted Herb Kelleher, chairman of Southwest Airlines when he is speaking about employee compensation:

  • “If somebody was working just to be compensated, we probably didn’t want them at Southwest Airlines. We wanted them working in order to do something in an excellent way. And to serve people.”

Southwest Airlines has a bonus program, but employees won’t see funds soon as the company invests them in an employee retirement plan.

Common characteristics of this level: 

  • Managers follow “Theory Y” approach;
  • There are no KPIs for rewards;
  • The whole company is rewarded according to base salary;
  • Rewards are not paid in cash, but are invested into the retirement plan or in purchase of shares;

Reward program in Apple

In a previous article I mentioned that Apple  can afford to have a higher than industry average turnover rate, and still find and retain the best talents in the industry. What about their reward system?

According to information available for the public, Apple suggests its employees stock purchase plan and product discounts. For example, in 2012 Apple was giving its employees a good discount on new Mac and iPad. Well, this might be considered as a reward as well as an employee engagement program.

Apple’s senior executives are in the list of Top 5 best-paid. Besides base salary they were paid compensation in the form of stock. This was done with a specific purpose: “to retain the company’s executive team during the CEO transition.” As for Apple’s CEO Tim Cook the new initiative links Cook’s stock award to the company performance index in the Standard & Poor’s 500.

It looks like Apple doesn’t follow advice of Henry Mintberg (see the “Level 4” section) and still have a reward program in the form of stock shares linked to a performance index. Probably they have mastered some new way to spend rewards wisely or simply have enough cash to allow this way of doing business.

Level 4. Fair pay, no bonuses

Henry Mintberg, a professor at the Faculty of Management at McGill University suggests an even more extreme point of view. In his article [6] for The Wall Street Journal he doesn’t suggest any cure to the problem of executive bonuses, he just says that “the problem is that they [executive bonuses] exist”!

Author consistently talks about five reasons why executives should not be paid any bonuses. As a possible alternative he names paying bonuses to all employees according to their base pay (similar to what was discussed on Level 3), but still sees that there is a possible problem as performance can never be evaluated correctly taking into account a long-term perspective.

It is obvious that to be able to operate on this level a company needs to have a strong leadership 100% focused on “Theory Y” way of working with employees. Also, the company should have an established brand among potential candidates to be able to afford filtering out employees that are looking for compensation plans.

Common characteristics of this level: 

  • Leadership according to “Theory Y” approach.
  • There are no reward KPIs.
  • There is no compensation or profit-sharing programs.
  • Employees are paid fairly, no additional bonuses are paid.

Where is the Golden Mean?

As we can see there are different approaches to compensation programs. There are companies like Apple that follow a traditional model, but there are ones like Southwest Airlines that prefer to focus on retaining people that are not looking for bonuses.

The executive compensation practice might be something that doesn’t help or even makes damage (see ideas by Henry Mintberg mentioned on Level 4), but they still are used widely.

For now I’d formulate this best practice regarding a reward system:

  • Choose the form of the reward program according to your current business challenges.
  • Don’t link reward programs to an employee’s performance.
  • Link reward programs to business outcomes that are connected to the strategic objectives.
  • Consider the shift from rewarding individuals to rewarding the whole company.
  • Avoid rewards in the form of cash, as stock purchases work better.
  • When possible find talents that are happy to work for a fair salary only.

Case study: “New Bonus System” introduced by Man Group

Good example of using of the Balanced Scorecard for top managers bonus

The new incentive plan “New Bonus System” was introduced by Hedge fund Man Group. The new plan replaces all other arrangements for top managers.

The awards in the new bonus system are determined against Balanced Scorecard. The assessment will be done during a one year period, and then raised to a two year period and finally to a three year period.

It is not reported in details which Balanced Scorecard will be used, the only known thing is that 80% of the scorecard is financial KPIs and 20% is non-financial metrics.

Two primary goals of these changes are:

  • Ensure transparency to the bonus system.
  • Align the bonus system with shareholders’ interests.

It is a good case-study for other companies to follow. Generally we don’t recommend introducing measures linked to financial awards, but here we see that it was done with full understanding of benefits and limitations of this method:

  • The new incentive plan was introduced to top management only (obviously here we have a lower risk for gaming with indicators)
  • 80% of KPIs are financial, meaning it is easy to measure values of these KPIs. Although there are no details about these KPIs, it is obvious that this measure reflects the past performance of the company in the best way.
  • Measures are introduced with two clear goals – transparency and aligning with shareholders’ interests.

Bonus scorecard with BSC Designer

In BSC Designer software one can use an indicator’s formula to link bonus calculation to the progress and/or the performance of certain indicator. The example below demonstrates how to do this step by step.

Prepare indicators

Go to the “KPI” tab and create two indicators:
  • “Project KPI” and “Bonus”
We will use the performance or the progress value of “Project KPI” to calculate the value of the bonus.

Build a bonus formula

Now, we need to setup formula for the “Bonus” KPI:
  1. Go to “KPI” tab, select “Bonus” KPI
  2. Click on “KPI Data Source Data” button KPI data source button in BSC Designer
  3. Choose “Use a formula for the value” and click OK
  4. Click “Add item to formula” button
  5. Select “Project KPI”
  6. Select in the “Use in formula” group box an appropriate option. If you want to link bonus to the performance select “performance,” if you want to link the bonus to the progress, then select respectively “progress.” Click OK.
  7. BSC Designer will add in the formula text box %[Project KPI] (if you chose “progress” on the previous step) or &[Project KPI] if you chose “performance”).
  8. Enter in the text box the formula that you want to use for the bonus. For example, it might be something like (%[Project KPI] – 100) * 20, where 20 might be some bonus coefficient.

How does it work in practice?

For example, if the progress according to the “Project KPI” is 120% (the team did better than planned), the value of “Bonus” KPI will be calculated as (120-100)*$20 = $400.
If the progress of “Project KPI” is lower than 100%, then the bonus value will be negative, telling that the bonus won’t be paid.
BSC Designer LogoMake your life easier by using professional software for KPIs! It will do all the scorecard design, calculations and other hard work for you. No need to maintain complicated spreadsheets, no need to normalize data manually, no need to copy-and-paste to get your data visualized on the strategy map. Check out the training video for KPIs function in BSC Designer or try the software right now.

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  1. ^ Douglas McGregor, The Human Side of Enterprise, 1960, McGraw-Hill
  2. ^ Aleksey Savkin, Calculate a Talent’s ROI to Improve All HR KPIs, 2013, BSC Designer
  3. ^ Aleksey Savkin, Guide for Tracking Marketing KPIs and Measuring Profitability, 2015, BSC Designer
  4. ^ KPIs, Performance & Reward, Paula Kager, Dirk Lindenbergh, Global Enquity Organization
  5. ^ How KPIs can help motivate and reward the right behavior, Jeremy Hope, 2013, IBM Software Business Analytics
  6. ^ No More Executive Bonuses!, Henry Mintzberg, 2009, The Wall Street Journal

Related Articles

Scorecard Expert | Speaker | CEO. Aleksey Savkin (LinkedIn, @bscdesigner) is helping companies to better formulate their strategies and make the process of strategy execution more tangible with KPIs. New book by Aleksey: 10 Step KPI System

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