Variable pay is a method of paying employees based on performance. It can comprise the employee’s total compensation or be paid in addition to their base pay. It’s usually tied to individual or company-wide results. Variable pay can help to incentivize employees to perform better, but requires effort to administer.
How Variable Pay Works
Variable pay can be used by any business that wants to incentivize its employees fairly based on some data point—such as units sold, sales revenues, customer service scores, number of clients, or any job-related criteria.
Variable pay is calculated as a dollar amount or a percent. It’s based on individual or business criteria—such as targets met or profits made. It’s designed to be paid to employees in addition to a base pay. Variable pay is often included as part of an overall compensation plan.
Strictly speaking, hourly employees who are paid based on the number of hours they work or employees who are paid by the piece receive variable pay. However, variable pay more commonly refers to a combination of pay types used to motivate employees to focus on key areas of the business, as illustrated below.
We consulted an attorney to get some insight into pay types and their risks.
Matthew Eanet, Attorney, Eanet, PC
There is a lot of uncertainty about this right now, and it changes on a state-by-state basis. For example, in California, an employee paid on a piece rate or commission basis must still receive minimum wage for each hour worked and the employer cannot average paid, “productive” hours with non-paid “nonproductive” time.
In 2016, the legislature in California adopted Labor Code section 226.2, requiring that employees must be separately compensated for “other nonproductive time,” defined as “time under the employer’s control, exclusive of rest and recovery periods, that is not directly related to the activity being compensated on a piece-rate basis.” There is an added cost burden of compliance for a company that decides to pay by the piece.
Disclaimer: Fit Small Business cannot provide legal advice on setting up your compensation program. Please consider reviewing your variable pay program with your attorney before finalizing.
Variable pay refers to a more complex payroll formula than salary or hourly pay, such as the number of sales per month, a percent of business earned, or a fixed amount per client.
However, many businesses choose to provide a base pay rate (hourly or salary) so that employees receive steady compensation. They then add the variable pay compensation on top of the base pay. That serves as an incentive to the employee to perform at peak levels or as a bonus that allows employees to share in the business’ growth.
Variable pay can be based on any kind of criteria, such as number of units sold, and can be done in the form of bonuses or incentives. Here are some scenarios to illustrate.
Variable Pay as a Commission
Sam works for a farm equipment company and is paid a commission in addition to his base salary of $500 per week. Sam’s pay is variable pay. One week he may make no commissioned sales, and only receive a check for $500. The following week he may make $1,500 extra based on having sold a large piece of farm equipment. Therefore, his pay is variable. Sam’s variable pay is designed to incent him to sell big-ticket equipment items, in addition to helping existing customers with parts and service.
Variable Pay as a Percent of Sales
Julia works as a media advertising executive and manages several accounts. In addition to her hourly pay rate, she receives 5 percent of all advertising dollars paid by her clients each month. That means that her pay (her variable pay compensation) changes based on her client’s payments. Her variable pay works as an incentive to Julie to keep her current advertising customers happy, as well as to find new ones.
Variable Pay as a Bonus
Kiko works as an IT programmer on a project. He receives a base pay of $65 per hour. In addition, he is eligible for a bonus based on variables, such as whether his projects are completed on time and what percentage of his code passes testing criteria. His variable pay compensation encourages him to meet deadlines as well as to provide code that is accurate.
Peer-driven Variable Pay
Newer software tools like Motivosity and Bonusly allow employees to provide feedback and bonuses to co-workers based on their work—from high levels of workplace performance to demonstrating how they live the company values. This type of incentive can improve teamwork by inspiring employees to do the right thing on the job in hopes of earning bonuses or rewards from their peers.
For tips on how to set up employee compensation with variable pay, read our article on How to Create a Compensation Plan in 6 Steps.
Who Variable Pay Is Right For
Variable pay is right for any business that wants to improve performance based on measurable productivity increases. Here are some examples:
- Sales organizations that want to increase units sold
- Food service establishments that want to increase sales of certain menu items
- Home service companies that want to get more referrals
- Business services that want to increase their client base
- Healthcare companies that want to reduce costs
- Marketing firms that want to increase their revenues
- Manufacturing firms that want to shorten their time to market
However, managing variable pay typically requires a business software system to manage the data or criteria on which the variable pay is based. For example, if a computer salesperson receives $10 when they sell a computer, but only $5 when they sell a printer, the business will have to keep track of those dollar increments by sales person and type of sale. That may require some kind of system so that the variable pay component can be processed correctly when it’s time to do payroll.
Here are some questions to ask yourself before setting up a variable pay compensation program:
- Do you have the time to manage the data on which employees are compensated?
- Do you have software that can manage sales and revenue data, such as a POS system, CRM system or accounting software?
- Is your compensation system fair to all employees?
- Does your payment structure meet minimum wage guidelines for your state and industry?
- Are your incentives going to motivate employees to do what you want them to do?
Businesses like real estate brokerages tend to pay using variable pay. Real estate software systems are set up to manage real estate commissions. If you’re creating your own variable pay system, you’ll want to be sure that you have a way to manage the calculations and payments for the variable portions of your employees’ pay and what’s common in your industry. Here’s one CEO’s suggestion:
Kristen McAlister, CEO, Cerius Executives
Variable pay serves a purpose for both obtaining and retaining top talent. The challenge is to align it with both what will motivate and drive the employee as well as the company’s goals. When considering it, first answer the “why” you are offering it before determining when, to whom, and how much.
Variable Pay Costs & Benefits
The type of variable pay you choose and the amount or percent you pay will affect what it costs you as a business owner. There are multiple ways to set this up. However, you shouldn’t look at the cost by itself—consider the benefits as well. For example, if paying your service people an incentive to cross-sell additional services drives up your overall revenues, the variable pay component pays for itself.
Here’s how to figure out what variable pay methods may cost as compared to the benefit:
- Flat Rate Amount – If you pay a flat rate of variable pay, you’ll have to estimate what that will cost you each month based on sales projections or other data. For example, if you pay $5 for each water heater sold, or $1 for each customer comment card received, you’ll have to guesstimate your totals and plan ahead to pay out that amount. This is best if you are able to make a profit on each item after paying the bonus or incentive, and is also best if you have a software system that records what each employee does.
- Percentage – Paying employees a percentage instead of a dollar amount is often a difficult number to estimate. Let’s say you give your clerks 3 percent of all the full-priced shoes they sell and 1 percent on sale items. You’ll want to figure out in advance what that’s going to cost you if, for example, your volume increases by 10 percent.
Percentages can also be calculated at the department and company level. To figure out how much it’s going to cost, consider what your business did last year and what your increase in revenues might be this year with the incentives in place.
- Weight – You can provide weights to your variable pay if you want to get very specific on what you value. For example, you might offer employees one incentive based on a variable like overall sales volume, another based on customer retention and a third based on client feedback. You could then weight each of these variables, e.g., with 50 percent of their bonus based on sales and the other 50 percent based on a 25 percent split of the customer variables.
- Ad-hoc – Rather than building a process with dollars or percentages, you could make your variable pay somewhat random—meaning you choose what to pay, and what criteria to use. For example, one month you may want to incentivize employees to improve how friendly they are to clients, whereas the next month you may want to incentivize employees to maintain their work vehicles. When you catch them in the act, you hand them a bonus on the spot.
In terms of cost, you may want to budget how much to give out in advance, such as $1,000 a month for random incentives. You’ll know if it pays off by watching how people change their behavior based on what you’re paying attention to and paying bonuses on that month.
Your variable pay program may be costly to administer depending on how complex it is, what data you need and what systems you use to track that data. For example, if you need to use a CRM system to keep track of customer data, or an accounting system to keep track of receipts, you may want to factor the cost of those systems into your variable pay program.
Variable Pay Providers
Variable pay is generally too complex to manage without software unless you’re super-proficient with Excel and have the time to do tons of data entry. Therefore, you’ll want to find business or payroll software or a performance management system to help you calculate the performance data on which your variable pay is based.
Here are six options for you to calculate and manage variable pay for your workers:
Payroll software can be used when your variable pay is fairly simple, such as incentives you give to employees for making a big sale, or bonuses when they complete a project. Payroll software costs between $10 and $200 per month (or more) and typically has additional fees per employee.
If you’re looking for all-in-one HR/payroll software that can manage variable pay, consider Gusto. Gusto provides employee onboarding and can also set up employee benefits and perks to your team for a low base price of $39 per month, plus $6 per month per employee.
HR Software with a Performance Management Feature
If your variable pay is based on performance, such as goal completion or peer feedback, then you may need to use HR software like ADP that has a performance management feature. This allows you to set up the performance aspects of the software in such a way that the data feeds into your HR/payroll system. HR software often costs more than payroll software alone.
For example, if an employee receives an “exceeds” rating on a quarterly review, perhaps you want them to get a bonus of $500. HR Software that has a performance management feature can often be set up to tie to the employee’s compensation. That compensation data is then passed to the payroll side of the software or to your payroll system.
We recommend ADP for HR/payroll software that has a performance management module you can add on. ADP is the top-named brand in the payroll space and therefore has lots of features you can obtain by upgrading.
Performance Management Software
Performance management software is designed to capture the employee’s progress toward goals and contributions to key result areas of the business. Many of these applications tie employee ratings to a numeric value that can be used when determining how much variable pay to provide to an employee. For example, if one employee earns a rating of five out of five, perhaps that’s worth a bonus of $1,000, whereas a rating of four earns only $250.
Performance Management software typically costs $1 to $10 per month or more per employee based on the system you choose.
Some of the newer performance management apps, like Bonusly, allow variable pay to be managed by the employees themselves. Each employee is given a monetary amount that they “award” to peers for great performance using an app. The employees can also give praise at the same time as they “recognize” their peers with cash incentives.
We recommend Zoho People as low-cost integrated software that can manage your variable pay with pay-for-performance features like peer feedback and 360-degree reviews.
A CRM system like Zoho can be used to track customer data, including customer sales, projects and feedback. You can then use that data to feed into your variable pay program, such as providing an incentive to employees when their customers renew a contract. CRM systems typically cost between $10 and $30 per month per user.
An accounting system like QuickBooks can be used to track customer payments if you want to tie compensation to payments rather than to sales. That makes sense, as you don’t often want to pay out incentives on income that hasn’t yet been received. To learn more, read our article on best accounting systems for small business.
A point of sale (POS) system like Square or a POS app can be used if you want to, for example, track retail sales by salesperson or food sales by server, thereby enabling you to provide incentives. You can use this data to determine what incentives to pay each employee. See our article on the best POS systems for small business to see why we think Square is the best.
If you don’t use a vendor to manage your variable pay program, you may want to talk to an HR consultant or outsource to a labor law attorney to make sure that your variable pay compensation approach doesn’t violate any labor laws. We recommend using LawTrades to find an attorney to help.
Variable Pay Features
Variable pay is typically a component of an employee compensation program. It can take many forms, such as incentive payments, bonus payment or employee recognition and rewards. We’ll go through the different types of variable pay and kinds of employees each might be best for.
Incentive pay as part of a compensation program is typically designed to motivate an employee or a team to complete an assignment or goal. It can also be used in project management settings with either employees or contractors. For employees, it would be explained in their offer letter. For contractors, it would be described in their employment agreement or contract.
Incentive Pay Example
Let’s say a project is due to be completed by year-end and you need both employees and contractors to stay throughout the entire duration of the project, since turnover mid-way would delay the project. You can offer an end-of-project incentive that isn’t paid until the project is completed. In other words, what the workers will be paid will vary, and will increase significantly if they don’t quit before the project is done.
To determine whether incentive pay make sense for your business, ask yourself, “What kind of projects or goals are most important for your employees to complete?” Those goals and projects are the ones you might want to consider offering an incentive on, so that employees focus on those first.
Keep in mind that incentives don’t have to be cash. They may be in-kind incentives such as trips, prizes or gift cards that have monetary value. If you’re looking for incentive ideas, read our article on best employee incentive programs.
Bonuses are more common as part of an employee’s compensation program in businesses that pay for performance. For example, if your company employs sales or customer service staff, you may want to provide variable pay in the form of a bonus based on how much revenue each employee brings into the business. Or, you could pay based on criteria like customer satisfaction feedback scores.
Bonus Pay Examples
If your business sells furniture or jewelry, you might give employees a percentage of each sale. If you run a restaurant, you might provide small bonuses for sales of high-profit menu items. If you manage an insurance agency, you might provide the entire team a bonus each quarter if your customer feedback scores reach or stay above a certain level (such as four out of five). If you run an HVAC shop, you might give a bonus when an employee gets their HVAC license.
To determine what to offer your employees in terms of a bonus, ask yourself, “What kind of product or service do you want employees to focus on? Or, what key result areas should be recognized?” Those are the ones to consider providing employees a bonus for.
Rewards & Recognition
Rewards and recognition are another aspect of variable pay that can be used to motivate employees to perform. They also have the benefit of improving overall employee engagement and retention. But, they don’t always have to be paid in cash. For example, rewards can be in the form of products, services or points that may or may not be redeemable for cash, but nevertheless have value to employees.
Rewards & Recognition Example
Your IT team members may not sell products, but can receive rewards for aspects of their work they have control over—like quality specifications, internal customer support, or the number of days the system has gone without crashing.
Your warehouse team might receive rewards for days without safety violations or weeks with zero customer complaints. Recognition can also be a feeder to other incentives. For example, the employee with the most positive customer feedback cards perhaps earns a badge and a $100 bonus in a given month.
Here are other ways that aren’t overly expensive to recognize your employees and show appreciation.
Pros & Cons of Variable Pay
On the pro side of variable pay, you will likely get more out of your workers than standard pay that provides no incentive for top performers. However, variable pay can be unwieldy if your variable pay compensation program is too complex or causes issues if employees feel it’s unfair.
Pros of Variable Pay
There are many positive benefits of paying employees with variable pay:
- High performers will thrive – Variable pay feels more “fair” to those who perform at a high level, since they have the chance to be compensated and acknowledged for the extra effort and higher-level results they bring to the business.
- Average performers will be inspired to work harder – Once employees understand which behaviors (customer service, safety, quick turnaround time) you value, they’ll be focused more on those aspects of their job, and work harder to earn those rewards.
- Your payroll expenses will more closely match your business results – In months that employees don’t earn sales, or your revenues are off, your payroll will also be lower as you won’t be paying workers bonuses if they aren’t bringing money in the door.
Cons of Variable Pay
Variable pay has its downsides as well, mostly on the business / administrative side:
- It can be complex to manage – Unless you have a very simple system, tracking variable pay can be tricky. For example, if you bonus your sales staff on units sold each week, you’ll need to track units sold by worker in order to calculate each employee’s bonus weekly.
- You have to budget for it – You may have a budget line item for payroll that’s consistent each pay period. You’ll need to do the same for your variable pay. For example, if variable pay is expected to be about 25 percent of an employee’s compensation, you’ll need to have that much extra in your payroll account ready to be paid out once it’s earned—whether that’s monthly, quarterly or annually. That requires you to estimate and set the funds aside in advance.
- It may backfire – This is the most misunderstood downside of variable pay. You need to be very careful about what you incent employees to do. For example, if employees are given incentives for high customer service scores, might they be “giving away” product to earn higher ratings? Or if they’re incented for faster delivery times, might they be taking shortcuts in safety?
In addition, Eanet provided this advice:
The use of variable pay may create legal obligations for the employer and may need to be taken into consideration when determining the employee’s “regular rate” of pay for compensation of overtime, sick, and vacation pay.
Alternatives to Variable Pay
Many businesses don’t mess with variable pay, especially for jobs like laborers or entry level staff. There may not be much difference between poor performers and top performers in those roles. Variable pay is also not common in positions where customers of the business provide cash tips, like servers or housekeepers—those tips serve as a variable payment method and already incent workers to perform well.
Here are some alternatives to variable pay:
Employee Cash Tips
Workers in jobs that are likely to receive cash tips, such as valet parking attendant, wait staff or exotic dancers, don’t need to be paid with variable pay from you, the business owner, as they are already paid for performance by their customers.
However, if your employees don’t receive tips, you as the employer can set aside a cash fund, say $200 per month, to be used to pay out small random amounts. For example, if you see an employee helping their co-worker, you can hand them a $20 bill to pay for their lunch, or give one of your consultants a $5 gift card to grab a latte en route to the appointment they took on at the last minute to help you out.
A fun way to incent employee performance without creating a complex variable pay structure is to invest in a peer feedback mechanism as part of your employee culture. It can be as simple as setting up a Slack channel for workers to provide shout-outs to their peers. Or you could invest in a praise app like Motivosity to allow co-workers to rate and praise their team members. That kind of praise serves to motivate employees to continue doing well (as long as their base pay is fair to start with).
Pay Based on Tenure
This is the method used by governments and school districts. It may make sense if your business values longevity, such as if you’re in an academic, science/research, or skill-based industry where you want to retain employees’ institutional wisdom. Rather than paying for performance (goals and accomplishments), you pay more to those employees who have been there the longest.
Commission only is a kind of pay that may be considered variable in the sense that the more product is sold, the more commission is earned. However, commission-only pay provides no base pay. Pure sales roles may be set up as commission only. However, there are risks to paying workers by commission, according to Angela Nuttle.
Angela Nuttle, CEO, Corporate Talent Institute
The risk of commission only is simple: if they don’t get wins, they get discouraged. My business is a relationship-oriented business versus a quick sale product, so the wins are big but it takes time to develop the relationship with a potential client because we offer high-end coaching experiences. There are definitely seasons of spending in the business world, so having a consistent income from commission is not realistic.
Some companies pay by piece, meaning that payment is entirely based on what the worker produces. Again, there’s no base pay involved. Examples include businesses that assemble products, such as furniture, and companies that make items like custom T-shirts or wind chimes. Workers may be paid a flat rate per piece, such as $2 per swimsuit sewn, or $10 per cabinet built. This allows the business to tie their manufacturing costs directly to the product.
For more on setting up your payroll process to run payroll using these different ways of paying employees, read our article on payroll processing. It covers labor laws, including minimum wage laws in all 50 U.S. states.
Frequently Asked Questions (FAQs)
Here are some common questions small business owners may have regarding variable pay.
Can My Payroll Service Manage Variable Pay?
Many of the best payroll service options can manage multiple payment types. If you’re already using a payroll vendor, contact your sales or service rep and let them know that you’re considering adding variable pay in terms of bonuses, commissions or other incentives. Ask for their suggestions on how best to set that up within the system you’re already using. If that is not feasible, you may be able to import data manually using a CSV file. Or you could simply type in the bonus amounts each pay period.
What if I Want to Change the Pay Structure?
It’s not uncommon to set up a variable pay structure, only to find out that it’s not working as you intended. For example, if you pay employees based on their sales, you may find that customer service suffers, or that profitability plummets.
Consider the pros and cons of your current pay structure to see how modifying it may improve the performance that matters most to your business. Then consider re-communicating the new structure in the same way you communicated your original variable pay program, such as in your employee offer letter, employment contract or employee handbook.
What if My Variable Pay Is Less Than Minimum Wage?
Variable pay is typically payment that’s on top of base pay. But if not, you’ll need to make sure you abide by minimum wage laws in your state. For a complete list of minimum wage rates by state, refer to our article on the payroll process.
The Bottom Line
Variable pay is merely a tool that employers can use to motivate workers on the job. It’s an option that tends to engage employees by giving them skin in the game. The harder they work, or the better they do their job, the more opportunity they have to increase their own pay. Variable pay can be a great choice when setting up a compensation plan for your team.
We recommend using a payroll provider like Gusto that can easily manage your variable pay program. In addition, it can store all your employee files, from their offer letter to your employee handbook. Gusto also provides a great new hire experience to your employees, giving your business that professional look and feel.