MANAGEMENT & ACCOUNTING

KPI BASED
Compensation Framework
Patrick PC Ow

Given that a CEO’s greatest concern is sustaining top-line and profitability growth,
compensation packages today are promoting negative short-term behaviour and
increasing the temptation for fraudulent activities within the organisation.

T
he Conference Board’s CEO
Challenge Survey 2006 that
was conducted during July and
August 2005, asked 658 CEOs
worldwide to rate their challenges over the
next year. Their greatest concern is “sus-
tained and steady top-line growth” (38 per
cent), followed closely by “profitability
growth” (36 per cent) and “consistent ex-
ecution of strategy by top management”
(33 per cent).
Unfor tunately, we also know from
PricewaterhouseCoopers’ (PwC) Global Eco-
nomic Crime Survey 2005 for Malaysia that,
21 per cent of frauds reported by Malay-
sian companies in the past two years in-
criminated senior management. The sur-
vey also reported that 23 per cent of Ma-
laysian respondents (of the survey) re-
ported economic crime in the last two
years, compared to 45 per cent globally.
This was an eight per cent increase from
the previous survey. Globally, there is a 140
per cent increase in the number reporting
financial misrepresentation.
The tendency to commit fraud will be
greater as pressure mounts to sustain short-
term top-line growth by various methods like
reporting financial misrepresentation, all at
the expense of the company’s long-term value.
A good solution is to completely restruc-
ture how we financially reward or compen-
sate our executives and employees by posi-
tively (constructively) motivating them to
sustain long-term top-line and profitability

30 ACCOUNTANTS TODAY • February 2007

 KPI Based Compensation Framework

growth, focusing on non-financial mea- takes into account the score of every mem- Implement a 360-degree team perfor-
sures instead of just short-term financial ber of the team. This ensures that the mance scoring by individual team mem-
targets (e.g. yearly profitability). leader manages the performance of all in- bers, in addition to self-evaluation scores
A balanced performance framework or dividuals that are reporting to him/her, to determine the final scores. Gaps be-
Key Per formance Indicator (KPI)-based thus naturally promoting and rewarding tween team and self-scores are discussed
compensation framework seeks to address positive teamwork and cooperation. openly and reasons for performance (or
this challenge in two areas: Company-based KPIs, likewise, is appli- non-performance), competency and per-
䡲 Specific, measurable, achievable, realis- cable generally for individuals who man- ception gaps are identified and addressed
tic and timed (SMART) KPIs that posi- age at the company-wide level. constructively.
tively motivate employees to: Once the personal scorecard is devel- Such open two-way communications pro-
• Objectively perform beyond their cur- oped, assign numeric values (say, 0 to 3) vide opportunities for employees to “de-
rent abilities and performance levels, to the pre-set weighted targets (Figure fend” their self-scores based on factual evi-
both from the short-term and long- 3). dence of performance that might not be
term perspectives; and
Figure 1 Performance Scorecard
“Tendency to commit fraud Balanced Illustrative Illustrative Weighting Self- Team- Final-
Perspectives Measures Threshold Targets Scoring Scoring Scoring
will be higher as pressure Financial Gross Annual RM 1.0 Mil 30% 2 2 2
[Outcomes] Revenue/ (0.6)
mounts to sustain short-term Total Staff
Customer Customer 80% High Score 30% 3 2 2
top-line growth by various (Internal/ Ratings (Perception Scale (0.6)
External) – High, Met, Low)
methods like reporting financial [Outcomes]
Internal Turnaround 95% On Time 20% 3 3 3
misrepresentation, all at the Process (Days) Delivery (Promised (0.6)
[Drivers] Deadline)
expense of the company’s Learning/ Employee 70% Agree 20% 1 0 1
Growth Satisfaction Perception Scale (0.2)
long-term value.” [Drivers] Employee – Agree, Neither Agree
Opinion Survey) / Disagree,Disagree)
Total Performance 100%
• Maintain or enhance the achievement Composite Personal 2
of company goals/ targets, both from Scorecard Score (AT)
the financial and non-financial perspec-
tives.
Figure 2 Weighting and Balancing Scorecard Measures
䡲 Objectively and fairly compensating or
Levels Company-Based KPIs Team-Based Personal Individual’s
rewarding the achievement of individual KPIs KPIs Total
Financial Non-Financial
performance targets, both from Performance
a) financial and non-financial, and Senior Management 50% 30% 20% — 100%
b) short- and long-term perspectives.
Middle Management 20% 30% 35% 15% 100%
This requires discipline to set aside
Executives/Non-Executives — 30% — 70% 100%
funds and not change the rules half way
through by not paying even when indi-
viduals meet their targets. Figure 3 Scoring Mechanism
Clear targets and automatic trigger Below Average — Average (AV) Above Average — Exceptional —
points are essential for the implementation Performance is not At Stretch (AT) Outstanding
Acceptable (NA) Performance (OS)
of a KPI-based compensation system, mo-
tivating our employees to perform (Figure Score “0” Score “1” Score “2” Score “3”
Threshold Target

Mid-Point Target

1). Not Applicable 0.01 – 1.00 1.01 – 2.00 2.01 – 3.00

Stretch Target

Depending on the individual’s level Any achievement Achieving above Achieving above Achieving above
within the organisation, sub-divide the equal/ below a Threshold to Mid-Point to Stretch Target
Threshold Target Mid-Point Target Stretch Target
scorecard measures into weighted and
will NOT be
balanced categories (Figure 2). rewarded
Use team-based KPIs if the individual is NA Performer — AV Performer — AT Performer — OS Performer —
managing a team/group of employees. No discretionary 0.5 X Monthly 0.75 X Monthly 1.5 X Monthly
This team score is a composite average that bonus Salary Salary Salary

February 2007 • ACCOUNTANTS TODAY 31

KPI Based Compensation Framework

known to his/her superior (using Johari commit and allocate the payment for at ployee is important to motivate behaviours
Window). This eliminates any form of sub- least the Individual Performance Incentive.positively.
jectivity, “rumour-mongering” or “politick- Example: Use KPIs to determine the actual size of
ing”. 䡲 0.5 times monthly salary for an average the financial pool of the variable compo-
Within this framework (Figure 4), an (AV) performance grading. nent. KPIs are determined from the Criti-
individual’s total compensation package cal Success Factors (CSF) of a company.
䡲 0.75 times monthly salary for an above
may consist of: For Team-based Performance Incentive
average (AT) performance grading.
and Corporate Incentive, trigger the actual
䡲 Fixed Base Monthly Pay — Normal 12 䡲 1.5 times monthly salary for an outstand-
or 13 months salary, based on the (con- payout pool of funds based on the objec-
ing (OS) performance grading. tive achievement of corporate or team-
tractual) appointment letter.
based KPIs (Figure 6).
Eliminate contractual bo-
nus, where possible. Figure 4 KPI-Based Compensation Framework for Individuals For a more sophisticated
scheme, break down 2.0 months
䡲 Variable Incentive Compo- corporate incentive pool:
nents — Administered at
䡲 Senior Management — five
the discretion of manage-
Corporate Incentive to 10 per cent to individual bo-
ment (as provided for in the Scheme
nus/ pension plan.
appointment letter), com-
prising of financial and non-
Incentives 䡲 Middle Management — 10 to
Team-Based 30 per cent to the bonus pool,
financial balanced mea-
Components

Discretionary Bonus Performance

Variable

sures: Incentive allocated on individual’s perfor-

mance.
䡲 Individual Performance In- Individual
Contractual Bonus Performance 䡲 Executive/Non-Executive —
centive — Paid either on a Incentive
60 to 80 per cent to the bonus
monthly, quarterly, or half-
pool, allocated on individual’s
yearly basis, depending on
performance.
company and industr y re-
quirements. Also referred to Customise score grading to
as pay-for-performance sys- your company’s system and cul-
Fixed Component

Base Monthly Pay Base Monthly Pay

tem. (12 months) (12 months) ture and industry needs.
Objectively link the quantum
䡲 Team-based Performance
of the variable component pay-
Incentive — Reward all in-
able and the triggering of
dividuals within a team or
changes in salary components to
group based on the agreed
Current Future
company and economic perfor-
per formance or KPI
mance through clearly defined
achievement of the entire
and robust KPIs and CSFs.
team. If the team does per-
Figure 5 Splitting Frequency of Payouts Compute the final combined
form, reward ever y indi-
performance and competency-
vidual within the team Yearly Half-Yearly Quarterly
Evaluation Evaluation Evaluation weighted scores (Figure 7). An
equally, paid either on a
employee scoring an OS would
monthly, quarterly, or half- Average (AV) 0.5 0.25 0.13
Performance Grading get 1.5 times his or her monthly
yearly basis. This facilitates
Above Average (AT) 0.75 0.35 0.15 salary as yearly Individual Per-
teamwork.
Performance Grading formance Incentive. No more
䡲 Corporate Incentive — Outstanding (OS) 1.5 0.75 0.35 adjustments, if-buts, “bell-
Compensate all individuals Performance Grading curve” manipulation, or force
within the company based ranking, which can all be de-
on long-term corporate performance, but Split payments over a half-yearly or quar- motivating.
on a deferred or “subject-to” conditional terly basis, in-line with the company’s fre- Postpone payment of corporate incen-
basis during financial payout, paid either quency of performance evaluation HR prac- tives until the achievement of a pre-agreed
on a yearly or three-yearly basis (e.g. tices (Figure 5). KPI to avoid short-term negative/fraudu-
share option scheme based on pre-de- Generally, an average employee can only lent behaviours (e.g. stock price hitting a
fined target price or revenue). This elimi- achieve an AT performance grading if the specific price).
nates shor t-term negative or even Stretch Targets are set correctly. Therefore, Compute quantum of financial rewards
fraudulent behaviours. we will never draw down the budgeted al- based on normalised and weighted scores,
During a company’s budgeting cycle, location. The perceived value to the em- and pay employees promptly and fairly re-

32 ACCOUNTANTS TODAY • February 2007

 KPI Based Compensation Framework

gardless of company cash flow.

Figure 6 Funding Incentives from KPI Achievement
Personal performance measures and tar-
gets must be relevant before objectively Corporate KPIs Weighting Percentage of Target Over Budget/ Planned Composite Score
linking financial rewards to specific mea- Revenue 10% • > 25% Budgeted - 3.0 times monthly salary
sures and targets (KPIs). Financial re- • 15% to 25% - 2.0 times monthly salary (Assume) 0.2
• 10% to 15% - 1.0 times monthly salary
wards given too early may motivate the
wrong behaviour. Profitability 10% • > 35% Budgeted - 3.0 times monthly salary (Assume)
• 30% to 35% - 2.0 times monthly salary 0.3
As the performance of executives and • 25% to 30% - 1.0 times monthly salary
senior management are linked closely to
Customer 25% • 20% Planned - 3.0 times monthly salary (Assume)
corporate performance, the proportion of Satisfaction • 15% to 20% - 2.0 times monthly salary 0.75
the variable incentive component in their Ratings • 10% to 15% - 1.0 times monthly salary
compensation should be higher than that Defect/ 35% • 30% Planned - 3.0 times monthly salary
of an executive/ non-executive (Figure Reject Rates • 25% to 30% - 2.0 times monthly salary 0.35
• 20% to 25% - 1.0 times monthly salary (Assume)
8).
Employee 20% • > 20% Planned - 3.0 times monthly salary
Objectively link yearly increments to the Satisfaction • 15% to 20% - 2.0 times monthly salary (Assume) 0.4
base monthly pay using: Ratings • 10% to 15% - 1.0 times monthly salary

䡲 Pay increase matrix on a fixed percent- Total 100% 2.0 months

age of say five per cent, based on the
country’s CPI index.
Figure 7 Scoring and Weighting Performance and Competencies
䡲 Employees’ average weighted scores from
Scorecard Components Weighting Individual Score (Unweighted) Weighted Score
previous performance evaluations. Quar-
terly performance evaluation in a year Performance Measures/ Targets 70% 2.0 1.4
is preferred to determine the increment Core Competencies (Behavioural) 30% 2.3 0.69
quantum accurately, giving individuals a Composite Score 2.09
chance to recover a “bad performance” Overall Rating Outstanding Performer (OS)
quarter in the next quarter, rather than
Yearly Individual Performance Incentive 1.5 X Monthly Salary
in the following year.
Corporate Incentive 2.0 X Monthly Salary
䡲 Job evaluation that determines (Figure
9):
• Relative value of the job and job size Figure 8 Weighting Based and Variable Incentive Pay
relative to the company as a whole
Levels Fixed Base Monthly Pay Variable Incentive Component
(evaluate the job size not the person
doing the job); and Senior Management 50% 50%

• Who is over or under-paid, rationalising Middle Management 60% 40%

outliners against the trend line and pre- Executives/ Non-Executives 70% 30%
determined salary ranges/bands.
䡲 Current market rate, through industry
benchmarking, thus avoiding “salary-at-
Figure 9 Job Evaluation Graph
risk” situations.
Company A
䡲 Regression analysis of per formance
Job Evaluation
scores and job evaluation ranking.
4
A KPI-based compensation framework
3
will positively reward employees based on
Monthly Pay RM

2
Thousands

their measurable per formance, whilst

compensating fairly and in good time for 1
positive long-term conduct, thus avoiding 0
any negative actions that may affect the -1
long-term top-line growth and profitabil- -2
ity of the company. AT 100 150 200 250 300 350 400 450 500
Job Points
You can contact the author at patrickow@
gmail.com. Pay -2SD
Median R&F
+2SD Exe

February 2007 • ACCOUNTANTS TODAY 33