Performance Bonus

What a performance bonus is

A performance bonus (مكافأة الأداء) is an amount an organisation pays an employee who reaches a defined result within a stated period, under a written calculation rule announced before the period begins. Entitlement depends on a result reached by the employee, by the team or by the organisation. It does not depend on the passing of time alone, or on an unplanned event.

The bonus exists only when four things are in place: a measure by which performance is known, a period in which it is measured, a rule that turns the result into an amount, and a date of payment. If the measure is missing, the grant becomes a personal judgement. If the rule is written after the result appears, the decision is taken by someone who already knows who will benefit from it.

How a performance bonus differs from neighbouring payments

Payments of this family are alike in being sums paid on top of what is fixed, and they differ in what the payment is tied to. A performance bonus is tied to reaching a target, and each neighbouring payment is tied to something else:

• Immediate recognition. A spot award is given for an event that was not announced beforehand, and nobody can claim it. The rule of a performance bonus is known in advance, so the employee can work out the share that will be due.
• Presence until a date. A retention bonus depends on the employee still being there on a stated date. An employee who stayed earns it even without reaching a result.
• A share of profits. Profit sharing links what the worker receives to the result of the whole organisation, not to the worker’s own performance alone.
• Commission. Commission pay is a percentage of a value the employee generates, such as the value of what was sold. What the employee receives therefore moves with that value and not with reaching a target figure.
• Measured savings. Gainsharing is an arrangement in which the organisation distributes to a defined unit a share of a saving, measured against a baseline agreed before the period.

All of these are forms within one family, which is described under variable pay, the part of an employee’s income that changes with a particular result. A performance bonus is the form in which the target is the condition of payment.

How the payment rule is built

The rule needs three points on the scale of achievement: a threshold, a target and a cap. Each point is written as a percentage of the target, together with the share of the target bonus that is paid at that point:

• The threshold. Payment begins at this point, and below it nothing is paid. Say it is 80% of the target, and the payment at that point is half of the target bonus.
• The target. The announced amount is paid in full at this point: 100% of the target against 100% of the bonus.
• The cap. Payment stops at this point however much achievement rises. Say it is 120% of the target, and the payment there is 150% of the bonus.

Between any two points the payment is worked out in proportion. Take a hypothetical employee whose target bonus is 20,000 currency units. Achievement of 90% is halfway between 80% and 100%, so the payment is 50% + (10 ÷ 20) × 50% = 75%, which is 15,000. At 110%, which is halfway between 100% and 120%, the payment is 100% + (10 ÷ 20) × 50% = 125%, which is 25,000. At 130%, past the cap, the payment stays at 150%, which is 30,000. Below the threshold, at 70%, the amount is zero.

One consequence of this rule deserves attention. An employee at 79% receives nothing, and an employee at 80% receives 10,000, which is 20,000 × 50%. A single percentage point separates zero from ten thousand. That sharp break may push someone close to the threshold to make up the missing points in a way that does not serve the work, such as bringing a deal forward before its time. When the threshold is written, the question to ask is therefore what a person standing one point short of it might do.

How the bonus is calculated when there are several measures

If the bonus depends on several measures, each measure carries a weight, and the weights add up to 100%. A payout factor is worked out for each measure under its own rule, multiplied by its weight, and the results are added together.

Take a target bonus of 20,000 with three measures: revenue at a weight of 50%, customer retention at 30% and delivery of a project at 20%. Revenue achievement was 92% of its target, so its payout factor is 50% + (12 ÷ 20) × 50% = 80%. Customer retention achievement was 105%, so its payout factor is 100% + (5 ÷ 20) × 50% = 112.5%. Achievement on the project was 76%, which is below the threshold, so its payout factor is zero.

The overall factor is therefore (50% × 80%) + (30% × 112.5%) + (20% × 0%) = 40% + 33.75% + 0% = 73.75%, and the amount is 20,000 × 73.75% = 14,750. The calculation shows that a measure that missed its threshold removed only its own share of the bonus, not the whole bonus. An organisation can set a different rule that makes the entire payment depend on the threshold of one particular measure. That is a decision to write into the rule before the period begins, not after the result appears.

How many measures one bonus can carry

We found no established number of measures that we could adopt. Each measure added to a bonus does, though, weaken the effect of the others on the amount. Suppose a bonus has ten measures at a weight of 10% each. If one measure improves from its threshold to its target, the payout changes by 10% × 50 points = 5 points, which is 1,000 out of 20,000. If the weight were 50%, the change would be 25 points, which is 5,000. An employee who sees that effort on one measure moves only 5% of the bonus may ignore that measure, and the ten measures remain on paper without changing anything in the work.

Measures are chosen so that the employee can influence them. Each is written with a starting figure, a target figure and a date, as the SMART goals approach requires. If the employee does not know the starting figure of a measure, nobody can tell how far it has moved.

How targets are set without being gamed

The target is the point of dispute in a bonus, because the person who sets it does not know what the period will bring, and the employee who is held to it knows the work better than the person who set it. This gap in knowledge may lead an employee to ask for a low target, and it may lead the organisation to raise the target whenever the target seems to have been reached easily.

If the employee knows that next period’s target will be built on what was achieved in this one, the employee may defer part of the achievement until after the period closes, so that the target does not rise. This possibility is reduced when the target is built from inputs outside the employee, such as the organisation’s plan, the size of the market and the capacity of the team, and not from past achievement alone.

When the measure is a manager’s estimate and not a figure, such as a rating in a performance appraisal, the bonus is affected by each manager’s rating habits. The organisation therefore needs performance calibration before it approves the ratings on which amounts are based, so that a difference between two employees does not turn into a difference between their managers.

How a part period is handled

An employee may join in the middle of the period, or move from one role to another within it, so the rule needs a clause that says how the share is calculated. The target bonus can be worked out in proportion to the time spent in the role, and the result multiplied by the payout factor. A hypothetical employee who joined three months into the bonus year has spent 9 months of 12, which is 75%, so the proportionate target bonus is 20,000 × 75% = 15,000. If the payout factor is 73.75%, the amount is 15,000 × 73.75% = 11,062.5.

The position of someone who leaves the organisation before the payment date, and of someone who spends part of the period on long leave, is a decision that is written into the rule itself before the period, so that it is not improvised at the first case.

How the cost is estimated before the period

The cost is estimated as two amounts: the cost when the target is reached and the cost when the cap is reached. Suppose a team of 50 employees, each with a target bonus of 20,000. The cost at target is 50 × 20,000 = 1,000,000. If everyone reaches the cap, the cost is 50 × 30,000 = 1,500,000. If the average payout factor is 90%, the cost is 900,000.

Before the period the organisation also needs to decide whether the amount is a closed pool, divided among those who qualify, or a commitment that moves with the results. In a closed pool, each employee’s share may fall as more people reach the target. In an open commitment, the cost may exceed the budget if everyone does well. Either choice is possible. What matters is that one of them is written down and announced together with the rule.

How a performance bonus is examined within the pay package

A performance bonus is not examined on its own, because its effect on employee behaviour may depend on its size within total income. Pay mix describes that size: for example, 80% of target pay fixed and 20% tied to the result. A mix that makes the part tied to the result small may change no behaviour, and a mix that makes it large may place on the employee a fluctuation whose tools the employee does not control. As the variable share widens, the fixed share narrows, so what the employee can bear is considered before what the organisation wants.

How a performance bonus goes wrong

A bonus goes wrong when its rule is announced after the period, when it is tied to a measure outside its owner’s control, and when a single measure stands without a qualitative counterpart. Each case has a sign that points to it:

• A rule announced after the period. The amount is taken as a gift and not as an entitlement, and the employee loses the ability to steer effort by working out the bonus.
• A measure outside its owner’s control. If, for instance, an operations employee’s amount is tied to the result of a department unconnected with that employee, the outcome may be frustration and not motivation.
• A single measure with no qualitative counterpart. The figure improves at the expense of what is not measured, as when sales are raised with customers who do not stay. The remedy is a qualitative measure alongside the quantitative one.

What size of performance bonus is suitable

In the sources we reviewed, we found no reference percentage of income that we could adopt for a performance bonus, and we do not propose a figure of our own. The size changes with the role, with what the holder can influence and with the pay mix the organisation has chosen. It is written before the period as a target amount, a threshold and a cap. After the period the rule is reviewed with two questions: did the people who should have reached the target do so, and did the amount change anything in the work?

Paying a bonus does not prove that performance improved because of it. The figure may rise because the market widened or because the target was set low, so its result is judged against the target and the conditions of the period together, and not apart from them.

This is an explanation of the concept, not legal advice.