A comprehensive guide to variable compensation

Today’s HR professionals are facing budget cuts, layoffs, and an increasingly difficult business climate.* The current labor market is also tight. People leaders have to manage the challenge of attracting and retaining top talent amid rising inflation and salary competition.

Despite a general upturn in hiring activity in 2024, 64% of recruiters are still struggling to find the right candidates.** What’s more, 77% of employees worldwide feel disengaged, leading to additional challenges with organizational productivity and retention.***

To address these challenges, companies need to rethink their approach to compensation. One powerful strategy is implementing variable compensation, which rewards employees based on performance rather than hours worked. 

When well-designed, variable pay structures motivate employees, align their work with company goals, and demonstrate appreciation for their contributions. This could be the key to giving your company a competitive edge.

*Leapsome’s Workforce Trends Report, 2024

**Totaljobs, 2024
***Gallup, 2024‍

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What is variable compensation?

Variable compensation refers to pay added to an employee’s base salary and fluctuates based on performance or results. Organizations with a variable compensation plan typically pay team members at least 8% to 19% of their base salary as extra.

This type of compensation is often performance-based, rewarding employees who meet or exceed targets. It can also be tied to company growth milestones. By linking rewards to achievements, variable compensation incentivizes productivity and acknowledges individual contributions.
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Why offer variable compensation?

If you’ve already implemented a fair salary structure for your organization, you might wonder why you should consider a variable compensation plan. Here are three compelling reasons to add variable pay to your compensation management strategy:

• Create alignment between employees’ daily tasks and company objectives — Variable pay links rewards to specific goals that fit into your organization’s overall goals. This encourages the whole team to work toward the same objectives and means they’re more likely to achieve them.
  
  

• Incentivize peak performance — Variable pay encourages employees to work more efficiently and deliver their best work. A well-managed compensation plan also shows people what to do to get recognized with a cash bonus or other benefits.
  
  

• ‍Retain employees and find talent — Some employers offer variable compensation as a hiring and retention strategy. Cash incentives make roles more appealing to high-performing professionals and can reduce turnover by rewarding impactful contributions.
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What businesses are suited to the variable compensation model?

All kinds of companies can adopt variable compensation, but organizations that focus on sales and professional services are most suited to it, as it’s easier to measure the relationship between revenue and performance. 

For instance, at a software company, sales teams generate revenue by closing deals, developers drive growth by creating high-value products, and customer support ensures retention through excellent service. Variable pay creates a clear link between these contributions and rewards.

Types of variable compensation

When designing a compensation strategy, consider the common types of variable compensation outlined below. Many businesses use a combination of these to meet their needs:

Commission

Commission is a type of payment that employees receive based on the revenue they directly generate for the company — usually a flat percentage of sales.

Some businesses use tiered commission structures where percentages increase as employees meet higher sales targets. For instance, a salesperson might earn 5% on all sales up to US$1,000 and 10% on anything above that.

Most commission-based jobs combine variable pay and a fixed salary. For example, sales reps in the United States earn variable pay of around US$11,000 per year and base pay of US$75,000, on average. In contrast, other commission-based jobs (like real estate agents and telemarketers) have a high ratio of commission pay to fixed salary and rely heavily on that portion of their income.
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Bonus 

Bonuses are lump-sum payments employers use to reward employees for hard work or significant achievements.

The main difference between a performance bonus and commission pay is that bonuses aren’t directly proportional to the revenue someone generates. Employers often decide whether to award employees bonuses (and how much) using performance appraisals and individual objectives and key results (OKRs). 

Businesses may also offer retention bonuses to encourage team members to stay during a tricky transitional period or to acknowledge their years of contributions. 

Some employers also decide on payment bands for different levels of achievement. For example, a company might pay someone an extra 15% of their salary for meeting targets and 25% for exceeding them. 
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Management by objectives (MBOs) 

This is a variable compensation strategy where management helps each staff member set the targets they need to reach for extra bonus pay and increases during salary reviews. 

Typically, the MBO process follows these five steps:

1. Set or revise company-wide objectives
2. Break down these objectives into measurable goals for each team or role
3. Customize goals for individual employees
4. Support employees as they work toward their goals
5. Evaluate progress and award extra pay based on achievements

For best results, ensure objectives follow the SMART framework: specific, measurable, acceptable, realistic, and time-bound goals.
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Profit-sharing

Profit-sharing involves dividing a portion of a company’s profits among employees. Instead of being tied to individual performance, bonuses are based on company-wide success.

Employers can determine the percentage of profits to share and allocate payments based on factors like role, tenure, or performance. Alternatively, businesses may opt for equal distribution to all employees as a one-time bonus following a successful quarter or fiscal year.

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Pros of variable pay

There are several benefits to a variable compensation plan — keep reading to explore them.
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Improving employee experience

Fixed salaries offer stability, but they don’t always acknowledge individual achievements. One of the main aims of employee compensation is to motivate employees, and variable pay can provide another layer of incentive. Even though variable pay isn’t the only way you should recognize employees, it’s a great way to show them they’re valued. 

For example, rewarding top performers with bonuses shows appreciation for their contributions and reinforces the value they bring to the organization; when you measure employee engagement in a company that prioritizes recognition, you’ll notice the effect it can have. Recognition has been proven to improve the employee experience, and team members who receive recognition are more engaged and less likely to suffer from burnout.

💡 Combine financial rewards with other forms of recognition, like feedback and praise, to maximize their impact.

Keeping your organization competitive

According to the CIPD, 24% of organizations planned to increase base pay by 4 to 4.99% in 2024 in response to rising inflation. And yet, three-quarters of poll respondents still didn’t think they’d meet current pay expectations.

In tight labor markets, companies face the challenge of attracting and retaining top talent amid rising salaries. Variable compensation offers a fair and flexible way to provide competitive compensation while rewarding employee contributions.

‍For example, offering variable pay on top of a solid base salary allows employers to recognize hard work without inflating fixed costs — giving them an edge in the war for talent. That is, provided you already provide a good base pay with benefits and have an interesting incentive pay scheme.
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Driving better employee performance

Variable compensation can motivate professionals to perform at their best. With a potential incentive, people are more likely to produce excellent results and work more effectively. For example, a sales rep will likely try harder to close deals if they’re awarded a percentage of the earnings.

Plus, employees often expect a degree of variable pay in roles like sales and marketing. If you only offer a fixed salary, you might struggle to find top candidates for open positions or discourage existing team members from trying their best to reach their full potential.

Cons of variable pay

When businesses don’t introduce incentive-based pay correctly, they may face some of the problems below.
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Risk of lower profitability

Variable compensation programs require careful planning to avoid budgetary strain. Mismanagement of budgets or incentive structures can lead to excessive payouts that hurt the company’s bottom line.

Managing complexity

Variable compensation plans can be complex to administer, especially in larger organizations. Considerations include:

• Budget allocation
• Determining roles eligible for variable pay
• Criteria for performance measurement
• Evaluation methods for allocating rewards

Without a well-structured approach, the complexity of variable pay can overshadow its benefits.

Chance of a toxic workplace 

When poorly implemented, variable pay may foster a competitive, rather than collaborative, work environment — negatively affecting the employee experience.

Employees might withhold resources or avoid teamwork to meet their personal targets. Additionally, if fixed salaries are insufficient, employees may become anxious about covering living expenses, leading to disengagement and higher turnover.

Incentivize success with people enablement software

Struggling with retention? Aiming for higher employee engagement? Trying to cultivate a healthier and more productive company culture? Consider adding variable compensation to your compensation management plan.

While these reward frameworks may not fit every organization, they’re particularly effective for industries like sales and service-based sectors. That said, with thoughtful planning, variable pay plans can motivate all employees and reduce turnover — regardless of their role.

But financial incentives like bonuses and commissions are only part of the picture. To create a truly well-rounded approach to people management, consider combining compensation strategies with people enablement initiatives that empower professionals to reach their full potential.

Leapsome’s HR platform simplifies compensation and payroll management, helping you build and maintain solid pay structures without all the manual work. Beyond compensation, our platform includes a range of core HR and people enablement tools designed to support a meaningful, engaging work environment.

With seamless integrations, data-driven analytics, and AI-powered automations, our people-centered HR software is all you need to elevate your people strategy — now and in the future.

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