Variable Compensation

What is Variable Compensation?

Variable compensation, also known as variable pay or performance-based pay, is the portion of an employee's total compensation that is not fixed but instead depends on individual, team, or company performance. Unlike base salary, which is paid regardless of results, variable compensation is directly tied to measurable outcomes such as sales figures, customer satisfaction, project completions, or other Key Performance Indicators (KPIs).

Variable compensation typically represents between 10% and 50% of total target compensation (On-Target Earnings or OTE), depending on the role and industry. For salespeople and account executives, the variable portion often falls on the higher end, while support functions and managers typically have a lower variable component.

Why Does Variable Compensation Matter?

Variable pay plays a crucial role in modern corporate compensation strategies for several reasons. First, it creates a direct link between an employee's effort and reward, which motivates higher performance. Second, it helps companies attract and retain top talent, especially in sales and other results-oriented functions.

Additionally, variable compensation gives companies a natural mechanism to adjust labor costs in relation to business results. During periods of high growth, employees are rewarded for their contributions, while costs automatically decrease when results are weaker. This creates a win-win situation for both company and employee.

According to recent studies, companies with well-designed variable compensation plans see up to 44% higher sales performance compared to those with poorly structured plans. This makes getting your variable comp strategy right a critical business imperative.

Types of Variable Compensation

There are several different forms of variable pay that can be combined or used individually depending on the company's needs and the employee's role:

Commission

Commission is the most common form of variable compensation in sales. The employee receives a percentage of the revenue or gross margin they generate. Commission rates typically vary from 5% to 20% depending on industry, product type, and company margins. Common commission structures include:

• Revenue-based commission: A percentage of total sales value
• Gross margin commission: A percentage of the profit margin on sales
• Tiered commission: Increasing rates as performance thresholds are met

Bonus

Bonus programs pay a fixed amount or a percentage of base salary when specific goals are achieved. This can be individual goals, team goals, or company goals. Bonuses are often paid quarterly or annually. Types include:

• Spot bonuses: One-time awards for exceptional performance
• Quarterly bonuses: Regular incentives tied to short-term goals
• Annual bonuses: Year-end rewards based on yearly performance

Stock-Based Compensation

Stock options, Restricted Stock Units (RSUs), and other equity-based compensation forms give employees a share in the company's value creation over time. These arrangements are particularly prevalent in the tech industry and at startups. They serve as powerful retention tools and align employee interests with shareholder value.

Profit Sharing

Profit-sharing arrangements give employees a share of the company's profits, typically based on a formula that accounts for tenure and salary level. This approach fosters a sense of ownership and encourages employees to think about the company's overall success.

Calculating Variable Compensation: An Example

Let's look at a concrete example with an Account Executive in the United States:

Compensation Structure:

• Base Salary: $6,500 per month ($78,000 annually)
• Variable Pay at Target (OTE): $5,200 per month ($62,400 annually)
• Total OTE: $11,700 per month ($140,400 annually)
• Pay Mix: 55/45 (55% fixed, 45% variable)

Quota Structure:

• Annual Sales Quota: $624,000 in new ARR
• Quarterly Quota: $156,000
• Commission Rate: 10% of new ARR

Scenario 1: Performing at 100% of Quota

If the employee hits their quarterly quota of $156,000, they earn:

• Base Salary (3 months): $19,500
• Commission: $156,000 × 10% = $15,600
• Total Quarterly Compensation: $35,100

Scenario 2: Performing at 150% of Quota

With overperformance of $234,000 in sales with a 1.5x accelerator above quota:

• Base Salary (3 months): $19,500
• Commission on Quota: $156,000 × 10% = $15,600
• Commission Above Quota: $78,000 × 10% × 1.5 = $11,700
• Total Quarterly Compensation: $46,800

Scenario 3: Performing at 75% of Quota

With underperformance at $117,000 in sales with a 0.5x decelerator below 80% of quota:

• Base Salary (3 months): $19,500
• Commission (with decelerator): $117,000 × 10% × 0.75 = $8,775
• Total Quarterly Compensation: $28,275

Benefits of Variable Compensation

Variable pay brings a range of benefits for both companies and employees:

For the Company

• Increased Motivation and Productivity: Employees work more purposefully when they see a direct connection between effort and reward.
• Better Talent Recruitment: Ambitious candidates are attracted by the opportunity to increase their income through strong performance.
• Flexible Labor Costs: The company's labor costs naturally scale with business results.
• Clearer Goal Management: Variable pay models force the company to define clear, measurable success criteria.
• Reduced Employee Turnover: Top performers are better rewarded, which increases their loyalty.
• Alignment with Business Objectives: Variable comp can be designed to drive specific behaviors that support strategic goals.

For the Employee

• Higher Earning Potential: Skilled employees can earn significantly more than their base salary.
• Recognition of Performance: Variable pay makes individual contributions visible and rewarded.
• Career Development: Strong performance documented through variable pay distributions supports career advancement.
• Transparency: Clear compensation plans give employees control over their own income.
• Meritocracy: Hard work and results are directly recognized and compensated.

Challenges and Drawbacks of Variable Compensation

While variable pay has many benefits, there are also challenges that companies should be aware of:

Potential Pitfalls

• Short-term Focus: Employees may prioritize short-term gains at the expense of long-term relationships and sustainable growth.
• Complex Administration: Variable pay models require robust systems to track performance and calculate payouts correctly.
• Risk of Errors: Manual calculations and spreadsheets increase the risk of errors in commission payments.
• Disputes and Dissatisfaction: Unclear rules or errors in calculations can create conflicts between employees and management.
• Uncertainty for the Employee: A high variable component can create financial stress, especially during periods of lower performance.
• Sandbagging: Reps may hold deals to hit accelerators in future periods.
• Gaming the System: Complex plans with loopholes can be exploited.

How to Minimize Risks

To avoid the most common pitfalls with variable pay, companies should:

• Implement dedicated software for commission calculation and administration
• Ensure transparent and well-documented compensation plans
• Balance short-term and long-term incentives
• Review and adjust compensation plans regularly
• Give employees ongoing insight into their performance and expected payouts
• Include clawback provisions for churned customers
• Set appropriate caps to prevent windfall payouts

When Should You Use Variable Compensation?

Variable pay is particularly effective in the following situations:

• Sales Roles: Account executives, sales managers, and business development representatives, where results are directly measurable.
• Customer Success: Roles focused on customer retention, upselling, and expansion revenue.
• Project-Based Work: Consultants or project managers with defined deliverables and deadlines.
• Leadership: Bonus arrangements tied to department or company goals.
• Revenue Operations: Roles that directly impact revenue generation and efficiency.

Variable pay is less suitable for roles where:

• Results are difficult to measure individually
• Quality is more important than quantity
• Long-term projects make it difficult to define short-term goals
• Teamwork is so integrated that individual measurement undermines collaboration

Best Practices for Implementing Variable Compensation

To maximize the effectiveness of variable pay, the following approach is recommended:

1. Start with Clear Objectives

Define precisely what behaviors and results you want to incentivize. Goals should be Specific, Measurable, Achievable, Relevant, and Time-bound (SMART). Align compensation metrics with overall business strategy.

2. Choose the Right Pay Mix

Balance base salary and variable pay based on the role's nature, market standards, and the company's risk appetite. A typical distribution for sales roles is 60/40 or 70/30. More aggressive splits like 50/50 work for transactional sales environments.

3. Keep It Simple

Avoid overly complex models with too many variables. Employees should easily be able to understand and calculate their expected earnings. If a rep can't explain their comp plan in 30 seconds, it's too complicated.

4. Communicate Clearly

Ensure all employees fully understand their compensation plan, including calculation methods, payment timing, and any caps or accelerators. Provide written documentation and regular training sessions.

5. Use Technology

Invest in dedicated commission calculation software to eliminate errors, save time, and give employees real-time insight into their performance. Manual spreadsheets don't scale and create unnecessary risk.

6. Review and Iterate

Compensation plans should be reviewed at least annually to ensure they still align with business objectives and market conditions. Gather feedback from the sales team and finance to identify areas for improvement.

Related Concepts

To fully understand variable compensation, it's useful to know related compensation concepts:

• On-Target Earnings (OTE): The total expected compensation when goals are met at 100%.
• Pay Mix: The ratio between fixed and variable pay (e.g., 70/30).
• Accelerator: Increased commission rate for overperformance.
• Decelerator: Reduced commission rate for underperformance.
• Clawback: Repayment of commission upon customer cancellation.
• At-Risk Pay: The portion of compensation that is only paid upon goal achievement.
• Sales Performance Incentive Fund (SPIF): Short-term incentives for specific behaviors or products.
• Quota: The sales target an employee is expected to achieve.

Automate Your Variable Compensation with Prowi

Manual handling of variable pay through spreadsheets is time-consuming and error-prone. Prowi is a commission calculation and management platform that automates the entire process from data input to payout.

With Prowi you get:

• Automatic calculation of commissions based on your unique compensation plans
• Real-time insight into performance and expected payouts for your sales team
• Elimination of errors and disputes around commission calculations
• Integration with your CRM and financial systems
• Time savings for your finance and revenue operations team
• Complete audit trail and compliance documentation
• Scenario modeling for plan design and forecasting

Book a demo today and see how Prowi can transform your variable compensation management.