A Comprehensive Guide to Variable Pay: Definition, Types & Advantages

Variable pay is a compensation structure designed to reinforce favorable work performance from employees and exhibit how the company values its workforce.

There are different ways a business can implement the said program to acknowledge the effort of its workers and boost job satisfaction.

Keep reading to learn more about the meaning or definition of variable pay, variations, advantages, and disadvantages. If you stick with us until the end, you will also learn how to calculate variable compensation!

Key Takeaways

• Variable pay is the added compensation given to employees as a reward for their exemplary service or performance. It also promotes productivity and encourages workers to meet key metrics their employer sets.
• The different types of variable compensation include performance-based incentives, commissions, differential pay, profit-sharing, bonuses, and recognition programs.
• Variable pay depends on an employee’s work performance compared to fixed salaries. The latter also unlocks more earning potential for workers.
• Variable incentives and bonuses encourage growth and improvement and align employees with company goals. In contrast, the said compensation structure incites employee conflict, pressure, and stress.

What is Variable Pay?

Variable pay, or performance pay, is compensation given to employees to reward them for commendable work performance and encourage them to keep up the excellent work.

It is paid on top of their regular pay. Companies sometimes base performance pay on the business’s progress and success.

The most common variable pay examples include sales commissions and performance bonuses. With sales commissions, the sales representative’s variable pay is based on their average quota, on-target earnings, and the company’s annual sales goals.

Performance bonuses are often given after a scheduled performance evaluation of each employee. Some companies use a rating system to determine whether employees have executed their tasks poorly or excellently and calculate the corresponding bonuses accordingly.

Variable Pay vs. Fixed Pay

Variable pay in salary differs significantly from an employee’s fixed pay. Fixed pay refers to the regular income or basic compensation paid to workers every payday, following the company’s pay cycle.

Performance pay is given only when employees achieve a specific milestone while fulfilling their jobs. It can be given as a quarterly, semi-annual, or annual bonus.

The table below elaborates more on the differences between variable pay and fixed pay:

Types of Variable Pay

Variable pay comes in different forms, depending on the company’s structure and size, nature of work, and workplace policies.

The following are the different types of variable pay:

#1. Performance-Based

Performance-based variable salaries are given based on how well employees perform their jobs. Typically, the staff’s direct superior evaluates their monthly, quarterly, semi-annual, or annual performance and assesses whether they have met any prearranged goals set by the company.

The pay rates also differ based on the employees’ rank or position in the company.

For instance, sales and marketing personnel at the junior level may be entitled to a performance bonus ranging between 10% and 15% of their regular income. On the other hand, if the employee holds a senior-level position, their bonus increases to 30% to 50% of their fixed salary.

#2. Commission-Based

This type of pay is more common in sales, and there are different sales commission structures that employers use.

Examples of commission-based variable salaries include:

• Straight Commission Structure. This type of structure is used to compensate contractual sales representatives. Sales reps are paid a fixed commission for every sale made. They do not earn a commission if they do not make sales or close deals.
• Base Salary with Commission. Some companies use this structure to entice more top-tier sales personnel to join their team. Unlike the straight commission structure, this program offers employees a commission on top of a base salary.
• Gross Margin Structure. In this structure, the commission is based on the gross revenue generated by each sale.
• Draw Against Structure. It is applicable to newly hired sales personnel. The structure pays the new hires a specific or fixed commission monthly, regardless of whether the employee makes stellar sales. A “draw against structure” is helpful when onboarding new sales reps.
• Tiered Commission. The tiered commission structure best suits employers aiming to escalate sales performance by rewarding top-earning sales personnel.

#3. Profit-sharing

This variable pay program involves distributing a percentage of the company’s gross profits to the employees upon reaching the target sales or revenue for a specific period. Profit-sharing can either be paid in cash or stocks.

Employers typically pay profit-sharing incentives annually, and they do so only when the business is doing well financially.

#4. Differential Pay

Differential pay is the extra compensation given to hourly wage earners to make up for adjusting to changes demanded by their jobs. For instance, workers who take shifts at night become entitled to shift differential pay.

Differential compensation also applies when workers must be on duty during the holidays or are required to take extra shifts beyond the business’s regular operating hours due to a limited workforce.

#5. Bonus

It is a common incentive awarded to employees for exemplary work performance. Employees also receive bonuses when they help the business meet its set objectives and reach a certain number of years of service in the company.

The most common types of bonuses widely used by different companies include retention, project, and referral bonuses. A retention bonus is given as a loyalty incentive. Project bonuses are awarded upon the completion of a project or an undertaking.

Referral bonuses are awarded when the staff recommends a job applicant to fill vacant positions in the company. Sometimes, the referral bonus comes with a sign-on bonus when the applicant passes the hiring process and gets the job.

#6. Recognition Program

A recognition program is given in exchange for exceeding specific KPIs or achieving a particular milestone in the company.

Spot awards, employee appreciation events, gift cards, extra PTO, promotions, and opportunities for professional development are all examples of recognition programs.

Advantages of Variable Pay

There are specific advantages that make variable pay a must-have in every company’s employee acquisition and retention program.

These benefits are as follows:

• Increased earning potential. When businesses offer bonuses, performance-based salary increases, and other types of variable pay, they also allow employees to expand their earning potential. Knowing they can potentially raise their take-home pay through their hard work and perseverance, workers feel compelled to continue supporting the company in its endeavors.
• Growth and improvement. Performance incentives encourage workers to meet their target key performance metrics consistently. The more consistently they hit their goals, the more motivated they become to surpass their achievements every month, quarter, or year.
• Healthy competition. With an increased interest in career growth and improvement comes the development of healthy competition among colleagues. A healthy workplace competition can spark collaboration among co-workers and push employees to step outside their comfort zone and exceed company expectations.
• Emphasis on core objectives. Associating variable pay with meeting specific key metrics helps ensure employees stay focused and aligned with the company’s core objectives. In response, workers become more aware of their role in shaping the company’s success.
• Identifies areas for improvement. Since employers base variable pay on their employee’s deliverables, they also get the chance to look into specific factors in the workplace that may be affecting their performance. These factors may be a non-inclusive work environment, unhealthy working conditions, or a lack of communication among team members and their supervisors. Addressing these concerns helps create a workplace that’s more conducive to learning, improving, and building rapport.

Disadvantages of Variable Pay

While implementing a performance pay program is ideal for both employers and employees, it is only sometimes a smooth sailing journey for both parties.

Variable pay also comes with inevitable disadvantages, such as:

• Conflict among the staff. Employers must explain thoroughly how their incentive programs and variable compensation work. Otherwise, it could spark misunderstandings among employees. Managers and supervisors should exhibit objectivity in awarding bonuses and rewards to prevent favoritism and inequality in the workplace.
• Entails efficiency and consistency. Relying on bonuses and performance increases alone to retain employees and keep them motivated at work may only sometimes be the most appropriate action. Some employees may need help to remain consistent with their work achievements. Also, a company’s growth should not just be imposed on the workforce. The management has an integral role in securing higher revenue and stability for the business.
• Pressure and stress. Employees constantly pushed to meet the company’s variable pay expectations may suffer from burnout. While acknowledging and encouraging excellent work performance is paramount, it should not be done at the expense of the employee’s well-being.
• Unpredictable and unsustainable. Variable pay is heavily reliant on how well a business is doing. After all, it would be impossible to give bonuses and additional compensation while the industry struggles to boost sales and profit. Furthermore, the lack of a solid and clear plan for the company’s variable compensation program may make it challenging to implement and maintain.

Final Thoughts

A thriving business can be credited to happy and productive employees.

Whether employers give additional compensation, incentives, or one-time bonuses, practicing impartiality and establishing clear guidelines on how employees can qualify for variable pay is essential.

Doing so ensures fairness, consistency, and sustainability in implementing variable compensation.

Variable Pay FAQ

#1. Is variable pay taxable?

Variable pay is taxable, particularly when the IRS considers the reward or incentive taxable income. Employers should assess the possible bonus tax rates imposed on the type of variable pay they wish to offer and consult a tax professional to gain a better understanding of the different tax implications on performance pay.

#2. What is target variable pay?

Target variable pay refers to any short-term cash bonus or commission given to employees for meeting all the target performance metrics required in their position. The target variable compensation rates differ per company and industry.

#3. What is the difference between a bonus and an incentive?

The difference between a bonus and an incentive is that the former can be a one-time compensation to reinforce a specific employee's behavior or achievement positively. It does not have long-term implications.

Meanwhile, incentives are set and arranged in advance and are often given in alignment with long-term company objectives. Companies also give employees incentives alongside opportunities for career advancement or leadership roles.

#4. How do you calculate variable pay?

The general formula used to calculate variable pay is as follows:

Variable Pay = (Base Income) + (Performance Multiplier) X (Variable Performance Component)

The base income refers to the employee’s base pay, while the variable pay percentage is the criteria used to measure employee KPIs. The variable performance component is specific external factors, such as customer satisfaction surveys and revenue, directly affecting the worker’s performance.