How to Calculate Bonuses for Employees

How to Calculate Bonuses for Employees

Our team has been working hard this past year. We’re having conversations about what to give for bonuses or if we should give raises – or both. We know that not offering bonuses could be bad for morale. Still, we’re not sure what we can afford to give and stay profitable or even how to calculate dividends. How do we get it “just right” to reward our employees, keep the company good, and ensure that employees will keep up efficiency?

Thoughts of the Day: Bonuses are a great way to reward employees while also giving the company more flexibility as revenues and profits go up or down from one year to the next. You should do a reality check on salaries first before deciding on bonuses. Before deciding on the amount of bonus to give, check the trends on overhead payroll vs. revenue and COGS payroll vs. revenue ratios. The healthiest way to provide employee bonuses is to base the reward on overall company performance and profitability to get everyone on the same page. If you have a 401k plan, check on your policy – are bonuses included in matching funds. Use a budget to stay realistic.

Build a budget to see the overall picture of how things should play out.

Build a budget to see the overall picture of how things should play out. Include numbers for revenue, cost of goods sold, overhead expenses, and loan payments. You should also include investments in infrastructure, building cash reserves, paying taxes, rewarding shareholders, and rewarding employees. Make sure it all adds up so that you can pay employee bonuses and still have funds left over to grow and protect the business.

Your cash-on-hand position can change surprisingly quickly.

Set a goal for having enough cash in reserve to pay for three to six months of overhead expenses. It is crucial to ensure the company remains financially healthy, and savings is one way to do that.

Never pay bonuses out of guilt or fear. If you don’t have the money in reserve for emergencies, paying out dividends jeopardizes the company. If something goes wrong down the road and you can’t cover your bills, you also won’t make payroll. Be sure to explain that to anyone who doesn’t get it whenever you say you can’t afford bonuses.

If you have enough savings on hand, then start a bonus pool.

Make sure you put a portion of profits toward paying quarterly or year-end taxes. Put some profits into further increasing savings, some toward paying off the principal on any debt, and the remainder into an account you can use to pay shareholders and bonus employees.

If you’re unsure how company revenue and profits will trend from year to year, use bonuses instead of raises to reward people in good years. In down years, the business owner can lessen the financial burden on the company as they cut back or eliminate bonuses.

Consider Bonuses Instead of Raises for Employees

There’s a massive difference between raises and bonuses. If you’re unsure how company revenue and profits will trend from year to year, use bonuses instead of raises to reward people in good years. In down years, a business owner can lessen the financial burden on the company if you cut back or eliminate bonuses.

Employees expect to keep raising raises yearly, and taking away a raise means a demotion to most people. Taking away a raise also signals a business that’s fallen on hard times — neither of which might be the case. It may be that you’re simply tired of paying more than you have in the past for the same old results.

When was the last time you gave salary raises to your employees?

Check on each position’s salary before committing to a bonus strategy and amount per person. In low unemployment cycles, wages tend to rise. Make sure your wages are competitive. Do you see more turnover lately, and if so, is it due to people getting offers of better income and opportunities elsewhere? If so, it’s probably time to increase the amount of base salary you’re paying. Establish minimum, median, and maximum salary amounts and jobs, and rate employees as entry-level, qualified, or highly skilled for the job they’re assigned to do.

Ratios to look at before deciding how much bonus to give

Take a look at overhead payroll – overall company carrying costs. Compare overhead payroll without and with bonuses to revenue, gross profit, and net income. These ratios should all be holding steady or dropping. If the proportions are rising, figure out how to get more revenue and gross profit to cover rising overhead costs before throwing out bonuses.

Separate payroll for employees essential to your operations – doing the work of serving your customers. That’s the Cost of Good Sold payroll. Check on the ratio of COGS payroll compared to revenue. Is it trending up, down, or the same vs. last year? You want the percentage to be down or constant. If the ratio increases, productivity has to go up to justify increased salaries and bonuses. Consider investing in technology and process improvements to get the ratio down before throwing around significant bonus amounts.

Employee compensation tied to company profits is a great way to focus everyone on a common goal.

It’s not just executives or salespeople who need to be rewarded for higher-level output. Figuring out how to divide up profits can get complicated. Basing bonuses on a standard set of results, i.e., the company’s profit, helps focus employee attention on the company’s overall goals. Under these conditions, bonuses are above and beyond payments, given to some or all employees to achieve some specific purpose.

When it comes time to pay bonuses, you want a fair and equitable distribution method. It helps if you’re comfortable that what you distributed is somehow proportional to the benefit each individual provided to the company. The last thing you want is defending a bonus you can’t explain.

Set up a rating percentage for performance categories. Please consider how people perform their tasks and contribute to the company’s welfare throughout the year. Try rating employees on a scale from 1 (top performers) to 4 (poor performers). Give each group a percentage of the pool – with the most significant percent going to the 1’s. For example, imagine weight 1’s at 50%, 2’s at 35%, and 3’s at 15%. Consider not paying a bonus to anyone who’s at a 4 (poorest performer).

Teach employees that bonuses are tied to specific company goals to track and measure progress.

Employees may expect to see bonus payouts year after year if that’s been the historical precedent. The best bet is to teach employees that bonuses are not an entitlement but are awarded when good things such as profits happen to the company. It is usually best if bonuses’ funds are calculated based on some measurable outcome. Give the bonus participants a way to track progress toward the result to see how their efforts are having an impact.

You’ll need to create a method for scaling base pay. There are several ways to calculate this. Once you have both performance percentage and salary percentage for each individual, you can multiply them together by an individual. Add up all individuals to get a total ratio. Divide each individual’s share by the full rate, and that’s the portion of the bonus pool that an individual receives.

It may sound a little complicated, but it’s straightforward and fair. Spend a little time to rate each employee. Put the ratings and salaries into an excel spreadsheet. You’ll be able to calculate the amounts to pay each individual in no time.

What company metrics to track and reward employees with a bonus is up to you.

Think about what it is that you want your company to achieve. Increasing revenue and expanding profit are two of the most common objectives. Safety improvements, increased productivity, on-time delivery, keeping all positions fully staffed, and managing within budget. These are all things that that ultimately should contribute to profit enhancement.

Decide how increased revenue or improved performance will translate into additional profit that the company can use for employee bonuses.

Don’t plan to distribute all, or even most, of the increase in profits as bonuses. First, you’ll need to pay taxes on profits, add money to reserve funds to keep the company safe and pay down credit lines and loans. Only a portion of additional profits should go to an employee bonus plan, and the keyword here is “additional.” Ensure your program rewards increases in yield, output, and performance. Give people something to strive for. Don’t reward maintaining the status quo from previous years.

The next decision is who gets to participate in the bonus plan.

It’s common to pay top executives a bonus for improved performance. The other people in your company who may be used to compensation at risk are salespeople. Why not get everyone in the company focused on the same set of goals and use a bonus pool to reward the results you’re hoping your company can achieve.

It’s essential to let employees know how bonuses are calculated. For example, you can establish a single bonus pool and divide it based on everyone’s portion of the total salary. That rewards employees based on seniority and position within the company.

Make sure your compensation plans describe the practice correctly and include a clause that says people must be employed and in good standing to earn bonuses. Tie bonuses to overall company revenue growth and profit improvement to get everyone focused on the essential goals.

How to pay out employee bonuses

Consider dividing up bonuses into quarterly or monthly payments rather than hitting the bank account for a significant annual bonus distribution in one month. Shorten the linkage between actions, results, and rewards to make bonuses more meaningful.

You can payout of the bonus pool based on job performance — higher job performance ratings entitle people to a higher portion of the bonus pool. You can reward an entire department as a group or calculate rewards by an individual. The permutations are endless.

Bonuses can come in cash, gifts, travel, entertainment, or any other reward. When considering what form dividends should take, make sure it’s a form that employees will value. Generally, the lower the income, the more likely employees will appreciate cash. Keep in mind that any gifts or travel have to be included in the employee’s W-2, and they have to pay taxes on the benefit.

Check on your 401k plan policy. Are bonuses part of matching funds? If so, make sure to calculate that as part of your total bonus pool, and then work backward to the number of individual bonuses to be paid out.

Start small if you don’t have the funds for bonuses right now but still feel committed to making some gesture. The statement you make can still be meaningful. Take the time to express a heartfelt thank you. Be sincere and put energy into it.