What is Variable Compensation?

As an HR leader, you already know that developing an effective compensation strategy is more than just setting salaries. It's about building a system that motivates your people, syncs with company goals, and helps attract and retain top talent.  

One of the most powerful tools in that system? Variable compensation. 

A solid and strategic variable compensation plan can elevate your total rewards strategy, drive performance, and provide flexibility to grow with your business. 

Let’s dive into this topic. Here are three key takeaways you’ll learn in this article: 

1. What variable compensation is 
2. Why it matters as part of your HR/People strategy 
3. How to build it into your pay structure 

What Is Variable Compensation? 

First off, what is variable compensation? In simple terms, it's any part of an employee's pay that's tied to performance, results, or specific achievements, rather than a guaranteed salary. 

It means that employees earn variable pay only when certain goals or outcomes are met, such as for hitting sales targets, achieving key performance indicators (KPIs), or contributing to overall company profitability 

Here are a few examples of variable compensation: 

• Performance bonuses 
• Sales commissions 
• Profit sharing arrangements 
• Incentive-based pay 
• Short-term or long-term incentive plans 

It differs from fixed pay or base salary, which is stable and predictable. On the flip side, variable compensation flexes depending on outcomes. It’s often used as a reward and a motivational tool, especially in roles where output and impact are measurable. 

Which Roles Typically Include Variable Compensation? 

Certain roles lend themselves more naturally to variable pay, such as: 

• Sales, which are often commission based on deals closed 
• Executives and leaders, where bonuses are tied to business performance 
• Customer success or account management, where incentives are tied to renewals or satisfaction scores 
• Operations or manufacturing, where bonuses are tied to efficiency or quality metrics 

With that said, any role can include variable pay. It just needs to make sense to do so and be designed thoughtfully. 

Why Companies Use Variable Compensation 

A well-designed variable compensation plan offers clear benefits for both employers and employees. Here’s why companies increasingly make it a key part of their overall strategy: 

1. Aligns Pay with Performance: Variable compensation directly connects employee rewards with the outcomes that matter most to the business. It aligns your pay strategy to support your goals. 
2. Motivates and Drives Productivity: When employees can clearly see how their efforts impact their paycheck, they’re more likely to stay engaged, motivated and work hard. 
3. Helps Control Costs: Instead of locking into high fixed salaries, organizations can reward performance after value is created, offering more flexibility in managing payroll expenses. 
4. Attracts and Retains High Performers: Top talent, especially in competitive markets, expects to be rewarded for strong and consistent performance. A solid variable compensation plan makes your organization more attractive. 

Types of Variable Compensation 

There are several ways to structure variable pay, and each type serves a different purpose. Here are the most common ways: 

• Individual Performance Bonuses: Tied to personal goals, KPIs, or objectives and key results (OKR), these bonuses recognize individual contributions and are often used in professional or leadership roles. 
• Team-Based Incentives: Ideal for collaborative or project-based environments, team bonuses reward collective achievements, cultivating shared accountability. 
• Sales Commissions: Commissions are classic examples of variable compensation. This approach is where employees earn a percentage of the revenue they generate. 
• Profit Sharing: These are company programs that distribute a portion of the organization’s profits to employees. They help connect every employee to the business’s overall success. 
• Short-Term vs. Long-Term Incentives: Short-term incentives might include quarterly or annual bonuses, while long-term incentives, such as stock options, are aimed at retention and aligning with long-term company growth. 

How Compensation Philosophy Shapes Your Variable Compensation Plan 

Before building or expanding your variable compensation plan, revisit your compensation philosophy, your organization's guiding principles around pay. 

Ask yourself: 

• Do we prioritize pay-for-performance? 
• How do we define fairness and transparency? 
• Are we communicating clearly and consistently about compensation? 

The answers will influence how you structure your plan. For instance, if pay equity is a core value, then you’ll want to make sure that your variable pay isn’t unintentionally rewarding only a few while leaving others behind. Transparency is also key, so employees should understand what they need to achieve, how their performance will be evaluated, when and how they’ll be rewarded. 

Integrating Variable Compensation into Your Pay Structure 

The next step is weaving variable pay into your overall compensation philosophy. Here’s how to do that thoughtfully and seamlessly: 

• Clarify Eligibility: Decide which roles qualify for variable pay and why. Not every role will, or should, include it. 
• Set Clear Targets: Ambiguity kills motivation! Make sure goals tied to variable pay are realistic, specific, and aligned with business priorities. 
• Balance Fixed and Variable Components: Structure compensation by role. For example: 

• • Sales roles might be 60% base, 40% variable 

• • Professional roles may lean more toward 80% base, 20% bonus 

• • Executives often have significant long-term incentive components 

• Use Job Families to Guide Strategy: Some roles, like sales or leadership, warrant a higher variable component. Others (like HR, finance, or legal) may rely more on fixed pay with more modest bonuses. 
• Benchmarking: Market data is a must when setting both fixed and variable pay. Benchmarking helps you stay competitive while avoiding internal problems like pay compression. 
• Avoid Internal Pay Inequities: You want your compensation to reflect experience, performance, and responsibility, not random variations. Benchmark variable pay alongside base pay to avoid pay compression and reward gaps. 
• Stay Competitive: Use industry and regional benchmarks to see what similar companies are offering, not just base salaries, but incentive opportunities as well. 
• Maintain Equity: Pay equity should extend to your variable compensation plan. Benchmarking helps identify and correct any disparities across teams, levels, or demographics. 

For more information on compensation benchmarking, download our Compensation Benchmarking eBook today.