Bonus budgeting
/How to Budget for Bonuses
Some companies like to budget for bonuses that employees earn if they reach certain performance targets. This presents a budgeting conundrum – what if you budget for a bonus that does not occur, or you elect not to budget for a bonus that does occur? For example, if you budget for a bonus that does not occur, this creates a favorable compensation expense variance, since the company spent less than expected. However, not paying the bonus also meant that the employee to whom it would normally have been paid did not achieve his objectives, which presumably translated into reduced financial performance by the company. Thus, budgeting for a bonus can result in offsetting performance results. This is not an issue that has an easy solution.
How to Budget for a Bonus
How you choose to budget for a bonus may be impacted by the following factors:
Historical-basis bonus. If a bonus is essentially a roll-forward of the company’s performance from the preceding period into the budget period, the recipient of the bonus plan presumably only has to copy existing performance to achieve the bonus. In this case, the payment is probable, so you should budget for the bonus expense.
Attainable bonus. If the bonus is based on an improvement in the company’s present performance, you should base the decision to record the bonus on a qualitative estimate of how difficult it will be to attain the bonus. If it is more likely than not that the recipient of the bonus plan will be paid the bonus, then budget for the bonus expense.
Theoretically attainable bonus. If the bonus is only paid if one or more extremely difficult targets are met, then do not budget for the bonus expense. In these cases, the bonus is based on the achievement of targets that may only be theoretically possible, such as running a production facility at 100% of its capacity. Given the low probability of success, there is no reason to budget for the bonus expense.
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Example of Bonus Budgeting
Albatross Corporation has implemented a performance-based bonus plan for its sales managers. The bonus is tied to a 10% increase in total sales revenue compared to the previous year. If the sales target is met, each eligible manager will receive a $20,000 bonus. In order to budget for this budget plan, the company’s accountant follows these steps:
Step 1: Assessing Performance Improvement Likelihood
Last year’s total sales revenue was $10 million, so the 10% increase needed for bonus eligibility will require sales to reach $11 million. The current sales trend indicates a 7% increase at mid-year, with strong seasonal performance expected in the second half. Based on market conditions and historical trends, management estimates a 75% probability that the sales team will meet the target.
Step 2: Determining Bonus Expense
There are five eligible sales managers, so the total potential bonus payout is as follows:
Five sales managers × $20,000 = $100,000
Since there is a greater than 50% likelihood of meeting the goal, the accountant will budget for the bonus expense.
Step 3: Recording the Budgeted Bonus
The company decides to record 75% of the total potential bonus expense in the budget to reflect the likelihood of achieving the target. This results in the following budgeted bonus expense:
$100,000 × 75% = $75,000
If performance trends improve or decline, the budgeted amount may be adjusted accordingly.
Bonus Budgeting Alternatives
There are several ways to budget for bonuses. Consider using one of these options:
Budget the most likely outcome. If there are several possible payouts under a bonus plan, then budget for the amount that is more likely than not to be attained. An alternative is to calculate the most likely payout based on probabilities, and add this expected bonus amount to the budget. However, be aware that doing so means that the actual bonus payment will never match the exact amount budgeted.
Restructure the bonus plan. Restructure the bonus plan itself, so that the bonus is paid on a sliding scale, rather than as a binary (yes or no) solution. This means that the bonus payment is set at a specific percentage of the goal, such as two percent of sales or three percent of net profits – no matter what the total amount of sales or profits may be. Further, try to avoid imposing an upper boundary on the amount paid. Instead, the bonus is a simple percentage of the goal. By doing so, you budget for the amount of bonus that matches the goals listed in the budget. If the employee responsible for the goal achieves the target amount, then the budgeted bonus amount is paid. If the employee achieves a slightly lower amount, then he is paid a slightly lower bonus.
Update the budget. Constantly update the budget with new iterations. By doing so, the most likely probability of bonus achievement can be included in the most recent version of the budget.