Raise vs. Bonus for Your Small Business Employees

Hiring and retaining top-tier talent is a key objective for business owners, and paying employees adequately is an important part of the recipe for success. Employees are the backbone of every small business. They are the face of the enterprise and directly influence its success or failure.

Evaluating the pros and cons of raises versus bonuses—and striking the right balance between the two—can help a business owner achieve staffing goals while also maintaining a healthy bottom line.

Understanding the Right Compensation Mix

Most people go to work to make money. From an employee's perspective, more is better. However, employers may not always be able to pay their employees more. As a result, many small business owners offer employee compensation packages that are made up of a mix of salary and periodic bonuses. This type of compensation package gives an owner the flexibility to reward employees when business conditions are good and adjust variable costs to reduce expenses when business conditions are tough.

Raises

Some companies give out across-the-board raises each year, with every employee receiving the same amount. The raise could be a set percentage based on the employee's pay. An annual raise helps employees plan and budget for their monthly expenses and keep up with the cost of living. Although there are many ways to motivate and retain a company's best employees, raises help boost employee morale and ensure that long-time employees are rewarded more than new hires.

A small percentage raise each year can be less costly than paying bonuses that may fluctuate with sales or production numbers. However, annual raises represent a permanent increase in the cost of doing business. Oftentimes, payroll is the largest expense for a company. As a result, it's important that business owners determine whether the company generates enough revenue and monthly cash flow to meet the increased payroll expenses.

Cash flow is the net amount of inflow and outflow of cash from a company and is reported on a cash flow statement. Business owners must include the increased salary expenses in their monthly budgets using their cash flow and revenue estimates. A cash-flow shortage could disrupt a business' day-to-day operations.

Companies with predictable and steadily rising profits might find it easier to issue raises than companies with periodic or seasonal earnings. Also, companies with variable costs and less-predictable revenues are typically more reluctant to impose a permanent increase in payroll expenses.

Bonuses

Bonuses can be more financially feasible for business owners to manage since they're a variable cost, with payment tied to sales or production volumes, for example. Bonuses incentivize employees to exhibit the behavior that a business needs to be successful, whether it's bringing in new clients, client retention, or improving cost controls. While pay raises typically reward longevity, bonuses are paid based on performance.

Since the compensation is variable, bonuses can be reduced or eliminated if business conditions make it difficult or impossible to fund them. The variable cost structure of a bonus package helps business owners during times of low sales or production volumes. Pay raises are permanent, but bonuses keep payroll costs lower when the revenue isn't there to pay them.

While the ability to minimize or avoid the expense of bonuses is attractive for business owners, it can be detrimental to staff morale. Employees rely on their income to pay bills and put food on the table. Large, unpredictable fluctuations can be disruptive and cause workers to seek employment elsewhere.

Because of this, employers need to communicate to staff members that the ability to reduce expenses when necessary not only helps the company save money but also avoids the need to make staff reductions when business temporarily slows. In a well-run business, cutting bonuses can save jobs.

How Big a Bonus and What Type?

A typical bonus payout structure is 3% to 5% of annual salary for clerical and support staff. Managers might receive payments in the low double-digit percentage range, and executives in the mid-double-digit range. Senior executives at the highest levels may receive the bulk of their compensation via bonus payments.

However, bonus-granting practices (and employee expectations) can vary widely from one industry to another. In some industries, a majority of employees may have access to bonuses, while in others they are reserved for a smaller group.

Bonuses can be structured to recognize individual merit or to reward collective success. Individual merit-based bonuses reward top-producing employees for their efforts.

Sales-based bonuses, for example, could be paid to employees who generate the most new business. Production-based bonuses could be structured for those who answer the most customer phone calls or produce the most widgets.

Also, bonuses can be set up as a short-term incentive, say, for a new directive or sales campaign. A three-month sales initiative to bring in new business or a business with seasonal production increases, for example, could be tied to a bonus system.

A bonus can also be based on the company's overall success. If the company hits its sales goals, profitability goals, or other defined metrics, all employees are rewarded. Under a company-based system, employees often receive a predetermined payment amount that is based on the collective achievements of the corporation rather than individual performance.

In short, bonuses can be part of an employee's ongoing compensation package or offered as one-time events to recognize significant milestones such as growth, profitability, or longevity.

Other Forms of Compensation 

While cash bonuses are likely the most familiar form of a bonus, there are other forms that may be worth considering. Companies can offer an ownership stake in the company, which can come in the form of a partnership offer in the firm, or through shares of stock. Smaller companies that cannot extend such offers could consider the creation of a profit-sharing plan that makes a discretionary payment toward employees' retirement savings.

There are also various unique employee offerings that can provide an incentive for team members. Possibilities include granting extra vacation days, awarding tickets to sports or cultural events, or giving movie passes or gift certificates. These small tokens of appreciation are available to even the smallest businesses at a reasonable cost.

What's the Financial Impact on the Business?

It's also important to consider the impact of bonuses and raises on a company's profit margins. A company's margin is the amount of profit generated as a percentage of sales. If, for example, a company has a margin of 35%, it means the company generates 35 cents for each dollar of sales. Business owners must analyze how a bonus versus a raise would impact their company's profit margin.

It can be helpful to backtest a raise or bonus incentive plan with a prior year's financial performance to gauge how much expenses would rise and impact profit margins. Of course, it's difficult to estimate the increased amount of sales that would have been generated had a bonus structure existed in prior years. However, applying a potential raise and bonus payout structure to prior years' sales and revenue figures should provide owners with a sense of the potential cash flow scenarios.

Since employees are at the heart of every business, rewarding them properly is critical to success—and to holding on to your best performers. Any compensation model should involve incentivizing employees and providing ongoing communication to ensure team members know their efforts are appreciated.

The Bottom Line

Giving a bonus can help a company retain an employee, but offering a permanent raise really shows them you care. If done at the right time, this can be the difference between an employee staying or leaving. Oftentimes, a small bonus can cost less than the investment required to hire and train a new employee, which is one reason why keeping the solid performers is paramount.