Pay for Performance Variable pay plans can save you money--and your employees may prefer them.

When David Hayes offered employees the chance to take lower salaries in exchange for potentially higher bonuses based on performance, he wasn't sure how they'd take it. But when 75 percent of the eligible workers at Skyline Construction in San Francisco opted for the lowest salary combined with the highest bonus, Hayes had his answer. "It was incredibly well-received," says the 44-year-old founder and CEO. It helped Skyline, too: After two years, sales had climbed from $36 million to $71 million, while costs as a percentage of sales shrank. This year, the company projects sales of more than $100 million.

Pay for performance is a growing phenomenon, according to a Hewitt Associates study that found employee pay raises inching up an average of 3.8 percent in 2008, maintaining the tepid growth of the last few years. Bonuses based on performance, meanwhile, were set to hit a record high this year of 12 percent, as a percentage of payroll, up from 8.8 percent in 2003. Ninety percent of companies offer at least one broad-based variable pay plan, Hewitt found, up from 80 percent in 2006 and 51 percent in 1991.

Cash-strapped companies unable to afford big raises can use pay for performance to single out their most valuable workers so they can be recognized, rewarded, motivated and retained, explains Manny Avramidis, senior vice president of global human resources at the American Management Association. "It is truly a differentiator in tight times to recognize individuals and pay them a little more than the average. The attention goes a long way, and it's really a cheap way to show that you care."

If you don't do pay for performance correctly, however, it can work against you. Entrepreneurs must make sure they don't inadvertently reward employees for the wrong thing. For instance, if you base bonuses on annual sales, employees may push sales into this year at the expense of next year. "You run the risk that they're selling the future," Avramidis says. You may also alienate employees who feel their bonuses are endangered because other members aren't pulling their weight.

To avoid problems, make sure your plan fits your goals and that you carefully define performance. Team-based companies, for instance, should reward teams rather than individuals. To keep employees from selling the future, consider dual programs that reward for one-, two- or three-year periods. Monitor results and tweak plans as you go. Hayes spent most of the first two years modifying various details before he got big dividends.

Next, Hayes hopes to expand pay for performance beyond sales and project management employees to operations personnel. That will require new ways to measure performance, but he's anxious to get the rest of his 67 employees on a similar pay schedule. Says Hayes, "We're hoping to capture that same lightning in a bottle on the operational side."