Optimizing fixed and variable compensation costs for employee productivity

Purpose – The purpose of this paper is to develop a conceptual framework to determine the optimal balance between fixed and variable compensation costs incurred by a firm. Design/methodology/approach – In 2004 Burke and Terry used an economic framework to demonstrate how variable pay can reduce operating leverage and hence increase a firm's value. Their theme is extended to develop a conceptual framework for ascertaining the optimal balance between fixed and variable pay components. Findings – As demonstrated with an example, the choice between fixed and variable pay affects the firm's employee productivity, operating leverage, market risk, cost of capital, and cash flows. The ultimate choice of the variable and fix compensation “mix” should meet the goal of management – maximizing the firm value, and hence the shareholders' wealth. Practical implications – Evidence suggests there is a growing use of variable pay schemes in firms to increase employee motivation and productivity. Originality/value – The framework allows a firm's cash flows to vary due to the changes in the variable pay component.