Fixed Comp vs. Variable Comp and When to Use Each

Lars Lofgren Avatar
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Fixed comp, short for fixed compensation, is the set salary or hourly wage you give an employee. It stays the same unless you give the person a raise. 

Variable comp is compensation that changes from pay period to pay period. This could mean things like bonuses, commissions, tips, and profit sharing. Variable compensation is usually performance-based.

Both are considered direct compensation, payments that go directly to the employee.

Industries and departments all have established norms for what percentage of someone’s compensation should be direct or indirect.

Fixed Comp vs Variable Comp for Salaried Employees 

When you offer an employee a salaried position, you’re guaranteeing that you’ll pay them a set salary for each pay period. Like every two weeks. This is considered fixed compensation.

It’s also possible to have variable compensation as a salaried employee:

  • An annual bonus based on the subjective assessment of leadership.
  • A flat performance bonus if your entire team hits their annual goal.
  • Sales commissions based on the revenue they close in the month.
  • Profit sharing that goes out to employees.

For most salaried employees, the bulk of their compensation is fixed from their salary. But a few types of roles have a lower salary and a much higher variable compensation package. 

Most salaried employees expect the vast majority (80-90%) of their compensation to be fixed. Any variable compensation on top of this is a nice perk but folks don’t want to rely on it. 

Sales is the main exception for salary positions. Many sales roles will have a 50/50 split, or an even higher weighting towards their variable comp. This is expected and preferred for a lot of folks in sales. They want to make money and want a path that rewards them for working really hard.

Fixed Comp vs Variable Comp for Hourly Employees

Hourly employees are far more likely to depend more on variable comp than their salaried peers.

Tragically, the variable vs fixed compensation dynamic is used to take advantage of many hourly employees.

Federal law and many states allow tips to factor into the minimum wage. This allows businesses to pay an extremely low fixed compensation as long as tips can cover the gap and get the employee to the required minimum wage.

Employees who earn tips are the perfect example of this. 

In the United States, federal law says that employers only have to pay a fixed comp rate of $2.13 an hour if the person’s monthly tips make up the difference and equal the minimum wage of $7.25 an hour.

This is a… very low wage.

Many states have stricter laws for tips. In California, employers cannot use tips to make up the difference between a low, fixed hourly wage and the state minimum wage of $15.50. They must simply pay their employees $15.50. Any tips the employees receive is theirs to keep as variable pay on top of that fixed minimum wage rate. 

Other states don’t have these laws. Because of this, they default to that embarrassing federal minimum wage of $2.13 an hour for tipped employees.

It’s a way to take advantage of tipping norms.

Regardless of the state laws, I don’t personally believe this is the right thing to do. I’d much rather give folks a fair wage, incentivize performance, reduce turnover, and build a healthy long term business. But that’s me.

There’s also an entire category of borderline exploitative businesses offering sales roles while paying next to nothing for the hourly rate. During college, my long-term partner got a sales gig selling local advertising placements in a coupon book. The pay was atrocious. Even if you did fairly well, you were basically making minimum wage.

Since most folks making an hourly wage have less room for error, I’d make the case that using fixed compensation whenever possible is the right thing. Folks need dependable paychecks. Nothing wrong with offering variable compensation for extra upside, I’d just make sure folks have a dependable floor to their comp.

When to Use Fixed Compensation 

My recommendation: use fixed compensation whenever you can. There’s a few situations where people expect and want variable compensation (like Sales roles) but outside of that, most folks want steady compensation every month.

It’s also better for the employer, paying fixed salaries makes creating a payroll budget super easy.

I’ve managed a team of sales folks that had a large variable compensation package. Budgeting was always a huge gamble. I had to claim huge budgets to catch the outlier months and avoid shortfalls. But would come WAY under budget regularly. Actuals are all over the place. If I could have made the program work with a simple fixed compensation plan, I would have. My life would have been much simpler.

Besides, it’s no question that employees value their base pay more than anything else. And if you offer a competitive base salary or hourly rate plus other benefits like healthcare, tuition support, PTO, and paid holidays, you’re more likely to attract and retain good employees.

I have this belief that most employees don’t understand any of the complicated compensation options. Everything just gets lumped into two buckets:

  1. Annual total comp or the hourly rate.
  2. A rough subjective judgment of how good the benefits package is (vacation, holidays, health insurance, etc).

Better to keep things simple and find ways to improve your compensation package that truly moves the needle on one of those items.

When to Use Variable Compensation

While I greatly prefer to use fixed compensation whenever I can, I’m also careful not to go against entrenched norms.

The two easy examples are Sales and service industry roles. Most folks will walk if they can’t earn a bunch of money through a variable compensation plan. Same with service industry folks. They’re competitive and want the ability to win.

Occasionally, I’ll come across a case study of a business owner bucking trends by getting their sales time or service folks on fixed compensation. I’ve never seen it work in person. I’m not going to say it’s impossible but it is extremely rare.

So if industry has a norm around variable comp, I’d also use it.

Also keep in mind that your “variable compensation” quickly becomes the employee’s “fixed compensation.”

Take an annual subjective bonus for example.

Let’s say you have a range of $0-5,000 for each employee. Your compensation team meets each year and comes up with a number. Let’s also say that one employee, Jane, has gotten $2,000-3,000 each year for the past few years.

What do you think would happen if you only gave her $1,000? She’d be pissed.

Maybe her performance declined and the lower bonus is justified. That’ll be a tough conversation even if it’s a legitimate decision. My point is that employees quickly expect any compensation that they’ve received regularly. Outside of roles that rely heavily on variable compensation (like Sales and service industry roles), any variable comp will become an expectation. Employees will perceive it as fixed.

And nothing angers employees like taking away compensation.

So be careful. You might have variable comp but your employees could start to expect it.

Since it’s really easy for variable compensation to become an expectation, I only consider offering it in a few situations:

  1. Performance bonuses for specific events. Like if you’re trying to sell your business, giving your team a bonus to hit certain targets and keep the acquisition on track can work well. Same if you just acquired a business, connecting part of the purchase offer to performance metrics after the sale is widely used (assuming some of the team or the owners are staying on).
  2. Surprise bonuses after a tough period. I’ve used these a few times and they work really well. At one company, we had a really tough year, got through it, and gave everyone a few thousand dollars as a one-time bonus. Folks were so appreciative they were crying on the all-hands call.
  3. Surprise bonuses after record-setting periods. If your business has had an incredible run recently, you could share some of that upside as a one-time bonus to everyone. I like this a lot better than profit sharing, it’s way simpler to execute and won’t set any expectations on similar payouts in the future.

I’m sure there’s a few other specific situations that make sense. To get the full impact out of these bonuses, I follow these rules:

  • Keep variable bonuses extremely simple. One-time and flat amounts for everyone.
  • Avoid offering them annually. What gets offered regularly becomes an expectation.
  • Be careful about tying variable compensation to company metrics. What you incentivize, you WILL get. But the unexpected consequences can cause far more damage than you’d ever expect.

Review Fixed Compensation for Each Employee Annually 

One of the best parts about fixed compensation as a business owner is that once you agree on the amount with a new employee, you don’t have to revisit it. At least for a while.

I do strongly recommend that compensation gets reviewed on an annual basis. Or at the very least, every 2-3 years. This is called compensation management.

Even with a small company at 10 employees, compensation does get messed up after 4-5 years. Some of the best employees end up with below-market comp, others end up with comp that completely exceeds the market rate. Both can become serious issues.

The best way to handle this is to use a compensation benchmarking tool, then check market rates for your positions based on company size, industry, and region. This isn’t an exact science, but you are looking for major gaps so you can address them with employees sooner rather than later.

As you get deeper, you’ll run across compa-ratios. It’s just a quick ratio that compares an employee’s compensation to their market rate, telling you how close they are. I break down how to calculate and use compa-ratio here.

You’ll also want to get a compensation philosophy that tells your team how compensation gets increased. There’s only 3 options so pick the best one for your company. This makes the annual compensation reviews a LOT easier once you’ve decided how these decisions get made.

Official Sources That I Used 

Always a good idea to double check facts these days, these are the official resources I used:

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