5 Steps to Creating a Merit Matrix


Most companies today are actively working to develop a pay-for-performance culture. As an HR Professional, how can you position yourself as a strategic partner to your executive team and help them achieve this goal? One way is through use of a merit matrix.

A merit matrix is a two-factored table created by HR Departments to help managers equitably allocate raises across their employee population. It provides a framework for managers and guides them through the merit increase decision-making process. To develop one, follow the five steps below.

Step 1: Anticipate the distribution of employees across the matrix

The two factors most commonly used in a merit matrix are performance and position-in-range. Performance rating options are plotted along the vertical side of the matrix and the position-in-range options along the horizontal side.

Examine the potential performance ratings (in our example, we’ll use ratings 1 through 5) and estimate the percentage of employees you believe will receive each type of rating. What should guide your estimation? Consider evaluating previous years’ distributions to see if there is a pattern/trend that you can lean on to make your best guess. You could also get the estimate directly from managers, based on how they think their employees are going to perform in the coming year. Alternatively, you could wait until you’ve received all the performance evaluation scores from your managers, as that will tell you the actual distribution.

Once you’ve determined your performance distribution, enter the percentage of employees alongside each rating category. Next, look at the current distribution of employees across your pay ranges. You can do this either in thirds (bottom third, middle third, top third) or in quartiles (first quartile, second quartile, third quartile, fourth quartile). Whichever way you choose, once you have the range distribution, enter the percentage of employees that fall into each position-in-range category.Double check your math – add up the percentages across the top and down the side to ensure they equal 100%!

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 (15%)
4 (40%)
3 (35%)
2 (10%)
1 (0%)

 

Step 2: Determine the mean performance rating

To calculate the mean performance rating, multiply each rating by the percentage of employees you anticipate are going to receive that rating. In the example above, we are anticipating that 15% of employees with receive a rating of 5. The calculation would be .15 x 5 = .75. Repeat that calculation for all categories and then add the results together. This will give you the mean performance rating, which in our example is 3.60.

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 x .15 = .75
4 x .40 = 1.60
3 x .35 = 1.05
2 x .10 = .20
1 x .00 = .00
TOTAL: 3.60

 

Step 3: Build the matrix

The vertical column includes your performance rating categories along with your assumptions about what type of rating employees are likely to receive. The horizontal row includes where employees are falling in their range. Now, consider your budget and the mean performance rating.

Budget = 3.0%
Mean Rating = 3.60

Use your mean rating as a guide and find the cell that aligns with the rating and the most employees in that area of the range. In our example, 65% of employees are in the middle third of their range, so we are going to choose a cell in the column. The mean rating, however, is not quite as cut and dry – the rating is more than three and a little less than four, so which cell should we use?

This is the art piece of compensation – use your best judgment considering where most employees fall relative to their range and where most employees fall regarding performance. Enter your budget (3.0%) in the cell you choose – in our case, we selected cell 4/Middle Third.

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 (15%)
4 (40%) 3.0
3 (35%)
2 (10%)
1 (0%)

 

Once you’ve determined where to place your starting budget, add percentage to every cell in the matrix. How do you decide what amount to allocate in each cell? Again, this is the creative side of compensation. Consider how aggressively your company wishes to reward performance – you may decide to put higher increases in cells lining up to ratings 4 and 5, focusing less on the position in range for those performance ratings. Work your way out from you first cell (both vertically and horizontally). In this case, we chose not to allocate increases to any employee who receives a 1 (unsatisfactory) rating or to an employee who needs improvement and is in the top third of their range. 

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 (15%) 6.0 5.0 3.5
4 (40%) 4.0 3.0 2.5
3 (35%) 3.5 2.5 2.0
2 (10%) 2.0 1.5 0.0
1 (0%) 0.0 0.0 0.0

 

Step 4: What’s the cost?

About this time you’re probably thinking, how do I know if I’m staying on track with my budget if I’m “arbitrarily” choosing percentages for each cell? In this next step you will need to calculate the cell contribution payout to determine if the percentages you selected – the art part – are affordable per the budget.

To calculate the cell contribution payout, multiply the percentage of employees estimated to receive the performance rating by the percentage of employees in each position-in-range and by the projected increase amount. The formula should look something like this: Percentage in each Rating x Percentage in each Position-in-Range x Projected Increase.

So, for cell 4/Bottom Third, the calculation would be .40 x .20 x 4.0 = .32

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 (15%) 6.0 5.0 3.5
4 (40%) 4.0 (.32) 3.0 2.5
3 (35%) 3.5 2.5 2.0
2 (10%) 2.0 1.5 0.0
1 (0%) 0.0 0.0 0.0

 

Repeat this calculation for all cells in the matrix. Once finished, add together the cells in each row, then add all five rows together. Your results should look like this:

Position-in-range
Ratings Bottom Third (20%) Middle Third (65%) Top Third (15%)
5 (15%) 6.0 (.18) 5.0 (.49) 3.5 (.08) .75
4 (40%) 4.0 (.32) 3.0 (.78) 2.5 (.15) 1.25
3 (35%) 3.5 (.25) 2.5 (.57) 2.0 (.11) .92
2 (10%) 2.0 (.04) 1.5 (.10) 0.0 (0) .14
1 (0%) 0.0 (0) 0.0 (0) 0.0 (0) .00
3.05%

 

Step 5: Revise (if necessary)

The matrix, as it is currently built, is going to give us a merit budget of 3.05%. Depending on the size of your payroll, this could be close enough to the budget to get approval from your CFO. However, if your company has a billion dollar payroll, then that extra .05% is going to make a big difference in cost. When that is the case, you will need to go back and revise some of the percentage increase amounts to bring you in at, or below, budget.

If the projected merit budget is larger than the actual merit budget, then you will need to decrease some of your percentages in the matrix. If the projected merit budget is smaller than your actual merit budget, then you may want to increase some of the percentages in your matrix.

Other Considerations:

The above merit matrix assumes that all employees are paid in range. If you are implementing a new or revised compensation plan, it is likely you will have some employees that are paid above and below range. If the company’s plan is to increase all employees who are paid below range to at least the range minimum, then that may take up a large chunk of your budget, leaving less available for merit increases. Some savings could be achieved if your eliminate raises for employees who are at or above the maximum of their range.

When might you NOT want to use a Merit Matrix?

1) Poor/No Performance Evaluation Process: In order to appropriate link pay and performance, you have to do performance management well. If your company’s performance evaluation process is broken or non-existent, then creating a merit matrix may be a misguided endeavor. If your goal is to move toward pay for performance, then your first task should be to formalize your performance management practices. Make sure the goals set for employees are clear, actionable, and easily measured. Calibrate with managers to ensure there is consistency in how employees are rated (is a performance rating of 3 meeting expectations or exceeding expectations?).  Create timelines around when performance evaluations take place and when results are due to HR.

2) A Complicated Rating System: Alternatively, sometimes more isn’t necessarily better. Let’s say your company has a robust performance management process in which employees are rated on series of categories/metrics and their overall score is an average of all scores in each category, usually carried out two decimal places (i.e. an overall rating of 3.78). So if you have a rating scale of 1.00 to 5.00, that means there are over 400 possible numerical ratings an employee could receive. Talk about a challenging merit matrix! Even more importantly, your already stretched budget is going to be further diluted due to the sheer number of cells in the matrix. If you have such an evaluation process in place and want to incorporate use of a merit matrix, try bucketing your ratings into broader categories – for example, ratings from 4.01 to 5.00 are equivalent to “exceeding expectations.”

As with any HR project, creation of a merit matrix should be customized to your company’s budget and compensation philosophy. When done well, providing this type of information to managers and executives can enhance the perception of HR as a strategic contributor to the mission of the company. For managers, you are providing guidance on how to best use their budget and retain their top performers. For the leadership team, you are demonstrating ways in which the company can control cost while keeping consistent with the message of paying for performance.

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2 Comments on "5 Steps to Creating a Merit Matrix"

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Abdrabah
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superb job

Ravi Shankar
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Very useful in having budgets and mapping of the resources based upon merit rating.

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