There are many articles, case studies, blogs, videos and theories around motivation and reward system. When it comes to bonus system, it helps to think from two perspectives: equity and expectancy. They can be applied to understand the motivation oriented compensation. To reach a solid structure for a particular company, other factors like the history, recent events, and members also play a big part.
Equity PerspectiveOne way or another, individuals will compare their job inputs and outcomes with those of others and then respond to eliminate any inequities. People have strong psychological reactions to fairness in how they are paid and these need to be managed carefully. Given the uncertainty of bonus for each year, this psychological need is especially strong during the payout period. A effective bonus system can present enough degree of fairness and continue motivate even those who don't receive them. When not managed carefully, a bonus system can generate anger for the under-rewarded, guilt for the over-rewarded, and confusion across the organization, thus defeats the purpose of the bonus system as a motivation tool.
When inequity is perceived, the result can be damaging. Some will lower their input; some will change their outcome (e.g. increased units produced at lower quality); some will distort perception of self; some will distort perception of others; some will choose a different reference for comparison; and mostly commonly in silicon valley, some will leave the field or the company.
The key element here is an individual's perception of justice. While the differences of opinions make it hard to manage, the subjective element suggests that the most important piece is the perceived fairness of the process used to determine the distributed rewards. For employees to see a process as fair, they need to feel they have some control over the outcome and feel they were given an adequate explanation. It is important for the manages to be consistent, unbiased, make decision on accurate information and is open to appeals. This is why it is important for managers to provide early feedback as well as frequent feedback to detect inconsistency and gather more information base on the reaction from the employees. This interaction is more important in the case of bonus, because there is an implicit reset after each year. At the beginning of the year, the employees and the manager start the process again by providing the employee an opportunity to present his or her point of view about the desired outcome to decision makers.
Expectancy PerspectiveThe following picture illustrates the expectancy theory (source: Wharton MGMT 621 class material)
In practical term, employees will be motivated to exert a high level of effort when they believe that effort will lead to a good performance appraisal; that a good appraisal will lead to organizational rewards such as bonus, a salary increase, a promotion, or a public recognition; and that the reward will satisfy the employees personal goals.
This is particular applicable to bonus because of the one time nature of the rewarding system. The reward only applies to the past review period, thus giving managers and employees a common ground to repeat the motivation process on annual basis. Among others, bonus remains as a desired outcome for most employees because it is always extra money that is in proportion of the regular income. In this case, an effective manager will be able to build the shared connection between performance to outcome, and from effort to performance.
Performance to Outcome: While it is easy to define outcome (bonus rewards) and performance (annual appraisal), it is harder to build the connection from performance to outcome in an organization where there are different teams and roles. The perspective of equity mentioned above goes a long way to design a process that can be perceived as fair.
Effort to Performance: In the context of bonus system, the manager can set goal ahead of the time, and use it for performance appraisal. When the right goals are set, the employees can see a strong connection between their effort and the performance rating they will get. The most effective goals are difficult but not impossible, specific, and have to be accepted by the employee. Another way to describe the criteria of a good goal is SMART: specific, measurable, attainable, relevant, and time-bound. These criteria, especially time-bound, fit very well in the bonus system.