Are you overpaying your sales staff?

March 22, 2011

Designing effective sales compensation is an art. When done well, it enables companies to develop the right mix of individual motivation and teamwork while balancing the needs for both short-term financial gain and long-term strategic positioning. When done poorly, however, companies can end up creating at best a culture of complacency and entitlement, and at worst a culture where sales representatives are working to maximize their own incomes to the detriment of the company.

Many providers of supply chain services, such as transportation brokers, customs brokers, freight forwarders, warehouse operators, third-party logistics companies, and carriers, compensate their sales force using approaches that are more suited to start-ups than to mature, established businesses. By using the best practices outlined in this article, these types of companies can maximize the return on their sales investments and become stronger competitors.

Article Figures

[Figure 1] A well-balance sales compensation plan Enlarge this image

Don't pay more for less work
Providers of supply chain services tend to approach incentive compensation from a simplified, "cost of sales" viewpoint. After determining how much they think they can afford to pay for the sale of a particular product or a service, they establish a straight-line commission plan—for example, 5 percent of margin for truckload brokerage or 0.5 percent of revenue for third-party logistics (3PL) services. They then pay that percentage for as long as the salesperson and the customer remain with the company.

This approach may work for start-up companies, but it quickly falls apart for high-growth or mature organizations that invest large amounts of money in marketing, advertising, customer service and support, technology, training, and other programs that build brand awareness and help to attract and retain customers. That's because the "cost of sales" approach fails to take into account the fact that these programs also have the effect of reducing the effort a sales representative must put forth to secure and retain customers. In fact, the contributions of other employees may have a greater impact on customer retention than those of the sales representative, who perhaps only gets involved with the customer when it's time to renew the contract.

For example, if a company starts by paying its sales staff 10 percent of revenue and continues this approach as the company grows, it could end up paying more than the market rate for similar positions. Furthermore, it will be compensating sales representatives at the same level for what is likely to be less work. As a result, the company risks creating a complacent sales force that does not bring in enough new customers.

Three best practices
To avoid developing a complacent sales force, companies need to shift from the start-up "cost of sales" mentality to a more mature "cost of labor" approach. To accomplish this, it's important to follow three best practices in sales compensation design:

Set the target total compensation (TTC) based on current market value
Match the pay mix to the sales role
Design pay elements to provide the right balance

To start then, companies need to determine the market value for each sales job. This ensures that they will be able to attract and retain top talent without overpaying or creating a disincentive for newclient acquisition. There are many market surveys available that can help you benchmark pay levels, but be sure to look at "actual total compensation" (or "target total compensation" if actual is not available) and not just salary to get the full picture for a sales job. Total compensation is important because the salary may be only 50 percent of the compensation package, and the portion that comes from incentive compensation (commonly called "sales commissions") can vary greatly from one company to another.

Similarly, benchmarking based on commission rates alone is a mistake. In the logistics industry, one company may pay a higher portion in salary and have a lower commission rate for a given product or service, while another company may offer a lower salary but a higher commission rate. Further, well-designed plans should have other variable elements besides commissions; for example, a commission rate based on margin may be offset by a bounty for new business acquisition.

Once you know the industry baseline, set the pay mix based on the nature of the selling role. "Pay mix" refers to the portion of target total compensation that comes from salary (fixed pay) versus incentives (variable pay). Not all selling roles in an organization should have the same pay mix. The more direct and personal control the sales representative has over the outcome of a sales call, the more compensation should come from variable pay (incentives) rather than from fixed pay (salary). When other factors, such as high brand awareness, low price, limited product availability from other sources, aggressive marketing promotions, or high switching costs weigh heavily in the customer's decision to buy (or keep buying), the salesperson is less directly and personally responsible for the revenue from the customer, therefore less compensation should come from variable pay and more should come from fixed pay.

Generally speaking, "hunters," or salespeople who focus on gaining new accounts, should have more variable pay than "farmers," or account managers who focus on maintaining and growing existing accounts. Most customer support roles have the least amount of variable pay of all.

After determining the right mix of variable and fixed pay, companies need to make sure the elements that determine incentive pay provide a balance between financial and strategic objectives, individual and team effort, and shortand long-term focus. An element is the combination of:

performance measure (the metrics used to judge performance; for example, revenue, number of new customers, or percentage of margin);
scope (the level of aggregation at which performance is measured, such as individual, team, region, or company);
performance period (what time horizon determines the start and end for sales credit);
pay frequency (how often incentives will be paid); and
mechanics (what mathematical formulas will be used to calculate pay).

Well-designed incentive plans like the example in Figure 1 include more than one measure of performance. The bestdesigned plans have three elements, but a case can be made for using two or four elements in some circumstances. Going beyond four makes it difficult for the sales representative to give adequate attention to all parts of the plan, and he or she may decide to focus only on those elements that will make the most money and ignore the rest.

By following these three best practices in sales compensation design, companies can maximize the return on their investments in what is likely a very large part of their selling, general, and administrative (SG&A) budget. Additionally, the right design can help companies position themselves for increased growth and improved strategic position relative to their competitors, whether they are competing for customers or for top sales representatives, or both.

Calculating sales compensation: What's the right formula?

The mechanics (mathematical formulas) used to calculate pay can be one of the trickiest parts of sales compensation design. The wrong mechanics can lead to payouts that are either too high or too low for the performance, or they can create a "phantom" base salary that leads to complacency. One of the keys to sound mechanics is to use a goal or performance expectation against which the payouts are calculated. A commission mechanic (where a percentage of revenue or margin is paid) is fine for many types of hunter (new-client acquisition) roles, but it should pay using a lower rate at below-target performance and a higher rate at above-target performance. It should also avoid creating an "annuity" whereby a representative can make a sale, hand over the account to someone else, and continue to generate income from that sale for years to come. Hunters need to be rewarded for hunting!

Be careful, too, of using a retroactive commission rate (where the higher rate applies back to the first sale), as this plan creates an inverse economic relationship for the additional amount of money that moved the salesperson up to the next compensation level—it costs the company more in incentive pay than it made from that additional sale. This type of mechanic can be highly motivational, but it may also lead to unethical behavior because it offers a disproportionately large additional reward for what could be very little effort.

A goal-based mechanic typically has a performance range in which some pay is earned below goal, but significantly more pay is earned above goal, at a ratio that is typically greater than 2:1. A goal-based approach is often appropriate for account managers or territory managers who have unequal opportunities. Using a goal allows the company to pay the same amount in incentive for the same level of effort, even if that effort does not lead to the same financial result. In supply chain service companies, a goal-based approach is often appropriate when some operations people have inherited large, contracted accounts but others are being asked to solicit and grow smaller accounts. In theory their roles are the same, but the level of effort required to produce the same amount of revenue or profit is very different. If you have different commission rates for different customers (house accounts, contracted accounts, new accounts, and so forth), it may be time to think about shifting to a goal-based approach.

In both the goal-based and the commission approaches, there comes a point where deceleration in the payout curve needs to happen in order to allow for windfalls or unforeseen circumstances where a rep could end up at 400 percent or more of the expected productivity level. Consider the cases where this could happen and plan accordingly. Avoid overall caps if at all possible, opting instead for a decelerated payout curve and perhaps a per-deal cap.

—Beth Carroll, The Cygnal Group

Beth Carroll, CCP, GRP, CSCP, is a principal with The Cygnal Group, a con-sulting firm that helps companies design, communicate, and manage their sales compensation plans.

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