Rethinking Sales Compensation

Contrary to popular belief, gross profit dollars aren't the only metric for paying your salespeople

By Mike Emerson and Mike Marks, Contributing Editors -- Industrial Distribution, 8/1/2006

Here's a question for you: Suppose you have one sales rep who sold $2 million worth of product last year, and another who sold $1 million last year at the same profit margin. Who should have been paid more? If you said the one that sold $2 million, you're in the majority and may benefit by reading the rest of this article.

Many companies have strongly ingrained beliefs that a sales representative's compensation should be tied to the amount of gross profit that he or she generates. The logic is straightforward: The more money you bring to me, the more money I should pay you. The prominence of this mentality is illustrated by the fact that so many companies still use commissions in their sales compensation program.

Let's go back to the question posed above to illustrate the potential flaw with basing income strictly on territory size. Would the following change your opinion that the rep who generated $2 million in sales should be paid more?

• The rep who did $2 million was down $500,000 from the previous year, while the rep who did $1 million was up $300,000.

• The rep who did $1 million generated more than $200,000 in sales from new customers, while the rep who did $2 million generated none.

• The rep who did $1 million had the highest percentage of sales from products you have identified as strategic in your company, while the rep who did $2 million had the smallest percentage.

• The rep who generated $2 million is in a territory that has some of the biggest buyers of the products you sell in the country, while the rep who generated $1 million is in a somewhat rural territory.

Clearly, gross profit dollars are important. They're what we use to pay the bills and make a profit, but as the bullet points above illustrate, they may not be the only metric used to gauge true performance. Growth, types of products sold, and customer-base expansion, to name a few, are all relevant factors when measuring a sales representative's performance.

Ensuring that the key performance metrics you have for your sales reps are the ones incorporated into your sales compensation program is the key to an effective program. We call this alignment: where a decision a rep makes based on maximizing his income is the same one you would have him make based on what's best for your company.

Identifying the key performance factors for a sales representative is one thing, but structuring a compensation program around them that is fair and cost effective is another. Many companies that have incomes strongly tied to territory size realize that their sales compensation programs are misaligned, but are at a loss about how to restructure them.

In our experience, there are two approaches to addressing the issue that are predicated on how disruptive the misalignment is to the company's overall health. If a company is otherwise healthy, i.e., growing and profitable, it should consider modifying its existing commission program in an effort to minimize disruption. An effective modification approach is to incorporate a booster based on secondary factors to the existing commission program.

The booster approach takes the existing commission rate and reduces it, typically around 20 percent, creating a new base rate. For example, if you were paying a commission equal to 20 percent of GP, your new base commission rate would be 16 percent. This rate would be paid on all gross profit generated by a sales rep, with the exceptions that existed previously—i.e., past due accounts, low margin sales, etc.

However, using the booster approach, an opportunity exists to realize higher commission rates based on achievement of secondary objectives. For example, goals would be set for sales of specific product lines deemed strategic (we get large rebates or have significant inventory investments), a certain customer segment (those we're probably not calling on enough), and overall territory gross profit (incorporating some amount of growth).

The achievement of each of these objectives would add 2 percent to the base rate, for a total commission opportunity of 22 percent. In other words, if none of the three objectives are achieved, a rep would realize a 16 percent commission rate; if two objectives are achieved, a 20 percent commission rate would be realized; and if all three objectives are achieved, a 22 percent commission rate would be realized. An approach to ease adoption and effectiveness of this program is to initially set goals so that one is rather easy, one contains minor stretch, and one requires major but realistic stretch.

If a company is not growing and/or is unprofitable, more drastic actions should be considered, since trying to avoid disruption is probably an unaffordable luxury. In these circumstances, an exhaustive review of alternatives is warranted. These include completely abandoning the commission approach and moving to a salary and bonus option.

A salary and bonus approach has several positives. First, it decouples territory size from earnings. This allows for cost savings from the merging of territories, if necessary, and makes it much easier for focus to be placed on specific objectives that can be product and/or customer centric. Many companies that find themselves underperforming rarely need to do the same things better—they need to do better things. For this reason, focusing incentives on very narrowly defined objectives provides the shock the sales organization needs to reallocate their energy, time and activities. The nature of salary and bonus programs also allows a company the flexibility to set different objectives for different territories and change objectives on a quarterly or annual basis.

Regardless of what changes are made to the compensation program, it is important that sufficient modeling and clear communication take place. Sales reps are no different than anyone else when it comes to income—it's something that hits very close to home. Modeling reasonably possible scenarios will minimize the possibility that morale-debilitating adjustments be made shortly after implementation.

One-on-one communication of the new program with each rep, along with thorough documentation on the program and the rationale behind it, are also strongly recommended to ensure that all reps have a clear understanding of the new program as well as to address the inevitable rumors that will have circulated.