I recently listened to a human resource manager restructure the compensation plan for a group of salespeople. “Sounds like I’m going to make less money next year,” someone said. I watched the two top salesmen dust off their invisible resumes. I’ve seen owners use everything from Apple watches to vacations in an attempt to improve sales performance. Many owners and sales managers feel that salespeople thrive under straight commission compensation plans. Most of this, however, is a combination of collective wisdom and “hey how do you pay your guys?” conversations. Over the last 30 years, however, a great deal of mathematical and behavioral economic analysis has contributed quantifiable recommendations as to which compensation plan most effectively improves a firm’s profitability while reducing the uncertainties and asymmetries influencing the effort.
I have read and relied heavily on a number of expert sources for this blog:
Salesforce Compensation Plans: An Agency Theoretic Perspective; Basu, Lal, Srinivisan
A Study of a Class of Simple Compensation Plans; Basu, Kalyanaram
Optimal Incentive Plans with Imperfect Information; Grossman
Salesforce Compensation: An Empirical Investigation of Factors Affecting the Use of Salary versus Incentive Compensation; John, Weitz
I recommend all of these for anyone interested in further research.
Compensation plans don’t exist in a vacuum. There are variables involved in developing a compensation plan that need to be considered:
- The selling environment is uncertain as is the salesperson’s effort.
- The salesperson may be accustomed to a given compensation plan and may be asked to switch from a previous to a current compensation.
- The salesperson is risk averse. Although many stereotype salespeople as having a high level of risk tolerance that typically isn’t the case–they value security and will stick to what works in the interest of avoiding risk, a lack of self-preservation, an economic change in their quality of life. Sales people are best characterized by “The Happy Loser” archetype as found in Clotaire Rapaille’s research.
- Sales is stochastic rather than deterministic profession.
Compensation plans must also account for various internal uncertainties effecting a salesperson’s effort. Marketing, for example, is an uncertainty. Is the firm’s marketing plan on-going, sporadic, promotional? Are competitive marketing efforts more robust? Does the firm allocate sufficient funds in order to generate consistent opportunities for salespeople? Do selling technicians impact opportunities? Is there a lack of transparency between the sales manager and the sales team? These and other variables should be considered as the compensation plan has a specific goal: Maximize a firm’s profit. Considering external and internal uncertainties, owners and managers then determine the compensation plan.
There are four fundamental types of compensation and incentive plans:
- Straight salary
- Straight commission
- Ala Carte: the salesperson is able to select his or her own type of compensation plan, typically reflective the salesperson’s risk tolerance (Gonik 1971)
Straight salary compensation plans are best applied when the selling effort involves a team. Straight salary compensation plans appeal to security oriented individuals rather than achievement oriented individuals. And while straight salary compensation plans are easy to administer there is a drawback. This type of compensation plan results in “the total inability on the owner or sales manager’s behalf to provide the strong motivation that induces high performance” (Basu 1985). I’ve worked with firms that relied on a straight salary commission plan. The salespeople were happy, the owner believed that every employee deserved stability, and that sales people would do the right things for these reasons. He was correct in his thinking on the first two outcomes. Less so on the final outcome–specifically pertaining to new business results.
Straight commission compensation plans are perceived to be fair. Over a period of time good performers are rewarded while poor performers are discouraged. But there are limitations to straight commission compensation plans in both B2B and B2C settings. Salespeople will be hesitant to spend much effort on opening new accounts, administrative duties or other activities perceived to be not financially rewarding (John, Weitz). In B2B selling this is evident in insufficient prospecting activities that are not viewed as a priority because they don’t reward the salesperson. In B2C selling this often results in poorly assembled job packets, a lack of customer follow-up, and lackluster reporting efforts on the part of the salesperson. Finally, straight commission plans are unstable. Market uncertainties, inconsistent marketing efforts, economic or seasonal shifts, and aggressive competitive tactics challenge risk-averse salespeople with financial uncertainties.
Contests are a form of compensation. Contests, games, and rewards are intended to raise a salesperson’s effort for a short period of time. Contests are also used among field teams for the same reason. Unfortunately this type of compensation has a flaw: the best salespeople typically win while the lesser salespeople fail to improve their effort or, worse yet, slacken their efforts.
Ala Carte compensation plans allow salespeople to select a compensation plan that satisfies their risk tolerance. Highly risk averse salespeople are likely select a salary while risk tolerant salespeople are likely to select a straight commission based compensation plan (Gonik 1971). I’d like to point out that this this conclusion preceded current Agency Theory research. I work with a company using this compensation model. It accomplishes the goal of meeting individual requirements. It does not result in a consistent effort across the sales team. This model also results in an element of unfairness as salary based salespeople are less impacted by market variables while maintaining an income while others are susceptible to inconsistencies.
In theory the compensation plan that best protects a firm’s profit is one in which a salesperson is guaranteed a salary only when the firm’s profit goal is met and a commission only when the firm’s goals are exceeded. If the goals are not met the salesperson does not receive any compensation (Grossman). In reality, however, there are obvious problems. Firm’s who are profitable some months and not profitable during others risk losing salespeople to competitive offers.
The compensation plan that is most accepted combines a salary and a commission. However, the salary and the commission rates must be based on a realistic assessment of the role that a salesperson plays in the sales cycle. Should the salary be higher or lower? Should the commission rate be higher or lower? Basu and Kalyanaram recommend the following considerations when determining a salary:
For example, a salesperson’s salary should be lower if their “personal skills in making sales” is “considerable” and the salary should be higher if their personal skills only slightly contribute to the sale. In the trades, a market in which product parity is widespread, the salesperson’s salary should be lower. If the salesperson’s product has a distinct advantage over competitive products then the salary should be higher and the commission should be lower. If there are important factors beyond the control of the salesperson’s influence then the salary should be “slight.” This is important in that revenue producers play a significant role in the firm’s net profitability. As well as determining the current salary level given the above variables, owners must also determine the correct commission levels.
Sliding scale commission rates are less effective that fixed rates (John, Weitz). Consider product mix, for example. Risk averse salespeople are more likely to sell less profitable projects despite the fact that their commissions increase with higher margin product sales. They reduce their effort accordingly (“something is better than nothing”). In turn, this makes it more difficult for the firm makes less money. In the trades we see this in a consistently imbalanced unitary mix. Sliding scale commission rates are also more difficult to administer. Fixed rate commissions based on net profit provide the truest compensation for effort.
Commissions based on gross profit are less effective than commissions based on net profit. This is particularly true in B2C sales. Gross profit commission plans relieve the salesperson from accountability regarding application errors, parts and material omissions, labor overage caused by hasty or poor planning. In other words, the salesperson is paid regardless of any intentional or unintentional oversights. Owners and sales managers then have to determine any deductions, communicate these deductions, and negatively impact the risk averse salesperson’s future effort.
Owners and sales managers should determine the appropriate salary level as well as a fixed commission rate based on net profit.
Risk averse salespeople want security and stability. Compensation plans must be easy to understand. I often ask salespeople how they are paid and I often hear: “I really couldn’t tell you.” The goal of a compensation plan is to maximize a firm’s profit given the salesperson’s effort. This effort is best ensured when the salesperson understands how he is paid and therefore how he should best exert himself.
Zig Ziglar was quoted as saying “Timid salespeople have skinny kids.” He’s only partially correct. Is the firm providing sufficient selling opportunities? Does the firm invest in training? Are market conditions uncertain? Does the firm respond to competitive adjustments proactively or reactively? Is the salesperson the right fit for the job? And if he is then is the compensation plan creating the right results? A firm’s sales compensation plan should maximize profit while reducing as much uncertainty as possible. Yet many owners and sales managers determine a compensation plan through arbitrary methods and then wonder why the team isn’t performing at or above expectations. Why won’t they sell more high-efficiency products? Why won’t they sell more accessories? Why does salesperson X always make layout related mistakes while salesperson Y acts like a project manager? Why won’t salespeople spend more time prospecting? Why do salespeople stick around for just enough time to find a better job? The mathematical and behavioral economics suggest that the right compensation plan will significantly reduce these uncertainties while extracting the right efforts from risk averse salespeople.