Throwing Away Money On Sales Compensation

September 9, 2010
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Which of the accounts below is better for the long term value of a wholesale firm?  
    Account A-Sales $1.2MM, Margins $350,000, GM% 29%  

    Account B-Sales $950,000, Margins $250,000, GM% 26%
 
The obvious answer is A. Right!? Anyone with any experience in wholesaling would know this. The answer is simple, isn’t it?  

Look again at the question. It asks about “long-term value.” What is long-term value? For all intents, it’s what the shareholders could sell the company for, because value has to be tangible and selling a distribution firm entails a view of the long-term financials. Additionally, the best sale prices are achieved by pretax earnings that are substantially above industry averages.   

Consider the following costs to serve the two accounts.  
    Account A=$414, 000  

    Account B=$210,000
 
Costs to serve are simply operating expenses allocated to the account. Why allocate operating expenses? We are talking about long-term value which, based on the allocations, gives Account A a net loss of ($64,000) and Account B a profit of $40,000. Hence the contribution of Account B to pretax earnings is positive while that of Account A is a big drag on earnings. In other words, Account B enhances long-term value while Account A destroys it.   

Consider if our wholesale firm compensated outside sellers on straight commission margin dollars to the tune of 15%. In this case, the seller for account A would get $52,500 while Account B would generate $37,500.  

Now the picture gets really interesting. If Account A loses $64,000, then why pay the outside seller $52,500 to call on the account? Similarly, if Account B earns $40,000, why pay the outside seller $37,500 to service the account? With both accounts, the outside seller earns income whether there is an operating loss on the account or more in compensation dollars than the firm earns in net profit on the account. But this is just an example and this really doesn’t happen in distribution – or does it?

What if I told you that it happens, on average, over 40% of the time!

That’s right, over 40% of sales territories fail to produce a contribution to operating profit, but sellers get paid on the margin dollars produced. Another 25% of accounts fail to produce a profit that is acceptable for the capital investment of the shareholders. The disconnect is in the way compensation programs work and how the firm makes profit.

Measuring vs. Counting

For most of its 100-year+ history, distributors have driven the profit in their firms by metrics and comparisons from the income statement. Gross margin dollars, gross margin percent, top line sales, and operating expenses are captured in time periods and benchmarked versus prior time periods. In many industry associations, PAR reports capture data from wholesaler members where the incoming data is disguised, aggregated and normalized. This allows distributors to further compare operating data.  

The problem with the comparisons is that they are based on counting and not measuring. In short, financial accounting compiles or counts transactions within time periods of months, quarters, years, etc. But counting is not measuring and, as in the preceding example, there are many instances where, with proper allocations, gains become losses.   

To drive long-term value, wholesalers should focus on earnings and what customers, transactions, sellers, and segments contribute to earnings. Financial accounting gives wholesalers insights into various expense categories and returns on assets. Assets are primarily inventory but financial accounting treats inventory sold to customers as the same and gives no insight into the operating profit contribution of a marketing or sales investment. Hence, a reasonable method is needed to allocate cost to expenses related to marketing and sales entities to understand how those entities contribute to operating profit. We have chosen transaction types to develop allocations as exhibited below for the accounts mentioned.

For an allocation methodology, we follow the rules suggested by Robert Kaplan of the Harvard Business School that the logic must be a single allocation method (baseline) logic and be consistent throughout the firm. The logic also must be understood and actionable by the firm.  Hence we use transaction types as methods of allocation.  

Our work is called Labor Differential Transaction Management (LDTM) and our findings, when allocating costs to accounts is that financial accounting metrics such as gross margin dollars and gross margin percents are crude means to drive profits and long-term value for the wholesale firm.

In the example above, the firm rewards the seller without any acceptable rewards, in the form of earnings, for the shareholders. Furthermore, we find than any substantial compensation on margin dollars has a very low correlation with earnings. Without allocating expenses to accounts on their costs to serve, wholesalers literally throw away profits on margin dollar rewards. In a thin operating margin business like wholesaling, the practice is madness.

Moving Toward Better Compensation and Profit Measures

After working with LDTM in the field for four years, our advice to wholesalers is to understand that any compensation plan for sellers and with a strong component of margin dollar rewards, is nearly as likely to decrease earnings as it is to increase them. It doesn’t matter if the compensation is salary and bonus, salary and commission, or straight commission; the use of margin dollars as a financial reward has nothing much to do with whether or not the margin dollars flow to earnings.  

Accounts consume operating expenses at different rates and this consumption is driven by the size of the individual transaction in margin dollars, the type of the transaction and its cost, and the mix of transactions. Wholesalers need to learn to link compensation to the ability of the individual account to contribute to operating profit. Without this understanding, wholesalers throw away profit and destroy long-term value in their compensation systems. Our advice based on our consulting work is for wholesaler leaders to consider the following steps to rectify this issue:
  • Develop a meaningful allocation method of operating expenses to customers and to understand their contributions to operating profit.

  • Use an allocation methodology that has a single full-firm logic, is understood in the lexicon of the industry and is actionable.

  • Thoroughly understand the allocations and methodology.

  • Reward sellers on their territories’ contribution to operating profit once costs to serve have been allocated.
 
Wholesaling is an industry that adds considerable value to the North American economy. Destroying this value by the use of period-based financial accounting measurements and their design into compensation systems is throwing away money in a historically thin margin environment and destroys long-term value.

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