The Pay Plan Traps
Outside sales representatives are most distributors' most potent weapons in the battle for sales growth; however, they are also the most expensive. It's no exaggeration to say that your company's fate relies heavily on their performance. Considering the importance and cost of this sales force, it is no wonder that great efforts are made trying to improve its effectiveness through its pay plan.
Intuitively, attempting to influence sales representatives by modifying pay structures makes sense. Outside sales representatives are typically among the most highly compensated in the company and have most likely selected the profession for that reason. If the old adage, “sales reps are money motivated,” is true, changing how sales representatives earn their incomes should change their behavior and ultimately the results they achieve. The latest research has validated that restructuring sales compensation programs can have this effect, but only if certain prerequisites are in place.
The recently released study, “What's Your Plan? Smart Salesforce Compensation in Wholesale Distribution,” from the Distribution Research & Education Foundation (DREF), concludes that most companies fail to realize tangible benefits from redesigning their sales compensation programs because the basic foundation is missing. They attempt to implement a new plan with:
n Poorly defined or communicated objectives.
n Inadequate sales management.
n An imprecise approach.
Redesigning a sales compensation program without addressing these fundamental issues essentially guarantees failure.
Does this mean that, once the foundation is in place, the details of the plan don't matter? No. There are several common traps, some of them currently quite trendy, that can doom a pay plan to failure even after the fundamental management issues have been tackled. This article covers two such pitfalls.
TRAP 1: Managing Activities With The PlanMany companies become so frustrated with their sales force that they resort to paying directly for activities instead of results. These companies make the fundamental mistake of disconnecting the payouts with the revenues that fund them. There are ways to include activities into sales compensation programs but it must be done carefully.
A company needs to be sure that the revenues funding compensation, i.e., gross profit dollars, are tightly coupled to the performance factors that affect payouts. Generating quotes, performing demonstrations, filing reports, attending training courses, etc., may be very important, but if incentives or bonuses are paid for these without having some type of overall funding mechanism, there is no guarantee that the results produced by these activities will produce acceptable profit after payouts have been made.
One way of incorporating activity performance into a sales compensation program is to fund incentives through commissions or bonuses based on gross profit, but use activity performance factors to determine the payouts. For example, if your existing sales compensation program utilizes a commission, consider reducing the existing commission rate by 25% and channeling these funds to a quarterly bonus. Sales reps collect the bonus based on their activity performance. If the primary incentive mechanism for your sales force is a bonus, reducing above-quota payouts 50% unless additional objectives are achieved can also raise the importance of secondary objectives without jeopardizing profits.
Of course, you should implement any such changes to your pay plan with great care. To be effective, the new plan must be properly packaged and communicated to your sales force as a win/win proposition. It is not possible to over-communicate when you are dealing with people's income.
Using the pay plan to encourage specific activities is probably the biggest tip-off that inadequate sales management exists. The DREF study emphasizes that pay plans should be used to align the incentives of the sales reps with your company's objectives, not to micro-manage the sales force. In our experience, attempting to control behavior at this level through compensation is counterproductive.
It is the sales manager's responsibility to hold sales representatives accountable for doing what they said they were going to do. A sales manager and sales representative should jointly set goals for an upcoming period of time and develop action plans to achieve them. When that period is over, the manager and rep review how successful they were in achieving these goals. If such accountability does not exist in your organization, a new pay plan will not create it for you.
TRAP 2: Percentages Don't Keep The Lights OnThis may not be the first time you've heard this phrase, but many wholesale distributors get into trouble by favoring percentages over dollars in their sales compensation programs. Of course, gross profit dollars are not the only consideration; any company can easily increase gross profit all the way to bankruptcy by dropping a few points of margin. However, gross profit dollars can easily become the victim when trying to incorporate other factors by the use of percentages.
The most common percentage that finds its way into sales compensation programs is gross profit percent. Many companies use a tiered commission structure where the commission rate increases as gross profit percent increases to discourage sales representatives from cutting prices. This is a proven technique, but companies get into trouble by not modeling possible scenarios.
Let's say that a sale at 20% gross profit pays a 20% commission rate and that a sale at 25% gross profit pays a 25% commission rate.
Scenario Part I:
Now let's assume that a $1,000 sale is made at the 20% gross profit level. This would generate $200 of gross profit from which the rep would earn $40 ($1,000 X 20% X 20% = $40), leaving the company with $160 to pay the bills and generate some profit.
Scenario Part II:
Here's the scary part: using the same math but looking at a $700 sale at 25% gross profit, here's what happens. A gross profit of $175 is generated, which means the sales representative is paid $43.75 ($3.75 more than the previous sale), leaving the company with $131.25 to pay the bills ($28.75 less than the previous sale).
A sales representative earns more for selling less and generating less for the company.
Fundamentally, any percentage that finds its way into a sales compensation program outside of a commission rate should be considered suspect. Remember, a percentage consists of two numbers, a numerator and a denominator. Typically, when companies use a percentage as a factor in a sales compensation program, they intend for the numerator to increase, e.g., percent of business to new customers. However, it doesn't take sales representatives long to figure out that decreasing the denominator can just as easily improve the percentage.