Make it Your Business: Update your compensation program

Finally, there’s some optimism in the marketplace around the sustained traction the economy seems to be making lately. During the Great Recession, many business owners and sales managers modified the company sales compensation plan by shifting the bulk of payouts to commission, bonuses and incentives, rather than salary. If any sales people were added, it was not uncommon to make commission-only offers to job candidates or sign on independent sales reps—thus, further minimizing risk and financial burden of heavily-salaried employees. 

The Alexander Group’s 2003 Sales Compensation Trends Survey revealed that over 90 percent of sales organizations make revisions to or completely overhaul their sales compensation plan every year. In fact, the lifespan of any compensation plan is, at best, no more than one to three years. 

Perhaps, now is the optimum time for smart business owners and sales managers to evaluate the effectiveness of their current plan, develop and evaluate possible model changes, engineer new plan components and prepare a plan to “sell” the new plan to the sales force. Putting off a sales compensation-plan review usually results in a hastily-formulated, untested, poorly communicated plan which neither the sales team nor the support staff charged with the its administration will readily or favorably accept.

So, what are the favorable components of an effective sales-compensation plan? How can a business owner be reasonably certain the new plan will produce the desired top- and bottom-line results? While “one size definitely doesn’t fit all,” what follows are several design tips to assist you in developing a compensation plan that fits your business to a tee. 

First, a little quiz

Answer the following questions to help you decide if you need to tinker with your sales-compensation plan:

• Has it been over 18 months since you last made significant changes to the plan?

• Does the total compensation for your sales force cost you more than 25 percent of gross profit? (Note: Consult your last year-end Profit and Loss Statement. Gross profit is the difference between gross sales revenues and the cost of goods sold.)

• If the sales force costs you 25 percent or less, is the business still failing to achieve a satisfactory growth rate?

• Are you facing more significant competition today than before the Great Recession?

• Is there an inherent dichotomy between achievement of the business’s strategic goals and how much the sales force is rewarded? (Note: If your business does not have a written, published strategic plan, the answer to this question has to be “yes.”)

• Do you believe you may not have the right salespeople in place today to ensure your company continues to be successful over the next three to five years?

• Are you having a difficult time finding and hiring new salespeople who will contribute to the profitability of the business as quickly as you’d like?

If you answered “yes” to two or more of these questions, you would have reason to consider a revision to your plan. More than four answers in the affirmative would be an indication your sales compensation plan needs a major makeover.

The right components

If you are paying your salespeople a straight salary, you’re using an obsolete formula. Likewise, if you are compensating your sales employees on straight commission, you’re also using a formula that may not lead to sustained growth. The only justification for a straight-commission sales force is if they are all independent reps and not direct employees of the company.

Sales representatives are the business’s ambassadors to the marketplace. They are the collective face and voice of the company and its products and services. Everyday, they are on the front lines between you and your customers. The way salespeople conduct themselves in person and on the phone has a direct impact on how the marketplace perceives your business and is a reflection of the effectiveness of your sales-compensation plan. If your sales force is under-compensated relative to their peers in the industry, don’t be surprised if the reputation of your company is, well, less than stellar.

Base salary, commissions, bonuses and perks—company vehicle, Smartphone, expense budget and sales campaign prizes, to name a few—make up the bulk of a typical salesperson’s compensation package. And stock options to top sales people and managers are making a comeback these days.

Sales commissions, in incentive-based plans, usually account for 30 to 50 percent of a sales rep’s cash compensation and are typically based on sales revenue or gross profit margins. For example, if a sales rep’s base salary is $40,000 and he earns $17,250 in commissions, his commissions would be 30 percent of his total compensation. If another sales rep with the same base salary were to accumulate $40,000 in commissions, her total cash compensation would be made up of equal parts salary and commissions.

The right mix

Remembering that one size definitely doesn’t fit all, the ratio of base salary to commissions and bonuses for your business may not perfectly fit the above rule of thumb. A business owner should consider the sales environment and requirements when developing a sales-compensation formula. Here are some questions that may assist you in picking the right mix:

• Is the sales cycle—that is, the average length of time from first contact with a prospect to a signed agreement or first order—longer than six months?

• After a sale is made, will the salesperson need to dedicate a significant percentage of time revisiting and servicing the account?

• Is your overall gross profit margin significantly lower relative to the industry? (Note: Sign and digital graphics businesses typically command 30 to 60 percent gross margin.) 

• Did you hire your sales rep more for her technical knowledge and expertise than her ability to sell?

The more “yes” answers you gave yourself, the more your sales force’s compensation should be made up of salary. The combination of short sales cycles, selling highly profitable goods and services without the need for highly-developed technical skills to make one-time or once-a-year sales is a case for a mostly-commission compensation plan.

Remain in the ‘how’

The most important part of any compensation formula will be how your salespeople will be able to earn the largest commission. A poorly designed plan can have unintended results such as rewarding employees for the sale of new products that cannibalize more profitable ones.

Most effective compensation plans place no limits on what a salesperson can earn. Capping the size of commission checks will most certainly entice a sales rep to monkey around with the timing of closing business—suppressing orders until the same sale will net them a larger commission.

Before one starts fiddling with commission rates and ideas for bonuses, a smart business owner will first calculate the company’s current gross profit, the percent of that gross profit that represents the compensation to the sales force, and establish strategic goals for the next year. A good rule-of-thumb is the total sales compensation pot is equal to 25 to 35 percent of gross profit dollars.

Let’s play with some numbers. If the company collects $1 million in gross revenues and its cost of goods sold is $550,000, its gross profit is $450,000—a gross margin of 45 percent. If the total compensation to its sales force—salary, commissions, bonuses, incentive prizes and the like—is $130,000, the percent the sales team is costing the company is 28.9 percent.

Our fictitious company has one outside and two inside sales representatives that have been credited with $500,000, $300,000 and $200,000 in sales, respectively. For the sake of simplicity, let us say the profit generated from each of their sales is the same—45 percent gross margin. While attempting to forecast the next 12-month period’s sales, the business owner believes gross revenues can grow 20 percent to $1.2 million—one would say an ambitious but reachable goal. Still, each salesperson believes expanding their existing sales bases to $600,000, $360,000 and $240,000 is very doable.

Let’s be conservative for a moment and concede that to grow the business that much may require the company to offer more price incentives to customers and erode the gross margin slightly to 42 percent. Therefore, $1.2 million in sales will yield a gross profit of $504,000. And to motivate your sales team to reach its goal, you are willing to raise the percent the sales team is costing you to 30.9 percent—meaning the total sales compensation pot should hold $156,000.

Coincidentally, this translates to exactly 20 percent pay increase for your sales force—identical to the increase the company experiences in sales. Sounds like a fair deal for all, doesn’t it? Ah, but just because the available pot of compensation grows 20 percent doesn’t mean every sales rep’s pay will bulge that precise amount. The sales must materialize before the commission checks get cut.

The right formula

Sometimes just crunching a few numbers helps bring into perspective how you will dole out sales compensation. You need to know where you are at now, before you can figure out the direction you want to take the business.

All of this begins with a sound strategic plan with three to five goals for the company; for example, to more deeply penetrate a new market segment. But with each stated goal, be SMART: that is, be Specific, make sure it’s Measurable, require some Action to be taken, check to see that it’s Reachable and place a Time limit on achieving the goal.

Consider these tips as you review and revise your compensation plan:

• Expect to have a unique sales-compensation plan for each unique sales job. The one for outside sales may be different than the one for your inside sales reps.

• Keep the number of performance measures to three or fewer per plan.

• Set the pay mix for the job—salary vs. incentive opportunity—as a function of the degree of sales expertise. The more sales influence required, the greater the commission and bonus potential.

• Pay for results, not effort. If not every sales rep makes planned (and, subsequently, optimal compensation potential), don’t make adjustments to reward a “nice try.” It sets a dangerous precedent.

• Don’t be afraid to make mid-year adjustments to the plan as long as you communicate accurately why changes are needed and are working to provide fair and equitable quota allocation.

Good luck!