Crooked thinking about straight commission plans

by Scott Benfield

In recent visits with senior distribution executives, we have encountered a bias toward straight commission compensation. Straight commission typically refers to a fixed or straight percentage of sales or margin dollars that compensate the sales effort.

For instance, 17 percent of margin dollars or 4 percent of sales are fixed percentages of territory margins or sales, respectively, that go to sellers. For example, if a territory yields $625,000 in margin dollars, the seller gets 17 percent or $106,250 in compensation. Depending on the plan, straight commission can specify that travel, entertainment and benefits are paid from the generated income.

The idea behind straight commission and why it’s attractive to sales managers and executives is the concept of assumed risk by the seller for all territorial activity. If the seller doesn’t perform, they get a small salary. If they perform well, they are paid well.

Distributors assume that the seller’s risk potential will drive the seller to higher levels of performance. Our work in sales compensation finds that straight commission plans and the idea that assumed risk drives performance are both errant and naïve. The balance of this article will explain our findings and how to move away from the crooked thinking about a straight commission structure.

Assumptions about assumed risk
In offering a straight commission plan, distributor management is under the assumption that the increased downside risk and upside gain induce the seller to work more effectively and efficiently to maximize personal income.

If sales tank, the seller receives little if any income, and the employer is not liable for the fixed cost of maintaining the seller during a down cycle.

But, when this is reviewed in practice, the assumption is not entirely valid. In a traditional sales territory, suppose the seller received a base salary and a commission. If the previously mentioned territory of $625,000 margin dollars paid a base salary of $75,000 and a commission of 5 percent of margin dollars ($31,250), the total income of $106,250 would be the same as the straight commission structure of 17 percent of margin dollars.

However, straight commission fans argue that, since there is not a protected base salary of $75,000; the seller assumes greater risk and is motivated to sell more because of greater downside risk and/or upside potential.

Suppose the territory declined in the following year to $325,000 margin dollars. The base salary and commission seller would get an income of $91,250 while the straight commissioned seller has an income of $55,200.

In both instances, we believe the seller would leave or get the pink slip. Barring an instance where the economy tanks, the huge decline in margin dollars is typically indicative of a loss of several large accounts and, if service and product quality are assumed competitive, the cause for decline is most likely sales related and there is little choice for the sales manager but to move the seller out of the territory.

If territories suffer a substantial decline, the result is that the seller is moved out of the territory and possibly from employment. Whether the compensation plan is straight commission or salary plus commission has little bearing on the outcome.

In a different scenario, suppose the territory increased to $825,000 margin dollars. The salary and commissioned seller would receive $116,250 while the straight commissioned seller would get $140, 250.

Again, straight commission fans argue that the increase in margin dollars is more likely because the perceived gain and assumed downside risk from the straight commission plan is greater.

But, in our research we find that the more weighted a compensation plan is toward margin dollars, the higher the risk is of several factors, including the following.

• Plans heavily weighted on margin dollars encourage account hoarding where the seller hoards many small accounts that often yield negative activity profits.

• Plans heavily weighted on margin dollars encourage price-cutting where the seller drives up volume and, hopefully, margin dollars. Price is a powerful short-term tool for volume gain and sellers often seek new accounts with price incentives. Many times the price-cutting does not cover the long-term service costs of the account.

In short, the straight commission plan pays out more for greater margin dollars and often drives up operating expenses faster than margin dollars.

The result for the distributor is double-hit to profits from both a higher payout to the seller and operating expenses that rise faster than the margin dollars. We have seldom found where straight commission plans have governance regarding account size and activity thresholds.1

In recent research of industrial and contractor distribution sellers, 42 percent said they had no account size minimums.2

In summation, the argument that straight commission plans yield different outcomes, to corporate earnings, when sales fall or rise is largely untrue. If the sales decline is substantial, the seller is demoted, moved to another position or released from employment. If the sales increase is substantial, the rise in operating expenses from hording small accounts or low margins from price cutting often drain profit dollars at a faster rate than margin dollars are added.

Territory design issues, fallacies of growth and anchor work
Experienced sellers have a market value and this value has to be funded. Assigning accounts that generate a minimum amount of margin dollars typically funds an experience seller’s cost.

Generally, we find that $500,000 margin dollars are a common target for developing a pool of accounts for the outside seller. The problem with the margin-dollar threshold is that is strictly formulaic. For example, if the seller costs $100,000, then the sales cost to margin dollars would be 20 percent. Furthermore, this ratio would be the guiding formula to structure new territories.

Unfortunately, formulas are generally used to drive the sales process. And, frequently, this has profit destroying consequences for the firm, including the following.

• Too many perennially active negative accounts are assigned to the seller.

• Accounts that have sporadic buying histories are assigned to the seller.

• There is no consideration of the service capabilities of the firm to support the seller, specialized needs of larger accounts, and alternate and less costly models of solicitation.

• No consideration of the seller skills and alternate sales roles and placing of sellers into positions that are outside of their skill set which decreases performance and increases turnover.

Numeric formulas for territorial design bypass the strategic sales processes of aligning sales skills with customer segments, using activity thresholds to increase productivity and matching product and service capabilities with chosen segments.

Numeric territorial design formulas that keep compensation at a fixed percentage of the firm’s margin dollars don’t substitute for strategic sales management and yet we find many companies think otherwise.

Straight commission proponents, because of their desire for a simple one-size-fits-all approach and monetary motivation bias, are typically the most egregious violators of a strategic sales management process.

Too many executives think they can simply change their compensation plan and their sales management job is largely done. Whether the compensation method is straight commission, salary and commission, or some other design, using total margin dollars as a singular driver of territory design and compensation frequently causes more problems that it solves.

A more strategic view of the marketplace that includes the capabilities of the firm, the seller, his capabilities, and the alignment of products and services with chosen market segments is needed.

Changing compensation in hopes of correcting market mix or solicitation cost issues is largely anchor work. The term, common to southern bass fishermen, describes the bass master who, when moving to a new spot, stripped down to his skivvies, dove to the bottom of the lake, and pushed the anchor back into the boat instead of pulling it up by the rope.

Compensation is at the anchor end of the marketing process. Market strategy including pricing, services, products and sales capabilities should precede compensation strategy and changes. As in anchor work, changing compensation may get the job done, but it starts at the wrong end of things to be very effective or efficient.

Further research on the “No Effect” of compensation plans
In 2003, a DREF research project entitled What’s Your Plan was released by Indian River Consulting.3 The research found no correlation between sales performance (measured in share of market) and differing compensation models. In essence, there was no effect from compensation on a firm’s market share. The compensation models reviewed included straight commission plans.

Furthermore, in our 2006 release Restructuring the Distribution Sales Effort4 , and after five years of research and redesign of distributor sales efforts, we cited spurious evidence that differing compensation plans had a prevailing effect on sales performance. Most of the evidence of one compensation choice over the other was anecdotal, having more to do with the comfort zone and wives’ tales of the existing sales culture.

Four years after the Indian River research and a year after the release of our work, we continue to fight the perceptions of distribution sellers and executives who believe compensation is a strategic advantage to sales and market performance.

In a recent visit to a significant player in the industrial markets, we came across sales and operations executives who believed that a simple change to a straight commission plan from a salary and commission plan would solve their growth issues. Our conversation with the executives uncovered that they had little outside information on growth markets, didn’t use segmentation for sales strategy and had no concept of account activity thresholds and capacity analyses.

Succinctly, these employees of significant experience were starting with a 20-year-old perspective of sales management and strategic growth. They believed in the power of compensation to correct the growth issues of the firm and showed little understanding of the complexities of growth and a modern-day market perspective that places product, service, and pricing strategies before selling and sales compensation.

Until distribution executives assume greater leadership in understanding the marketing mix of product, service, price and sales promotion along with sales strategies and compensation, the industry will continue to suffer from “compensensationalism” or the naïve and largely errant belief that differing compensation programs provide significant strategic and lasting advantage to growth.

Scott Benfield is a consultant to industrial manufacturers and distributors on channel issues. He is the author of four books and numerous research projects. He can be reached at (630)-428-9311 or at www.benfieldconsulting.com.

1 Activity threshold is defined as the annual revenue of an account where there is a 50 percent or greater probability the account will yield a negative activity profit. See Restructuring the Distribution Sales Effort, by Scott Benfield and Rich Vurva, page 48.

2 See “Salespeople rate their job satisfaction,” by Rich Vurva at www.progressivedistributor.com.

3 See What’s Your Plan?, DREF Publications, 2003, Indian River Consulting, at www.nawpubs.org

4 See Restructuring the Distribution Sales Effort, by Scott Benfield and Rich Vurva, Brown Books Publishing, 2006, at www.nawpubs.org and www.progressivedistributor.com

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