All pay plans are not created equal

Compensation programs that balance individual goals and company goals are more effective than simple margin plans.

by Scott Benfield

Some years ago during a downward business cycle, a large distributor asked our help to determine why profits were dropping much faster than the rate of the downturn. We surmised that part of the problem was that the distributor had not shed overcapacity. This was not the case, however. The company did a good job of getting rid of overcapacity without hurting customer service. Still, the firm was headed into the red, and our investigation found that margin percent was decreasing faster than the rate of decline for the overall economy.

The culprit was a compensation system that paid salespeople approximately 40% of total compensation on margin dollars. The compensation plan paid a higher percentage on territory margin dollars above the prior year, plus salespeople controlled price. Since sales in the prior year were robust, salespeople simply cut price in a down cycle to drive margin dollars above the prior year and earn their bonus.

A margin dollar or sales-only compensation system in a sharp or prolonged downward cycle can create profit misery. For instance, suppose fictional distributor Boudreaux Supply paid salespeople a base salary of $50,000 and 7% of margin dollars for sales below the prior year’s margin dollars, and 8% on sales above the prior year. Compensation on a $400,000 territory baseline would fluctuate with the business cycle.

Attention distributors! Maximize your sales force’s productivity. The new book Restructuring the Distribution Sales Effort for Maximum Productivity, from distribution industry consultant Scott Benfield and Progressive Distributor editor Rich Vurva is available now. Did you know that inside and outside sales forces are 30% to 40% of the typical distributor’s operating expenses? To learn more about this important book, click here.

If the business cycle spikes by 10% in a year, the territory would increase $40,000 and yield a bonus of $35,200 (.08 x $440,000). If business declined 10%, the bonus would decline significantly (7% of $360,000 would generate a $25,200 bonus). The $10,000 net difference is probably not indicative of the salesperson’s efforts.

Peaks and troughs in a business cycle make it problematic to understand if a salesperson is actually affecting their territory growth. The cycle also whipsaws at-risk compensation for salespeople and creates an environment where they’re less sure of their long-term effect on sales.

Some sales managers try to time or predict the cycle and lower at-risk compensation during peaks and increase it in troughs. In the previous example, one way to do this would be to decrease the margin base to $360,000 in the trough and increase it to $440,000 in the peak.

Timing the cycle is risky. Your timing could be off and you could create more of a problem. Or, you could make so many changes to salary and bonus that you confuse and/or demoralize your salespeople.

If you insist on rewarding salespeople on top-line sales or margin dollars only, we suggest you smooth out business cycle fluctuations with a moving average territory goal. For instance, if the Boudreaux salesperson has a three-year territory margin history of $360,000 in year one, $400,000 in year two and $440,000 in year three, the territory’s three-year average is $400,000, which would be the margin goal used in the next year’s compensation. If the territory yielded $425,000 margin in year four, the bonus would total $34,000. Some distributors assign higher weights for more recent years because they are more indicative of the current business environment. We recommend that sales managers not try to time the cycle with compensation changes. The cycle is notoriously difficult to predict. With margin dollar and/or sales dollar compensation, especially with progressive payouts, smooth out the territory threshold with a three to five-year average.

The need for balance
Reward-based compensation plans dominate distribution. Any plan that attempts to drive performance with a single metric is, by definition, unbalanced. Balancing is crucial for controlling behavior and aligning a company’s varying goals. Compensation that pays on margin dollars or top-line sales are largely unbalanced reward plans. They reward salespeople but often cause problems that dampen sales efforts because they have no checks and balances in their design. Examples of unbalanced compensation plans include:

• Plans that reward on margin dollars with loose control on service promises. The unbalanced result: Salespeople give services away, make their bonus, and the firm is left with low profits from excessive operating expenses.

• Plans that reward ontop-line sales or margin dollars without attention to pricing. The unbalanced result: Weak salespeople cut price to reach sales or margin dollar goals. The firm, as a whole, is left with poor profits and well-paid salespeople.

Balanced compensation plans can help control and mitigate undesirable or profit-destructive behavior. The following is a brief look at two balanced compensation models excerpted from the book “Restructuring the Distribution Sales Effort for Maximum Productivity” by Scott Benfield and Rich Vurva.

The Margin Matrix Model
A typical problem with gross margin plans is giving control of pricing and margin percent to salespeople. During down cycles, weak salespeople lower price to drive volume above prior year margin targets. For example, suppose a Boudreaux salesperson has a prior year margin dollar territory of $400,000 at a 21% gross margin. The plan pays 7% of margin dollars under $400,000, and 8% on margin dollar sales above $400,000. The salesperson is motivated to drive total margin above the margin goal. If sales fall 5% and the margin remains constant, the total margin would fall 5% also. However, margins can decrease faster than the rate of the top-line sales decline. With a 5% sales decline, it would be reasonable to expect the margin percent to decrease close to the rate of decline. In our example, the percent would fall to around 20% of sales (21% x .95). Our work finds that the rate of margin percent decline in unbalanced plans typically doubles the top-line sales decline. If sales decline 5%, the gross margin percent will likely decline 10%. When the business cycle improves and sales rise, the margin will only rise to around half of the previous decline.

The Margin Matrix Model balances territory margin dollars with territory margin percent (see Exhibit 1). In the exhibit, the territory yielded $400,000 margin at 18%. The following year, if the salesperson sold $475,000 in margin at 22%, he or she would earn total compensation of $60,000, including a bonus of $20,000 (1.5 x $40,000 = $60,000). The intersection of the x- and y-axes determines the salary for the year which, when subtracted from the base, yields the bonus payout. Note that the payout factors can increase even though total margin dollars can remain the same. For instance, if our salesperson sold $400,000 at 18% gross margin, the individual would earn no payout. However, if the margin percent rose to 26%, the salesperson would receive a payout of 1.4, or $56,000.

Most managers have trouble with this as they continue to think in a one-dimensional world of margin dollars that drive earnings. Our experience with activity profits in sales territories finds that margin percent has a two to three times higher correlation in determining higher earnings and higher activity profits than total margin dollars. In essence, a higher margin percent means the firm will receive higher operating profit and higher earnings. Why? Simply put, a higher margin percent on sales is indicative of a firm where salespeople do not give away services to consummate the sale and operations run smoothly because services are streamlined and aligned with segment dynamics.

The Margin Matrix Model can reward a higher payout for higher margin percentages because the effect on operating income exceeds the higher bonus payout.

The Margin Matrix Model is a simple yet effective way to balance margin growth with margin percent preservation. In designing a Margin Matrix Model for your sales force, consider the following:

• Review the sales history of your firm and the fluctuations of margin dollars. If you have a highly fluctuating year-to-year history of territory dollars, the plan is not advisable.

• Consider giving a column/row or two to sales below the prior year. In our example, Boudreaux may start the first row at 17% GM and $375,000 in margin dollars.

• Work with salespeople to find ways to increase margin percent, including limiting services, charging for specialized services, and increasing prices on slow-moving items.

Piece of the Territory Model
In many industries, selling costs are high and salesperson discretion on billing services has a large impact on profitability. In these situations, it is prudent to put the cost of sales and cost of select services against the generated margin dollars. This gives the salesperson incentive to manage expenses and billings because they directly impact his or her income.

We have used the Piece of the Territory Model with distributors in industries with high travel costs and high discretionary service costs. Exhibit 2 illustrates a territory that generates $500,000 in margin. Expenses include the base salary, benefits, a car, and travel and entertainment totaling $88,000. Unrecovered freight totals $25,000.

The salesperson decides whether to bill freight, and unrecovered freight is also placed against the margin dollars. Bonus determination is performed after deducting salary, expenses and unrecovered freight, which, in this example, totals $113,000.

Multiplying the resulting margin dollar pool of $387,000 by 4% determines the bonus of $15,500. In short, the salesperson earns a predetermined percentage “piece of the territory” after deducting key expenses.

In the Piece of Territory Model, salespeople have a clear understanding of how their expenses and service decisions impact their income. We have used the Piece of Territory Model in large territories with expensive travel costs, at large accounts with expensive entertainment costs, for manufacturer rep/distributor sales forces and industries with large freight expenses including bulk chemicals, PVF, fabricated and structural steel, and building supplies. It is much easier for salespeople to drive up expenses if the expenses do not directly impact them. In this model, management reviews the expenses at the beginning of the year, and encourages salespeople to manage them to maximize their bonus while continuing to serve the customer.

The Piece of Territory Model can drive higher gross margins by increasing the bonus percent with higher margin dollar attainment. Plus, the model balances the need to manage expenses with the desire to increase margin dollars. The model is also good for highly motivated salespeople since there is no cap on compensation after deducting expenses.

The right mix
One final subject to consider is the mix of variable compensation to base salary. In some instances, it is appropriate to have a high percentage of compensation at risk. In other circumstances, it is more appropriate to have higher base pay and lower at-risk compensation.

At-risk compensation can vary by the product life cycle, the tenure of the salesperson, technical support need of the product and the territory upside. In a selling situation where there’s a new product requiring considerable technical support, significant territory upside and seasoned salespeople to manage the business, base pay should be comparatively high with low pay-at-risk. Why? New products take time to develop, so salespeople need a reasonably strong base salary.

Conversely, many products sold by distributors are well known and require limited technical back up, which keeps salesperson tenure and compensation low. In general, when there’s a need for advanced technology or experience, base salaries escalate. When there is significant territory growth potential without the need for significant technical expertise, pay-at-risk will be substantial.

The mix of base salary to pay-at-risk must be realistic with the prevailing compensation available in the market place. It is not advisable to offer a substantial upside in territory earnings but a below-average base salary. Salespeople know their market value. Those who don’t understand their worth or aren’t competent may cost less but generally don’t perform well.

Many distributors want a quick fix to sales issues and tinker with compensation models to drive change. This seldom works. Compensation is more tactical than strategic in the performance of the sales force. We believe the models represented here can help in the quest to develop meaningful compensation.

We do not recommend single-metric compensation, whether rewarding on margin dollars, top-line sales, or other measures, simply because they lack balance. A lack of balance exacerbates problems of geographic sales models that encourage or allow price-cutting and giving away services for free. Should you wish to change your compensation plan, do so slowly. Pick representative territories with willing participants and decide if a new sales model is needed before changing your compensation plan.

This article is excerpted from the upcoming book “Restructuring the Distribution Sales Effort for Maximum Productivity,” by Scott Benfield and Rich Vurva. Contact Scott Benfield of Benfield Consulting at bnfldgp@aol.com.

This article originally appeared in the September 2005 issue of Progressive Distributor. Copyright 2005.

back to top                         back to Sales Management archives