Profiting from a New Sales Force Compensation Strategy

As appeared in the March 2001 issue of SLC Insider.

By David J. Cocks

Most companies use the same basic compensation structure as the other businesses in their industry. Quotas, commission levels, incentives – they vary little from one firm to another. If asked why they were set up that way, most managers would be hard-pressed to come up with a good explanation.

Wouldn't it be better to have a compensation structure based on solid numbers, which was fair to everyone and removed the disincentives that keep sales associates from performing at their peak? And even better if it guaranteed that the company would reach a pre-defined level of profitability?

That's the promise of a new approach to sales force compensation.

With this strategy, sales representatives become responsible for contributing their fair share toward corporate expenses and profit. Once their contribution is paid, they keep the rest of the money they bring into the company.

Instead of arbitrary quotas, commissions are based on solid numbers – corporate expenses and profitability. The company takes what is needed to run and grow the business, and the sales representatives keep the rest.

This way, sales associates can reap the benefits of their hard work. The barriers and disincentives to production that many top producers face are removed. Their commissions do not decline as sales increase, and there's no ceiling on what they can earn.

The opportunity to make an unlimited amount of money provides a significant incentive to sales representatives. Typically, when a system like this is implemented, sales productivity increases significantly. In addition, the aggressive compensation structure makes it easier to recruit new sales associates.

This approach also almost always results in greater profitability for the firm. The increase is due, in part, to fixing an incorrect business model. But the main cause is the improved productivity of the sales associates. The ability to recruit more sales representatives is also a factor, translating into faster growth and increased market share.

So, how does this strategy work?

Calculating Commission Levels

The first goal of any company should be to make sure it can pay its bills. An accounting concept that is valuable here is the distinction between fixed and variable expenses. To simplify a little:

Fixed costs are expenses that do not increase as business increases. Examples include office space, utilities and salaries for support staff and management.

Variable costs are expenses that vary with the amount of business you do. Commissions, telephone charges and manufacturing costs are variable expenses.

Variable costs are tied to revenue – if you don't have any sales, for the most part, you don't have those expenses. But whether or not you bring in any money, you still have to cover your fixed expenses.

We start by allocating fixed expenses equally among sales associates, with each associate responsible for bringing enough revenue into the company to cover his or her share.

Variable costs are also paid out of the revenue a sales representative brings in. However, because these costs are tied to sales, instead of allocating them equally, it makes more sense for each representative to be responsible for the variable costs associated with his or her sales.

The second goal of any company should be to make a profit. The best way to ensure profitability is to add the desired amount of profit into the expense allocation as the first expense. We combine profit with variable expenses, so that as revenue grows, profit does too.

This approach is an unusual one – most businesses define profit as what is left over after expenses – but treating profit as an expense, and planning for it, is the most effective way to make sure the company is profitable.

We already have our breakeven point, which is the amount of money each sales associate needs to bring in to cover corporate expenses. Now we determine what percentage of each sale needs to be held back to cover variable expenses and profit. That tells us the maximum the company can afford to pay out once a sales representative reaches the breakeven point.

So, at the beginning of the year, a representative's commission level starts out low. The company is keeping enough money to pay both fixed and variable expenses. Once enough money has been taken out to cover fixed expenses, that contribution stops. The money that was going to pay fixed expenses now goes directly to the sales representative, who will now receive a substantially higher commission.

With this approach, there is no cap. Once representatives reach the breakeven point, they stay at the higher commission level for the rest of the year.

Improving Recruiting, Productivity, Profitability

Virtually every company that has tried this approach has found it extremely successful. One firm that implemented this strategy increased production 32% in the first year – with the same sales force. Over the next couple years, their recruiting became so much more effective that their sales force is now four times what is was. Revenue has increased comparably and profitability has improved dramatically.

Another company was able to quadruple recruitment within two months.

A third company went from a $34 million loss to a $5 million profit in just over a year.

The competitive advantages of this approach are clear:

• There's no upper limit to how much a sales representative can earn – no barriers to high performance. This motivates the sales force and makes recruiting easier.
• These compensation plans are aggressive, yet tied to the company's actual costs of doing business. The risk associated with being so aggressive is virtually eliminated. Finally, profitability is built in. Not only does the company reap the benefits of a motivated and expanded sales force, it does so while putting the business on a sounder financial footing and building long-term value into the firm.

This strategy also aligns the goals of the sales representative and management: both want each associate to reach the higher commission level as quickly as possible. The sales representatives want to attain that level so they can start receiving a higher percentage of each sale. Management has the same goal, because at that point corporate expenses are covered and profit is assured. The result is that everyone pulls in the same direction.

While this approach offers substantial benefits, it is more appropriate for some firms than others. Several indicators can be used indicate whether it would be worth considering for your company:

1. Is the product a commodity?
The more similar its product is to the competition's, the more aggressive a company must be in its compensation plans.

2. How easy is it to make sales?
If sales people are primarily order takers, there's less need to motivate them. The harder they have to work to close a sale and the more skill is involved, the more important it is to attract quality sales representatives.

3. How fast does the company need to grow?
The stronger the pressure for rapid growth, the more representatives are necessary and the more aggressive a company must be in its compensation structure.

Recruiting, retaining and motivating sales people is a challenge for every firm. This new approach offers exciting opportunities for the firms that choose to use it. The key to success is to commit to the strategy, and partner with an experienced firm to implement it.