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Contribution-based compensation is a time-tested approach to sales force compensation that has been proven to offer significant benefits. At the foundation of this strategy is the belief that the best
way to set up compensation plans is to tie them directly to the costs of running
the company. Sales representatives contribute their share towards corporate
expenses and profit. After their contribution is paid, they keep most of
the rest of the money they bring into the company.
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Firms that have introduced this approach benefit in several ways: |
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The opportunity to make an unlimited amount of money provides a significant incentive to sales representatives. They typically become more productive, so corporate revenue increases. |
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It becomes easier to recruit new sales associates, particularly top producers. Improved recruitment translates into faster growth and increased market share. |
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A pre-defined level of profit is built into the plans, ensuring long-term profitability, which adds value to the business and enhances the firm's financial stability. |
Here's how it works...
Cover corporate expenses
The first goal of any company should be to make sure it can pay its bills.
Expenses come in two types: fixed and variable. To simplify a little, fixed
costs are expenses that generally do not increase as business increases.
Examples might 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.
Fixed costs can be allocated equally among sales associates, with each
associate responsible for bringing enough revenue into the company to cover his
or her share.
Variable costs also need to be paid out of the revenue a sales representative
brings in. However, because those 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.
Build in profit
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.
Profit can be treated as either a fixed or a variable expense. If it is
designed as a fixed expense, that puts an upper cap on profit. So most companies
prefer to define it as a variable expense. This allows them to continue to
benefit as revenue grows.
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.
Allocate expenses among sales associates
The next step is to allocate the expenses fairly among the sales
associates. You need to make everyone responsible for contributing the same fixed amount. Anything else penalizes top producers. It is a disincentive to selling more and discourages better associates from working for your company.
But you can't
simply divide expenses equally among the sales associates.
Often, a significant portion of the associates do not produce enough revenue to reach the breakeven point of plans where the company's fixed expenses are divided evenly among all associates. In this case, the company as a whole will not break even unless sufficient surplus is generated by other associates.
Instead of dividing by the number of sales associates, CompensationMaster uses a number we call the Fully Productive Equivalent (FPE).
Determining the FPE is not a trivial exercise. The calculation is based on the production of the associates as well as the interaction between the expenses of the company, the compensation plans, the target profit level, and the revenue production of the associates.
This method of accounting for the reduced contribution of low producers
brings a higher level of accuracy to the expense allocation. However, sophisticated software like CompensationMaster's is necessary to ensure that the number is correct; an Excel spreadsheet cannot
accommodate this type of calculation. Additionally, the result will change
when revenue, expenses or compensation plans change. Since this number is essential to correct plan design, we recommend that you re-calculate it every year.
For a better understanding of the complexity of this issue,
please watch our six-minute video on Breakeven Analysis.
Derive commission levels
The next step is to identify the correct placement of commission levels.
Divide total expenses by the FPE. This provides the breakeven point, or the amount of money each sales
associate needs to bring in to cover corporate expenses and profit.
Then determine what percentage of each sale needs to be held back to cover
variable expenses. That provides the maximum a company can afford to pay out
once fixed expenses are covered.
Design plans
Once you have calculated the amount each representative must contribute for
corporate expenses and profit, along with the highest commission level the
company can afford to pay, you are ready to begin designing compensation plans.
One way to structure plans is to have the representative's commission level
start out low, because the company is keeping enough money to pay both fixed and
variable expenses. Once the company has taken out enough money to pay fixed
expenses, that contribution stops. The money that was going to the company to
pay fixed expenses now goes directly to the sales representative. The sales
representative will now typically receive a substantially higher commission.
This type of design is most effective at aligning the goals of the sales
force with the goals of the company, and at reducing waste.
However, it may not be appropriate for your sales force. Using
CompensationMaster's software, you can design any type of compensation plan you
want: salary plus bonus, 100% commission, high split, retroactive, etc. You can
build in any type of perquisites, any type of benefits.
The software will tell you whether each plan you create meets your
profitability goals or if it will put you in the red. This reduces the risk of
implementing new commission structures, and allows you to design compensation
plans with confidence.
Align goals
A unique benefit of this strategy is that it aligns the goals of the sales
representative and the corporation. Both want each sales representative 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 as quickly as possible to maximize their personal income.
Management wants the sales representatives to arrive
at that point because corporate expenses will be covered and profit
assured. This gets everyone pulling in the same direction.
Reduce waste
An additional benefit is that the sales force no longer wants unnecessary
services and benefits, as these costs reduce their income. The company
is thus able to pare down expenses to those that are effective and desired by
the sales force. This makes the firm more nimble and better able to respond to
changes in the market.
Offer a choice
A crucial component of CompensationMaster's approach is to offer sales
representatives a choice of compensation plans. Experienced representatives who
are confident in their own abilities appreciate the option of taking on more
risk in order to maximize income. They may want to pay some of their own expenses
in exchange for a higher commission rate.
New recruits or those who have high fixed expenses,
such as children in college, may prefer to trade some of their commission
potential for a higher level of guaranteed income.
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Offering a choice brings powerful benefits: |
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Improved motivation - when representatives choose the
compensation structure they find most appealing, it motivates them more
effectively and more permanently than any temporary incentive plan. |
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Easier recruiting - offering a choice of compensation
plans is an attractive benefit that provides a competitive edge in
recruiting. |
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Expanded labor force - there are many people for whom your
current style of compensation is not appropriate, yet who would make
excellent members of your sales force. By offering different plans, you
expand your potential pool of recruits. |
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Eases introduction of new plans—providing a choice of
compensation plans gives sales associates more control during a time of
change, increasing retention rates. |
Recoup costs
When commission structures are designed to meet the needs of
various types of employees, the company can also more accurately recoup its
costs. For example, an experienced representative who does her own lead
generation and requires little in the way of support services costs the company
much less than a newer associate who needs extensive training and support. On
the other hand, a top producer who requires a corner office, a late model
company car, and two assistants may be very expensive to support. By offering a
choice, the company can customize compensation plans so that all members of the
sales force receive—and pay for—the support and services they need, without
having to pay for things they don't want.
Although the logistics of offering a variety of plans might seem
intimidating, it's actually much simpler than might be expected. You can handle
compensation the same way you do health insurance: once a year, employees choose
their plan for the following year. Typically, there is an open season or
representatives make their choice on the anniversary of the first day they
started with the company.
The bottom line is that when sales representatives are able to
choose the type of compensation plan that best fits their needs, their tolerance
for risk, and their lifestyle, they are motivated far more effectively than with
any one-size-fits-all type of commission structure. The result is a more
productive and stable sales force.
To learn more, schedule a demonstration over the Internet.
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