Sales Compensation Design: A Cross - Functional Challenge

Compensation design practices vary from organisation to organisation, and also across job families, and levels. Variation of compensation across job levels is known in India, and it is often seen critically by international bodies. Pay gap between the least paid and the highest paid in an organisation is very wide in India, creating serious problem for pay inequity. Although at institutional and regulatory level we have several mechanisms to enforce control over this issue, things are yet to get addressed. This paper being more focused on creating win-win compensation design mode; will not discuss these issues of pay inequity.

Among all the compensation design practices, design of sales compensation is considered complicated and requires more strategic consideration. Here our discussion will focus on design of sales compensation that can successfully address all stakeholders’ needs. Some of the challenging issues in sales compensation design are presented below.

Biggest challenge faced by organisations is effective design of sales compensation. Sales performance is the lifeline for organisations, as a good performing sales team can ensure uninterrupted cash flow. When cash flow is maintained, organisations do not struggle for operating capital. Many departmental undertakings, despite high market demand and order bookings for their products and services, had to become sick for poor cash flow. We can attribute this to poor sales management practices. Some of these undertakings had to go for distress sales by the government divesting their stake. We will not go into such details here, but at least examine how faulty sales compensation design can adversely affect the cash flow of the organisations.

Theories of Sales Compensation

Sales compensation design is different from any other types of compensation design, as here we emphasize on compensation payouts based on contribution margin. Salespeople get minimum fixed compensation component, and the rest part of their compensation is aligned with their performance. Organisations select various incentive systems to make a tradeoff between competitive compensation and retention of talent. A typical employment contract for a salesperson will have mention on fixed component and average incentive payouts. Average incentive payouts do not indicate guaranteed component, rather it indicates average incentives that are earned by salespersons of the organisations. However, if an individual salesperson is performing better than average, he/she can earn even more, and such increased incentive payouts to him/her do not strain company’s compensation budget, as payments are made from the contribution margin. This can be understood with examples, presented later.

For designing sales compensation managers need to understand the peculiarities of the sales task that is different from other organisational activities. Sales compensation design includes a series of decisions to objectively reward the sales persons, based on the achievement of individuals, groups and of organisation. Separate sales compensation plans are required to control cost, achieve of goals and objectives, and face competition. Sales force in an organisation plays important role in improving the both top line and bottom line financial performance of the organisation.

In designing sales compensation, organisation focuses on identification of realistic and challenging sales goals, translating sales goals into measurable objectives, and in designing the sales compensation plan that is competitive and motivational. Obviously, such process requires basic understanding of sales jobs, understanding of organisational sales goals and objectives, basic understanding of all controllable and measurable elements of the sales function, determination of various levels in sales compensation, methods, etc. After consideration of all these aspects, it is necessary to go for pilot testing of initial compensation plan, and carry out corrections, wherever necessary, and finally rolling out of the compensation plan.

Various components of sales compensation are; base salary (fixed), short-term incentives (aligned with short-term goals), long-term incentives (linked with annual target achievement), incentives in the form of sales commissions, and various perquisites to support sales function. For mutual interest, organisation prefers contribution-based sales compensation strategy, as it benefits the organisation by relating the compensation to the operating costs of the organisation. Such practices benefit sales personnel to earn with no limits or a payment ceiling, without straining the organisation’s compensation budget. Also organisations can drive the culture of performance, and at the same time cost efficiency, avoiding payment to those who underperforms. But designing an effective contribution-based sales compensation plan is not so easy. It requires strategic focus, as it helps on the one hand coverage of organisational expenses, both fixed and variable, and at the same time consideration of built-in profit. Among others, it considers decisions on commission levels, and selection of suitable accelerators and decelerators.

Figure-1: Industry Thumb Rule

Ideally, sales compensation plans are designed to encourage behaviours that support business strategy. More than 90 percent of companies change their sales compensation plans annually. At different phases of growth, and so also for different verticals, organisations may go for different sales compensation plan, primarily to achieve business goals. For example, in the introduction phase (which is also known as start-up phase), organisations design sales compensation plan for achieving top-line (sales revenue) growth. In the growth phase, organisations emphasize on revenue management, focus on new market development and customer retention, and introduce new products and services. In the maturity phase, organisations re-evaluate themselves, focusing on price curtailment by efficient price management to stay competitive in the market. Gradually organisations achieve optimisation by strategic market segment, new market development, and with new value proposition.

This entire journey of organisations, unless reinforced by appropriate sales compensation plan, it will experience difficulty. At every stage, compensation metrics would be different as phase-wise selling objectives also change. For example, in the first or start-up phase, organisations need to emphasize on persuasive selling, which requires aggressive variable compensation in the form of incentives and commission. Here incentives and commission are based on sales revenue, and the payouts are from contribution margin. In the second phase, focus being on volume growth, sales incentives and commission are linked with the sales volume. In the third phase, cost of sales may be added as an additional metrics. Finally, in the optimisation phase, focus being on new value propositions, new market penetration, segmented growth; new metrices are developed for achieving such selling objectives. Developing new KPIs (key performance indicators) or new metrices, matching with organisational needs can only make sales compensation plan effective.

Again, compensation payouts to salespeople require adjustment with appropriate accelerators and decelerators. Sales compensation metrices can be profit-based, revenue or quota-based, balanced (both profit and revenue), and team-based. But its selection is the prerogative of the top management, as changing sales objectives, strategies, and phases of organisation can potentially alter the sales compensation plan. While selecting KPIs or sales compensation metrices, it is also important to be strategic in quota setting. Sales potentialities vary territory-wise; hence same KSOs (key sales objectives) or KRAs (key result areas) may not be right. For example, in some market territories, market share of the company may be higher, where salesperson may be at ease in achieving assigned KSOs or KRAs. While in an unrepresented or underrepresented market territory salesperson may face the challenge in achieving the results, hence in such cases, KSOs and KRAs need calibration pacing with market situation.

Sales Compensation Design: Challenging Task for Managers

Importance of effective sales compensation design has already been highlighted above. Depending on the strategic needs, sales compensation design can be tiered or incremental. Tiered sales compensation plan make provision for higher commission earning with higher levels of sales revenue. For example, commission rate for sale of INR 5 lakhs would be lower than the commission rate for sales above INR 5 lakhs. Some organisations use accelerators and decelerators as multiplier instead of tiered sales compensation. Incremental sales compensation plan uses incremental sales for the purpose of calculation of sales compensation. A base sales level (often organisation use the term threshold level of sales) is assumed while organisation considers average incentive payouts. This level is considered easily achievable; hence salesperson can earn this variable component even with average performance level. Salesperson can earn more incentives, when deliver results over and above the base or threshold sales level. Usually, organisations calculate the sales incentive on incremental sales (increased sales over the base level sales).

Some organisations to ensure they remain performance driven, often enforce claw back provision on salespeople. Claw back denotes recovery of the incentives paid in preceding year when performance level in succeeding year falls. However, when performance achievement cannot be attributed to drives or initiatives of the salespeople, like in impending pandemic situation; enforcement of claw back provision should be avoided. In such a situation, organisation can think of embracing performance engineering to calibrate the performance criteria, i.e., review of KRAs, KSOs, or KPAs, and then come out with new set of KPIs. Like in pandemic situation, organisations can make use of their salespeople to contribute to market intelligence, changing expectations of customers, innovative product design, etc. This can ensure retention of salespeople; else organisations may face the challenge of voluntary attrition.

Another important challenge for sales compensation is selection of appropriate sales metrics. Sales metrics or compensable factors differ from organisation to organisation, and often decided by the strategic level keeping in view the strategic and business needs of the organisation.

We have some common sales metrics, like; sales turnover, cost of sales, lead time for concluding a sales deal, average size of sales deal, conversion rate, new market development, market share percentage, effective sales incentive, etc. Effectiveness of sales incentives is measured in terms of cascading effect of incentives on increased performance of salespeople. But such list of sales metrics may widely vary depending on the organisational needs. Some organisations assign weightage on sales performance in terms of their creative or innovative pursuit in designing new products or services, in framing strategies to fight with competitors, etc. Rather than having multiple sales metrics or compensable factors, it is desirable to have four to five metrics that can best address organisational business and strategic needs.

Some of the industry thumb rules for sales compensation plan are:

• Pay three times more incentives to top 20 percent of your sales force to retain talent
• Limit performance measures to minimum for successful tracking of performance
• Decide on KSOs that can ensure atleast achievement of threshold level of performance by two third of the sales force
• Salespeople who deliver higher performance, there earning should be capped at above market rate
• Salespeople who under performs should earn less than market average

Strategically organisations calibrate their sales compensation plan time to time by quota setting, performance engineering, territory mapping, potentiality assessment of aggressive sales performer, etc.

Understanding Sales Compensation Based on Payout Calculation

For any sales compensation plan, it is already mentioned that payouts are from contribution margin, and such payouts again depend on variation to margin, i.e., the difference between variable revenue and variable cost. From the problem below we can understand how variation to margin increases along with the tiered commission structure. With 30% contribution margin, and tiered commission rate, for different sales figure, salespersons are able to earn higher, and at the same time with increased variation to margin, organisation can cater for different expenses and make surplus. This problem can be better understood with the following example:

Let us assume a sales representative has target earnings of INR 150,000 for the year. This includes a fixed component of INR 1,00,000/- and a variable component of INR 50,000/-. The company earns a 30% margin on the sales revenue. The company has tiered commission rate for different levels of performance in terms of sales figure. In table below, we have showed the details, including variation to margin in the last column (see Figure 2).

Figure-2: Sales Compensation Based on Payout Calculation

From the figure we can see how the salesperson’s contribution to sales revenue and subsequent variable compensation payouts begin to impact variance to margin. At INR 5,00,000 in sales revenue and a 5% commission rate, the leftover gross margin is INR 25K. Based on the remaining expenses for most companies, this will not allow the company to “breakeven.” Two options to mitigate this:

• Lower the commission rate to improve the margin.
• Set a “minimum expectation” in which the representative produces enough to pay for the cost.

Correlating sales representative’s sales revenue to cost is critical in this model. Hence decision on the rate of sales commission is critical here. It is important to determine breakeven point of sales productivity minus cost of the sales representative, setting a minimum performance standard and raising payouts accordingly. This will shift the focus of sales representative from quota attainment to commissions earned, and hence can make the sales compensation design effective. Variation to margin is the difference between variable revenue and variable cost.

In many organisations, we have systems of assigning weights to different nature of contributions made by salesperson, based on which compensation payouts are determined. For example, a tentative checklist for measurement of effectiveness of salespersons can be drawn classifying their performance in strategic, financial, and tactical types. Here organisations require to develop their own measurement criteria for each of these categories, and also pre-decide weights for each category and subcategories. For example, under strategic category there are number of sub-categories. From organisation point of view decide what are those, then measure the performance of the salesperson using a scale. If it is a 5-point scale, when scores of salespersons are less than three, then put them in underperformer category, and limit their incentive payouts to minimum. But when such performance, as per your scale is more than three, then depending on your grading put them in higher incentive tier. Likewise, we have to do for all categories. Sales Head, HR Head, and Finance Head here must work as a team first identifying categories and sub-categories, and then deciding on the tiered, or incremental incentive payouts. They can also pre-decide accelerators or decelerators to simplify the process of incentive payouts. In all such cases, however, we have considered annual sales cycle, and final incentive payouts at the end of the sales cycle.

Accelerators, Decelerators & the Hockey Stick Effect

When sales cycle is less than a year, say, monthly or quarterly, then more strategic thoughts on accelerators and decelerators are required, else it may affect the cash flow of the company. This is particularly important for consumer durable companies, automobile companies, or even for capital goods companies. Salesperson to avoid the threat of reduced incentive earnings, may carryforward the poor sales in one sales cycle to next sales cycle. This can get them more incentive payouts for multiplier effect with higher accelerators (as sales performance of two cycles are added together). This is known as ‘hokey stick effect’, as data (in our case incentive payouts) rise and fall sharply for multiplication with accelerators or decelerators.

Accelerator/multiplier/bump can also be explained using a sliding scale model. These are intended for upward and downward adjustment of commission percentage. Let us assume target gross margin percentage of a company is 30 percent and the target sales commission percentage is 10 percent of gross margin. In a sliding scale model, the commission percentage would be adjusted upward if the gross margin for a transaction is higher than 30 percent and downward if the gross margin is lower than 30 percent. Some of the incentives offered in sales compensation plan, in addition to fixed rate of commission are; new business development, team selling, cross-selling, sales of specific products, increases in customer satisfaction, etc. In Figure-3 sliding scale is explained:

Figure-3: Sliding Scale

Conclusion & Cross-Functional Imperatives

Sales compensation design is the most daunting task for any organisation. While effective sales compensation plan can drive sales performance, ensure cash flow, motivate, and retain salespeople on the one hand, on the other hand it can also ensure organisational growth and sustainability. Organisations can optimize sales compensation costs and at the same time can achieve higher sales performance when a cross-functional team decides on various parameters of sales compensation in alignment with strategic and business needs of the organisations.

Sales compensation plan requires time to time calibration with the market conditions with performance engineering approach, else wrongly organisation can adjudge a salesperson as under performer, and correspondingly decrease his/her earnings. In the reverse case also, organisations need to consider upward revision of sales goals, when market is booming. Wrong sales compensation design can adversely affect cash flow of the organisation, primarily for underperformance of the salespeople for poor earning potentiality.

While organisational practices vary, in deciding the KSOs it is important to focus on four to five KPIs, which can be decided with inputs form cross-functional team represented by Marketing, HR, and Finance functional heads. It is always advisable to pilot test the sales compensation plan, carry out the corrections, required if any, and then implement it. Depending on the changing business needs, organisations need to calibrate its sales compensation plan.