Money Talks -- Part II | SalesAndMarketing.com
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Money Talks -- Part II

The math behind effective sales compensation plans

This is Part II of a two-part article. If you haven’t read Part I, you can find it here.

In Part I of this article, I asserted that the fundamental problem with most sales compensation plans is they don’t work well. They don’t motivate the performance and behavior that employers are looking for. I reviewed the most common salesperson salary structure of base pay plus commission and also looked at base pay plus commission plus a bonus.

How do you put all of the components of a complex salary structure together to create a highly effective compensation plan? Let’s start with a set of assumptions:                       

  1. You are hiring a new salesperson.
  2. You can reasonably expect $350,000 in sales volume from your new salesperson in the first full year on the job.
  3. Your average gross profit on that volume will be 40%
  4. You are willing to share 30% of that gross profit with your salesperson.

Let’s do some quick arithmetic to see how much this job is worth. 40% of $350,000 equals $140,000 of gross profit, and 30% of that equals $42,000 in compensation. (Please note that I’m not saying that $350,000 is reasonable for every salesperson, or that you should be operating at 40% gross profit, or willing to share 30% of it, or that $42,000 is the right amount to pay a salesperson. At this point, I’m just trying to show you how to work the arithmetic. Please also note that this analysis is where you start this process. The two most important questions in compensation planning are how much volume/profit can you reasonably expect and how much are you willing to pay for it?

We have established that you’re willing to pay $42,000 in return for $350,000 in sales volume. Obviously, that could be paid as a straight salary of $42,000 or straight commission at the rate of 12%. A better approach, though, would be a salary of $1,000 per month, 7% commission, two short-term bonus opportunities paying $1,000 each and a $3,500 quota-based full year bonus opportunity. That all adds up to the same $42,000, and it provides motivation to address all but possibly one of the “I wants” above – and I’ll get to that one in just a moment. For now, I hope you’ll see the wisdom in a three-part approach to compensation. Money talks, and compensation works best as a reinforcement to management. These are the things I want you to do, and this is how you’ll make money by doing them!                                                                                                                          

Revenue Sharing vs. Profit Sharing

The missing piece in my example so far is the “I want” relating to profit dollars. You can address that by basing the commission component on gross profit as opposed to gross sales volume. Let’s say that your salesperson is competing for an order and your full-markup price is $1,000. Your production cost – or acquisition cost – is $600. At 7% straight commission based on gross sales, if your salesperson sells the order at full price, she earns $70 and you net $330. If the salesperson discounts to $900, though, the commission only drops by 10% to $63 while your share drops by almost 30% to $237. Discounting further only increases this disparity.

Now let’s change the commission rate to 17.5% of the gross margin. The revenue distribution of the full-price sale is exactly the same. The $900 sale pays the salesperson $52.50 and you net $247.50. Discounting further provides the same 17.5%-82.5% split of every gross profit dollar.

I think the point is pretty clear: You’re better off sharing profit with your salespeople than sharing revenue. Again, don’t read anything into the percentages I used, they were just for illustration. If we changed the straight commission rate to 4% in this example, that would equalize at 10% of gross margin. Converting a revenue sharing commission rate to a profit sharing commission rate is really pretty simple arithmetic.

Salary vs. Draw

There is one more missing piece in my example, the issue of meeting a salesperson’s earnings needs. Look back at the compensation plan I’m suggesting for the new salesperson and the $350,000 sales expectation. I think you’ll find plenty of takers for a job that is likely to be worth $42,000 in the first year, but very few for a job that only guarantees $1,000 per month!

One solution to this problem is to allow a draw against future commissions. I have a situation going on right now where we’re allowing the salesperson to draw the difference between what she actually earns in salary plus commission and $3,000 per month. We have shown her the pace at which we expect her to build her earnings to more than $3,000 per month and to pay back the draw – which is essentially a no-interest loan – with future earnings serving as collateral. Most important, everyone is comfortable with the arrangement.

In the past, the same client used to start with a higher salary and reduce it over time, but that never created the motivation he was hoping for. “They’d be complacent for the first six months at the high salary,” he told me, “and then they’d get panicked and start looking for another job. This way, she’ll be aware of the draw balance she’s building up, but she’ll also be able to see her progress against the timeline we’ve shown her.”

Don’t forget, by the way, that established salespeople also have earnings needs, and that the selling cycle and seasonality can make actual earnings somewhat irregular and unpredictable. Many companies allow their established salespeople to draw up to 80% or even 90% of their previous year’s earnings on an annualized basis, and I think that’s a reasonable practice.

For example, if a salesperson earned $80,000 in commission last year, the monthly draw might be set at $5,333 ($80,000 x 80% ÷ 12) or even $6,000 (80,000 x 90% ÷ 12). For payroll purposes, a draw is typically paid on the same schedule as a salary, the total amount divided by the number of pay periods in the year. Commissions are typically paid after the middle of the month, allowing for normal month-end bookkeeping and accounting to be completed. In a draw situation, if a salesperson fails to cover the draw for the previous month, there is no additional payment, and that continues until any draw shortfall is corrected

Setting the draw at 80% or 90% of the previous year’s earnings is pretty safe from the company’s perspective, but it doesn’t protect you against a major catastrophe, like the loss of a major customer. For that reason, I recommend setting a cap on the draw, usually 5% of the previous year’s earnings. In other words, if the salesperson in this example got to a draw status of minus $4000, the draw would stop and only commissions actually earned would be paid.

Multiple Plans

I mentioned in Part I of this article that I’ve seen many situations where individual salespeople are operating on different compensation plans within the same company. That’s sometimes the result of simple tweaking, or minor adjustments to make an old plan fit a new person, or to try to improve on an established plan. Unfortunately, it’s often the result of a new salesperson coming aboard from another company and bringing his compensation plan along for the ride.

It is a bad idea to let a salesperson dictate compensation, and that’s not even considering the fact that many “job hoppers” have been known to exaggerate both their sales volume and their earnings when negotiating with owners and/or sales managers, who often seem more interested in hiring sales volume than sales talent. Please remember that the two most important questions in compensation planning are (1), How much volume/profit can I reasonably expect? And (2), how much am I willing to pay for it? Please also remember that your raison d’être is profit, not just volume. The most frequent complaint I hear from business owners and managers is that “I’m paying my salesperson too much (in return for the performance I’m getting).”

Having said all of that, I have no problem with individual salespeople working on different compensation plans within the same company. After all, different people will have different motivational triggers, and different compensation wants and needs. As long as each plan speaks clearly and effectively – and as long as you remember that compensation works best as a reinforcement to management – you should be able to use compensation to achieve better performance from your salespeople.

David Fellman is the president of David Fellman & Associates, a sales and marketing consulting firm based in Cary, NC. He is the author of “Listen To The Dinosaur” (2010). Contact him by phone at 800-325-9634, or by e-mail at dmf@davefellman.com. You can also visit his websites at www.davefellman.com and www.dinosaurwisdom.com.