(889 words – 7 min)
The most common sales compensation is a base pay plus a commission rate as a percentage of the revenue.
The base is justified as payment for activities the company wants them to perform that take them away from selling. These are activities like forecasting, training someone new or working with engineering on a new product.
The exciting part of the compensation plan is the commission. For example, if a salesperson makes a 4% commission, then when he sells $1 million worth of products, he earns $40,000. This seems like a good plan to motivate salespeople to sell at higher prices.
For example, assume $1 million revenue comes from selling 10,000 widgets at $100 apiece. The buyer asks for a 10% volume discount during the sales process. If the salesperson gives in, then the revenue from the sale becomes 10,000 times $90 or $900,000. The commission on this is only $36,000. It costs the salesperson $4,000 to give that discount. That’s $4,000 worth of incentive not to lower the price.
Although that’s true, it’s not the whole story. The salesperson looks at the discount slightly differently. The salesperson is thinking, “Do I want a sure $36,000 commission check, or should I stand firm and risk losing the whole deal? I could end up with nothing. Besides, how much more time and energy do I have to spend to get that additional $4,000?” Sure, the salesperson would give up $4,000, but the company would be out $100,000. If you are the CEO of this company, do you want to give up that $100,000 for a sure thing, or do you want the salesperson to try harder?
In the book “Freakonomics,” Steven Levitt and Stephen Dubner provide an example using the real estate market. The selling realtor receives half of the 6% commission, or 3% of the price of a house, when it’s sold. Usually, the realtor has to split that with her broker, so she gets only 1.5%. That’s still a good incentive. On a $300,000 house, the selling realtor makes $4,500. And the higher the price, the larger the commission. All seems well. This should incentivize the realtor to get the highest possible price for the house. But it doesn’t.
What if the realtor could have sold that house for $310,000? She would have made an additional $150, and the homeowner would have made $9,400. One hundred fifty dollars may not be worth the effort and risk of holding out for the extra $10,000.
What would be different if the realtor were selling her own house? Assume all of the above numbers are the same. Now holding out for the additional $10,000 would yield $150 plus $9,400, totaling $9,550 additional income. That’s a lot more incentive. Does the realtor work harder to sell her own home at a higher price?
Levitt and Dubner looked at the sales data of 100,000 houses in the Chicago suburbs — 3,000 of which were owned by realtors. They compared the selling price and how long the house was on the market for realtor-owned and non-realtor-owned houses. They found that realtors kept their own houses on the market an average of ten days longer, and received 3%+ more on the price. That’s almost $10,000 on a $300,000 house.
This same story is true for salespeople making a commission based on revenue. Their incentive to spend more time, energy and effort to achieve a higher price is lower than the incentive of the owner of the company. The owner of the company pockets the vast majority of any price improvement. The salesperson earns a small percentage.
Revenue-based commission plans don’t provide enough incentive to salespeople to achieve the best price. One alternative would be to pay them based on the profit margin. Commission based on profit margins more closely aligns with the company’s and salesperson’s incentives.
An easy way to operationalize commission based on margin is to share the cost information with the sales force. Any salesperson can see the cost and calculate their anticipated commission on any deal due to any discount.
Although some companies have had good results in letting salespeople know their costs, companies often move away from this because bad things tend to happen. Since salespeople know the costs, they tend to argue more inside the company for lower prices because they know the company will still make margins at lower prices.
The other bad outcome from sharing cost information with sales is that customers and competitors may gain access to it. Nothing good will come if either of those two learns the costs.
Compensating salespeople on margin is a more powerful incentive, but it’s diluted or even negated by the impact of sharing cost information. A solution that can provide the right incentives while keeping your costs secret uses target prices to determine compensation rates.
To make this work, the business unit needs to set three price points: list price, target price and floor price.
With these three price points, you set two commission rates. Most commonly, these are as a percentage of the deal’s revenue. For example, when a salesperson sells above the target price, he receives 10% of the deal. However, when that salesperson sells below the target but above the floor, he receives 2%. Anything below the floor price pays no commission.
Creating a commission plan is tricky, but the key is to align the salesperson’s incentives with the company’s objectives. If the company wants to win at higher prices, commission based on revenue is not optimal. Instead, create one that incentivizes margin without sharing cost information.