Compensating Salespeople
Topic 18
I. Why Compensation Plans Should be Driven By Marketing Goals
II. Establishing Compensation Objectives
III. Compensation Methods
IV. Expense Accounts and Fringe Benefits
V. Setting Pay Levels and Evaluating the Plan
VI. Example
I. Why Compensation Plans Should be Driven By Marketing Goals
Compensation is one of the most important tools for motivating and retaining salespeople.
Compensation plans must be custom designed to meet the goals of the firm. People act in response to rewards
and sanctions. Compensation must be carefully linked to the goals of the firm or behaviors will be encouraged
that will not lead to the firm's success.
You need to motivate salespeople to reach the firm's goals without bankrupting the firm. Also, 30 40% of all salespeople are unhappy with their compensation plans at any given time, so there is almost always
room for improvement.
To design an effective compensation plan you first start with the firms strategy and marketing goals.
Then, a choice between compensation levels must be made. Then set pay levels, select expense plans and
fringe benefits and assemble the plan. Successful compensation plans have simple goals. The temptation to
harness the compensation system to fix everything wrong should be resisted. Too much micro managing
compensation to drive specific behaviors and product sales can cause problems.
II. Establishing Compensation Objectives
Compensation objectives come from strategic marketing plans. A good compensation plan can make
it easier to recruit and retain desired salespeople. It directs salespeople to specific customers, products, or
areas; boosts sales or profits and can simplify the control of field sales reps.
A. Compensation Plans Must Be Reviewed on a Regular Basis - Things change, and compensation
plans will also vary over time. Focus will shift to different products, customers, and strategic objectives as
business conditions change. The compensation plan must be adjusted to meet these changing objectives.
Salespeople have great skill in manipulating compensation programs to boost their own wages. But it is the
sales manager's job to be sure that the goals of the firm are achieved with the compensation plan.
The overall effectiveness of the compensation plan must also be reviewed every year. Over time,
small changes in the compensation plan made to meet short-term goals can yield a compensation plan that fits
poorly with the firm's overall strategy. The compensation plan can also become internally inconsistent. The
performance of the overall plan must be reviewed on an annual basis to be sure it is working properly and still
fits within the firm's goals.
B. Compensation Plans Must Consider Different Aspects of the Selling Job - Straight commission
is a great motivator, but leaves the firm with little control over salespeople. Straight salary gives a high level
of sales force control, but motivation to get sales suffers. You want to reward superior performance, but
salespeople want income stability from month to month as well as pay fairness. Bonuses may be needed to
accomplish specific tasks.
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III. Compensation Methods
The major methods are salary, commissions and bonuses. They can be combined in a variety of ways.
Expense accounts and fringe benefits are also part of the compensation plan and must be factored into total
compensation costs.
A. Straight Salary - a fixed amount is paid each period. Straight salary is used by 18% of firms. It
provides the greatest control over wage levels, salesperson activities, and generally has lower total
compensation levels. Fixed costs are higher which gives greater risk to the firm. Straight salary plans require
closer supervision by sales managers. They tend to overpay the least productive members of the team and
underpay the star achievers. In sum, straight salary is risky because it is a fixed cost which must be paid even
when sales are not occurring. But straight salary also usually results in the lowest total compensation cost for
the firm.
Salary is a fixed cost, which increases risk and lowers motivation. However, the proportion of wage
expense declines as sales increase. Straight salary makes it easier for managers to divide territories and
reassign salespeople to new areas. Salaried salespeople tend to exhibit higher loyalty to the firm. It is easy to
explain and simple to administer. Salespeople have security with steady, predictable monthly income.
Trainees in particular favor this because commission systems can provide little or no income initially.
However, it does not provide strong incentives for extra effort. Performance evaluations and salary
adjustments are usually done every six months or annually which precludes immediate reinforcement.
Straight salary plans are used most often in situations where it is difficult to assess sales force
activities and performance and in firms that have salespeople spend a lot of time on service and paperwork. It
is most appropriate when it is difficult to relate the efforts of individual salespeople to the size or timing of a
sale. Often used when team selling is important, for technical advisors and when products are presold through
advertising and the salesperson primarily is an order taker. Straight salary may also be used for trainees until
their skill set is fully developed.
B. 100% Commission - salespeople are paid a percentage of sales (sales commission) or gross profits
(gross profit or gross margin commission) they generate. It rewards people for accomplishments, not for their
time or effort. Salespeople on 100% commission are usually paid more money than with other wage programs
which tends to attract better qualified applicants. They give great incentive to work smart and hard. 19% of
firms use them. Many combine with a draw so there will be some stability of income in the face of erratic
sales (draw system will be explained in the video).
Commission plans can be flat (most common), progressive or regressive. Commission caps are
sometimes used - usually with bad outcomes. An example will clarify this. Suppose a salesperson generated
$1,200,000 in sales. Let us look at three different commission plans:
A] 10% straight commission. Pay is $1,200,000 x .1 = $120,000.
B] Progressive Commission of 8% on first $500,000; 10% on pay of $500,000 to $1 million; 15% on pay in
excess of $1 million. Compensation would be (.08 x $500,000) + (.1 x $500,000) + (.15 x $200,000) =
$120,000. Note that the commission rate increased as different sales levels were reached (thus progressive).
C] Regressive Commission might be 12% on the first $500,000; 10% on next $500,000 and 8% on sales over
$1 million. Pay here is (.12 x $500,000) + (.1 x $500,000) + (.08 x $200,000) = $126,000. It is regressive
because the commission rate decreases once different sales targets are hit.
D] Commission caps = 10% straight commission on sales up to $1,000,000. Here pay is $1 million x .1 =
$100,000.
Commission caps and regressive commissions are rare, and usually the result of manager ego getting
in the way of making money.
Commissions foster independent action geared towards results. Commission plans are easy to
understand and implement. Sales costs are straight variable expenses which lowers risk to the firm. It is easier
to match expenditures with sales receipts. Commissions are paid when revenues are received so there are few
cash flow problems (and reps have great incentive to get collections). The rate of commission can be varied
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by product line which allows the firm to push new products or high margin brands. For example, the firm may
give a 5% commission on existing accounts and a 10% commission on sales to new accounts for the first year.
But straight commission gives sales managers less control over salespeople and nonselling activities
may be neglected. Reps tend to service only the best accounts. Territory changes become very difficult
because a change in the territory has a direct impact on future earnings (explain). Turnover is horrible when
business conditions are bad and salespeople have little company loyalty. Wide variations in pay may lead to
poor morale among lower paid salespeople. It is very difficult or highly expensive to get star performers to
move into management. Straight commission tends to overpay salespeople in boom times and under pay them
in recessions (explain).
C. Combination Plans - combine a base salary with a commission or bonus in an attempt to give
management the advantages of both plans. The base salary provides income security and the
commission/bonus gives added incentives to meet company objectives. Some form of combination plan is
used by 63% of U.S. firms. Salary plus commission, salary plus bonus, and salary plus commission plus
bonus plans will be discussed.
D. Salary Plus Commission - provides the incentive of a commission with the known cost structure
of a salary plan. Used by 20% of firms. Commissions can be tailored to the needs of the firm. Firms wanting
more sales push can have higher commissions. The commission rates can also be manipulated to achieve a
variety of goals. For example, 40% of firms using this plan establish commission thresholds that must be
reached before commissions apply. Often commission rates increase when different sales level are exceeded.
For example 5% on the first $50,000 per month; 6% on the next $50,000; and 7% on anything greater than that
(this is a progressive commission rate). 52% of firms use progressive commission rates, 37% used constant
and 2% used regressive commission rates.
Commission rates can also be adjusted to give more to certain products (usually with higher margins
(or larger quantities ordered - explain) or new products) or to attract new business. The differential
commission rates may be used for short periods of time like a sales contest.
Commissions are usually paid monthly, providing quick reinforcement for the salesperson's efforts.
However, spreading commissions over a period of time also discourages a person from leaving a firm when a
big sales is made. They can be costly to administer. Detailed sales records must be kept.
E. Salary Plus Bonus - a bonus is a discretionary payment for reaching a goal and is usually paid
annually as a percentage of salary (usually 5 to 15%). Single most common type of pay plan used by 24% of
companies. Used by managers to encourage salespeople to perform special tasks and to limit total pay. They
are most commonly used by sales managers in consumer product firms. Salespeople generally become eligible
for a bonus when they reach their sales quota. It may vary depending with the amount of sales over quota
(which resembles a commission plan with a very high base or starting point).
The size of the bonus payment is arbitrary in many bonus plans. The sales manager reviews total
performance (sales, customer relations, customer service, promotional activity etc...) and then decides how
much each person should receive. Sometimes salespeople have no idea how bonus payments are determined
which hurts motivation and performance. Bonus payments may be too small to have much impact on the
activities of the salesperson. Salary plus Bonus often acts as a wage cap which can decrease motivation.
F. Salary Plus Commission Plus Bonus - Combine the stability of a salary, incentives of
commissions and the special rewards of a bonus. Primary benefit is the ability to reward almost every
salesperson activity. Sales reps love these plans because there are so many ways to make more money. Used
by 18% of firms.
Administration costs are high. They often reward perverse behaviors and may direct salespeople away
from the goals of the firm. Supervision and review of these plans is critical.
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G. Optimum Pay Plans - It has been shown that when incentive payments are based on a percentage
of the sales of each product, it is unlikely that salespeople will sell the mix of items that will lead to the most
profits. Salespeople seldom have data on costs and economies of scale and direct their efforts towards selling
what will give them the most compensation.
Gross Margin Commissions try to get away from this problem by paying salespeople a percentage of
the gross margin. Percentage of total profit is seldom used because allocation of fixed costs and overhead
becomes complicated to factor in. These commissions are used to have salespeople focus on what will make
the most profit for themselves and the firm. These plans are less complicated to execute when there are a few
items to sell. When there are many brands, the administration of the plans become very complicated and
salespeople may get confused about what the reward specifics are.
In theory, these are a great idea. In practice, too many items with different cost structures make it next
to impossible to work well (economies of scale and economic order quantities make it even more difficult).
To overcome this problem many firms group products into categories and pay a gross margin % that is equal
within that group. For example, the company has 100 product lines. Group A (40 product lines) pays a 5%
gross margin commission. Group B (40 product lines) pays a 6% gross margin commission. Group C (20
product lines) pays an 8% gross margin commission.
This type of plan is commonly used when salespeople can negotiate price within certain limits. You
don’t want sales staff paid a straight sales commission or a progressive commission to have price setting
powers. But salesperson pricing power can work fin with a gross margin commission.
An example will clarify this.
Salesperson A makes a 5% straight sales commission. Salesperson B makes a 12.5% gross margin
commission. Both salespeople sell $100,000. The current gross margin is 40%. Using this information,
salesperson A makes $5,000 in commissions (.05 x $100,000). Salesperson B also makes $5,000 in
commissions (Sales = 100,000; Cost of goods sold = .6 x $100,000 = $60,000. Gross Margin = $100,000 $60,000 = $40,000. Commission = $40,000 x .125 = $5,000).
Now, suppose the salesperson cuts price by 10% to gain the $100,000 order. The cost of goods sold is
unchanged at $60,000. For the straight sales commission the pay is ($100,000 - $10,000 price cut) = $90,000
in revenue x .05% = $4,500. The commission fell by 10% ($500/$5,000) but the company profit fell by:
Original profit = $100,000 - $60,000 = $40,000 - $5,000 commission = $35,000.
New Profit with price cut = $90,000 - $60,000 = $30,000 - $4,500 commission = $25,500. New profit
percentage is $25,500 / $35,000 = 72.85%. So profit percentage fell by 27.15%.
With a gross margin commission the rate of commission falls at the same rate as the price cut since the
commission is paid on the gross margin amount. From above the original gross margin commission was
$5,000. With a 10% price cut the new gross margin commission would be:
$100,000 - $10,000 price cut - $60,000 cost of goods sold = $30,000 gross margin. Gross margin commission
is $30,000 x .125 = $3,750. As you can see, the commission amount takes a much more substantial hit with a
gross margin commission accompanied by price cuts than it does for a straight sales commission.
H. Customer Satisfaction Bonuses - are salesperson bonuses paid for customer satisfaction – usually
measured through a customer survey. Appealing on its face, but customer satisfaction is hard to measure.
Without clear measures, the process blows up. Salespeople will attempt to manipulate satisfaction data.
Salespeople also have complaints about product failures beyond their control lowering customer satisfaction
(and their bonus). Still, customer satisfaction is critical for long run profits.
I. Team Selling Compensation - It is very difficult to set up optimal pay plans when multiple people
are responsible for sales response. This is even harder when support staff are important for maintaining
customers and gaining new business. Often a group bonus is used.
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IV. Expense Accounts and Fringe Benefits
Almost every compensation plan other than straight commission has a considerable part of
compensation in fringe benefits and expense accounts.
A. Expense Accounts - are payments for expenses such as automobile and other travel, tips, lodging,
food, samples, telephone, postage, and client entertainment expenses. These expenses can range from a slight
amount to a considerable part of total compensation.
The objectives of expense accounts is flexibility and equity that maximize sales while minimizing
costs. Expenses will vary by region and customer. The goal is to reimburse the sales force for all legitimate
field expense that occur in the normal pursuit of business. However, these are direct expenses. But making
the expense plan too bare-bones can discourage salespeople from going after new accounts or distant accounts.
Unlimited Expense Accounts - salespeople submit itemized forms showing their expenditures and the
firm pays all reported, documented expenses. This allows salespeople wide discretion on where they travel
and how they entertain customers. The lack of expense money can never be used as an excuse for losing a
sale. It is cheap to administer since no one regularly spends time checking expense accounts to see if they are
overstated. They are favored by small firms that don't want to be bothered with expense account audits. They
are also used by firms that sell very expensive products. The drawback is that the costs can be steep.
Per Diem Plans - pay salespeople a fixed dollar amount for each day or week spent in the field. It is
designed to cover food, gas, lodging, phone calls and other expenses. It is simple and inexpensive to
supervise. However, salespeople may try to make money off the plan by spending less than the allowance
(usually by cutting back on travel). There is also less incentive to entertain customers. This plan can keep
salespeople under their expense allowance, but it may cost the firm sales revenues. They must be adjusted
periodically to reflect inflation.
Limited Repayment Plans - the firm sets limits on each category of sales expenses. For example: .48
per mile, $85 a day for food and $90 per night lodging. The limits must reflect actual field experience and
have to be adjusted to reflect inflation. Budgeting is easier and expense account padding may be reduced.
The problem comes with miscellaneous expenses and cost differences between territories. Also, salespeople
may spend their time juggling expenses from one category to another to make sure their costs are covered
instead of selling.
B. Fringe Benefits - Can be used to attract and reward salespeople. Typical benefits include medical,
life insurance, disability, dental, pension, profit sharing and employee stock option plans. The explosion in
medical costs have made this a major area of concern and many firms have dropped plans, raised deductibles
or gone to managed care systems (difficult for field salespeople).
Firms have to decide how much salespeople and the firm will contribute. Also, there is a big
difference in providing extra pay and giving benefits from a tax perspective. Some firms are moving towards
a menu approach.
V. Setting Pay Levels and Evaluating the Plan
A. Setting Pay Levels - Once a manager has selected a compensation method, the next job is to select
the best wage level for salespeople. They can pay the average prevailing wage, pay a premium or offer less
than the going rate. Often, you get what you pay for. There are many secondary sources available for
determining the going rates. But the natural bias is to overpay the sales force. Paying too much can make
salespeople reluctant to move into management and can cause low morale and increased turnover among
senior executives. Paying too little will attract and retain weaker sales people.
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B. Evaluating the Plan - It is the responsibility of sales managers to combine the various wage
elements into an appropriate compensation plan and then predicting its effectiveness. A good starting point is
the average wage paid by other firms in the industry.
The sales manager must also evaluate the plan on an annual basis for effectiveness in meeting the
firm’s goals. You don't want to over compensate the sales force, but you don't want to lose your people either.
A balance has to be struck. Paying the existing salesforce less is almost a guarantee for low morale and high
turnover.
VI. EXAMPLE
You own the XYZ Company and your goal is to maximize your before tax profits. You currently pay
salespeople a base salary and a flat 4% commission on sales. You sell three products. There is an excel
spreadsheet associated with this example. You start with the "Current Situation" with the starting information.
Unit Costs do not include sales commission costs. You have 10 sales people. You pay them $20,000
salary and $10,000 benefits each. This gives you $300,000 fixed sales costs. You have annual fixed costs of
$1,200,000 (including fixed sales costs).
Unfortunately, your firm keeps losing the best salespeople. You are considering several options to
retain your best salespeople. 1] Increase the commission to 6% or 2] alter the commission structure to reflect
the profitability of each product.
You think that if the total compensation plan is increased for the salesforce that your sales will
increase 10% next year due to retaining the best people and increased motivation. Without this increase in
sales compensation, you think that sales will increase 6%.
You might want to look at the potential financial impact of: a] Doing nothing, b] increasing the
commission from a flat 4% to a flat 6% and c] increasing the commissions in a manner that reflects the
profitability of each product.
1] What was your total profit before taxes this year?
2] What is your expected total profit before taxes next year if the salesforce payment plan remains the same?
3] What is your expected total profit before taxes next year if you increase commissions to 6%?
4] If you raise your commissions to 6% sales are expected to increase next year by 10% instead of 6%. Is this
a reasonable expectation? What is the percentage increase in before-tax profit next year for a 6%
commission compared to a 4% commission?
5] What were your unit contributions this year for products A, B and C?
6] Since your goal is to maximize before tax profits next year, specifically how should you increase the
commission structure to retain your best salespeople? Be sure to explain your answer.
ANSWERS
The solution is provided in two parts. First, is a summary of the solutions and a justification for the
suggested decisions. Second is a series of spreadsheets showing the complete situation for each situation.
1] Pretax profit = $1,155,053.29
2] Pretax profit next year with no changes in salesforce payment method = $1,296,356.49
3] Expected pretax profit if compensation increases to 6% = $1,271,094.02
4] It is reasonable to expect sales to increase next year over current forecast if sales commissions are
increased. There is more motivation for the salesforce to generate sales which should yield higher sales.
With a 6% commission, the percentage increase in expected before tax profits would be:
(1,271,094 - 1,155,053)/1,155,053 = 10.05% increase.
With a 4% commission, the percentage increase in expected before tax profits would be:
(1,296,356 - 1,155,053)/1,155,053 = 12.23% increase
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5] Contributions this year for Products A, B & C are:
A - $57.32 per unit, $898,434 total.
B - $10.44 per unit, $128,767 total.
C - $145.55 per unit, $1,327,853 total.
6] On first glance, it would seem best to stay with the 4% commission plan. The pretax profit is $25,000
higher. However, the case states that turnover is a big problem which yields higher recruiting costs and lower
service levels for customers. If these costs are more than $25,000 (which is probably the case), then you
should go with the 6% commission.
However, an even better solution would take into account the sharply different unit and total
contribution figures for the three products.
Another reasonable solution would be:
B should not be raised - 4% commission
A raised some
- 5% commission
C raised most
- 6% commission
This solution does two things: It gives more motivation to sell the most profitable products and it also would
probably lower sales force turnover.
The following pages have spreadsheet printouts for:
a] Current Situation.
b] Keep Current Compensation Plan, Results Next Year
c] Next Year, Commissions Increased 6%.
Please note that these results incorporate the expected sales level given each situation. You can see the
impact of other sales levels with a few simple changes if you are working this out on a spreadsheet program.
This makes “what if?” analyses much easier.
Some Final Thoughts on Compensation
- You want to attract & keep sales superstars.
- Commission as a sales component keeps giving incentives while other methods don’t
- Capping pay (including salary & bonus) may be a bad idea
- Best to be simple – but special case for bringing in new business
- If structured reasonably, be happy when writing commission checks
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