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RETHINKING SALES COMPENSATION

Posted Wednesday, October 10, 2018 by Bob Lindgren, The Management Guys.

Article by PPI Trusted Partner

Achieving success as an outside sales rep requires an unusual ability to listen to customers, learn their needs but then accept “no” as the answer but keep on trying. It’s generally acknowledged that some form of commission on sales is the best way to incentive these folks to keep on trying. The simplest form of such an approach is a percentage of sales, usually around 8% or 9%.

Because printer’s estimating/pricing systems produce quotes that include not only the actual expenditures to produce the job (production wages, materials, outside services, etc.) but also allocations of all the overhead costs of the business (plant, machinery, front office, etc.) they usually identify amounts charged to the customer in excess of this as “margin” and think of it as “profit” in the same sense as profit for the business as a whole at the end of the month. Because of this, some firms have keyed commissions on margin (25% to 50% of the margin) or a sliding scale based on gross sales but varying it by margin (0% on negative margin, 5% on a 5% margin, 10% on a 10% margin, 15% on a 20% margin). The motivation for these approaches is the belief that “margin” equals “profit” for the business as a whole.

However, the reality is that profit for the business as a whole is reached when the “contribution” from the jobs produced for the month covers the overhead for the month. The typical job involves an actual expenditure (paper, outside services, factory wages) of about 60% of the invoice price and thus produces a 40% contribution to overhead. If a job is sold for $10,000 about $6,000 will be spent to produce it and $4,000 will be left to cover the overhead. If the overhead is $75,000 per month, the firm is now $4,000 closer to profit. A moment’s thought makes it clear that if the job had sold for $9,000, the firm would still be $3,000 closer to profit than if the order had been lost to a competitor. Similarly, if the job had been sold for $11,000, the firm would be $5,000 closer to profit. Simply put, any job that is sold to produce a positive contribution makes the firm better off. If the price is increased by $1 dollar the firm is $1 better off.

This reality demonstrates the problem with commission systems that are keyed on margin. They discourage the sales reps from selling jobs that would contribute contribution dollars while at the same time they give a disproportionate reward to jobs that contribute at a higher level as the contribution dollars are not more valuable as they get larger. Also, since really high contribution jobs are scarce, the sales reps focus on them may starve the firm for overall contribution dollars and make achieving profit at the end of the month more difficult.A far better approach would be to pay the sales reps a percentage of contribution. However, this would sensitize their compensation to variations in plant performance beyond their control. As a practical matter, a percentage of value added is preferable as it achieves the same result and is easier to understand. “Value added” is the difference between the invoice to the customer and the actual cost of paper and outside purchases.

If the firm has decided to make a change in its system, implementation must be carefully planned if disruption of the sales force is to be avoided. First, the rates used should not effect a global change in the rep’s compensation. If they continue to sell the same jobs for the same prices, their pay will not change. What the firm is trying to do is to get them to sell more jobs for as much as the customers will pay with the goal of fully utilizing plant capacity which will maximize the firm’s profits. For example, if the reps are now being paid 8% of gross, the value-added equivalent would probably be about 12%. This can and should be tested by looking back at a year’s sales data and identifying gross sales and value added. This is relatively easy as paper and outside services are usually identified.

Then the new system must be explained to the sales reps not as an attempt to cut their pay but to make both them and the firm better off by selling more work at the most that the customers will pay. It is also wise to implement the change with a transition period of at least six months where the commissions will be computed under both the old and new systems and the rep will receive the higher of the two. Reps who grasp the opportunity, will sell more jobs and make more money. Those who can’t will eventually leave.