A fundamental question for any business when setting up a sales force is how to compensate them- particularly when it comes to their commission for closing a deal. The issue is that if you give sales people the wrong incentives, it could result in negative outcomes to your business.
The first rule of building a great sales compensation plan is to make it simple. My metric has always been that the salesperson should be able to calculate the amount of their commission check in their head during the two minutes it takes for them to walk to their car after closing a deal. If it takes any longer, it's likely too complicated- which can become demotivating. The key is to build you plan around straight-forward numbers that the salesperson has good line of sight to.
That's why the best sales compensation plans are usually built around one of three numbers: revenue, gross margin, and profit. Each has its pluses and minuses.
The simplest way to construct a compensation plan is to base it on the revenue that results from the sale. For example, if you pay a salesperson 2% commission, and they close a $1 million sale, it's easy for them to calculate that they just earned $20,000.
The challenge with basing a plan on revenue comes down to price control. I have written before about how the people who study the field of behavioral economics have found that real estate agents, as well as investment bankers, will lower the price of a house or business to help ensure they get the sale. They'd rather drop the price to ensure that they get something in terms of their commission, rather than trying to maximize the commission and your revenue.
That same dynamic applies here. Let's use the same example where we pay the salesperson 2% on revenue. If the salesperson has price control, they may decide to drop the price to the customer to $800,000 instead of a $1 million. While the salesperson makes less, just $16,000 instead of $20,000, it's still better than zero. But what is the impact to the company as a result of that price drop? If you profit margin is lower than 20%, it might mean that this salesperson just closed an unprofitable deal.
That's why you can't let the salesperson control the price if their commission is based on revenue. You might set up rules where if they want to drop the price up to 5%, they have to check with their sales manager first. Or, if they want to drop it even further, that discount would need to be approved by the company's president. The point is that you don't want to leave your salesperson unchecked if you are rewarding them on revenue alone or you risk lots of unprofitable business.
Companies can eliminate some of the problems created by a revenue-based model by basing a commission plan on gross margin- which is your revenue minus your costs- instead. That way, any drop in price the commission drops even more dramatically. This now allows you to give your salesperson some control over the price-;while also keeping them motivated to get as high a price as possible.
Let's return to our example. Let's say that the cost of producing the product you're selling is $500,000. And you set up your compensation plan so that the salesperson will earn 4% on the gross margin of a deal. If they sell the product for $1 million, they earn $20,000. But if they drop it to $800,000 and your margin to $300,000, their commission is cut almost in half to $12,000. Their motivation, obviously, is to try and drive up that price.
Of course, to make a plan like this work means that you have to be willing to be transparent about how much money your products earn in gross margin, which not every company is willing to share with its salespeople.
A third option for building your sales compensation plan is to base it on the final net profit of a sale- which is revenue minus costs and overhead expenses. This obviously requires an even deeper level of trust and transparency with your salesperson to make it work. But if you're willing to share, it creates great alignment between sales and the bottom line for the business and you as the owner.
Using our example, we might find that our product carries an additional $300,000 in overhead expenses. Add that to the cost of the product, and we get a total of $800,000. Now let's say that you're willing to pay your salesperson 10% of the profit on a deal. If they sell it for $1 million, they earn their $20,000, 10% of $200,000. But if the salesperson drops the price to $800,000, what happens? No profit-;and no commission. How hard do you think the salesperson might be willing to work to close the deal at a higher price with that kind of incentive in place? Even if they have price control, they now have the same motivation that you as the owner or CEO have to try and maximize profit on every deal.
Each of these three approaches has their pros and cons. So when you're thinking about building a commission plan for your sales team, the key is to find the balance you're comfortable with in terms of price control, transparency, and creating the motivation for setting the team to fight as hard as possible to get the best deal possible. If you get this wrong, get ready for lots of revenue, happy salespeople and an unprofitable business.
Jim can be found at www.IncCEOProject.com