#1 Incentive Compensation Plan Design Mistake
This is a summary of a topic that a member
brought up in a Chief Executive Boards International meeting. Confidentiality
rules preclude any details about the city or the member, but the lesson is
solid, even in generic terms. The issue was designing and installing an
incentive compensation plan for sales people -- something managers have
wrestled with from the beginning of time.
In an earlier
article, I emphasized that the foundation of a good incentive compensation
plan is its alignment of the employee's self-interest with the company's
interests. Said another way, "Figure out exactly what you want an
employee (or group of employees with like responsibilities) to do, and then
figure out exactly how to pay them for doing just that.
As a friend of mine says, "Says easy, does hard." But this is
important work that counts as working on rather than in
your business, and you'll make the time to work on it if it's important to
Then, the question is how to make the numbers work. That's the subject of this
article. In my experience there's ONE single mistake plan designers
consistently make. What is that? I call it the "sensitivity" factor.
We generally have an idea of where we want to be "on average" --
what we're willing to pay for "good" performance. In our example
case in the meeting, a member said he was thinking of paying his inside sales
people 1% of the gross margin on their monthly sales. 1% is not a lot, but
inside sales people are generally paid a base salary, and this was conceived
as a "kicker" on top of an existing base. So the AMOUNT of the
compensation seemed fair, especially when we drilled down into the numbers.
The board asked him if he planned to pay that 1% from the "first
dollar" of sales -- in other words, if a sales rep sells 1 thing for $100
GM, does he get $1? The member said "I guess so -- why wouldn't I?"
In general "first dollar" plans have the fatal flaw of lacking an
important factor -- "sensitivity". In other words, once "in the
money", does the plan pay enough for incremental performance to appeal to
the self-interest of the employee?
How do you examine the plan's sensitivity factor? Graphically is the best way,
and using some real number examples is a good way to build the graph. First,
decide what "good" is. I sometimes call this the "par"
value of the plan. If a rep is doing well, what might you expect for a typical
month's sales? Maybe $100,000 in total sales with an average 40% gross margin,
resulting in $40,000 in gross margin. At "par" what does the sales
rep earn? In this example, 1% or $400. See how long that took to convert into
words and for you to parse through and absorb? A graph says it in a second.
So, let's graph the same thing. Start with two axes -- Sales on the
horizontal, Commission on the vertical, with some units that match your
example, then put a point at "Par":
Now, draw a line from zero through Par:
What does this tell us? We pay something to anyone who sells anything -- it's
a classic "first dollar" style commission plan. These work for full
commission jobs. They don't serve us very well in jobs like inside sales,
where there's a base salary, and we expect some base performance.
So, this is the the interesting part -- Does
this match what we're really trying to do? Is the objective to pay the
"par" sales rep $400, or is the objective to motivate the
"par" sales rep to do, say, 10% better? So, let's look at what 10%
better performance does for the sales rep:
Disappointingly (if I'm the sales rep), if I put out enough effort to increase
my sales 10%, making the company $4,000 in additional gross margin, what do I
get? A lousy 40 bucks.
Worse, If I let my sales slip by 10% for a month, it only costs me 40 bucks.
Who cares? This totally fails the sensitivity test.
How could we fix this? One way would be to make the plan richer and pay, say,
5% of gross margin. Here's what that looks like -- either re-draw the line, or
change the scale on the commission axis:
Then if the rep increased his sales 10%, the company still makes an additional
$4,000, and the rep makes make two hundred bucks -- about 10%
of a month's salary! This starting to sound like something he might be
interested in doing. But wait! If we start paying at first dollar, that means
$200 on top of $2,000! Wow, this is starting to get expensive. I'm now paying
5x what I wanted to pay, and at "par" I'm paying $2,000, rather than
$400. If I put this on top of an entry-level inside sales base salary, it's
almost a 100% raise.
Is there a better way?
Again, what are we trying to do? We want to incentivize improvement and
disincentivize slacking, right? And we think it'll take about a 5% slope in
the commission line to be sensitive enough to get their attention, right?
How about NOT paying from first dollar? After all, these people have a base
salary. Shouldn't I expect something from them for that? Of course.
So, let's take the 5% "sensitivity" line and lay it over the 4% at
"Par" pay point. Completely different answer. What I have to do is
set a "quota" below which I'll pay NOTHING, and then I'll pay 5% on
anything above that. How does that look?
So, if everyone sells at "par", I'm
even. Of course if they all take off like rockets, it's going to cost me.
Would I be happy with, say, an additional $10,000 in gross margin that cost me
only $500 in commissions? Probably so!
And how does this work out in terms of overall costs? Not bad. First, for
those reps who don't make quota, I pay nothing. For those who
do, I'm paying LESS than the "first dollar" formula until they hit
Par. Look at it this way -- for every $1,000 UNDER Par a rep falls, I SAVE
$50, and that goes to the rep that does $1,000 over quota. That's a breakeven,
and I got the effect I wanted -- a noticeable change in the pay envelope (both
Then we apply the "sniff" test.
Would $50 motivate a rep to upsell an order by $1,000 GM? Seems a lot more
likely than $40 motivating him to upsell an order by $4,000.
OK, what if someone really hits the ball out
of the park -- sells fifty percent over quota in a given
Under Plan A (first-dollar), beating quota by
50% is worth a lousy two hundred bucks. Again, "why bother?" Under
Plan B, beating quota by 50% is worth an extra $1,000! Now, would I happily
pay $1,000 commission for an additional $20k in GM? All day long! If everyone
did that, I could cut my inside sales force by 1/3!
The two important variables in this model are
the % and the quota. This gives you the flexibility of setting a lower quota
for new sales reps. Maybe the first-year quota is 1/3 of the
"standard", second year is 2/3, etc. Now, moving quotas is a major
sales rep dissatisfier, so be careful in setting quotas that work, rather than
to save money. I wouldn't suggest tinkering with both the quota and the
percentage. Get the percentage right for the business model and lock it down.
What can go wrong? The most likely is that a
rep sees himself without a prayer of making quota, and just gives up for the
month. How might you solve that? First, you might apply a secondary annual
bonus to overall % of quota performance -- if he's close to quota a couple of
months and over the rest, those close months help out in hitting the annual
Another pitfall is the setting of the quota itself. Keep the carrot in sight!!
We actually want to be paying some incentive comp, right? If
that's not the case, nothing works. So, make sure the quota-setting process
meets the "SMART" goals test:
- Specific - Yes, sales
are usually rep-specific. You may find a need to introduce a
"split-credit" mechanism for larger sales requiring reps to
cooperate with each other.
- Measurable -- What's
more measurable than sales?
- Achievable - This is
the critical success factor for a quota-based bonus --
the carrot has to appear to be within reach, almost every measurement
- Relevant - Measuring
revenue or profits surely qualifies.
- Time-Based -- Specific
timeframe for achievement is identified -- usually a month or a quarter,
depending on the sales cycle and frequency of sales. Annually is too long
for most people -- again, the carrot is so far away it's almost invisible.
This also meets another litmus test of
incentive compensation: "Can the sales rep explain the plan to his wife
over no more than one martini?" Not a bad question to apply to any plan.
Designing compensation systems is not
simple, and not a one-pass process. In a future article, we'll explore how to
use modifier factors to minimize employees "gaming" the system to
the disadvantage of the organization.
This prototype addresses a method of taking
base salary into account while at the same time making the plan
"sensitive" enough to motivate incremental performance. The concept
is that above par, the employee is covering his costs by >10x, and we'll
pay well for any performance above that point. Try this on for size in your
own organization and see if it fits. And let us know some of your ideas for
effective incentive compensation design.