2. Risk / Reward

When addressing how to compensate salespeople, you always want to consider the principle of risk / reward. The more important the role, the higher paid the role. The higher the reward that someone will gain from effective completion of the role, the more important it is to make the compensation variable.

Fundamental Structure

The basic structure of compensation for salespeople varies, depending upon the relative importance of the role, and the risk / reward involved in the position.

For anyone who has direct control over his/her sales, we recommend that at least half of the compensation come from some commission or percentage of sales/profits generated.

If your salespeople want to share in the rewards of more sales (and you definitely want them to) then they need to share in the risks as well. You want your salespeople to take ownership of their role within the company. The best way to do this is to allow them access to the same economic realities that you as a business owner have. If sales occur there is money to split, if not, the money is just not there.

A key element of success is to align your self-interests (to increase your gross sales, gross margin and net income) with those of your salespeople (to increase their earnings). The closer the link, the stronger your informal partnership in achieving what becomes your common goal. That is, the profitable growth of your business.

Some Compensation Alternatives

There are as many ways to pay people as there are people to pay. What follows is a brief summary of some of the main structures more commonly used to compensate salespeople.

Hourly Pay

Most often used in retail, this form of payment is also used when the salesperson is processing business rather than finding and initiating new customer relationships. Sometimes there is also some sort of “spiff” as well. A spiff is a minor commission or over-ride (for example, half to one percent of sales), based upon either the person’s direct sales, or those of the department.

Telemarketers are also paid primarily on an hourly basis, with a bonus per appointment booked, or a larger bonus for each booked appointment that turns into a new customer.

Salary

People in inside sales (inbound) are usually paid either entirely or mostly on a salary basis. The lower the relative importance of the position, the higher the portion of fixed income (whether hourly pay or monthly salary) and the lower the bonus or commission involved.

Base Salary plus Commission

This is very common. A good rule of thumb is that the higher the income potential of the salesperson, the more of the total compensation you want as commission rather than base salary. For sales positions that are expected to be at $5,000 per month or more, you want at least 40% and hopefully 50% or more of that to come from commissions earned.

One way to accomplish this is to include a draw component to the compensation package. A draw is simply an advance against future commissions. The difference between a draw and base salary is that no commissions are paid until sales exceed the advances paid in the draws.

A draw can be very useful, especially as a transition tool. We had one client whose salespeople were being paid a base salary of $70,000 or more, with a small commission as well. In good times, these salespeople earned over $100,000 per year. However, when times were more difficult, they would still get $70,000 despite their lack of productivity.

As a transition strategy, the owner reduced the base salary to $48,000 per annum and kept a draw in place for one year for the other $22,000. He then increased the commission levels so that in a good year, the salespeople would do even better, based upon increases in gross margin (rather than gross sales). By spreading the risk out to his salespeople, the owner was able to increase the commission rate, reduce the risk of downturns, and avoid the necessity to lay off anyone if times turned sour in the market.

The sales staff gained increased ownership and influence in customer acquisition activities, and they gained the support of a New Business Development person as well (funded by the owner). Overall, the company has thrived as a result of the changes. The salespeople earn more and the owner has his risks better managed.

Draw Against Commission

This is a variation on the theme above. The benefit to this arrangement is that your salespeople will be effectively on straight commission, with cash flow support from the company. The potential difficulty with a draw against commission without a base, is that it is very easy for a salesperson to hit a slump and then make it worse by digging a financial hole for him/herself that must be repaid before commissions are enjoyed once again.

One innovative way around this that we have used in the past was to make arrangements that half of commissions earned (as an individual works his/her way out of a slump) in excess of the current draw would go toward repaying any old amounts due, while the remainder was paid to the salesperson. While this may not fit all situations, there have been times where it has been used successfully to support a salesperson who has fallen behind to catch up without getting demoralized in the process.

An alternative to the draw against commission is a base salary and a sales quota, with commissions being paid for sales in excess of the quota, either each month or each quarter. The decision of which method to use comes down to what will work the best in the market you are in, your industry norms and the risk tolerance of the people you are seeking to hire.

Straight Commission

Under this arrangement, there is nothing paid to the salesperson that is not earned. While this looks like the best financial arrangement for an employer, it has the risk of losing people when a market levels off, when competition erodes margins or alternative distribution affects sales.

It also encourages salespeople to concentrate on what's easiest to sell. This can work against your overall business strategy. The potential is higher of that new, more profitable line being ignored to sell the tried and true.

It also makes it difficult to attract high quality salespeople who may also be concerned about their family’s financial stability. A salesperson will need to fund him/herself during the initial ramp-up period or that person cannot afford to work for you, under this arrangement.

Bonus Schemes

There are many bonus arrangements that have been attempted. Some of them have been more successful than others. Bonuses are often used in addition to base salary under a quota system of some sort.

One client of ours paid all of her salespeople a base salary (ranging from $48,000 to $60,000 per annum) and a bonus of up to anywhere from $5,000 to $10,000 per person. The bonuses were based upon quotas of sales and measurable service activities provided to their distribution network.

These reps were dealing with a clientele of agents selling high volumes of low dollar value products each. The collective volumes, the measurable service levels of those agents and the consistency of reporting were the main factors determining the success of the business. The compensation system was designed to match those factors.

While this system was a little more complicated, the systems for data collection were sound and reporting was easy to track. The salespeople could always tell how they were doing, and the compensation system supported a direct focus on the appropriate measures.

Bonuses and Teamwork

One issue that business owners face is how to create a sense of teamwork and still reward individual initiative. There are a couple of ways to manage this. One is to simply split a commission between the various members on a team.

A second way is to build a multiple bonus arrangement. Bonuses would be paid for productivity (and profitability) at the individual level, at the team level and at a company wide level. This generates enthusiasm for the growth of all parts of the company, by aligning self-interests with the various events that have the company move forward.

Commission on Gross Sales or Gross Profit?

This is a very common question, and the Risk / Reward section is a good place to address it. If your margins are fairly stable and your salespeople have no control over pricing, then you may choose to structure commissions based upon gross sales.

When there is no added benefit to tying commissions to gross margins, all you are doing is complicating matters. You would also be divulging information to your salespeople that might adversely affect you in the future (in the event that you lost a salesperson to your competitor).

If your salespeople influence your gross margin, or if your gross margin varies from case to case, then it is usually a much better idea to tie commissions to gross margin generated rather than gross sales. Under this scenario, the same event that has you win, also has your salesperson win. Also, if you are asked to make fairly major concessions to a particular customer, then your salesperson shares that risk along with you.

The flip side of this, when you pay your salesperson based upon gross sales in an industry with varying margins, can be very expensive for you. If you go into a large project with thin margins (let’s say 10%) and in order to get the business, you drop your selling price by 4%, this results in your margin dropping by about 40% from its original level. Meanwhile, your salesperson’s commission will only have dropped by 4%.

Salespeople often get caught in the trap of “buying business” through lowering margins. How much of this downward pressure was your customer’s push and how much was your customer reading from your salesperson that there might be more “room” in the price?

This problem is easily rectified by aligning the same elements that have you win (or lose) with the elements that compensate your salespeople. If the salesperson has to incur a 40% loss in commission to facilitate the transaction, the recommendation to proceed (or not) will at least be based upon common self-interests.

In some instances, where gross sales are important (to achieve volume discounts with suppliers, for instance) but gross margins are also a priority and variable, there have been programs set up based upon a combination of gross sales and gross margins. Be careful not to get too complicated, however.

The salesperson must be able to clearly understand what activities and results will directly impact his/her income.

Overall, the rule of thumb is that simpler is better, and the closer you can align the risk / reward of your sales staff to your risk / reward as owner, the better.

Commissions on Amounts Invoiced or Paid?

Another factor in the Risk / Reward evaluation is to determine whether to pay your sales staff on amounts invoiced or amounts actually paid. The answer to this is simple. While you may advance on amounts invoiced, you pay (and ultimately reconcile accounts) based upon amounts actually paid to you by your customers, not amounts invoiced.

If you did not receive the money, your salesperson often has much larger influence on the situation than you think. Regardless of this, the simple reality is that if the customer does not pay for all or part of the products / services provided, then the money is simply not there to pay out a commission (or anything else for that matter).

This is simple business reality. To pay on any other basis is to open yourself (and the business) up to a whole host of potential difficulties, all of which can be easily alleviated with the policy of ultimately settling accounts based upon amounts paid, rather than invoiced.

end of Part 2      Part 1