Friday, February 1, 2008

The #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 you.

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 ways).

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 month:

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 target.

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 period.

  • 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.

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Terry Weaver

Chief Executive Boards International
864 527-5917

Chief Executive Boards International: Freedom for business owners & CEOs -- Less Work, More Money, More Freedom to enjoy it


  1. After posting this, it occurred to me that it focused only on a sales compensation example. The same idea applies, regardless of the metric. If you're measuring business unit, department or project profitability, for example, a high-sensitivity plan with a "quota" or "pay point" above zero works equally well. That way you don't pay anything for mediocre. You only start paying at "good" and then pay really well at "great".

  2. Nice article. This is what I was looking for. Thank you...


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