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Table of Contents

Introduction ............................................................................................................................................ 2

Basic Sales Compensation Terms ............................................................................................................. 3

Target Cash Compensation .................................................................................................................. 4

Mix Of Base And Incentive Pay ............................................................................................................. 5

Pay-at-risk leverage ............................................................................................................................. 5

Selection Of Sales Incentive Performance Measures ............................................................................ 6

y Business growth stage. ............................................................................................................. 7

y Sales territories ........................................................................................................................ 7

y Marketing focus ....................................................................................................................... 7

y Application of thresholds .......................................................................................................... 7

y Application of maximums ......................................................................................................... 7

y Salesperson influence ............................ ................................................................................... 8

y Quota allocation .................................................................................... ................................... 8

y Sales event ............................................................................................................................... 8

y Windfalls .................................................................................................................................. 8

y Shortfalls .................................................................................................................................. 8

y

Payment timing ........................................................................................................................ 8

y Draws ....................................................................................................................................... 8

Basic Sales Compensation Design............................................................................................................. 9

Plan Implementation Considerations ................................................................... .................................. 12

When Incentive Programs Go Awry: The Chrysler Example .................................................................... 14

The Hockey-Stick Phenomenon .......................................................................................................... 15

Conclusion ............................................................................................................................................. 18

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IntroductionSales compensation, or incentive pay, is a method or pay system that allows an

organization to reward a salesperson for positive results. The method or system creates an output that

typically is dollars paid to that person. Sales compensation enables management to align pay opportunity

with the strategy and objectives of the business. If done correctly, compensation will help an organization

attract, retain and motivate top salespeople. If done incorrectly, it can result in turnover issues, drive

inappropriate behavior and/or increase uncontrolled sales costs. Sales compensation plans cover

employees who are fulfilling sales jobs. Such plans have four fundamental elements: the range of cash

compensation opportunity, the mix of base and incentive pay, the extent pay-at-risk is leveraged, and the

selection of pertinent incentive goals.

A sales compensation plan is put in place to motivate and reward certain sales

behavior. The behavior can range from selling more products ("any sale is a good sale") and retaining and

renewing current contracts, to acquiring new customers. Before designing a plan, you must know what the

organization wants to achieve. Without that knowledge, it is like asking a tailor to make you a suit, but

then leaving the shop before your measurements are taken. You cannot create the end product without the

right input first. Knowing the strategy is important because it:

y Helps you understand what the organization wants to do,y Provides a road map and helps you define success, andy Allows you to tie pay to the achievement of success.

An employer, in general, awards compensation to an employee for the employees services

rendered to the employer. An employers sales compensation program focuses on the employees revenue

production and other important job characteristics that are unique to the sales function.

The purpose of sales compensation is to:

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y Recognize the role fulfilled by company sales personnel to obtain and retain revenues fromcustomers,

y Align pay opportunities with the revenue objectives of the business by creating mutual successbetween the company and its sales employees,

y Attract, retain, and motivate talented sales employees,

y !Provide members of the sales force with credible performance measures that compliment, andmay even replace, the need for employee supervision, and

y Manage a major portion of sales costs by linking selling success directly with compensationexpenditures.

Sales compensation can be distinguished from other employee pay programs because salespeople have a

direct and measurable impact on the companys revenue productivity. This impact creates the opportunity

to directly link a salespersons individual performance as it relates to developing a positive impact on the

business by:

y Supporting the companys marketing and selling plans,

y Communicating performance expectations,

y Influencing the efforts and behaviors of employees engaged in the selling process by rewardingbased on performance outcomes, and

y Contributing to the culture of the sales organization.

Basic Sales Compensation TermsThere are four sales compensation terms that are basic to plan design:

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y Target cash compensation,

y Mix of base and incentive pay,

y Pay-at-risk leverage, and

y Selection of sales incentive goals.

Target Cash Compensation

Target cash compensation is the amount of base pay plus incentive payments that are made available by

the sales compensation plan for eligible employees who achieve expected performance results. Eligible

employees are those that fulfill customer facing jobs that have a direct impact on sales results, and

therefore, can be assigned a measurable sales quota. The amount of cash compensation to target for the

purpose of attracting and retaining the caliber of sales talent needed to achieve company revenue goals is

influenced by job content and scope of responsibility, competitive pay philosophy, portion of the sales

and marketing budget allocated for sales compensation expenditures, and internal equity of payments

to sales employees. Job content and scope pertains to understanding each sales role by the breadth of

responsibility, degree of accountability, focus on customers, and influence over financial goals. Consider,

for instance, how a sales managers job may differ from a sales representatives job. For instance, a sales

managers job has more administrative responsibility. A competitive pay policy articulates an

organizations strategy for competing within targeted labor markets to recruit the employees it needs to

achieve business success.

Consider the availability of capable employees within your recruiting markets to determine your

competitive pay policy. Targeting a compensation level at the 75th percentile of competitive pay practices

may enable a company to be more selective of their employees than another employer that targets the

market median pay level. Financial resources that a company can avail to execute its sales and marketing

plan includes the expenditures it expects to pay the sales force for achievement of the plan. Sales

compensation competes with other expenditures to produce company revenues. Sales compensation plans

must be designed to ensure that pay levels are commensurate with performance results. Assuming that

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goals are credible to the sales force and meaningful to the success of the business, internal equity occurs

when top performing sales employees receive higher pay relative to average performers.

Mix OfBase And Incentive Pay

Mix, in sales compensation, is the relationship of fixed and variable cash, where the fixed portion is base

pay and the variable portion is incentive pay. Compensation mix is expressed as a percent of target cash

compensation. In practice, mix represents the ratio between fixed and variable compensation in the

targeted cash compensation value at expected (i.e., planned) performance. The ratio is expressed with the

first value representing fixed compensation and the second representing variable. For example, a mix

expressed as 25:75 means that target cash compensation is composed of 25% base salary and 75%

incentive. For instance, a target cash compensation amount of 100,000 would be composed of 25,000

base salary and 75,000 incentive. The basis for incentive payment can vary. The incentive opportunity is

typically expressed as a percent of base salary or target cash compensation for bonus plans. For

commission plans, the incentive is typically expressed as a share of each occurrence such as for each

profit dollar, each revenue dollar, or each unit sold. The extent to which a salesperson can influence the

customers decision to buy is the primary factor used to determine pay mix. Incentive opportunity tends to

correlate with the role of the salesperson to impact the customers. decision to buy. Generally, the more a

salesperson has to rely on influencing skills to produce a sale, the higher the incentive opportunity in the

mix proportion.

Pay-at-risk leverage

Leverage is the rate at which incentive compensation is enhanced for degrees of performanceimprovement. The maximum incentive opportunity is added to base salary to determine cash

compensation at the established level of optimum performance.

Double leverage means that the target incentive for expected performance is twice that amount for

optimum performance achievement. .Triple leverage follows the same logic. Double or triple leverage are

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typically used to motivate the sales force to achieve optimum performance. Leverage is important because

it defines the point at which optimum performance is achieved and rewarded. Leverage also links the

value of additional sales over targeted goals to the amount of incentive opportunity. The extent to which

incremental sales are valuable to the business determines the amount of leverage the company will offer

its sales force.

Selection of Sales Incentive PerformanceMeasures

The sales and marketing strategy plus the product distribution channels determine the suitable

performance measures for sales compensation plans. All sales compensation plans should incorporate a

production goal. Additional measures, such as product, customer, and milestone measures can be used in

addition to the production goal. The following are the four categories of sales measures with sample

goals:

y Production (volume)

Revenue: total, new, renewal, price, margin

y Products (includes services)

Units sold, product mix, up-selling

y Accounts (customers, channels)

New, retained, expanded, satisfaction

y Milestones (events and activities)

Threshold achievement, contract commitment

When designing sales compensation plans, select performance measures that support the

organizations business objectives. Volume is commonly used since the core responsibility of most sales

jobs is to expand the companys market share, develop new business, and grow the customer base.

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Changes in sales volume are the best way to measure the successful production of the business. Incentive

goals must consider the accountability of the salesperson to impact the performance measure. The

incentive goal must have a basis for being measured, and the number of different measures should be

limited to three. Several business factors must be considered to determine the fundamental strategy for

sales compensation design:

y Business growth stage. If the business is a new start, there may be zero cash to pay a salesrepresentative a base salary. Product delivery may be dependent on influencing prospective

customers to purchase a product to fund that products development. In such a case, the sales

representative would be paid purely by incentive (a 0/100 pay mix). If the business is more

mature and established, then performance will be more predictable and target cash compensation

may consist of a mix that includes a base salary and an incentive that is based on a quota.

y Sales territories. Geographic territories must offer equivalent sales potential to the sales force.If designing a sales compensation plan around geography, study dimensions such as territory size

and demographics.

y Marketing focus. the plan and the selling role will have greater complexity if the company isconcentrating its product to market efforts in many markets as opposed to fewer.

y Application of thresholds. Thresholds are minimal levels of performance that must beachieved before an incentive is paid. Thresholds are used to cover the fixed costs of base salary,

to establish a minimum performance standard, and to recognize a margin for quota-setting

inaccuracies. At least 90% of sales personnel should meet or exceed the threshold performance

level. Thresholds may be determined based on historical customer buying trends or breakeven

volume.

y Application of maximums . Maximums are total compensation that may be earned and areotherwise known as a .cap.. Generally, sales incentive plans are designed without a cap so as not

to limit the performance capabilities of top producers. The rational for caps would be to limit

earnings to profitable levels of sales volume, to control costs, and to overcome erroneous quota

setting (e.g., windfalls).

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y Salesperson influence. The degree to which demand for company products must be created,versus satisfied, by the salesperson.

y Quota allocation. The degree to which sales quotas can be reliably and accurately determinedis compromised if the business is very dynamic such that setting quotas is difficult.

y Sales event. An occurrence when a sale may be counted for compensation purposes.Management

must consider the point at which sales credit is assigned because once assignment occurs, the salesperson

will no longer be concerned with the sale.

y Windfalls. A major sales event may result outside of the salespersons normal influencing role.Maximums and other techniques are sometimes imposed to control for windfall events.

y Shortfalls. A sales result significantly below expectations which are not influenced by the salesrepresentative may be addressed by adjusting the quota downward, providing a guaranteed

incentive payment, changing the mix to emphasize the base component, or adding a bonus

component with a predetermined incentive goal.

y Payment timing. A performance cycle is a period in which performance can be measured (i.e.,monthly, quarterly, annually). Determining the timing of sales incentives depends on how the sale

is made such as size of the sales transaction, number of transactions, length of the sales cycle,

forecast accuracy (quota setting reliability), and the desired sales force behavior.

y Draws. A plan designed with a draw feature is for new salespeople that are accustomed to arelatively stable compensation cash flow. A draw is a compensation that is paid in advance of

performance and is used to provide temporary cash flows to the salesperson until she beginsearning incentive pay.

There are two types of draws:

A .recoverable. draw provides for a minimum cash flow that is paid-back when actual earnings

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exceed the draw. Payback typically occurs at the next payment.

A .non-recoverable. draw provides compensation guarantees to new salespeople that expire at a

predetermined time. No compensation needs to be paid back if sales performance doesnt create

earnings that meet or exceed the draw.

Basic Sales Compensation Design

There are four basic sales incentive plan designs:

y Base salary only plans.

y Commission only plans.

y Base plus bonus plans.

y Base plus a combination of commission and bonus plans.

Base salary plans pay total cash compensation in the form of base salary only (mix is 100/0). These plans

are rarely used in sales compensation unless supplemented with non compensation methods to encourage

desired salesperson behavior. Base salary only plans may also be appropriate where quotas are impossible

to set and there is a complex multiple year sales cycle (e.g., commercial aircraft). On the other hand, sales

compensation plans can have a pay mix that is 0/100, meaning that no salary is paid and salesperson

earnings are 100% at risk. These are called pure commission plans and compensation paid to the

salesperson is either a percent of the sales revenue or a flat dollar amount for each unit sold.C

ommissiononly plans reward the individual effort of the salesperson to deliver sales results by focusing on increasing

product volume, and to ensure variability of the compensation expenditure.

There are three types on commission plans:

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y Flat. Whereby cash is paid on a volume rate that doesnt vary.

y Ramped. Whereby the rate changes after an objective has been met. The ramp may beprogressive whereby the commission rate increases, or regressive whereby the rate decreases.

y Variable. Commission rates in the incentive plan may vary depending on the salespersonsperformance or on the particular measurement used.

Combination plans (i.e., base salary plus commission and/or bonus) are commonly used because quotas

can be difficult to set or management wants to reward specific behaviors using a bonus. The rules for

calculating a bonus payment are the same as for a commission plan. The difference is that commission

plans provide afixedrate of earnings for each sales event, whereas, bonus plans provide a variedrate of

earning based on individual quota for each sales event. In other words, commission plans act as an

absolute calculation method whereas bonus plans act as a relative calculation method.

The Optimal Sales Compensation Design Process lays out the fundamental process for sales

compensation design. As such, it establishes the foundation for all that follows. The Growth Management

System shows that effective compensation evaluation and design is driven by an understanding of the

organizations decisions on strategy and market coverage. The Optimal Sales Compensation Design

Process takes that concept to the next level, illustrating the seven aspects to address when evaluating and

designing sales compensation plans. As shown in Figure 3 below, effective sales compensation or the

optimal design process starts at the top position with "job-role validation" and moves clockwise,

ultimately coming full cycle to the "evaluation & next cycle planning" step. These seven steps create a

simple yet potent process for sales compensation design. Once you understand these steps and the proper

questions to ask the sales team or organization, you are well on your way to fashioning an effective

design.

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Every step has a role and is important to the process. It is important to stay focused on this process. Also,

steps cannot be skipped, as they are sequential. Think about it: You cannot get to 8 p.m. until you have

moved through the morning and afternoon. It is the same thing with sales compensation. You cannot start

talking about the measures in a plan and the commission rates until you have determined whether the job

is eligible and what the mix of base pay and incentive will be. Remember that all aspects of the optimum

design process tie back to strategy; if you do not know your strategy, stop right here. There is no point in

taking any more steps if you have not taken the critical first step. Anyone who has been involved in sales

compensation for any period of time likely has encountered the Growth Management System and Optimal

Sales Compensation Incentive Design Process, or similar charts with different names. The source of a

chart and its title do not matter it is the concepts that count.

y Get a handle on how your organization directs, organizes, executes and supports strategy in thesales organization.

y Make sure any blips in sales performance truly are compensation-related before embarking onincentive redesign.

y When you set out to monitor a sales compensation plan or design a new approach, let the componentsof the optimal design process guide your effort.

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Plan Implementation ConsiderationsA plan document must be written to state the terms and conditions of the plan. The plan document states

the purpose of the plan in a way that avoids confusion should unexpected outcomes arise to protect both

the company and the employee. The plan document specifies eligibility criteria, performance measures,

and timing of awards, among other matters such as termination of the employee or the plan. Company

leadership should review plan documentation with legal counsel before implementing the plan .Once the

plan terms and conditions have been decided, communicating the compensation program to the sales

force may begin. The new plan must be communicated with positive influence over salespersons for a

smooth transition to occur. Senior and field sales management must own the plan design and

communicate it to the sales force. Face-to face (superior-to-subordinate) communication is preferable.

Communication must not stop after the initial plan introduction. Management will gain significant

advantage through ongoing communications. Salespersons will gain advantage by monitoring their

achievement toward established goals. Finally, testing the plan before initial communication and

Subsequently (after implementation) is critical to determining if a sales compensation plan is an effective

one that is operating as planned. Annually evaluate the plan from two perspectives:

y The employers perspective considers cost versus plan budget, observation of desired behaviorsamong the sales personnel, quota distribution against actual results, sales outcomes versus

established goals, and Competitiveness of earnings generated by the plan.

y The sales employees perspective considers the equity of a pay-for-performance plan (e.g., do top performers earn the top awards), quota and goal attainment difficulty, total pay levels versus

expected pay levels, and perceived competitiveness of the companys sales compensation plan.

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When Incentive Programs Go Awry: The Chrysler Example

Car dealer volume incentives have long been part of the automotive industry, and auto manufacturers

frequently introduce novel programs to catalyze dealer sales. Not all of these innovations, however, are

successes, and indeed some dealer programs can have unintended negative consequences on both sales

and operations. Examining how some incentive programs have gone awry can help any manager seeking

to design a sales force incentive plan.

Consider the experience of the Chrysler division of DaimlerChrysler. In an effort to spur U.S. sales in

2001, the company offered dealers a stair-step incentive plan. For each dealer, Chrysler specified a

monthly sales target. Dealers were then offered bonuses for fulfilling different percentages of this target,

such as 75 percent, 100 percent, and 110 percent. Figure 1 shows how such a program works, using a

hypothetical sales target of one hundred cars per month.

Figure 1: Example Dealer Incentive Program with Target of 100 Cars/Month

Dealers, Chrysler believed, had every incentive to climb these stairs and sell cars, but that is not what

happened. Instead, sales dropped and Chrysler was left with the painful choice of piling up inventory or

idling capacity, neither one of which is good for the bottom line.

Why did the plan fail? The company found that when dealers realized they could not reach their monthly

goals, their sales efforts plummeted. Dealers waited for the next montha new targetrather than push

cars in a month for which the quota and bonus were out of reach. As a result, Chrysler sales cycled

through booms and busts. Dealers would order fewer cars during months in which they felt they could not

reach their quotas, but more cars during months where they felt they could. The result forChrysler was an

increase in the variability of sales numbers, as well as increased production and inventory costs which

eroded profits for the auto manufacturer.

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The Hockey-Stick Phenomenon

This may all sound painfully familiar to managers whose firms set quotas for their sales force. Often,

nothing happens in the sales period until a manic rush of orders as the incentive period comes to close.

Demand consequently follows a hockey-stick pattern of level sales followed by a sudden, rapid

increase, as illustrated in Figure 2.

Figure 2: Hockey-stick Sales Pattern

Such behavior results in wide variances in work levels for the manufacturing and logistic operations.

When orders are high, the manufacturer must pay its labor force overtime fees to produce the quantity

desired. However, when sales volume is low, the company experiences low productivity rates, high

inventory storage fees, and excess capacity. It is nearly impossible for manufacturing managers to

forecast these sales swings and keep their plants operating smoothly. However, the lessons of a few automanufacturers may offer insights to reduce such incentive-driven sales variances.

Four Mechanisms to Create Effective Stair-Step Incentive Programs

In designing sales incentive programs, executives must be cognizant of sales variance in order to manage

costs. An effective way to minimize marginal costs is to achieve monthly sales numbers that are close to

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the forecast demand. When designed properly, incentive programs can help to increase the predictability

of demand, and there are four mechanisms that managers can use to accomplish this objective, as seen in

Figure 3.

Figure 3: Mechanisms forCreating Effective Incentive Programs

The first and most obvious mechanism involves setting realistic and attainable goals for the sales force.

Too often, managers use stretch targets in order to push employees towards the upper range of

achievable sales levels. High sales numbers are always desired, but firms must understand how sales

representatives respond to such incentive quotas. Without realistic goals, incentive programs can result in

higher sales variability and have a negative effect on profitability.

The second mechanism that firms can use entails extending their incentive horizons to align with the

natural sales cycle and selling environment of their industry. In the auto industry, dealers previously had

thirty days to reach quota, which was often insufficient to guarantee dealer effort. This was due to a

natural seasonality in the car sales business with both busy months and slow months. By extending

incentive horizons to a longer period of time (three months or more), automakers could allow dealers to

weather a slow month and take advantage of a busy month to achieve sales targets. As dealers began to

believe that their sales targets were attainable, they were willing to ramp up their sales efforts to pursue a

bonus. This illustrates that extended incentive horizons can smooth out the manufacturers variability in

sales. By designing an extended horizon that incorporates factors such as seasonality, their agents selling

environment, and their agents ability to move product, managers can avoid the dreaded hockey stick

effect on sales.

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A third mechanism involves the use of rolling horizons. An alternative to the extended horizon, this

mechanism creates an environment in which each month is alternately the first, middle, and last month in

different incentive periods. To clarify this concept, consider an environment in which dealers have

continuous incentive windows throughout the year. For example, March is the last month in the window

from January to March, the second month in the window from February to April, and the first month in

the window from March to May. In this scenario, the dealer is rewarded for maximizing his effort in the

month of March, and in every other month, because the sales number affects three different incentive

horizons. The result of such a program is a flatter sales forecast that minimizes the hockey stick effect.

Such enticements for selling agents help the manufacturer both maximize dealer effort every month and

minimize marginal costs by reducing sales variance.

The fourth mechanism consists of creating incentive systems that are particular to a specific product

rather than to a wide array of products. For example, car manufacturers have used direct-to-consumer

incentive programs that had one sales target for all models carried within a dealership. This

unintentionally created an incentive for sales representatives to sell the model car that would make it

easier for them to achieve their volume targets. As a result, the variances in sales from model to model

and from month to month increased as dealers pushed different models at different times. Now

automakers use incentive programs that have a different sales target for each type of model. By doing so,

manufacturing variance for specific makes and models has been reduced, and the band of sales variance

within the industry has narrowed considerably.

Selling agents will act in their best interests, and manufacturers must create

incentive programs that fully support such action. Following its tumultuous experience with its initial

incentive program, DaimlerChrysler revised its stair-step program by extending its windows and lowering

its sales goals. As a result, the company has been able to capture cost savings in its supply chain by

reducing sales variance. Managers across the industry spectrum can learn from the experiences of

automakers and establish incentive programs that create consistent and predictable selling patterns across

their business. The result will be a significant reduction in manufacturing costs and the first step toward

higher profits.

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Conclusion

Sales compensation designers should assess the current incentive plan to confirm and validate the

following areas of interest:

Is the structural design of the plan appropriate; does it properly apply the principles of sound

compensation design? Three areas to assess include:

1. Consistency with the job content and scope ofResponsibility

2. Competitiveness with pay levels, mix and leverages (i.e., is the plan attracting and

retaining the desired talent?)

3. Comparison with common plan practices to assess whether the calculation method,

commission or bonus, is consistent with recruiting market competitors.

To determine whether the plan contributes to business success, assess the plans alignment

with business and human capital management objectives, pay-for-performance results, sales talent results

(i.e., ability to retain top talent) and the competitiveness of sales compensation in the relevant recruiting

markets. Sales compensation may complement other forms of pay, but the distinguishing factor is that

sales compensation recognizes and rewards the unique responsibilities of a salespersons job. In no way,

shape or form is compensation a proxy for managing sales professionals. Managers need to manage reps

by teaching, motivating and driving behavior. Compensation then becomes the means to focus reps on the

right goals and reward behavior that produces sales results. As the business changes, so must sales

programs and compensation plans. Companies typically move through several growth phases as they

mature. In each phase, the company uses unique sales strategies, coverage approaches and sales

compensation plans. If the organization does not recognize these changes in its market, competition and

business environment, programs that previously were effective become ineffective, putting the company

at a competitive disadvantage.