Should companies pay salespeople based on profits?
Most agree the key measure of sales performance is revenue, what the company gets paid for the sale. Expressed as a sales goal, sales departments link sellers’ pay to “winning” as much revenue as possible. However, not all revenue will prove profitable for the company. Should management link the payout of the sales compensation plan to sales profitability of the orders?
Aside from the finance team cheering “absolutely,” most sales leaders agree, if the seller can and should influence order profits, then management will add a second measure of profits—in addition to revenue—to the sales compensation plan.
So, the key phrase here is “if they can influence.” Sales compensation plans reward successful persuasion. If sales management requests sellers to contribute to improve sales order profits and they can affect the profit outcome, then include a profit measure in the incentive plan.
The following are typical types of profit measures and their applications.
- Gross Profit Dollars. A common (and disappointing) profit measure is gross profit dollars. Gross profit dollars is the sale price minus the cost of goods. This is a common profit measure when companies give sellers pricing flexibility above the cost of goods. Disappointing? This measure—used alone—has proven to suppress volume and in some cases erode percent profit. Sellers might ignore large, thin margin business, which the company uses to fund the business as the sellers pursue smaller volume deals with higher margins. Additionally, sellers will “discount” the margin percent to “save the order.” Thus, earning an incentive, but substantially reducing the order percent profitability, therefore degrading the company’s overall profitability.
- Percent Profit. Whether measured at the order, account or territory level, percent profit divides the profit dollars by the revenue. This is a powerful measure of sales profitability. However, to avoid suppression of volume, it is best to use this as a second measure to sales revenue. Using both measures informs the seller: Sell as much as you can, sell at the highest percent profit. A preferred formula mechanic features a payout calculated for volume modified (up or down) based on percent profit performance.
- Price Realization. A better term than “discounting,” is price realization, i.e., the sale price compared to the target/list price. It’s a good measure of seller success at securing the best pricing. Price realization avoids revealing the “cost of goods,” which occurs when using gross margin measures. While sales management grants sellers pricing flexibility, leadership expects sellers to close business as close as possible to list price. There may even be a sanctioned discount schedule based on volume and terms, yet the objective remains for the sellers: “Follow the pricing line as close as possible.” In some instances, companies do not have a price list, such as custom configured solutions. In such cases, a pricing tool or a pricing department provides the “list” price for the configured solution. In summary, price realization is a great second measure when linked as a modifier to the primary measure of sales volume.
- Product Mix/Solution Selling. As companies attempt to improve profitability, selling a preferred mix of products or an enhanced solution offers higher deal margins. A second measure of product “cross-sell” or preferred product mix can reward sellers for closing the most profitable mix of business.
- Contract Length/Terms and Conditions. In some instances, a longer contract might be more profitable for the company. Or, contracts that include customer rewards/charges based on payment timing. Each of these variables could have a material impact on order profitability. If the seller can influence these factors, then consider including them in the incentive plan.
- Average Sales Price (ASP). Average sales price measures the market “going price” for a product. As demand rises and falls, the average sales price will move with the market. The seller role is to sell above the ASP. Meanwhile, ASP has its critics: ASP disconnects pricing from cost of goods. Not a comforting reality.
Each of these profit measures applied correctly in the sales compensation plan can improve order profitability.
How Growth Affects the Use of Profit Measures
The growth rate of a company has an impact on the use of profit measures. Consider the young start-up: It needs revenue, almost any revenue. It’s not uncommon for most of the early revenue to be “not profitable.” These young companies will provide a fixed list price to sellers. Yet, management will step in with price concessions if securing the deal warrants a discount. However, for the most part, selling without pricing flexibility is the norm and is not part of the incentive plan.
What About Fast-Growing Companies?
Scaling companies—those growing really fast—more volume is better because it reduces unit margin of production, thus fueling profits. While sellers may not have pricing authority, management will give them sanctioned discount lists. Adherence to pricing schedules could be part of the incentive plan. In low-growth companies, securing volume becomes tantamount, but not at the expense of profits. Greater pricing freedom is afforded to sellers with both associated risks and rewards. The use of profit measures increases significantly and becomes an important feature of the incentive plan. Finally, when adopting new product and segmentation strategies to reignite growth, sales management will use profit measures to protect the core business but use production measures—absent profit measures—to drive new strategies.
Survey Announcement: Are you prepared for sales compensation changes in 2021? Take the Alexander Group’s 2021 Sales Compensation Trends Survey to learn the latest on sales compensation trends, including sales compensation budgets, pay levels, staffing, quotas, COVID-19 changes and other sales compensation topics. Survey closes December 15. Results published in January.
David Cichelli is a revenue growth advisor for the Alexander Group. Connect with him on LinkedIn.