Misguided compensation: more is NOT better when it comes to variable pay
By Beth Carroll and Brenda Maldonado
Many sales leaders and CFOs believe paying company sales representatives as if they were agents (100 percent variable pay) strengthens alignment between a company’s objectives and sales representatives’ focus and results; however, the absence of a base salary often has an adverse effect with significant unintended consequences: Lack of Control, Complacency, and Limited Flexibility.
Consequence #1: Lack of Control
Sales representatives who are on 100 percent variable pay plans (often called 100 percent commission plans) see themselves as masters of their own destiny. In their minds, they are taking all of the risk and therefore should be able to decide how they work, when they work, where they work, which offerings they emphasize and which types of prospects or customers receive most of their attention. The problem with this philosophy is that the sales representatives’ preferences may be at odds with the interests of the business. The ensuing conflict of interest undermines a company’s ability to present a consistent message to the market, execute an important strategy, or even ensure sales methods and processes comply with ethical standards and local laws. Industries in which sales representatives have the worst reputations for misleading customers (used-car dealerships, mortgage brokers, and time-share sales come quickly to mind) are industries in which 100 percent variable pay plans are common and sales representatives are willing to do “whatever it takes” for the next sale.
One might counter that insurance is also an area where sales representatives (agents, in this case) are on 100 percent variable compensation, and yet their image is not as negative. There is a key difference: insurance agents work to build a long-term portfolio of satisfied customers. For the sales reps mentioned above, repeat business is not their goal. This does not mean, however, that the prevalence of 100 percent variable pay arrangements in industries that focus on managing repeat business exist without consequences. These sales roles often suffer from Consequence #2: Complacency.
Consequence #2: Complacency (The Phantom Base Salary Effect)
Sales representatives who are on 100 percent variable pay plans but have considerable recurring business develop what is known as an annuity, or “phantom base salary”. This model is extremely attractive to sales representatives because they know if they work hard for a few years, the resulting annuity stream will allow them to collect a comfortable paycheck with comparatively little additional effort. When a sales representative can predict on January 1, with some measure of accuracy, what his/her pay will be for that year, a phantom base salary has been created. The annuity stream undermines the sales representative’s drive to continually acquire new business. Admittedly, there are some sales representatives who will always be driven to acquire new business in order to build up an ever larger annuity, however, many will reach a plateau where their annuity stream supplies enough income, and the extra work is not worth it. Managers in these organizations often find themselves frustrated with sales representatives who are comfortable at a level of sales and earnings below what is needed for the health of the business. At this point, management typically considers ways to change the compensation arrangement, only to realize they are caught in Consequence #3: Limited Flexibility.
Consequence #3: Limited Flexibility
As a solution to complacency, or for other reasons, management may decide it needs to reassign territories or accounts, split territories, or focus some representatives on a targeted customer type. In the case of 100 percent variable commission-based plans, these actions are viewed by sales representatives unfavorably as if management were suggesting they swap families. Customers are viewed as the “property” of the sales representative who landed them, and often will join a competitor and take their customers with them in response to changes.
Another challenge occurs when a sales representative leaves the company and his/her accounts must be reassigned. This situation creates a quandary for management: sales reps who are assigned these accounts need to be compensated for the additional work (they have no fixed compensation after all, and it cannot be expected that they will do it out of the goodness of their heart), but most will agree that compensation for assigned accounts should be lower than compensation for acquired accounts. In these situations, management may develop complex workarounds, such as “house account” rates or territory/account-buyout deals. These side deals can become cumbersome to manage and may open the door for claims of inequity.
What’s the solution?
A 50/50(1) pay mix (50 percent of the target total compensation comes from salary and 50 percent comes from incentive) is considered by many sales compensation design experts to be the tipping point in terms of balance between control and motivation. At 50 percent of target total compensation, the salary gives the business a reasonable claim to control behavior and manage account and territory assignments. The 50 percent of target total compensation that is at risk (variable pay) is generally sufficient to motivate continued growth. Once the pay mix tips beyond 50/50 and more comes from incentive (at target performance) than from salary, focus and control for the company will not be much different from a 100 percent variable pay plan. With at least 50 percent of the target total compensation coming from salary, management can design the mechanics of the variable pay portion so as to truly reward performance.
When shifting from a 0/100 pay mix to a 50/50 pay mix, the incentive portion can become truly variable in ways that were not possible when it was the sole source of income. At a 50/50 pay mix, a threshold may be introduced below which no incentive pay is earned. Economically (and psychologically) once this downside is introduced into the plans, the leverage on the upside can be increased so representatives who exceed expectations make even more. The world of a flat commission rate can morph into escalating rates, goal-based rates, or goal-based linear incentives – all of which provide far greater motivation to meet and exceed expectations.
Even though 50/50 is an important tipping point, it is not the case that all sales representatives should have a 50/50 pay mix. Pay mix should be a function of the selling role and should reflect the degree of influence a sales representative has in making the sale. The more directly responsible the rep is for closing a sale, the more variable the pay mix should be at target. Typically, hunter roles in start-up businesses or new product launches will have the most variable pay mixes.
Those who would likely have less pay at risk as a percent of total compensation include account manager responsible for expansion selling with existing customers, or sales representatives who sell on teams with technical engineers, pricing specialists and other support resources. All of these tend to have less pay at risk because the sale is driven by a numerous factors, in addition to the skill, initiative and creativity of the individual seller. These roles tend to skew more toward a 70/30 pay mix or even an 80/20 pay mix in some circumstances.
Companies often miss the opportunity to direct sales representative behavior through annual performance reviews and salary increases. Without a salary, any conversations you may have around more subjective measures of performance such as teamwork, completion of administrative tasks, or other necessities will have no teeth. Having at least 50 percent of the target total compensation in the salary gives management an additional lever to provide direction and differentiate performance along dimensions other than just the numbers.
The best sales compensation plans have balance – balance between financial and strategic performance measures, balance between short-term and longer-term results, balance between individual and team performance, and balance between fixed and variable compensation. The right balance for each of these dimensions depends on the business strategy, the company culture, and the type of selling role. For these reasons, a sales compensation plan that has no fixed pay component is rarely the right answer; it lacks a necessary ingredient that allows management to guide behavior, create greater motivation by making the variable pay truly variable, and manage account assignments based on what is best for the company and the customers.
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(1) When stating pay mix, the first number given is the salary portion, the second is the incentive portion, and both must add to 100 percent.