Part 2 – Unintended consequences and Clarity
We are often asked “What is ‘the right way’ to pay?” but there is no easy answer to this question. The “right way” depends on a variety of factors particular to each company. There are some definite wrong ways to pay, and this three-part article will outline the six most common compensation mistakes we’ve seen in our work with more than 40 Transportation & Logistics companies in over 14 years’ as sales compensation consultant working with private and public companies from a variety of industries, ranging in size from small privately held companies to multi-billion dollar global giants.
In Part 1, originally published in the May 2012 Logistics Journal, we examined Top Compensation Mistakes #1: Not realizing that compensation is part of a complex and interconnected system, and Top Compensation Mistakes #2: Thinking about compensation as only an economic deal with the employees. We will now look at the next two top compensation mistakes.
Top Compensation Mistakes #3: Not considering short-term and long-term unintended consequences.
Short-term consequences from ill-designed incentive plans typically involve damaging customer and/or carrier relationships and damaging employee interactions. For example, if a plan puts too much pressure on margin percent, you might find your employees negotiating too hard with your customers or carriers and costing the company current business, and worse--the opportunity for future business. Likewise, if a plan rewards only individual performance, then employees may work against each other to maximize their own paychecks. Some examples familiar to many of you are carrier reps not letting their colleagues know about available trucks (truck hording) or, worse, changing the code on a load to their own. I’ve even heard of reps “paying each other” for loads. If any of these things are happening in your office you have a problem with your incentive plan!
Long-term consequences are harder to anticipate because, by definition, the effects do not manifest themselves for months or even years. The most common long-term consequence is sacrificing long-term growth for short-term gain. This is often found among Branch Managers whose incentive plans pay a percentage of profit. Branch Managers may resist hiring employees under this type of plan as they will inevitably take a short-term hit in their incentive compensation while they train the new employee. Everyone will agree that in the long-run the branch will increase in performance, but managers rarely have the kind of long-term vision as entrepreneurial owners; they are worried about their mortgage and the next car payment. Owners, by definition, are more willing to take risks than employees, and they are more likely to see the long-term benefit from making “investment” decisions. Hint: If your employees were willing to take these kinds of risks they wouldn’t be working for you.
Another long-term consequence is the creation of annuity pay. While it may seem perfectly sensible to arrange a “forever” deal with an outside sales rep who brings new customers (say 10% of all gross margin from that customer for as long as it remains your customer and as long as the rep works for you), five years from now this deal will not make as much sense. For starters, your once superstar hunter will spend more and more time on non-working activities (like golf) and your flow of new customers will have dwindled to a trickle. Most importantly, the economics of the deal will no longer make sense because in the intervening years you will have invested in a better TMS system, a better CRM system, support resources, and marketing, all of which make the job easier for your sales rep. And yet the sales rep is making the same percentage that he/she made when the job was considerably harder. You must have a system which ensures that your cost of compensation as a percentage of gross margin DECREASES over time, or your business will not thrive.
Top Compensation Mistakes #4: Not clarifying goals to enable the shift from transactional to growth-focused plans.
The most common complaint from business owners is the inability to grow. It’s no wonder when:
No one in the organization (including the owner) can articulate a specific growth goal, and;
The compensation plan pays only on a transactional (load-by-load) basis.
We say it all the time but it bears repeating… ”MORE” IS NOT A GOAL!" You need to make your growth goals clear, to yourself and your employees, or there is no accountability when you fail to reach them or celebrations when you do. You also need to pay using performance expectations, as this will drive employees to higher levels of performance. At a minimum you need to use three levels: Threshold, Target, and Excellence.
Threshold
is the minimum level of performance required to earn an incentive. If your employees have a base salary, there should be minimum level of performance before incentives kick-in. However, it’s rarely a good idea to make this an explicit function of their salary (though I’m well-aware many brokers do this…and so do many banks). Effective compensation design actually separates salary and incentives into two different categories of compensation. Salary increases should be earned for teamwork, punctuality, attitude and any number of other intangibles that differentiate a good employee from a problematic one. Incentives should be used to reward performance in areas that are objective, measurable, relevant to the business, and controllable by the employee. Many brokers miss this opportunity to reward (or correct) the intangibles by never giving salary increases, tying salary increases only to productivity, or tying incentive thresholds to salary (which actually makes any salary increase feel like a punishment). This is not to say that there should not be an economic relationship between the cost of someone to the organization and the expected productivity -- there absolutely must be a connection in an aggregated way between the cost of compensation for the employee population and the company’s gross margin. But there will be fluctuations in this number over time, and between employees, as some employees provide value that goes beyond pure productivity.
As a good rule of thumb, 90% of your employees should be at or above threshold in any pay period, and payout at threshold should be anywhere between 1% and 25% of the target incentive. If this figure is not being achieved, your incentive plan is not providing much in terms of motivational value.
Target
is the level of performance expected from an average performer and should bear some relationship to the growth goals of the organization (the sum of the targets for all employees should equal or slightly exceed the overall company goal). We often refer to a concept called “Target Incentive Compensation.” This is the amount of incentive pay earned when target performance is attained. When added to the salary, this becomes Target Total Compensation. When you look at what an employee actually earned in a year (salary plus all cash incentive payments), this is called Actual Total Compensation and is the only number that could be compared across companies. Some companies pay more in salary and less in incentive than others. Some companies use a pure commission approach, others use a commission combined with team incentives, bounties, or other payout mechanics. Comparing just the base salary misses anything from incentives. Likewise, comparing just the “commission rate” does not factor in the salary or if any pay is coming from other components, such as a quarterly team payout. Be wary of companies who report inflated Target Total Compensation. A true Target Total Compensation figure should be achievable by 50-60% of the population. If a company is telling prospective employees (or competitors) that their Target Total Compensation is a figure that has only been achieved by 1 employee in the last five years, they are deceiving themselves, prospects, and the market at large.
Excellence
is a bit trickier to define, but a good rule of thumb is to look at the top 10% of your performers and tie Excellence to the level of productivity they achieve. In Excel, the formula for this is =percentile(array,.90) where array is the list of performance (such as monthly gross margin) achieved by your employees. By the way, =percentile(array,.60) would give you a really good idea of where to set the target productivity level, as this would skew your goals 10% higher than the median actually attained. Then check to see if the sum of targets equals the company goals, and if not, then consider how you are going to close the gap.
Once you’ve determined the Excellence level of performance (yes, this is odd grammatically, but it’s how we compensation consultants talk about it), you then need to determine the appropriate leverage factor. The leverage factor is the multiple of the target incentive earned at Excellence. Typically it should be 2-3x target, with higher leverage for roles that have more pay at risk. The payout once you get above target should be steeper than it was leading up to 100%. This makes sense from the company perspective also, as once an employee has hit target all fixed costs should be covered and the company can afford to share a higher % of the profits.
In Part 3, we will finish up with Top Compensation Mistakes #5: Not understanding the legal ramifications of incentive compensation (yes, there are laws about incentive pay!), and Top Compensation Mistakes #6: Not communicating and supporting the plans, and not following up with solid tracking and feedback.
This excerpt was originally published in the July 2012 issue of The Logistics Journal.