"We make it on volume" is not the way to go: Growth in sales is important, but profit needs to result. The compensation of the sales team must be based on volume and your profit margin—our readers all say that loud and clear.
The compensation issue has certainly touched a hot button. So many MarketingProfs readers responded to the following dilemma (and in such great detail), that we can't include all their comments in this issue. We will cover this topic in more depth in future issues. Thanks again for sharing your advice and strategies.
Current Marketing Challenge
Do I pay commissions on gross sales or gross profit for services?
Our star salesman is the best closer I've ever seen. He sells products and services. He's paid a salary plus commission on gross sales. He does have some pricing latitude. I've noticed a fairly stable gross profit percentage on products, but it's much different on service sales.
It looks like he's "giving away" services to get more product sales. Service costs are somewhat vague and hard to accurately measure, but I need to grow the service side of our business profitably.
Should I switch his commission structure to a gross profit percentage on services?
—Julian B., Sales Director (company name withheld)
Besides sharing their own experience (and chanting "gross profit, gross profit"), readers suggest the following:
- Develop a standard costing guideline and service revenue targets.
- Start a deal-review process.
- Adjust compensation for unmet profit margins.
- Stick with the current game plan.
- Reduce pricing latitude.
Develop a standard costing guideline and service revenue targets
An executive director gives first-hand experience in creating a services revenue target:
All commissions should be driven by profit margin, but especially those for product services. Working with clients, we have changed commissions for product-services sales versus new-product sales. Product-services sales, upon analysis, had margins that were, on average, 100 percent higher than new-product sales (excluding R&D, which was almost exclusively oriented toward new products). We doubled the commission on a revenue basis for product-services sales.
If you sold a $100 new product, for example, you received a 5 percent commission or $5. If you chose to take the net present value of future fees, and that came out to $70, as the salesperson, you'd get 10 percent or $7 commission. Guess how quickly the focus of the sales force turned to product-services?
Sales increased by 20 percent in the first year alone from a product-services business that was growing only 10 percent, but that was still much better than the 1 to 2 percent new product sales!
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If your service costs are somewhat vague, put more energy into quantifying them. The service business is tougher to sell, as it is much like selling the sleeves out of your vest (no tangible receivable). You should commission service sales on gross dollars plus gross profit. Provide some incentive in getting the agreement at the point of sale, while also ensuring the salesperson focuses on the long-term relationship.
A reader warns of the possible negative impact on customer loyalty when compensating on service sales alone, without clear targets and measurements:
Selling services is often up to twice as profitable, dollar for dollar, as the actual product sale. In addition, by cutting the margins on service, your salesperson may affect the service quality that ultimately gets delivered over the product lifecycle. This, in turn, can create customer dissatisfaction issues that hinder any future follow-on product sales.
Given these factors, it is short-sighted on the part of the salesperson to "give away" highly profitable services that may have more impact on customer loyalty than the product itself. I would highly suggest you either commission on gross profit or completely separate product and service sales targets, discounts and measurement.
Brian Peterson, director of inteLogica, Inc., gives two costing examples:
You can go two ways in paying commission on selling professional services. Suppose you put a consultant on a project at $100 per hour, and the cost and support of that consultant is $60 per hour. Therefore, you have a profit of $40 per hour.
Version 1: Using this example, you can offer a commission on the gross sales ($100 per hour) and provide your salesperson—let's say a 10 percent commission—so it works out to be $10 per hour in commissions.
Version 2: An alternative is to pay your salesperson on the net profit of the consultant ($40/hr) at a rate of 25 percent, which works out to be also $10 per hour. The challenge is to be very clear on any additional costs the consultant adds to the overall cost, as in Version 2.
Michael Szot stresses gross profit:
Drive commissions by profitability, not gross sales. I have seen too many instances where commissions were based on gross sales, but the overall margins were below expectations. When that happens, commissions paid become a larger percentage of your profit. If you base commissions on profitability, your sales staff can focus on the margin. Increasing profit increases commissions, and the reverse should also be true.
A managing director recommends going the gross margin route:
Gross margin is the way to go. The trick is to define the cost of goods to drive the correct behavior that yields profit on the bottom line. The calculation to get this right requires a clear understanding of the end-to-end process that delivers the "product," whether it is goods or services.
A company president provides three steps to end this giveaway pricing problem:
1. Communicate the cost/benefit scenario to the sales team.
2. Choose a commission plan that properly motivates the sales team.
3. Productize your service offerings.
Start a deal-review process
A division vice-president suggests creating a deal-review process in order to ensure customer proposals align with your business targets:
We have found that focusing service sales commissions on gross bookings (70 percent) and target revenue (30 percent) drives growth. To manage margins, implement a deal-review process that reviews and approves proposals before customer submittal to ensure the deals you get align with your firm's expectations for financials, customer value, etc.
Adjust compensation for unmet profit margins
In addition to creating a review process, it's also wise to adjust compensation to sales team members when they do not meet your profit margins. A VP suggests a reduced commission:
Keep in mind the old saying, "Compensation drives performance." Reduce commissions or install a penalty if the service sales margin is not sold at an acceptable level. Also, you could pay a flat commission on the renewal of service contracts at a targeted profit margin at the time of the sale. This would be an incentive to retain and sell service contracts.
Stick with the current game plan
Justin Schroder, president of Listen Hear, Inc., recommends not changing a star salesman's commission structure:
If he sells, don't be afraid to pay him. Changing his commission structure might give him the impression you feel he is overpaid. This would be a sure motivation and commitment killer. I would suggest encouraging a balance of "give-aways" between products and services to your salesman. This will also give you the chance to show how his earnings increase when his gross sales are up.
However, it seems that if you do not accurately know your margin on services, you would have no solid proof that "giving away" less service would increase your salesman's earning potential. Know your margins, and make products and services as equally profitable for your sales staff as possible. You didn't say this, but I imagine that your products add up quicker for gross sales than your services do. Switching to a commission structure based on service sales simply causes your sales staff to give away products.
Reduce pricing latitude
A regional sales manager suggests tightening up pricing instead of changing your compensation plan:
You may not need to change your compensation plan at all. Perhaps you should allow less latitude in pricing by setting parameters on just how much you can adjust service pricing.
A sales manager also advises against going in the opposite direction—inflating costs to ensure a profit:
I believe all salespeople should be paid on gross profit—a good percentage of the gross profit against a realistic cost. Too many companies, managers or owners feel they need to inflate the cost to ensure profit. Salespeople should also be given a draw vs. a salary. They need to feel they are in their own business with true income and expense responsibility. But, these entrepreneurial people are hard to find—everyone wants a guaranteed salary.
Compensation needs to encourage more sales at acceptable profit margins. You can't keep giving away the store. Services should not be loss leaders. To develop a compensation plan that works, know the costs, make sure the sales team knows them, and reward on higher profit margins.
Next Marketing Challenge: Can You Help?
I dread our weekly staff meetings
Every Wednesday, seven other managers, VPs and I are required to attend an executive staff meeting at our company. For years, our president has been doing these to keep us informed and talk about current projects, new business, problems, sales trends, etc.
It sounds productive, but it isn't. The meetings never start on time, people stroll in late, answer their cells phones, and there's much socializing. When the meeting finally starts, it's haphazard at best. Some people monopolize the conversation and topics; important things are often never discussed.
Sometimes, I feel like standing up and saying, "C'mon, let's get down to business; we all have work to do." But I don't. I know the president thinks these meetings are worthwhile. If they were better organized, I think they could be very productive and not just two-hour "bull sessions" or ego builders.
—R.W., (company withheld)
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