Building Compensation Plans - Where to Start …. Where to Finish
Compensation plans need to be competitive to attract the best sales talent and leverage the appropriate commission structure to incentivize increasing sales growth levels. This is a lot easier said than done. Most companies I have worked with have identified a competitive base salary but then create a simple commission percentage, based on revenue, that does little to recognize the expected value of a given territory. The opposite extreme is even worse and has multiple, seemingly random, commission rates and bonus structures that attempt to incentivize individual activities rather than a territory achievement goal. An effective compensation plan has a competitive salary, a variable commission based on the expected value of a territory, and an accelerator rate that rewards achievement.
The justification to hire a sales rep is positioned as an investment in the company's future to many companies. I agree with this premise that it is indeed an investment decision, which means the position's success needs to be measured on financial terms that should be used in any investment decision. To make this type of investment decision, you should know the breakeven point, the ROI at goal, the ROI at 120%, 150%, and 200% of the goal. If you do not set these financial goals for this investment, you will never be able to evaluate whether or not the decision met, exceeded, or fell short of your financial goal.
So… Where to Start?
The first step is to look at the territory that the rep will handle. The most crucial factor is to determine the expected revenue that should be produced in that territory. All the calculations and financial modeling start with this step. There are many ways to estimate this value, which varies by industry, product sets, business model, history, comparable territories, and way too many variables for this discussion. The territory value needs to be determined based on your unique business model.
Once this value is determined, the next step is to understand what you would invest in attaining this territory's revenue value. If you decided that a territory should deliver, say, $1M in revenue, what would you invest in getting that return? The answer has several variables, including the obvious OTE (on-target earnings) for the rep, your average margin for the products to be sold in that territory, employee benefits, and payroll costs (generally 25% of OTE), T&E expenses, and finally your ROI expectation.
To create a hypothetical example using some of the data above, a 50% product margin and a 20% ROI threshold, we can complete this investment picture. $1M in territory revenue turns into $500K of margin. T&E expense for a territory of this size runs $50K per year (again, hypothetical). At this point, the $1M territory has a profit potential of $450K. The next question is, what is the highest OTE that would yield a 20% ROI? One more math quiz in that the OTE needs to be multiplied by 1.25 (25%) to know the actual cost of a rep at plan. Without delving into the formulas, a $300,000 OTE multiplied by the 1.25 employee cost yields $375,000. That total cost multiplied by the 20% ROI expectation yields the $450,000 of expected margin. We now know the maximum OTE, $300,000, that still meets our investment objective of 20%. If this were a guaranteed return, we should hire a rep with an OTE at this amount. The reality is that there are many risks to this decision and the decision, therefore, needs to be risk-adjusted. To complete this hypothetical, let's say that history has shown that 2/3rds of these new territories hit their target in the first year. If we apply this 66% risk factor to our maximum $300,000 OTE, we arrive at a risk adjusted OTE for this position of $200,000.
We now have an OTE for this new rep position, $200,000, which is goaled at $1M and produces a risk-adjusted ROI, after all, fixed and variable expenses of 20% at plan.
So… Where do we finish?
One of the last steps is to determine the base salary and the variable commission for this position. Should the $200,000 OTE be mostly base salary or commission? The answer to this question is based on your business model. If your model is high volume, low-value sales, then a high commission percentage, even 100% commission, is appropriate. Many inside sales jobs match this model. If your model is low volume, high value with long sales cycles, then a model where a higher percentage of the OTE is salary is more appropriate. A 60/40 plan where 60% of the OTE is salary and 40% is variable commission is typical. If your model is a farmer model where an "account manager" is responsible for customer satisfaction and sales growth, then a high salary, a low variable is appropriate (90/10).
Let's go back to hypothetical land and say that we determined a 50/50 plan is the most appropriate for this territory. That means $100k salary and $100K variable commission at plan. The next step is easy, figuring out the variable commission rate, which is calculated by dividing the variable commission of $100,000 by the territory revenue goal at plan of $1,000,000. This yields a variable commission rate of 10%.
We are almost done. We still need to figure out the accelerator for the commission rate of $1M. Should there be multiple accelerators at different over goal production, say 12% from $1M to $1.5M and 15% on any revenue over $1.5M. Each company will be unique and answer these questions differently according to their situation. In any event and to complete the financial investment decision, you need to use this data first to determine the breakeven point for the rep; at what revenue production does the rep position start paying for itself? Assuming you use accelerators, which I highly recommend, what is the ROI at each of the accelerated revenue levels of 120%, 150%, and 200% of goal?
We now have a very rational, financially sound compensation plan built on you reaching your investment goals. It is based on a financial understanding of the investment required and expected return for reaching the revenue potential in a given territory. The OTE is a mixture of base salary and variable pay that matches the industry and your business model. The costs and ROI of various production levels can now be modeled to provide a thorough financial understanding of the territory and the rep position. The final step is to use this territory plan, OTE information based on salary and variable to create a sales commission plan document executed by the rep and the company. You now have that competitive compensation plan that attracts the best sales talent and is leveraged with the appropriate commission structure to incentivize increasing sales growth levels—all based on you meeting your investment and financial goals.
I have built many compensation plans for companies using the methodology described above. I have created the financial modeling capability that determines the financial measures of breakeven analysis and ROI at various revenue production levels. Individual sales commission plans are an automatic byproduct of this model. If you would like to learn more about this process and the associated financial models, let's talk.