October, 2003

The Paycheck Conundrum: Salary vs. Commission

The most effective compensation plans must align sales activities with a company's mission, providing security while fostering an entrepreneurial attitude that grows the business.

By Craig A. Shutt

Some swear by salary, with the security if offers, as the best compensation and retention tool to build and retain a crack sales force. Others swear by the carrot of commissions to encourage top sales efforts. What works best?

The answer is, there is no one perfect compensation plan that will fit all dealers like a well-worn shoe. But each company can create a program to meet its own unique needs that will keep it from stumbling as it faces new market challenges

At Bender Lumber in Bloomington, Ind., for instance, most sales people are compensated solely on commission, using a sliding scale based on gross margin. But several long-time staffers are salaried, having been grandfathered into the new program when they expressed concerns about the ups and downs inherent in commission-only compensation. Meanwhile, at Dunn Lumber in Daytona Beach, Fla., sales people are paid a combination of salary and commission, receiving essentially a nonrefundable draw against monthly commissions. During their first six months, however, new sales people receive only salary while they begin to generate commissions; then the salary becomes reduced as they bring in more sales.

"There are a wide range of compensation approaches available, and the success of any particular one is dependent on the company's situation," says Dave Kahle, president of sales-consulting firm DaCo Corp. in Grand Rapids, Mich. Variables such as product mix, management system, culture, sales tools and processes will impact which format proves most successful. "Most companies find a combination of salary and incentive will work the best," he says. "But I would never say, 'This is the best approach for everyone.' There are too many details that affect it."

Industry consultant Bill Lee endorses that assessment. "Helping to create a compensation plan is probably the most common request I receive," Lee reports. Straight commission formats based on measurable criteria are the most typical, he notes, "but there are a lot of exceptions." Variations include straight salary, salary plus commission, salary plus a bonus tied to a measurable goal and salary plus a discretionary bonus.

Pros and Cons Exist for Each

Some of the pros and cons of each system are obvious and others are less apparent. Salaries, of course, provide security so sales people aren't running scared or pushing high-commission products that benefit the sales person's income more than the customer. The size and location of the market also may prevent the sales person from making sufficient sales to base pay strictly on his orders, notes Lee. "In some markets and for some companies, the opportunities just aren't there to base sales people's salaries entirely on commission."

In addition, dealers who sell primarily to production builders may find it more efficient to use salaried "negotiators" rather than commissioned sales people. "The profile of the ideal sales person servicing a production builder is not the same as the profile of a sales person who must close the business," Lee says. Production sales call for more responsiveness and service and less digging and persuasion-traits that usually bring higher compensation.

Sales commissions in the building material industry run approximately 3 percent of sales, Lee estimates. "If a large, highly efficient lumberyard could reduce commissions, odds are that they would be reducing their overall cost of doing business by a significant amount."

But most dealers rely on all of the selling and entrepreneurial skills of their sales people to build business and keep it flowing. In those instances, commissions based on incremental sales encourage sales people to sell more products-and sell the right ones.

At Dunn Lumber, for instance, commissions are based on a sliding scale of gross margin, with sales people receiving a higher percentage of the total on higher-margin products. That encourages them to focus on the most profitable products. "It works well, because there's an incentive to sell at higher gross margins, and that's what we strive to do," says Gary Farber, CEO. "The sales people absolutely are motivated by their compensation. They begin to make larger commissions and start to rely on that money, and they're motivated to maintain that compensation and build on it."

Mark Hershberg, president of Bender Lumber, also prefers a commission system. The company uses a sliding scale based on gross-margin dollars, a system that's been in place for four years. "It helps us focus on selling the higher-margin products, including windows, insulation and kitchen cabinetry," he indicates.

Commission Has Drawbacks

But straight commission programs do have drawbacks, says Kahle. "It's inaccurate to believe that sales people always are motivated by making more money. They work up to the economic status at which they're comfortable." At some level, each person is satisfied with his compensation, at least enough to consider the incremental effort needed to raise it further not to be worth the work required to do so. Most sales people don't reach that level easily, Kahle notes, but some do.

Straight-commission sales people also may not want to participate in finding new accounts. That long-term approach to growing a business may not offer any obvious payback to a sales person who believes the time could be better spent selling high-margin products to existing customers.

The focus on higher margins also may become too intense, notes Bender's Hershberg. "There are times when a poor manager who doesn't track his sales people well enough might have one walk away from a low gross-margin sale, such as a package of lumber, because it pulls down his average margin," he says. "It's a challenge to ensure that sales people don't walk away from business because their commission on it doesn't make them want to go after that sale." Dunn's Farber agrees. "We regularly evaluate sales people's performances." That helps ensure they're following up on all opportunities and using all the sales tools available.

"Incentive pay is no substitute for strong management," stresses Lee. In fact, he argues in favor of breaking down compensation plans beyond gross-margin approaches by setting quotas in each category rather than to simply set an overall number. Creating a chart listing customers and categories, and checking off where the two parameters match up, can show where opportunities exist for sales people. "It's rare to find a sales manager who takes this approach," Lee laments. "It's harder to track, but it can be done, and it pays off." In some companies, product specialists are created to focus on key categories, ensuring each product line is represented to appropriate customers.

Match Program to Needs

The key to creating a successful compensation plan is to ensure it pays off for the sales techniques that best suit the company's approach to the market, all agree. "You can only afford to pay so many gross-margin dollars in pay, so you have to structure the program to incent behavior properly," says Hershberg. "There are a million variations to use, and different ones may be right for each company or store."

Hershberg stresses that no matter what type of program is used, it should be instituted uniformly and be given time to work-despite the inevitable howls from sales people who resist change. "The most important element is to be consistent and stick with it," he has found. "Too often, I see companies jump from one plan to another from year to year, and they never allow their sales people to adjust to the program and try to adapt. That's a mistake." Sales people will be uncomfortable until they learn how to make their successful methods work in the new system, and they always will fear they will lose out until they are reassured that they won't.

Updating or changing an existing program also can cause consternation, all agree. Hershberg discovered that when he instituted his new plan four years ago. "There was a great deal of concern initially, but we worked with each person, and they saw that the gross-margin payout would be higher. So they saw the light quickly." Attitude can be everything when creating a compensation program that works, he notes. "We try to hire sales people with the right attitude and the ability to thrive with a commission compensation plan."

Include Other Departments

When dealers find success with a program for outside sales people, their focus often turns to creating incentives that will boost productivity in other departments-and help mitigate concern by employees who believe the company's success should be reflected in their compensation, too. "Most dealers are in favor of providing incentive for inside sales people," reports Kahle. "But the problem is that the compensation must connect to behavior, and it's hard to track inside sales." Inside sales people who have specific "booking numbers" or work directly with specific outside sales people can be tracked more easily, he notes. "The problem comes when there is no direct tracking method for the group. How do you measure what each has accomplished?"

Hershberg's system tracks each inside sales person's orders, so his system can pay an hourly wage (as required by law) that is supplemented by a percentage of the sales tracked to the employee's number. Bill Lee reports that one company he has worked with gives each inside sales person a blue chip to be awarded to another inside sales person whenever the chip holder observes an outstanding effort. Any sales person with a chip at the end of the month can pull a prize from a hat, with prizes including free dinners and high-end pens. "Inside sales people are much more enthusiastic," Lee says.

It's possible to include all employees in incentive compensation plans if the programs can be tied to behavior that is measurable, Lee stresses. Inside sales people can receive credit for each order taken; yard foremen can receive bonuses based on their ability to control operating costs; credit managers can be tracked on the average number of collection days and bad-debt expenses; drivers can be compensated based on number of trips or size of loads; purchasing agents can receive an annual bonus based on inventory turns or gross margin; and general managers can have compensation tied to bottom-line budget items or return on assets.

Technology Aids Tracking

Each of these programs requires tracking key figures and identifying individuals-but technology is rapidly reaching the point where that is as easily done as said, according to Kahle. "Many companies now have the ability to measure things like gross profit per line of billing, profitability per customer, profitability per product line and sales costs as a percentage of gross profit per territory. This increase in information sophistication should be viewed as an opportunity for increases in sales productivity."

Dunn's Farber definitely sees potential. "We're looking at a new computer system that will give us technologies to track or identify sales better," he says. It includes an employee credit card to swipe at key locations in the yard, allowing the system to track pick tickets and times at which loaders entered and left the yard. "We will be able to track the number of loads an employee builds from pick tickets and the dollar amount of the loads," he indicates. The company also is looking at global-positioning technology that will allow managers to see how many miles drivers cover and how many loads they deliver.

"We hope to put together some incentive programs to enhance their income and improve their productivity using this information," he says. He also hopes to post results (but not compensation) and let all involved see how they're faring as compared with others. "We can make it more competitive and give them a reason to improve. The critical part is that we can measure their performance so the ratings aren't subjective." More and more, computers and other technology are allowing that to happen, creating new ways to keep every employee focused on profitability and productivity.

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Are You Being Fair?

If your sales compensation plan isn't based on straight commission, your sales people may not be compensated equitably. Bill Lee suggests following this procedure to see how equitable your plan is:

Write down each sales person's sales volume, gross profit dollars and compensation for 2002. Divide their compensation by their total sales to determine how much they're paid as a percentage of sales. Divide each sales person's 2002 total compensation by their 2002 gross profit dollars to determine how much they're paid as a percentage of gross profit. Compare these two percentages.

"Odds are, some of your lowest-producing sales people are earning far more as a percentage of sales and gross profit than some of your highest-producing people."

To learn more about Lee's programs, visit www.leeresources.com

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Compensation Analysis

Dave Kahle offers this evaluation tool to analyze whether your sales-compensation plan needs revision. The more "No" answers you provide, the more reason to consider reviewing the plan.

1. Have you updated your plan significant in the past three years?

2. Does your sales force cost you less than 25 percent of gross profit?

3. If the rate at which your company is growing is 25 percent or less, are you happy with your current rate?

4. Has the percentage of sales-force cost compared with gross profit (from No. 2) been growing in the last few years?

5. Are you facing less competition today then a few years ago?

6. Assuming you have a strategic plan, do you specifically and significantly reward sales people in a way that directly supports your strategic goals?

7. Are you satisfied with your sales force's ability to support commitments you've made to your vendors?

8. Are you satisfied that you are using your sales management to its best use?

9. Are you satisfied that you have the right kind of salespeople to succeed in the 21st century?

10. Are you satisfied with the speed with which your newly-hired sales people bring profits to the company?

To learn more about Kahle's programs and download a free spreadsheet to help measure sales productivity, visit www.davekahle.com