Most organizations design incentive based on one sales performance metric. Often, the chosen performance metric is revenue. Many incentive plans include either a bonus for attaining a revenue-based quota, or a commission paid as a percentage of revenue. There is social proof that variable pay based on revenue does increase sales motivation. However, many organizations now expect salespeople to deliver more than just revenue – they also expect improved profitability. Because sales incentive plans should be aligned with business objectives, it can make sense for some incentive plans to take profitability into account.
When a bottling company decided to pay commissions based on profit instead of revenue, there was a noticeable effect. Sales representatives stopped granting excessive discounts. They focused more on selling products with a higher margin. However, it also backfired. Sales representatives had to become familiar with each product’s margin. They refused to grant discounts, which upset customers. Their focus on profitability was disrupted after manufacturing costs changed for some products. Commission calculations were made a lot more complicated than when using gross revenue. Ultimately, the company had to revert to using a revenue-based incentive plan.
Did they give up too easily? Probably. Here a few things to consider before adopting a profit-based incentive model, and how to combine revenue and profit to measure sales performance.
What is your company’s #1 strategic goal?
Is your organization more interested in growth or in profitability? Often the answer is both. However, given a product line and/or territory, you should pick a primary sales performance metric. For most emerging businesses, growth is usually #1 the priority because it provides a first-mover advantage (or an opportunity to raise more capital). For more established businesses, profitability is the priority, with a focus on cross-sell or up-sell strategies. Note that it’s possible to use a both within an organization – for example by designing different incentive plans based on specific territories or product lines. However, given a particular segment, the sales force should have a clear message regarding the dominating business priority so that they can focus their efforts in the right direction. In other words, you can slice and dice it, but you still have to choose.
Can sales representatives grant discounts?
Suppose that your incentive plan is based on profit. If sales representatives aren’t allowed to grant discounts, then all they can do is promote some products based on profitability. Essentially without the ability to grant discounts, sales representatives have limited flexibility in terms of managing profitability and make tradeoffs. To some extent, this simplification helps keep things sane, and encourages them to focus on profitable product lines. However, representatives may complain about their lack of control, and feel that an approach based on profitability without the ability to grant discounts is unfair. Also, this approach cause your sales force to ignore less profitable products which generate the bulk of the revenue. An option is to use a revenue with a profit-based multiplier. For example, if a deal included a discount higher than 10%, then only 75% of the revenue is credited. However, if discounts were kept under 10%, then 100% of the revenue is credited. Make sure to use a commission management solution capable of scoring sales transactions.
How large is your product catalog?
If your organization has a large product catalog, your sales team might need to remember each product’s margin. Assuming they can grant discounts, their job becomes a complex game of chess whose goal is to maximize profit. This may be viable if your sales force is sophisticated and enjoys playing a complex game of chess, but it can create issues in other environments. A possible simplification is to group individual products into product lines, and apply a single margin to each product line. It’s often acceptable for the margin to be slightly incorrect depending on the exact product – as long as it remains correct overall for the product line. Make sure you leverage a commission management solution with the ability to specify (override) product margins. Finally, note that profitability of your product catalog must be managed. Profitability may change over time, and so additional administration will be required to update your catalog from times to times.
Is profitability a confidential metric?
To measure performance based on profitability, you must disclose confidential information to your sales force. Your sales representatives need access to profitability information to verify their commissions and to optimize their sales behavior. For this reason, you should expect profitability information to ultimately flow to some customers or competitors. In addition, disclosing profitability can be distracting to your sales representatives because it can cause them to question whether their “cut” of each deal is reasonable. If confidentiality is an issue, you are probably better off using revenue as a sales performance metric. It’s still possible to create abstract representations of margins (ex: profitability scores) and award commissions based on those, but this adds another level of complexity.
Think twice before choosing profitability as a sales performance metric. Simply using profitability is a risky all-in approach. It can make sense if it’s applied to a particular territory and/or product line. But it comes with some caveats, such as increased complexity, and an elevated risk of information disclosure. We feel that the best way to balance revenue and profit is to use a flexible score-based approach. As a baseline, each dollar in revenue can be valued as one point. You can then apply multipliers based on the product line or any other factor (ex: you could further penalize returns / refunds by applying a 2x multiplier). The calculated score is essentially a “modified revenue”. It’s still largely understandable as revenue, yet it integrates profitability as an influencing metric.