Sales Commission – How to Develop an Effective Sales Compensation Plan

Sales commissions should not be paid until the customer pays.

I often get asked about sales commission structures.  My short answer is “tie it to profits not to gross sales”. The long answer is much more involved. Here is a guest post by someone who is very knowledgeable on the subject. -TW

Sales Commission – How to Develop an Effective Sales Compensation Plan

By Alan Rigg

 

The most common question I hear concerning sales compensation goes something like this: “What commission percentage should I pay for _____________?”

I’m sorry, but there is just isn’t a “standard” answer to this question! Why? Because there are a huge number of variables that impact commission percentage calculations. Here are just some of the variables:

  • Products or services sold
  • Target markets
  • Target geographies
  • Target contacts (C-level, department manager, purchasing, etc.
  • Sales environment (company office, home office, etc.)
  • Sales approach (telephone, in-person, etc.)
  • Company profitability
  • Individual product or service profitability

Despite the fact that there is no simple answer to the “What commission percentage should I pay?” question, determining the right commission percentage is not rocket science, either. There ARE specific questions you can answer that will lead you to the right commission percentage(s) for your company.

Here is an overview of the process I take clients through when we develop or revise their sales compensation plans:

1. What is the average profitability of your company’s sales transactions?

If there are significant differences in profitability between product or service groups or between new business and repeat business, calculate profitability by group and/or business type.

2. How much of this profit are you willing to contribute to sales compensation?

Look at all of your costs and the percentage of profit you want to re-invest in growing your business. If the best you can do is determine a range of profit that you are willing to contribute to sales compensation (example: 10% to 30%), that’s OK. You will refine the percentage as you continue working through the questions listed below.

3. What is the desired mix of new business vs. repeat business?

A key consideration is how deeply your salespeople have already penetrated their existing accounts. If they are doing a great job of selling your company’s entire portfolio of products and services in every assigned account, you should probably put more focus on finding new accounts.

If your salespeople are just scratching the surface in terms of selling your company’s entire portfolio of products and services to existing customers, your focus should be on increasing account penetration. Why? Because it is easier and faster to sell more to existing customers than it is to sell to new customers. Plus, sales to existing customers tend to be larger and more profitable.

4. How much can a salesperson realistically sell in one year?

You will zero in on the answer to this question by answering a number of other questions such as:

  • How many properly qualified opportunities can a salesperson manage at once?
  • What is the length of the average sales cycle?
  • Do you think this time frame can be shortened?
  • What is the average close ratio?
  • Do you think this close ratio can be improved?

5. What is the total target income you are willing to pay for this amount of annual production?

If you have determined the percentage of profits that you are willing to contribute to sales compensation, and you have determined how much a salesperson can sell in a year’s time, you have the factors you need to calculate a target income. Once you have made this calculation, consider another question: Is this target income significant enough to motivate successful salespeople to join your company and stay with your company?

6. How much and what kind of income “floor” are you willing to provide to your salespeople?

Now that you know the total target income for your sales position, you can break it down into fixed and variable compensation. The fixed compensation provides a “floor” to income and is usually paid as a salary or draw. The variable compensation consists of commissions, bonuses, and any other incentives that you choose to include in your sales compensation plan.

7. What commission percentage will you pay?

Once again you will find the answer by answering a number of additional questions, including:

  • Does it make sense to pay a single commission percentage, or do you want to have different commission percentages for new business and repeat business?
  • Should commissions be calculated based upon revenue or gross margin?
  • Does it make sense to have a “sliding scale”, where the commission percentage increases as the gross margin percentage increases, and decreases as the gross margin percentage decreases?

8. Do you want to include any bonuses for achieving specific performance targets?

In addition to paying commissions, you may want to consider paying bonuses to salespeople who achieve specific performance targets. For example, you may want to pay a quarterly bonus for achieving each quarter’s sales target, and an annual bonus for achieving the annual sales target.

9. What other sales behaviors are critical enough to attempt to motivate via the sales compensation plan?

You may find it desirable to tie bonuses or other incentives to specific behaviors such as team selling, cross selling, etc. However, it is important to recognize that the motivational value of your sales compensation plan will decrease as its complexity increases. If your salespeople cannot easily determine how much they will earn from their efforts, they will not perform as well as they would if they could easily correlate sales performance to earnings.

If you develop carefully considered answers to the preceding nine questions, you will have the core information you need to develop an effective sales compensation plan for your company!

Copyright 2007 — Alan Rigg

Sales performance expert Alan Rigg is the author of “How to Beat the 80/20 Rule in Sales Team Performance” and the companion book, “How to Beat the 80/20 Rule in Selling”. His 80/20 Selling System (TM) helps business owners, executives, and managers end the frustration of 80/20 sales team performance, where 20% of salespeople produce 80% of sales. For more FREE sales compensation information, visit www.SalesCompensationStore.com.

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  • Hey Tiffany,
    Interesting article. I take a little bit of exception when you seem to tie sales commissions to profit. Commission, as you well know, is a pre-profit operational expense category. Tying it so directly to profitability is a mistake, I feel that many corporations, that are run be accountants seem to make.

    Companies, usually SMBs that depend upon an outside commissioned sales force really have no choice in the matter, if they wish to sell their products; they must pay the going rate. Internal sales forces should be constrained to sell to assure the company that they are selling at reasonable prices and therefore ought not to have any decision authority on pricing, at all.

    In order to attract a reasonable, quality sales person, the company must provide for a lucrative commission structure. Obviously, this depends upon the corporation’s position in the market, its position in terms of whether or not its attempting to gain market share, etc.

    I support a consultative sales model that forces the sales person to sell value, rather than price. If he or she convinces the prospect that the product being sold solves a problem better than competition, then pricing is less of an issue. If the product is a commodity, than most of this goes out the window.