2015-03-26 10:30:50
Doug J. Chung
From the April 2015 Issue
Before I became a business school professor, I worked as a management
consultant. One engagement in particular had a profound influence on my career.
The project involved working with the Asia-based sales force of a global
consumer products company. This company practiced route sales, which meant
reps spent their days visiting mom-and-pop convenience stores, servicing
accounts. One thing about the organization surprised me: Its sales managers
spent inordinate time listening to the reps complain about their compensation.
The complaints were based on what the reps saw as a myriad of problems. Their
quotas were set too high, so they couldn t possibly reach them. Or their
territory was subpar, limiting their ability to sign new accounts. Sometimes
the complaints focused on fairness: A rep who was hitting his quotas and making
decent money would want a manager to do something about a lazy colleague who
was earning outsize pay simply because he had a good territory. Imagine any
conceivable complaint a salesperson might have about pay, and I guarantee that
sales managers at my client s company had heard it.
The reps weren t the only ones obsessed with the compensation system. The
company liked to play around with the system s components to try to find better
ways to motivate reps and boost revenue, or to increase the return on the money
it spent paying salespeople a large part of its marketing budget. This company
s sales comp system was fairly basic: Reps earned a salary and a commission of
around 1% of sales. The company worried that the system was too focused on
outcomes and might over- or under-reward reps for factors outside their
control. So it began basing compensation on their effort and behavior, not just
on top-line sales. For instance, under the new system, a portion of
compensation was based on customer satisfaction surveys, the number of
prospective accounts visited (even if they didn t buy), and the retention of
existing accounts.
Largely because of this consulting assignment, I became so curious about the
best ways to compensate salespeople that I began reading academic articles on
the subject. Eventually I pursued a PhD in marketing at Yale, where I studied
the theory and practice of how companies can and should manage and pay
salespeople research I now continue at Harvard Business School.
Although there are fewer academics studying sales force compensation and
management than researching trendy marketing subjects, such as the use of
social media or digital advertising, in the past decade it s become a
fast-moving field. While some of the basic theories established in the 1970s
and 1980s still apply, academics have begun testing those theories using two
methods new to this area of research: empirical analysis of companies sales
and pay data, and field experiments in which researchers apply various pay
structures to different groups of salespeople and then compare the groups
effort and output.
This new wave of research is already providing evidence that some standard
compensation practices probably hurt sales. For instance, the research suggests
that caps on commissions, which most large companies use, decrease
high-performing reps motivation and effort. Likewise, the practice of
ratcheting quotas (raising a salesperson s annual quota if he or she exceeded
it the previous year) may hurt long-term results. Research based on field
experiments (as opposed to the lab experiments academics have been doing for
many years) is also yielding new insight into how the timing and labeling of
bonuses can affect salespeople s motivation.
In this article I will take readers through the evolution of this research and
suggest the best ways to apply it. With luck, this knowledge not only will help
companies think about better ways to compensate salespeople, but also might
mean that their managers spend fewer hours listening to them gripe about unfair
pay.
The Dangers of Complex Compensation Systems
Researchers studying sales force compensation have long been guided by the
principal-agent theory. This theory, drawn from the field of economics,
describes the problem that results from conflicting interests between a
principal (a company, for instance) and an agent hired by that principal (an
employee). For example, a company wants an employee s maximum output, but a
salaried employee may be tempted to slack off and may be able to get away with
it if the company can t observe how hard the employee is working. Most
incentive or variable pay schemes including stock options for the C-suite are
attempts to align the interests of principals and agents. Commission-based
plans for salespeople are just one example.
Salespeople were paid by commission for centuries before economists began
writing about the principal-agent problem. Companies chose this system for at
least three reasons. First, it s easy to measure the short-term output of a
salesperson, unlike that of most workers. Second, field reps have traditionally
worked with little (if any) supervision; commission-based pay gives managers
some control, making up for their inability to know if a rep is actually
visiting clients or playing golf. Third, studies of personality type show that
salespeople typically have a larger appetite for risk than other workers, so a
pay plan that offers upside potential appeals to them.
During the 1980s several important pieces of research influenced firms use of
commission-based systems. One, by my Harvard colleague Rajiv Lal and several
coauthors, explored how the level of uncertainty in an industry s sales cycle
should influence pay systems. They found that the more uncertain a firm s sales
cycle, the more a salesperson s pay should be based on a fixed salary; the less
uncertain the cycle, the more pay should depend on commission. Consider Boeing,
whose salespeople can spend years talking with an airline before it actually
places an order for new 787s. A firm like that would struggle to retain reps if
pay depended mostly on commissions. In contrast, industries in which sales
happen quickly and frequently (a door-to-door salesperson may have a chance to
book revenue every hour) and in which sales correlate more directly with effort
and so are less characterized by uncertainty, pay mostly (if not entirely) on
commission. This research still drives how companies think about the mix
between salaries and commissions.
To get the optimal work out of a rep, you should in theory tailor a comp system
to that individual.
Another important study, from the late 1980s, came from the economists Bengt
Holmstrom and Paul Milgrom. In their very theoretical paper, which relies on a
lot of assumptions, they found that a formula of straight-line commissions (in
which salespeople earn commissions at the same rate no matter how much they
sell) is generally the optimal way to pay reps. They argue that if you make a
sales comp formula too complicated with lots of bonuses or changes in
commission structure triggered by hitting goals within a certain period reps
will find ways to game it. The most common method of doing that is to play with
the timing of sales. If a salesperson needs to make a yearly quota, for
instance, she might ask a friendly client to allow her to book a sale that
would ordinarily be made in January during the final days of December instead
(this is known as pulling ); a rep who s already hit quota, in contrast, might
be tempted to push December sales into January to get a head start on the
next year s goal.
While a very simple comp plan such as the one advocated by Holmstrom and
Milgrom can be appealing (for one thing, it s easier and less costly to
administer), many companies opt for something more complex. They do so in
recognition that each salesperson is unique, with individual motivations and
needs, so a system with multiple components may be more attractive to a broad
group of reps. In fact, to get the optimal work out of a particular
salesperson, you should in theory design a compensation system tailored to that
individual. For instance, some people are more motivated by cash, others by
recognition, and still others by a noncash reward like a ski trip or a gift
card. Some respond better to quarterly bonuses, while others are more
productive if they focus on an annual quota. However, such an individualized
plan would be extremely difficult and costly to administer, and companies fear
the watercooler effect : Reps might share information about their compensation
with one another, which could raise concerns about fairness and lead to
resentment. So for now, individualized plans remain uncommon.
Concerns about fairness create other pressures when designing comp plans. For
instance, companies realize that success in any field, including sales,
involves a certain amount of luck. If a rep for a soft-drink company has a
territory in which a Walmart is opening, her sales (and commission) will
increase, but she s not responsible for the revenue jump so in essence the
company is paying her for being lucky. But when a salesperson s compensation
decreases owing to bad luck, he or she may get upset and leave the firm. That
attrition can be a problem. So even though there are downsides to making a
compensation system more complex, many companies have done so in the hope of
appealing to different types of salespeople and limiting the impact of luck by
utilizing caps or compensating people for inputs or effort (such as number of
calls made) instead of simply for closing sales.
Using Real Company Data to Build Understanding
The big difference between earlier research on sales compensation and the
research that s come out in the past decade is that the latter is not based
just on theories. Although companies tend to be very secretive about their pay
plans, researchers have begun persuading them to share data. And companies have
been opening up to academics, partly because of the attention being given to
big data; managers hope that allowing researchers to apply high-powered math
and estimation techniques to their numbers will help them develop better tools
to motivate their workforce. Indeed, these new empirical studies have revealed
some surprises, but they have also confirmed some of what we already believed
about the best ways to pay.
Tom Steenburgh, a professor at the University of Virginia s Darden School of
Business, published one of the first of these papers, in 2008. He persuaded a
B2B firm selling office equipment to give him several years of sales and
compensation information. This unique data set allowed Steenburgh to look at
sales and pay data for individual salespeople and use it to make assumptions
about how pay influences behavior. The company had a complex compensation plan:
Reps earned a salary, commissions, quarterly bonuses based on hitting quotas,
an additional yearly bonus, and an overachievement commission that kicked in
once they passed certain sales goals. He focused on the issue of timing games:
Was there evidence that salespeople were pushing or pulling sales from one
quarter to another to help them hit their quotas and earn incentive pay? That s
a really important question, because pushing and pulling don t increase a firm
s revenue, and so paying salespeople extra for doing that is a waste.
Even though the salespeople in the study could receive (or miss out on)
substantial bonuses for hitting (or missing) quotas, Steenburgh found no
evidence of timing games. He concluded that the firm s customers required sales
to close according to their own needs (at the end of a quarter or a year, say)
and that the firm s managers were able to keep close enough tabs on the reps to
prevent them from influencing the timing of sales in a way that would boost
their incentive payments. That finding was significant, because quotas and
bonuses are a large part of most sales compensation plans.
In 2011 Sanjog Misra, of UCLA, and Harikesh Nair, of Stanford, published a
study that analyzed the sales comp plan of a Fortune 500 optical products
company. In contrast with the firm Steenburgh studied, this company had a
relatively simple plan: It paid a salary plus a standard commission on sales
after achieving quota, and it capped how much a rep could earn in order to
prevent windfalls from really big sales. Such caps are relatively common in
large companies.
As they analyzed the data, Misra and Nair concluded that the cap was hurting
overall sales and that the company would be better off removing it. They also
determined that many reps motivation was hurt by the firm s practice of
ratcheting. Setting and adjusting quotas is a very sensitive piece of the sales
compensation formula, and there s disagreement over ratcheting: Some feel that
if you don t adjust quotas, you re making it too easy for reps to earn big
commissions and bonuses, while others argue that if you raise a person s quota
after a very strong year, you re effectively penalizing your top performers.
Misra and Nair estimated that if this firm removed the cap on sales reps
earnings and eliminated quotas, sales would increase by 8%. The company
implemented those recommendations, and the next year companywide revenue rose
by 9%.
A third empirical study of sales rep pay, on which I am the lead author, was
published in Marketing Science in 2014. Like Steenburgh, we utilized data from
a B2B office equipment supplier with a complex compensation plan. We examined
how the components of the plan affected various kinds of reps: high performers,
low performers, and middle-of-the-road performers.
We found that although the salary and straight commission affected the three
groups in similar ways, the other components created different incentives that
appealed to certain subsets of the sales force. For instance, overachievement
commissions were important for keeping the highest performers motivated and
engaged after they d hit their quotas. Quarterly bonuses were most important
for the lower performers: Whereas the high performers could be effectively
incentivized by a yearly quota and bonus, more-frequent goals helped keep lower
performers on track. Some people compare the way people compensate a sales
force to the way teachers motivate students: Top students will do fine in a
course in which the entire grade is determined by a final exam, but
lower-performing students need frequent quizzes and tests during the semester
to motivate them to keep up. Our study showed that the same general rule
applies to sales compensation.
Researchers have begun persuading companies to share their data about their pay
plans.
Our research also suggested that the firm would benefit if it shifted from
quarterly bonuses to cumulative quarterly bonuses. For example, say a
salesperson is supposed to sell 300 units in the first quarter and 300 units in
the second quarter. Under a regular quarterly plan, a salesperson who misses
that number in the first quarter but sells 300 units in the second quarter will
still get the second-quarter bonus. Under a cumulative system, the rep needs to
have cumulative (year-to-date) sales of 600 units to get the second-quarter
bonus, regardless of his first-quarter performance. Cumulative quotas do a
better job of keeping reps motivated during periods in which they re showing
poor results, because reps know that even if they re going to miss their
number, any sales they can squeeze out will help them reach their cumulative
number for the next period. In fact, even before we made our recommendations to
the company in our study, managers there decided to move to cumulative quotas.
Out of the Lab, Into the Field
In addition to sharing sales and compensation data with academics, companies in
the past several years have been allowing controlled, short-term field
experiments in which researchers adjust reps pay and measure the effects.
Prior to the use of field experiments, most academic experiments regarding
sales force compensation took place in labs and involved volunteers (usually
undergraduates) rather than real salespeople. Shifting from this artificial
setting into actual companies helps make the results of these studies more
practical and convincing.
Sales reps work harder for the chance to earn a reward than they do after
receiving one.
As an example of one such experiment, consider recent work my colleague Das
Narayandas and I did with a South Asian company that has a retail sales force
for its consumer durable products. The company uses a simple system of linear
commissions reps earn a fixed percentage of sales, with no quotas, bonuses, or
overachievement commissions. Managers were interested in seeing how instituting
bonuses would affect the reps performance, so over six months we tested
various ways to frame and time bonuses always comparing results against a
control group.
For one of our experimental groups, we created a bonus that was payable at the
end of the week if a rep sold six units. For another group, we framed the bonus
differently, using the well-known concept of loss aversion, which posits that
the pain people feel from a loss exceeds the happiness they feel from a gain.
Instead of telling reps they would receive a bonus if they sold six units, we
told them they would receive a bonus unless they failed to sell at least six
units. To test the concept even further, the company s managers suggested
another experiment in which we paid the bonuses at the beginning of the week
and then had the reps return the money if they missed the goal.
The results showed that all three types of bonuses exerted similar effects and
that in every case the group receiving the bonus generally outsold the control
group. Loss aversion didn t have much effect. We believe that s partly because
we were using cash, which is liquid and interchangeable; in the future we might
experiment with noncash rewards, such as physical objects.
We also tried to measure the impact on sales reps effort of cash payments that
were framed as gifts (as opposed to bonuses). Whereas bonuses are viewed as
transactional, research shows that framing something as a gift creates a
particular form of goodwill between the giver and recipient. In our study we
used cash but told employees it was a gift because there were no strings
attached they didn t have to meet a quota to receive it. We found that the
timing of a gift directly influences how reps respond: If you give the gift at
the beginning of a period, they view it as a reward for past performance and
tend to slack off. If you tell them they will receive a gift at the end of a
period, they work harder. We concluded that if companies want to encourage that
kind of reciprocity, they need to pay careful attention to timing.
Other researchers are using field experiments to better understand how
salespeople react to changes in payment schemes, but most of this work is so
new that it hasn t been published yet. One paper presented at a conference in
2014 showed that if salespeople receive cash incentives for passing tests about
the product they are selling, they will sell more. (This is an example of sales
compensation based on effort as opposed to results.) Another recent field
experiment found that sales reps valued noncash incentives (such as points that
could be used for vacations or for items such as televisions) more than the
actual monetary cost of the good the points could purchase. As more researchers
and companies embrace the use of field experiments, sales managers will learn
even more about the best ways to motivate their teams.
It Pays to Experiment
After spending a decade in academia studying sales force compensation, I
sometimes wonder what would happen if I were transported back into my job as a
management consultant. What would I tell sales force managers to do
differently?
Some of my advice would be straightforward: I would urge managers to remove the
caps on commissions or, if they have to retain some ceiling for political
reasons, to set it as high as possible. The research is clear on this point:
Companies sell more when they eliminate thresholds at which salespeople s
marginal incentives are reduced. There might be problems if some reps earnings
dramatically exceed their bosses or even rival a C-suite executive s
compensation, but the evidence shows that firms benefit when these arbitrary
caps are removed.
I would tell sales managers to be extremely careful in setting and adjusting
quotas. For instance, the research clearly shows that ratcheting quotas is
detrimental. It s tempting to look at a sales rep who blows through her yearly
number and conclude that the quota must be too low and quotas do need to be
adjusted from time to time. But in general it s important to prevent reps from
feeling that unfairness or luck plays a part in compensation, and resetting
quotas can contribute to that perception. And if something outside the
salesperson s control such as an economic downturn made it more difficult to
hit a goal, I would consider reducing the quota in the middle of the year. It s
important to keep quotas at the right level to properly motivate people.
On the basis of my own research, I would advocate for a pay system with
multiple components one that s not overly complicated but has enough elements
(such as quarterly performance bonuses and overachievement bonuses) to keep
high performers, low performers, and average performers motivated and engaged
throughout the year.
Finally, I would urge my client companies to consider experimenting with their
pay systems. Over the past decade managers have become attuned to the value of
experimentation (A/B testing, in particular); today many consumer goods
companies experiment constantly to try to optimize pricing. There are important
lessons to be learned from doing controlled experiments on sales reps pay,
because the behaviors encouraged by changes in incentives can exert a large
influence on a firm s revenue, and because sales force compensation is a large
cost that should be managed as efficiently as possible. Involving academic
researchers in these experiments can be beneficial: Having a trained researcher
take the lead generally will result in a more controlled environment, a more
scientific process, and more-robust findings. These studies also help the world
at large, because research that improves how companies motivate salespeople
will result in better and more-profitable businesses for employees and
shareholders.
Doug J. Chung is an assistant professor of marketing at Harvard Business
School.
How to Create a Sales Comp Plan
STEP 1 SET THE PAY LEVEL
This is crucial for attracting and retaining talent.
STEP 2 BALANCE SALARY AND INCENTIVES
The proportion of earnings that comes from
salary and from incencives determines the
riskiness of the plan. The proper balance
varies by industry and is often based on the
degree of certainy that a salesperson's efforts
will directly influence sales.
STEP 3 DESIGN THE PLAN
Metrics: Most companies still pay salespeople
a commission based on gross revenue,
although some companies pay on the basis
of profitabity of sales.
Plan Type: Many companies supplement
salary and commissions with bonuses based
on exceeding quotas or reaching other goals.
Payout Curve: Caps on earnings limit the pay
of top performers and flatten the payout curve
(or make it ''regressive''); accelerators or
overachievement commissions ramp up
the pay of top performers, creating a
progressve'' structure.
STEP 4 CHOOSE PAYOUT PERIODS
Companies can set quotas and bonus structures
to cover periods ranging from a single week
to an entire year. Research shows that shorter
payout periods help keep low performers
motivated and engaged.
STEP 5 CONSIDER ADDITIONAL ELEMENTS
Many companies use nonmonetary incentives,
such as contests or recognition programs.
SOURCE ADAPTED FROM THE POWER OF
SALES ANAlYTICS, BYANDRIS A. ZOLTNERS,
PRABHAKANT SINHA, AND SALLY E. LORIMER
FROM 'HOW TO REALLY MOTIVATE
SALESPEOPLE'
HBR.ORG