The importance of stress testing the commission system

The vast majority of organizations dedicated to sell either products or services through their sales-force employ a sales compensation scheme in order to stimulate salespeople and keep them motivated to perform at their highest levels.

Financial means are required as these compensation schemes consist mostly of a monetary reward for successful actions such as closing a sale or contributing to the success of the company otherwise.

Budgeting these financial rewards and staying aware of the implied costs is a must for the organization, no matter if these precede a monetary gain. Depending on the size and overall success of the company, these can amount to significant sums of money.

While working for a financial institution, I witnessed dozens of millions in Euros destined to the sales compensation plan. The budget for incentives is usually a big expense,  especially if one considers that many companies pay their salespeople roughly 8% of the total revenue on average with commissions many times going up to  20%.

In the case of a firm with an annual revenue of 20 million USD, 1.8 million USD would end up in the pockets of it’s sales-force based on the above given rate. It may seem like a small portion compared to the vast amount of total revenue, but it’s still an important sum which has to be taken care of and planned for in advance. This is only one example, these numbers increase drastically when talking about bigger companies.

Sales incentives come in many forms. They can be monetary rewards, as in commissions or bonuses, vouchers or even materialistic prizes such as free trips.

Cash paid to salespeople through incentives can be calculated in either of the two following ways:

1.As a part of the profits of a product or service. Let’s say that a company generates 10% profit on a sale. The salesperson who closed the transaction gets 8% of that 10% profit. Sharing profits with salespeople is an advisable and healthy compensation plan approach.

But how does a company incentivise its sales-force when the product or service doesn’t generate any profit?

2.In case a product or service line is unprofitable, the company may still pay incentives.

a)It might be a deliberate decision. Even if the product or service isn’t profitable yet, incentives are still necessary to keep salespeople motivated.

b)In other cases, the gains of a profitable product line may be funding other products or services which don’t generate any financial profit but have a strategic purpose.

c)The company may not only reward the sales-force with incentives for monetary success. This is sometimes known as MBO (Management By Objective) which is a reward for achieving certain goals, such as landing a new client independently of the revenue this particular customer may generate.

What does “stress testing” mean?

At the start of a new year almost every organization undergoes budget planning, which means predicting the revenue, the profitability and the costs of the business.

Incentives amount to a substantial expense for the company, therefore predicting this cost is extremely important for the overall business and especially the financial team. The main objective for the compensation scheme is generating a ROI (Return On Investment), which means that every penny invested in the incentives program should bring sales success and revenue to the company.

  1. The concept of stress testing includes two areas of interest:.By stress testing I refer to a quantitative calculation in which the level of the salespeople’s performance and the probability of them achieving their goal based on previous years is taken into account. The purpose of this calculation is to estimate the necessary budget for the compensation scheme. The salespeople’s performance level and ability to achieve their targets is crucial, as a company with 90% of its sales-force reaching 100% of their objectives requires a different budget than a company with 60% of its sales-force achieving 100% of their targets. The budget exercise requires that the performances taken into account follow historical performances and assumes that most of the sales people achieve their targets. The output of this exercise is then used to budget the cost of incentives for the forward financial periods. 
  2. The above estimation isn’t the only calculation we need to perform. What if among the 90% of salespeople that reach their targets, 50% of them reach above 150%? What if the incentives scheme has an accelerator that pays significantly higher commissions above 100% of target realization, how much will the total costs amount? Is the company ready to spend this kind of extra money? The required budget will without a doubt increase in this case.

Because of these possible situations, the company needs to perform stress tests, calculating the cost of incentives according to different scenarios.

To simplify these calculations, follow the table below to calculate compensations using the current incentives plan and the various combinations. In my opinion, 6 is the ideal number of scenarios to take into account. 2 for normal situations, 2 for underperforming ones and 2 for over-performing scenarios.

Why stress testing the motivation system in place?

While advising a professional who ran a sales team, he told me about his company suffering losses a few years earlier. This happened mainly because of inadequate budgeting and overpaying commissions to his salespeople. Evidently the commission system was miscalculated but the company also failed to take into account the maximum payment made under the system in place.

Market conditions and other important factors may change during the year. This affects salespeople’s behaviour, sales performance and last but not least, the sales incentives to be paid. In some cases the company may not be able to predict possible scenarios.

Stress testing – an important procedure when modifying the system

A head of sales of a company which I knew, decided to modify the firms commission system after 5 years without any changes. They did a great job gathering professionals to think the process through thoroughly. 

A few weeks later, a fresh incentives plan was born and presented to the salespeople. The way quotas were assigned was altered and the sales-force were given slightly different sales territories. This was a big rearrangement!

At the end of the Q3 (the 3rdquarter), the company realized that although they had met 60% of their objectives for the year, they already spent a significant sum of money. The financial department started to panic.

The company failed to stress test the new scheme. It is crucial to test any changes in the compensation plan, as for example calculating the cost of incentives when all objectives are met successfully under the new plan. It is a hypothetical yet precise prevision which demonstrates the cash flow and the expense of the company towards a project. 

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