Download a version of this article formatted for printing, and including additional tables and details of the analysis: Sales Compensation – pay mix and compensation cost 101010
If we want to keep our fixed cost low and only pay sales people when they “perform,” is it smart to have a lower base and higher variable pay to control compensation costs?
Many sales leaders, and perhaps most Chief Financial Officers, feel there are real business benefits to a high-risk / high-upside comp plan. Those who advocate aggressive pay mixes generally believe that:
- More risk and more upside make for more focused, effective and productive sales people, and
- Less base pay means less fixed cost and less total compensation cost in case of underperformance.
In this paper, we explore a case example for a direct sales force on a simplified typical compensation plan for software sales. For this analysis we will leave the motivational aspects of pay mix aside and focus on the cost of compensation for different pay mixes.
The perhaps surprising finding from this analysis is that a more aggressive pay mix results in a higher compensation cost over the expected range of performance (organizational quota attainment of 90% to 110%).
The results of this analysis are presented in the following sections
- The assumptions
- Summary conclusions
- Details of the analysis (available only in the downloadable version)
- Other scenarios (changing a few of the key assumptions, and how the results change)
For this analysis we considered an individual contributor sales role with the following compensation plan parameters:
Annual bookings quota: $5,000,000
Annual target total compensation: $200,000
Acceleration over quota: The plan accelerates for bookings over the annual quota up to 150% of quota, then decelerates somewhat over 150%, but continues uncapped based on the following table:
So, for the middle case, the 60/40 pay mix, the payout table in dollars with commission rates would be:
Performance distributions: To predict the cost of compensation, we will need to recognize the fact that even at 100% of the organizational quota, some of the sales people will have under-performed and others will have over-performed. For the purpose of this example, we have constructed three performance distributions: Low (90% of overall quota), Target (100% of overall quota) and High (110% of overall quota). The histograms for these distributions are shown in the following table.
The cost of compensation in all cases for a person earning exactly their target total compensation ($200,000) by achieving exactly their quota is 4% of bookings ($200,000 / $5,000,000). However, the cost of compensation for the “Target” case above, which yields exactly 100% of the organizational target bookings, is 4.15% to 4.25% of bookings (depending on the pay mix).
The more incentive-rich the pay mix (that is, the less is in base and the more is in the incentive at target), the higher the total cost of compensation as a percent of bookings for at-target and over-target organizational performance. For under-target organizational performance, the difference is negligible.
If the sales team’s overall performance is close to or above target, the lower the base, the higher the cost of compensation, by as much as 5% of total compensation (base + incentive). In a low-performing scenario, the compensation cost as a percent of bookings is negligibly higher for the more base-rich pay mix (4.46% > 4.45%).
This analysis demonstrates that there are no meaningful cost savings resulting from a more incentive-rich pay mix. In fact, the more pay at risk, the more aggressive the acceleration over quota, and the higher the cost of comp for the over-performers, which is not fully offset by the reduced pay delivered to the under-performers.
Details of the analysis
For details that show how the results were calculated, see the downloadable version.
If the cost of comp is slightly less for a more incentive-rich mix in a 90% of target scenario, what would happen in an 80% of target scenario?
The lines do indeed cross below 90% of the organizational quota. So if a seriously underperforming year is anticipated, there may be some cost savings associated with a more incentive-rich pay mix.
If the leverage factor is as high as 3.0, the more aggressive (incentive-rich) pay mix is more expensive across the full range of outcomes for organizational performance (80% of quota to 110% of quota).
What about a more sophisticated plan in which the leverage factor increases with pay at risk, and the payout curve below quota decelerates at low levels of attainment, and accelerates somewhat as quota is approached?
Once again, across the full performance range considered, the least costly plan is the plan with the highest base as a percent of total compensation at target.
The cost of compensation for a team of sales people who together deliver exactly 100% of their collective quota will be somewhat higher due to the acceleration in the plan. The over-achievers will earn leveraged upside, and the under-achievers will not offset this leverage in their payouts. The result is that the expected total compensation cost is over 4% of bookings at target.