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The Building Blocks of an Effective Sales Compensation Plan

By: J. Mark Davis, Managing Principal, Valitus Group, Inc.

One of the most common questions I hear as it relates to structuring a sales compensation plan is, “What commission rate should I pay my salespeople?” I once had someone pose this question to me as he was trying to diagram a sales compensation plan on the back of a cocktail napkin. In and of itself, there is nothing wrong with this question (or a cocktail napkin, although I prefer using a spreadsheet). However, it becomes a problem when that is the only question being asked. To focus on determining a commission rate implies a gross over simplification of a much bigger management challenge. In fact, an exclusive focus on defining the commission rate covers only a fraction of the core elements of a well constructed sales compensation plan.

The Basic Building Blocks

There are essentially eight core elements to a sales compensation plan. Each element is defined below and listed in sequential order in terms of when that element is typically considered in the sales compensation design process.

• Target cash compensation (TCC) – The TCC defines the economic value of a job. It is the annual cash compensation amount paid for achievement of expected levels of performance (i.e., 100% of goal or quota). TCC is comprised of two components: 1) base salary at the midpoint of the salary range and 2) the target incentive compensation (TIC) earned for performance at 100% on all performance goals or quotas.
• Pay mix – Mix is the relationship between the base salary (either the uniform salary or the midpoint of the salary range) and the target incentive compensation amount in the TCC package at planned or expected performance. The two portions of the pay mix, expressed as percentages, always sum to 100%. For example, a 70/30 pay mix means that 70% of the TCC for the job is in base salary and 30% is in target incentive compensation.
• Leverage – This is the defined upside incentive opportunity earned for above-target performance. Specifically, leverage is the amount of incentive compensation available for performance at a defined level above target or quota, often referred to as the “excellence” performance level (see Performance Range below). Leverage is commonly expressed as a multiple of the TIC (e.g., a 2.0 leverage multiple pays two times the TIC for performance at excellence).
• Performance measures and weighting – Arguably the most critical decision in any sales compensation design process, the performance measures define the metrics used to evaluate performance and determine incentive compensation earnings. Each performance measure is given a “weight” as a percentage of the TIC; the total weighting of all performance measures sums to 100%.
• Incentive form and mechanics – In its most basic sense the incentive form is either a commission or a bonus, but with many potential variations on each. A commission is incentive compensation paid as a percentage of sales measured in either dollars or units. This type of pay is based on a commission rate that is either fixed or variable, and is paid as a direct function of a sales transaction (or the total of multiple transactions). A bonus is a planned dollar amount (expressed either as a percentage of salary or as a target dollar award value) that is earned on the basis of actual performance (the sum of many transactions) relative to a defined goal or quota. Incentive mechanics deal with the incentive formulae used to calculate incentive compensation and define the slope of the payout curve.
• Payout frequency – As the name implies, this is simply how often incentives are calculated and paid for a given performance measure or incentive component. The most common are monthly, quarterly, semiannually, and annually. The length of the sales cycle and the amount of incentive pay attached to a given component influence payout frequency.
• Performance measurement approach – This deals with the manner in which performance is measured over multiple individual performance periods (e.g., months or quarters) throughout the course of a year. A “discrete” performance measurement approach measures and pays for each individual period on a stand-alone basis. A cumulative year-to-date (YTD) performance measurement approach accumulates performance results with each successive period over the course of the year. For example, with a quarterly payout frequency, a YTD measurement approach in the second quarter would measure performance over the first and second quarters combined (i.e., all six months).
• Performance range – This defines the boundaries within which incentive compensation is earned and helps determine the slope of the incentive payout curve. There are typically three points that define the performance range: threshold (i.e., the minimum performance required to earn any incentive), target (i.e., the expected performance level, often expressed as 100% of goal or quota), and excellence (i.e., the outstanding level of performance which typically earns the defined upside leverage amount). The performance range is typically determined by considering statistical performance norms, with the historical 5 th percentile performance level defining threshold and the historical 90 th percentile performance defining excellence. For example, if the historical 5 th percentile performance level is 68% of quota and the 90 th percentile is 134% of quota, then a good starting point for establishing threshold and excellence in the new plan is 70% and 135%, respectively.

Fitting the Pieces of the Puzzle Together

As you can see, the design of a sales compensation plan goes well beyond determining a base commission rate. Even more challenging, all of these incentive plan elements don’t fit neatly on the back of a cocktail napkin! Each of these incentive plan elements must be considered in the context of a company’s business objectives, go-to-market strategy, and the definition of the various jobs in the sales organization. It all comes down to effectively translating management’s priorities for a sales force in a way that reinforces the desired selling behaviors. Does it require more than simply determining a commission rate? Absolutely!