Rethinking Sales IncentivesRethinking Sales Incentives
A refined sales force compensation structure can more closely align reps' motivations with company goals.
March 1, 2007
ADVERTISING, DISTRIBUTION, & SALES
With the goal of aligning sales reps' motivations with the goals of the company, many medtech manufacturers implement commission-based incentive plans that pay reps on every dollar of sales. The impetus behind such plans is that the more a sales rep sells (good for the company), the more commissions the sales rep makes (good for the reps). Confidence in this link drives more than 60% of medtech sales forces in the marketplace to pay out a significant portion of their sales incentives as commissions. Although on the surface the belief in the linkage is valid, such commission plans do not always align rep motivations with company objectives.
A key factor affecting the effectiveness of a commission-based sales structure is a phenomenon called carryover. The carryover concept recognizes that sales during a given year are not entirely driven by sales rep efforts during that year. Some portion of the sales volume—often a majority—is due to other factors. Such factors include sales and marketing efforts in prior years, general market conditions, an outstanding product with good word-of-mouth advertising, competitive issues or failures, government regulation, and even the weather. Due to these and other factors, a portion of sales carries over from one year to the next. Thus, only a part of each year's sales is driven by the current efforts of the sales force. The magnitude of a company's carryover sales depends on many things, but in the medical device industry, carryover is frequently more than 50% and can, in certain situations, reach up to 100% of sales.
The most significant driver of carryover is the prominence of the sales rep in the sale of a medical device. In evaluating carryover, companies must consider how much of a sale is due to a sales rep's effort and how much is due to other factors, such as unique product characteristics, regulatory requirements, or attractive pricing. For example, capital medical equipment such as diagnostic imaging equipment typically has very high sales rep prominence, and therefore low carryover. If a rep sells a magnetic resonance imaging (MRI) machine to a hospital in one year, it is highly unlikely the hospital will buy another MRI machine from the same company the following year—even if it's needed—unless the sales rep works closely and tirelessly with the customer to accomplish the sale. Even if a customer is looking to standardize its equipment based on the type of equipment purchased the previous year, it is still unlikely the sale will be accomplished with no effort on behalf of the sales rep. Factors leading to low carryover rates include the following.
Capital equipment and expensive products.
Small purchase volumes without contracts.
High levels of competitive noise.
Low switching costs.
Products for which a manufacturer's sales force is the main promotional vehicle.
The low level of carryover frequently seen in capital equipment sectors contrasts significantly with that seen in the sale of simple medical supplies, such as standard syringes. Supplies such as these are frequently purchased on long-term contracts. Although a sales rep may play a critical role in securing the original contract, it does not require much effort to maintain the contract during following years. It is highly likely that a hospital will continue to buy a particular brand and type of syringe as long as orders are fulfilled accurately and the manufacturer's customer service does not falter. In situations such as this, carryover is high—possibly 90% or greater.
Factors leading to high carryover rates include the following traits.
Highly differentiated products.
Products purchased on long-term contracts.
Products with strong brand or company loyalty.
High switching costs.
Products with high maintenance or service activity.
Products with many promotional vehicles beyond a manufacturer's sales force.
Failing to Align Interests
When manufacturers' commission plans are structured to pay reps on every dollar of sales in a given territory, a lot of money can be spent paying for carryover sales that were not affected by the efforts of the sales force. Although sales management may intend for commission dollars to motivate rep behavior, carryover results in a portion of commissions being considered a freebie or hidden salary by the reps. Sales reps often do not consider commissions on carryover sales to be at risk of being lost.
In a case in which sales reps are paid only on commission with no base salary and carryover sales are 80%—meaning 80% of the sales from the prior year would repeat even without sales rep effort—only a small portion of the money spent on commissions is actually motivating rep behavior.
Figure 1. Example of how carryover sales affect the percentage of sales for which a sales rep is directly responsible in a given year.
The impact of carryover is best demonstrated with a quantifiable scenario. For example, if a medical supplies company is paying commissions on $1.2 million of sales in a given year, but $0.8 million of the sales would exist without rep effort, then 66% of the rep's commissions are virtually guaranteed. Therefore, only 33% of the commission money is at risk for the rep (see Figure 1).
As this example illustrates, when sales reps are paid a commission on all sales in a territory for a product line that has high carryover, reps can make a good living without having to put much effort into their territories. In large-volume territories with high carryover—and therefore a high level of guaranteed income—sales reps can become complacent. They may not push hard for additional sales when the upside income opportunity is small compared with the amount that is already considered guaranteed. In this sense, commission-based incentive plans may not be as aligned with management objectives as they appear.
Figure 2. Example of how a salary base and carryover sales affect the amount of sales for which a rep is directly responsible.
The same situation exists in incentive programs that provide reps with base salaries and the opportunity to earn commissions on top of that (see Figure 2). In such situations, a manufacturer already guarantees a certain amount of rep income. For example, a rep may earn a $70,000 salary with a $30,000 commission expectation for the year. By applying the previous example, in which $0.8 million of the total $1.2 million in sales is carryover, $20,000 of the commissions would be guaranteed. In this case, only 10% of the rep's income ($10,000) is really at risk, versus the 30% that management may have intended to put at risk.
Another problem associated with commission plans that pay from the first dollar of sales—with or without a base salary component—is that they inhibit management's ability to change territory configurations. Under such plans, sales rep income is directly proportional to territory revenue volume. Thus, when management attempts to reconfigure territories, perhaps due to an upsizing or restructuring of the sales force, members of the sales force may vehemently resist any reduction to their territory sizes. Reps' motivation to resist territory reductions is obvious—their income will be reduced in direct proportion to the amount of territory sales volume taken away.
The frustration brought on by management's desire to change their territory alignment can lead reps to threaten to quit—and take their business to a competitor—if their territory sizes are reduced. In such circumstances, two management reactions are common.
One common response is for sales force leaders, in order to avoid a mutiny, to give in to the desires of the sales reps and not cut territory size. This is an especially common way of managing the most vocal of the reps, who typically have the largest territories. When sales managers back down in this manner, the manufacturer fails to optimize its market coverage by shrinking territory size. Regrettably, it is usually the largest territories—and the loudest reps—that are most in need of additional resources to improve market coverage and penetration.
A second common response to sales force protest is to proceed with the plan to reduce the size of large territories, but offer the reps in those territories some form of income guarantee to make up for lost sales volume and their inherent commissions. Although such an approach keeps reps happy, it also raises costs for the company and can undercut reps' incentives to work hard by guaranteeing an additional level of income. One effective way to manage this issue is to put conditions on the additional income by making it contingent on achieving a minimum level of performance in the new territory.
Alternative Incentive Structures
Despite the drawbacks outlined in this article, commission-based incentive plans that pay from the first dollar of sales are not necessarily a bad idea for all sales situations in the medtech industry. Under the right circumstances, such plans are effective and powerful. For example, when launching a new product, such commission plans directly link rep incentives with the company's objectives. Such plans are also appropriate for products or markets with very low carryover sales—situations in which a sales rep's efforts are critical to achieving every sale, as is the case with capital equipment. However, problems begin to arise when commission-based incentive plans that pay from the first dollar are used in the wrong situations.
Figure 3. Two types of sales commission plans offer distinctly different incentives to sales reps. However, rep compensation at and above the performance goal is equal in both plans.
Once a new product has been launched, manufacturers may want to consider discontinuing paying commissions on every dollar of sales. After the initial launch period, manufacturers can continue to drive sales reps' motivations by paying commissions only on sales growth or only after sales have hit a certain threshold. For example, in the case of the medical supplies scenario given earlier, a manufacturer may decide not to pay commissions in a given year until a territory exceeds 80% of the previous year's volume (see Figure 3).
Designing commission plans in such a way ensures that incentive dollars are being allocated to the sales volume for which the reps are truly responsible. It pays for results affected by the sales force during the current year--not for sales in the territory that can be attributed to other factors. Such a structure avoids the risk of reps becoming complacent while reaping incentive rewards from carryover sales. The refined commission structure also makes it easier for management to change territory configurations by eliminating the close link between rep income and terri-tory size.
By moving from paying commissions on every dollar of sales--except in certain appropriate situations--to paying commissions only on sales that are driven by the sales force, companies can ensure better alignment of the reps' motivations with company growth objectives. Furthermore, such a change in commission structure can give management more flexibility to design sales territories to maximize market coverage.
Marshall Solem is the managing principal of ZS Associates' office in Evanston, IL, and leader of the firm's medical products and services practice.
Copyright ©2007 MX
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