Motivating through Monetary Incentives

by Tim Smith, PhD, 12 September 2005

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Perhaps the most examined structural motivation tool is the incentive structure of the compensation package. Managers have tinkered with this issue more than any other. Researchers have demonstrated links between incentives and performance more clearly than any other structural tool.

A plethora of theory and data supports the impetus to tinker and research the compensation package. Adam Smith’s self interested worker, also known as homo-economicus, is presumably motivated by money. The availability of hard data allows for easy regression analysis to demonstrate correlations between incentive structures and performance. The combined accepted theory and rich data encourages people to examine this area perhaps at the expense of more difficult to research but relevant areas. Nevertheless, the research is clear.

The design of an incentive structure can be deconstructed into three different components: the split between base salary and performance based income; providing incentives based upon end-results; providing incentives based upon strategic or tactical goals.

Base plus Performance
The starting point for any salesperson compensation package is the division of total monetary compensation between base salary and performance based income. The split is influenced by the need to smooth income, balance risks and rewards between the company and salespeople, and maintain managerial control. The next step is the determination of the mechanism for pay-outs on the incentive portion of the compensation package. While the most common approach is to tie incentives to revenue, there are other approaches each with its own advantages and disadvantages.

End-Results Incentives
Revenue based incentives have the advantages of simplicity and of relating a desired business outcome to the salesperson’s responsibilities. However, revenue based incentives are not perfect. They encourage a single-minded focus on closing deals at the expense of developing prospect relationships, maintaining workforce cohesiveness, or negotiating for the highest price.

The effect of encouraging salespeople to focus on revenue rather than profits has been well examined. Perhaps the clearest example comes from Levitt and Dubner’s Freakonomics. They examined 100,000 sales of Chicago homes, controlled for variables such as size, location, age, quality, aesthetics, etc., and demonstrated the bias of realtors towards closing deals rather than seeking higher prices. When realtors were selling homes they themselves owned, they left the house on the market for an average of 10 days longer and held out for a price that that was greater than 3% higher than that which they would take when selling a client’s home. Consider the realtor’s profit motive when selling a client’s home. While the difference between a $150,000 sale and a $155,000 sale means an extra $5,000 in profit to the owner, the real estate agent is looking at a mere $150 increase in income with the risk of loosing the sale to another realtor. For the realtor, the risk of a lost sale and the known income deferment isn’t worth encouraging the homeowner to hold-out for a higher price. Similarities hold for salespeople negotiating prices on behalf of their company.

To counter this bias, many are proponents of tying incentives to profits rather than revenue. Some companies have instituted such policies. While profit based incentives counter the bias towards accepting lower prices, they also create new biases and challenges. Left unrestrained, profit based incentives encourage price gouging and discourage salespeople from interacting with known tough negotiators. Profit based incentives also have the disadvantage of increasing the complexity of the compensation package, creating a greater administrative challenge and encouraging salespeople to gold-plate their offerings.

Related to revenue and profit based incentive packages are volume based incentives. These too have their advantages and disadvantages.

Revenue, profit, and volume based incentive structures each provide rewards based upon measurable end-results. They have the advantage of rewarding salespeople based upon their contribution to the strategic goal of the company.

Tactical or Strategic Goal Incentives
While incentives based on metrics such as revenue, profits, and volume focus on end-results, other incentive metrics can be used to encourage salespeople to focus on intermediate or strategic results. Tying incentives to the number of qualified leads uncovered, meetings with new prospects, or prospects developed beyond a key threshold helps keep the sales-team focused on managing the sales funnel. Strategically, a company can provide incentives based on the number of new customers acquired, the development of a new territory or target market, or the customer satisfaction level of captured accounts. The potential to provide incentives in relation to intermediate sales goals or strategic business objectives is limited only by the creativity of the sales manager under the constraint of not providing too many objectives so as to distract the sales team or confuse the compensation package.

Sales managers can make significant headway in motivating performance through the compensation package. Striking the right balance between base and performance driven incentives and determining the correct mix of end-result, tactical, and strategic metrics, requires careful considerations of risks, control mechanisms, and desired behavior.

Not Enough, But a Good Start
Alone, incentives will never be sufficient to guide behavior. There will always be attempts by salespeople to game the system or uncover loopholes. But monetary incentives are a good starting point to encourage performance and motivate behavior.

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Author
Tim Smith, PhD, Directorial Editor of The Wiglaf Journal and Adjunct Professor of Marketing at DePaul University.

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