Profit-Based Incentives: Doable and Valuable through Alignment of Goals
This Executive Summary reviews the concept and application of deal points, which are a method of profit-based incentives for salespeople that aligns their interests with those of the firm better than alternative methods.
It summarizes a more detailed white paper, which is available on the Wiglaf Pricing site.
In many industries, salespeople negotiate deal prices and receive commission to incentivize good deals. Unfortunately, many of the most common incentive types have serious shortfalls that negatively affect company performance.
Incentivizing a salesperson on their revenue fails in that there is a fundamental discrepancy between revenue and profit. Putting the target on revenue encourages sales volume, which may be profitable or may not. If the incentive is for sales volume, it encourages all sales, even those that reduce profit.
Product mix incentives are similarly, at best, an imperfect measurement of the true goals of the firm. Incentivizing a good product mix, however defined, cannot ensure that the prices and margins of said products are strong. In fact, the tendency will be to lower price in order to hit the target product mix.
Revenue and product mix incentives, even when used simultaneously, can fail to encourage the outcome desired. Not only is it possible for a salesperson to achieve revenue targets but fail to achieve product mix targets and vice versa, but it is possible for salespeople to do both and still fail to be highly profitable in the face of negotiated discounts.
Profit sharing at the level of a business unit is too disconnected from an individual’s contribution size and ability to influence total team performance. Profit sharing is not an incentive aligned to an individual salesperson’s performance. It is a good team incentive to encourages teamwork within a business unit, but it poorly tracks the performance of any individual salesperson.
Profit-based incentives at the individual customer transaction level ensure that the performance and actions of an individual salesperson are both measured at the individual level and are aligned with the profit goals of the firm. The company wants profits, so incentivize salespeople on the profits they create. Simple?
While compensating sales based on profit contributed sounds good in theory, many executives are wary of profit-based incentives because they fear revealing cost information to sales. Directly compensating salespeople on the profitability of their sales would require revealing to them variable costs of products and transactions. This could anchor salespeople at a low price level as well as create an administrative headache to keep variable costs up to date.
However, there is a method of profit-based incentives that provides the benefits of simplicity and incentive alignment without revealing cost information. This method is called deal points.
Deal points, like revenue, are calculated at the individual transaction level according to the quantity sold and the price at which they are sold. Importantly, deal points also include factors related to the target price and a parameter, k, commonly known as the sales kicker.
Deal points = Quantity Sold × [Target Price – k × (Target Price – Deal Price)]
If the sales kicker is one, deal points are simply quantity multiplied by price, or revenue. Adjusting the sales kicker, therefore, affects how sensitive deal points are to changes in price.
Take a sale of 1,000 liters of a product with a target price of $500 and a margin of 40%. Assume a revenue commission and that the salesperson and customer negotiate an 8% discount on the price. After discount, this transaction contributes $460,000 toward revenue.
But while the 8% discount only reduced the salesperson’s revenue performance by 8% ($500,000 to $460,000), for the company that same discount reduced the deal profitability by 20% ($200,000 to $160,000). The discount is felt by the company much stronger than by the salesperson.
Let’s see what would happen in the deal point scenario, using a sales kicker of 2.5 on the above transaction. With the same 8% discount, the salesperson’s deal points would decline by 20% (500,000 to 400,000).
Whereas before only the company felt the 20% loss, now both the company and the salesperson do. A higher kicker would of course make the salesperson even more sensitive than the company. Incentives are aligned.
Deal points internalize for salespeople the actual effect of their price concessions. This has wide ranging positive effects for sales, marketing, finance, product, and the company as a whole. Deal points:
- Incentivize salespeople to seek the highest price and margin per transaction
- Reward salespeople according to the profit they accrue
- Reduce the incentive for salespeople to negotiate internally for a price reduction
- Empower salespeople still to make price reductions when necessary
- Hold salespeople accountable for their price concessions
- Enable salespeople to walk away from unprofitable deals
- Encourage proper product mix by using different kickers for different product groups
- Maintain company focus on profit
If you reward salespeople for profits, you tend to get more profits.
While deal points are a powerful tool, implementing them requires careful thought. List prices, sales kickers, commission rates, and various approximations through product groupings have to be determined to create a workable plan. And, once a workable plan is defined, sales managers may determine that a sales territory realignment is furthermore in order.
Each of these can be addressed in a pricing policy improvement project and have been detailed in a white paper available on the Wiglaf Pricing site.