Should Salesmen's Compensation Be Geared to Profits?

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1 Should Salesmen's Compensation Be Geared to Profits? RALPH L. DAY and PETER D. BENNETT Do mosi sales managers tf7 to maximize sales volume to the detriment of profits? The authors do not think so. Methods are proposed for shifting incentives from sales volume to profits through better utilization of data available from electronic data processing systems. O SALES managers focus on sales volume attainments, and thus overlook profitability as long as profits are adequate to keep the firm in business?i Often this may appear to be the case, but little actual evidence is available. The central role of sales volume in the control of marketing activities does not imply that sales managers intentionally overlook the profit goal. Sales data are more readily available and are seemingly more precise than profit data. Increased sales are assumed to mean increased profits unless clear current evidence to the contrary is available. In the absence of current profit information, sales managers tend to maintain procedures which serve to maximize sales volume. An example of this is the widespread practice of basing incentive compensation to salesmen on sales volume measures rather than profit measures. Almost all sales managers are aware that sales volume alone is a poor indicator of the contribution to overhead and profit made by an individual salesman. However, total sales volume is still an important element in the salesman compensation and evaluation plans of a great many companies.^ In part, this can be attributed to the cost and complexity of the computations involved in making analyses of sales results in the depth necessary to provide the basis for sounder compensation policies. The availability of high speed electronic data processing equipment makes it possible for the marketing department of many firms to obtain data for better analysis of sales results as a relatively inexpensive byproduct of machine order processing.^ By modest extension of data processing routines, it is often possible to collect and summarize data which will facilitate control of sales activities and provide more realistic bases for salesman compensation. Compensation Methods For a few industrial goods, especially those of a highly technical nature, it is extremely difficult to relate the ability and effort of an individual salesman to the sales results obtained during a given period. Sales may vary widely as the result of factors beyond the salesman's control. For such situations, a straight salary basis of compensation is usually indicated. More often, there is a clearly discernible relationship between 1 See William J. Baumol, Business Behavior, Value and Growth (New York: The Macmillan Company, 1959), p "Don't Tie Incentives, to Volume When It's Profits You Want," Sales Management, "Vol. 85 (July 1, I960), pp "How Data Processing Helps Raytheon Boost Sales," Sales Management, Vol. 85 (September 16, 1960), pp. fi2-66.

2 Should Salesmen's Compensation Be Geared to Profits? the effectiveness of the field salesman and the results obtained in his territory; but the exact nature of this relationship is seldom crystal-clear. Many other factors affect the nature of sales results in any territory, but the salesman's activities clearly have an important effect on sales obtained. In general, sales compensation plans attempt to provide strong incentives to the salesman to utilize his time and abilities in the most effective way by providing, financial rewards which vary with his performance.-^ Many firms have held to the point of view that the simplest incentive system is the best. Consequently, they base their compensation plans only on results as measured by sales volume figures, compensating on the basis of either a fiat rate or a sliding- scale commission. Other firms modify the straight commission plan only slightly, providing a "floor" on earnings by means of a base salary tied to a quota beyond which additional earnings accrue. Such plans are conceptually simple, easy to administer, and clearly understood by the salesman. Total sales volume is usually an important part of even the most complex compensation plans. Obviously, a substantial volume of sales must be maintained if a company is to make a profit. But it does not follow that the greater the volume of sales, the greater is the profit. Maximizing sales volume is a poor substitute for maximizing profit when the profitability of sales varies by products, classes of customers, and geographical areas. Effects of Incentives If an incentive system is based mainly on sales volume attained and if the salesman is responsive to the incentive, he will attempt to maximize sales volume. He will concentrate on those products, customers, and areas which he believes will yield the greatest sales volume. It will be to his interest to attempt to convince management that prices are too high any time he encounters price competition, regardless of any quality advantages his product might have. It is generally easier to convince a buyer that your product is equal in quality when its price is lower than it is to sell quality at a premium price. If he knows that he cannot infiuence price, then the logical thing for the salesman to do is to concentrate on selling his competitively priced items to potential high-volume customers. To the extent that he reacts to a sales volume incentive, it is of little concern to him that he is producing considerable volume but little profit. Of course, there are various ways in which the sales manager can combat the undesirable effects of sales volume incentives. These range from sales "How Salesmen Are Paid Today," Sales Management, Vol. 88 (January 19, 1962), pp , contests to "pep talks" on selling quality instead of price. Perhaps the most direct way is to establish different classes of products according to relative profitability, with differing commission rates on the sales volume in each class. This is a step toward the "contribution to profits" method discussed below. Some compensation plans have become extremely complex as attempts have been made to offset the undesirable effects of the underlying sales volume incentive system.^ Such plans often commit the error of treating the symptoms instead of curing the disease. The Gross Margin Approach Compensation plans can generally be kept simple and made more effective by basing the commission rate on a measure of the contribution to overhead and profit of an order, rather than on its contribution to sales volume. A rough measure of the contribution to overhead and profit of an order is tbe gross margin obtained. The idea of basing incentive compensation on gross margin rather than sales volume is not new. It has been used to a limited extent for many years but the availability of electronic computers has made it feasible for the first time in many firms. The difference between net sales and the cost of goods sold can easily be accumulated for all of a salesman's orders each pay period when a modern data processing system is used. The incentive portion of a salesman's compensation can then be computed easily by applying- a suitable commission rate to the salesman's total contribution to gross margin. The accumulation of gross margin from orders usually requires the use of a standard cost of acquisition or production for the various products '> "Are You Paying- Your Salesmen for 'Full Line' Selling?", Sales Management, Vol. 85 (September 2, 1960), pp ABOUT THE AUTHORS: Ralph L. Day is Associa+e Professor of Marketing Administration at the University of Texas. He earr^ed his B.S. and M.S. degrees at the Georgia Institute of Technology and his Ph.D. degree at the University of North Carolina. He Is the author of MARKETING IN ACTION: A DY- NAMIC BUSINESS DECISION GAME end several articles on the application of quantitative techniques to marketing problems. Peter D. Bennett, Data Processing marketing representative with International Business Machines Corporation, is currently on educational leave of absence from IBM. He earned his B.B.A. and M.B.A. degrees at The University of Texas, where he is a Lecturer in Marketing Administration.

3 sold. If product costs vary sharply with levels of sales, this may cause difficulties, especially when a gross margin incentive system is first installed. If costs follow a step function,*' the gross margin at a budgeted level of sales may lead salesmen to shift their sales emphasis in such a way that a resulting change in volume alters the product cost and hence the unit contribution to gross margin. Such problems can generally be minimized by sound costing procedures and frequent review of sales patterns. When commissions are based on gross margin, incentives are more correctly placed. Harder-toget orders for higher quality, higher priced, higher margin products are likely to be seen in a different light by salesmen. The same can be said for orders from higher margin customers and of higher margin size. The incentive system is far less likely to work against the most profitable mix of products and customers. The case of a large hardware wholesaler will serve to illustrate the role that a data-processing system can play in a highly meaningful compensation plan. This company installed a mediumscale data-processing system for the primary purpose of order processing and inventory control. Every order is now processed through the system where it is extended, totaled, and printed out as an invoice. The process includes a complete updating of inventory records and sales history by salesman, customer, and product. The inventory record contains a cost figure which is extended and subtracted from the extended price. This deduction of "cost of goods sold" reveals gross margin for the item, and when summarized, for the order, the salesman, and the customer. This gross margin information becomes a part of the sales history for the product, customer, and salesman. The salesman's earnings are now based on his contribution to gross margin, instead of the previous commission on sales volume. This system has given the firm's sales management better information on the effectiveness of its sales force and provides a direct incentive to the salesmen to work for higher margin sales. An Approximation of Profits While it is a better measure than sales volume, gross margin is only a general approximation of the salesman's contribution to profit for many firms. Just as there is a variability in the gross margin among products, there is generally a considerable variability in marketing costs among products and among customers. Some products typically require more advertising and sales promotion activity than Francis W. Fehr, "Some Points to Watch in Studying the Fluctuation of Cost With Volume." N.A.A. Bulletin, National Association of Accountants, Vol. 41 (March, 1960), Section 1, pp Journal of Marketing, October, 1962 others. Delivery costs and "free" services vary by product and by the type and location of customer. When a close approximation of direct marketing costs is deducted from the gross margin contribution of an order, the "contribution to marketing overhead and profit" is obtained. An incentive system based on a measure of the salesman's contribution to marketing overhead and profit places the incentive squarely where the profit-conscious sales manager wants it. Although such a measure can never be perfectly accurate, a commission system based on a close approximation to the profit being obtained seems clearly preferable to existing systems where incentives are based on measures which do not accurately reflect the contribution to profits. If an incentive system is to be effective, the salesman must be able to relate his results directly to the amount of compensation he will receive. Therefore, he must know in advance the approximate amount of contribution to profit which will result from any order. Since some items of marketing expense cannot be predetermined exactly, a system of estimated marketing costs is necessary. These estimated costs would logically include all true variable costs plus "fixed but separable costs."''' The necessity for completely arbitrary allocation of items of marketing overhead can be avoided by seeking only the "contribution to overhead and profit," rather than a net profit fig.ure. Careful Analysis Required A system of estimated marketing costs requires both careful analysis of particular items of marketing cost and careful budgeting procedures in order to obtain meaningful unit cost figures. Few firms presently have costing and budgeting systems which can supply sufficiently accurate cost estimates.^ The apparent reason is the belief that such data are prohibitively difficult and expensive to obtain. In the pre-computer era, there was a better basis for such belief.^ But a great many firms which have "computerized" their paperwork are already generating most of the raw material for a system of estimated marketing costs; and many others could do so by revisions of their data processing procedures. William J. Baumol and Charles H. Sevin, "Marketing Costs, and Linear Programming," Harvard Business Review, Vol. 35 (September-October, 1957), pp Ed W. Kelley, "Marketing Cost Analysis The Accountant's Most Neglected Opportunity," N.A.A. Bulletin, National Association of Accountants, Vol. 41 (July, 1960), Section 2, pp American Marketing Association, Committee on Distribution Costs and Efficiency, "The Values and Uses of Distribution Cost Analysis," JOURNAL OP MARKET- ING, Vol. 21 (April, 1957), pp , at p. 399.

4 Should Salesmen's Compensation Be Geared to Profits? 9 For instance, the hardware wholesaler referred to previously has much of the data necessary for more extensive profit analysis. Other data could be generated from the customer, product, and salesman's history records. The company's physical distribution costs are associated with variations in products and in customers' geographical location. Order-processing costs are very nearly as large for a $5 as for a $500 order. Sales administration and salesman's travel costs are associated with variations in the nature and location of customers; and advertising costs normally vary by product. By establishing estimated unit costs, the hardware company could incorporate an estimation of marketing costs into its order-processing procedure. The simple "cost of goods sold" figure in the inventory record could be expanded to include estimates of marketing costs associated with the product and other marketing costs derived from customer and salesman records. Through these changes, the order-processing procedure could yield an estimation of the "contribution to marketing overhead and profit" for each salesman in each pay period. This would provide the basis for an incentive compensation plan In which commission earnings could be based on a far more accurate measure of the salesman's contribution to overhead and profit than simple sales volume. Variations Among- Firms The extent to which a data processing system can provide a meaningful measure of the contribution of sales activity to marketing overhead and profit will vary among firms. There are many practical difficulties in establishing such a system. Initiating and maintaining the requisite data processing procedures alone might be a staggering task for some firms; although for others it will appear as a logical extension of existing procedures. All firms will face the problem of providing the salesman with the information he will need in order to gear his actions to the incentive system. However, modern advances in data handling methodology make it imperative for every firm to re-evaluate its time-honored methods. This in no sense implies that the sales manager should turn his job over to an information processing system. In fact, it will require him to be more alert and less inclined to relinquish the exercise of judgment to a mechanically implemented procedure than in the past. He must continually monitor the system, to be sure that it is not causing salesmen to overlook the small company with growth potential or to neglect implicit "tie-in" relationships of low profit items to higher profit items. When carefully conceived and properly administered, a profit-based compensation plan can be an effective managerial Broader Benefits If the only benefit to be obtained from an improved system of profit analysis is the facilitation of a better salesman compensation plan, its adoption might be questionable from a cost standpoint. However, the broader benefits for marketing control are obvious. Such a system would provide a means for continued profitability analysis of the entire marketing operation which almost certainly would lead to a more effective marketing org-anization.^i Profit potential instead of sales potential can be the basis for such decisions as advertising appropriations, territory assignments, pricing policies, and the product mix. A salesman compensation plan which more accurately relates financial reward to desired performance is but one of the benefits to be obtained. i«claire Trieb Slote, "Keying Sales Calls to Profits," Dun's Review and Modem Industry, Vol. 76 (November, 1960), pp John W. Barry, "How to Keep the Controller Off Your Back," Sales Management, Vol. 87 (October 20, 1961), pp Reprints of every article in this issue are available {as long as the sjtpply lasts) at the following prices: Single reprint $i.00 Four to 99, each $.50 Two reprints 1.50 First Three reprints 1.80 Additional loo's Quantity Discount Special prices for large quantities. Send your order to: AMERICAN MARKETING ASSOCIATION 27 East Monroe Street, Chicago 3, Illinois Duplication, reprinting, or republication of any portion of the JOURNAL OF MARKETING is strictly prohibited unless the written consent of the American Marketing Association is first obtained.

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