Before discussing the solution to the problem described in the first case study, examining a second scenario might prove helpful. In this case, the owner of a thriving novelties supplier, whose customers included over ten thousand convenience stores located throughout the US, generated so much business volume that he realized he needed an automated commissioning system. The initial analysis of this business’s commission process revealed that forty sales reps received eleven percent of revenue for commissioned sales. On the surface, this appeared to be a very straightforward commission model.
A deeper analysis revealed, however, that this business sold approximately 90,000 different products. Since that number was too large for the company’s manual commissions’ calculation process to manage, the products were categorized into loosely-related groups, typically based upon their uses. During the analysis, the owner of the company was asked if all of the products being sold carried the same profit margins. The simple answer was no.
The more involved answer revealed that some products were used as loss-leader products, while others might be sold in conjunction with other products, which carried a different profit margin than if they were sold separately. Since most of the products were manufactured overseas, profit margin could also vary for the same product, depending upon the costs to manufacture it over the course of several years. The business owner was then asked to explain how he decided to use a flat commission rate for all of the company’s sales. He explained that he concluded that it was an acceptable portion of the overall cost of sales. Eleven percent of revenues seemed to be fair compensation and he was still very profitable.
This quickly emerged as a case of allowing what you don’t know that you don’t know to prevent you from leveraging what you didn’t know. Yes–that is what I meant to say; and the explanation is just about as convoluted as the statement itself. By using specific examples, however, the scenario becomes clear. In order to introduce potential customers to the high-end products, the company sold similar, low-end products either at cost or below.
This is a common practice in the retail industry. Unfortunately, given that the loss-leader products fell into the same product categories as their more profitable counterparts, it was difficult, or nearly impossible, to differentiate between them. Since the company didn’t collect the product data for all 90,000 products, but only used summarized data collected through its invoices, the business decided that it was an acceptable loss to pay commissions on sales that did not produce profits; the thought being that the low margin items would eventually lead to sales of the high-margin products.
A complete analysis of the commission process revealed what was really happening. First, virtually all sales were generated by a small number of people. The company, however, hired people as account managers to interact with the retail outlets and maintain customer relations. Although the account managers provided an important service, the company eventually realized that they had very little to do with the actual sale of products. It was ultimately determined that only three of the forty commissioned employees actually influenced the sales process.
Second, the analysis revealed that a higher than expected number of sales being made were tied to loss-leader products; and there was no direct correlation between their sales and increasing sales of higher-margin products. Rather, other buying influences had greater impact on present high-margin sales. Third, commission on revenues had little to do with an account manager’s motivation to grow the business. Conversely, activity-based incentives, which motivated the account manager to visit each store and build customer relations, proved to be more effective.
The analysis revealed that effective incentives required products to be identified by the value they brought to the company. In order to accomplish that, the company needed to define products using more than just a general description. Product definitions might include packaged elements within a product, territorial considerations, dependent or mutually exclusive relationships between products (e.g. selling a certain number of one product type before receiving commission on another product), promotional considerations and several other factors that would determine the value of a sale. A considerable amount of potential profit was overlooked just because of the limitations caused by the commissioning system the company used.
The second adjustment that the company made was to tie employee behavior to corporate objectives by modifying their performance measurements. Rather than pay commissions based on revenues, the company adopted a true pay-for-performance model. Account managers were compensated by the number of store contacts made within a specific time period. They also received bonuses based upon a variety of activities that were related to customer retention, store manager evaluations, product turnover, etc. This exercise taught the business owner that commissions weren’t simply an element of the cost of sales and his employees’ overall compensation; they were a key element in his overall business strategy.
These two examples are indicative of the disconnect that exists between corporate strategies and how they manifest themselves through employee behavior. In both cases, the companies made decisions based upon filtered information. That information led to decisions that were ultimately counter to company interests. This same condition is what lies behind the frustration companies experience when they decide to automate the compensation management process.