3 Keys to Creating Your First Compensation Plan

Creating a compensation plan can feel overwhelming because there are so many ways to structure the plan.

A great compensation plan:

• Creates a win-win-win for the employee, customer and company
• Rewards the behavior you want
• Boosts profitability and cash flow

The key problems with most compensation plans:

• Focused on solving only part of the problem
• Created to reward the first person in the department
• Defaults to the common math formula (commissions = total sales x commission percentage)

Consider these common pitfalls before you finalize your compensation plan. 

1. Should I pay based on sales or gross profit margin (sales – cost of goods sold)?

Pay commissions on total sales.

        Pros

• Easy to calculate
• Simple to track
• Less friction between the sales team and operations

Cons

• No financial consequences for the employees that rely on giving discounts to close the sale
• Employee is not incentivized to consider all costs when calculating the sales price

Pay commissions on gross profit margin.

Pros

• Only pay when the project meets profitability goals
• Employee is financially incentivized to get the sales price right

Cons

• Identify why costs were higher than expected – sales team made a mistake or operations had a problem
• Calculation and tracking may be more complicated and confusing.
• Possible friction between departments – sales and operations

As you can see, there are pros and cons to both. They both can work.

Before you choose,

• Run the numbers
• Communicate expectations with your team
• Remove silos between departments 

2. When should I pay the sales commission?

So, you made the decision of how the commissions will be calculated, but when will you pay the commission?

You have three primary options: after the proposal is signed, after the service is delivered or after the customer pays.

Collecting money from your customers is a step that is often overlooked during the sales process.

In the perfect world, you’ll collect money from customers before you pay the sales commissions, but that is not always realistic. I like to choose the option that aligns with when the sales person finishes their responsibilities – they’ve earned the commission. Here are some highlights for each option:

Commissions are paid after the customer signs the proposal. This option works best when…

• commission is paid on total sales
• sales team is not responsible for collecting money from the customer

Pay commissions after you deliver the service. This option works best when…

• commission is paid on gross profit margin
• sales team is not responsible for collecting money from the customer
• customers are allowed to cancel the project after the proposal is signed. This option helps prevent paying sales commissions on cancelled projects.

Collect first, then pay commissions. This option works best when…

• sales team is responsible for collecting money from the customer
• customers pre-pay or pay at the time of service
• Warning: It does not work well when customers are allowed more than 30 days to pay or there is a long delay between signing the proposal and providing the service.

Before you make a decision, consider

• who is responsible for collecting money from customers.
• how your cash flow will be affected if you choose to pay the sales team before your customer pays you.
• how you’ll keep the sales team motivated after the sale if you pay before the project is complete.

3. Is the compensation plan realistic for the employee?

After one of my clients interviewed their first sales person, they told me their plans for how they will compensate the new sales person - 3% of sales generated by the employee.

Sounds easy enough, right?

Here’s more to the story…

• Employee expected to earn at least $60,000 per year
• Company’s current annual sales were $1,800,000

Will this compensation plan work for the employee?

Do you see anything wrong with this situation?

The employee will need to sell $2,000,000 when the company only sells $1,800,000 per year. Is it realistic for the new sales person to sell more than the current sales?

I’m all for dreaming big, but…

Where will the leads come from to generate an additional $2,000,000 in sales?

How many people will the company need to hire to deliver the services?

Will the company need to buy more assets – computer equipment, company vehicles and office furniture?

How much will the overhead expenses increase – office space, training and employee benefits?

Thankfully, my client told me about the idea before they made a decision. I shined a light on the potential problem before the owner hired the employee and invested in training. Eventually, my client and their new employee would have figured this out on their own, but it’s better to run the numbers before the decision is made. You’ll reduce your stress and save money.

Bottom line

Compensation plans should benefit everyone involved…reward and incentivize the employee plus boost profitability and cash flow.

Don’t design the plan around one employee, one position or one problem. Step back and look at the big picture. Consider the decision from every view point:

Human resources - Jobs that are substantially the same require the same pay. Will the compensation plan work as the company grows and you hire more people? Also, consider how the exempt vs non-exempt employee status affects the compensation plan.

Employee – will the compensation plan motivate the right actions? Will it be worth their time? Is the sales goal realistic?

Team – how will this compensation plan affect the culture of your company?

Cash management - Consider the timing of when you will you pay the sales commissions: after the proposal is signed, service is delivered, or customer pays.

Profitability – Run the numbers to see how the commission will affect your profitability.

Prices - Update your prices to include the cost of the compensation plan.

Marketing – How will the company generate the leads the sales team needs to be successful? How much will it cost to generate the leads?

Sales – Does the sales presentation need to change to reflect the new prices and value you provide?

Communication – document the compensation plan and communicate it to everyone involved. Show an example and explain the why you made key decisions.

System – How will you track, review, approve, pay and record the transactions to ensure the compensation plan is paid correctly?

Operations – How will the increase in sales affect your operations? Will you need to hire more employees or buy new assets?

Brand – How will the new sales team serve your customers and protect your reputation?

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