iStock_000036214184_SmallMost sales forces link some portion of salespeople’s pay to sales metrics. For example, they pay a commission on the revenues salespeople generate or a bonus for achieving a territory sales quota. This proven “pay for performance” approach motivates salespeople to work hard and drive sales results.

But today, companies increasingly expect salespeople to deliver not just sales but profitable sales growth. Logically then, it follows that a sales force can align salespeople’s effort with company profitability goals by linking incentives to profit, rather than sales metrics. When an industrial lubricants distributor started paying commissions on gross margin rather than on sales, the message to the sales force was clear and the impact immediate. Salespeople curtailed price discounts and focused their effort on more profitable product lines, leading to accelerating margin growth. However when  a medical device company started paying commissions on margins instead of sales, constant change in product costs, distribution costs, product rebates, and portfolio rebates made it a nightmare to determine territory-level margins. The plan was abandoned after just one quarter.

To help you determine if paying salespeople on profitability is something you should consider, start with two questions.   

  1. Is Profitability Strategic? Companies sometimes sacrifice profitability for reasons such as building market share, blocking a competitor, or gaining entry into a market. Consider paying salespeople for profitability only if profitability is a strategic goal.
  1. Is Profitability Controllable by Salespeople? Salespeople who sell a single product at a set price have no impact on the gross margin of sales; the way they increase profits is by increasing sales. Thus, there is nothing to be gained by paying on profitability; the result will be the same as paying on sales. Salespeople have the ability to impact gross margin when – 1) they can influence price and/or 2) they sell multiple products with varied margins. Paying salespeople for profitability only makes sense if at least one of these conditions applies.

If profitability is both strategic and is within salespeople’s control, then four additional questions can help you determine the best approach for using incentives to encourage more profitable selling.  

  1. Can You Measure Gross Margin at the Territory Level? The most straightforward way to encourage salespeople to sell more profitably is to use the approach that worked for the industrial lubricants distributor -- pay incentives on territory gross margin rather than sales. But as the medical device company discovered, measuring and reporting on territory gross margin in a timely and accurate fashion is sometimes more difficult than it seems. Even when information systems allow measurement, complex calculations can make it challenging to gain sales force understanding and acceptance of gross margin metrics. If you can measure and report on territory gross margin at reasonable cost, then pay on gross margin. But if the cost is too great, consider other options for using incentives to encourage more profitable selling (see questions 5 and 6).
  1. Do You Want to Share Gross Margins with Salespeople? If you can measure territory-level margins but want to protect the confidentiality of profit margins from customers and competitors, you may want to avoid sharing margin information with salespeople. Some companies have had success paying on margin proxies -- artificially calculated margins that reflect the relative profitability of products, without revealing actual margins. Yet margin proxies still reveal a lot of information. If confidentiality is a big concern, consider other options for encouraging more profitable selling (see questions 5 and 6).
  1. Do Salespeople Influence Price? If the cost of measuring and sharing territory gross margin is too great, then linking incentives to average selling price is a good alternative for encouraging profitable selling when salespeople influence price. For example, an office products supplier had a commission plan with a multiplier linked to average selling price performance. Deals booked at more than 3% below list price earned the salesperson a base commission rate. For deals booked within plus or minus 3% of list price, salespeople earned the base commission rate times a 1.1x multiplier. For deals booked at more than 3% above list price, salespeople got the base rate times a 1.25x multiplier. The multipliers discouraged salespeople from conceding price in order to outperform on volume.
  1. Do You Want to Drive Sales of Higher Margin Products? If the cost of measuring and sharing territory gross margin is too great in a sales force that sells multiple products with different margins, then paying on sales by product grouping is a good alternative for encouraging salespeople to spend time on more profitable or strategically important products. For example, a technology company created an incentive plan with two product groupings -- “strategic products” (newer products with paramount strategic importance and an average 50% gross margin) and “core products” (older products with an average 30% gross margin). Salespeople earned a 5% commission on sales of strategic products, but just 2.5% on sales of core products. The commission rate differential encouraged salespeople to focus on higher margin products, thus boosting overall profitability.

Sales incentive compensation plans can play a key role in aligning sales force effort with company strategies. When profitability is a strategic objective and is also within salespeople’s control, a sales incentive plan that rewards salespeople for profitable selling can be an effective way to motivate achievement of company financial goals.  

Copyright (c) 2015 by Harvard Business Publishing. Reprinted with permission. This blog originally appeared on the Harvard Business Review website: (https://hbr.org/2015/06/when-sales-incentives-should-be-based-on-profit-not-revenue)

Topics: incentives, sales compensation, Andy Zoltners, Prabha Sinha, Sally Lorimer