A frequent question during our Price class is “How should we compensate our sales force?”
Salespeople have a huge influence on our achieved margin. They are the front line in any negotiations. They are the ones who communicate our value to the customer. They set the customer expectations on what price they should be paying.
Since they have so much influence, how do we influence them to do the right thing when it comes to getting the highest price?
You may have heard the phrase, “Salespeople are coin operated” meaning they do what they are paid to do. (Nothing against sales people because I think we all do this.) However, salespeople usually make commission on the sales they make. The most common type of commission is a percentage of revenue.
Unfortunately, when we use a percentage of revenue as their compensation plan, it motivates them to close more deals quickly, even at lower prices. That’s not what we want. We like the more deals quickly part, just not at lower prices.
Here is a good explanation by the Freakonomics authors, Steven Levitt and Stephen Dubner on why real estate agents don’t try to get the best price for your house. The same is true for most sales situations. It’s hard work to get the last few dollars in a sale, and it’s just not worth the salespersons time to go get them.
How can we structure a compensation plan that will go get those last few dollars? First, please know that compensation is a huge topic which we are not exhaustively covering here. Instead, we only want to focus on the price piece.
One idea would be to compensate sales as a percentage of the margin achieved. That way when the company makes more profit, so does the salesperson. Sales would have a decent percentage of the profits so they have more incentives to get higher prices. The big downside to this is most companies don’t want to share their costs with their salespeople. When sales knows the costs to build a product, it often drives prices down, not up. Sales then knows how low they can go and the company will still accept the deal.
A better solution is to determine a target price for each sales situation. What price should a salesperson be able to achieve? This target price is often a function of the industry, geographic territory, type of customer, size of the deal and more. You can determine this target price by what customers have historically paid.
Once you have a target price, you can then offer incentives based on how much above or below the target price the salesperson closed the deal at. For example, you might have a commission structure that looks something like this:
- 10% for any deal at or above 10% over target price
- 8% for any deal at or above 5% over target price
- 5% for any deal at or above target price
- 3$ for any deal at or above 5% below target price
- 1% for any other deal we accept
With a compensation plan that looks like this, small changes in realized price can make a big difference in the salesperson’s commission. Hence, the incentives are more aligned for sales to try to get the highest price possible.
Sales compensation is a big topic, but the lesson here is important. If we want to get that last 1% of the price, we need to find ways to incentivize our salesforce to try harder. This technique does that.