Types of Sales Compensation Plans

The four elements of compensation are combined into hundreds of dif­ferent plans, each more or less unique. But if we disregard the “fringe benefit” and “expense reimbursement” elements—as is entirely reason­able, since they are never used alone—there are only three basic types of compensation plans: straight salary, straight commission, and a combina­tion of salary and variable elements.

1. Straight-Salary Plan

The straight salary is the simplest compensation plan. Under it, salesper­sons receive fixed sums at regular intervals (usually each week or month but sometimes every two weeks), representing total payments for their services. The straight salary was once the most popular sales compen­sation plan, but it has been declining in importance. A recent study by Executive Compensation Service, Inc., shows that under 17.5 percent of all selling organizations use straight-salary plans. Firms that formerly used the straight salary have tended to combine a basic salary with a variable element—that is, they have switched to combination plans.

In spite of the trend away from its use, sometimes the straight-salary plan is appropriate. It is the logical compensation plan when the selling job requires extensive missionary or educational work, when salespeople service the product or give technical and engineering advice to prospects or users, or when salespeople do considerable sales promotion work. If non-selling tasks bulk large in the salesperson’s total time expenditure, the straight-salary plan is worthy of serious consideration.

Straight-salary plans are commonly used for compensating salespeo­ple heavily engaged in trade selling. These jobs, in which selling amounts to mere order taking, abound in the wholesale and manufacturing fields, where consumer necessities are distributed directly to retailers. Frequently, too, the straight-salary method is used for paying driver-salespersons selling liquor and beverages, milk and bread, and similarly distributed products.

From management’s standpoint, the straight-salary plan has import­ant advantages. It provides strong financial control over sales personnel, and management can direct their activities along the most productive lines. Component tasks making up salespersons’ jobs can be recast with min­imum opposition from those affected, so there is flexibility in adjusting field sales work to changed selling situations. If sales personnel prepare detailed reports, follow up leads, or perform other time-consuming tasks, they cooperate more fully if paid straight salaries rather than commissions. Straight-salary plans are economical to administer, because of their basic simplicity, and compared with straight-commission plans, accounting costs are lower.

The main attraction of the straight-salary plan for sales personnel is that stability of income provides freedom from financial uncertainties inher­ent in other plans. In addition, sales-personnel are relieved of much of the burden of planning their own activities (the practice of providing detailed instruction, for example, on routing and scheduling, generally goes along with the straight-salary plan). And, because of its basic simplicity, sales personnel have no difficulty in understanding, straight-salary plans.

The straight-salary plan, however, has weaknesses. Since there are no direct monetary incentives, many salespeople do only an average rather than an outstanding job. They pass up opportunities for increased business, until management becomes aware of them and orders the required actions. Unless the plan is skillfully administered, there is a tendency to undercom­pensate productive salespeople and to overcompensate poor performers. If pay inequities exist for long, the turnover rate rises; and it is often the most productive people who leave first, resulting in increased costs for recruit­ing, selecting, and training. Other problems are encountered in maintain­ing morale, as arguments occur on pay adjustments for ability, rising living costs, and length of service. Because all the selling expense is fixed, it is difficult to adjust to changing conditions—a knotty problem during busi­ness downswings, when selling expenses can be reduced only by cutting salaries or releasing personnel. Moreover, during business upturns, there is difficulty in securing the company’s share of rising industry volume, because salaried salespeople commonly are not disposed to exceed pre­vious sales records by any large amount. However, many of the straight- salary plan’s weaknesses are minimized through good administration.

In administering a straight-salary plan, individual sales personnel are paid, in so far as possible, according to their relative performance. The dif­ficulty is in measuring performance. Management needs to define “perfor­mance” and the meanings of good, average, and poor performances. When management has these definitions and develops methods for performance measurements, it can set individual salaries fairly and intelligently. Users of the salary plan define performance as total job performance, not merely success in securing sales volume or in performing some other aspect of the job—and this is theoretically correct, because the payers of salaries assume they can exercise maximum control over the way salary receivers perform all job aspects. Some salary plan users attempt to measure perfor­mance by relating the salesperson’s total selling expense (including salary) to total sales. While it is desirable to control total selling expenses, using the expense-to-sales ratio as the sole criterion of performance overemphasizes the importance of cost control.

In the absence of well-defined quantitative performance standards, and few companies have them, the sales job description, if up to date and complete, is the place to start in appraising job performances of sales personnel. All sales personnel need rating not only on their achievement of sales and cost goals but on their performance of each assigned duty. The total evaluation of an individual is a composite of the several ratings, weighted according to relative importance. Persons rated as average are paid average salaries. Salaries of below-average and above-average sales personnel are scaled to reflect the extent to which their performances vary from the average. Each individual’s performance is regularly reviewed and upward adjustments made for those showing improvements, and down­ward adjustments made for those with deteriorating performances.

2. Straight-Commission Plan

The theory supporting the straight-commission plan is that individual sales personnel should be paid according to productivity. The assumption underlying straight-commission plans is that sales volume is the best pro­ductivity measure and can, therefore, be used as the sole measure. This is a questionable assumption.

The straight-commission plan, in its purest form is almost as simple as the straight-salary plan, but many commission systems develop into com­plex arrangements. Some provide for progressive or regressive changes in commission rates as sales volume rises to different levels. Others provide for differential commission rates for sales of different products, to different categories of customers, or during given selling seasons. These refinements make straight-commission plans more complex than straight-salary plans.

Straight-commission plans fall into one of two broad classifications:

  1. Straight commission with sales personnel paying their own expenses. Advances may or may not be made against earned commissions.
  2. Straight commission with the company paying expenses, with or without advances against earned commissions.

There is a general trend away from the straight-commission plan, and today many companies use such plans.

The straight-commission plan is used in situations where non-selling duties are relatively unimportant and management emphasizes order getting. Straight-commission plans are common in the clothing, textile, and shoe industries and in drug and hardware wholesaling. Firms selling intan­gibles, such as insurance and investment securities, and manufacturers of furniture, office equipment, and business machines also are frequent users of straight-commission plans.

The straight-commission plan has several advantages. The greatest is that it provides maximum direct monetary incentive for the salesperson to strive for high-level volume. The star salesperson is paid more than he or she would be under most salary plans, and low producers are not likely to be over compensated. When a commission system is first installed, the sales personnel turnover rate accelerates, but usually the exodus is among the low producers. Those remaining work longer and harder, with more income to show for their efforts. Straight-commission plans, in addition, provide a means for cost control—all direct selling expenses, except for traveling and miscellaneous expenses (which are reimbursable in some plans), fluctuate directly with sales volume changes and sales compensa­tion becomes virtually an all variable expense. The straight-commission plan also is characterized by great flexibility—by revising commission rates applying to different products, for instance, it is possible to stimulate sales personnel to emphasize those with the highest gross margins.

However, the straight-commission method has weaknesses. It pro­vides little financial control over salespeople’s activities, a weakness fur­ther compounded when they pay their own expenses. Salespersons on straight commission often feel that they are discharging their full respon­sibilities by continuing to send in customers’ orders. They are careless about transmitting reports, neglect to follow up leads, resist reduction in the size of sales territories, consider individual accounts private property, shade prices to make sales, and may use high-pressure tactics with con­sequent loss of customer goodwill. Moreover, unless differential commis­sion rates are used, sales personnel push the easiest-to-sell low-margin items and neglect harder-to-sell high-margin items; if management seeks to correct this through using differential commission rates, it incurs increased record-keeping expenses. Under any straight-commission plan, in fact, the costs of checking and auditing salespeople’s reports and of calculating payrolls are higher than under the straight-salary method. Finally, some salespersons’ efficiency may decline because of income uncertainties. If a sales force has many financially worried salespeople, management may have to invest considerable time, effort, and money to buoy up their spirits.

Determining commission base. One important aspect of designing a straight-commission system is to select the base on which to pay commission. Company selling policies and problems strongly influence selection of the base. If obtaining volume is the main concern, then total sales is the base. If sales personnel make collections on sales, commissions are based on collections. If a firm has excessive order cancellations, com­missions can be based upon shipments, billings, or payments. To control price cutting by sales personnel, some companies base commissions on gross margins. Other companies use net profits as the base, seeking simul­taneously to control price cutting, selling expense, and net profit.

Drawing accounts. A modification of the straight-commission plan is the drawing account method, under which the company establishes sepa­rate accounts for each salesperson, to which commissions are credited and against which periodic withdrawals are made. Drawing accounts resemble salaries, since customarily individual sales personnel are allowed to over­draw against future earnings. If sales personnel become greatly overdrawn, they may lose incentive to produce, because earned commissions are used to reduce the indebtedness. More important, some sales personnel become discouraged with the prospects of paying back overdrawn accounts and quit the company.

To forestall quitting by overdrawn salespeople, some firms use “guaranteed” drawing account plans. These do not require the paying back of overdrawals. Sales executives in these firms are conservative in setting the size of guaranteed drawing accounts, for they are in effect com­bination salary and commission plans. Commonly, drawing account plans include a provision that covers the possibility of overdrafts. Legally, an overdraft cannot be collected unless the salesperson specifically agrees to repay it, or it is really a personal loan, or the salesperson has given a note acknowledging its receipt. Without a formal understanding, most courts hold that the relationship between the salesperson and the company is a partnership in which the company agreed to finance the salesperson and that the resulting loss is a normal risk incurred in doing business. Even if the company has an ironclad agreement with its sales personnel, there is a problem in collecting money that overdrawn sales personnel do not have.

3. Combination Salary-and-lncentive Plan

Salary plus commission. Most sales compensation plans are combina­tions of salary and commission plans. Most developed as attempts to cap­ture the advantages and offset the disadvantages of both the salary and commission systems. Where the straight-salary method is used, the sales executive lacks a financial means for stimulating the sales force to greater effort. Where the straight-commission system is used, the executive has weak financial control over nonsel-ling activities. By a judicious blending of the two basic plans, management seeks both control and motivation. Actual results depend upon management’s skills in designing and admin­istering the plan. Unless there is skillful adjustment of salary and commis­sion, weaknesses of both basic systems reappear.

Strengths and weaknesses of combination plans. A well-designed and administered combination plan provides significant benefits. Sales personnel have both the security of stable incomes and the stimulus of direct financial incentive. Management has both financial control over sales activities and the apparatus to motivate sales efforts. Selling costs are composed of fixed and variable elements; thus, greater flexibility for adjustment to changing conditions exists than under the commission method. Nevertheless, sell­ing costs fluctuate some with the volume of business. There are benefi­cial effects upon sales force morale. Disagreements on pay increases and territorial changes are less violent than under a straight-commission plan. Further, if salespeople realize that the company shares their financial risks, a cooperative spirit develops between them and the company.

The combination plan, however, has disadvantages. Clerical costs are higher than for either a salary or a commission system. More records are maintained and in greater detail. There are risks that the plan will become complicated and that sales personnel will not understand it.

Sometimes a company seeking both to provide adequate salaries and to keep selling costs down uses commission rates so low that the incen­tive feature is insufficient to elicit needed sales effort. But, if the incentive portion is increased, salespeople may neglect activities for which they are not directly paid. Therefore, the ratio that the base salary and the incentive portion bears to the total compensation is critical. As mentioned earlier, most companies split the fixed and variable elements on a 70:30 basis.

Source: Richard R. Still, Edward W. Cundliff, Normal A. P Govoni, Sandeep Puri (2017), Sales and Distribution Management: Decisions, Strategies, and Cases, Pearson; Sixth edition.

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