Tying Pricing Performance to Sales Incentives

BROOKLYN, NY, December 22, 2010

Smart business executives have always tried to hold sales representatives accountable for performance, and the simplest - and therefore most common - way is to set revenue targets: the more money a sales rep brings in for the company, the more she takes home in the form of a bonus.

This is a good start, but measuring revenues alone does not ensure that salespeople will make profitable pricing decisions at the point of sale.

Example: Sally Salesperson sells 100,000 bearings in a year, and she charges $3.00 per bearing. She achieves $300,000 in revenue for the company, and she has met her sales quota. All well and good, unless each bearing actually costs $3.00 to produce. In that case, she hits her revenue target but generates no profit at all.
A Possible Solution: Measure Gross Margin (or Gross Profit)

To address this issue, some companies have added a gross margin or gross profit1 metric to sales incentives. This is a step in the right direction, but it, also, has drawbacks as a tool to evaluate salespeople. The problem is that gross margin also factors in the cost of producing your product, and your salespeople have no control over that.

Example: Sally sells 100,000 bearings at $3.00 each. The gross margin on the item at that price is 50%. Next year, management sets a 5% price increase target for her, and they intend to measure her performance against that target by examining her gross margin. She successfully raises the price of bearings in her territory to $3.15 per unit. But back at the factory, the cost to manufacture a bearing has gone up from $1.50 to $2.00 per unit. Even though Sally successfully implemented the price increase management set for her, her gross margin will drop from 50% to about 37%. This is no fault of hers, and therefore not an effective measure of her performance.

Let's consider the five key elements that affect the profitability of a salesperson's territory:

1. Revenue (a proxy for Volume)
2. Price
3. Cost
4. Product mix
5. Customer mix

Here's a little more background on what we mean by product and customer mix:

Product Mix: Different products have different margins, so selling more of the higher-margin products will result in more profits for the business.

Sally can sell bearings or valves for $3.00 per unit. If bearings have a gross margin of 50%, but valves have a gross margin of 60%, management should take this fact, along with her current sales of each product, into account when setting her revenue growth targets by product next year.

Customer Mix refers to the relative share of business in a salesperson's portfolio from each customer, in a market in which customers pay different prices for the same products. A positive shift in the customer mix occurs when more customers paying higher prices buy from the sales rep. An adverse shift in customer mix occurs when more of the customers paying lower prices make purchases.

Sally has one customer who pays a price of $3.00 per valve. But there's another customer she's made a deal with whose price is $2.50 per valve. If all other factors remain constant, her company is better off when she sells more to the customer who is paying $3.00 for the same item.

So, which of the five elements above should Sally be held accountable for?

* Total Revenue is important and should be part of the overall evaluation;
* Management should set pricing targets and should measure pricing performance;
* Management should measure changes in Customer Mix, to determine its effect on pricing and profitability in a sales rep's territory;
* And management should encourage salespeople to sell a richer Product Mix, by developing well thought-out sales targets unique by sales rep and product line.

If you define individual targets for every sales representative for each of the four items listed above, you are setting incentives at the appropriate level of granularity and encouraging your salespeople to pursue strategies within their control that really affect the profitability of the company.

The flaws in traditional incentive models, therefore, can be boiled down to:

* High (often exclusive) emphasis on Revenue (Total revenue or volume incentives are fine but not enough because they do not ensure profitable sales growth).
* Inclusion of Costs: Costs have a direct effect on gross margins, but they are not within the control of a salesperson and should not, therefore, be included in salesperson incentives.
* Little to no measurement and reward based on Pricing, Product Mix shift, and Customer Mix shift, which the salesperson can influence or control, and which can have game-changing effects on the company's bottom line.

Your salespeople can influence which products they focus on selling, which customers get most of their energy, and what prices they charge on each transaction. All of these decisions ultimately drive profitable revenue growth.

Improving gross margins and profits is what it's all about. But focusing simply on the gross margin without examining how you got there (i.e., the individual effects of pricing, costs, and shifts in your product mix and customer mix) does not give you the information you need to take action to improve your profits. And it doesn't give your sales force the information, or the incentives, they need to improve their performance.
Summary

* Holding a sales representative directly accountable for margin is like holding a plant manager directly accountable for revenue: neither makes much sense, because they are metrics that the person involved cannot fully control. However, a salesperson can directly influence what products are sold to what customers, and at what price - all of which directly impact margin.
* This is not to say that broad metrics (such as overall revenue in the organization or overall gross margin in a region) are inappropriate as part of a sales incentive plan, but they should be supplements to focused, clearly aligned incentives at the individual level.
* The most effective metrics to add to the traditional one of Revenue are Price, Customer Mix, and Product Mix.

About the author: Dev Tandon is the President of KiniMetrix (www.KiniMetrix.com), a division of Kini Consulting (www.KiniConsulting.com), a New York-based management consulting firm specializing in marketing strategy.

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Kinimetrix is a group of former McKinsey pricing Consultants who have developed a disruptive price performance methodology. We are addressing a critical gap in the standard pricing analysis by measuring pricing down to the sku or point of sale level.