As CFO, you’re scratching your head over your Q1 financials. Something isn’t adding up. The sales team met its target, but your commission expense is way over target. Profits are eroding right in front of you.
As commission dollars grow, why isn’t sales revenue rising?
It’s a straightforward question. But the answer may not be so simple. You and the VP of sales could be looking at one of several underlying problems.
The Most Likely Culprits
In our experience working with SMBs, we see these issues time and again. One, two, or all three might factor into your outsize commission expense. Here, we’ll outline some best practices that can eliminate the problem at its roots.
#1: With Pre-Revenue Commissions, You’re Building a Backlog.
This is the simplest possibility. You’re paying sales commissions based on generated bookings. You’re creating backlog that won’t turn into revenue for another six to 12 months. Yet you’re measuring your expense in relation to revenue.
What We Recommend:
Consider paying half the commission at booking and half when revenue is realized.
Accounting is important here. The first half should be considered a prepaid asset, not an expense. When revenue occurs, pay off the second half. Expense the second payment; pull the first payment out of pre-pays on the balance sheet. Book it to expense.
#2: Your Achievement Distribution Curve Is Too Wide.
Some members of the sales team are performing well above quota. Others are performing well below. Commissions paid on the high end of the curve are accelerating. They may be two to three times higher than those on the low end. But the low performers’ commission rates aren’t offsetting these costly incremental dollars.
What We Recommend:
To narrow the curve, you must properly define territories and set realistic sales quotas. Quotas shouldn’t be based on run rate, but on true account potential.
To make these changes, account segmentation is essential. It will provide the critical inputs you need.
#3: You’re Understating the Accrual Rate.
You’re forecasting commission expenses based on target compensation. You assume everyone will hit the target. You do some division, come up with a rate, and use it for accruals.
What We Recommend:
Simply calculating an average comp rate is guaranteed to understate commission expense. Consider this: Your high performers might earn 2.7% per dollar of revenue. But others might earn only 0.5%. Achievement distribution must factor into your calculations.
We’ve created a Sales Comp Checkpoint guide to help you inspect your comp plan for some common pitfalls. The tool has 11 questions that will give you a clear understanding of how your comp plan is performing. You can download the Sales Comp Checkpoint for free here.
3 Reasons You Shouldn’t Change Your Comp Plan
A comp plan redesign seems the most obvious remedy. But before you pull the trigger, consider this:
It’s the nuclear option.
This decision is not to be made lightly. Changing your comp plan design should be your very last resort. A midyear quota adjustment should be avoided at all costs. (Exception: It may be required if your forecasting was off by 25-30% or more.)
If you feel you must take this step, here’s what you can do.
- Include or adjust hurdles. No pay whatsoever until a certain milestone is reached.
- Lower your ramp to total target comp. Keep payouts low until quotas are nearly met.
- Flatten the curve. Establish an upper limit for all high performers.
- Over allocate quota. With a sales goal of $100 million, allocate $105-$110 million. If you have a wide distribution curve, this will provide modest relief.
It doesn’t solve the problem.
A comp plan adjustment will only mitigate the problem. That’s because it doesn’t address root causes (backlog, bad territories/quotas, understated accrual rate).
There is a better way.
We can’t stress this enough: Account segmentation is a make-or-break tool. Your sales organization’s success and the strength of your financials depend on it. You and the VP of sales should focus there first.
Here at SBI, we’ve developed a Make the Number Framework. It addresses account segmentation, territory design, and quota setting. Our Account Segmentation Case Study can help clarify your understanding.