Compensation

Compensation

Have you ever asked yourself as a business owner, “What is the best way to pay our employees?”  I have seen some pretty unusual compensation schemes, and the ones that are pay based on a formula or structure where you must consider a little from column A + B + C + D, well, they drive me nuts. Why? Because they are too complex, it takes copious time for payroll clerks to calculate, mistakes are often made, and most importantly, they rarely serve the needs of the company… to compensate employees commensurate with their performance (or expected performance).

Our employees are our most critical asset, and because of that we have one very solemn duty to them, and that is to pay them on time and accurately.   All too often we design compensation systems that work against our company goals.  For example: paying commissions on gross revenue rather than net profit thereby incentivizing closing the sale rather than closing a profitable sale. I will get back to compensation by commissions in a moment.

First, let’s discuss front-line workers making hourly pay and exempt employees making a salary.  In most cases the company goal here should be to get everyone working as a team to ship product and/or provide services.  We pay them by the hour, or with a salary to help avoid them doing their job at the expense of making someone else’s job more difficult.  This is critical because we want everyone focused as a team on selling/shipping as many products and/or providing as many services, at the highest quality, as possible.  This can’t be done unless everyone is working together.

I am talking about the operational side of your business, and here we pay them by the hour, or as a salary, and give raises based on how well they contribute to the team, the operation, and toward the company goals. Operations is like a live performance on stage.  Everyone can say their lines and hit their marks perfectly, but when one person makes a mistake, then the whole performance or experience is essentially ruined.

Complex compensation systems have no place in operations if we are looking for longevity from our employees. We can do that through benefits collectively, but reward merit and performance with increased, or decreased pay rates individually.  This is why it is important to separate in your mind who you like best, from who performs the best, fairly and equitably.

We build the simple compensation system knowing the number one goal of operations is to deliver what our customer wants with efficiency and high quality.  Compensating for anything else is not only a waste, but it sends the wrong signals to our workers, and sometimes leads to empire building.

Our sales department however has a different goal and that is to make sales… right?  But selling is easy if you have control of the product or service price.  Even I can sell dollar bills all day long at 90 cents! The goal isn’t sales, the real goal is profit, so base your remuneration on PROFIT.  If we have properly calculated our proforma on our goods and services, then we know what the net profit is, and we can pay accordingly.

So, if we were selling widgets, and those widgets cost us 90 cents, rather than paying a 10% commission, let’s pay them 25% or more on the net profit.  Example:

• Widget costs 90 cents
• Widget sells for $1.00
  • NO – Gross commission = 10 cents (or all your profit)
  • YES – Net commission = 2.5 cents (you still make a profit of 7.5 cents)

It has been my experience with way too many clients that the commission was being paid to salespeople based purely on the sales revenue generated. Using the previous example as a model, can you see that there is really no incentive for the company to increase sales? Furthermore, with every increase in the price of the item because of increased cost, the salesperson gets a raise while the company does not receive any additional benefit. For a company, there truly is no point in selling just to sell.

A commission structure based on net profit incentivizes the salesperson to sell for higher margins which benefits both the company’s goal, as well as the salesperson’s wallet.

Example:

• Widget costs 90 cents
• Widget sells for $1.20
  • NO – Gross commission = 12 cents. Only 2 cents for the increased difficulty (your profit 18 cents)
  • YES – Net commission = 7.5 cents. 300% increase in commission is a huge incentive (your profit 22.5 cents)

Providing salespeople with a copy of the proforma, or just a list of products and services with your fully burdened cost will allow them to be in control of their own income aspirations while ensuring your profitability as a company. Win-win for company and employee. Even at 50% on net profit this method will, a.) ensure that you have profit remaining after the sale, and b.) create the incentive to sell more and at higher prices.

In conclusion, all too often we look at what others are doing when it comes to designing our compensation system.  Well, I’ve seen the books of many of those companies, and what they are doing is hurting their bottom line.  Instead, I recommend the following strategies:

• Clearly define and communicate the goals you have set forth for the company as a team
• Understand and identify the goals you need accomplished for each position
• Design a pay system that incentivizes that goal
• Keep it simple to understand, and more importantly simple for you and them to calculate on pay day
• Keep in mind that YOUR goal is to make profit rather than revenue

A simple question we have asked many business owners during our travels around the country; “Would you rather have 1% of $1,000,000 or 10% of $100,000?” It seems like a strange question but as you can quickly calculate, the answer is the same. Surprisingly most people answered with “the former”. The fact of the matter is generating $1m takes much more effort while churning through assets and production hours to achieve the same result.

All things taken into consideration, if you do it perfectly, then you can’t help but make profit…

 

 

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