Seventh AIMS International Conference on Management
December 20-23, 2009
Strategic Compensation Plan: Rebalancing Fixed and Variable Pay Pankaj Madhani ICFAI Business School (IBS), Ahmadabad
[email protected],
[email protected] This paper aims to investigate the relationship between fixed and variable pay compensation in the sales organizations and their impact on employee motivation, productivity and overall performance. As a part of overall compensation strategy, impact of compensation structure (fixed pay and variable pay), on the performance of organization is not explored adequately by researchers. Hence, this paper reviews various components of compensation plan and provides an outline which shows the importance of rebalancing fixed pay and variable pay in strategic compensation management. Keywords: Compensation, Fixed pay, Variable pay, Sales organization
1. Introduction Salesforce compensation costs represent a large percentage of total costs for most sales organizations. Rebalancing of fixed and variable pay in compensation structure offers HR managers financial flexibility to deal with economic changes such as business cycles, market variability and salesforce performance. Rebalancing fixed and variable pay components in pay mix can be an effective management tool when used to accommodate and compensate for varying selling role of salesforce as well as changing financial times during vagaries of business cycle. An effective design of competitive pay depends on how the sales compensation elements are structured (fixed versus variable pay). Such compensation structure identifies how much of the total pay opportunity varies on the basis of selling performance and how much is in the form of base pay, and what causes this pay structure to change? Rebalancing of fixed and variable pay can provide an opportunity to HR managers to link compensation costs to evolving selling situation and reflects changes in sales roles, marketing mix, products and markets. All these factors are likely to be a key determinant of compensation strategies and their effectiveness in achieving organizational goals.
2. Benefits of Effective Sales Compensation Apart from recruitment or retrenchment strategy, the sales compensation plan should also be viewed as a fundamental sales management tool to aid in achieving desired results for HR managers. Pay is in general provided by sales organization to their salesforce for services rendered (i.e., time, effort and skill of sales people).The purpose of sales compensation is to: 1. 2. 3.
Recognize the role fulfilled by organization’ s salesforce to achieve, maximize and retain sales revenues from customers. Align pay opportunities of salesforce with long term revenue objectives of the organization by creating environment of mutual trust, confidence and success between the organization and its salesforce. Attract, retain, and motivate salesforce in the organization.
Salesforce compensation should be distinguished from other employee pay structures because salesforce have a direct and measurable impact on the organization’ s revenue performance. This impact provides the opportunity to the sales organization to directly link a sales person’ s individual performance as it relates to developing a positive impact on the sales organization by: 1. 2. 3. 4.
Enhancing and supporting the sales organization’ s marketing and selling plans. Communicating expectations of sales performance. Influencing the efforts and behaviors of salesforce engaged in the selling process by rewarding them based on performance outcomes. Contributing to the culture of the sales organization.
When sales compensation plans are not aligned with corporate strategy of the sales organization, sales people often work their own plan, to the organizations’ disadvantage. Sales people might spend their time, efforts and energy on what they believe will generate the most commission or sales reward rather than focusing on what 1
Electronic copy available at: http://ssrn.com/abstract=1527328
Seventh AIMS International Conference on Management
December 20-23, 2009
provides the best value to the customer and, in the long run, to the organization. With short term view, salesforce might focus excessively on one product, for immediate gain, and neglect others that are more strategic to the organization. They might sell items with lower margins that increase their commission amount, but generate less profit for the organization. Or they might focus on existing customers instead of courting new ones. Worst of all they may ignore customers’ real needs in favor of sales that have a very short-term benefit, for example increasing their earning potential through variable pay i.e. commission. The sales compensation plan, when designed properly, has a significant and positive impact on performance of salesforce, customer loyalty, and organization’ s financial results viz. Salesforce 1. Increased motivation and retention of sales talent. 2. Better sales focus and performance. Customers 1. High rate of customer acquisition and account penetration. 2. Enhanced customer satisfaction and loyalty. Organization 1. Top line sales growth and improved profitability. 2. Better stability and sustainability of performance.
3. Sales Compensation: Fixed Pay versus Variable Pay Sales compensation comprises of two core elements viz. fixed pay and variable pay as explained below: 1.
2.
Fixed pay - It’ s also known as ‘ base pay’ . Fixed pay is non discretionary in nature and does not vary according to performance or results achieved by salesforce. Fixed pay compensation is usually determined by the sales organization's overall pay philosophy and compensation structure. Variable pay - It’ s also known as ‘ pay at risk’ . Variable pay changes directly with the level of performance or results achieved. Variable compensation is a one-time earning that must be reestablished and re-earned each performance period. Variable pay can be short term or long term. Shortterm incentive pay is designed to focus and reward performance over a period of one-year or less. While, long-term incentives pay, is designed to focus and reward performance over a period longer than one year.
Base pay or salary only plans may be appropriate where quotas are impossible to set and there is a complex multiple year sales cycle. On the other hand, sales compensation plans can have a pay mix that is 0/100, meaning that no salary is paid and sales person earnings are 100% at risk. These are called pure commission plans and compensation paid to the sales person is either a percent of the sales revenue or a flat dollar amount for each unit sold. Commission only plans reward the individual effort of the sales person to deliver sales results by focusing on increasing product volume, or sales revenue. A well designed compensation plan with the right pay mix will encourage sales people to directly support organization’ s business objectives. Pay mix represents the ratio between fixed and variable pay in the targeted cash compensation value at expected (i.e., planned) performance. The ratio is expressed with the first value representing fixed compensation and the second representing variable. For example, a mix expressed as 25:75 (25/75 pay mix) means that target cash compensation is composed of 25% base salary and 75% incentive. For instance, a target cash compensation amount of $100,000 would be composed of $25,000 base salary and $75,000 incentive. In fixed pay plus variable pay package scenario, base pay or salary only is paid until some sales quota or target sales figure is achieved and beyond the sales quota or target, total direct earnings increase, according to a pre-determined formula for sales commission.
4. Performance and Reward: Selection of Fixed versus Variable Pay As HR managers strive to pursue excellence with their recruitment, selection, compensation, and training interventions, it is increasingly important to demonstrate that their efforts add value to the firm. HR managers are continually in search of ways to motivate and reward employees in order to increase their motivation and performance level. One primary HR tool that is used to influence motivation and performance level is compensation. Pay is a strong communicator between an organization and its employees, and the success or 2
Electronic copy available at: http://ssrn.com/abstract=1527328
Seventh AIMS International Conference on Management
December 20-23, 2009
failure of a pay system can ultimately have an effect on the overall success of a company. Pay is a powerful communicator of organizational goals and priorities and firms that expect to be successful must make employees become partners in their success. Sales employees’ performance is affected not only by factors specific to them such as skill and aptitude, but also by the reward structure used by a company. Consequently, it is not surprising that firms spend a significant amount of time and effort designing reward structures for their sales employees. The key to motivating people that supplements an organization’ s goals lies in the manners the organization’ s incentives and pay structure relate to the individuals’ goals. Some marketing firms state that they recruit good sales employee, pay them well, and then expect good performance, which is called a fixed pay system. As firms increase salaries and wages, inevitably there is an escalation of payroll expense. Compound that by an adjustment each year for bonus, perks etc. and the overall impact on pay pool is a significant. There is also the carry over that this fixed salary expense may have on the future cost of retirement and other fringe benefits. Other marketing firms state that they recruit good sales employee, expect them to perform well, and pay them well if performance is actually good, which is called variable pay or performance-based pay. Variable pay ties individual economic performance to financial success of the firm.
5. Advantages and Disadvantages of Variable Pay There are specific gains associated with variable compensation schemes. Compared to fixed pay or salary, variable pay can lead to an increase in motivation and employee performance. In this situation, for sales person on ‘ commission’ only basis, there is high degree of motivation to work hard and it also increase firm revenue. This is largely due to the incentive effect that variable pay has on employee behavior. Also, when truly aligned with individual, group, or company performance, variable pay reduces profit volatility and enhances earnings stream for shareholders. If a firm changes to a complete variable compensation scheme, there would likely be some disadvantages (i.e. losses) associated with doing so. As an example, the marketing firm would likely fail to attract or maintain those sales employees who prefer a fixed element of their pay and thus have to suffer resulting turnover costs. In sum, the choice between fixed and variable pay portions of a firm’ s compensation strategy affects the firm’ s cash flow, operating leverage, and BEP (Break Even Point).
6. Conclusion This paper underlines crucial role of HR managers in compensation management of sales employees in a marketing firm. It also explains relationship between fixed and variable compensation. This paper also strengthens the concept that variable pay compensation increase sales employee efforts, performance and motivation level. However there are many disadvantages associated with variable pay. In fact there exists optimum balance between fixed and variable pay compensation. The purpose of this research is to study the uses and effectiveness of variable pay as a viable alternative to traditional compensation systems in increasing employee performance.
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Seventh AIMS International Conference on Management
December 20-23, 2009
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