One of the most common and significant topics during sales compensation design engagements focuses on the right mechanic to use – whether to use a Cost of Sales or Cost of Labor model. In simplest form, Cost of Sales models use absolute commission designs while Cost of Labor models tend to use quota-based plan mechanics. A Cost of Sales model offers a set commission percentage against the volume results generated. Meanwhile, a Cost of Labor model attempts to deliver market appropriate pay levels aligned to a job’s worth in the market for delivering an expected level of production. There is of course a lot more to this story, and deciding on the right approach is an essential design question.
Cost of Sales Model
As mentioned, the Cost of Sales Model implies using an absolute commission mechanic. For example, a salesperson may receive 10% of each dollar of revenue generated. Typically, such designs may start with some expectation of performance so the commission rate can be set to deliver some approximate income level. For example, if a company believes a typical salesperson should generate $1,000,000 in revenue and wants to pay them approximately $100,000 in variable pay, then the rate would be the 10% mentioned above. In some cases, the absolute commission rate is simply selected based on some dollar amount a company is willing to share with a salesperson, in effect to offer someone a “cut” of the deals one drives. These designs are simple, not particularly elegant, and can fairly be described as “old school”. They are generally used for specific cases including:
- When a company first opens its doors – classic startup plan and that sometimes continues through the high growth phase.
- If a company is not confident or able to identify expected productivity expectations, also known as quotas or goals.
- When most salespeople have similar territory opportunities and thus earning opportunities.
- More transactional environments often with shorter sales cycle times.
- Salesperson rather than company “owns” the customer.
In most cases, companies using a Cost of Sales variable incentive model will still offer some kind of base pay – very few sales environments are truly 100% commission. Quite often though, this Cost of Sales model will eventually start to show its age and begin to break:
- Startup companies often move from SMB customers to Enterprise sales – that often means much larger deal sizes resulting in much larger incentive payouts. Earnings can begin to dwarf the market cost of the sales talent needed. A common story occurs the first time a sales rep makes more than a C-level executive, design questions will start to crop up. This issue can bubble up even more quickly if C-level resources are also helping to create and close the new massive Enterprise deals – “why should the sales rep get all that commission for the deal I drove?” becomes a familiar refrain.
- Salespeople will sometimes build up a book of business that is large enough to sustain a comfortable wage year over year. Growth can often start to stall in these instances if the extra incentive doesn’t feel significant enough to reward for the extra sales efforts.
- Adding products or services often leads to more complex sales environments requiring added sales resources including sales specialists, technical specialists, and inside sales. The initial absolute commission rate is no longer cost appropriate, but reducing a legacy commission rate usually goes over like a lead balloon. You’ll soon hear, “What happened to my 10%?!”
- Without clear quotas and incentives directly tied to quotas, leadership may feel disconnected from a clear vision on how the overall corporate goal will be achieved.
Those and other issues almost always arise, leaving companies looking for a solution to drive growth in a more reasoned, exciting, and cost effective manner. Enter the Cost of Labor model.
Cost of Labor Model
The Cost of Labor model attempts to offer a market appropriate total pay level to salespeople who achieve fair and reasonable productivity expectations, again often called quotas or goals. The market level is usually identified as Target Total Compensation (TTC) and is a combination of Base Pay and Target Incentive, the balance of which is represented in the Pay Mix, e.g., 50/50 means half in base and half in expected variable pay. When a salesperson hits his or her quota, that person earns one’s individual Target Incentive amount. There are a plethora of design nuances to consider, such as when incentives should start being paid (threshold) and what happens for above quota results (usually some acceleration). We can leave those details for another day, but companies usually find Cost of Labor quota-based models are useful in many cases:
- More moderate to low growth stages where every dollar of growth can be more challenging and feel more important – acceleration above goal creates the growth energy needed.
- Need to protect and penetrate a base of current accounts in addition to acquiring new ones.
- Unequal volume potential in assigned territories or books of accounts – can lead to unequitable earnings opportunity from winning the “territory lottery”.
- Complexity requiring multiple sales participants versus “lone cowboy” market makers.
- Companies have a better understanding of the levels of productivity that can be expected from the salespeople – the data and process for setting goals exists.
- A desire to have clear accountability for who is responsible for delivering a part of the total organizational goal.
It is extremely important to clarify that Cost of Labor models are no less exciting or energy-filled than Cost of Sales models. If anything, a well-designed quota-based plan can create more energy, both including enough downside risk (the “stick”) and upside urgency (the “carrot”). Offering the right level of upside by way of the acceleration rate is absolutely essential, and that topic alone deserves its own study and consideration.
In some sales environments and with some stakeholders, you may find nostalgic feelings for the “good old days” of absolute commission plans. Or some may hold on to an ideology that absolute commission plans are simply “the right way to pay” and will best drive growth. Case after case though shows that in most instances, goal-based plans actually drive better results and create more fair payouts than traditional absolute commission models. We published one such example in Workspan where we piloted quota-based plan designs vs. legacy commission designs in a relatively flat growth environment; those on the quota-based plan drove revenue 3% higher than those on absolute commission. The new goal-based plan design was considered a stunning success.
Earlier I used the phrase “fair and reasonable productivity expectations”, which is almost always the most challenging part of quota-based plan designs. Establishing a clear methodology, ideally that improves over time, is at the foundation of doing high quality quota setting. Few companies feel particularly good at quota setting yet just about all of them do it, certainly at the topline level and quite often down to territories or accounts. There are a number of best practices that we can share at another opportunity.
In terms of plan designs, I often say to my clients that, “There are no fundamentally bad plan designs, but there is a time and place to use each type of design”. Admittedly, that may be a bit generous to some of the plan designs we’ve seen out there, but most are developed from some point of reason by someone trying to do the right thing or to solve a business issue. When it comes to using Cost of Sales or Cost of Labor models, here too there is a time and place for each option. In most cases though, companies will benefit by eventually evolving to well-reasoned and carefully crafted quota-based plans.
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