Destroying value with margin dollar compensation
Rewarding outside sales on margin dollars runs contrary to driving shareholder value
by Scott Benfield
The predominant distributor practice is to reward outside sales on margin dollars. Unfortunately, this mechanism often runs contrary to driving maximum returns. Many distributors unknowingly reward sellers at the expense of the long-term market value of the firm. A better understanding of how profits are generated, and linking compensation to account returns, can help adjust the imbalance.
Outside selling is one of the more revered positions in the wholesale firm. It offers a greater chance in controlling one’s personal income and more freedom than most positions, including executive management. Our work in evaluating the contribution of outside sales efforts finds that 60 percent of the margin dollars generated by assigned accounts either destroy returns (negative profits) or generate low returns. Only 40 percent of assigned accounts generate returns which cover the low or negative investments.
The primary dislocation in financial logic between sales compensation on margin dollars and measuring returns (defined as return on transactions), is the difference between financial accounting, predominantly the income statement approach, and managerial (cost-to-serve) accounting used to develop a financial return on customers and associated entities. The difference in these approaches, and their effect on returns, is significant. We define Transaction ROI as the total of labor costs and support costs allocated to the customer on a transaction basis and divided into the returns after deducting transaction costs. We consider the ratio to be a value measure, as it looks at returns on service labor that produces “value added” services and is akin to return on capital measures which have a strong correlation to value. While labor or human capital is not on the balance sheet, returns on human capital investment have a long history of research and relation to the overall return of the firm.
Balancing financial accounting-based compensation, tempered with a return logic, can lead to greater returns and better value. Transaction ROI is not without detractors. It measures the return on human capital, which is outside the return on invested capital measurement that primarily uses assets of plant, property and equipment. While there are arguments to place labor capital on the balance sheet, the hesitancy from accounting is that the “capital” is not owned; it can walk out the door at any moment. However, return on labor is important for supply chain firms in that the primary expense outside of cost of goods is labor. Typically, 60 percent to 70 percent of operating expenses are in labor. Additionally, since activity costing determines profitability of customers, segments and sales territories, it is appropriate to measure the return on labor of these entities for insight into the financial productivity of the labor.
Most wholesalers pay a substantial portion of sales compensation in the form of commissions or bonuses based on gross margin dollars. Over the past six years, using a transaction-based cost-to-serve model for merchant wholesalers, we have found no instance of gross margin-driven compensation that has any meaningful correlation with generating returns, defined as Transaction ROI. In essence, the seller whose compensation is tied to margin dollars has no financial incentive to improve the long-term value of the organization. Why? Simply put, increasing margin dollars, without consideration of cost-to-serve expenses associated with said margin dollars, has a very low correlation with Transaction ROI. Further, variations on gross margin compensation, including straight commission, salary and bonus, or salary and commission, have an insignificant correlation toward improving returns.
Too often, distributors dismiss our findings by pointing to instances where, when changing compensation programs, margins go up and so do bottom-line profits. Where we have dissected the financial results of changes to compensation programs, our findings include:
- Most changes to compensation and ensuing growth in sales or bottom-line profits are not isolated from other macro-economic events such as GDP growth or key
- customer changes that lift earnings.
- The before and after time periods are not sufficiently isolated and don’t contain enough data points to smooth out random noise.
- Management changes other variables as compensation is changed, including decreasing expenses as costly sales are brought into the firm. Low or negative cost-to-serve sales are pulled into the firm in a current time period and are served from an existing labor capacity buffer. Their destruction of value occurs in later time periods when the capacity buffer is depleted and management has to incur overtime or add headcount. Management almost never measures the effect of the new business on later time periods when the existing capacity buffer is depleted.
Hence, management too often believes that margin dollar-dominated compensation schemes automatically increase bottom-line profits and improve value, but the proprietary research is often poorly designed or the logic is flawed. Our research overwhelmingly finds that sales compensation plans that predominantly rely on margin dollars have almost as good a chance of destroying value as they have of increasing it.
To drive returns and, more importantly, link returns and value to sales compensation, most distributors will have to undergo a substantial change not only in the compensation system but in their understanding of why managing value is important. Without value enhancement, distributors will remain mired in a kind of linear (income statement) thinking, substitute accounting profits for financial value, and unnecessarily, but severely, limit shareholder returns.
To improve Transaction ROI, distributors must understand what caused some customers to be of low value while others generate stellar returns. The difference in customer value is due to the mix of transactions which closely models labor costs, and linking transaction costs to compensation, specific to the account, to drive returns. In essence, distributors need to engage both the margin dollars and the supporting expense dollars to drive growth while improving territory Transaction ROI. This calls for a substantial change in sales compensation as well as changes in what sellers, their managers, and supporting personnel do.
Our white paper on this topic goes into greater detail, but here is a brief look at how to make the greatest impact on improving a distributor’s capital investment.
1) Trim back the outside sales effort and supplant it with lower cost of solicitation models. We are not anti-outside sales but we have found no financial logic to support putting the most expensive functional resource on negative investments.
2) Engage transaction type pricing. We have employed transaction type pricing in the field for a decade and the results are often operating profit increases of 30 percent or more. Transaction type pricing means that stock transactions are priced differently versus non-stock transactions, counter transactions and drop shipment transactions.
3) Remove or scale back unwanted or too costly services from low or negative ROI territories or accounts. Events such as placing a break-even order size for FFA orders, requiring a deposit for non-stock specials, moving transaction intensive accounts to e-commerce, charging a re-stocking fee and charging for late payments are common ways to align services with costs-to-serve.
4) Create a balanced compensation system using ROI metrics and transaction profit measures along with margins and sales. We suggest a balanced approach between sales, margins, capital return and transaction (operating profits).
In summary, there are many ways to balance compensation using transaction profits and Transaction ROI measures. The goal is to respect the existing objective to drive sales and margins, and balance that with goals to drive returns and operating contribution of the territory. It’s also important to realize that some means of improving Transaction ROI don’t reduce the expenses of the organization but do reduce the labor consumed by an individual account or territory. Our hope is that as labor capacity is freed up, the firm can reduce the capacity overage or use it for incremental business without adding overtime or headcount.
While value is typically linked to return on invested capital, wholesalers need a new measure to understand how one of their most significant costs, labor, can drive returns.
Scott Benfield is a consultant for B2B manufacturers and distributors on sales, marketing and channel issues. Reach him at (630) 428-9311 or bnfldgp@aol.com or at www.benfieldconsulting.com. This article was excerpted from his upcoming book, “Building Value: Driving Wholesaler Returns through Strategic and Tactical Investment.”
This article originally appeared in the March/April 2012 issue of Industrial Supplymagazine. Copyright 2012, Direct Business Media.
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