Following the money

PETER COLMAN presents the first in a series on behavioural economics in sales management – reacting to biases to grow profits “Show me the incentive and I’ll show you the outcome”

This famous quote from Charlie Munger gets straight to the point regarding the behaviour of individuals (and companies), and as vice chairman of the hugely successful US investment firm Berkshire Hathaway, he is certainly someone who understands how this links to long-term financial gain.

Nowhere do incentives play a bigger role than in the steering of a salesforce, with its successes and failures impacting heavily on earnings. Given their importance, how can sales leaders and their remuneration committees galvanise their salesforce to outperform the competition and increase profits?

As businesspeople and leaders, we’d like to think that our decision-making is wholly rational. Unfortunately, studies of how people make decisions – the hot topic of behavioural economics – show that this is often seen not to be the case. We are heavily influenced by a range of biases that can cause irrational and often detrimental actions. If we want to run a smart sales incentive scheme, it is important to consider these biases during their design.

As a topline-focused consultancy, we at SimonKucher are asked to conduct many commercial excellence programmes every year. Consequently, we are frequently called on to assess our clients’ sales incentive schemes. Here, we’ll cover a few of the biases we have most frequently observed, and consider how sales organisations can either counteract them or deploy them, depending on their usefulness. BIASES TO COUNTERACT

1. “REVENUE IS VANITY, PROFIT IS SANITY” (ATTRIBUTE SUBSTITUTION BIAS) “It’s crazy. My previous firm paid me on gross margin; here it’s revenue. I’ve told the management at least twice that they should change it but they haven’t listened. So what am I supposed to do? I want to stay top so I’m going to beat my quota!” This was a direct quote from a client interview I conducted with the leading salesperson at a large manufacturing company. We hear things like this on a regular basis.

While remuneration committees usually want to increase profitability, profit-based incentive metrics can seem complicated. Substitution for a revenue-based metric seems like an easy option, but this assumes that salesforce behaviour will remain similar.

The reality in most cases is that this gives little reason for the salesforce to fight for higher prices (see box opposite, “Do the maths”), so deals get closed through discounts in order to move on to the next prospect quickly. As price is every company’s strongest profit lever, this discounting behaviour results in a damaging effect on the firm’s bottom line profitability. 2. “A SALES PLAN FOR SALESPEOPLE BY SALESPEOPLE” (DUNNING-KRUGER EFFECT) Creating good incentive plans requires a considerable amount of work to be done in both the plan design and the financial modelling. If

“Nowhere do incentives play a bigger

role than you’ve developed lots of these in the you will be aware of the many steering of a pitfalls. Unfortunately, nonsalesforce, with its experts don’t always realise the limits of their knowledge and often overlook this complexity successes (the Dunning-Kruger effect). and failures I remember very clearly the impacting case of one firm where the sales heavily upon leadership team designed their earnings” own scheme to help their salesforce compete. It was best summarised as, “We won’t lose on price”. During one account team meeting I sat in, the energy was palpable as a group of 10 or so account managers planned how they could collectively maximise their commissions for that year. While we should expect that, it was clear from the discussions that the plan had serious flaws. Not only was the scheme revenue-based, but the sales leadership had used such strong kickers that they had effectively poured lighter fuel on the fire. As the price war broke out, profits plummeted. The scheme was killed before the half-year point and a remuneration committee, including representation from finance and human resources, was created to try sort it out – while the after-effects in the market remained.

“DO THE MATHS”

The scenario below shows the dangers of revenue-based incentives on profitability. Alan and Lucy are account managers who are both working on a similar deal with different customers. Alan closes his deal with an agreed discount of 10%, whereas Lucy negotiates a bit harder and closes with a 5% discount. They are both paid a 1% commission on net revenue. Look at the difference in terms of outcome for the company and for the salesperson. Lucy makes her company £5,000 more profit than Alan (ie. 100% higher) yet receives an extra reward of only £50 (5.6% higher) for the effort she put into achieving that outcome. The incentive to negotiate harder isn’t really there.

Gross revenue Discount Net revenue Cost Profit for company Reward for salesperson (1% commission on revenue)

ALAN

£100,000 10% £90,000 £85,000 £5,000 £900

LUCY

£100,000 5% £95,000 £85,000 £10,000 £950

3. “HOW BIG IS THE POT?” (FRAMING EFFECT) How does your organisation think about the money used to pay the salesforce? Do you think about it as a cost, a budget or an investment?

These varying types of framing can result in very different incentive plan designs. For example, we’ve come across lots of schemes where doubledigit growth was wanted but the budget requirement was cost-neutral – even when an increasing, yet still self-funding, scheme would have been far more sensible.

We recommend thinking about investment, as this focuses the remuneration committee on what proportion of annual revenue should be re-invested and also what the expected return on investment and acceptable risks should be.

PETER COLMAN is a partner at global strategy and marketing consultancy Simon-Kucher & Partners, where he leads the sales effectiveness practice for the UK and Ireland. He specialises in commercial excellence programmes to address strategy, sales, marketing, and pricing. Email peter.colman@simon-kucher.com or visit www.simon-kucher.com

“OF COURSE WE KNOW WHO OUR BEST REPS ARE”

One of our clients was very surprised when we decided to rank one of their account teams by profit, rather than their usual ranking on revenue. When ranked on revenue, Josh, Daniel and Esther were the top reps and life was pretty uncomfortable for Martin, Kirsty and Steve. The results can be seen in the “Revenue rating” column below.

But look now at how the situation changes based on profit. Now Paul comes out top (+14 places), with Josh and Esther maintaining the top 3 positions (in yellow). The bottom 3 (in red) changes too, as now their “worst rep” Steve has shot up to a highly respectable 6th position. Kirsty is up in the middle of the pack at 14th, and Martin is struggling even more at the bottom.

Finally, take a look at Dave. His behaviour was quite interesting and the best analogy for this is, “You don’t have to run faster than the lion to get away – you just have to run faster than the person next to you.” When Dave was struggling on his numbers he’d offer big discounts to bring in the deals. This kept him in the middle of the pack and off the radar until his profit performance was made transparent, earning him the nickname Discount Dave. (He has since worked hard to reverse this, showing that peer comparison can also be a strong motivator.)

Salesperson

Josh Daniel Esther … Joe … Dave … Paul … Martin Kirsty Steve

Revenue rating

1 2 3 … 10 … 12 … 15 … 18 19 20

Profit rating

2 9 3 … 18 … 19 … 1 … 20 14 6 4. “WE MUST HAVE A CAP!” (AVAILABILITY BIAS) A data-driven remuneration committee will be able to monitor the exact number of really big individual payouts granted. Too often though, the evidence is anecdotal – these occurrences are easily remembered, while the bulk of more moderate cases don’t stand out.

This “availability bias” unbalances proceedings, resulting in too strong an influence from the exceptions rather than the normal situations. This fear causes a watering down of the scheme, often by capping the payout. The outcome: a demotivated salesforce, the exact opposite of an effective incentive scheme.

BIASES TO ADOPT While the above biases need to be counteracted, there are others that we recommend deploying: 5. “I’M NOT ALLOWED TO GIVE ANY MORE DISCOUNT” (LOSS AVERSION) People generally dislike losing things more than they like receiving them. If used wisely, this loss aversion can be a powerful ally.

We’ve helped numerous companies deploy incentive schemes where the more discount the salesperson uses, the more of their payout is sacrificed. This can be made even more powerful if combined with the next bias.

6. “IT TELLS ME WHAT I EARN FROM THIS DEAL” (PRESENT BIAS) “Present bias” tells us that people place more weight on things that are happening now compared with at some point in the future. Consequently, we like to incorporate the incentive calculation into a salesperson’s quoting tool. That way, as they vary the parameters of the deal, they see live what their return will be.

USE DATA TO DRIVE CHANGE A carefully designed incentive scheme will guide a salesperson’s decision-making, and can therefore steer the behaviour of the salesforce. To do this well though, knowledge of both traditional and behavioural economics is needed.

While we’ve seen lots of schemes based on rules of thumb or gut feel, there really is no substitute for detailed analyses of the existing scheme (using salary benchmarking, quota attainment vs pay-out, survey questionnaires etc.), and thoroughly stress-testing the planned new scheme (estimated return on investment, payout variance, winners vs losers modelling etc.). Only when you are fully armed with this data are you in a position to prepare the communication collateral you will need to explain the change to the new scheme to the salesforce.