How Much Are Your Sales Commission Plans Costing You?

One of the most important questions that company leaders ask is “How much are these comp plans going to cost us?”  That is where plan modeling or costing comes in. 

This is the time of year when companies are creating sales compensation plans for next year.  They usually invest time in determining the best mechanics (e.g. thresholds, accelerators, caps, etc.).  They also spend an extensive amount of time determining quotas, which is good.  However, one of the most crucial items to get correct, and that is typically not done well, is plan costing.  The most effective way to determine the cost of a sales compensation program is through a cost model.

A cost model is just that, a model that you can use to determine your cost.  Whether that’s a sales compensation program or some other project the company wants to launch.  Typically cost models are custom built and are done before executing the project. 

If you’re in finance, you’ve probably heard of this and know the value of it.  However, most companies use the “back of the napkin” approach, or they estimate a multiple of target variable plus a spiff budget.  You can choose to use this approach too, but with a cost model you have a more accurate projection of cost along with the ability to fine tune your plans before launching.  The cost model will show you how much your sales commission plans are costing you based on projected sales.

Failure to properly model a sales compensation program is sometimes due to plan complexity, lack of time, or simply lack of knowledge.  Accurately forecasting the cost of a sales compensation program becomes cumbersome if you don’t know where to start.  Hence the reason for this post.

WHAT ARE THE CONSEQUENCES OF NOT DOING A SALES INCENTIVE COST MODEL?

A cost model allows you to fine tune your sales comp plan structures, determine your CCOS (Compensation Cost of Sales) and determine your sales compensation budget.  When you build the cost model based on plan structures, you will “test” your mechanics with your sales comp committee, or sales compensation steering board, and finalize plans. 

If you don’t build the cost model then these top 3 things could happen:

1. Underpaying sales commissions: As an example, let’s say you agree that the AE role should get 1.5x over quota based on a certain attainment level. You will build your cost model to reflect that 1.5x payout.  Based on your plan structures and revenue brought in, you will see your cost and will determine if that expense is in line with revenue generated.  You will also see if top performers are still getting top pay.  We know that the most common action a sales rep does when they first receive their comp plan is to plug in their performance from prior year and see if they are getting paid the same (I would do the same).  With a cost model you can see this and correct it, before launching plans.  Thereby avoiding underpayment and affecting employee morale.
2. Overpaying sales commission: The same holds true for over payment, without a cost model its hard to forecast expected commission spend.  Maybe you want to pay 4x over quota, and when you run the cost model then you see that it’s costing you way more per dollar of new revenue then it did last year. With a cost model, you will be able to see your high level CCOS and see if its historically in line.  You will also be able to evaluate lower performer incentive payouts compared to prior plans.
3. Having to do mid-year plan changes: when you test the mechanics of the comp plans (e.g., accelerators, thresholds, caps) you can see if they are fair to the company and fair to the sales team. Fine tuning your plans via a cost model will allow you to adjust your plans before plan rollout.  This way you don't have to tell your salespeople you made a mistake mid-year and now have to change the comp plan.  If you don’t test out the plans then when the commission payments are sent out, they maybe too high, and leadership may want to adjust plans (yes this happens, unfortunately).

Thankfully, we have some general guidelines in this post to help you get started with building a cost model for your sales compensation program.  With a cost model, you can do it right from the beginning.

WHAT ARE THE ITEMS THAT SHOULD BE INCLUDED IN A SALES COMPENSATION COST MODEL?

There are various items needed to create a cost model.  At a high level, this is the information you need to build a cost model: 

• Sales Compensation Plan Structures: From the plans you designed, you will be building formulas to show the payout of these plans based on various inputs.
• Sales Employee Data: Include both current employees and new hires, with their OTE & Pay Mix, because each will have different attainment levels and therefore payouts.
• Quotas: This is your target revenue for the cost model, the sum of quotas. It is also used to derive projected sales from standard quota attainment distribution.

After you have this data, you will need to assign the plan structure to each person based on their role.  Plans are designed per role, not per person.  Afterward, you want to project sales based on standard attainment distribution.  Most effective plans will have a bell curve shifted slightly to the right, where 60-70% of reps should be at or above quota.  You can randomize attainment based on this statistic, with some below quota and some above quota.  Perhaps, if you have it, you can just plug in your historical performance attainment with some judgement on expected performance with the new plans.  However, the end goal is for quotas to be met.

THE MODELING PART

The format of a sales compensation cost model typically includes a results page or summary, assumptions page and the detailed data.  The summary page updates automatically based on the data you change in the assumptions tab.  Ideally when you build a cost model, you should only be adjusting the assumptions tab.  The assumptions should include those key mechanics from your sales incentive plan designs that you want to fine tune (e.g. upside, caps, gates, thresholds). 

Once your sales incentive plan structures are built into the cost model, you will see how much the comp plans are costing as designed; with projected revenue based on estimated attainment.  The sales compensation cost will also include a SPIFF budget.  CCOS and other useful metrics such as Multiple of Target Variable (or “Multiple of TV”) should be easily calculated based on the information in the model and included as part of your summary.  This is your starting point in the analysis.  If the numbers don’t make sense, then you go through and test out changes in the assumptions tab.  This is the process of fine tuning the sales compensation program with your sales comp committee.  You will have the birds eye view on the summary tab, along with the individual payouts in the details tab.

You also should play with your model, to see what the commission expense looks like if everyone blows out their quota or vice versa.  Though, don’t fall into the trap of just looking at commission expense.  In the cost model, you want to look at revenue as it relates to sales commission expense – not just sales commission expense alone.  Because if plans are built properly, commission expense only increases when revenue also increases. 

OTHER ITEMS TO CONSIDER

Now when building a cost model, it's good to be aware of a few things... 

• You have to be pretty good at Excel to build it, because you have to build a formula that shows payout based on proposed plan designs and projected attainment.
• These are general guidelines on how to build a cost model, but each model is customized.  Since each cost model will have a combination of different sales incentive plans unique to each company.
• There will be nuances in the cost model. As an example, for your new hires, you have to factor in ramp time and project their sales a bit differently; possibly include a recoverable draw or non-recoverable draw if you want to get extra specific. 
• There are many ICM’s that claim to have plan modeling, or plan costing. In my experience, I haven’t had one ICM tool that was really effective at this.  However, in this time and age there is probably one out there!  My recommendation is to build it yourself and then see if the ICM gives you similar results, before relying on it completely.  
• The standard quota attainment distribution for compensation plans is 60-70% of sales employees should be at or above quota, but maybe your company has a different viewpoint. Perhaps your company is more finance oriented and you expect 50% of your sales employees to be at or above quota, or maybe the culture you have expects everyone to go over quota.  If that is the case, then just factor that into your cost model.  This way you have a more realistic view on how much you're paying for each dollar of new revenue.  You want to be pragmatic and realistic with your sales compensation cost model.  As mentioned previously, you can even look at historical performance to see what is the standard for your company.

If you’re not familiar with cost models, then this may sound somewhat complicated.  This is why in our Sales Compensation Plan Creation Course we actually built a cost model for course takers that you can use.  Along with the downloadable cost model, you have guided training in the course that goes into more detail than what is in this post.  The sales comp course is a guided training on how to create a sales compensation program from scratch. 

If you learn how to build a cost model for your sales compensation program, and you analyze it correctly, then you will be ensuring your sales compensation program makes financial sense.

There is no other sales compensation course that teaches you how to build a cost model and gives you one already prebuilt as a template.  A cost model is essential for every sales compensation program and will help you manage your costs and perfect your plans!  You can find out more about our sales comp course, which includes the cost model here.