Ian Larkin studies the use of "high powered" quarterly sales commissions, used by virtually every firm that sells software. A typical incentive compensation scheme (as a function of sales) is highly convex: a sales person earns 2% if she sells $100,000 worth of software; 5% if $500,000; 8% if $1,000,000, ..., up to 25% if $8,000,000.
Ian finds that these high-powered (convex) compensation schedules give sales people an incentive to "bunch" sales into the same quarter. Just as convex production costs can be reduced by "smoothing", i.e., holding inventories to buffer sales shocks, so too can convex commissions be increased by "bunching" sales into the same quarter, the opposite of "smoothing."
Using proprietary data from a large vendor he finds that 75% of sales are occur on the last day of the quarter; and 5% of sales occur on the first day of the quarter, as sales people give discounts to customers to accelerate or delay purchases. These discounts cost the firm about 7% of revenue, which is about the same amount that it pays out in sales commissions.
The 7% revenue loss suggests that there is a way to make both firm and its salespeople better off: adopt linear commission schemes to eliminate the incentive to "bunch," and split the 7% savings between the firm and its sales people in the form of higher commission rates.
When asked why they use these costly incentive compensation schemes, managers say only that they need them to retain their "superstar" sales people. But surely there is a better way to retain superstars, isn't there? As always, I would like to hear from readers on whether they think this would work.
By removing the convex commissions, wouldn't managers create a more lackluster incentive for salespeople? Let's assume I can normally sell 800k. With minimal effort I will sell 600k, and with maximal effort I will sell nearly 1000k.
ReplyDeleteIf I receive 2% for sales over 100k, 5% for sales over 500k, and 8% for sales over 1000k, then I will be incentivized either to work minimally (and receive 5%) or to work hard and bunch my sales in order to guarantee the 8% commission.
A linear commission will remove my incentive to be lazy; that is for sure. I would be making less commission with 600k than with 800k sold.
At the same time, a linear commission would eliminate bunching--since by pulling sales from the next quarter, I send myself to a lower commission rate in the future.
But in the absence of bunching, would I really ever sell as much? Since my commission would go up incrementally for every additional unit sold, might I hit a point where the marginal cost to me (in terms of effort) exceeds the marginal revenue (in terms of additional percentage points of commission)? What if that point is just below 1000k, say at 930k units sold? Then I will stop at 930k...a loss of 7% of revenues for the store compared to what I would have sold were I to have bunched. Bunching gives me a means to inflate my sales without additional cost to me (remember: in a bunching system with convex commissions, I can bunch without incurring a hit to my commission in the next quarter). Therefore, if we penalize bunching by introducing a linear commission system, we will also reduce the ability for workers to maximize total sales. Depending on where workers' marginal costs (i.e., effort) equals their marginal revenue (i.e., commission increases), this may result in more than a 7% loss of revenues for the store. Therefore, bunching may minimize lost revenues.
Earning through commissions can be just so handy thing to do, but at the same time it is so tough to work out things in wrong field. I do Forex trading where I can earn massive commission with OctaFX broker, it is a regulated company with having 14 awards in just 4 years to their name, so working with them is absolutely pleasure, they help me earn up to 15 dollars commission per lot size trade through their rebate program.
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