Why Your Sales Bonus May Be Destroying Profit
Your sales team will do exactly what you pay them to do.
That sounds obvious. But it is one of the most common reasons businesses lose margin without realising it.
If you reward revenue, you will get revenue – even if it comes with reckless discounting, poor-quality customers and profit quietly disappearing out of the back door. If you reward the wrong number, you get the wrong behaviour.
So before blaming your sales team for discounting too easily, look at the incentive scheme. You may be paying them to do it.
Getting Incentivisation Schemes Right (Or Watching Your Margins Disappear)
I was listening to an episode of the Freakonomics podcast recently and the host, Stephen Dubner, mentioned a quote attributed to Charlie Munger, who was vice chairman of Warren Buffett’s Berkshire Hathaway investment business: “Show me the incentive and I'll show you the outcome.”
There’s another good quote by Upton Sinclair, the American author and journalist: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”
Nowhere are these insights truer than with regard to pricing.
One of the points I frequently make is that very often the people within a business who are customer facing and who have authority to vary prices don’t really understand the difference between gross and net margin, and don’t understand the impact even small discounts can have on profitability. And that’s compounded when they are incentivised such that they will act in a certain way, even if it actually harms net margin.
The people who set and vary prices are almost always paid against a number, and whatever that number is, that's the behaviour you'll get. If you want to understand why a business is leaking margin, the bonus scheme is usually the first place to look.
This month I want to walk through the most common incentivisation schemes I see, roughly from worst to best for pricing, add a few you might not have considered, and then share the practical advice that actually matters once you've chosen one.
Before I get into this, I have an apology to anyone from sales reading this. To be fair, there are certainly sales people who understand the numbers deeply, or are motivated by doing the best for the company rather than what's best for their pockets. I've just seen far too many examples where personal motivation or the easy sale (i.e. just discount) takes over, and that's what I'm addressing this time.
The schemes, from worst to best
Revenue: sales income or volume
This is the most common bonus scheme I come across, and it's the most dangerous for your prices. The problem is simple: customer-facing teams who have the authority to vary prices are now incentivised to win sales at any price.
One distributor I worked with had grown from £10m turnover making £1m operating profit to £20m turnover making £200k profit. They'd doubled the size of the business and almost wiped out their profit, because the sales team would match any price or offer any discount to win a deal. It was all about volume, and that drove the pricing behaviour.
Back in the 1990s I remember working with a wholesale cable distributor. This is when TVs were changing from analogue to digital, so everyone’s aerial and downlead needed upgrading. We couldn’t keep up with demand for the appropriate cable, which came from the far east a container at a time via 6 weeks on a ship. We received a whole container which we had been waiting for, and a couple of days later one of the sales team comes in and proudly announces he’s sold the whole container for about £3 profit per reel of cable. £3 didn’t even cover overheads! But it was a multi £10,000s deal, and his revenue share bonus was off the scale.
The flaw with revenue-based schemes is that they treat every pound of sales as equally valuable, when they simply aren't. A pound won at full price and a pound won by giving away half your margin are just as good to the sales person, so the easiest sale (which is usually the biggest discount) always wins.
Gross margin
A better approach is to base the bonus on margin, and in practice this almost always means gross margin, because it's easy to measure. It's a real improvement, but without controls it can still cause problems.
Someone who knows the gross margin on a product is 45% might happily offer a 10% discount to land a sale. After all, there’s still 35% of margin left! But if the costs to deliver that product are high, the real net margin might be 8%, or 6%. After the discount, they're now selling at a loss without realising it.
There's a second, subtler trap with gross margin. If you incentivise margin percentage, you encourage people to chase small, high-percentage deals and to walk away from large deals at a lower percentage but a much bigger cash contribution. Sometimes rewarding gross profit in pounds (the cash margin) gives you better behaviour than rewarding the percentage. Which one is right depends on whether your constraint is capacity or cash.
Discount budgets
This one is worth knowing because it's so directly tied to pricing behaviour. Instead of rewarding margin after the fact, you give each salesperson a notional discount allowance and treat every point of discount they give away as a cost to them. The more they discount, the more their own commission shrinks.
It does a remarkably good job of curing the "just match the price" reflex, because suddenly the discount isn't free. It comes out of the discounter's pocket, not just the company's.
Contribution margin
Contribution margin sits between gross and net. It strips out only the variable costs to serve a customer or order, rather than every fully-loaded cost. It's a sensible middle ground when a full net-margin calculation is too hard to do reliably, and it gets you most of the way to rewarding real profitability without the heavy lifting.
Tiered accelerators and SPIFFs
Accelerators pay a higher commission rate once someone passes a target. They reward over-performance, which sounds good, but they create cliffs – and cliffs cause behaviour you don't want, like deals being dumped at a discount at the end of a quarter to tip someone over a threshold, or genuine deals being held back to the next period.
SPIFFs – which stands for Sales Performance Incentive Funds, and no, I don’t know why there are two ‘F’s – are short-term incentives to push a particular product or clear specific stock, and are usually used tactically. However, they should be used sparingly. Overused, they distort your product mix and train customers to wait for the next promotion.
I often mention my own reaction to them. I love chocolate, and in particular, Fox’s Milk Chocolate Rounds. They normally retail for £2.50. But they seem to be on a 6-week-on 6-week-off promotional cycle when they drop to £1.75. Knowing that it will soon be cheaper I never buy at £2.50. I can afford the £0.75, but I hate thinking that I’ve bought at full price when I know it’ll soon be discounted. The real irony is that I’ll happily buy the M&S equivalent for £3.50 and not think twice!
Balanced scorecards and mixed schemes
Rather than betting everything on one number, you can combine margin with strategic objectives: new account acquisition, product mix, customer retention, even cash collection. Done well this is powerful, because it stops people optimising one metric at the expense of everything else. The risk is that too many measures dilute focus and nobody knows what they're really being paid for. Keep it to a small number of weighted metrics, and make sure the weighting genuinely reflects what matters.
Customer and relationship metrics
Where repeat business and churn matter, schemes built around customer lifetime value, retention or share of wallet can be valuable. They reward building a profitable long-term relationship rather than winning a single discounted order, which is a useful counterweight to one-off deal-chasing.
Net margin
The best approach (in my opinion) is to base a bonus on net margin, but this usually needs to be calculated on a per-product basis to take into account the things that gross margin ignores, such as:
Different product weights and volumes, which affect shipping costs
Different buying multiples and selling multiples, which affect the cost of handling
Different handling requirements – something fragile, or that needs two people to deliver
It's because net margin is hard to calculate that it's so seldom used. But it's the best way to link an incentive scheme to price, because it rewards the profit you actually keep rather than the profit you appear to make on paper.
The pricing ladder
Whichever margin measure you use, a pricing ladder gives your team the structure to act on it. It starts at the top with a Reference Price of some kind – perhaps an RRP. Below that sits the Target Price, the price we genuinely expect to achieve in the market.
When a customer wants to negotiate, perhaps because they're buying in volume, the salesperson is incentivised to land as close to (or above) the Target Price as possible – but they have authority to deal down to the Minimum Price, which is calculated from the product's margin. Anything below the Minimum Price can only be signed off by senior management, who weigh things like the strategic importance of the customer, or efficiencies such as shipping a full container in one go. Even then there's a Walkaway Price below which the business will never go.
The sales team are incentivised on how much higher than the minimum price they can achieve.
Net-margin calculations make this ladder far more accurate, because they let you set Minimum Prices and Walkaway Prices that reflect the true cost of serving each product rather than a blunt gross-margin assumption. For businesses with large numbers of SKUs with very different properties such as weight, volume, fragility etc it can be complex to calculate.
How to manage incentive schemes well
Choosing the right metric is only half the job. The other half are the controls and discipline around it. Here is what makes the difference in practice.
Incentivise the pocket price, not the invoice price. As a business, the price on the invoice is not always the price you keep. Rebates, settlement and early-payment discounts, freight, returns, marketing support and other off-invoice items all eat into it. Map your "pocket price waterfall" so you can see what really lands in the bank, and make sure the number people are paid on is that real figure, not the headline one.
Make discretionary discounts hurt the person giving them. As with the discount-budget approach, the single most effective control is to ensure that a discount comes out of the salesperson's own commission. A discount that costs the discounter nothing will always feel like the easy option.
Don't expose raw costs – use a margin index instead. Net margin is hard to use for a variety of reasons – it might be that the underlying cost data is sensitive, it might be too complex to calculate, it might vary wildly and frequently, etc. This is where a price ladder helps, or alternatively you can develop a margin scoring system (a red-amber-green rating per product, or a numerical ‘margin score’ from 5-1 per product), so people know which deals are good for the business without ever seeing the actual costs. Sometimes this is what makes net-margin incentives workable at all.
Build in floors and clawbacks. Set a minimum margin below which no commission is earned, so nobody is ever rewarded for a loss-making sale. And claw bonuses back where a sale turns sour – returns, bad debt, or a customer who churns within a few months. A sale isn't a sale until the cash is in and it stays in. This also incentivises longer-term thinking (not just ‘get this sale and move on’) and win-win thinking (not zero-sum), both of which are better for your business.
Assume the scheme will be gamed. Goodhart's Law warns that when a measure becomes a target it stops being a good measure. Before you launch, sit down and work out how a clever, self-interested person would exploit your scheme – because someone will. The aim is to make the profitable behaviour and the rewarded behaviour the same thing.
Avoid cliffs and period-end distortion. Hard thresholds and quarter-end drives cause discounting sprees and held-back deals. Smooth your accelerators and consider rolling targets so there's no single date that warps everyone's behaviour.
Keep it simple enough to actually change behaviour. There's a real tension here: net margin is the best measure, but if people can't understand or predict their own pay, the scheme won't influence what they do day to day. A margin index resolves most of this – it carries the sophistication of net margin in a form a salesperson can use instantly.
Back-test before you launch. Run the proposed scheme against last year's actual deals and see what it would have paid out and what behaviour it would have rewarded. This almost always throws up surprises – the bonus scheme that everyone was proud of but would have earned nothing, or the quiet account that turns out to be your most profitable.
Align across functions. Don't let the sales incentive pull against operations or finance. If sales are rewarded for winning business that ops can't serve profitably, you've simply moved the problem. The scheme should reward total company profit, not local optimisation in one department.
Review it, and be willing to change it. Every scheme is eventually gamed or outgrown. Review it at least annually against what the business needs now, not what it needed when the scheme was written.
The bottom line
The journey from revenue to net margin is really a journey from rewarding activity to rewarding value. A revenue scheme pays people for being busy; a net-margin scheme pays them for making you money. Get the number right, give your team a ladder to act on it, and protect the whole thing with the right controls – and the pricing behaviour you actually want will follow on its own.
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