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Four Pitfalls to Incentive Compensation

Four Pitfalls to Incentive Compensation

By Mark Snyder

Why are so many employee incentive plans ineffective and counterproductive? The plans often make one of the four following mistakes.

1. Solely Focused on Top Line Revenue or Volume

The first mistake is the plan is solely focused on top line revenue or volume. An organization had the sales force on a bonus structure that was based only on revenue. This was great for driving top line revenue growth, but the sales force would often default to the most price competitive stock keeping units (SKU) to sell. In this business there were loss leaders, or low profit SKUs, in the portfolio that were meant to draw customers and provide a gateway to selling more profitable SKUs. The sales team quickly figured out that focusing on the loss leaders would help them make up gaps in their quarterly sales quota. This plan ended up being counterproductive causing gross margin erosion while sales were increasing.

2. Only Focused on Profit

The second mistake is a plan only focused on profit. Another organization sold hardware and accompanying long-term service contracts. The sales organization bonus plan was based only on the hardware gross profit.
This plan created two issues over the long term. The first issue is the sales team would pack all the margin into the hardware sale and then lower the price on the service, which was the recurring revenue stream. This required constant monitoring by management to ensure guidelines were being followed on service contract pricing. The second problem was packing too much profit into the hardware sale. Most of these hardware sales were financed and by packing too much hardware profit resulted in a higher monthly payment for the customer as they paid off the hardware over time. This higher payment created a perfect future opportunity for a competitor to provide more reasonable pricing on the replacement hardware increasing the probability of losing the customer over the long term.

3. All Carrot and No Stick

The third mistake is a plan that is all carrot and no stick. A division had acquired a competitor’s brand as well as the sales force that had been selling that brand. The organization had plans to wean customers off the competitor brand over time and move them onto the legacy brand. The team had set up incentives for the new sales force to earn additional payouts if they converted customers to the legacy brand. The new sales force continued to sell the competitor brand due to their familiarity with the competitive product and avoiding the hard conversation with the customer. The bonus plan was modified to exclude the sales of the competitive brand from the sales team’s quota. This change literally turned off the spigot to the sales of the competitor’s brand.

4. Too Many Components and is Overly Complicated

The last mistake is a plan that has too many components and is overly complicated. A service division had an incentive plan with so many bonus drivers that it took a significant effort to calculate and determine the bonus payout. Most service technicians had no idea why their bonus went up or down and didn’t really understand how to affect change in their pay based on their efforts. When everything is important, then nothing is important.

Overall a good incentive program should have two or three measures and should be balanced between top line revenue and profitability. Having the right program for your organization will cause all team members to begin rowing in the same direction.

Mark Snyder is a Principal with FocusCFO based in Cleveland, OH.

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Cash Discounts, Friend or Foe?

Cash Discounts, Friend or Foe?

By Mark Snyder

Should you be offering cash discounts to your customers to encourage accelerated payment of your accounts receivable?

I still remember a conversation I had years ago with the leader of our customer service group. He wanted us to increase our division’s accounts receivable discount terms to match the other divisions within the company in order to make their job easier. Increasing the discounting term would’ve have removed almost 2% of our annual division’s earnings without any appreciable offsetting benefit, since we had ready access to cheap capital as an organization.

A quick education of discounting, standard discount terms of 2/10 net 30 means a 2% discount to a customer’s bill if customer pays in 10 days otherwise full amount due in 30 days. Another common term is 1/10 net 30 or 1% discount to overall bill if paid in 10 days otherwise full amount due in 30 days.

The annual percentage rate (APR) on these common discount terms is approximately 37% and 18% respectively.

A business needs to approach the concept of cash discounts much in the same way they would look at borrowing money from a lending source. Are annual APRs of 37% and 18% acceptable and would you borrow money at these levels?

Many businesses would shudder at borrowing money at those rates, yet they are extending these payment terms to their customers without considering the actual costs. Especially, when we live in a world where the prime rate currently hovers in the 5% range and short-term LIBOR rates are around 2%?

There are certain instances when offering cash discounts makes sense:

• A business has exhausted their traditional lending sources [high growth phase] or their risk profile if unattractive to the lending community and they are looking to get creative to free up capital without giving up control

• The current cost of capital within the organization is at a similar level to the APR associated with the discounting, such as at smaller publicly held companies the cost of capital can be 20%+ when factoring in the compliance costs that burden public companies

Most often apathy and inertia are the biggest reason for these discount terms persisting. Changing customer discount terms is often a difficult conversation with customers and most companies seek to avoid agitating their customer base. Customers will consider any reduction to discount terms as an effective price increase from your company.

In the long run companies would be much better served by strategically deploying a 1% to 2% price reduction, via a trade program associated with volume or customer performance metrics, that will result in increased sales and profits. Merely giving away significant discounts is not helping to further your business objectives and is a drug from which you must wean your customers.

Someday we may return to an environment where the time value of money is significant or credit access is severely restricted, but until that time the concept of cash discounts needs to end.
Mark is a Principal with FocusCFO and is based in Cleveland, OH.

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Matt Cooksey

Welcome Matt Cooksey

Welcome to the FocusCFO Team!

Matt has more than 20 years of experience in finance, accounting, and managerial roles. He has worked in a variety of organizations but is most passionate about small/mid-sized entrepreneurial environments. He spent 7 years with a privately held company in Controller and CFO roles during which the company grew from $12M-$40M in revenue. In his career he has had responsibility for Accounting, Cash Flow, Operations Analysis, Bank Covenants, Budgeting & Forecasting. Matt, his wife Sharyn, and three children live in Kenwood, Ohio.

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Welcome David Tramontana

Welcome David Tramontana

Welcome to FocusCFO

 

David has over 27 years of entrepreneurial experience in business development, strategic planning, and growing businesses. He’s analytical, visionary and a relationship builder; known for systematic planning, servant leadership, and financial acuity. He’s a nationally respected thought leader within Home Healthcare with strong executive management experience.

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