Over the last 5 years we have seen dramatic changes in the economic world. This includes a number of Regulatory changes that included TARP, Guidance on Sound Incentive Compensation Policies, and Dodd-Frank. While there is a focus on the financial industry in these regulatory acts, is there not potential for other industries to learn lessons and adjust. As part of the Guidance on Sound Incentive Compensation Policies issued in June 2010 by the Federal Reserve, OCC, OTS, and FDIC, it was noted that mechanisms to evaluate compensation to risk were not adequate. If this is the case in the financial industry, what does this mean for all other industries?
Tying compensation to a compensable event and evaluating future risk to the event is not something highly analyzed in many industries. Clawbacks or the recoupment of compensation paid is a standard across many industries but the rules regarding these are not always clear. While incentive compensation tied to sales activity is the life of many organizations, it can be one of the biggest risks as well.
Many organizations are realigning sales compensation plans from focus on revenue generation to profit generation. This means redefining the compensable event to be based on some profitability metric. By example, this may be Gross Margin at a transactional level. But then the organization needs to show that the gross margin at a transactional level correlates to the gross margin level for the organization in some way. This requires visibility at the event level as well as at other organizational levels like a branch, district, region, and overall organization.
For consideration, the definition of the profitability metric needs to be accepted across the organization. For incentive compensation, since many system are home grown or excel based, it is not unusual to find multiple definitions of a given metric. This can cause confusion, and increase the risk of the sales event having negative impacts on the bottom line of an organization.
An implementation this author worked on had five different definitions for Gross Margin in their incentive compensation plans. This developed out of an Excel Spreadsheet based system, and through a number of different analysts working across different plans. The plans did not clearly define the metric of Gross Margin, and over time the Gross Margin was interpreted and calculated differently by plans and analysts. This was discovered, and the organization began the process of editing and redefining Gross Margin so that it more closely related to the Financial Statements metric.
The mechanism to analyze the impact of the compensable event to the organization needs to take into account the event, the cost of the event and how it is associated to the event, and any risks to the event. In the case, where the event is the sale of equipment, some of the questions to ask are:
- Is the equipment returnable?
- What is the risk and timeline for warranty or return?
- How to tie the compensation to the event, but in addition take into account possible loss of the sale?
In the case of bundled equipment, it can be noted that in order to save money a client might buy a bundle even if it contains equipment they will not use, and then return the unused equipment at a later date for a partial refund or exchange. If this does occur, then how does the organization adjust the compensable event, how does the organization recoup compensation paid to better match the event, and what mechanism gives them the ability?
In the case that the event is a service, some things to consider may be the life of the service contract, and the payment terms of the service. In this case, compensation may be tied to payment of a percentage of compensation owed based on the life of the contract and receipt of payment. The visibility of this process is crucial to accurately handling the compensation and the financial impacts.
Another example is within the Insurance industry. Compensation for a policy may allow for a residual compensation based on the renewal or the life of the policy. It is important to be able to track the status of the policy and know when it may expire or if the policy lapses due to non-payment of the premium. The risk that compensation will continue to be paid on a lapsed policy is significant unless there is a mechanism is place to track this and tie the compensation back to the event, which would be the payment of the premium.
There needs to be consideration into educating the sales personnel on the product or product mixes and the pricing considerations, including how discounts may affect their compensation. In addition, how are discounts and rebates tracked? How will these affect the profitability of the compensable event if they are tracked outside of the Compensation Process e.g. in an excel spreadsheet or an accounts payable system. Merging this type of data into the compensation process is critical to evaluating the impact against the profitability of a sale. This allows organization to analyze the true financial impact of a product or product mix, and the profitability of the plans and the product management strategy.
In addition, the organization has to be aware of other payments that may be made. An example that can be made is that it is not hard in an Excel Spreadsheet environment to have someone hard code an amount within a calculated field and it be overlooked for a period of time. In environments where the system is a main frame program, there could be code allowing for incentive that should have expired or is no longer valid that continues to be paid out. An example of such occurred with one of the authors co-workers, in review of the main frame JCL Code, it was discovered that it contained a number of expired policy rates, and due to a commented out code line there was close to half a million in commission over payments.
While Incentive Compensation has always been a convoluted mix of possibilities, the systems available today allow for clear visibility, traceability, and analysis of impacts. In some of the main frame systems, the detailed events are loaded, and then the only visibility at the end of the cycle is a lump sum payment. This made auditing the actual compensation against the compensable events difficult and time consuming.
The ability to have visibility into a compensable event, and the effects of that event at the Organizational, Regional, District, and other reporting entity levels is critical in the current fluctuating economic environment. The ability for Sales Executives, CFO’s and CEO’s to trace the impacts of an event and the positive or negative impacts on the bottom line are critical to the profitability and the viability of the organization. Large revenue generation does not necessarily equate to a profitable and viable business. This is a very clear message that has been broadcasted loudly since 2008. Analysis of the viability of an organization is a necessary function of today’s financial departments. The compensation tied to a compensable event is a significant impact to the ability of the organization to continue to function both from an organizational level, and from the perspective of training and keeping the sales personnel engaged and productive.
In summary, it is necessary for an organization to clearly define the eligibility of a compensable event, the compensation basis for the event, and risk management of the event and the compensation tied to it. The mechanism to track the event, the compensation, and the financial impact of the event needs to allow for visibility, traceability, and analysis. IBM Cognos Incentive Compensation Management has become a proven tool in this area, and offers an organization the visibility and traceability to track incentive compensation and the financial impacts of the events driving compensation. In addition, used in tandem with other IBM offerings like Cognos TM1, there is a true ability to analyze and report on the profitability and viability of the organization.
To find out more about Sales Performance Management, be sure you check out IBM Cognos ICM.