Corporate Budget i n g Is Broken Let's Fix It Traditional budgeting processes waste time, distort decisions, and turn honeSt managers into It doesn't have to be that wayif you're willing to the ties between and compensation by Michael C.Jensen NOVEMBER 2001 95 Corporate Budgeting Is Broken - Let's Fix It C ORPORATE BUDGETING IS A JOKE, and everyone knows it. It consumes a huge amount of executives' time, forcing them into endless rounds of dull meetings and tense negotiations. It encourages managers to lie and cheat, lowballing targets and inflating results, and it penalizes them for telling the truth. It turns business decisions into elaborate exercises in gaming. It sets colleague against colleague, creating distrust and ill will. And it distorts incentives, motivating people to act in ways that run counter to the best interests of their companies. Consider just two examples. At one international heavy-equipment manufacturer, managers were so set on hitting their quarterly revenue target that they shipped unfinished products from their plant in England all the way to a warehouse in the Netherlands, near the customer, for final assembly. By shipping the incomplete products, they were able to realize the sales before the end of the quarter and thus fulfill their budget goal and make their bonuses. But the high cost of assembling the goods at a distant location - it required not only the rental of the warehouse but also additional labor-ended up reducing the company's overall profit. Then there's the recent debacle involving a big beverage company. The vice president of sales for one of the company's largest regions dramatically underpredicted demand for an upcoming major holiday. His motivation was simple-he wanted to ensure a low revenue target that he could be certain of exceeding. But the price for his little white lie was extremely high: The company based its demand planning on his sales forecast and consequently ran out of its core product in one of its largest markets at the height of the holiday selling season. Such cases of distorted decision making are legion in business. No doubt, you could list similar instances that you've observed-or perhaps even instigated-at your own company. The sad thing is, these shenanigans have become so common that they're almost invisible. The budgeting process is so deeply embedded in corporate life that the attendant lies and games are simply accepted as business as usual, no matter how destructive they are. But it doesn't have to be that way. Even if you grant that budgeting, like death and taxes, will always be with us, deceitful behavior doesn't have to be. That's because the budget process itself isn't the root cause of the counterproductive actions; rather, it's the use of budget targets to determine compensation. When managers are told they'll get bonuses if they reach specific performance goals, two things inevitably happen. First, they attempt to set low targets that are easily achievable. Then, once the targets are in place, they do whatever it takes to see that they hit them, even if the company suffers as a result. Only by severing the link between budgets and bonuses-by rewarding people purely for their accomplishments, not for their ability to hit targets- will we take away the incentive to cheat Only then will we eliminate the budgeting incentives that drive individuals to act in ways that destroy corporate value. Cheaters Prosper Let's look more carefully at how budgets drive compensation and, in turn, behavior. In a traditional pay-forperformance incentive system, a manager's total cash compensation (salary plus bonus) is constant until a minimum performance hurdle is reached-commonly 80% of a budgeted target. (The target might be expressed as profits, sales, output, or any number of things; for our purposes, it doesn't matter what's being measured.) When the manager exceeds that hurdle, she receives a bonus, often a substantial one. The bonus then increases as performance mounts above the hurdle until the bonus is capped at some maximum level-120% of the target is usual. This system is illustrated in the exhibit "A Typical Executive Compensation Plan." The kinks in the pay-for-performance line-caused by the minimum hurdle bonus and the maximum cap-create strong incentives to game the system. As long as the manager believes she can make the minimum hurdle, she will naturally try her best to increase performance-by legitimate means or, if push comes to shove, by illegitimate ones. If the measure is profits, for instance, she will have a strong incentive to increase the current year's earnings at the expense of next year's, either by pushing expenses into the future (delaying purchases or hires, for example) or by moving future revenues to the present (booking orders early or offering special discounts to customers, for example). If, on the other hand, the manager concludes that she can't make the minimum hurdle, her incentives flip 180 degrees. Now her goal is to move earnings from the present to the future. After all, her compensation doesn't change whether she misses the target by a little or a lot; she still gets her full salary (assuming she doesn't get fired, of course). But by shifting profits forward-by prepaying expenses, taking write-offs, or delaying the realization of revenues - she increases her chances of getting Michael C. Jensen, the Jesse Isidor Straus Professor of Busi- a large bonus the following year. This is a variation on the ness Administration, Emeritus, at Harvard Business School "big bath" theory of corporate financial reporting: If you're going to take a loss, take as big a loss as possible. in Boston, is the managing director of the organizational strategy practice of the Monitor Group, a collection ofglobal Finally, if the manager is having a great year and her professional services firms with headquarters in Cambridge, performance is nearing the budget cap, she again has an incentive to push profits into the future. Because she's Massachusetts. 96 HARVARD BUSINESS REVIEW C o r p o r a t e B u d g e t i n g Is B r o k e n - Let's Fix It not going to get any additional compensation if performance exceeds the levei at which the cap is set, accelerating expenses or postponing sales will have no negative impact on her current earnings, but it will raise the odds that she'll reap a high bonus next year as well. This perverse incentive becomes even stronger if her current year's performance is used in setting the following year's targets, as is often the case. When these kinds of subterfuge simply move profits from one year to another-by changing accruals, for example -the adverse impact on company value is probably small. But rarely is the activity so benign. Usually, the shuffling of dollars results from decisions that change the operating characteristics of a company, and it generates high, if sometimes hidden, costs that erode the total value of the company. We saw such erosion in the two examples presented earlier. We see it as well in the common practice of channel stuffing-when managers ship loads of products to distributors to meet immediate sales goals, A Typical Executive Compensation Plan In a traditional pay-for-performance compensation plan, a manager earns a hurdle bonus when performance reaches a certain level (A). The bonus increases with performance until it hits a maximum cap (B). The kinks in the pay-for-performance line create incentives to game the system. When performance approaches the hurdle target, a manager has a strong incentive to accelerate the realization of revenue and profit When performance hits the cap, the manager has a strong incentive to push revenue and profit into the next year. Performance NOVEMBER 2001 M e a i u re even though they know many of the goods will soon come back as returns. And we see it in distorted pricing decisions. The managers of one durable-goods manufacturer, struggling to meet their minimum bonus hurdles, announced late one year that they would be raising prices io% across the board on January 2. The managers made the price hikes because they wanted to encourage customers to place orders by year-end so they could hit their annual sales goals. But the price increase was out of line with the competition and undoubtedly ended up costing the company sales and market share. Even more insidious effects are common. One of the main reasons that big companies have budgets in the first place is to help coordinate the disparate parts of their businesses. By openly sharing accurate information and basing decisions on a common set of numbers, the thinking goes, you ensure harmonious interactions among units, leading to efficient processes, high-quality products, low inventories, and satisfied customers. But as soon as you start motivating unit and department heads to falsify forecasts and otherwise hide or manipulate critical information, you undermine the salutary effects of budgeting. Indeed, the whole effort backfires. You end up with uncoordinated, chaotic interactions as people make decisions on the basis of distorted information they receive from other units and from headquarters. Moreover, since managers are well aware that everyone is attempting to game the system for personal reasons, you create an organization rife with cynicism, suspicion, and mistrust When the manipulation of budget targets becomes routine, moreover, it can undermine the integrity of an entire organization. Once managers see that it's okay to lie and conceal information to enrich themselves or simply to hold on to their jobs, they soon begin to extend their dishonest behavior to all parts of the company's management system and even to its relationships with outside parties. Managers start to feed misleading information to customers, suppliers, and employees, and the CEO and CFO begin to "manage the numbers" to influence the perceptions of board members and Wall Street analysts. Even boards of directors are drawn into the fray, as they end up endorsing deceptive reports to shareholders. Sometimes, outright fraud ensues, as we've seen recently in high-profile cases involving companies such as Informix, Sabratek, and Lernout & Hauspie. The damage can go well beyond the walls of individual companies. Think about what happens, for example, during a boom. As financial analysts and investors raise expectations for growth beyond the capability of companies, many managers begin to borrow from the future to satisfy the present demands. This results in an overstatement of earnings and cash fiows for many companies and an exaggeration of the extent of the good times. Conversely, during the early stages of an economic slowdown, as demand falls below predicted levels and inventories 97 C o r p o r a t e B u d g e t i n g Is B r o k e n - L e t ' s F i x I t build up, managers often find themselves falling short of their bonus targets. When they and their companies all react in the same, predictable way-taking big baths by maximizing the bad news-the cumulative effect is to exaggerate the economic weakness, perhaps deepening or extending the recession. Macroeconomic statistics and even public policy are likely distorted in the process.' Getting the Kinks Out The only way to solve the problem is to remove all the kinks from the pay-for-performance line-to adopt a purely linear bonus schedule, as shown in the exhibit "A Linear Compensation Plan." Managers are still rewarded for go in each year, for a total of $24,txx'). But if she could manipulate that same amount of profit so that she hit 80% of the goal in one year and 120% in the next, she would receive $io,cx>o in one year and $20,i.xx> in the other, for a total of $30,000. The curvilinear plan, in other words, has given her a strong monetary incentive to start fudging the numbers again, and, in this case, she would be rewarded for increasing the variability of performance. What's more, she would be willing to do this even if it lowered overall performance within some range. In contrast, under a truly linear scheme, the manager would receive the same total ($3o,(xxi) in both scenarios. Last January, Chrysler Motors introduced a new dealerincentive plan that was based on a curvilinear pay-forperformance scale. The plan paid dealers a monthly bonus ranging from zero (for those who achieved less than 75% of their sales targets) to $soo per car sold (for those who achieved more than iK>% of the target). When car sales began to slow in April, many Chrysler dealers realized that they were unlikely to exceed the targets for the month and therefore they reduced inventories, shifting sales of cars from April to May, when they could be much more certain to earn the $500 per car bonus. In the end, Chrysler's CEO bad to announce that company sales fell i8% in April as a result of its dealer bonus program, while overall industry sales were down only u)%. Lead from the top. Given the complexity of designing a new pay system, as well as the controversy it inevitably sets off, CEOs will feel a natural desire to hand off responsibility for the effort to the human resources department. That would be a mistake, probably a fatal one. HR has neither the standing nor the influence to make a fundamental business change that will have a profound impact on the decisions of line managers. And that's exactly NOVEMBER 2 0 0 1 the kind of change that I'm talking about: All members in the organization will have to shift their thinking about the rote and use of both budgets and incentives. Performance measures will have to be changed, and bonus levels will have to be recalculated. Since these issues are as sensitive as any within a company, strong leadership is essential. Only the CEO has tbe credibility to make the business case for the changes and to rally tbe troops behind them. The CEO should recognize that the new plan will meet with intense resistance, even at the highest reaches of the organization. Some of the strongest objections, I have found, tend to come from CFOs and their teams. Finance executives naturally fear that reducing the importance of budget targets in motivating line managers will make it more difficult to control results and avoid surprises. It will be the CEO's responsibility to make sure the CFO, not to mention Wall Street analysts, understands that the new approach will improve the quality of both the information provided and the incentives paid to managers. And better information and better incentives will lead to better results. Yes, there may be greater uncertainty in quarter-to-quarter results-as there will no longer be any motivation to set artificially low targets and then do everything possible to meet them-but the longrun profits will be superior. Finally, every line manager will have to understand the new system and the theory behind it and be prepared to explain it and defend it against opposition and opportunism from the ranks. There are no shortcuts through the education process. Organizations don't change overnight, particularly when the very frame through which we see the business is involved. Remember, it has taken many years to weave lying and deceit into the fabric of our businesses; cleansing the fabric will take time as well. ^ 1. See M.C. Jensen,"Paying People to Lie: The Truth About the Budgeting Process," working paper (Harvard Business School, April 2001). Available on-line at http://ssm.conv'paper=26765i2. To read more on how goals can distort behavior, even in the absence of ties to tangible rewards, see M. Schweitzer, L. Ordonez, and B. Doiima,"The Dark Side of Goal Setting: The Role of Goals in Motivating Unethical Behavior," working paper (Wharton School, University of Pennsylvania, 2(.xii). 3. See Edwin A. Locke, "Motivation by Goal Setting," in Handbook of Organizational Behavior, ed. Robert T. Golembiewski (Marcel Dekker, 2(wi). Also see Edwin A. Locke and Gary P Latham, 4 Theory of Coal Setting and Task Performance (Prentice Hall, 1990). 4. See Michael C. Jensen,"Value Maximization, Stakeholder Theory, and the Corporate Objective Function," Business Ethics Quarterly, January 2tx>i. Available on-line at http://ssrn.conVpaper=22o67i. The author thanks Joseph Fuller, Michael Gibbs, Jennifer Lacks-Kaplan, and Edwin Locke for their contributions to this article. Reprint ROIIOF To order reprints, see the last page of Executive Summaries. To further explore the topic of this article, go to www.hbr.org/explore. 101 Harvard Business Review Notice of Use Restrictions, May 2009 Harvard Business Review and Harvard Business Publishing Newsletter content on EBSCOhost is licensed for the private individual use of authorized EBSCOhost users. It is not intended for use as assigned course material in academic institutions nor as corporate learning or training materials in businesses. Academic licensees may not use this content in electronic reserves, electronic course packs, persistent linking from syllabi or by any other means of incorporating the content into course resources. Business licensees may not host this content on learning management systems or use persistent linking or other means to incorporate the content into learning management systems. Harvard Business Publishing will be pleased to grant permission to make this content available through such means. For rates and permission, contact permissions@harvardbusiness.org. Spotlight on Smarter Sales Spotlight 70\u0007Harvard Business ReviewJuly-August 2012 Artwork Chad Wys Hymn 2, 2011, chromogenic print 30" x 24.2" HBR.ORG Thomas Steenburgh is an associate professor in the marketing unit at the Darden School of Business and formerly worked in incentive strategy at Xerox. Michael Ahearne is the C.T. Bauer Chaired Professor in Marketing at the University of Houston and the executive director of the Sales Excellence Institute. Motivating Salespeople: What Really Works S Companies fiddle constantly with their incentive plans but most of their changes have little effect. Here's a better approach. by Thomas Steenburgh and Michael Ahearne SALES EXECUTIVES ARE always looking for ingenious ways to motivate their teams. They stage grand kickoff meetings to announce new bonus programs. They promise exotic trips to rainmakers. When business is slow, they hold sales contests. If sales targets are missed, they blame the sales compensation plan and start from square one. The finance organization, meanwhile, views the comp plan as an expense to manage. That's not surprising: Sales force compensation represents the single largest marketing investment for most B2B companies. In aggregate, U.S. companies alone spend more than $800 billion on it each yearthree times more than they spend on advertising. So naturally finance tries to ensure that comp plans have cost-control measures designed into them. Some companies offer flat commission rates so that compensation costs rise and fall with revenues. Others cap compensation once salespeople hit certain performance targets. Still others use bonuses to control spending by pinning salespeople's quotas to Wall Street revenue targets. (See the sidebar \"When Finance Calls the Shots.\") But a few progressive companies have been able to coax better performance from their teams by treating their sales force like a portfolio of investments that require different levels and kinds of attention. Some salespeople have greater ability and internal drive than others, and a growing body of research suggests that stars, laggards, and core performers July-August 2012Harvard Business Review71 Spotlight on smarter sales are motivated by different facets of comp plans. Stars seem to knock down any target that stands in their waybut may stop working if a ceiling is imposed. Laggards need more guidance and prodding to make their numbers (carrots as well as sticks, in many cases). Core performers fall somewhere in the middle; they get the least attention, even though they're the group most likely to move the needleif they're given the proper incentives. Accounting for individual differences raises the odds that a compensation plan will stimulate the performance of all types of salespeople. In this article we will discuss how companies can do this to deliver greater returns on investment and shift their sales-performance curve upward. Motivating Core Performers Ironically enough, many incentive plans come close to ignoring core performers. Why does this group tend to be off the radar screen? One reason is that sales managers don't identify with them. At many companies the managers are former rainmakers, so they pay the current rainmakers an undue amount of attention. As a consequence, core performers are often passed over for promotion and neglected at annual sales meetings. But this is not in the best interest of the company. Core performers usually represent the largest part of the sales force, and companies cannot make their numbers if they're not in the game. Here are some proven strategies for keeping them there. A Performance Curve for the Sales Force A typical sales force has a clear majority of \"core\" performers, a small but elite group of stars, and a group whose performance trails. It's possible to boost performance at all points on the curvebut the wise sales executive uses different tools for each group. Laggards Core performers Stars Key incentives Quarterly bonuses social pressure Key incentives Multi-tier targets \u0007Sales contests with prizes that vary in nature and value Key incentives No caps on pay Overachievement Commission rates 72\u0007Harvard Business ReviewJuly-August 2012 Multi-tier targets. A project that Mike recently worked on with a national financial services company shows that such targets help motivate core performers. At the company a major proportion of the salespeople fell into this category. In bearish months they almost always found a way to hit their targets, but in bullish months they seldom exceeded their numbers substantially. In an effort to nudge them upward, the company experimented with tiered targets. The first-tier target was set at a point that a majority of the company's sales agents had historically attained, the second-tier target at a point reached by a smaller percentage of the sales force, and the thirdtier target at a point hit only by the company's elite. All the firm's agents were divided into two groups: The first was given targets at tiers one and three, and the second group got targets at all three tiers. The hypothesis was that tiers would act as stepping stones to guide core performers up the curve. The tiered structure indeed had a profound impact. Core performers striving to achieve triple-tier targets significantly outsold core performers given only two tiers. By contrast, multi-tier targets did not motivate stars and laggards as much: No significant differences in performance were found for those segments. These results suggest that core performers exert more effort if given additional tiers. Stars are presumably unaffected by the extra stepping stone because they view the top tier as attainable regardless of the number of targets. And the inattentiveness that laggards show suggests that they typically aim for and are satisfied with achieving the first-tier target. Prizes. A research project that we're both currently working on investigates how prize structures in sales contests can engage core performers. The problem with contests is that stars usually win them. Knowing this, core performers don't bump up their own efforts. You can handicap contestants on the basis of their prior performance, which alleviates the problem to a certain degree. But that creates its own problem: What's fair about core performers' and laggards' taking home the top prizes, if stars are left with lesser prizes or no prize at all? Ideally, sales executives would design contests so that both stars and core performers would go home satisfied. This isn't easy to do, but if you keep in mind that people are hardwired to adapt to their position in a social hierarchy, it is possible. The key is to offer gifts (not cash) for the lower-level prizes that can be seen as equal, or even superior, to the top-level prizes Motivating Salespeople: What Really Works hbr.org Idea in Brief A growing body of research suggests that the laggards, core performers, and stars who make up a sales force are each motivated by different facets of the compensation plan. Yet very few companies focus on getting the most out of the full range of their salespeople. Instead, most firms zero in on their starseven though it's their core performers whose improved performance will move the needle. Additionally, many companies respond to cost-cutting pressure from the finance department with incentives that backfire. Companies that take individual differences into account will realize better results across the performance curveand see a higher return on sales expenditures. on some dimension. Suppose a prestigious golf vaca- both carrots and sticks) effectively motivate the tion is awarded as a top prize and a local family get- \"good\" laggards to move up the curve. away is awarded as a lower prize. The family getaway Pace-setting bonuses. A current study of has a lower market value than the golf vacation, but Tom's looks at the most common carrot: the bonus. core performers can adapt to their central position This study, based on field data from a Fortune 500 on the performance curve by shifting their prefer- company that sells durable office goods, separately ences. They can rationalize their prize by saying, models the behavior of stars, core performers, and \"I've golfed plenty latelywhat's important to me is laggards within a number of different compensaspending time with my family.\" We consistently find tion plans. that core performers work harder and perform better The study found that removing quarterly boin contests of this kind than they do in contests with nuses from laggards' incentivesand keeping only cash prizes. Furthermore, their increased effort does an annual bonuswould decrease their overall pernot come at the cost of decreased effort from stars or formance (as measured by the revenues they generlaggards. ate) by approximately 10%. The same change would However, this approach won't work if the gifts decrease the overall performance of core and star offered at lower performance tiers are simply lower- salespeople by 4% and 2%, respectively. There is no grade versions of those at the top tier. Core perform- downside to including quarterly bonuses. They help ers will never perceive 18 holes at a run-of-the-mill laggards contribute to the bottom line without degolf course as more desirable than 18 holes at a pres- tracting from the performance of other groups. tigious course. The lower-level prize must have some Pace-setting goals have been found to change quality that the higher-level one does not. In this ex- the behavior of low performers in other domains, ample, it was the local getaway's family appeal that too; education researchers see similar patterns allowed core performers to remain engaged in the among students. Weaker students need periodic contest. quizzes throughout the semester to keep them on We've also seen that core performers near the track. In the absence of such mechanisms, they perbottom of their cadre are motivated by incentives form poorly on comprehensive exams. By contrast, designed to improve the performance of laggards. strong studentslike star salespeoplemake an efThis happens because they fear falling into the lower fort independently and have less need for intermitcategory. Now let's take a look at the incentives that tent goals. work for the salespeople in that group. Natural social pressure. Managers often mention that having a high-quality pipeline of new sales talent naturally puts social pressure on lowMotivating Laggards performing salespeople. This is commonly referred The low-performing group in a sales force is usually to as the \"man on the bench\" effect, because it is heterogeneous: It may include new hires in need of similar to the pressure that second-string quartertraining and senior salespeople who have become backs, say, place on starters in football. complacent, as well as people who are simply less In a current study, we measure the impact of talented and motivated than their colleagues. Most bench players on the performance of existing sales laggard groups we've observed have members whose teams. Using advanced econometric techniques, we performance can improve if the right incentives are compare districts with and without bench players. in place. The following strategies (which include About the Spotlight Artist Each month we illustrate our Spotlight package with a series of works from an accomplished artist. We hope that the lively and cerebral creations of these photographers, painters, and installation artists will infuse our pages with additional energy and intelligence to amplify what are often complex and abstract concepts. This month's artist is Chad Wys, whose work explores the objectification of history, people, and artwork. \"I openly play with the allure of foreign and aggressive new colors and forms in otherwise familiar and traditional settings,\" writes the Illinois-based Wys. \"Barriers and obstacles are thereby created between the viewer and the object through which one must negotiate an understanding of what is both present and hidden.\" View more of the artist's work at chadwys.com. July-August 2012Harvard Business Review73 Spotlight on smarter sales When Finance Calls the Shots We recently surveyed more than 600 strategic account managers to better understand how their sales and finance organizations worked together. We found that in slightly more than half the companies, finance and sales jointly developed revenue and expense management plans, especially for strategic accounts. (About a quarter of the firms reported that finance was primarily responsible for creating those plans.) Nevertheless, around half the strategic account managers stated that the finance organization interfered with their ability to get their job done. When we asked them what they would do if they believed finance was going to impose expenserelated controls at the end of the fiscal year (a common tactic), most admitted that they would probably shift customerrelated travel and entertainment expenses to earlier in the year. They would also probably try to prepay mar- We've observed that salespeople in districts with a bench player perform approximately 5% better than those without one. The greatest increase in performance takes place in the laggard group. In the long run the overall increase in revenue easily outweighs the additional costs associated with hiring bench players. When a company has a disproportionate number of laggards, it's usually the result of sales managers' reluctance to face a difficult transition period. Often managers are forced to make a trade-off between retaining chronic low performers and enduring vacant sales territories. Hiring bench players can help ease this transition. Program-induced social pressure. Programs that put social pressure on laggards should be implemented with care. Successful programs are born out of rigorous pilot testing and are sensitive to the culture of the firm. When designed well, programs heighten laggards' sense of responsibility to the team and motivate stars to help laggards out. They avoid demoralizing people. One company we've observed puts laggards' performance under the microscope by occasionally posting sales numbers in ascending order from laggards to stars (rather than the more conventional re- Capping commissions when salespeople are hot may control costs, but it also encourages stars to quit selling. 74\u0007Harvard Business ReviewJuly-August 2012 keting expenditures to protect them from a freeze. More often than not, controls encourage salespeople to spend time with customers according to the company's internal needs, rather than when the customer is ready to buy. verse order). Another company publicly posts a sign in its sales bull pen that lists each of its salespeople in one of three categories: starters, benchwarmers, and the penalty box. While this type of public display is relatively extreme, it seems to work within this company's competitive and transparent culture. Wins are celebrated with ostentatious prizes, such as courtside seats for sporting events and leases for Porsches. Losses are taken bitterly. Motivating Stars Since stars represent the most efficient portion of a company's performance curve, incentive plans should favor them. Yet in many companies sales commission rates are capped and winner-take-all prize structures dominate the incentives. A primary reason is cost control, driven largely by the finance department. But are these practices rational? The simple answer is no. Executives who impose these cost-control measures encourage the same form of irrational behavior that Colin Camerer and his colleagues discovered in their study of New York City cabdrivers. Camerer researched whether cabdrivers worked longer hours when more people wanted a taxi (\"law of supply\") or quit for the day once they reached a certain number (\"income targeting\"). It wasn't even close: Overwhelmingly, cabdrivers quit for the day once they reached their target. By placing caps on commissions when salespeople are hot, executives encourage stars to quit sellingjust as cabbies go home early on rainy days, when their hourly earnings are highest. Companies would be better off if stars worked more intensively during times of high demand. No ceiling on commissions. A recent study by Sanjog Misra and Harikesh Nair examines the impact of capping salespeople's pay. They looked at the compensation plan of a large U.S. contact-lens manufac- Motivating Salespeople: What Really Works hbr.org Different Strokes for Different Folks turer. This company stopped paying commissions once salespeople's performance reached a quota ceiling. In response, the salespeople always held sales under the ceiling. By eliminating it and making other changes to the compensation plan, the company kept its salespeople motivated and increased revenue by about 9%. Overachievement commissions. These are higher rates that kick in after quotas are met. For example, salespeople may earn a penny on a dollar with their regular commission rate until quotas are reached, but earn two pennies on a dollar on all sales above quotas. Tom's research at the office supply company, mentioned earlier, proves the effectiveness of overachievement incentives. Removing them from a compensation plan would reduce stars' sales by approximately 17%, the research showed. An overachievement commission rate can help keep stars in the field during the fourth quarteroften the period in which customers are most ready to buy. Multiple winners. A study of Mike's reveals that contests with multiple winners boost sales effort and performance better than contests with winner-takeall prize structures. And Noah Lim, one of his coauthors on the study, has done further work demonstrating that more (rather than fewer) prizes should be awarded as the proportion of stars increases. This finding suggests that executives should offer at least as many prizes as there are stars in a sales force. The reason is intriguing. Increasing the number of prizes in a contest increases the chances that a laggard or a core performer will win a prize in place of a star, which motivates stars to work harder. On the whole, these results show that frugality toward top salespeople is detrimental to firm performance. Shift Your Performance Curve Upward Together, we have more than 40 years' experience working with companies on sales-related problems. When we first meet with executives, we always ask which decisions they sweat over the most. Deciding how to compensate salespeople is invariably at or near the top of the list. When we follow up by asking whether they have enough information to support their comp-related decisions, they nearly always say no. It's time for that to change. We've reported here on research that reveals that salespeople at different points on the performance curve will respond to different incentives, and we hope that managers will Quarterly bonuses are especially important to laggards. At the other end of the performance spectrum, overachievement commissions are far more important. % Decrease in Revenue 0 Laggards Core Performers Stars 2 4 7 10 13 Without quarterly bonus Without Overachievement Commission rates 17 think about the implications for their firmsand follow that stream of research as it develops. But there's no reason to rely just on studies being done by academics. We hope that companies will develop their own field experiments and learn what works best for their salespeople. The first step for any company is to get a clear understanding of its own performance curve. Ideally, this would be done through sophisticated econometric methods, but an approximation can be obtained as follows: If you simply calculate each salesperson's performance against sales targets and then create a histogram of those data, you'll have a rough understanding of whether your company's curve is normal (mostly core performers, with about equal numbers of laggards and stars), laggard-heavy, or star-heavy. The shape of the curve will suggest which incentives will give you the most leverage. (If you have a disproportionate number of laggards, you'll want to focus first on pace-setting bonuses and natural social pressure, for example.) But remember, the existing sales culture can't be replaced all at once. Rather than set up a whole new comp structure, you should form a hypothesis about one element of the planthat your laggards would perform better with more-frequent pace-setting bonuses, perhaps. Design an experiment that includes both a treatment and a control group. Then pilot the change in just one part of the sales organization. Test one hypothesis at a time, in a limited pilot run. (For advice about how to do that, see \"A Step-by-Step Guide to Smart Business Experiments,\" by Eric T. Anderson and Duncan Simester, HBR March 2011.) Sales compensation plans that take into account the different needs of different salespeopleand that are based on real evidence rather than assumptionswill ensure that your sales department gets a significantly higher return on its investments. HBR Reprint R1207D July-August 2012Harvard Business Review75 Harvard Business Review Notice of Use Restrictions, May 2009 Harvard Business Review and Harvard Business Publishing Newsletter content on EBSCOhost is licensed for the private individual use of authorized EBSCOhost users. It is not intended for use as assigned course material in academic institutions nor as corporate learning or training materials in businesses. Academic licensees may not use this content in electronic reserves, electronic course packs, persistent linking from syllabi or by any other means of incorporating the content into course resources. Business licensees may not host this content on learning management systems or use persistent linking or other means to incorporate the content into learning management systems. Harvard Business Publishing will be pleased to grant permission to make this content available through such means. For rates and permission, contact permissions@harvardbusiness.org. SPOTLIGHT INSPIRE YOUR SALES FORCE SPOTLIGHT ARTWORK Bruno Quinquet Salaryman Project, International Forum Tokyo, 2009, archival pigment print How to Really Motivate Salespeople New research challenges conventional wisdom about the best ways to pay your team. by Doug J. Chung 54\u0007Harvard Business ReviewApril 2015 HBR.ORG Doug J. Chung is an assistant professor of marketing at Harvard Business School. April 2015Harvard Business Review55 B SPOTLIGHT INSPIRE YOUR SALES FORCE BEFORE I BECAME a business school professor, I worked as a management consultant. One engagement in particular had a profound influence on my career. The project involved working with the Asiabased sales force of a global consumer products company. This company practiced \"route sales,\" which meant reps spent their days visiting mom-and-pop convenience stores, servicing accounts. One thing about the organization surprised me: Its sales managers spent inordinate time listening to the reps complain about their compensation. The complaints were based on what the reps saw as a myriad of problems. Their quotas were set too high, so they couldn't possibly reach them. Or their territory was subpar, limiting their ability to sign new accounts. Sometimes the complaints focused on fairness: A rep who was hitting his quotas and making decent money would want a manager to do something about a \"lazy\" colleague who was earning outsize pay simply because he had a good territory. Imagine any conceivable complaint a salesperson might have about pay, and I guarantee that sales managers at my client's company had heard it. The reps weren't the only ones obsessed with the compensation system. The company liked to play around with the system's components to try to find better ways to motivate reps and boost revenue, or to increase the return on the money it spent paying salespeoplea large part of its marketing budget. This company's sales comp system was fairly basic: Reps earned a salary and a commission of around 1% of sales. The company worried that the system was too focused on outcomes and might over- or under-reward reps for factors outside their control. So it began basing compensation on their effort and behavior, not just on top-line sales. For instance, under the new system, a portion of compensation was based on customer satisfaction surveys, the number of prospective accounts visited (even if they didn't buy), and the retention of existing accounts. Largely because of this consulting assignment, I became so curious about the best ways to compensate salespeople that I began reading academic articles on the subject. Eventually I pursued a PhD in marketing at Yale, where I studied the theory and practice of how companies can and should manage and pay salespeopleresearch I now continue at Harvard Business School. Although there are fewer academics studying sales force compensation and management than 56\u0007Harvard Business ReviewApril 2015 researching trendy marketing subjects, such as the use of social media or digital advertising, in the past decade it's become a fast-moving field. While some of the basic theories established in the 1970s and 1980s still apply, academics have begun testing those theories using two methods new to this area of research: empirical analysis of companies' sales and pay data, and field experiments in which researchers apply various pay structures to different groups of salespeople and then compare the groups' effort and output. This new wave of research is already providing evidence that some standard compensation practices probably hurt sales. For instance, the research suggests that caps on commissions, which most large companies use, decrease high-performing reps' motivation and effort. Likewise, the practice of \"ratcheting\" quotas (raising a salesperson's annual quota if he or she exceeded it the previous year) may hurt long-term results. Research based on field experiments (as opposed to the lab experiments academics have been doing for many years) is also yielding new insight into how the timing and labeling of bonuses can affect salespeople's motivation. In this article I will take readers through the evolution of this research and suggest the best ways to apply it. With luck, this knowledge not only will help companies think about better ways to compensate salespeople, but also might mean that their managers spend fewer hours listening to them gripe about unfair pay. The Dangers of Complex Compensation Systems Researchers studying sales force compensation have long been guided by the principal-agent theory. This theory, drawn from the field of economics, describes the problem that results from conflicting interests between a principal (a company, for instance) and an agent hired by that principal (an employee). For example, a company wants an employee's maximum output, but a salaried employee may be tempted to slack off and may be able to get away with it if the company can't observe how hard the employee is working. Most incentive or variable pay schemesincluding stock options for the C-suite are attempts to align the interests of principals and agents. Commission-based plans for salespeople are just one example. HOW TO REALLY MOTIVATE SALESPEOPLE HBR.ORG Idea in Brief THE RESEARCH In the past decade, researchers studying sales force compensation have been moving out of the lab into the field, doing empirical analysis of companies' pay and sales data and conducting experiments with actual reps. THE FINDINGS Companies sell more when they remove caps on commissions; \"ratcheting\" raising a rep's quota after a good year dampens motivation; and a pay system with multiple components (such as various kinds of bonuses and commissions) can engage a broad range of salespeople. THE IMPLICATIONS Many companies use experiments to improve pricing, marketing, and website design. Because sales compensation is a large expense and sales force effectiveness is a primary revenue driver, companies should apply analytics and experimentation to find better ways to pay and motivate their salespeople, too. Salespeople were paid by commission for cen- formula of straight-line commissions (in which salespeople earn commissions at the same rate no turies before economists began writing about the matter how much they sell) is generally the optimal principal-agent problem. Companies chose this way to pay reps. They argue that if you make a sales system for at least three reasons. First, it's easy to measure the short-term output of a salesperson, un- comp formula too complicatedwith lots of bonuses or changes in commission structure triggered by like that of most workers. Second, field reps have hitting goals within a certain periodreps will find traditionally worked with little (if any) supervision; commission-based pay gives managers some con- ways to game it. The most common method of doing that is to play with the timing of sales. If a salespertrol, making up for their inability to know if a rep is actually visiting clients or playing golf. Third, studies son needs to make a yearly quota, for instance, she of personality type show that salespeople typically might ask a friendly client to allow her to book a sale have a larger appetite for risk than other workers, so a that would ordinarily be made in January during pay plan that offers upside potential appeals to them. the final days of December instead (this is known as During the 1980s several important pieces of re- \"pulling\"); a rep who's already hit quota, in contrast, might be tempted to \"push\" December sales into search influenced firms' use of commission-based systems. One, by my Harvard colleague Rajiv Lal January to get a head start on the next year's goal. While a very simple comp plan such as the one and several coauthors, explored how the level of uncertainty in an industry's sales cycle should influ- advocated by Holmstrom and Milgrom can be ence pay systems. They found that the more uncer- appealing (for one thing, it's easier and less costly tain a firm's sales cycle, the more a salesperson's pay should be based on a fixed salary; the less uncertain the cycle, the more pay should depend on commission. Consider Boeing, whose salespeople can spend years talking with an airline before it actually places an order for new 787s. A firm like that would struggle to retain reps if pay depended mostly on commissions. In contrast, industries in which sales happen quickly and frequently (a door-to-door salesperson may have a chance to book revenue every hour) and in which sales correlate more directly with effort and so are less characterized by uncertainty, pay mostly (if not entirely) on commission. This research still drives how companies think about the mix between salaries and commissions. Another important study, from the late 1980s, came from the economists Bengt Holmstrom and Paul Milgrom. In their very theoretical paper, which relies on a lot of assumptions, they found that a To get the optimal work out of a particular salesperson, you should in theory design a compensation system tailored to that individual. April 2015Harvard Business Review57 SPOTLIGHT INSPIRE YOUR SALES FORCE How to Create a Sales Comp Plan Sales compensation plans need to support a company's strategy; motivate a broad range of performers; be fair and simple to explain and understand; and result in payouts that are within a company's budget. Here are the steps sales managers must take to design a plan that meets those criteria. STEP 1 SET THE PAY LEVEL This is crucial for attracting and retaining talent. STEP 3 DESIGN THE PLAN STEP 2 BALANCE SALARY AND INCENTIVES The proportion of earnings that comes from salary and from incentives determines the riskiness of the plan. The proper balance varies by industry and is often based on the degree of certainty that a salesperson's efforts will directly influence sales. Metrics Most companies still pay salespeople a commission based on gross revenue, although some companies pay on the basis of profitability of sales. Plan Type Many companies supplement salary and commissions with bonuses based on exceeding quotas or reaching other goals. STEP 4 CHOOSE PAYOUT PERIODS Payout Curve Caps on earnings limit the pay of top performers and flatten the payout curve (or make it \"regressive\"); accelerators or overachievement commissions ramp up the pay of top performers, creating a \"progressive\" structure. Companies can set quotas and bonus structures to cover periods ranging from a single week to an entire year. Research shows that shorter payout periods help keep low performers motivated and engaged. STEP 5 CONSIDER ADDITIONAL ELEMENTS Many companies use nonmonetary incentives, such as contests or recognition programs. SOURCEADAPTED FROM THE POWER OF SALES ANALYTICS, BY ANDRIS A. ZOLTNERS, PRABHAKANT SINHA, AND SALLY E. LORIMER to administer), many companies opt for something more complex. They do so in recognition that each salesperson is unique, with individual motivations and needs, so a system with multiple components may be more attractive to a broad group of reps. In fact, to get the optimal work out of a particular salesperson, you should in theory design a compensation system tailored to that individual. For instance, some people are more motivated by cash, others by recognition, and still others by a noncash reward like a ski trip or a gift card. Some respond better to quarterly bonuses, while others are more productive if they focus on an annual quota. However, such an individualized plan would be extremely difficult and costly to administer, and companies fear the \"watercooler effect\": Reps might share information about their compensation with one another, which could raise concerns about fairness and lead to resentment. So for now, individualized plans remain uncommon. Concerns about fairness create other pressures when designing comp plans. For instance, companies realize that success in any field, including sales, involves a certain amount of luck. If a rep for a softdrink company has a territory in which a Walmart is opening, her sales (and commission) will increase, but she's not responsible for the revenue jumpso in essence the company is paying her for being lucky. But when a salespe