Corporate finance executives are by now well aware of the risks they run when relying too heavily on spreadsheets to support business performance management (BPM) activities as forecasting and planning processes expand. But an overreliance on spreadsheets in compensation management activities also poses a risk, according to Xactly Corporations's CFO Scott Broomfield.
In this risk chat, Broomfield argues that an automated compensation management process can limit these risks while introducing real-time visibility into the degree to which sales behaviors reflect management priorities.
Eric Krell: What are the primary financial risks in sales compensation, and why is proper compensation management critical for CFOs and risk managers?
Scott Broomfield: There are three risks. The first is compliance. You have to show that the company has proper internal controls. For example, in the typical software company, 70 to 80 percent of the cost structure is salaries. In sales, variable compensation is as much as 50 cents on the dollar -- meaning if you pay a base of $100,000, there will be a $100,000 variable compensation cost. If you have 10 salespeople, that's a million-dollar cost center. If you don't manage this cost center correctly and accurately, you run the risk of having a material control weakness.
The second risk is error rate, which is largely a derivative of control weakness. Gartner estimates that the error rate on a spreadsheet for a larger company is anywhere from 3 to 8 percent. Run that against a million-dollar cost center -- which, again, is a company with just 10 sales reps -- and you have an $80,000 error rate. When you automate compensation processes you eliminate this error rate, and with it, a tremendous amount of risk.
The third risk revolves around financial forecasting. When you're forecasting, you are signaling an earnings-per-share number to investors. If you're managing compensation in a spreadsheet, there's a risk of having a large error in your variable comp accrual, which can cause your earnings per share number to be materially off. Speaking as a CFO, this is a finance person's nightmare.
What are ways to reduce risk in sales compensation?
Broomfield: Principally, you need to automate the compensation management process and get rid of spreadsheets. First off, your error rate goes virtually to zero because you leverage automatic data entry and rules-based calculation to ensure accuracy, eliminate over- and under-compensation payouts, and lower the risk of commission claw-backs. You are also able to use built-in compliance rules to ensure that transactions meet federal audit requirements. Plus, you have a full audit trail and access to transaction details. On the efficiency front, you are able to accelerate compensation processes and ensure a smoother monthly and quarterly close.
Automating also integrates sales and finance at a fundamental level as the two groups work together to establish the rules that the system uses to determine compensation. Variable compensation is a strategic business tool, and the rules baked into a compensation system reflect what the company wants its sales reps to do.
With the spreadsheet model, reps typically receive a check several weeks after quarterly close, along with a spreadsheet report that shows how they were paid. This is too late to positively influence sales behaviors. Conversely, with automation, they can have real-time visibility via the Web into how they are going to be paid when they do certain things -- things that align with management expectations. This kind of visibility changes behaviors and boosts sales performance in ways that the after-the-fact spreadsheet-based model cannot begin to touch.
What are some tips for designing a better compensation plan that alleviates risk, while maximizing results?
Broomfield: Clearly it's a balancing act. You need all the data and insights you can get to design a plan properly and avoid paying too much or, worse, de-incentivizing your reps. Here are some example considerations.
Let's say that management wants $10 million in bookings and you share that number with the board. A quota plan has to be devised to drive that $10 million, but the quota plan is invariably going to be larger because you always want some space as a risk mitigation factor between the quotas you will comp your sales team at and the number you expect to attain. So the first consideration is: What will be the difference between the quota number and the attainment number -- 10 percentage points, 20 percentage points, etc. -- and why?
Second consideration: Should you put in a linear rate of attainment from the first dollar up to attainment? Or perhaps, should it start from the 50 percentile up to attainment? Or, should it start from a different base? Third consideration: Once you hit either attainment or quota, should you bake accelerators in at quote or at attainment? Fourth consideration: What should the accelerators be and how many of them should there be? For example, should you have an accelerator that's, say, 15 percent once they hit quota? Should it be 30 percent? 50 percent?
All these questions have to do with balancing risk and performance, and it's a complex endeavor. You need to ensure that reps get enough lift so that once they hit their quota they'll still work hard. There's always a bell-shaped curve of performance within a sales organization. If you design the compensation model such that when the person that hits quota stops the effort, you will never attain the mid-part of the bell curve because there are always salespeople that don't hit quota. But you also don't want to be throwing money around needlessly.
The best way to truly discover what it takes to drive optimal performance with the least amount of risk is to have historical data and a way to analyze it, so you can see what worked, what didn't, and why. And it helps to have this data not just for your own company, but for companies across your industry and of similar size. Then, once you've made your decisions, you want a way to model them to prove their effectiveness and a way to accurately forecast commission expenses.
Inaccurate forecasting presents a major risk. If you have a sizable number of reps and a great quarter, the expense shortfall can be huge and may even result in a restatement, if you are a public company. And on the flip side, if you can't accurately forecast commission expenses and the sales team underachieves, you can still end up paying in excess of forecast due to accelerators in individual salespersons' plans.
The only way to effectively do all of this -- collect and analyze information, model your decisions, and accurately forecast expenses -- is with an automated system. You cannot get there with manual spreadsheets or guesswork, and it's simply too risky to try.