Stair Steps to Heavenly Savings

Manufacturers and retailers often use incentive programs to motivate their sales forces to perform. Volume-based incentives, which reward sales teams based on the number of units sold, are particularly popular; such incentives can boost unit volumes for the company, thus improving market share and creating economies of scale.

Unfortunately, if designed incorrectly, these types of programs can also wreak havoc on a company’s supply chain by causing unpredictable highs and lows in product demand. In their working paper, “Impact of stair-step incentives and dealer structures on manufacturers sales variance,” Kellogg professor Sunil Chopra and his co-authors Usha Mohan (Indian School of Business), M. Nuri Sendil (McCormick School of Engineering, Northwestern University), and Milind Sohoni (Indian School of Business) propose that by designing effective incentive programs, companies can create more predictable patterns of demand, which can allow a company to better capture cost savings across its supply chain.

When Incentive Programs Go Awry: The Chrysler Example

Car dealer volume incentives have long been part of the automotive industry, and auto manufacturers frequently introduce novel programs to catalyze dealer sales. Not all of these innovations, however, are successes, and indeed some dealer programs can have unintended negative consequences on both sales and operations. Examining how some incentive programs have gone awry can help any manager seeking to design a sales force incentive plan.

Consider the experience of the Chrysler division of DaimlerChrysler. In an effort to spur U.S. sales in 2001, the company offered dealers a “stair-step” incentive plan. For each dealer, Chrysler specified a monthly sales target. Dealers were then offered bonuses for fulfilling different percentages of this target, such as 75 percent, 100 percent, and 110 percent. Figure 1 shows how such a program works, using a hypothetical sales target of one hundred cars per month.

Figure 1: Example Dealer Incentive Program with Target of 100 Cars/Month

Dealers, Chrysler believed, had every incentive to climb these stairs and sell cars, but that is not what happened. Instead, sales dropped and Chrysler was left with the painful choice of piling up inventory or idling capacity, neither one of which is good for the bottom line.

Why did the plan fail? The company found that when dealers realized they could not reach their monthly goals, their sales efforts plummeted. Dealers waited for the next month—a new target—rather than push cars in a month for which the quota and bonus were out of reach. As a result, Chrysler sales cycled through booms and busts. Dealers would order fewer cars during months in which they felt they could not reach their quotas, but more cars during months where they felt they could. The result for Chrysler was an increase in the variability of sales numbers, as well as increased production and inventory costs which eroded profits for the auto manufacturer.

The Hockey-Stick Phenomenon

This may all sound painfully familiar to managers whose firms set quotas for their sales force. Often, nothing happens in the sales period until a manic rush of orders as the incentive period comes to close. Demand consequently follows a “hockey-stick” pattern of level sales followed by a sudden, rapid increase, as illustrated in Figure 2.

Figure 2: “Hockey-stick” Sales Pattern

Such behavior results in wide variances in work levels for the manufacturing and logistic operations. When orders are high, the manufacturer must pay its labor force overtime fees to produce the quantity desired. However, when sales volume is low, the company experiences low productivity rates, high inventory storage fees, and excess capacity. It is nearly impossible for manufacturing managers to forecast these sales swings and keep their plants operating smoothly. However, the lessons of a few auto manufacturers may offer insights to reduce such incentive-driven sales variances.

Four Mechanisms to Create Effective Stair-Step Incentive Programs

In designing sales incentive programs, executives must be cognizant of sales variance in order to manage costs. An effective way to minimize marginal costs is to achieve monthly sales numbers that are close to the forecast demand. When designed properly, incentive programs can help to increase the predictability of demand, and there are four mechanisms that managers can use to accomplish this objective, as seen in Figure 3.

Figure 3: Mechanisms for Creating Effective Incentive Programs

The first and most obvious mechanism involves setting realistic and attainable goals for the sales force. Too often, managers use “stretch” targets in order to push employees towards the upper range of achievable sales levels. High sales numbers are always desired, but firms must understand how sales representatives respond to such incentive quotas. Without realistic goals, incentive programs can result in higher sales variability and have a negative effect on profitability.

The second mechanism that firms can use entails extending their incentive horizons to align with the natural sales cycle and selling environment of their industry. In the auto industry, dealers previously had thirty days to reach quota, which was often insufficient to guarantee dealer effort. This was due to a natural seasonality in the car sales business with both busy months and slow months. By extending incentive horizons to a longer period of time (three months or more), automakers could allow dealers to weather a slow month and take advantage of a busy month to achieve sales targets. As dealers began to believe that their sales targets were attainable, they were willing to ramp up their sales efforts to pursue a bonus. This illustrates that extended incentive horizons can smooth out the manufacturer’s variability in sales. By designing an extended horizon that incorporates factors such as seasonality, their agent’s selling environment, and their agent’s ability to move product, managers can avoid the dreaded “hockey stick” effect on sales.

A third mechanism involves the use of rolling horizons. An alternative to the extended horizon, this mechanism creates an environment in which each month is alternately the first, middle, and last month in different incentive periods. To clarify this concept, consider an environment in which dealers have continuous incentive windows throughout the year. For example, March is the last month in the window from January to March, the second month in the window from February to April, and the first month in the window from March to May. In this scenario, the dealer is rewarded for maximizing his effort in the month of March, and in every other month, because the sales number affects three different incentive horizons. The result of such a program is a flatter sales forecast that minimizes the “hockey stick” effect. Such enticements for selling agents help the manufacturer both maximize dealer effort every month and minimize marginal costs by reducing sales variance.

The fourth mechanism consists of creating incentive systems that are particular to a specific product rather than to a wide array of products. For example, car manufacturers have used direct-to-consumer incentive programs that had one sales target for all models carried within a dealership. This unintentionally created an incentive for sales representatives to sell the model car that would make it easier for them to achieve their volume targets. As a result, the variances in sales from model to model and from month to month increased as dealers pushed different models at different times. Now automakers use incentive programs that have a different sales target for each type of model. By doing so, manufacturing variance for specific makes and models has been reduced, and the band of sales variance within the industry has narrowed considerably.

Conclusion

Selling agents will act in their best interests, and manufacturers must create incentive programs that fully support such action. Following its tumultuous experience with its initial incentive program, DaimlerChrysler revised its stair-step program by extending its windows and lowering its sales goals. As a result, the company has been able to capture cost savings in its supply chain by reducing sales variance.

Managers across the industry spectrum can learn from the experiences of automakers and establish incentive programs that create consistent and predictable selling patterns across their business. The result will be a significant reduction in manufacturing costs and the first step toward higher profits.