How To Build Effective Channel Compensation Systems
What is Channel Compensation? Sometimes, suppliers get caught up
in thinking that channel compensation consists solely
of their back end rebate programs and market development
funds (MDF). These programs have a high level of visibility
since they show up clearly as line items on the supplier’s
income statement. To really understand a channel's
overall compensation, a supplier needs to consider
the front end margin that the channel earns in addition
to the back end programs.
Take for example, a supplier with sales of $100 million.
It is typical for suppliers across industries to provide
back end rebates in the range of 3% to 5%. Of course,
in some industries rebates can reach levels of 20%
or higher. In addition, there are often market development
funds or coop advertising programs that cost an additional
1%. At first blush, in our example, backend channel
compensation for our supplier costs approximately
$5 million on $100 million in sales.
If the channel adds a 20% front end margin to the
supplier’s $100 million in sales, total channel
sales are $125 million. When we add the $25 million
in front end margin to the $5 million in back end
programs, this supplier allows its channel partners
to earn a total of $30 million on $100 million of
its own sales. With the exception of special programs
such as financing, fees or other less common approaches,
this is a good baseline for determining whether a
supplier is over or under compensating a channel.
What Motivates Channel Behavior?
Before we launch a discussion into the appropriate amount
of compensation, we need to understand the role of compensation
and its influence on channel behavior. This requires
that we investigate factors that drive channel behavior.
Compensation is only one factor that drives channel
behavior. A supplier could offer a distributor huge
discounts and massive rebates with no impact at all
on behavior. Without understanding what drives the
channel's behavior, the supplier is at risk of overpaying
or underpaying the channel. Key factors, listed in
order of importance, include:
Customer Need - a reseller will source what its
customers require. This gets to the heart of the
channel's role. Most channel partners are not out
developing new applications. As a supplier, it is
likely that you are wasting your resources if you
are paying your channel to create need where none
exists.
Customer Demand - many suppliers have their own
sales force or sales tools to generate demand that
is then fulfilled by the channel. The best way to
ensure that a channel partner supports your brand
is to go out and sell it for them. A brutally honest
distributor manager recently summed it up this way
when he said to our client: “Why should we
bring in your line if you’re not going to
sell it for us!”
Product and Service Business Model - product
margins may be irrelevant to a channel that operates
primarily a service business. The importance of
a line to the channel’s business is a significant
factor in determining how much compensation it will
take to motivate behavior.
Customer Preference - this is similar to Customer
Demand however in this case, the customer is not
pre-sold but indicates a brand preference. Dealers
sell brands that their customers request. If a customer
asks for Brand A, all things being equal, the distributor
will sell brand A due to the switching costs.
Inventory investment - distributors sell what
they stock. It's an old school axiom that a “loaded
distributor is a loyal distributor.” Suppliers
must carefully consider whether to drive inventory
onto the shelf. Doing so increases the likelihood
of sale as distributors seek to turn their inventory.
Excessive loading, however, increases supply chain
costs both for the channel and the supplier and
erodes margins through forward buying.
Relationships- these play an important role in
determining the brands that a channel will support.
A distributor may simply like to work with a friendly
sales rep. A supplier may have good or strained
relationships with its channel partners. It often
comes down to a matter of trust. Suppliers can pay
less if they maintain good and trusting relationships
with their channel partners. In some cases, no amount
of channel compensation will overcome a poor supplier-channel
relationship.
Price - channels go for the sure sale because
their sales force compensation plans usually include
large variable components. Most channel sales reps
do not present a higher priced option if it puts
them at risk of losing the sale. When designing
a channel compensation system, it is necessary to
determine whether the system must compensate for
an offering that is priced too high or can reflect
an offering that is priced too low.
Each supplier must clearly understand its own position
relative to these factors. Only then can the supplier
develop a channel compensation system that pays the
right amount and drives appropriate behavior.
Four Key Questions
There are four key questions that suppliers should
ask as they develop their channel compensation programs:
Whom to pay?
How much to pay?
What to pay for?
How to structure the pay?
Who To Pay?
Not all channel partners are created equal. Suppliers
must determine whether to do business with many or a
select few partners. In addition, the supplier must
determine whether to do business with all types or just
certain channels. For example, in construction products,
should all suppliers do business with big box retail
and specialty distribution? These questions are at the
heart of a supplier’s channel strategy. A good
first step in the development of a channel compensation
program is to determine the right number and type of
channel partners.
The number and type of partners that a supplier goes
to market with impacts the amount of channel conflict
in the system. Conflict has a direct impact on channel
behavior since it impacts channel margins. As we've
noted previously, channel sales representatives are
compensated based on the margins that they return.
A reduction in margin due to excessive channel conflict
will erode selling effort by the channel. Other factors
that impact levels of channel conflict include:
Demand for the brand—channel partners will
sell what customers ask for and therefore strong
brands generate higher levels of conflict.
Distribution costs—products with low freight
costs are easier to ship across geographical boundaries
and therefore can generate higher levels of conflict
The Channel’s Business Model—some
resellers apply low product margins in order to
accelerate high profit service sales
When utilized effectively, compensation is an effective
tool for managing channel conflict. Channel compensation
manages conflict by paying partners that add value
on behalf of a line and not paying partners that add
little or no value. Compensation must be structured
carefully as the wrong type can actually make channel
conflict worse. This can be the case as when, for
example, a supplier with a leading market share causes
channel stuffing by using order quantity discounts.
Suppliers must coordinate their channel strategy
and compensation. A supplier with too many or the
wrong type of partners may end up using extra discounts
and rebates to manage its own conflict. This is an
expensive way to manage conflict and is a sure way
to erode profitability.
How
Much To Pay?
Suppliers continually question the discounts, rebates
and allowances that they provide to their channel
partners. “We must be paying that distributor
too much—Look at that brand new Lexus!”
Are the discounts too deep? Can or should we cut rebates?
What will happen if we raise price?
An important first step in determining how much to
pay a channel is to identify the “Target Street
Price” (TSP). This is the price that a supplier
needs in order to win or maintain the business with
the end user. The TSP is based on the value of the
supplier’s offering relative to competition.
This is also the price that should be the starting
point for channel discounts, rebates and other forms
of compensation.
Once the Target Street Price is identified, the supplier
can examine the following factors in order to determine
appropriate compensation levels:
Competition—a good starting point is the
compensation programs that your competitors offer
to the channel. Do not copy competitor programs
however find out how much they pay.
Market Power—a supplier with a strong brand
can pay less for the same performance as a supplier
with a weaker brand. To understand this, consider
the discussion above as to why resellers or other
channels sell what they do.
Cost of Performance—we need to determine
what we expect our channel partners to do in exchange
for the compensation that they earn. If it costs
a distributor 25% to sell to small customers, we
will have a hard time motivating them with 15%.
Cost however, is not the total picture. A supplier
with a very strong brand can motivate the distributor
to perform distribution functions while paying less
than the cost of those functions. In this case,
weaker brands end up subsidizing the channel’s
cost. This is one of the key benefits of a strong
brand.
Switching Costs—channel partners often
make large investments in a supplier’s line.
These investments include physical inventory and
years of accumulated support for a line. Suppliers
should understand their channels’ switching
costs in order to determine the amount of channel
compensation to pay.
Value—a supplier may value certain behaviors
by its channel partners and pay for that behavior.
For example, a supplier may target a certain vertical
market and provide deeper discounts or bigger rebates
on sale into that space.
What
To Pay For?
A discount off of list price carries an expectation
that a channel will perform certain functions in exchange
for that discount. Typically, when a supplier provides
a discount to a distributor, it expects that the distributor
will sell, inventory, market and support the supplier’s
line. There are cases, however, when a supplier does
not need its distributors to perform all of these
functions. If a supplier has a direct sales force
that generates demand in the market and fulfills through
distribution, the supplier does not need to pay the
channel for the selling function. Likewise, a supplier
does not need to compensate a distributor for carrying
inventory when most sales are drop-shipped.
A supplier may choose to drive channel behavior with
compensation. Channel partners are motivated by margin.
Watch the increase in days outstanding when you change
payment terms from 2% 10 days to Net 30. Compensation
can influence the way channels buy, inventory, sell
or support products or services. Typically, incentives
built into a channel compensation system range from
0.5% to 3% for each activity. These incentives are
often stacked so that programs can place as much as
5% to 15% or more at risk. These programs motivate
channel behavior and create separation across channel
members to manage conflict.
There are two places to look when considering what
behaviors to motivate with a channel compensation
system. The first place is to determine what end customers
value. If, for example, end users value local inventory,
then a supplier can pay its channel partners to stock
inventory in the field. A second place to look is
at the supplier’s own values. A supplier may
value that its channel partners provide point-of-sale
information or sell into selected vertical markets
and pay for those behaviors.
Each value in the channel compensation system should
be weighed against re-deployment of those resources.
For example, is 1% in market development funds a better
investment than using that 1% to hire more sales representatives?
Suppliers need to identify their own values and then
determine whether channel compensation is the most
cost effective way to drive results.
How To Structure The Pay?
The last question is how to structure a channel compensation
program to include the right mix of discounts, rebates
and allowances in the right order. This is the part
of the process that offers the highest potential for
creativity and differentiation.
Since a key goal of the system is to motivate channel
behavior, an effective channel compensation system
matches the form of payment with the structure of
the channel. Each form of channel compensation has
a unique impact on different channel types and levels
within a channel.
In order to determine the optimal compensation structure,
it is necessary to identify degrees of influence in
the channel. There are two key groups within the channel
that are involved—management and sales. Management
usually prefers incremental rebates over discounts
since they can be hidden from the sales force, used
to fund pet programs and pad profitability. When the
supplier provides rebates however, it typically keeps
prices higher or reduces discounts in order to cover
the rebate cost.
How channels account for rebates is another important
consideration relative to program structure. Rebates
do not always make it to their intended target. Rebates
issued to the channel at the corporate level may not
make it to the branch. Even if distributors allocate
rebates to individual branches, they may be lumped
in with those from other suppliers and lose their
impact.
Suppliers must also consider how channel partners
deploy different types of channel compensation. Distributors
can use rebates like cash. They can choose to invest
this money in the supplier's brand or conversely use
it to support competing lines. Many channel partners
simply choose to take rebate dollars out of the business.
In contrast to discounts or rebates, marketing allowances
or funds can be utilized to pay for specific activities
that require an investment by the channel partner
on the supplier’s behalf. Each of these factors
should be considered in order to structure an optimal
channel compensation system.
Summary
We understand that there are many factors that contribute
to the development of an optimal channel compensation
system. We often find that many suppliers simply tweak
their current programs of play “follow the leader”
due to the complexity of these factors. By carefully
considering these key questions:
Who to pay?
How much to pay?
What to pay for?
How to structure the pay
Suppliers can fundamentally alter the playing field
in ways that significantly accelerate their profit
and growth.
