The Impact of Manufacturer Rebates on Channel Sales Behavior

How do your dealers, distributors or resellers pay their sales people? Most provide their sales reps a percentage of the margin typically in the 25% - 33% range. Arguably, this percentage of the margin encourages distributor sales representatives (DSRs) to sell products at the highest possible price. (For convenience we use the term "distributor" to apply to any channel partner. This includes dealers, resellers and other B2B channels).

Unfortunately, DSR compensation plans that pay a flat percentage of the margin are out of touch with the economics of many industries.

Margin-based comp plans did encourage DSRs to sell products that optimized overall distributor profitability when manufacturer rebates were much lower than they are now. Today, rebates in many industries start at 5% and range as high as 20% or more. While these rebates seem good for the distributor, DSR compensation plans drive behavior that undermines the potential benefit.

We must analyze the way distributors account for rebates to understand these economics. Generally accepted accounting practices require that rebates reduce a distributor's cost of goods sold. In effect, the rebates should increase the distributor's gross margin. This margin increase should translate into higher DSR commissions on the rebated products. Many distributors, however, hide the rebates from their sales force by booking the rebates as other income. Some distributors even account for rebates as increased sales.

This situation sets up two distinct entities within the distributorship-the sales force and the "house." The house guarantees its profits by hiding the rebate from the sales force. Under this model, the house is not overly concerned about street price because the compensation plan should encourage the DSR to sell at the highest price possible.

Unfortunately, DSR compensation plans can have the reverse of the intended effect. They may encourage DSRs to sell the least profitable products at the lowest available margins. Obviously, sales reps seek to maximize their own income. All things being equal, a sales rep will sell a product with a $250 commission over one that pays $200. A sales rep will also seek to minimize risk. The sales rep will support an item with a $200 commission and an 80% chance of sale over an item that has a $250 commission but only a 50% chance of winning. These risk assessments are usually made with incomplete information and DSRs often overestimate the risks associated with selling higher priced products.

The DSR faces competition on virtually every equipment sale and the DSR will sell at a price designed to minimize risk. Often this takes the form of a standardized mark-up of 10% - 15% over "cost." The DSR will not try to sell an item at a higher price for fear that a competitor will come in with a lower bid. The house isn't overly concerned because the rebate dollars on the back end ensure profitability.

The following example helps to illustrate the point. In the example, the DSR must choose whether to offer Product A or Product B:

	Product A	Product B
Street Price	$5,500	$4,950
Mark-up	10%	10%
Distributor Invoice Cost	$5,000	$4,500
Rebate %	10%	5%
Net Distributor Cost	$4,500	$4,275
DSR % of Margin	25%	25%
DSR Commission	$125	$112
Distributor Profit	$875	$563
DSR Confidence Factor	50%	80%
Risk Adjusted DSR Commission	$63	$90

A number of issues emerge from this situation:

An additional issue comes into play. Some distributors hide rebates from their DSRs while others do not. DSRs who work for distributors that hide the rebates are even less likely to promote a higher priced, highly rebated brand because they are frequently undercut by distributors that do factor rebates into the price. DSRs do not like to be embarrassed and if this happens more than once, the DSR may never support the brand with the higher rebate again.

It is clear that DSR compensation plans based on a percentage of the gross margin can undercut overall distributorship profitability. Distributors must develop compensation plans that optimize profitability in today's rebate-intensive market. This means that distributors must link DSR compensation to the rebates that they earn on each product line.

A simple approach is to provide a base percentage of the margin commission plus a factor that is linked to the rebate rate. For example, a program that paid the DSR 10% of the margin plus 2.5X the rebate rate as a percent of the margin would have the following impact on the example demonstrated above:

	Product A	Product B
Street Price	$5,500	$4,950
Mark-up	10%	10%
Distributor Invoice Cost	$5,000	$4,500
Rebate %	10%	5%
Net Distributor Cost	$4,500	$4,275
DSR % of Margin	35%	23%
DSR Commission	$175	$101
Distributor Profit	$825	$574
DSR Confidence Factor	50%	80%
Risk Adjusted DSR Commission	$88	$80

Under this scenario, the DSR is motivated to push a higher priced item that not only pays a significantly higher commission but also a higher commission after the confidence factor. Motivating the DSR to push the higher priced, more profitable product in this case increases the distributorship's overall profitability by over 40%.

Manufacturer rebates are an effective way to protect distributor profitability. Unfortunately, DSR compensation plans that do not factor rebates into the equation can seriously undermine a distributor's return on investment. We understand the desire for distributors to hide rebates from their sales force. However by doing so, the sales force may be hiding profits from the distributor and stealing sales from the brands that provide the optimal customer solution.