How to Avoid Perverse Incentives in Your Sales Compensation Plan

Mar 30, 2022

What do cobras, Colombian cars, and salespeople have in common? Not much, but they have all fallen victim to a perverse incentive — also known as the "Cobra Effect" — when a well-intended incentive backfires, often worsening the very thing it was intended to improve.

Over $1 trillion is spent on sales incentives every year in the US — think commissions, bonuses, and sales contests. These incentives are meant to align salespeople's behavior with business goals but can have the opposite effect if not carefully planned.

It's shockingly easy for a perverse incentive to emerge, motivating salespeople to go against corporate interests and costing businesses tens of millions of dollars.

As a sales compensation technology company that deals in sales compensation plan design, we see the impact of perverse incentives all the time. Confusing plan terms, conflicting priorities, and complex payout schemes all play a role in perverse incentivization.

Below, you will find some of the most common perverse incentives we see in sales compensation and learn the steps we take to help our customers get their incentives back on track.

What is The Cobra Effect?

The Cobra Effect got its name from a supposed incentive scheme set up by the British Imperial Government in Delhi. To control the local cobra population, the Government offered a cash reward for every snakeskin brought in. Enterprising locals began to farm Cobras instead of hunting, allowing them to "breed" cash. When the British found out and ended the incentive scheme, the farms released their cobras into the streets, resulting in more snakes than before the bounty.

There are countless examples of well-intentioned incentives leading to unintended consequences. In Hanoi, a similar situation occurred when the French offered a bounty on rat tails. They attempted to reduce congestion in Bogota by restricting odd-numbered license plates to certain days and even-numbered on other days. Bogotians bought more cars, leading to more congestion.

The most famous case of The Cobra Effect in recent years was the Wells Fargo account fraud scandal, where aggressive sales quotas drove some employees to open dozens of unauthorized checking accounts. At Fannie Mae, just a decade earlier, executive bonuses for increased earnings led many to artificially inflate earnings statements. The misapplied pressure to produce short-term gains resulted in long-term damage to shareholder value and profitability.

The Cobra in Sales Compensation

The primary objective of a compensation plan is to motivate sales reps to do what you want them to do to drive the business forward. Sales comp should be designed to drive the behavior that supports your business objectives.

When organizations get it wrong, it's usually for one of two reasons:

1. Solving for too many things.

People innately understand the power of incentives, particularly financial ones. The sales compensation plan — especially if it's historically produced results — can often become the go-to solution for solving any business problem.

When organizations try to solve too many problems using the compensation plan — rather than through coaching or other sales effectiveness drivers — the program quickly becomes a bloated mess. The more incentives in the plan, the more likely a conflict will occur that produces unintended consequences.

Making an incentive isn't how you solve all business problems.

2. No second opinion

Another major cause of perverse incentives is when organizations fail to engage enough people to think through the implications of a new plan design. Humans have many natural biases, and it is very hard to self-identify them, especially when wrapped up in the business.

Getting advice from external consultants is one way to help mitigate this issue. Unless you have ongoing support from a provider like Forma.ai, this can be an expensive way to find out an incentive produces the wrong results long after it has had a negative impact.

Setting up the systems and KPIs to monitor the ongoing impact of the sales compensation plan is essential to identify perverse incentives before they impact the business. Gathering regular feedback from across the organization by surveying reps and sales managers is another way to help identify variable compensation issues before impacting revenue.

How to Avoid Perverse Incentives in Your Comp Plan

1. Avoid Individual Product Incentives

Reps in mature sales organizations often carry a portfolio of products. Based on their customer's needs and pain points, they will promote more of a certain product over others.

Some compensation plans are designed to encourage salespeople to sell multiple products. For example:

Each product or category is its own metric that carries a certain weight.
Reps must hit all (or most of) their product quotas to be eligible for a commission payout or to hit their accelerator.

Product-specific incentives are commonly used when new products and services are added to the plan or product managers make a case for a product to have its component in the core plan.

There are a couple of major risks to this incentive plan structure.

Salespeople Dropping Products

If sellers achieve their quota on one product line or SKU, they'll often stop selling it to customers or significantly reduce the effort they put into selling it to focus on hitting their other targets.

In other words, they are no longer focused on maximizing total sales for the business. This likely isn't the behavior you want to encourage. It can slow revenue growth and reduce customer satisfaction because your customers may not always be getting sold the best product for their pain, but instead the one that will help the rep hit their quota.

This very problem occurred in the early history of Xerox. A poorly planned comp structure unintentionally encouraged salespeople to sell their older product line at the expense of their new, vastly superior machines.

Demotivating Your Sales Team

It is significantly harder to hit multiple quotas across multiple products than a simple revenue quota. Experienced sellers know it, so when handed a compensation plan with various product quotas, they are far more likely to lose steam early in the year, causing sales to drag and morale to fall.

2. Plan Individual Product Incentives Carefully

Assuming you care more about total sales than individual product sales, in aggregate at least, it's crucial to think about the implications of setting individual product quotas and how they will affect rep behavior and your company's overall performance.

While not entirely against individual product quotas, we must think carefully about how and when they're used. Sometimes there is a solid business case for pushing a new product, but that needn't mean changing the core plan. Consider pursuing the goal through better management, more training, or a short-term incentive like a SPIF or kicker.

The best way to ensure individual product incentives don't negatively impact the rest of your plan is to look at historical performance when designing the plan and use that data to model the financial implications of the proposed changes.

For example, if you want to consider the implication of individualizing product quotas, use last year's results to see how many reps would hit their quota under this new plan and how much it would cost in payouts. If possible, use multiple years of data to get a more accurate model.

3. Stop Capping Commissions

We've discussed why setting commission caps is a bad idea before, but we still see many companies using them.

Commission caps make sense at first glance. How else can a business limit the impact of a windfall sales event?

Finance teams, who are often key stakeholders in designing compensation plans, are often the first to push for caps. They may have been burned in the past by poor plan design or quota setting that caused an overpayment (in their mind). Their solution to cap all plans is not the answer.

Commission caps send the wrong message to your sales team. Even if no one is likely to hit the cap, knowing a cap is in place drives your best sellers away. It can also cause misbehavior and unprofitable gaming as reps hoard sales till the next year or quarter comes around to avoid getting capped and to maximize their earnings.

The best way to remove commission caps from your plan while limiting the risk to the business is to use your data.

Analyze historical data to gauge how often sellers would reach the cap threshold. What are the cost implications if the cap were removed? Knowing that it's likely tied to exceptional performance, can you live with them? Often, the overall benefits to the business and revenue growth still outweigh the costs, as high as they may appear to be to finance teams.

If you are still concerned, consider adding a decelerator instead. A decelerator (reducing commission % level at a certain threshold) still rewards reps for going above and beyond but manages the financial risk.

If you're concerned about that one windfall or bluebird deal that comes in once a year, it's simple enough to insert a separate clause to handle that issue.

If the cap exists because you are struggling to set quotas accurately — avoid trying to fix your quota issues with the plan design. Fix allocation separately (we'll cover this in detail in another article).

Other Incentives to Avoid

A couple of other perverse incentives have grown in popularity in recent years that we strongly encourage you to avoid.

Customer Satisfaction Incentives

Setting "customer satisfaction" as a payout metric may make sense at first glance.

Yet, in many cases, it encourages sales reps to seek satisfaction at the expense of sales. Even if you can tie customer satisfaction to increased sales meaningfully, it's best to save this incentive for your customer support reps.

Team Incentives

Team incentives have grown in popularity recently to encourage teamwork and a better sales culture. However, the reality is that not all sales reps will produce the same results.

Team incentives often encourage low-performing sales reps to sit back while top performers pick up the slack. Over time, this will irritate your top performers, creating resentment amongst team members and increasing their likelihood of leaving.

Sales Incentives Are for Selling

Several design issues arise when companies try to solve problems with their incentive plan.

We frequently ask our customers in this situation: is this problem even an incentive compensation problem?

Companies often overlook non-monetary levers to address sales challenges. Throwing money at the problem only works if you're throwing it at the right issue. When organizations default to fixing issues with sales compensation, they overcomplicate their plans and create perverse incentives that could go unnoticed for months or even years.

Incentive plan design changes should never be looked at as a "quick fix" to a business problem. When you embark on changing the comp plan, act out and analyze the possibilities beyond the compensation committee or finance team. Poke holes, get feedback from others and use historical data to forecast the impact.

Wherever possible, try to predict the negative behavior a new incentive could drive to mitigate any damage it may cause to the business. Like water, sales reps will take the easiest route to the highest earnings, regardless of the business impact.