Third Quarter 2014
Direct Salesforce
Versus Independent
Representatives:
A Strategic Choice Across
a Business Life Cycle
T
Pankaj M. Madhani, Ph.D.
ICFAI Business School
he salesforce represents a significant investment for
most organizations. U.S. companies alone spend an
estimated $800 billion on their salesforces each year
(Zoltners, Sinha, and Lorimer 2008). To improve profitability, many organizations have begun to scrutinize the
role of their salesforces and their overall compensation
costs. In properly designing a pay structure, the HR/
compensation manager, in consultation with the sales
manager, must determine how much pay should be
fixed (salary) and how much variable (commission).
The structure and composition of a salesforce varies
widely from one organization to another. The organization must adjust its overall systems to fit with
changing external and internal environments (Madhani
2010a). The salesforce compensation strategy should be
adjusted to support the organization’s changing business life cycle and structure as well as external factors
such as customers, territory and competitive response.
Rebalancing of fixed and variable pay in the compensation structure offers HR managers enough flexibility
to deal with market variability and organizational
changes. Business life cycle stages are likely to be a
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key determinant of compensation strategies and their effectiveness in achieving
organizational goals.
A salesforce structure of an organization must be well organized if it is to
effectively sell the products and services and satisfy customer needs. Salesforce
structure decisions influence how customers see the organization and affect the
selling skills and knowledge level required of salespeople. That, in turn, affects
the recruitment, training and compensation structure of the salesforce. Each organization must structure its salesforce to fit the unique needs of the organization
and its management (Aspley 1956). If the salesforce structure is adaptive, the sales
organization can react quickly to market dynamics without a major structural overhaul and disruption of the selling process. Salesforce structuring is considered an
art, as organizations do not have scientifically developed algorithms for optimal
salesforce structure decisions (Madhani 2012).
DIRECT SALESFORCE VERSUE INDEPENDENT REPS
Sales outsourcing refers to shifting an organization’s sales activities in part or as
a whole to an independent third party (Ross, Dalsace, and Anderson 2005). By
outsourcing a sales function, an organization uses external resources to limit its
risk exposure. Turning fixed costs of a sales organization into variable costs is
one of the most important reasons why organizations outsource the sales function. Sales employees who contract their services are called an indirect salesforce,
manufacturers’ representatives or independent reps; those who are employees of
the organization are generally called an in-house or direct salesforce. They can
be further classified as inside or outside sales reps. Inside reps almost always
operate from within the company premises, performing sales calls and support
functions. Conversely, outside reps perform their duties outside the company,
which involves traveling and visiting customers. Independent reps will have a
portfolio of products that are complementary, but not competitive. Independent
reps or agents represent almost 50% of the business-to-business and upper-channel
sales (Barrett 1986) and more than 37% of all customer contacts by manufacturers
(Churchill, Ford, and Walker 1997).
Organizations with complex, heterogeneous, high-margin products and long
sales cycles are more efficient with direct salesforces. Similarly, a large number of
geographically distributed and widely dispersed customers, frequently ordering
small quantities, may be more efficiently served by several independent reps
than by a direct salesforce. Since independent reps carry multiple products and
are known in their territory, they are frequently able to penetrate a geographical
market quicker.
The use of direct salesforces is associated with large organizations, larger average
orders, more complex products requiring technical service and less standard products (Anderson 1985). If the product is of low unit value, standard, well-accepted in
the market, ordered in small quantities and/or frequently re-ordered, independent
Third Quarter | 2014
17
reps may be the best choice (Powers 1991). The independent reps are a better
choice when the product is new and has no established demand, or the product
is infrequently purchased (Hawes, Strong, and Winick 1996). There is a considerable debate on reconsideration of direct salesforce vis-à-vis independent reps in a
salesforce structure (Taylor 1981). Hence, this research looks into this aspect and
studies the impact of a business life cycle on the choice of salesforce structure.
SALESFORCE STRUCTURE ACROSS A BUSINESS LIFE CYCLE:
AN INTRODUCTION
Choosing the proper salesforce structure of direct salesforce versus independent
reps depends on customer or product characteristics as well as stages of a business
life cycle. The more influence a salesperson has on the sale, the more important
is a direct salesforce for the organization.
As shown in Figure 1, the startup and decline stages of the business life cycle
are characterized by low growth and profit potential while growth and maturity
stages of the life cycle are characterized by high growth and profit potential.
Accordingly, independent reps are preferred in startup and decline stages while
Figure 1 | Growth Potential and Salesforce Structure Across a Business Life Cycle
Growth and Profit Potential
High
Growth Stage
Maturity Stage
Startup Stage
Decline Stage
Low
Independent Reps
Sales Structure
Source: Matrix developed by author
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Direct Salesforce
direct salesforces are preferred in growth and maturity stages. In the startup stage
of a business life cycle, there is a lot of uncertainty and business risk. Business
risk is a central determinant of an organization’s value in terms of the present
value of the risk-adjusted future profit. It is affected by various parameters such
as price, variable costs, operating costs and the stability of demand (Halil and
Hodgin 2003). Business risk has a negative impact on the operation or profitability
of an organization. A business risk can be the result of internal conditions, such
as high fixed operating costs, and external conditions, like a change in demand
for an organization’s goods and services (Madhani 2010b).
As business risk is high during the startup and decline stages of a business life
cycle, sales organizations should keep low operating leverage. (See Figure 2.) The
degree of operating leverage (DOL) is a function of the organization’s cost structure
in terms of the relationship between fixed costs and total costs. An organization
that has high operating leverage will also have higher variability in earnings than
a similar organization with low operating leverage. The more operating leverage
(fixed costs/total costs), the more profits will vary with changing sales revenue.
Figure 2 | Relationship of Business Risk and Operating Leverage Across a Business Life Cycle
Salesforce Structure
Independent Reps
Growth Stage
High
Maturity Stage
Startup Stage
Decline Stage
High
Low
Sales Revenue
Operating Leverage
Business Risk
Low
Direct Salesforce
Low
High
Source: Matrix developed by author
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In the growth stage, an organization’s operating income is increasing while
uncertainty and business risk are moderating. Similarly during the maturity stage,
uncertainty and business risk are low. While in the decline stage, uncertainty
and business risk are high again. Hence, during a period of low business risk,
high operating leverage is preferred while during a period of high business risk,
low operating leverage is preferred. Accordingly, independent reps are preferred
in startup and decline stages while direct salesforces are preferred in growth
and maturity stages of the business life cycle. Deployment of independent reps
will decrease operating leverage for an organization because they work on a
commission-only basis. Because a direct salesforce represents fixed costs for an
organization, its deployment will increase operating leverage.
By reducing the business risk, the cost of capital of the organization is also
reduced, thus increasing the economic value of the business (Madhani 2009).
Therefore, the independent reps are most preferred choice for the sales organization in an uncertain environment (Williamson 1979).
TYPES OF SALES ROLES: GENERALIST VERSUS SPECIALIST
Effective salesforce structure design involves finding the right balance between
generalized and specialized sales roles. Generalist salesforce structures are typically deployed in organizations that are either in their startup stage of the life
cycle, establishing their presence in the market, or in the decline phase, trying to
cut costs. During the startup stage, the independent reps have a strong influence
on the sales. However, for large accounts that buy on contract, independent reps
are usually less effective than a direct salesforce (Anderson and Trinkle 2005).
Organizations may employ a small in-house direct salesforce to service very large
or key sales accounts while permitting smaller accounts to be serviced by independent reps. Most startup salesforces structures are generalist, comprised of a
relatively small number of direct salesforce members who sell a narrow product
line to a limited number of target market segments along with a larger proportion
of independent reps. (See Figure 3.)
Similarly, during a decline stage of a life cycle, products are more efficiently
handled by independent reps or channel partners since their costs are lower and
less fixed. During the growth and maturity stages of a life cycle, a direct salesforce is preferred. As a business expands during the growth stage of a life cycle,
the salesforce has to call on prospects in a broader set of markets as the product
portfolio expands. This presents organizations with two challenges related to a
salesforce: specialization and size.
In a generalist sales organization, each representative or account manager sells an
organization’s entire, but usually limited, product line to customers who typically
are all in the same industry, thus providing a single point of business contact to
customers. Salespeople are expected to engage in all types of sales activities for all
of the products and sell to all customers. While in a specialist salesforce structure,
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Figure 3 | Salesforce Structure and Sales Roles Across a Business Life Cycle
Salesforce Structure
Independent Reps
Small
Big
Growth Stage
Maturity Stage
Startup Stage
Salesforce Size
Sales Revenue
Big
Direct Salesforce
Decline Stage
Generalist
Small
Sales Roles
Specialist
Source: Matrix developed by author
salespeople are expected to engage in a limited set of selling activities for only a
portion of the organization’s products and sell to only a certain group of customers.
Salesforces specialize in different ways such as by product, customer, geography or function within the sales process and vertical market, in which goods or
services are offered within a specific industry or specialized market. Specialization
by vertical market is recommended when a salesforce with deep industry knowledge represents a competitive advantage over a generalist salesforce. When an
organization plans to specialize, the choice of appropriate methods should be
dictated by overall sales strategy and stages of business life cycle.
Customer specialization makes salesforce structure more market driven and
focused on a select group of customers. Specialization by geography is the least
complicated. Salesforce specialization by function is illustrated by the delineation
between the “Hunter” and “Farmer” roles of the salesforce. Hunters typically focus
on new sales, while farmers cultivate current customer relationships. Depending
on stages of business life cycle, a salesforce structure may contain a mixture of
generalist and specialist roles.
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SALESFORCE STRUCTURE DURING VARIOUS STAGES OF A BUSINESS
LIFE CYCLE
Startup Stage
In this stage, the primary responsibilities of the salesperson is to overcome initial
customer resistance to the new product and focus on communicating product
performance. A higher level of product knowledge is required to explain the
benefits of the product to customers (Madhani 2011). When product demand is
uncertain, employing a direct salesforce is a risk. Deployment of independent
reps can help organizations better manage business risks because if they do not
perform as expected, their compensation in the form of commission is minimal.
A product launch always carries a certain level of business risk as profitability
projections are low and liquidity positions are strained. By engaging independent
reps for a product introduction, organizations can obtain a trained salesforce immediately and with virtually no fixed cost. Sales organizations in the startup stage of
a business life cycle are challenged to grow the business, yet often have limited
funding and face considerable uncertainty about the future. In this stage, outsourcing
is the preferred option. Independent reps are likely to be more effective than a direct
salesforce because they are skilled, experienced and create synergy for customers as
they offer multiple product lines. Independent reps visit a wide range of customers
to get them more interested in the product and are responsible for looking at the
early adopters. Independent reps can afford to call on small accounts because they
have multiple lines, thereby absorbing travel time between accounts.
Independent reps are a better option for small, seasonal or volatile products
and sparse territories where high travel costs may not warrant a direct salesforce. Startup sales organizations can enter markets rapidly by working alongside
independent reps who have sales expertise, influence over sales channels and
relationships with potential customers, which the startup sales organization cannot
replicate quickly enough with a direct salesforce. Deployment of independent
reps also helps the startup sales organization learn about the market in order to
successfully build its own direct salesforce.
Growth Stage
The growth stage is characterized by an organization rapidly expanding its niche
in the market. By this stage, the organization has achieved a degree of success,
largely overcome the previous concern for survival, and is exploiting expansion
opportunities. During the growth stage, the organization focuses on selling and
increasing product demand and market share. Large new investment is likely in
this period as the organization is growing in products, customers, sales volume,
geographic contact and number of sales employees.
In a growth stage, a direct salesforce is preferred when sales volume is high
enough that its overall costs are less than independent reps. As products are
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established in the market, repeat sales become a larger proportion of overall
sales and customers require service and support, adding to salesforce’s workloads.
As such selling and supporting tasks grow beyond the salespeople’s capacity to
perform their jobs, their companies need to set up specialist salesforces (Zoltners,
Sinha, and Lorimer 2006).
Maturity Stage
Direct salesforces classically are used by mature sales organizations with great
effectiveness because they are most efficient at selling compatible products to
one market. Hence, sales organizations are frequently structured into autonomous
divisions or profit centers, each with its own line of products and often its own
direct salesforce, responsible only for its product line. However, if such profit
centers simply cannot afford the fixed costs of a direct salesforce to provide
the necessary market coverage for introducing new products, they may deploy
independent reps. As the size and complexity of an organization increases, it
needs multifaceted, versatile and high-performing sales employees to face a more
competitive environment (Chen and Hsieh 2005). Such an organization may opt
for a direct salesforce if it can attract and hold salesforce talents, the market is
highly concentrated geographically, and it has very few customers or the sales
volume is large enough (Novick 2000).
The maturity stage is the relatively flat period in the business life cycle that follows
the rapid growth period. An organization at the maturity stage is experiencing
slower but more consistent growth in its market. In this stage, organizations have
stability and efficiency as their goals. As organizations mature, they focus more
on defending their existing market niches as products and services start to lose
their advantage, competition intensifies and profit margins erode. Organizations
emphasize retaining customers, serving existing segments and increasing the efficiency and effectiveness of the salesforce. During this period, the organization has
achieved the greatest economies of scale in its life cycle and is able to generate
steady and predictable profits. The environment becomes more stable and predictable in comparison with the growth stage.
Decline Stage
Although the maturity stage can be extended through proper management, internal
and external factors may, at any time, drive the organization into the decline stage
(Whetten 1980). During this stage, the organization begins to stagnate as markets
dry up and product demand decreases. The decline stage of the business life cycle
is characterized by a decrease in an organization’s resource base. In this stage, organizations are experiencing reductions in market share, reduced product demand and
even financial losses because of a variety of reasons, such as ineffective management
practices, changes in market environments and stiff competition. At this stage, organizations’ strategies emphasize retaining and serving existing customers and segments.
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When a revival is not likely and further decline is inevitable, a sales organizations
can only ensure that it remains profitable for as long as possible. Organizations
should use their salespeople to service the most profitable, loyal and strategically
important customers while discarding unprofitable product lines or territories.
In this stage, the size of the sales organization’s direct salesforce is generally
reduced substantially. The remaining salesforce should move from a specialist to
generalist focus, emphasizing value-based selling to large, profitable and strategically important customers or product lines. By using less expensive selling
resources, sales organizations can continue selling efficiently to some customer
segments. To preserve profitability, organizations should utilize independent reps
or selling partners to cover some market segments at less cost. Improving the
efficiency of a salesforce is critical. Organizations should use a generalist salesforce
structure when repeat sales are not the major portion of sales.
A DIRECT SALESFORCE VERSUS INDEPENDENT REPS:
An Economic Analysis
Using independent reps avoids the significant fixed capital costs and ongoing
costs of building and running a direct salesforce. A direct salesforce is difficult
to set up, slow to get up to speed and is predominantly a fixed cost comprised
of salespeople, sales managers and information systems. The cost of the direct
salesforce includes base salaries, 401(k)s, stock options, taxes and other fringe
benefits such as vacations, medical coverage and life insurance, training costs,
travel and other selling expenses and sales management overhead. On the other
hand, independent reps represent a variable cost since they are paid commission
on realized sales. Thus, if the product doesn’t sell, costs are minimal.
The decision whether to engage a direct salesforce or independent reps is generally influenced by the cost of serving the same level of sales. The convergence
of direct salesforce cost and commission paid to independent reps should play
an important role in the initial decision to use a direct salesforce or independent
reps. Such convergence is viewed in the terms of selling cost and sales revenue
and is stated by following formula:
Where:
OHd = Overhead cost of the direct salesforce
Cd = Variable pay (commission) of direct salesforce
Cr = Commission of independent reps
S = Sales revenue during life cycle of a business
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As shown in Figure 4, sales revenue changes across the life cycle of a business.
During the startup as well as decline stages, sales revenue (Ss or Sd) remains on
the lower side. During the growth and maturity stages, sales revenue (Sg or Sm)
remains on the higher side. Sales revenue during growth and maturity stages is
considerably higher compared to the startup and decline stages of the business
life cycle (Sm > Sg > Sd > Ss).
When this relationship is diagrammed in Figure 5, it can be seen that the cost of
independent reps (Cr) rises in direct proportion to increases in sales (S) because
sales costs of independent reps are primarily in the form of commissions (Cr).
Figure 5 represents the convergence of direct salesforce cost and commission of
independent reps for a mixed pay plan (variable pay along with base salary) of
a direct salesforce. In a mixed pay plan, the cost of a direct salesforce includes
sales overhead, such as base salaries and costs of sales support (OHd) as well
as commission (Cd) paid to the direct salesforce. The two cost lines converge at
point O, where the cost of the two salesforce strategies are equal (OHd + Cd =
Cr). Point O is also called the indifference point or break point and represents the
equilibrium of the sales commission (variable pay) paid to the independent reps
versus selling costs associated with a direct salesforce.
Therefore, based on a purely economic decision, during periods of low sales
such as in the startup or decline stages of a business life cycle, organizations
should use independent reps to gain sales at a lower cost as denoted by line
Figure 4 | Typical Stages of a Business Life Cycle
Business Life Cycle Stages
Startup
Sm
Sales Revenue (S)
Sg
Sd
Ss
Growth
Maturity
Decline
Time
Source: Chart developed by author
Where
Sm = Sales during maturity stage
Sg = Sales during growth stage
Sd = Sales during decline stage
Ss = Sales during startup stage
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Figure 5 | Salesforce Structure and Compensation Cost Across Business Life Cycle Stages
Where
Sm = Sales during maturity stage
Sg = Sales during growth stage
Sd = Sales during decline stage
Ss = Sales during startup stage
= Least cost path
Cr
D
Indifference
Point
Cd
Sales Compensation ($)
O
OHd
R
Ss
Sd
S
Sg
Sm
(Low Sales Revenue)
Source: Chart developed by author
(High Sales Revenue)
Sales Revenue ($)
RO and continue using them as long as their commission costs (Cr) remain
lower than the costs associated with a direct salesforce (OHd + Cd). As shown
in Figure 5, the least cost paths are RO and OD where the cost of a direct
salesforce is OHd + Cd.
Once the organization’s sales volume is high enough in the growth and maturity stages that the commission or variable pay paid to the independent reps
(Cr) is greater than the estimated total fixed cost and variable costs (OHd + Cd),
the organization should switch to a direct salesforce. If sales exceeded point
O, then the sales organization should convert to a direct salesforce to maintain
the lower costs as denoted by line OD. When sales revenue is low (as in the
startup and decline stages) and below the indifference point, independent reps
should be used.
This single evaluation, however, reflects only the economic aspect of the decision. Organizations should not choose a direct salesforce or independent reps
based only on these criteria. Other important non-economic factors in selection
of a salesforce structure are their relative performance in sales coverage/sales
generation and the costs/revenue effects during the process of switching from
independent reps to direct salesforce and vice versa.
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DIRECT SALESFORCE VERSUS INDEPENDENT REPS
An Optimal Scenario
As calculated in Table 1, considering independent reps instead of a direct
salesforce results in an increase in variable costs. It also results in decreases
in fixed costs, operating leverage and break-even point (BEP). BEP is a no
-loss, no-profit situation. Since using independent reps helps reduce BEP,
the organization can reach profitability faster. Table 1 demonstrates how
the break-even quantity and operating leverage will be lower for the sales
organization that has used independent reps instead of a direct salesforce.
If cost of coordination with independent reps is not considered, then fixed
costs will be zero and subsequently BEP will also be zero.
Table 1 illustrates the impact of employing a direct salesforce or independent reps on operating leverage and BEP. In the direct salesforce option, the
organization employs internal sales employees on a mixed pay plan (fixed
pay: $22,000, commission: 2%) while in the independent reps option, the
organization pays commission only at 13.94% of sales. The indifference, or
break point occurs at the sales volume of 60,000 units. At this point, the
costs of the direct salesforce and independent reps are equal (Scenario 1).
Below the indifference point, the cost of the direct salesforce will be higher
(Scenario 2) while above indifference point, the cost of independent reps
will be higher (Scenario 3). In comparison to a direct salesforce, the independent reps option offers a sales organization a lower degree of operating
leverage (DOL), lower market risk and its profits vary less with changes in
sales volume.
A critical requirement of such economic analysis is a complete and precise
estimation of the total fixed costs associated with the direct salesforce as well
as accurate forecasting of sales revenue. In the earlier illustration, certain
assumptions are made. It is assumed that a direct salesforce can achieve
an increase in sales volume with no increase in the number of salespeople.
Such analysis is a cost-based steady-state analysis. It means that the organization had either considerable slack resources at the beginning or there
was a large improvement in the organization’s selling efficiency over time. It
is also assumed that fixed costs associated with independent reps are zero.
However, some minimal fixed costs are still incurred with independent reps.
In reality, the cost curve will not vary directly with sales volume as considered in the illustration. Essentially, fixed costs of sales will increase with
increase in sales. Fixed costs are not fixed at a given level in perpetuity
(Guiltinan 1974). In fact, those costs are fixed within a range of relevant
factors such as sales volume or the number of customers. As the relevant
factor increases or decreases, the associated fixed cost changes as investment
must be made or reduced and is fixed again at the new higher or lower level.
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Table 1 | Salesforce Structure and Financial Performance: Various Scenarios
Step
No.
Salesforce
Structure
Calculation
Senario 1
Senario 2
Senario 3
Sales Organization
(At Indifference Point)
Sales Organization
(Below Indifference Point)
Sales Organization
(Above Indifference Point)
Direct
Salesforce
Independent
Reps
Direct
Salesforce
Independent
Reps
Direct
Salesforce
Independent
Reps
1
Unit sales (Monthly)
60,000
60,000
30,000
30,000
120,000
120,000
2
Unit selling price ($)
24
24
24
24
24
24
3
Unit variable cost
($)
12
12
12
12
12
12
4
Fixed pay (salary)
($)
22,000
0
22,000
0
22,000
0
5
Selling overhead ($)
150,000
0
150,000
0
150,000
0
6
Total Fixed cost =
(4) + (5) ($)
172,000
0
172,000
0
172,000
0
7
Variable pay (%)
2
13.94
2
13.94
2
13.94
8
Variable pay =
(1) x (2) x (7) ($)
28,800
200,800
14,400
100,400
57,600
401,601
9
Variable pay/unit
= (8)/(1) ($)
0.48
3.35
0.48
3.35
0.48
3.35
10
Total variable
cost/unit =
(3) + (9) ($)
12.48
15.35
12.48
15.35
12.48
15.35
11
Unit contribution
Margin = (2) – (10)
($)
11.52
8.65
11.52
8.65
11.52
8.65
12
Contribution margin
= (1) x (11) ($)
691,200
519,200
345,600
259,600
1382,400
1038,399
A Strategic Choice at Indifference Point
As calculated in Table 1, at indifference point there is no difference in choice
of direct salesforce or independent reps because the cost-to-sales ratios are the
same. However, magnitude and timing of cash flow will have major impact on
the liquidity position of the company. Independent reps usually bear all sales
expenses and are the manufacturer’s exclusive salespeople for a defined set of
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Step
No.
Salesforce
Structure
Calculation
Senario 1
Senario 2
Senario 3
Sales Organization
(At Indifference Point)
Sales Organization
(Below Indifference Point)
Sales Organization
(Above Indifference Point)
Direct
Salesforce
Independent
Reps
Direct
Salesforce
Independent
Reps
Direct
Salesforce
Independent
Reps
13
Contribution
margin ratio =
(11)/(2)
0.48
0.36
0.48
0.36
0.48
0.36
14
Total variable
cost = (1) x (10)
($)
748,800
920,800
374,400
460,400
1497,600
1841,601
15
Total cost =
(6) + (14) ($)
920,800
920,800
546,400
460,400
1669,600
1841,601
16
Total revenue =
(1) x (2) ($)
1440,000
1440,000
720,000
720,000
2880,000
2880,000
17
EBIT (earnings
before interest
and tax) =
(16) - (15) ($)
519,200
519,200
173,600
259,600
1210,400
1038,399
18
DOL (Degree
of operating
leverage) =
(12)/(17)
1.33
1.00
1.99
1.00
1.14
1.00
19
Decline in
EBIT on 20 %
decrease in Sales
= 20 x (18) (%)
26.63
20.00
39.82
20.00
22.84
20.00
20
BEP (Break Even
Point) = (6)/(13)
($)
358,333
0
358,333
0
358,333
0
21
Cost to sales
ratio = (15)/(16)
(%)
0.639
0.639
0.759
0.639
0.580
0.639
22
Strategic Choice
Depends on Magnitude and
Timing of Cash Flow
Independent Reps
Direct Salesforce
Source: Calculated by author
customers (Anderson and Schmittlein 1984) and usually do not take title or
possession of the product, which is usually shipped directly to the buyer or user
by each manufacturer (Heide and John 1988). Also, they are not paid when they
receive the sales order but are normally paid their commission when the product
is shipped or when the organization is paid.
On the other hand, direct salesforces are generally paid every month in base
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salary and commissions on pending sales. Therefore, deployment of independent
reps sharply improves the cash flow position of the company compared to a direct
salesforce. Especially for a long selling cycle, this can be a significant difference for
a sales organization with a direct salesforce since those employees are paid before
the sale is actually finalized. In reality, these amounts of commission and salary
paid during different time intervals are not the same, given the time value of money.
Figure 6 illustrates how these opportunity costs result in a decrease in cash
flow for an organization deploying a direct salesforce. An organization is selling
a complex, technology-intensive, big-ticket item to a government agency. The
selling cycle for this product is long and it takes eight months to close the sale.
The selling price of a product package is $500,000. The organization is evaluating
Figure 6 | Decrease in Cash Flow Caused by Using a Direct Salesforce
Option D
A
A
A
A
A
A
A
0
1
2
3
4
5
6
A
7
A
A
8
9
A
Time-line
PV = $47,483
Where A = Annuity
= $60,000 /12
= $5,000 (paid to salesforce as a salary in the beginning of each month)
Present value (PV) of this cash flow (annuity due) is given by following formula:
(1 - (1/ (1 + i)
PV = A x
n
))
x (1 + i)
i
Where i = 0.14/12
= 0.01167
and n = 10
Hence, PV = $47,483
Option I
$50,000
0
1
2
PV = $45,052
PV =
3
4
5
FV
(1 + i)
n
Where FV (Future value) = $50,000
i = 0.01167
and n = 9
Hence, PV = $45,042
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6
7
8
9
the options of a direct salesforce (D) versus independent reps (I). In option D,
the organization is hiring sales employees at an annual salary of $60,000. While
in option I, 10% commission is paid to independent reps on realized sales. The
weighted average cost of capital (WACC) for the sales organization is 14%.
Because the independent rep is paid the commission 30 days after the sale is
completed, that payment comes nine months after the sale was initiated. However
with the direct salesforce, this amount is paid as salary at the beginning of every
month, before the sale actually concludes eight months later. The difference in the
cash flow in this simplified example is $2,441 ($47,483 - $45,042), a 5.42% difference. Although the organization spends the same $50,000 amount, the payment
timing is different and causes a different cash flow. The lesson here is that all
dollars paid out are not the same; their value depends also on when they are
paid out.
An Ethical Perspective
Salespeople are recognized as the element of organizational function most likely
to find themselves in ethical dilemmas (McClaren 2000). If an independent rep
working on a commission-only basis takes a short-term view of sales by putting in
little effort while working dishonestly or unethically, he/she will be solely guided
by quick sales and will not be interested in building long-term relationships and
customer loyalty.
In this situation, the value of the business decreases as future cash flow and
profitability decline because of lack of repeat sales and decline in customer loyalty.
This situation is represented by Quadrant I in Figure 7. Quadrant I represents
dishonest or unethical behavior by a sales employee and is characterized by low
customer loyalty, low firm value and a higher proportion of variable pay. This is
also a reflection of low-level effort by sales employees as they focus on short-term
sales objectives for quick gains.
In the 1990s, incentive compensation inflicted great harm on the reputation and
integrity of Sears, Roebuck and Co. It was found by Sears that its automotive service
advisers, acting under a commission sales plan, were selling parts and services that
customers did not need. That behavior harmed both the customer and company
in the long run. Sears eliminated incentive compensation and instituted a noncommission program based on customer satisfaction (Bradley and Draeger 1994).
If a sales employee is motivated to act honestly, work hard and focus on
building long-term customer relationships and loyalty, the value of the business
will increase. This situation is represented by Quadrant II in Figure 7. Ethics is
a very important factor in the selection of a salesforce structure. Independent
reps’ commissioned-based compensation might motivate the salesperson to act
unethically to maximize sales. Pharmaceutical companies almost always use a
direct salesforce because of the ethical and accountability issues unique to selling
drugs (Making the Case 2002).
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Figure 7 | Relationship Between Pay Mix and Ethical Behavior of a Sales Employee
Pay Mix
Variable Pay
Long
Term
Fixed Pay
Quadrant - II
• Honest Behavior
High
• High Customer Loyalty
Firm Value
Sales Objective
• High Firm Value
Quadrant - I
• Dishonest Behavior
• Low Customer Loyalty
• Low Firm Value
Short
Term
Low
Ethical
Unethical
Sales Employee’s Behavior
Source: Matrix developed by author
OVERHAUL OF THE EXISTING SALESFORCE STRUCTURE:
SOME CONSIDERATIONS
As an organization’s sales increase, the decision of salesforce structure should be
based on many factors beyond cost. When switching from independent reps to
a direct salesforce, an organization will lose long-term continuity with customers,
which may result in some customers going to competitors. A direct salesforce also
provides less territory coverage. Interestingly, a study by Dartnell concluded that
the average stay of a direct salesforce within a given territory is only 22 months,
while for independent reps the time is more likely to be around 22 years (Kaufman
1999). This can be an indication of a stable and reliable service that independent
reps provide for the customers in a given territory.
A decision to shift from independent reps to a direct salesforce made purely on
economics can backfire. The qualitative factors such as special relationships of the
salesforce with customers, the trade-off between control and flexibility of the salesforce, and the short-term sales loss resulting from the switch should be considered.
Unless there are other compelling reasons for a sales organization to change
from independent reps to salesforce and vice versa, it is better to maintain the
salesforce structure. If after a thorough review of all economic and non-economic
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factors an organization decides to switch from independent reps to a direct salesforce, the transition should be done as quickly as possible because it is risky and
time-consuming. On the other hand, converting to a direct salesforce from independent reps is a slow, expensive process that incurs high initial costs, requires a
considerable commitment of overhead and takes time to generate returns (Zoltners,
Sinha, and Lorimer 2004). Therefore, organizations that demand quick returns on
investment may hesitate to convert to a direct salesforce from independent reps.
DISCUSSION AND RESEARCH IMPLICATIONS
To succeed in the long term, organizations must re-evaluate their salesforce structure
across the business life cycle. Salesforce structure decisions are likely to affect an
organization for many years. Salesforce structure is related to compensation management, distribution channels and territory management. No matter how well a sales
organization hires and trains its salesforce, inefficient structure during the life cycle
of the business will prevent the salesforce from reaching its full productivity.
It is difficult for organizations to isolate the effect of the salesforce from all the
marketplace factors that affect sales. Those factors include pricing, advertising,
sales promotions, changes in distribution, market needs and competitive behavior.
However, the salesforce is a strategic lever for improving sales growth, market
share and profitability. The salesforce represents expensive and important HR
assets for an organization because it requires full productivity to be competitive
in the marketplace. Management of a salesforce structure is a key factor and, if
implemented correctly, can act as a catalyst in synergizing the efforts of a salesforce leading to many positive outcomes such as increased revenue, reduced
compensation cost and enhanced profitability.
About 50% of North American businesses involved in sales use some form of
independent representative. Industries such as electronic components, hardware
and chemicals use independent reps for a substantial part of their business.
In times of recession and cost-cutting, the use of independent reps typically
increases. After the economic downturn of 2001, companies such as Intel, Texas
Instruments, Cirrus Logic and Hunt Wesson switched from a direct salesforce to
independent reps for some or all of their major product lines. Also many companies
chose to use independent reps after spinning off a division (e.g. the semiconductor
operation for Motorola and the Airpax for Phillips). (Making the Case 2002).
In the electrical as well as food service industries, 80% of businesses rely partially
or entirely on contract sales personnel (Weinrauch, Anitsal, and Anitsal 2007).
Waukegon, Ill.-based Cherry Electrical Products has had a very fruitful experience
working with an outsourced salesforce. Company officials estimated that building
direct sales organization from the ground up would cost about $5.7 million compared
to the $2.6 million it paid in independent reps’ commissions (Foster 2004).
An organization’s decision to serve a sales territory with independent reps or a
direct salesforces is evolutionary because as the business and its market change, the
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appropriate configuration of the salesforce structure should change. There are many
strategic issues in selection of salesforce structure: fixed versus variable cost-to-sales
ratio; type of sales territories (dominant versus marginal); availability of a trained
and experienced salesforce; product characteristics and order size, short-term versus
long-term selling approach; and the stability of relationships (Madhani 2012).
CONCLUSION
Salesforce structure refers to the differing roles that an internal salesforce (direct
salesforce) and external selling partners (independent reps) should play. Salesforce
structure is critical for an organization because it determines how quickly a salesforce responds to market opportunities, influences salespeople’s performances
and affects an organization’s revenue, compensation costs and profitability. An
organization that does not link evolving salesforce structure as it passes through
different stages of a business life cycle is placing itself at considerable risk in
implementing an effective salesforce management and compensation policy. While
organizations devote considerable time and money to manage their salesforces,
few focus much thought on how the salesforce structure needs to change over
the life cycle of a business. This research focuses on many economic and noneconomic factors for optimal choice of direct salesforce and independent reps
across the business life cycle. ❚
ABOUT THE AUTHOR
Pankaj M. Madhani, Ph.D. ([email protected]) earned his master’s degree in business administration
from Northern Illinois University, a master’s degree in computer science from Illinois Institute of Technology in
Chicago and a Ph,D. in strategic management from CEPT University. He has more than 27 years of corporate
and academic experience in India and the United States. During his tenure with corporate, he received the
Outstanding Young Manager Award. He is working as an associate professor at ICFAI Business School (IBS)
where he has received the Best Teacher Award. He is also recipient of the Best Mentor Award. He has published
various management books and more than 200 book chapters and research articles in several academic and
practitioner journals such as Compensation & Benefits Review and The European Business Review. His main
research interests include salesforce compensation, business strategy and corporate governance.
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