NET GAINS – Getting Real About Getting Paid

As a business school professor, my compensation is based in part on how satisfied my students are. The corporate world follows a similar logic. CEOs get paid based on how shareholders value their company’s stock. Companies such as Cisco Systems, Siebel Systems and Sun Microsystems link bonus compensation to customer satisfaction.

While most companies design employee compensation based on a “pay for results” scheme, they rarely apply the same logic to getting paid by their customers. When you think about how companies get paid for their products and services, you realize that it often has very little to do with customer success. Ideally, the more value you create for your customers, the more you should be rewarded. Value capture for the seller should be directly linked with value creation for the buyer. But that’s not what happens in practice.

Consider a commercial printing company that does direct-mail catalogs. The more catalogs it prints for its customers, the more it gets paid. Yet its customers define success in terms of the dollar sales generated per catalog mailed. From their perspective, the more effectively they target customers, the fewer catalogs they need to mail. So the printing company actually profits from the ineffectiveness of its customers.

Similar perverse logic applies to brokerage companies such as Ameritrade and E-Trade. They make their money on trading commissions, so they have an incentive to make customers trade more frequently. However, investment advisers will tell you that most investors are better off with a “buy and hold” strategy rather than trading frenetically in an effort to time the market. The more money that brokerage companies make from trading commissions, the less likely that their customers get superior returns.

Recognizing this problem, companies such as Charles Schwab and Merrill Lynch have moved away from commission-based compensation. Instead, they base their fees on a percentage of the client’s assets. But even this doesn’t align the client’s interest with the interest of the brokerage firm. Ideally, my broker should get paid more if I get superior returns on my investment. How about charging customers fees indexed to investment performance? Brokerage companies could agree to be paid based on their performance relative to a benchmark such as the Dow Jones Index or the Russell 2000. Mutual funds could base their fees on their percentile performance within a style class (value, growth or large cap). So why hasn’t any investment firm implemented this approach? Maybe it has something to do with the fact that investment advisers and actively managed mutual funds rarely beat indexes.

The IT industry suffers from the same problem. Enterprise software companies get paid based on the number of seats they sell, regardless of whether their software gets used and what people do with the software. Microsoft charges everybody the same price for Microsoft Office, regardless of what people do with the software. I have never used Access, and I have probably used less than 5 percent of the features in Excel. Yet I pay for all the features. The result: There is little incentive for software vendors to understand what features really add value and what business outcomes their customers are really trying to achieve.

IT consultants get paid based on time and materials. So the longer they stick around, the more money they make. Perhaps that is why, a decade ago, system integrators such as Cambridge Technology Partners shook up the market when they introduced a “fixed-price/fixed-time” model.

For What It’s Really Worth

But the winds of change are beginning to gather momentum. Last year, the Indian software company Wipro Infotech announced a “success fee” model, where it gets paid based on the value generated for the customer. The company fixes the price based on the value created for customers, and adds a premium if it completes the project before the deadline. Wipro is betting that it can implement software more successfully and faster than competitors, and that it will generate higher margins.

The advertising industry is also being shaken up by the move toward the payments by results (PBR) model. In PBR, a part of the advertising agency’s compensation is contingent on its performance measured on predetermined criteria. This throws out the time-honored practice of advertising agencies being paid 15 percent of the media spending budget of its clients. Companies such as Procter & Gamble are pushing to link agency compensation to outcome metrics such as sales, market share, advertising awareness and brand preference.

While service companies are at the forefront of performance-linked pay, product companies are also getting into the act. Hewlett-Packard has moved toward a flexible utility pricing model for its servers, where customers pay for only the resources they use. Its “partition pricing” scheme for its Superdome servers is based on the customer’s forecasted need for additional HP Superdome partitions and the timing of activation of the pre-installed partitions. IBM’s recent “e-business on demand” campaign is a move in the same direction.

To adopt a pay for results model, think through three issues.

• Understand how your customers define value and business success. Wipro’s customers may define value of a CRM project in terms of cost savings in customer interactions, total cost of ownership and execution time.
• Set up metrics and benchmarks for evaluating performance. For instance, brokerage companies may define metrics as risk-adjusted return and quality of customer service, and set up appropriate benchmarks. Such metrics need to be quantifiable and objective.
• Make sure that both you and your customer make significant commitments to the relationship. Both parties should have incentives to make the relationship work and not have the ability to hold the other party hostage. Vendors should ensure that they get deeply embedded into their client’s business so that they can extract a fair share of the value that they create. Conversely, clients should ensure that vendors invest in training, support and deferred compensation in order to have an incentive to stay in a long-term relationship.

In difficult economic times, customers are pressuring their suppliers to become more accountable for results. But the pricing mechanisms that most suppliers use are still based on the archaic notion that you get paid for selling a product or a service. The sooner you understand that you should get paid for creating value for your customers, the better positioned you will be to succeed in your business.