Breakage: MLM Compensation Planning

Sep 3, 2014Compensation Plans

by Michael L. Sheffield

Over the years, the most common question asked by our new clients regarding their MLM compensation plans is “What is the total commission we can expect to pay on our compensation plan?” My answer is always the same. “It depends on the style and structure of the plan (and subsequent MLM corporate software) and the distributor performance qualifications necessary to receive various income opportunities. (This article is one in a series by MLM compensation plans consultant Michael L. Sheffield on this and related topics.)

I have interviewed many of the top MLM software companies regarding what they see as the average “breakage” in various styles of compensation plans. Breakage is defined as unearned and unpaid commissions. These are commissions that do not get paid and, thus, increase the company’s eventual profits.

The consensus suggests that the average unpaid commissions of a traditional style plan are usually in a range of 10% to 15%. Any more than that and distributors will lose confidence in the compensation plan. It is important that the independent distributors believe the plan as fair and they can achieve various levels of profit if they work hard enough.

As MLM compensation plans mature, breakage acts as a control factor that can be altered to increase or decrease payout. This may delay the need to drastically alter the plan’s basic structure. Typically distributors must meet specific achievement and maintenance qualifications each pay period in order to qualify for various sources of income in the plan.

For example: An MLM compensation plan offers its distributors a 20 percent retail commission based on the suggested price and pays its bonuses on the balance of 80 percent. This is defined as BV or Bonus Volume.

Of the 80% of retail, the company offers a unilevel compensation plan structure based on five levels (the downline members personal sales) of 8 percent BV per level, paying out up to 40 percent.

Then there is a generation component offering another 5 percent of BV through four generations (the group volume of a qualified downline member at a specific rank) for a total of up to 20 percent. It is also important to point out that most plans require certain production qualifications in order to gain the additional depth of income stream on the downline levels or generations.

While totaling the BV percentages in our example indicates a combined exposure of 60 percent, historical observation indicates that the majority of independent distributors in the direct selling and MLM industry work part time or are possibly passive distributor/consumers. As a result, they achieve income in the lower levels of the compensation plan and will most likely never participate in the generation bonuses. Since part of the potential bonus volume percentage is never earned by that individual distributor, and it reverts back to the company as “breakage”. If you are new to MLM compensation plan development strategy, and all this seems a bit confusing at first, stay with the program because “breakage” will become an important factor in your ultimate corporate success.

Long Range Planning

Also, as is customary in the development of compensation plans, the rank attainment and bonus maintenance qualification become increasingly more difficult to attain as the distributor advances in the plan. While this may seem a bit unfair on the surface, it is important that you understand that plans that succeed in the long run are designed to reward workers who contribute to the growth and success of the company with significantly increased income potential. This usually happens by redistributing some of the unpaid commissions from non-performers to people who are being rewarded for their personal and group productivity.

Since the majority of distributors are working part time or are passive distributor/consumers, they earn a lower percentage of the available income. This contributes to distributors collecting about 10 to 15 percent less than the maximum potential payout suggests.

This would lead one to ask, “ Why not design a plan that pays out exactly the maximum amount that the company can afford?” The answer has to do with properly packaging the opportunity to not only be competitive but to look competitive as well as other financial considerations. The image package is an important factor in development of compensation plans because the compensation plan model will be compared to other competitive opportunities. Your plan must compete cosmetically as well as in actual financial potential with your competition’s offering if your company to attain stability and retain its distributors.

This can be compared to the retailing strategy of a product priced at $9.95 rather than $10.00. The price is basically the same but the customer will generally buy the $9.95 product. In addition, if a company’s bonus payout did not have the flexibility of “breakage”, it would be more difficult to reward the best distributors based on their level of sales and sponsoring contribution.

Also, the plan would be forced to show much lower potential and, thus, would appear to be less lucrative than plans incorporating breakage into their compensation plan model.

In general, the distributors that are the best business builders suffer the most because the company would not be able to shift some of the potential income to them based on lower earnings by marginal performers. Anticipating breakage at the lower levels of the plan where most of the part time distributors and distributor/consumers participate, allow the company to offer an enhanced income opportunity for those that truly perform.

Using Compression Wisely

Most companies incorporate a concept called “compression” in their plan. Compression occurs when distributors fail to meet the required qualifications for receiving bonuses. The non-qualifying distributor and customer volume available in their downline will compress to the next qualified person in their upline.

Typically, compression in a compensation plan is mandated by professional MLM distributors that are evaluating a company. It is important that the concept of compression is used wisely and that it rewards the desired distributor behavior.

Allowing income to compress to non-producers creates a “something for nothing” attitude. Using compression to extend the depth of income stream for business builders based on specific performance can redistribute some unpaid income wisely while still allowing for desired breakage percentages.

The concept of recruiting a master distributor should be addressed at this time. We have seen many cases where a top distributor has negotiated a master distributorship position. A master distributor is normally one person at the top of the entire distributor organization, possibly trapping all the breakage percentages.

This windfall potential for the master distributor can spell disaster for the company if it was not planned for in advance.

I am not suggesting that you shouldn’t create special financial opportunities to attract top performers. It is just a warning to plan for it in your compensation plan strategy if you decide to limit the width of direct company legs.

Adjusting The Plan

Corporate executives or industry consultants cannot totally predict how much a plan will pay, but a properly designed plan can be adjusted quite easily and with very little pain for the current distributors.

Changing the compensation plan, while sometimes necessary, tends to cause concern among distributors. There are several specific things that can create the need for a plan change.

  1. The plan is paying too much. There is too little profit for the company.
  2. The plan is not paying enough. There is too little profit for the distributor.
  3. Competition dictates changes to stay current with trends.
  4. The plan is not encouraging the right distributor behavior.
  5. There are changes in laws or legal interpretations of laws by federal or state agencies.

If the design and general structure of your compensation plan is based on time tested and proven concepts still valid in today’s marketplace, it should not require major adjustments for quite some time. However, only field-testing a new plan will allow you to make the necessary minor adjustments. These are easily handled by adjusting the distributor maintenance qualifications.

The most common reasons companies adjust their compensation plan are number one and two on the above list. This can only be determined through test marketing.

For new companies, test marketing can only be accomplished during a Pre-Launch period. This is usually considered to be the first six months of MLM business operations. Established companies can run financial models based on current distributor production information.

It is not uncommon to adjust the plan during this time based on the facts determined. If the plan’s qualifiers are too difficult, no one makes money so you will need to soften the requirements for earning various bonuses. If the qualifiers are too easy, your plan may mature too soon, creating a socialistic effect of spreading the wealth with no one making any serious money, including the company.

Plan For Success

In the case where the plan is paying too much too early, you could increase qualifiers while “grandfathering in” those present distributors at their old qualifier amounts for a certain period of time, but increasing it for all new applicants. Other than adjusting qualifiers to increase or decrease payouts, it is important to avoid major changes in a compensation plan too soon. This could tend to erode distributor confidence and create lost momentum.

In conclusion it is important that you have people you have confidence in to “Inspect What You Expect” as your business matures. They should be able to interpret the significance of sales activity, sponsoring activity, and distributor attitudes to assist in fine-tuning your business model.

Just as your chief financial officer (CFO) interprets your financial information, you must be able to interpret your distributor activity and commission information to understand where you company is headed.