Compensation Plans

Compensation Graphic
"Compensation plans are one of the great mysteries of the car business. We believe that if we pay managers on a performance indicator, and the manager has control of the people and processes involved, they will make the number move in the right direction. There is significant research on this subject and I aim to explain some of the more enlightening findings in this post."

We are a High Paying Industry

There is a lot at stake in hiring the educated and well-trained employee. It is interesting to note that a lot of us tend to see good performance as a "black box" and that some manager's "have it" and some don't. If I am managing a dealership, I want to surround myself with managers that "have it". The question is, do we need to search for and hire these people or can we develop them? If we need to search, how do we interview them and check their references to find out if they "have it"?

We know what it means to say a manager "has it" but it would be great if we could teach that type of performance. I am fairly confident in my knowledge of what makes dealership employees motivated and on what gives them line of sight (an employees ability to see how their actions and decisions lead to desired outcomes), that I believe I can make a store successful with everyone on salary. In fact, this is optimal in certain economic situations described as excessively "noisy" or in stores with low governance.

Why we need a Board of Directors

An effective Board of Directors is paramount to assist us with important decisions. And depending on who is elected, and their experience and skill level, they can be relatively inexpensive.

It is important that we take the role of our Board of Directors seriously and ask experienced, successful industry professionals to join us. I believe this is of paramount importance to help us navigate the risks associated with the growth of our business. Its as simple as "many heads are better than one."

It is also important to have people with automobile dealership experience on our Board. We can have our attorney and CPA on our board (if we really want them) but the rest should be experts in different aspects of operating successful automobile dealerships. We need those people that talk about and write about: 1) how to get the most out of your team, 2) protect your assets, and 3) minimize the risks you face.

The Board provides us with Governance. Governance refers specifically to the set of rules, controls, policies and resolutions put in place to dictate corporate behavior. Currently we hear about governance in the area of Data but governance applies to all aspects of the dealershp's operations. In fact, how we should compensate our people depends on the level of governance in our organization. If we have good governance, then we formulate your compensation plans one way; if we have poor governance, we should do it another way. This is why we might have someone in our twenty group tell us that a specific pay plan doesn't work at their store while it has always worked for us. Different organizations need different compensation plans depending on the style of management and level of governance.

Whether or not we have good governance in our organization determines whether actions by our employees are observable or unobservable (hidden). This can be seen when firms hire leaders from other industries that have little knowledge of automobile dealerships. Often these leaders have little going for them other than their authoritarian nature and the fact they were successful in a large organization. They may in fact not have the education, skills or training to understand the actions of employees and hence all actions would need to be considered unobservable in the absence of a strong governance. An interesting case I have seen is that of a CFO who was continually confronted with employee theft in his business offices. The CFO had one office in his organization in which three separate accountants stole over $100,000 each in a 10 year period. There were also two other business offices that had thefts (defalcations) as well during his tenure.

Experienced and trained CFOs understand systems and internal controls that make the results of actions by all employees observable. They implement reporting systems that shine a light on all activity so we are not "in the dark." Poorly trained CFOs, such as the one mentioned above, find that all they can do is blame the hiring process or employee moral fiber in the industry or region in general. When employee actions are effectively hidden to your executives due to the executives lack of experience, we end up with moral hazard which is a significant risk in the rough and tumble world of making dealerships successful.

Finding people that "have it" is a challenge and how to conduct the search, interview and hiring is mostly in the HR area. I recommend though, at a minimum, that our Board of Directors conduct group interviews of high level executives such as General Managers, Fixed Operations Directors and General Sales Managers. This assumes we have talented industry professionals on our Board.

How We Talk about Compensation Planning

In 2016, the Nobel (Memorial) prize in Economics was awarded to Oliver Hart and Bengt Holmstrom for their fundamental contributions to contract theory. Contract theory deals with the fundamental problem of economic cooperation. In addition, contract theory analyzes the optimal design of incentive schemes ("contracts") that induce the involved parties to behave more efficiently.

Logically, we cannot constantly monitor our employee's actions. The risk that the employee will shirk a responsibility, make a poor decision, or otherwise act in a way that is contrary to our best interest is significant. With today's reporting systems however, and the right access to your DMS' data, we can minimize that risk and improve our chances that our compensation plans work. This is the benefit of good governance.

Employee compensation should generally be understood through the dynamics of contracts and incentives and how a we can make sure our agents (employees, attorneys, CPAs, consultants etc.) do what we expect. This is known as the Principal - Agent model and although the details can be daunting, I will endeavor to illustrate how they should influence our thinking. The following key points will provide a foundation:

  • Communication of your expectations - Employee's guessing at how you want things done or even what you want done is to be discouraged. Your expectations should be communicated often to your top level executives and they should in turn communicate with their teams.

  • Employees produce output - Employees are hired to produce output in exchange for compensation. A salesperson's output is unit sales. A General Sales Manager's output is gross profit. An employee can have several outputs required by his employement such as good CSI, strong growth rate, gross profit and customer retention.

  • The Principal - Agent Problem - This is a formal observation in this area of economic research that says an employee may act in a way that is contrary to the best interests of a the owner. This is a significant risk for us. We see it often with poorly designed incentive plans. For example, if an F&I Manager is not charged for cancellations in their pay plan, then they may use the ability to cancel as a closing tool. The responsibility is on us to create incentives for the employee to act in a way that is in our best interest.

  • Reporting is Important - Our management reporting systems must allow drill-down to the individual level. For example, if we do not observe data on individual performance but only data on the performance of the team, then each employee of the team has an incentive to free-ride on the efforts of the other team members.

  • Signals are everything - Output is one signal and effort is another signal. We should pay on both and in such a way that removes payment on "noise" or "luck." Noise stems from paying on such indicators such as gross profit, which depends on the manager’s effort but also on other factors that are often random such as the economic conditions. Relative pay schemes (eg., your pay is determined by your performance rank on a sales team) tend to remove noise based on economic conditions. Large dealership groups can use this for higher executives as well. If you have good reporting systems always factor in a compensation on a signal of effort. These can include a subjective evaluation bonus or the number of dealership promotions conducted, etc.

Practical Applications In Our Stores

The contracting view of manager's compensation assumes that pay is used by us to solve the agency problem. Simple models of the contracting view predict that pay should not be tied to luck or noise which is defined as observable shocks to performance beyond the employee's control. Under this contracting view, pay is used to reduce the moral hazard problem that arises because manager's often have very little equity in the dealerships they control.

If we reward our manager on performance only (eg. gross profit), then if the noise factor is bad (say a recession) we may be punishing a hard working manager or, if the noise factor is good we could be rewarding a lazy manager. Employees won't put in much effort either way since their effort will tend to be overwhelmed by the noise, whether good or bad.

Do you have stair-step bonus plans? Think linear because stair-step bonus programs are prone to gaming if the employee is near the next level. It is interesting that some manufacturers tend to use stair-step incentive plans for the dealer and then scream loudly if gamed.

Relative pay plans mentioned above work well to eliminate noise but only if employee ability should be similar. If the salespeople, for example, come in different ability levels then relative pay means that neither the high ability nor the low ability agents will work hard. The high ability agents know that they don't need to exert high effort to win and the low ability agents know that they won't win even if they do exert high effort. Use signals (indicators) of effort in all compensation plans and you can have a bonus on relative rank as well.

The basic formula for the optimal compensation is: Compensation = Base Pay + a*Output + b*Effort. Don't forget the importance of an indicator of effort to include in compensation. It can be as simple as hours worked. The relative weights a and b will depend on the risk the employee is willing to take and the reward they will demand for that risk. And how much the output indicator and the effort indicator fluctuate (their variance). Sometime it makes sense if you can't come up with a measure of effort (with the right individual in the right job) to just pay a salary.

The Importance of Feedback

I am listening to the book Superforecasting by Phillip Tetlock and Daniel Gardner and they illustrate the importance of feedback in assuring an individual's improvement in any endeavor. In particular, they report that Police think they are very good at figuring out if someone is lying. It turns out they are not. Studies have been done on this and the reason is that they do not get feedback in a reasonable length of time as to whether or not they are correct in their original assessment. Only after a lengthy trial or a plea deal might they get some indication. Many times however, such feedback may be incorrect, too late or uncertain at best. My point is that a big part of successful performance regardless of compensation plan is immediate feedback.


In a future bog post, I will talk about reporting on these signals or indicators and also reporting on the employee actions that lead to them. This will insure the governance part that makes compensation planning so powerful.

A big part of our practice is not only setting up effective compensation plans, but also setting up reporting systems and automating them for automobile dealerships. With the opportunities presented by CDK Global (and other DMS') to access your data, we can automate reporting using email and presentation system's such as Microsoft's SharePoint (a part of Office 365) and others. These reporting system's can be current up to the latest 15 minutes.

Talk about getting the most out of your team! Call me (702 498 8777) to discuss opportunities for your team.

John Donnelly Intials

"Leadership is affirming people's worth and potential so clearly that they are inspired to see it in themselves" - Stephen Covey