Commissions 101 

Balancing Margins, Revenue, and Reward 

Over the past three months I believe I have had more calls regarding commission plans than anything else. In general these stem from a common 2010 occurrence: increased revenue but lower margins. What is typically happening is that management is pushing for increased revenue in the hopes of driving profit, but the commission structure is rewarding only top line or setting too low of a pricing floor - or both. There may be other profit-sucking issues such as operations processes that don't scale well with revenue or inaccurate cost accounting, but today we will just address the sales compensation portion.

Commission is an incentive to sell the right products, to the right customers, and profitably. We hope it will encourage our sales team to find new business too. Because we ask so much of commission, it makes sense to have multiple components. We will look at revenue, gross profit, and quotas.

Quotas

For this discussion we will look at two kinds of quotas: targets and floors. Target is the most common form of quota and usually turns up in revenue or accumulated gross profit goals. For most companies that the first dollar of revenue or profit often earns the same commission as the last one. To truly understand the purpose of a target, you need to apply its corollary: a floor. Floors are minimum expectations. They can apply to percentages or aggregates. When applied to revenue, passing a floor will trigger a new commission level. In gross profit models, we meet the floor on the way on the way down in competitive bidding. The following sections apply the quota/floor concept to commission calculations.

Revenue

Be careful what you wish for: high commissions on revenue often bring in unwanted business. It is important to balance revenue incentives against more practical elements such as gross profit. Consider making the revenue component of compensation low for account managers and higher for business development personnel. I prefer to account for revenue in the aggregate and distribute bonuses quarterly or annually. In the following example we will apply a quota as a floor that triggers the bonus.



The sales team above are all on the same plan. The important concept here is that bonus only kicks in when the quota is achieved and then it only applies to the amount above the quota. By adding a second quota tier we encourage more sales. Salesman A in this example not only exceeded her quota, she passed the second tier as well. So she received 1% bonus on revenue between $1M and 1.5M and 2% bonus on the amount over $1.5M. Salesman C receives no bonus for revenue, but he may have earned commission for his gross profit on projects.

Gross Profit

Because gross profit can vary from project to project and we want the sales person to focus on maximizing each order, commissions on GP should be calculated on a project basis. GP incentives can also have tiers, but it is first more important to make sure that different types of revenue (or channels, or verticals, or product lines) have an appropriate margin expectation. In the example below, the company has set "floors" for each revenue type. A floor is the minimum margin the salesperson is allowed to sell. In some projects a lower margin may be appropriate, but that decision will come from a sales manager.



The project in the above example was sold for 3% above the equipment margin floor - a commission-able $300. To that we apply a 50% commission or $150 paid to the salesperson. The labor was sold below floor (we can alternatively say this is below cost because the floor is generally defined as cost plus burden or overhead) and therefore earns no commission. Given that the profit margins on labor should be much higher than equipment, we expect to pay a higher commission when quotas are exceeded.

These are very simple examples that could apply to systems integrators or rental-stagers. Integrators have an additional tool in that they actually know what the cost of their equipment product will be. Rental companies have to work with a blended cost for equipment, which is less scalable and more difficult to track accurately and fairly. In etiher case there are applicable refinements that are specific to the type of business you operate.

There are many other issues to consider such as, whether Sales people are commissioned on what they sold or how the job turned out? Or, how often do you revise commission/bonus plans? Should you pool commissions? For these issues we consider the company culture and processes before choosing a solution. Perhaps the biggest challenge of all is for companies to accurately track what their costs are on a project basis. And that, is a discussion for another day.

Questions/Comments?