Beth Carroll | Prosperio Group
When it comes to sales compensation plans, people tend to “know what they know.” And because of this myopia, they also don’t know what they don’t know—failing to recognize the different approaches to calculating sales commissions that may be available to them. For this column, I’m going to focus specifically on sales commissions (that is, paying an incentive that’s a percentage of revenue or gross margin) rather than goal-based incentives, banks, bounties, or any number of other perfectly viable methods that exist for paying sales compensation.
To those who “don’t know what they don’t know,” this may feel like it’s going to be a very short column. After all, as I was asked at the 2011 TIA Capital Ideas Conference in Orlando, Florida, “How hard can it be to develop a commission plan? What? You just figure out if it should be 5% or 6%?” If it were only that easy! But even when we narrow the focus of our discussion to JUST commissions, there are still at least three basic methods of determining the fundamental pay rate, and then three different calculation models you can use to “do the math.” Combined, this gives you nine fully different methods you can use to calculate a commission payment, and there are probably more that I’m not thinking of.
First, the basic calculation involves how you will deliver any kind of fixed pay and determine your effective rate. You will understand why I’m using the term “effective rate” when we get to the second part of the discussion, which will be in my next column. Let’s start with some basic brokerage economics. In the world of spot market truckload brokerage1 it’s desirable to have 5% operating or net income. This is considered a healthy business level and is roughly the same as 95 OR on the truckload carrier side. If you have $1 million in revenue (just to make the math easy—scale up for your own business), then 5% net income is $50,000. If you have 15% Gross Margins (as many brokers do), you will be generating $150,000 in Gross Margin to allow for $50,000 in Net Income. $50,000 in Net Income is 33% of the $150,000 Gross Margin. This means you have $100,000 (or two-thirds of your Gross Margin) available to run the business. It really doesn’t matter that much how this is divided up, but you can’t have your total compensation and operating expenses exceed 67% of your Gross Margin and retain a 5% Net Income level (again assuming 15% margins—change it up if you need to for your reality).
Much inherited wisdom suggests that about half of the remainder should be allocated to cover compensation expenses—with the other half for things like TMS fees, rent, utilities, insurance, etc. This is why so many of the original cradle-to-grave brokers that paid 100% commission used rates that are between 25% and 35% to pay their brokers.
Let’s say you can afford to pay 40% of the Gross Margin out to your staff for their compensation expense (wages + taxes, I usually count benefits in the operating expense bucket). You can’t pay all of this to your sales staff, or you won’t have anything left to pay for accounting, HR, IT, management, marketing, etc., so you decide that 20% is the right amount to allocate for sales resources, allowing another 20% to cover all your support resources. OK, you’ve now tackled the cost of compensation from what is called a “Cost of Sales” approach.2 You have decided that your cost of sales can be 20%. But you will need to pay something in the way of fixed compensation to get anyone to agree to work for you, so how do you do that?
Option #1: Pay a Draw Against the Commission
In this method, you take production times 20% and then subtract any advanced payment (draw) made before paying the difference. If production was $20,000 for the month and the draw was $3,333 (equivalent to $40K annual salary), then the math works as follows:
$20,000 x 20% = $4,000 – $3,333 =
$667 Paid in Commission Above the Draw
Option 1 is mathematically pure and therefore very appealing to CFOs. You know with 100% certainty that you are always retaining 80% of the Gross Margin, provided the draw is considered “recoverable.” This means that if a month happened when the draw was not covered, then the negative is carried forward and must be covered the following month, as follows:
$15,000 x 20% – $3,000 – $3,333 = Negative $333
The negative is added to next month’s draw, meaning $3,666 needs to be covered before payout happens. As should be pretty obvious, this can become a downward spiral very quickly and tends to lead to very high turnover rates among new employees who have a bad month or two and get themselves into an ever-deepening hole. I say to the CFO in this instance, “what you THINK you are saving from the precision economics of this deal is blowing right out the door in recruiting and training costs.”
Under either the draw or the seat cost approach, a raise in salary means an automatically higher threshold. When you decouple them, you now have TWO motivational tools at your disposal instead of just one.
You can, of course, phrase the draw as “non-recoverable” so you don’t carry the negative forward. What you have really created then is a salary + commission plan that has a threshold. The threshold in this case is $16,665 in Gross Margin, as this is the amount that must be produced to cover the draw and start earning any incentive. You are really paying 0% commission below $16,665 and 20% commission on all dollars ABOVE $16,665 (check the math—you’ll see it works!).
One of the biggest challenges with this approach is the “push me—pull me” that results between getting the draw level high enough to compete with market salaries, while considering the limited production ability of new hires and the need to cover their draw relatively quickly. This tension tends to push commission rates higher, so the draw is covered faster and can lead to astronomical payouts for top producers and overall problematic economics for the business.
Option #2: Calculate a “Seat Cost”
& Pay Commission Once Seat Cost Is Covered
This may, on the surface, seem the same as Option 1, but it is pretty different and usually leads to a more attainable threshold production level with the benefit of a fixed salary for recruiting. In this method, a multiple of the salary (which often includes allocation for overhead) is used to calculate a threshold below which no incentive pay is earned. Once the seat cost is covered, then commission turns on. For example, if we used 3x the salary of our $40K earner, the monthly threshold is $10,000. A commission rate of 6.67% for all dollars above $10,000 would yield a total payout of $4,000 for the month at $20,000 in GM$ (the same as in Option 1).
$20,000 – $10,000 Seat Cost = $10,000 x 6.67% =
$667 Commission + $3,333 Salary = $4,000 Total Paid
But you can see how the trajectory for higher performance is now reduced from Option 1. In Option 1, pay at $40,000 in production is $8,000 ($40,000 x 20%). Pay under Option 2 at $40,000 is $5,334. ($40,000 – $10,000 = $30,000 x 6.67% = $2,001 + $3,333 salary = $5,334). Your effective rate is now 13.34% and it will REDUCE at higher production levels until it reaches 6.67% (in math this is called the asymptote because it will approach ever closer but never completely reach 6.67% because of the salary). Under Option 1, your cost of compensation is ALWAYS 20%.
There is a third option still, and that is to break the mathematical connection between threshold and salary, and instead, set the threshold based on realistic production levels according to time in position. This can allow for new employees to get a taste of incentive compensation sooner (pay them a lower rate, of course), while giving them an understanding of career progression that aligns with performance and tenure. As they are in the position longer, their production threshold will increase (as it should), but they may also be able to achieve a higher commission rate once they get over the higher threshold. This method also allows you to reward top performers with salary increases that do not carry within them a negative consequence. Under either the draw or the seat cost approach, a raise in salary means an automatically higher threshold. When you decouple them, you now have TWO motivational tools at your disposal instead of just one.
In my next column, we will look at the various ways commissions can be calculated beyond just a flat rate and provide you with an understanding of the economic and motivational dangers of the most common approach.
Beth Carroll is the founding partner of Prosperio Group, a business consulting firm that focuses on the strategic management of compensation for global transportation and logistics companies. Beth is based in Chicago, Illinois and has more than 20 years’ experience developing incentive compensation plans for companies across the globe in a variety of industries. Prosperio consultants have completed projects with more than 175 transportation and logistics companies. Beth can be reached at 815-302-1030 or via email at email@example.com.
1 These ratios do not apply to managed transportation, LTL, contracted freight, heavy haul, or specialty freight or any heavily technology-enabled brokerage business model.
2 Cost of Labor is the alternative approach that looks predominantly at the market value of the job and pays the prevailing wage rate that is required to attract and retain top employees. Production is looked at secondarily to ensure that enough is produced to justify the cost of compensation.
Image credits: nicemonkey/Shutterstock.com. Graphics courtesy of Prosperio Group.