The Economics of Commissions: Part 2

Beth Carroll | Prosperio Group

In the last issue of 3PL Perspectives, we looked at the three basic methods for calculating a commission relative to a production threshold: draw, seat cost, and threshold. Now we will look at the ways you can calculate the commission itself. There are also three methods to consider: flat rate, retroactive rate, and progressive rate.

The flat rate version is simple, and the most common method used when combined with a draw approach. In a flat rate, one rate is applied to all gross margin dollars produced—regardless of volume within a period. In fact, the only time that any kind of “period” needs to be considered at all is when you are considering if the draw has been covered. At some point, you have to cut off the calculation (and decide when a load counts in one month versus another) to know what number you are using to subtract the draw from (weekly, bi-weekly or monthly, for example). This takes us down the side path of credit point—when is a load a load?

Credit point is a controversial topic and one that is interwoven with many other factors (amount of pay at risk, role definition, degree of influence), but the most common choice among brokerage firms is delivery date, with a smaller segment using shipment date, some using invoice date, and still others using collection. Collection as the credit point only “works” with a flat rate commission, as it is hard for a rep to time collections enough to impact any kind of tier structure that we will discuss below. It also only makes logical sense in a 100% commission model, which for many valid reasons is fading out of existence for W-2 employees.

Managers will tell me that collection is often used to “encourage” reps to work with customers to collect invoices, and to guard against big payouts for bad debt accounts, but I contend this is a misuse of precious sales resources on an activity better managed by accounting.

Stated bluntly, if you pay your rep any kind of salary, you already have an “impure” economic relationship between their production and pay, so you are fooling yourself if you think paying them on collection makes for a “fair” deal.

Stated bluntly, if you pay your rep any kind of salary, you already have an “impure” economic relationship between their production and pay, so you are fooling yourself if you think paying them on collection makes for a “fair” deal. You may save a few dollars on the one rep who cheated you and walked out before you could claw back the funds you already paid them, but you are losing thousands of dollars in productivity from reps who are doing things the right way and would be more motivated by focusing on getting as many loads delivered this month as possible.

OK, back to the main highway. The problem with flat commission rates is that doing well on them is a bit like winning a pie eating contest when the award is a pie. It’s just more of the same, over and over. Eventually it becomes “not worth it” and most reps will stop working beyond their income needs.1

Under a straight commission (once they clear the draw, cover their base, or clear the threshold) they get to decide what good looks like, and they will do something like this. “I need to make $5,000 a month to sustain my desired lifestyle without killing myself. My flat, first dollar commission rate is 20%, so I need to generate $25,000 a month in gross margin to ensure I make $5,000. That, for me, is good enough.” Well, what if it’s not really “good enough” for the company? What if management has added resources or improved the TMS system or added automation so more work can be done faster? Is $25k a month really good enough? Will it still be good enough when the rep has been with you for five years? Should the employees be dictating what “good enough” is when they don’t understand the business economics and all the costs that go into running a brokerage? Of course not.

So, one solution to this is to create tiers in your commission plan that help them see what YOU define as good enough. We already understand the concept of a threshold (the point below which no incentive pay is earned) but now we need to introduce the concepts of goal or quota and excellence. At a minimum, you need to define these three points and change the pay rate between them. For example, you could say that the rate is 0% to threshold, 10% between threshold and quota, 15% between quota and excellence, and 20% above excellence.

Ahh, but now comes the question: Is the 10% that is paid when threshold is reached paid on all dollars generated to that point, or only on the dollars above threshold? This is the difference between a retroactive commission rate and a progressive (or marginal) commission rate.2 A simple graph should help illustrate:

As you can see, the retroactive rate creates a stair step effect on pay. This creates a disproportionate incentive to generate one additional dollar in gross margin.

In this example, the reward is relatively small ($200 for $1 generated above $9,999) because I used a low commission rate. But now consider the impact if the commission rate is higher. Retroactive rates BEG the reps to cheat the plan to succeed. In fact, I consider these plans to be an intelligence test of your staff. If they are not all landing at the start of the next higher step at the end of the period, either they don’t understand the plan, or they aren’t very bright. It also misaligns their economics with yours. As the owner, you would rather they didn’t generate that last dollar, but of course they will do whatever they can (often, unfortunately, unethically) to get that last dollar.

A better approach (though I admit it’s much harder to explain) is the progressive rate. This pays the higher commission rate only on the dollars within the tier—NOT back to previous tiers or the first dollar. This allows you to get a much smoother payout curve so there is now very little reason to cheat the plan. It’s only the next one dollar that is paid at that rate, not all the preceding dollars as well. You can also create a finer degree of control over the payouts under a progressive plan, allowing you to define the plan economics for poor performers versus top performers more precisely. In the graph, you can see that I set the rates (deliberately) to pay underperformers less and overperformers more. It doesn’t have to be this dramatic, however. I have converted companies from retroactive to progressive rates and the new progressive line cuts right through the middle of each step. It’s entirely up to you how you want your payout curve to look.

Both examples used for retroactive and progressive rates use “fixed tiers” in terms of how the goals are defined. This means that a dollar value for production is shown in the tiers used to band the rates.3

You can use relative tiers as well. This would come into play primarily for smaller sales forces (maybe your enterprise sellers) that have vastly different books of business, so that you cannot use one standard production number. Monthly quota for one of them might be $150k and another might be $300k. Both numbers are “good” based on where the rep is starting. In this case you would set a goal ($150k and $300k) and set the commission tiers relative to the goal. The first tier might be 0% to 49.99% of quota, the second 50% to 74.99% of quota, the third 75% to 99% of quota, etc. You get the idea. If you are using a commission, the person with the higher quota will still make more in absolute terms as they are using a larger number to multiply against the commission, but it gives the person with a smaller quota the chance to get into higher commission tiers faster as their production buckets are smaller in absolute numbers. Relative tiers could be paid using either a retroactive or progressive approach to the commission rate, as well.

Now, to sum up the last two articles. There are three basic approaches to figuring “cost covering” when using a commission: 1) Draw 2) Seat Cost and 3) Threshold. There are three approaches to the actual commission calculation: 1) Flat 2) Retroactive and 3) Progressive. There are also two-tier determination methods: 1) Fixed and 2) Relative. That gives you 18 different combinations of methods to calculate pay before even considering some progressive/retroactive hybrids I have seen, such as a retroactive rate that doesn’t go fully to dollar one, but only to the threshold. It also doesn’t begin to touch on the two-dimensional options which exist, where you can use a modifier or a matrix to consider a secondary element (gross margin percentage or load count) and allow performance on this element to change the commission payout on gross margin.

There are literally thousands of options you can use to develop your unique incentive plan, but if you start with a clear understanding of these first 18 methods, you are well on your way to becoming a sophisticated compensation connoisseur.

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 beth.carroll@prosperiogroup.com.

References
1 Yes, there are those for whom there is never enough money, but they are few and far between and tend to get fewer and farther between as the workforce ages and families are started that create time demands that didn’t exist before.
2 For years, I’ve called this a “marginal” commission rate, but since brokerage firms pay on gross margin (almost universally) this creates confusion because the term “margin” is being used in two different ways. If it helps ease understanding it could also be called a “progressive” rate.
3 You don’t have to use as many tiers as I have done, by the way, but more tiers allow finer control over the shape of the payout curve. At minimum you need four tiers: below threshold, threshold, target, and excellence.

Photo credit: kentoh/Shutterstock.com Image courtesy of Properio Group