The Economics of Commissions: Part 3 When Two Is Better Than One

Beth Carroll |Prosperio Group
In the first two articles of this series, we looked at the various ways commissions can be calculated in such a way that “costs are covered,” namely using a draw, a multiple of salary, or a threshold approach. In the second article, we looked at three different ways of scaling a commission rate relative to production: flat, retroactive, or progressive. We also discussed setting a fixed tier for production (e.g., $20,000) or a relative tier (75% of goal, where goal is individualized based on a person’s book of business). This article will focus on another very popular method for calculating commissions: the matrix.

Freight brokers live in a world of constantly competing interests. gross margin dollar gain, gross margin percentage loss, and increased load count for reduced gross margin dollars. These three things are constantly pulling against one another. For a pure hunter or outside sales role, I will have the occasional leader argue that revenue needs to be in the mix. If it does (and I could debate that), then we MUST use gross margin percentage as a counterbalancing influence. So, how do you address all of these push-me/pull-me factors while still creating a “relatively” simple incentive plan? The answer often lies in the use of a two-dimensional model to determine the commission rate used to pay the incentive. This is, appropriately, called a matrix (and a visual will certainly help you understand what I’m talking about).

In this example, there are two things being measured. These are called “performance measures” in an incentive compensation design. One is gross margin dollars and the other is gross margin % (percentage.) The commission rate that is earned is determined by the performance on both measures. Target is where the yellow lines cross—the rate is 10%. At 10% x $20,000, the pay for the month will be $2,000. If a sales rep can get to the upper right and get 15% of $30,000, then pay is $4,500 (which is more than twice the target payout amount of $2,000). At threshold, pay would only be $500 (or 25% of target), and then the opposite diagonals tell the story of what is more important to the company—gross margin dollars or gross margin percentage. In this case, but not all cases, the company chose to emphasize gross margin dollars. In some circumstances, or times of the year, the opposite could be true. A matrix is malleable and can be adjusted or tweaked to adapt to changing market conditions far more easily than other types of incentive mechanics.

As an example of this malleability, the horizontal axis could just as easily be load count, or either axis could be changed from individual performance to team performance. A very common matrix used for carrier sales is individual gross margin dollars and team load count. This encourages them to help each other out with those tough loads and to still “get credit” when they have to take a load at a loss.

As for paying this out as a commission, it has some interesting advantages and disadvantages. First, I need to explain what the alternatives are.

Instead of showing 10% in the center square, we could just show the value of $2,000. Each percentage above would be replaced by a fixed dollar value. $500 would be in the bottom left, $4,500 in the upper right, $2,250 in the upper left and $600 in lower right (and likewise all throughout). This makes it VERY simple for employees to understand how they are getting paid. They don’t even have to get out a calculator—all they have to do is know their performance on two dimensions and then find the intersection where those performance levels meet. Another alternative is to phrase the payout as a percentage of target incentive.

This could be helpful if you have different roles being paid off the same matrix and you don’t want to create multiple versions of them. Most likely, you would also phrase the goal as a percentage of goal, rather than a fixed dollar goal as I did above.

How do these approaches differ from the commission shown above, and which is better? Well, first a matrix uses, pretty much by necessity, a retroactive commission rate. The commission rate found in the cell applies to all dollars produced. While it might be possible to calculate this in a progressive fashion, the complexity that this would entail negates any value that may be gained from doing so. However, rather than a few big stair steps, the matrix has a bunch of smaller ones (other than the one at threshold), and this means there is reduced incentive to cheat along the way. Likewise, if you use a commission rate, additional pay is earned within a cell, whereas a fixed dollar value requires one to get to an entirely different cell to get more money. So, in this case, a fixed dollar payout creates more of a cliff or stairstep effect.

However, as is a common problem with commission rates—God help you if you want to change the rate later. Once people lock into “10%” as the center rate, you will have much better luck changing the $20,000 monthly gross margin requirement than changing the 10%. If production circumstances change, and now you believe a reasonable goal is $30,000, you will still be paying 10% of that number ($3,000), which is better than the $3,375 you were paying at 11.25% (before you slide the scale on the left down) but not as good as if you were paying $2,000 for $30,000, which you could conceivably do if the two values were not hooked together by a mathematical formula.

Incentive compensation design is a complex problem with many interconnected parts and trade-off decisions, and these are just a few. In our next article, we will look at some additional commission alternatives for hand-off situations (declining commission) or long-cycle sales that may be found in managed transportation environments (deal-value commissions).       

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.

Credits: Graphic courtesy of Prosperio Group. Images: iStock.com/Olivier Le Moal, kentoh/Shutterstock