3PL Perspectives
AS A COMPENSATION consultant who focuses on the freight broker industry, I’m often asked what the right commission rate should be. If you’ve read my other articles in 3PL Perspectives or the Logistics Journal or found my book Taming the Compensation Monster on Amazon, then you should already know that the answer to that question is… “That is the wrong question.” Without knowing the role in question (customer sales, carrier sales, accounting?!) or the structure of the brokerage (cradle-to-grave, pod, or split model) the use of salary, company culture, or even the geographic location of the company it would be completely irresponsible to even venture to guess at the proper rate.1
The right question is to ask what the total cost of compensation for the entire organization should be as a percentage of gross margin. For this, there is certainly an answer, though it will require a bit of math on your part, so bear with me. For years I would just spit back 30% – 45%, and I knew I would be close for 95% of the companies I was dealing with (all those who had 15% gross margin rates). However, that landscape has changed, and the answer is a bit more complicated, so let me walk you through how you get to YOUR answer. You’ll need to get your P&L out as we go through this.
First, let’s be sure we are speaking the same language as people use different terms for the same concepts. Here are the terms I will be using, but you can, of course, substitute your own terms:
- Revenue = the money paid to you by your shipper customers
- Purchased Transportation = the money you pay to your carriers
- Gross Margin (GM$) = Revenue minus Purchased Transportation
- Gross Margin % (GM%) = Gross Margin divided by Revenue (usually between 10% and 30%)
- Operating Expenses (OE) = Rent, utilities, TMS fees, insurance, benefits expenses, employer-paid payroll taxes, etc.
- Compensation Costs = W2 payroll data for ALL your employees, including back-office support staff; this includes salaries, commissions and bonuses, but EXCLUDES benefit costs, travel & entertainment (T&E), company cars, expense reimbursement, etc. as these should be counted in OE. It should also EXCLUDE owners’ distributions but include some reasonable salary level for owners who take most of their pay through distributions (follow your accountant’s guidance, but if you have a profit-sharing plan then you will want to run around $300k through payroll to maximize your ability to contribute to the plan; if you do not have this then you should count at least $150k as salary for the officers who take distributions). Some companies of course have all officer compensation counted through W2 payroll, so their cost of compensation will be higher than those who use distributions.
- Net Income = Gross Margin Dollars minus Operating Expenses and Compensation Costs2
Now we need to do some basic calculations. I’ll use the old numbers that held true for 90% of dry van truckload brokerages for the years 2010-2020. A healthy bottom line (net income) is often considered to be 5% of revenue. For small companies, this often becomes owners’ distributions or retained capital. For many years, expected GM% was 15% of revenue. So, if 5% of revenue is needed to be retained for a healthy bottom line, this is 1/3 of the 15% of revenue that is your GM$ amount. This leaves 2/3 to cover operating expenses and compensation costs. For many companies, operating expenses make up about 1/3 of the GM$ which leaves 1/3 left to cover Compensation Costs. This is why so many cradle-to-grave brokers with limited support staff started out setting commission rates at about 30% of GM$. This is the balance of the 1/3 to net income, 1/3 to operating costs, and 1/3 to compensation costs that made for a healthy brokerage.
The years 2020 and 2021 have created a new reality. With freight rates rising, GM% amounts have shifted (for many, not all, brokers) north of 20%. Also, remote workers, near shoring, and a very fluid employment situation created an increased focus on roles such as Account Manager, Customer Service, and Track and Trace.
To understand where you stand now, here is the math: Take your desired Net Income % (it may be more or less than 5%) and divide it into your GM%. Let’s say that its 5% and your GM% is now 20%. Your answer is 25%. Subtract this from 1, and this is how much of your GM$ you have left to covering operating expenses and compensation (75%). Gather a realistic estimate of your operating expenses and subtract that from your GM$ (some of these will be fixed in that increases in your GM$ and/or load count do not increase the expense, but others will be variable such as load tracking fees). What is left is the absolute most that you can use for compensation and still maintain your desired profitability. Let’s say you run a lean-mean machine, and your operating expenses are only 20% of your GM$. Using the math above, this would mean you have 55% of your GM$ left for compensation costs.
Now you are going to need to deduct the costs of your back-office staff (Accounting, IT, HR, Marketing, etc.); roles that are hugely valuable but are paid primarily on a fixed rather than variable method. What is left is what you can use to pay your sales and operations teams. Odds are high that this number is less than 40% of your GM$, and bear in mind that this percentage must include salary expenses for all the sales and operations roles as well. (It’s not just a commission rate!) Salaries have done nothing but INCREASE in the last 18 months and while the trend is cooling a bit, given current inflation rates I don’t see this trend reversing any time soon. Counterintuitively, you are economically better off to have MORE pay in salary among your sales staff with lower commission rates than lower salaries and higher commission rates. You have more risk on the downside, yes, but high salary means more of your compensation cost is fixed, not variable, so when your top line rises, your cost of compensation does not track right along with it but can allow you to drop more to the bottom line (or invest in other areas).
These changing economics are what cause many companies that use a 100% commission model to either transparently and directly reduce commission rates or (less transparently) add taxes and overhead charges and myriad claw backs and conditions that have the effect of reducing the commission rate without stating that they are reducing the commission rate. The upward pressure of rising salaries pushing against the math we just went through, makes continuing to use a draw plan very challenging (the rate must be high enough to cover the draw in a reasonable time period but not so high that the whole economics of the company are blown to bits).
Having higher GM% has allowed brokerage companies to expand into many areas—technology development, off-shoring or near-shoring of talent, increasing the use of account managers to manage and grow accounts landed by the sales force—all of which are good developments representative of a maturing industry. However, sooner or later, these changes will force changes to the way sales and operations staff are paid.
