Definition of a sales commission
A sales commission is additional compensation based on performance. Sales commissions are paid for meeting or exceeding specific sales objectives. Sales commissions are considered a form of variable pay because they fluctuate over time. Unlike with a base salary, sales representative may receive higher or lower commissions depending on their performance (or market conditions). Most sales commissions are paid in addition to a base salary.
Why pay sales commissions?
The main reason for sales commissions is to motivate the sales team to sell more. Sales commissions motivate representatives because it makes them feel like they have a personal stake each time they close a deal. Sales commissions can also be designed to encourage specific behaviors – for example spending more time selling a new product vs. managing existing accounts. Sales commissions also prevent the sales team from getting too comfortable. Sales commissions help recruit and retain top performers while encouraging poor performers to leave. Finally, sales commissions are part of any company’s competition for talent.
What are the key components of sales commissions?
All organizations have distinct business goals. Sales commissions should be in strong alignment with those goals. For example, in one organization, the main goal may be to increase total revenue. In another, it could be to increase profitability, promote the sales of new products, or create a competitive environment via sales contests. Finally, in some industries, commissions may be paid based on completing specific actions (ex: booking a demo, setting up an appointment, qualifying leads, etc.). This is called the producer model.
Sales incentive plans encapsulate all terms and conditions for obtaining sales commissions. Incentive plans specify how performance should be measured (in alignment with business goals), which rewards are available, and how those rewards should be assigned. Organizations typically create one sales incentive plan per position. For example, the type of sales activity required to manage well-established accounts is very different from that of cold-calling customers. Using different incentive plans helps representatives focus on the desired sales behaviors.
Individual vs. collective
Employers must design incentive plans which are in alignment with job functions. For example, if an inside sales team allows any representative to prepare a quote or respond to any customer inquiry, then measuring performance individually will prove difficult. Similarly, sales managers are typically measured on the collective performance of their sales teams. Additional mechanisms are required to measure collective performance and assign rewards – for example, split commissions, managers set-aside, revenue roll-ups, etc.
Quotas are a target dollar amount of sales which representatives are expected to reach within a specific time period (ex: month, quarter). Quotas must be set correctly to encourage representatives to sell more. If set incorrectly, they can negatively affect morale and increase stress levels. Well-designed quotas should be realistic, but also encourage the sales force to reach for the next level of performance. In short, they should signal a realistic opportunity to earn large commissions – given sufficient effort and focus of course. At least 70% of the sales force should be able to reach the main quota.
When it comes to designing rewards, there are two main approaches: bonuses vs. percentages. Bonuses are cash amounts awarded for reaching certain business objectives. Bonuses can be paid as a fixed cash amount, or as a percentage of salary. Percentages on the other hand are essentially a “tax” on each sales transactions, for example 10% of revenue, or 5% of profit. How bonuses and percentages are perceived by the sales force has a significant impact on performance and motivation. Learn more here.
Tiered commission plans
Often, incentive plans include more than one attainment level or quota. Tiered commission plans have multiple attainment levels – each with a different threshold. For example, payouts could be set to 2% of revenue under $30K, 5% of revenue from $30K to $50K, and 8% of revenue from $50 to $100K. Each attainment level can be cumulative or non-cumulative. Tiered commission plans can also combine percentages and bonuses. For example, sales representatives could receive a cash amount in addition to a revenue percentage for reaching a higher level of attainment. Tiered commission plans therefore allow sales leadership to fine-tune incentives.
Caps and limitations
An incentive plan normally includes legal terms and conditions which participants must accept in order to enroll in the plan. Those terms and conditions cover topics such as general eligibility, leaves of absence, terminations, etc. For example, it could state that interns are not eligible for sales commissions. Also, many incentive plans specify caps to prevent over-payment of commissions under abnormal situations (ex: such as an accidental mega-deal). Finally, many incentive plans include a draw, which is essentially a temporary loan to recently hired sales representatives. Learn more here.
Crediting and calculations
Crediting is essentially the attribution of sales transactions (orders, deals, etc.) to representatives or territories. Calculating sales commissions is usually quite complicated because of multiple plans, thresholds, reward types, taxes, margins, etc. In addition, calculations must often handle complex crediting rules – such as splitting revenue between different parties, rolling-up of revenue from child territories to parent ones, etc. Your best bet is to use a software-based commission management solution to perform and review commission calculations. Incorrect calculations can prove very costly and also impact team morale, as they feel their commissions aren’t handled properly.
Commissions are often included with any sales representative’s paycheck. Only deals which are confirmed to be closed (or have a very high probability of closing) are included. However, it doesn’t mean that the customer has paid their bill. Payment terms can vary, and there is often a significant delay between delivery and payment. By paying sales representatives as soon as their deals have been considered won, you reinforce their motivation. Also note that future refunds or returns can always happen, so making corrections is part of any robust calculation engine and is expected.
The main types of reporting include crediting, spend, and attainment. Crediting reports reveal the breakdown of commission-related revenue (or profit) by customer, products, representative, etc. Spend reports reveal the breakdown of commission costs by incentive plan, territory, etc. Attainment reports show whether sales attainment thresholds could be met, and help determine whether quotas were set correctly. Make sure to choose a solution with built-in reports but also the ability to create your own (for example, compatible with Microsoft Power BI).
Sales commissions have many moving parts. Designing realistic yet motivating commission plans is a balancing act. Calculations can get complicated fast, but their accuracy is extremely important. Your best bet is to use an automated commission management solution.